1. Islamic Compliant FX Forwards
Jonathan Lawrence
Derivatives and Structured
Products Group Meeting
4 August 2011

2. Background US regulatory issues for cash-settled FX business
i.e. non-deliverable currency forwards
Characterisation as swaps therefore potential regulation as swap dealers

3. Recognition of Hedging in Islam
Important objective of Shariah is to preserve and protect wealth
Many Quranic verses indicate importance of taking strategic measure to minimise anticipated risk to property

4. Conventional and Shariah Viewpoints on FX Forward
Conventional views:
Used to manage/hedge against risk of fluctuations in exchange rates
Is a derivative instrument conducting a sale in the future at a price fixed today
Contract sealed today but settlement & delivery in the future
Shariah Views:
Problem with FX: parties wish to exchange currency in future but have already fixed a rate today
Contravenes Shariah rules of bay’ al-sarf: exchange should involve transactions on a spot basis

5. Structuring
Contracts and principles in accordance with Shariah rules and principles
Not to be used as an excuse for practising the charging of interest
Each contract to be separate
Each contract to be actual – not fictitious
Each contract to have its own effect

6. Execution Each contract to be executed separately
Execution of contracts to follow correct and logical sequence
A real transaction must occur each time
Independent and separate nature of each contract

7. Usage Instruments only to be used for hedging and not speculation
Must be an underlying “real” transaction and not merely a sham
Must be a real need to undertake the transaction

8. Wa’dan Two unilateral promises given by two parties to one another
The two promises are not connected
Application depends on two different conditions shown in diagram below

9. Islamic Currency Forward Based on Wa’dan (two unilateral promises) at Dealing Date1
Customer
Bank
Promises to sell USD1 million at the rate of 3.5 if exchange rate USD/MYR >3.5 2
Customer
Bank
Promises to buy USD1 million at the rate of 3.5 if exchange rate USD/MYR is below or equal to 3.5

10. Islamic Currency Forward Based on Wa’dan (two unilateral promises) at Value Date
Scenario 1: If USD/MYR > 3.50 (e.g. 3.60), bank exercises its right under the first promise, to buy USD for MYR at agreed rate of 3.50
Scenario 2: if USD/MYR< 3.50 (e.g. 3.40), customer exercises its right under the second promise, to sell USD for MYR at agreed rate of 3.50

11. Tawarruq contract
A financial institution, either directly or indirectly, will buy an asset and immediately sell it to a customer on a deferred payment basis. The customer then sells the same asset to a third party for immediate delivery and payment, the end result being that the customer receives a cash amount and has a deferred payment obligation for the marked-up price to the financial institution. The asset is typically a freely tradeable commodity such as platinum or copper.

12. FX Forward Based on Tawarruq
Payment of US$ 10 Million at Value Date
Broker B
Bank
Customer
Broker A
US$ 10 Million
RM35 Million
Payment of US$ 10 Million at Value Date
Pay RM35 Million at Value Date
Forward Rate: US$/MYR =3.50

13. Conditions of Use
Approval given by Shariah committees only if the instrument is exclusively for hedging purposes. This means:
can only be used as insurance activity
cannot be used for funding and trading by means of speculation