The International Islamic Financial Market (IIFM) today announced the launch of standard templates for sharia-compliant foreign exchange forwards in a move to improve hedging practices in the industry and the need for more cost effective tools to manage foreign currency risks.
The Bahrain-based IIFM, which started operations in 2002, has outlined two templates to accommodate the main industry practices.
The standards involve the use of either one or two unilateral promises, known as wa’ad, which are committed separately by each counterparty, with the latter providing greater credit security.
Ijlal Ahmed Alvi, Chief Excecutive, IIFM, said: “Based on market requirement and feedback, our assessment is that the use of two unilateral wa’ad structure will increase. Certain other FX products can now be explored under two unilateral wa’ad concept, which IIFM may look into in the future.”
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There are currently several hedging tools used in Islamic finance. Some are based on a cost-plus-profit arrangement, otherwise known as murabaha, but these tend to be cumbersome as well as costly.
Islamic finance adheres to religious principles which ban the charging of interest and avoid ambiguity in contracts.
Islamic banks are thus precluded from traditional forwards as they are legally binding from the outset, leaving counterparties exposed to an uncertain outcome.
In an Islamic forward, the exchange rate is fixed at the outset but remains a promise until offer and acceptance is completed at the forward date. At this point, the transaction becomes a contract.
The choice of wa’ad also means that Islamic banks do not need to employ their balance sheets for their hedging needs, compared to previous practices under murabaha.
The IIFM, which developed the standards in combination with the International Swaps and Derivatives Association (ISDA), has previously launched templates for cross currency and profit rate swaps and the Islamic equivalents to repurchase agreements.