Islamic Compliant FX Forwards Jonathan Lawrence Derivatives and

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 § Characterisation as swaps therefore potential regulation as swap dealers 2

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 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 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 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 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 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 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 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 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 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 for hedging purposes. This means: § can only be used as insurance activity § cannot be used for funding and trading by means of speculation 13