Global standard-setting bodies have launched a standard contract template for Islamic profit rate swaps (PRS), in a move to help Islamic financial institutions hedge risk. By exchanging one cash flow for another, PRS function in a similar way to the interest rate swaps (IRS) widely used in conventional financial markets. But they do not use interest rates, which are banned under Islamic principles. The template was put together by the Bahrain-based International Islamic Financial Market (IIFM) and the International Swaps and Derivatives Association (ISDA).
“Due to the inter-linkages with the global financial system, the balance sheet of IFIs (Islamic financial institutions) are exposed to fluctuation in foreign currency rates and also cash flow mismatches due to fixed and floating reference rates,” IIFM chairman Khalid Hamad said in a statement. The PRS template aims to help the institutions manage this exposure. PRS are structured as a portfolio of murabaha contracts, in which a long-term leg is paired with a series of short-term murabaha deals that are bound together with a promise, or wa’d, to maintain the series. Murabaha is a common cost-plus-profit arrangement in Islamic finance. Trade in PRS is over-the-counter and its expansion has been slowed by the lack of a standard reference structure, bankers say. The first PRS was developed by Malaysia’s CIMB in 2007.
Ijlal Ahmed Alvi, chief executive of IIFM, told Reuters that one challenge in creating the template was defining a mechanism to close out transactions in cases of early termination. He predicted it could take one or two years before the PRS market became active. Alvi said the IIFM was working on several other standard contracts, including one for cross-currency swaps and an interbank wakalah (agency) agreement.
Simon Eedle, global head of Islamic banking at Credit Agricole, said the industry might adopt the PRS template faster than it had accepted previous IIFM contracts, which include documentation for basic interbank transactions. This is because of experience gained by banks, lawyers and Islamic scholars in handling the previous templates, he said. The IIFM moved relatively quickly in producing the PRS agreement, he said, “considering it took 12 years for ISDA to develop their first interest rate swap”.
