How Islamic Derivatives Are Transforming Risk Management in Muslim-Majority Countries

The demand for Sharia-compliant risk management tools, specifically Islamic derivatives, is experiencing significant growth in numerous Muslim-majority countries. This trend aligns with the expanding market shares of Islamic banks in these regions. Islamic derivatives, such as profit-rate swaps and forward foreign exchange contracts, are pivotal for these financial institutions. They play a crucial role in mitigating risks related to interest rates, foreign exchange rates, and commodity prices, thereby strengthening the banks’ credit profiles. As the Islamic finance sector continues to evolve, adopting these sophisticated financial instruments is essential for enhancing stability and competitiveness in the global market.

Increased Uptake Despite Challenges

In 2023 and the first half of 2024, nearly 75% of Fitch-rated Islamic banks used Islamic derivatives, showcasing a significant uptake despite challenges such as sharia restrictions, treasury infrastructure gaps, lack of standardization, and regulatory issues. The conventional derivatives market is underdeveloped in most Muslim-majority countries, and Islamic derivatives lag further in product range, liquidity, adoption, and awareness.

Malaysia Leads the Way

Malaysia leads in the development of Islamic finance globally. The signing of the Tahawwut Master Agreement (TMA) between CIMB Islamic Bank and PETRONAS in early 2024 marked a significant milestone. This agreement provides a standardized framework for Shariah-compliant commodity derivatives, expected to spur growth in Islamic hedging products internationally. PETRONAS, by leveraging CIMB Islamic’s hedging instruments, aims to manage its exposures in a Shariah-compliant manner​ (CIMB).

Developments in Saudi Arabia and the UAE

Saudi Arabia has also made strides in developing its derivatives market. The Saudi Exchange launched its conventional derivatives market in 2020, introducing products like MT30 Index Futures, single stock futures, and options. The Saudi Central Bank is working on implementing close-out netting legislation to align with global standards.

In the UAE, the central bank has directed Islamic banks to adopt hedging techniques, including Islamic derivatives, to manage foreign exchange exposures. This initiative is part of a broader effort to integrate Islamic financial solutions within the country’s banking sector.

Progress in Indonesia and Qatar

Indonesia has developed a Shariah-compliant hedging instrument to maintain rupiah stability, and Qatar is planning to launch a derivatives exchange as part of its strategic plan. However, in Oman, the availability of Islamic derivatives is limited due to the prohibition of tawarruq contracts, which are commonly used in Islamic derivatives. Despite this, Bank Nizwa has obtained a fatwa allowing the use of profit rate swaps based on investment agency contracts.

Regulatory Initiatives

Regulatory bodies in various countries are actively working to develop the Islamic derivatives market. For instance, the Shariah Advisory Council of Bank Negara Malaysia has allowed anticipatory hedging for Islamic banks, and the Securities Commission has updated guidelines to permit the use of Islamic derivatives for hedging purposes.