The process of financial intermediation responds to changes in the environment with product and service innovations, and in this manner have continually re-shaped the international financial landscape. Derivatives are among the most innovative sub-sectors of the financial industry. Specifically, the ‘over-the-counter’ (OTC) products are not derivatives on organized markets, but rather individually customized, often highly complex with combinations of standard financial instruments packaged together to meet the specific needs of clients. Such contracts involve very little direct lending by banks to clients, and generate little net interest income to the banks. Derivatives generate substantial fee and commission income without the need to commit any of the institution’s capital. This therefore involves a different risk management approach as there is a shift away from continuous risk assessment and risk monitoring of funded investment projects that usually produce recurring flows of interest payments over time to the identification of riskless ‘trades’ that produce large, single payments, with much of the residual risks carried by purchasers of such packages. This process has possibly been accelerated by the introduction of risk-weighted capital requirements. Market players and regulators both have a role to play in balancing potential risk with potential returns in order to promote a vibrant financial system, without compromising the stability and integrity or agility of the system. One of the Central Bank’s primary responsibilities is to maintain financial stability and confidence in the financial system and to ensure that the process of financial intermediation continues to function without disruptions.

The Bahrain-based International Islamic Financial Market (IIFM) has also endorsed the Sukuk in September 2003. The Labuan Financial Exchange has signed an MOU with IIFM to establish a framework for greater co-operation and to pave the way for both organizations to jointly develop an Islamic Capital Market with greater global reach. The importance to innovate and develop appropriate risk management tools is clear. There are unique challenges to manage in developing derivative products for Islamic banking and finance because the end product must not only be Syariah compliant, in form and substance but also be globally attractive to all customers. While Islam encourages risk management in financial transactions, the tools or instruments used in such management must not have the prohibited elements of riba (interest or usury), gharar (uncertainty) and maysir (gambling). Certain basic Islamic financial products already exist that offer the benefits of hedging. The Bai’ as-Salam contract, for instance, is essentially a forward contract where two parties agree to carry out a sale/purchase of an underlying asset at a pre-determined future date, but at a price negotiated and fully paid today. The Istisna contract is an example of a futures contract where a buyer contracts with a manufacturer to manufacture a product at a future date. A more interesting example is the Istijrar contract, introduced in Pakistan, which includes the characteristics of a put and call option, allowing the buyer to cap the purchase price, and the seller to set a floor for the selling price.