New Islamic products are hitting the market with astonishing rapidity, and now some banks have even claimed to have cracked the ultimate nut; derivatives. But should they, asks Robin Wigglesworth
Derivatives are an important component of the conventional economic system, by allowing the buying and selling of risk, but they have long been deemed off-bounds for Shari'ah compliant investors due to their speculative nature.
Derivatives can offer the prospect of large financial rewards, and can function as a form of insurance against fluctuating commodity prices, for example, by moving the risk from someone who cannot afford a major loss to someone who can hedge against it by buying some other derivatives. Alan Greenspan, the former chairman of the US Federal Reserve, has often spoken of the economic benefits of derivatives, and in 2003 claimed that the use of derivatives softened the impact of the economic downturn of the early 2000s.
Derivatives are certainly a tremendous market worldwide. The Bank for International Settlements (BIS) estimates that the combined value of all currency, stock market index, short term interest rate and long term interest rate futures and options will be over $1600 trillion dollars in 2006.
For Islamic bankers, the usefulness of derivatives is clear. "In order to have capital guarantee products, limited risk, in order to hedge rates, profits or currency exchanges and so on, derivatives are important," says Mishari Al Mishari, CEO of Bank AlJazira in Saudi Arabia.
On the other hand, the majority of Shari'ah scholars are vehemently opposed. "Speculation is a form of gambling," maintains Dr. Hussain Hamid Hassan, a renowned scholar. "Nothing actually happens. No goods are traded or sold, and it is not a production economy but a money economy, where some win and some lose, same as with gambling."
Sheikh Mohammad Taqi Usmani is also unimpressed by the efforts of Islamic banks to develop Shari'ah compliant derivatives. "They are completely against the principles of Shari'ah and I am of the view that we should not even enter the field," he says. He disagrees strongly with the efforts of Islamic banks and financial institutions to come up with Shari'ah compliant versions of every conventional product and service, and is not even "interested in looking at the mechanisms involved".
Following several high-profile scandals involving derivatives, skepticism is not limited to the Islamic world. In the US, the unfortunately named Long-Term Capital Management (LTCM) hedge fund went bankrupt as a result of trading on the derivatives market, as did Orange County in 1994, the largest municipal bankruptcy in US history. LTCM lost $4.6 billion in four months, whilst Orange County lost a 'mere' $1.6 billion.
The most infamous example of the danger of derivative trading came in 1995, when Barings Bank, one of the oldest British merchant banks, collapsed under the weight of the huge losses incurred by trader Nick Leeson through poor and unauthorized investments in index futures.
Some economists have warned that hedge funds and the derivatives that are an integral part of their hedging strategy could potentially unsettle entire financial markets. Should one fund or investor lose sufficiently, it might set off a chain reaction of bankruptcies, triggering a wider economic crisis.
As the European Central Bank report states in its ECB Stability Review in June 2006:
"As the hedge fund industry keeps on growing, its expansion continues to raise questions about capacity constraints and the impact of hedge funds' largely unconstrained investment strategies on financial markets.
In addition to potentially high leverage, the increasingly similar positioning of individual hedge funds within broad hedge fund investment strategies is another major risk for financial stability which warrants close monitoring despite the essential lack of any possible remedies. This risk is further magnified by evidence that broad hedge fund investment strategies have also become increasingly correlated, thereby further increasing the potential adverse effects of disorderly exits from crowded trades."
Warren Buffet, a canny investor to say the least, called derivatives for "financial weapons of mass destruction" in the 2002 annual report for his holding company Berkshire Hathaway.
However, this has not stopped banks from delving into this potentially lucrative market. With Islamic finance firmly on the radar of most self-respecting multinational banks, and voracious demand for each and every product introduced to the marketplace, no wonder there is a race to develop derivatives, regardless of the financial pitfalls and Shari'ah concerns.
The emergence of Shari'ah compliant hedge funds bears witness to the astonishing level of innovation, and keenness by conventional banks to get into the game. As Harris Irfan, director in emerging markets structuring at Deutsche Bank correctly points out, "If you told someone two years ago that a non-Islamic international bank will come along and provide a Shari'ah compliant hedge fund product, across all the hedge fund trading strategies, they wouldn't believe it".
Harris says Deutsche has come up with a proprietary technique for the use of derivatives, approved by six of the most renowned Shari'ah scholars, among others Dr. Mohamed Ali Elgari, Dr. Mohamed Daud Bakar, and most notably, the chairman of its Shari'ah board, Dr. Hussain.
Dr. Hussain is one of the world's leading Shari'ah scholars, and has been consistent in his opposition to classic, conventional derivatives. However, Harris stresses that whilst Deutsche "want to push the boundaries of what is possible", it will be done within a conservative Shar'iah framework. "We don't want to make money at the risk of our reputation, or against the letter and the spirit of Shari'ah, so it is important that the scholars are fully informed and involved on even the most complex and innovative structures."
Bank AlJazira also believes it is close to having its own proprietary derivatives structure, but Mishari is understandably cagey as to the exact method used. "The principles are based on the Shari'ah need for buying and selling to make a profit. As long as it is not money for money, or loans with interest, it is Shari'ah compliant. And it could prove beneficial for the whole macro-economic picture."
However, there are still some doubters, not least Majid Al-Refai, a veteran Islamic investment banker and founder of both Arcapita and Unicorn Investment Bank, who likens the quest for Islamic derivatives to the story of Adam and Eve, and the forbidden fruit. "Why, given that there are thousands of products and services that we can work on developing, would you focus on derivatives? Not a single Muslim investor has a balanced portfolio of cash, bonds and shares, so why look at derivatives?"
Majid's first big deals were in Malaysia for Kuwait Finance House, and he witnessed the meltdown of Barings Bank up close. "In Islamic finance methodology, ownership of asset is law number one," he points out, and says he wouldn't touch derivatives "with a ten foot pole".
Could Shari'ah compliant derivatives catch on, or will they fall by the wayside as irrevocably contrary to Shari'ah? If a way can be found to do it in a fashion concordant with Islam, it seems very likely that Islamic investment banks will enter the field with enthusiasm. Everyone in the industry is aware of the risks involved, but also the potential rewards. Goldman Sachs has managed to become the world's top investment bank mainly through its derivatives activities.
The DGCX is the Middle East's first futures market, and the DIFX has announced that it will list derivatives once it is fully up and running with sufficient depth and liquidity. Interestingly, the DIFC owns a stake in Euronext, Europe's largest derivatives market, and Dubai seems to be positioning itself as the derivatives hub of the Middle East. Goldman Sachs and Morgan Stanley have both recently moved to the DIFC, and Dr. Georges Makhoul, regional head for Morgan Stanley, says he is "very bullish" about the prospects of the DIFX. "It is unique to the region, and I think it is merely in the process of taking off."
The collapse of Barings was as much due to a lack of understanding of what derivatives were, lax oversight, a lax regulator, and the unfortunate earthquake which hit the Nikkei index so hard Leeson was unable to cover up his losses. The lesson might be for more corporate supervision and checks and balances rather than the vagaries of the derivatives market.
Let's discuss whether, done carefully in the right regulatory atmosphere and following strict Shari'ah principles, derivatives just might be exactly what the Middle East ordered.
© Banker Middle East 2006
