Copyright © 2011 by K&L Gates LLP. All rights reserved.

Islamic Compliant FX Forwards

Jonathan LawrenceDerivatives and Structured Products Group Meeting 4 August 2011

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Background

US regulatory issues for cash-settled FX businessi.e. non-deliverable currency forwards

Characterisation as swaps therefore potential regulation as swap dealers

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Recognition of Hedging in Islam

Important objective of Shariah is to preserve and protect wealthMany Quranic verses indicate importance of taking strategic measure to minimise anticipated risk to property

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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

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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

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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

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Usage

Instruments only to be used for hedging and not speculationMust be an underlying “real” transaction and not merely a shamMust be a real need to undertake the transaction

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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

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Islamic Currency Forward Based on Wa’dan (two unilateral promises) at Dealing Date

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

Customer Bank

Promises to sell USD1 million at the rate of 3.5 if exchange

rate USD/MYR >3.5

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2

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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

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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.

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FX Forward Based on Tawarruq Payment of US$ 10 Million at

Value Date

Broker B Bank

Customer Broker A

US$ 10 Million

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

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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