Islamic derivatives: What would Mohammad do?

Commodities and Islam
the Start of Something Big

By Mark Bendeich
Reuters
Friday, December 8, 2006

http://today.reuters.co.uk/news/articleinvesting.aspx?type=fundsNews&sto...

KUALA LUMPUR, Malaysia -- Global trade in commodities is booming, and not just because China is hungry for resources. Pious Muslims, too, are keeping commodity markets busy.

Islamic investors, whose religion forbids them from investing in many conventional financial securities, have discovered a growing appetite for metals, crude oil and, soon, vegetable oils.

"Daily turnover? I reckon it would run into hundreds of millions of dollars or maybe billions," said Mohamed Iqbal, a senior treasurer at Kuwait Finance House, when asked to estimate the value of commodities trade carried out in the name of Islam.

Islamic investors are not newcomers to commodities, but they have unique reasons for trading them.

For decades, they have quietly used trade in metals, such as copper, aluminium and platinum, to underpin all kinds of financial deals that would otherwise fall foul of Islamic or sharia law.

From cash deposits to a new breed of Islamic derivatives, commodities have been used to ensure investments abide by a central tenet of Islamic finance: that returns must be derived from a genuine business activity, such as trading goods.

For example, a trade in copper can be structured to give a return equal to that of bank interest, which is banned by sharia.

Instead of, say, paying $10,000 (5,000 pounds) interest on a term deposit, the bank sells an investor some copper for $10,000 below the market rate. The investor quickly sells the metal for a $10,000 gain. Under sharia law, this is a trading profit, not interest.

"It's not something new. It's been used quite widely in the (Middle East) Gulf," Iqbal said.

"We would go for copper, platinum and crude oil and now we are looking at palm oil," he added, listing the kind of commodities Kuwait Finance House employed in Islamic finance.

In October, Islamic investment bankers at Citigroup designed a currency swap it said was a first for Islamic finance.

It created the swap for Dubai Investment Group so it could hedge the currency risk on its 828 million ringgit (119 million pound) equity investment in Malaysia's oldest Islamic lender, Bank Islam Malaysia, a unit of BIMB Holdings.

Under the swap, if the ringgit falls against the dollar, the bank makes a payment to Dubai Investment Group to offset the drop in the dollar value of the group's investment. The bank does this by selling the group some metal at a discount to market value.

The group then sells the metal and treats the gain as profit.

It does not matter whether trades use copper or another metal under the five-year cross-currency swap, said Rafe Haneef, Citigroup Asia's head of Islamic banking.

"Most of the time, they will give us whatever is available. It doesn't have to be copper or aluminium as such. It's 100 dollars of metal, whatever metal they have," Rafe said.

Trades are often carried out through the London Metal Exchange, the world's largest non-ferrous metals market which boasts annual turnover of more than $4.5 trillion.

The LME could not give an estimate of the value of global commodities trade carried out to support Islamic finance.

"As a policy, we don't tend to comment on who uses the market," LME spokesman Adam Robinson said.

But London-based investment house Dawnay Day Group, which arranges commodities-based Islamic deals, said such trades ranged in value between $5 million and $100 million and sometimes more.

"Obviously it's significant," said Stella Cox, managing director of Dawnay Day Global Investment.

Among some of the other banks working on developing Islamic finance derivatives are HSBC, ABN Amro, Deutsche Bank, UBS and Standard Chartered.

Not all metals can support Islamic finance: gold is out because Islam treats it as a form of money, just as it was 15 centuries ago in the time of the Prophet Mohammad. Under sharia law, money per se is not an asset that can be traded.

Even food is being explored as support for Islamic finance, including palm oil in Malaysia, the largest producer of the edible oil and home to the world's biggest Islamic bond market.

Though liquidity is crucial -- trades must be done in minutes to achieve a predictable return -- Islamic bankers also use metals that are not exchange-traded, such as steel.

Suddenly, thanks to Islamic finance, steel makers can enhance returns, generating fee income on sale and repurchase agreements for stocks that would otherwise be gathering dust in a warehouse or on a waterfront or rocking gently at sea, bankers said.

Commodities usually do not have to physically move between seller and buyer to support Islamic finance, as long as the paperwork shows a change in legal ownership, bankers added.

But many sharia scholars frowned on trades where commodities never actually moved out of a warehouse and took a sceptical view of Islamic derivatives in general, they admitted.

"That's a very, very sensitive subject to just trade in assets that don't move," said Dawnay Day's Cox. "Physical delivery has to be an absolute possibility. Everyone needs to understand that if someone chooses delivery, that's the risk."

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