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Islamic Compliant FX Forwards Jonathan Lawrence Derivatives and Structured Products Group Meeting 4 August Islamic Compliant FX Forwards Jonathan Lawrence Derivatives and Structured Products Group Meeting 4 August 2011 Copyright © 2011 by K&L Gates LLP. All rights reserved.

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

Recognition of Hedging in Islam § Important objective of Shariah is to preserve and 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 3

Conventional and Shariah Viewpoints on FX Forward Conventional views: Shariah Views: § Used to Conventional and Shariah Viewpoints on FX Forward Conventional views: Shariah 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 § 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 4

Structuring § Contracts and principles in accordance with Shariah rules and principles § Not 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 5

Execution § Each contract to be executed separately § Execution of contracts to follow 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 6

Usage §Instruments only to be used for hedging and not speculation §Must be an 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 7

Wa’dan § Two unilateral promises given by two parties to one another § The 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 8

Islamic Currency Forward Based on Wa’dan (two unilateral promises) at Dealing Date 1 Customer Islamic Currency Forward Based on Wa’dan (two unilateral promises) at Dealing Date 1 Customer Bank Promises to sell USD 1 million at the rate of 3. 5 if exchange rate USD/MYR >3. 5 2 Customer Bank Promises to buy USD 1 million at the rate of 3. 5 if exchange rate USD/MYR is below or equal to 3. 5 9

Islamic Currency Forward Based on Wa’dan (two unilateral promises) at Value Date § Scenario 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 10

Tawarruq contract A financial institution, either directly or indirectly, will buy an asset and 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. 11

FX Forward Based on Tawarruq Payment of US$ 10 Million at Value Date Bank FX Forward Based on Tawarruq Payment of US$ 10 Million at Value Date Bank Broker B US$ 10 Million Pay RM 35 Million at Value Date RM 35 Million US$ 10 Million Broker A Customer Payment of US$ 10 Million at Value Date Forward Rate: US$/MYR =3. 50 12

Conditions of Use Approval given by Shariah committees only if the instrument is exclusively 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 13