Moody's says in a new report that a combined use of securitisation and derivatives offers considerable scope for reducing risk exposures of Islamic financial institutions (IFIs), thereby improving their overall creditworthiness. However, the rating agency warns that Islamic finance must develop its own innovation phase instead of imitating conventional derivative instruments in order for IFIs to maintain their special status and Shariah-compliant approach.

Islamic finance bucked the global economic trend by reaching new heights last year, with the industry's total assets for 2009 rising to US$950bn. Moody's believes the market will continue to expand and has the potential to reach US$5trn.

"In this context, IFIs are continuing to deliver Shariah-compliant returns whilst, at the same time, focusing on efficiently mitigating the associated risks through a new risk management approach, including the use of derivatives," says Anouar Hassoune, a Moody's vp, senior credit officer and author of the report.

"If employed with care, derivatives can enhance efficiency in IFIs through risk mitigation, thereby making them more competitive as well as appealing to customers. However, their application in Islamic finance is highly controversial for reasons of speculation and uncertainty - two practices forbidden under Shariah," Hassoune explains.

Conflicting scholarly opinions on the legitimacy of derivatives in Islamic jurisprudence has seen them used on a limited scale in some countries and banned outright in others. "IFIs aim to utilise derivative instruments to hedge against risk and to improve risk monitoring practices. However, they are keen to do so in a Shariah-compliant manner, rather than imitating conventional derivative instruments - in order to avoid losing their special status as Shariah-compliant banks, which makes them very attractive to a large population of Muslims. For this reason, a new innovation phase in the industry is critical," Hassoune concludes.