Gulf Report: Game Changer


By Anita Hawser


The arrival of the first globally standardized documentation for privately negotiated Islamic hedging products marks a major breakthrough in Islamic finance and risk management.


Compared to the conventional financial markets, Islamic finance is a relatively young industry, but it has achieved a lot within a short time frame. In March the industry marked a milestone in its development. After almost three years of deliberations between industry practitioners and Islamic scholars, the first globally standardized master agreement for privately negotiated Islamic hedging products was published. The Tahawwut (Hedging) Master Agreement (TMA) was jointly developed by the International Islamic Financial Market (IIFM), the Bahrain-based standards-setting body for Islamic capital and money markets, and the International Swaps and Derivatives Association (ISDA), the trade association for the conventional derivatives markets. IIFM provided the scholarly clout in terms of Islamic jurisprudence, and ISDA, the experience of drafting agreements for the conventional derivatives markets.

The Tahawwut Master Agreement is only the second standard document issued by the IIFM, the first being the Master Agreement for Treasury Placement. Crafting the Tahawwut was a labor of love: A reported 24 drafts were presented during the two-and-a-half years of industry consultation and shariah approval processes that were required to satisfy the different schools of Islamic jurisprudence throughout the Middle East and Asia. Shaikh Esam Mohammed Al Shaikh Ishaq, a member of IIFM’s shariah advisory panel, sheds some light on the lengthy negotiations behind the development of the TMA. “The process was arduous, involving tightrope-walking, navigation on many shariah issues and concerns, while keeping in mind the interests of the industry simultaneously,” he says.

Ghazanfar Naqvi, who is responsible for Standard Chartered Bank’s global Islamic wholesale and consumer product development, as well as being acting global head of Islamic origination and client coverage, applauded the IIFM’s shariah advisory panel, saying that the fact that it included scholars from the Middle East, Malaysia and Pakistan boded well in terms of convergence of shariah thinking. “There is no better example of scholars coming together from different regions and defining an agreement,” he says.

Like their conventional counterparts, Islamic financial institutions are exposed to risks—market, liquidity, currency and operational—and need to hedge these risks to reduce their exposure. Yet, while conventional market participants already had the standard ISDA master agreement for derivatives, Islamic financial institutions have had to negotiate hedging agreements on a bilateral basis. That meant every time a firm dealt with a new counterparty, it had to present them with documentation that then had to be approved by the counterparty’s shariah board and legal team. “This took much longer,” says Naqvi, “so the Tahawwut Master Agreement will help us further the reach of the market, reduce the time to market and help expand product offerings available.”

Having to negotiate bilateral pacts on a counterparty-by-counterparty basis has also incurred additional costs for Islamic financial institutions. “Having a standard agreement will take out some of the cost of doing things in a bespoke way, which will promote convergence of pricing between shariah products and conventional products,” says Habib Motani, a London-based partner at law firm Clifford Chance, which was involved in the drafting of the TMA. While the agreement is loosely based on ISDA’s 2002 master agreement, parts of it have been modified in order to achieve shariah compliance. With conventional hedges the risk is separated from the asset and traded separately; but under the Tahawwut, no interest is payable and hedging must be based on real assets or balance sheet items. Counterparties to the agreement must also “make representations to the fact that they are entering into shariah-compliant transactions only.”

As Naveed Khan, managing director of ABC Islamic Bank Bahrain and a member of the IIFM Board, points out, Islamic scholars want the master agreement to be used for the genuine purpose of hedging and not simply as a speculative instrument for short selling or leveraged trades without any underlying exposures.


Naqvi: “The TMA will help expand product offerings available”

Motani says the parts of the TMA that involved “close scrutiny” by Islamic scholars included early termination events, closeout and netting, which had to be adapted for Islamic purposes. The closeout and early termination of the contract is an essential part of the agreement as it stipulates how the respective obligations should be netted, or offset, to minimize the loss to both parties in the event of early termination.

Under the Tahawwut, the netting of transactions is based on the muqasa principle (offsetting of debt) using murabaha or wa’ad (promise). “The details of early closeouts required a lot of contemplation on the part of shariah scholars,” Khan says. Jurisdictional recognition of closeout netting is patchy across the Middle East and other regions where the master agreement is likely to be implemented. Although there is capital adequacy relief for netting in the US and Europe, this is not the case in other regions. “That is something the GCC and the Middle East will have to educate their regulators about,” Khan says.

Asia May Take Lead
Given the more liberal interpretations of shariah law in the Far East, some suggest the TMA will be adopted more quickly there than in the GCC, where shariah scholars are more stringent. However, Ijlal Alvi, CEO of IIFM, says Saudi banks have already expressed an interest in implementing the master agreement, and he is optimistic about market uptake. Motani adds: “In principle, the master agreement is equally usable across the Muslim world, including Malaysia and the GCC.”

The Tahawwut is a multiproduct framework, and is expected to be used primarily for profit-rate and currency swaps, which make up the majority of Islamic hedges. As it stands, Motani says, the master agreement meets approximately 80% of the Islamic hedging market’s needs, and he predicts that with only a small amount of tweaking it will cover the other 20% of products, such as arbun—the Islamic equivalent of options. “Arbun can be looked at over time [for inclusion in the master agreement], although at this stage it does not represent the bulk of the market,” Motani says.

Alvi of IIFM says it would need to consider to what extent arbun is used for Islamic hedging purposes and how it is viewed from a shariah perspective. “If there is enough understanding and momentum within the Islamic [finance] industry, then we will look at it,” he says. Lawyers have also suggested that firms’ use of the TMA will need to be closely monitored in terms of any additions or amendments that are made that may not be shariah-compliant. As the ISDA master agreement has gone through various adaptations, Naqvi of Standard Chartered says once it is implemented, it will bring out certain areas that need to be improved.

Implementing the Tahawwut is voluntary, and firms must gain the approval of their internal shariah boards before they can adopt it. Many, however, believe that achieving such approval will be straightforward, given that a number of the scholars who helped frame the master agreement are also on the shariah boards of a number of financial institutions. Naqvi says implementing the master agreement will entail some reengineering on the part of banks. “In terms of processes, every institution will have to look at what they use today, what is acceptable vis-à-vis the mechanisms they use, and adapt existing agreements.” Like any agreement, it will take time for the TMA to be universally adopted, says Motani, but he adds that the industry recognizes the need for broader risk management. “The master agreement enables them to do that in a shariah-compliant way.”