Issues in Islamic derivatives and proposals for reforms in the OTC market in Indonesia

Setiawan, Romi Adetio Article Issues in Islamic derivatives and proposals for reforms in the OTC market in Indonesia Journal of Risk and Financial Management Provided in Cooperation with: MDPI – Multidisciplinary Digital Publishing Institute, Basel Suggested Citation: Setiawan, Romi Adetio (2022) : Issues in Islamic derivatives and proposals for reforms in the OTC market in Indonesia, Journal of Risk and Financial Management, ISSN 1911-8074, MDPI, Basel, Vol. 15, Iss. 5, pp. 1-16, https://doi.org/10.3390/jrfm15050222 This Version is available at: https://hdl.handle.net/10419/274744 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Journal of Risk and Financial Management 15: 222. https://doi.org/10.3390/jrfm15050222 Academic Editors: Naseem Al Rahahleh and Muhammad Ishaq Bhatti Received: 2 April 2022 Accepted: 15 May 2022 Published: 18 May 2022 Publisher’s Note: MDPI stays neutral with regard to jurisdictional claims in published maps and institutional affiliations. Copyright: © 2022 by the author. Licensee MDPI, Basel, Switzerland. This article is an open access article distributed under the terms and conditions of the Creative Commons Attribution (CC BY) license (https:// creativecommons.org/licenses/by/ 4.0/). Journal of Risk and Financial Management Article Issues in Islamic Derivatives and Proposals for Reforms in the OTC Market in Indonesia Romi Adetio Setiawan 1,2 1School of Law, Western Sydney University, Penrith, NSW 2751, Australia; [email protected].edu.au 2Faculty of Islamic Economics and Business, Fatmawati Sukarno State Islamic University, Bengkulu 21352, Indonesia Abstract: This paper aims to propose reforms to develop the Islamic derivatives transactions in Indonesia’s over-the-counter (OTC) market. It is argued that the use of derivatives instruments is considered non-sharia compliant by the National Sharia Board (NSB) of the Indonesian Council of Ulama. However, other Ulamas had adopted a different approach in discussing the issues of derivatives contracts. Standard doctrinal and comparative approaches are employed in this discursive qualitative analysis using an extensive review of the literature from primary and secondary sources to collect the data on Islamic derivatives in the OTC market. This research concludes with two proposals for Islamic derivatives in the OTC market in Indonesia; first, the use of musawamah (sale without revealing the cost) in the swap, al-khiyar (the right to make choice) in option, ju’alah (commission) in future contracts, and wa’ad (a promise) in option can further boost the investors in the OTC market. Second, the Islamic scholars should be softening towards the decision of using derivatives instruments in Indonesia. Such as in the case of the forward agreements, which should be exempted from non-sharia compliance, provided they are used solely for reducing risk due to necessity in al-tahawuth lil hajah al-massah (sharia-compliant genuine hedging needs). Keywords: derivatives; riba; gharar; maysir; speculation; OTC 1. Introduction Each transaction should be based on underlying assets in the real sector under Islamic principles; any transaction traded in a malicious market, or the purchased item is not clear in terms of possession, including size and delivery, categorized as riba and invalid in Islam. With the expansion of economics globally, derivative transactions are unavoidable in this modern era, where every agricultural transaction and other commodity involves a forward, option, swap, and future contract market. The derivative is a financial instrument where trade value is measured based on the underlying asset, such as commodity, currency, or security (Somanathan and Nageswaran 2015). These types of transactions are not new to the Muslim community. The fact that for over centuries, Muslims have used transactions that can be seen resembles sales with immediate repurchase (bai’ ‘inah), to buy on credit and sell at spot value (bai’ tawaruq), future delivery (salam), manufacturing finance (istisna’), downpayment (bai’ urbun), general or limited partnership (mudarabah), join enterprise (musyarakah) (Saidu et al. 2018). In statistics, the notional amount outstanding of OTC derivatives in Indonesia is USD 81 billion in 2019, which is too small to compare to the notional value of global outstanding derivatives in 2019 at USD 610 trillion, or only 0.20% (Bank for International Settlements 2021a). There are several issues pertaining to the slow growth of Indonesian OTC derivatives, such as the lack of central clearing or central counterparty CCPs for OTC derivatives trading in Indonesia and there are uncertainties in the functioning of the current legal framework in bankruptcy that may hinder the introduction of efficient central clearing and margin requirements (Bank for International Settlements 2021b). In terms of Islamic J. Risk Financial Manag. 2022,15, 222. https://doi.org/10.3390/jrfm15050222 https://www.mdpi.com/journal/jrfm J. Risk Financial Manag. 2022,15, 222 2 of 16 derivatives, more than 30% of Islamic banks do not use derivatives; this is due to the fact that Indonesian Islamic scholars limit the use of these instruments to only OTC foreign exchange (Al Natoor 2020). However, there is an increased demand for Islamic hedging by Indonesian investors. This study thus aims to develop the Islamic derivatives transactions in the Indonesian OTC market. The modern way of the transaction using derivatives could be seen from the 1970s when development in pricing methodology spurred spectacular growth, causing the derivative instrument to grow 100-fold over the past 30 years, and it’s developed rapidly over recent decades (Bank for International Settlements 2012). However, derivatives have caused some important companies to collapse to some critics, such as Lehman Brothers and American International Group (AIG) 2008. There is also a critique described in (Mariyani-Squire 2013, p. 10) which says that Islamic derivatives are not meant to assist local businesses, but rather tailored to facilitate wealth generation and meet the need of the economic elite. In derivatives, one party can transfer the risk to another party in the form of futures through the financial exchange, normally on an over-the-counter basis or in the case of swaps. Most of the derivative’s investors are pragmatic and driven by a profit motive; thus, the actual want and need are to gain a surplus out of fluctuating market prices (Mariyani-Squire 2013, p. 11). In the literature, the use of derivatives in Islamic finance has been the subject of various studies. Some highlighted how the derivatives interact with the global economic activity (Bodnar et al. 2017), while in others, the empirical evidence on the importance of the financial derivatives to economic development (Vo et al. 2019). Due to the non-genuine use of derivatives in Islamic finance, there are many users who commercially use these instruments to gain more money by taking the advantage of market price fluctuation in derivatives which is similar to gambling (Kunhibava and Shanmugam 2010;Rizvi et al. 2014). However, Andreas (2013) indicated that the existence of derivatives in Islamic finance can improve the risk management in Islamic finance and arise the investor’s confidentiality toward the Islamic market. Additionally, Agha and Sabirzyanov (2015) criticized that Islamic hedging should only be applicable to tolerable financial risk, as it could also lead to failure in the financial system rather than benefit if proceeded without proper investigation. Several studies have examined the core causes of the global financial crisis in 2008, and the economists believed that derivatives were the core cause of the 2008 Global Financial Crisis (GFC) (Blundell-Wignall et al. 2008). However, the derivatives can still bring substantial economic benefits if managed and properly handled in a fair market (Somanathan and Nageswaran 2015), such as preventing excessive risk-taking, improving market management, fostering financial innovation, and market development. This paper will analyze the derivatives transactions in the OTC market in Indonesia from the sharia and conventional perspectives. In Indonesia, Islamic financial transactions are subject to sharia-compliant, which bans interest (riba), and activities akin to gambling (maysir) such as short selling and excessive speculation. The profit should derive from risk-sharing in business rather than guaranteed return. Although to some extent, from Islamic jurisprudence (fiqh mu’amalat) point of view, the derivatives are engaged in riskshifting and are not readily accepted in Islamic principles due to their excessive speculation and conventional nature, the use of derivatives remains controversial. As Islamic financial industries continue to develop, questions have been raised regarding the limitation of using derivatives. Furthermore, there is a demand from Islamic finance to manage risks using the existing conventional derivatives (Andreas 2013). For example, in Malaysia, the Islamic Scholars, Bank Muamalat Malaysia Berhad, and Bank Islam Berhad have agreed to use derivative transactions such as cross-currency swaps, profit rate swaps, total return swaps, and fund index-linked that are considered sharia-compliant (Andreas 2013). Conversely, in Indonesia, the National Sharia Board of Indonesian Ulama Council still holds the use of derivatives, which causes a lack of competitiveness for Islamic products in the OTC market (Jefriando 2016). J. Risk Financial Manag. 2022,15, 222 3 of 16 There are still limited studies conducted specifically in Indonesia on the Islamic derivatives in the OTC market. Therefore, this paper makes several contributions to the literature. First, this study extends the limited research on the understanding of Islamic derivatives and provides more effective sharia-compliant derivatives in the OTC market, based on the evidence of the legal cases between Indonesia and Malaysia. Second, the results of this study help provide better insight for researchers and regulators on how to develop the Islamic derivatives transaction in the OTC market in Indonesia. Finally, the approach used in this study is distinct from similar studies and the use of evidence of certain legal cases in Islamic derivatives may broaden this knowledge that can be used to build a flourishing financial system for future generations of Muslims, both in Indonesia and around the world. 2. Literature There is no doubt there has been much research on the development of Islamic banking today. These inferred that the current world had seen the Islamic financial institutions as vital in the economy. This development also means the Islamic Financial Institutions (IFI) cannot be detached from the prevailing hedging instrument and risk diversification through derivatives. However, this wide range of hedging products for managing risks often clashes with legal issues related to sharia aspects, which often put the investors at a disadvantage (Andreas 2013). In Indonesia, the NSB-ICU (National Sharia Board of Indonesian Council of Ulama) often states that their body will not approve the derivative instruments. The reason is based on their opinion that the current derivatives transactions contain the elements of gambling (maysir) and uncertainty (gharar) and are in conflict with Islamic principles (Jefriando 2016). However, the NSB-ICU also calls for further enhancement of Islamic derivatives studies from several private sector initiatives and the Islamic international standard body, such as ISDA (International Swaps and Derivatives Association) and IIFM (International Islamic Financial Market), to enhance the application of Islamic derivatives and enhance their standardization. Before looking into the argumentations of the sharia scholars on conventional derivative contracts and the sharia-compliant alternatives, knowledge of principles in Islamic financial transactions is needed as the basic in exploring this. Presley and Sessions (1994) found that there is a shift in knowledge in the West towards recognition of a new paradigm of Islamic economics. Since Islamic economics is a new paradigm, understanding the theoretical studies in Islamic finance is indeed highly efficacy before entering into the in-depth analysis. The objective of Islamic economics is taking benefit from lending money by adding a prohibition of taking interest (riba) in all forms of lending money is not permissible in Islam. These apply to individuals or banks, either on saving accounts or financing. Instead, Islamic finance is based on profit–loss sharing and profit from business transactions (buying and selling) (Nurhadi 2017). In an Islamic transaction, the buyer and the seller should come into a binding contract. The contract should be clear and have no hidden agenda and information (gharar) to avoid information asymmetry and deception. Therefore, the profit of a project in an Islamic contract is stochastic and depends on the state of nature. Presley and Sessions (1994) follow Holmstrom and Weiss (1985) in determining the model of Islamic contract, they assume that the outcome of a project depends upon managerial effort, e, the amount of capital investment, I, and the state of nature, 0. The two states of nature are assumed: bad, denoted by 0 1 and good 0 2 . The function for project outcome is denoted as below: Zi=fi(I,e)(1) Apart from riba,gharar (providing information asymmetric) is also prohibited in Islam, the transactions should not contain the element of highly speculative, and the characteristic of items to be sold should meet the Islamic tenet. A Muslim cannot sell commodities proscribed by Islamic law (haram). For example, the upfront price determination of a commodity is not permissible if the seller does not own a product and does not know yet J. Risk Financial Manag. 2022,15, 222 4 of 16 its exact size, space and price. Again, Presley and Sessions (1994) impose the following function for the incentive compatibility constraints: π1(x1)−s1⩾π1(x2)−s2,π2(x2)−s2⩾π2(x1)−s1,(10a,b)(2) where the constraints (10a) and (10b) simply ensure that the manager will report 0 = 0 i when state ioccurs (Presley and Sessions 1994, p. 591). According to Najeeb (2014, p. 45), any commercial transactions can be considered valid (shahih) in Islamic law if it is categorized as below: 1. Islamic law upholds the legality and the right to contract in the transaction (Ijab qobul). All parties in the transaction should agree to determine the price that should be fixed in the negotiation time. The price should be based on the agreed condition and not forcible or imbalance amongst the parties. The upfront price determination is allowed for future delivery, but the payment should be made at least 2 × 24 h from the on-the-spot agreement. 2. The characteristic of underlying assets and time of delivery should be cleared. This clarity is important to avoid dishonesty. It is also a means of moral commitment, where all types of goods proscribed in Islamic law are considered unethical. This includes the business that causes environmental degradation. The clarity of time delivery and good specifications is necessary to avoid exploitation against another party. The item sold should be able to be delivered and in existence or will exist, and the delivery could be estimated based on the previous deal. This clarity avoids ignorance (jahl), and no one party will feel deceived and disappointed. 3. The seller must have owned the goods. Selling an item that is not owned is prohibited in Islamic law. It is also applied to the leverage system in trading, where the trader has owned only a small capital of money in the market, but, in the leverage system, the trader can trade in the market with a larger amount of capital which he does not own, it is the broker’s money which is borrowed to the trader with interest and should be repaid upon maturity. All contracts and instruments in Islamic transactions must be based on real transactions and not on assumptions. In this regard, any financial instrument should be able to represent an actual real transaction. Thus, the trading should be based on the underlying asset and ownership of assets so that the real transaction could prevail. Derivatives transactions can occur both over-the-counter and on-the-counter of the stock exchange (U.S. Securities and Exchange Commission 2000). Investors use derivative instruments to protect the risk from the fluctuation of interest, currency, effect, and commodities (Syz 2008). Each market (either OTC or stock exchange) has different risks so the type of derivatives and the regulations are also diverse from another. The stock exchange is the regulated form of market, where the producers, traders, and hedgers are transacting in the market to gain profit from the price fluctuations in supply and demand. If more people want to buy a stock, its market price will increase. Likewise, it will fall if more people try to sell a stock. Only the members who meet the requirements and standards are allowed to do the trading in the stock exchanges, and all transactions should be done through the brokerage, margin account, future, option, and warrant are facilitated (Karim et al. 2014). The derivatives transaction on the over-the-counter (OTC) is a commercial contract privately made between the two parties; both determine the value of the price based on the reference rate or index (Rae 2008, p. 77). The products traded in the OTC market are normally based on the customers’ needs; both parties have the flexibility to decide the price, end of the agreement, and quantity of the commodity. The derivatives transaction occurred in OTC when the party decided to hedge the risks of price fluctuation, and the hedger can use forward, swap, option, and future. The OTC market has flexibility but is also a nightmare for the customers as it could be a disadvantage for them. In OTC, there is no transparency of price and possible complex requirements in the contract, which is J. Risk Financial Manag. 2022,15, 222 5 of 16 often very costly for customers (Garber et al. 1994). In fact, in most cases in Indonesia, the customers in the OTC market do not understand the contract’s content, which may cause deception and uncertainty (Rae 2008, p. 78). Under the OTC market, it is hard to identify the nationality, membership, and type of products, unlike in the stock market, where the address, membership of traders, and products are specified. There is no physical meeting between dealers and customers, and all transactions are done through telephonic conversation or computer. The dealers are often looking at the OTC market as speculation and gaining profit. When the demand at the OTC market is high, the dealers purchase more stocks in the stock market which cause the increased price in the stock exchange; the dealers then trade the stock using the derivatives at the OTC market to gain the differ as the demand is high (Garber et al. 1994). According to Redhead (1996), these four derivatives instruments discussed below are commonly used in the OTC, which are forward contracts, futures contracts, options, and swaps: 1. Forward contracts are agreements between two parties (buyer and seller), where both commit to the transaction of a commodity at a future date, with the price set and negotiated today. The uniqueness of this transaction is that the seller sold the product to a willing buyer before it was produced. By deciding the price today, both parties agreed to face the risk of price fluctuation at a future date. However, each party has to be ready to face future losses because one will win at the expense of the other. 2. In the financial transaction, futures contracts are the standard agreement between two parties or more, where both commit to buy or sell the commodity at a future date and the set price. Both parties must complete the transaction at the final settlement date. A futures contract enhances a forward contract where the contract size, maturity, product quality, and place of delivery are standardized. The pricing of a forward contract is locked based on negotiation. Still, the price could be refined in the future contract, and fair price prevails in commodity futures or financial futures markets. 3. Options are one of the derivative instruments where the holder of this contract can have two options in the transactions: call options and put options. A call option gives the holder the right to buy the underlying asset at a predetermined price before maturity. A put option entitles the holder to the right to sell the underlying asset at a predetermined price before maturity. Under the option, the holder has the right but not the obligation to sell and buy based on the holder’s need, as the holder can exercise whether there is an advantage or not to sell or buy. This flexibility gives a key advantage for the option over future and forward contracts. The holder of the options pays for this privilege by paying the seller a non-refundable premium. So, the maximum loss for the option holder is limited to the amount paid for the premium if the holder chooses not to exercise the option. 4. Swap is necessary for companies dealing with international currencies and often face the risk of currency fluctuations and interest rates. A swap contract is an alternative technique to hedge a potential risk embedded in the currency rate and interest rate fluctuations. A swap is a derivative instrument where both parties agree to exchange the cash flows or liabilities from two different financial instruments. Most swaps are traded in the OTC market, which involves cash flows based on a notional principal amount. Islamic scholars such as Rizvi et al. (2014) argue that the object of a transaction may not exist when a contract is signed, and there is an absence of predetermined object characteristics on the derivative. These cause the state-contingent pricing that leads to uncertainty (gharar) and excessive speculation (maysir) where there is possible exploitation of the ignorant. However, what if the object characteristic and the underlying asset are standardized and the market is controlled by the supervisor? These arguments may become invalid. Another type of transaction is the right but not obligation to buy and sell for the protection against downside risk via premium payments, where the buyer’s risk is limited to the cost of the premium of such an option cannot be categorized as excessive as risk is J. Risk Financial Manag. 2022,15, 222 6 of 16 fixed to premium (Andreas 2013). Again, the question was raised on how far uncertainty and excessive speculation could be reconciled in this matter. Kunhibava and Shanmugam (2010) criticize that the involvement of a derivative transaction in a non-existent asset or the asset is not in the seller’s possession is against the sharia and leads to the counterparty risk. However, the derivative does not resemble selling goods that are not in the seller’s possession. Andreas (2013) described derivatives supplement cash markets as alternatives to underlying trading assets by providing hedging instruments and low-cost arbitrage opportunities. The core reason for ulama to limit the use of derivatives lies in the excessive speculation in the derivatives market, where the holders use it to gain profit by looking into the possibility of future fluctuation in the short period. Another argument presented against derivatives is pertaining to legal ownership because the derivative involves the unfunded or partially funded transaction, which means the asset is not fully paid and is not legally owned yet. Thus, there is no guarantee that the asset could be delivered and no certainty at a future date (Usmani 1996). Although another scholar argues that the forward contract in the contemporary forms of futures trading may be akin to the forward contract during the prophet Muhammad, the risk arising from the practice of speculation and exploitation over another expense could be excessive in it and that there is a lack of physical ownership in the derivatives contract (Khan 1997). The deferment of asset delivery and the final payment in a futures contract has also raised another criticism by Islamic scholars. In the futures contract, the traders are allowed to lock in a price of the underlying asset or commodity, but the price could be re-fitted based on the market-to-market condition (Rizvi et al. 2014). These contracts have expirations date and set prices that are known upfront. In the futures market, the investor benefited from leverage using the margin call, and the investor could gain a higher profit with a minimum of capital. The price determination in the futures is generally priced market to market (MTM), and the cash transaction is settled upon maturity (Rizvi et al. 2014). This means in the future contract, each party will settle both the payment and the delivery in the future (bay’ al-inah) (Bhatti 2018, p. 155). This type of transaction is deemed non-compliant with sharia because the commodity cannot be exchanged between two parties for a future date if the price is different from the first commitment. The transaction cannot be made if both payment and delivery are delayed. There is also a controversial issue in options in the OTC market, which has not been answered conclusively. Islamic scholars consider options a promise (wa’ad) to buy and sell a thing at a specific price and specified period. This is because the holder of options has to pay an upfront non-refundable premium to obtain this access in the derivative transactions, which violates the sharia law, as the holder of the option may or may not use its right. The promiser is prohibited by sharia to charge a fee upfront in this matter (Usmani 1996) . Other scholars argue that options are primarily used for speculative gains and not genuine hedging, and thus it could be possibly a ground reason for excessive speculation and presumably gambling (Bacha 1999). In conclusion, the failure of asset ownership in the derivative transaction and no linkage of the transaction to the underlying asset seems against the principle of Islamic finance, which upholds risk-sharing and the delayed payment and delivery in the settlement period. Uncertainty in the contract has become the condition for Islamic scholars to consider derivatives as non-sharia-compliant instruments. However, there are several types of instruments akin to derivatives and regarded as accepted by the moral tenets of Islam. It could be the hope for Islamic derivatives instruments in future development. 3. Research Methodology This study employed a qualitative legal research method based on the standard doctrinal and comparative approaches. This kind of approach has been used by many scholars in scientific research to determine the problem of the study, its dimensions, aspects, and causes (Al Amaren et al. 2020). A standard doctrinal approach is used in locating, analyzing, and evaluating relevant regulations and laws relating to Islamic derivatives in J. Risk Financial Manag. 2022,15, 222 7 of 16 the OTC market in Indonesia. For comparative purposes, it will also locate, examine, and evaluate relevant regulations, and the law of Islamic derivatives in Malaysia. Regulations, standards, legal cases, and fatwa will be located, analyzed, and evaluated for the purpose of finding the effective sharia-compliant Islamic derivatives in the OTC market in Indonesia (see Figure 1). J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 7 of 17 3. Research Methodology This study employed a qualitative legal research method based on the standard doctrinal and comparative approaches. This kind of approach has been used by many scholars in scientific research to determine the problem of the study, its dimensions, aspects, and causes (Al Amaren et al. 2020). A standard doctrinal approach is used in locating, analyzing, and evaluating relevant regulations and laws relating to Islamic derivatives in the OTC market in Indonesia. For comparative purposes, it will also locate, examine, and evaluate relevant regulations, and the law of Islamic derivatives in Malaysia. Regulations, standards, legal cases, and fatwa will be located, analyzed, and evaluated for the purpose of finding the effective sharia-compliant Islamic derivatives in the OTC market in Indonesia (see Figure 1). Figure 1. Research Frameworks. This research focuses on examining and evaluating the relevant regulation and standard of Islamic derivatives in the OTC market in Indonesia and locating the use of Islamic derivatives by IFI in Malaysia for comparative purposes. Primary and secondary data are used where the Indonesian and Malaysian law regarding the derivatives and OTC market and the standards (national and international regarding the Islamic derivatives) are the main sources of primary data, and a good number of journals, magazines, scholarly books, and electronic manuscripts are used as the secondary data. A descriptive method of analysis by carrying out primary and secondary data are deployed in the research. The primary data is analyzed and criticized based on the fact that occurred in the present condition of the OTC market. The library research was conducted demonstrating the critics against an Islamic ruling given by a recognized Indonesian authority in referring to prescribing of derivative instruments in Indonesia. A viewpoint from conventional and alternative is also outlined to link such legal issues and see the opportunity for enhancement in a modern Islamic financial industry. 4. Results and Discussions In Indonesia, the OTC market is used by traders and buyers who do not wish to join the transaction at the stock market. Both buyers and traders are met at the OTC Market to negotiate the price of the underlying assets, (e.g., securities, stocks, currencies). Not all the stocks are listed on the stock exchange, and those unlisted stocks can be traded in the OTC market without restrictions. Some traders feel that they can boost their profit in the OTC market more than in the stock market. For some reason, the buyers who have less capital would be more enthusiastic about the OTC market due to the negotiability of the price of the portfolios, and the buyers and traders do not require to meet face to face at the OTC market. The transactions are normally either via phone or computerized system. The •Analyze •Evaluate The practice of Islamic derivatives at OTC Market in Indonesia •Compare •Evaluate •Examine The practice of Islamic derivatives at OTC market in Malaysia •Analyze •Evaluate International regulations, fatwa, and legal cases •Investigate •Analyze Relevant documentaries information Figure 1. Research Frameworks. This research focuses on examining and evaluating the relevant regulation and standard of Islamic derivatives in the OTC market in Indonesia and locating the use of Islamic derivatives by IFI in Malaysia for comparative purposes. Primary and secondary data are used where the Indonesian and Malaysian law regarding the derivatives and OTC market and the standards (national and international regarding the Islamic derivatives) are the main sources of primary data, and a good number of journals, magazines, scholarly books, and electronic manuscripts are used as the secondary data. A descriptive method of analysis by carrying out primary and secondary data are deployed in the research. The primary data is analyzed and criticized based on the fact that occurred in the present condition of the OTC market. The library research was conducted demonstrating the critics against an Islamic ruling given by a recognized Indonesian authority in referring to prescribing of derivative instruments in Indonesia. A viewpoint from conventional and alternative is also outlined to link such legal issues and see the opportunity for enhancement in a modern Islamic financial industry. 4. Results and Discussion In Indonesia, the OTC market is used by traders and buyers who do not wish to join the transaction at the stock market. Both buyers and traders are met at the OTC Market to negotiate the price of the underlying assets, (e.g., securities, stocks, currencies). Not all the stocks are listed on the stock exchange, and those unlisted stocks can be traded in the OTC market without restrictions. Some traders feel that they can boost their profit in the OTC market more than in the stock market. For some reason, the buyers who have less capital would be more enthusiastic about the OTC market due to the negotiability of the price of the portfolios, and the buyers and traders do not require to meet face to face at the OTC market. The transactions are normally either via phone or computerized system. The transaction system in the OTC market involves the charging of interest, hedging risks, and no standardization. Bank for International Settlements (2021b) reported that the Indonesia’s OTC derivatives market is relatively small compared to its economy but has had a steady growth over the past five years. The number of outstanding national OTC derivatives in Indonesia reached USD 81 billion in 2019 (0.7% of gross domestic products (GDP) and annual turnover reached USD 559 billion (51% of GDP). Turnover in IDR-denominated derivatives grew by an annual average of 13% between 2015 and 2019. OTC foreign exchange derivatives (Indonesia’s largest derivative class) accounted for 0.06% of the global trading volume in J. Risk Financial Manag. 2022,15, 222 8 of 16 2019, and turnover in IDR-based onshore foreign exchange derivatives grew by an annual average of 7% between 2015 and 2019. Currently, there are three classes of derivatives traded in the OTC market: foreign exchange, commodity, and interest rate. Foreign exchange is the highest traded class conducted in OTC with the turnover reaching up to 97% in 2019 (see Table 1). Commodity derivatives account for 2% of total turnover, and interest rate derivatives for 1% (Bank for International Settlements 2021b). Table 1. One-year turnover of Indonesian OTC derivatives market in 2019. Asset Class USD (Million) Percentage Commodity 9397 1.7% Foreign Exchange 544,818 97.4% Interest Rate 5075 0.9% Total 559,290 100.00% Source: Bank for International Settlements (2021b) and from Indonesian authorities. As of 1998 to 2019 the statistic shows that, the foreign exchange swaps make up the highest share in the OTC market in Indonesia, followed by foreign exchange forward (see Figure 2). It is very clear that foreign exchange swaps are an important part of money market instrument in Indonesia. J. Risk Financial Manag. 2022, 15, x FOR PEER REVIEW 8 of 17 transaction system in the OTC market involves the charging of interest, hedging risks, and no standardization. Bank for International Settlements (2021b) reported that the Indonesia’s OTC derivatives market is relatively small compared to its economy but has had a steady growth over the past five years. The number of outstanding national OTC derivatives in Indonesia reached USD 81 billion in 2019 (0.7% of gross domestic products (GDP) and annual turnover reached USD 559 billion (51% of GDP). Turnover in IDR-denominated derivatives grew by an annual average of 13% between 2015 and 2019. OTC foreign exchange derivatives (Indonesia’s largest derivative class) accounted for 0.06% of the global trading volume in 2019, and turnover in IDR-based onshore foreign exchange derivatives grew by an annual average of 7% between 2015 and 2019. Currently, there are three classes of derivatives traded in the OTC market: foreign exchange, commodity, and interest rate. Foreign exchange is the highest traded class conducted in OTC with the turnover reaching up to 97% in 2019 (see Table 1). Commodity derivatives account for 2% of total turnover, and interest rate derivatives for 1% (Bank for International Settlements 2021b). Table 1. one-year turnover of Indonesian OTC derivatives market in 2019. Asset Class USD (Million) Percentage Commodity 9397 1.7% Foreign Exchange 544,818 97.4% Interest Rate 5075 0.9% Total 559,290 100.00% Source: Bank for International Settlements (2021b) and from Indonesian authorities. As of 1998 to 2019 the statistic shows that, the foreign exchange swaps make up the highest share in the OTC market in Indonesia, followed by foreign exchange forward (see Figure 2). It is very clear that foreign exchange swaps are an important part of money market instrument in Indonesia. Figure 2. Foreign exchange derivatives daily market turnover in Indonesia by instrument. Source: Bank for International Settlements (2021b) as cited from BIS Triennial Central Bank Survey 2019. 0 500 1000 1500 2000 2500 3000 3500 1998 2001 2004 2007 2010 2013 2016 2019 FX Derivative Daily Market Turnover in Indonesia by Instrument FX swaps Outright forwards Currency swaps Options Figure 2. Foreign exchange derivatives daily market turnover in Indonesia by instrument. Source: Bank for International Settlements (2021b) as cited from BIS Triennial Central Bank Survey 2019. Indonesia’s financial sector is dominated by banks that are only allowed to trade OTC foreign exchange and interest rate derivatives. The domestic banks including local foreign banks are the largest participants in OTC foreign exchange and interest rate derivatives which account for 52% market share in 2019, followed by foreign clients of 31% and the rest are the domestic non-bank clients of 17% (Bank for International Settlements 2021b). Although there is a steady growth of derivatives trend in Indonesia, the use of derivatives in Islamic banks is smaller than their conventional rivals. However, the use of derivatives is still limited due to sharia-compliant reasons. More than 30% of Fitch-rated Islamic banks do not use derivatives. Most of the remaining 70% use it in a limited capacity, which is still considered a big constraint for Islamic finance development (Al Natoor 2020). This limited J. Risk Financial Manag. 2022,15, 222 15 of 16 only future and forward agreements in applying foreign exchange transactions. However, other types of derivatives are still impermissible. The release of fatwa by the ISDA/IIFM on tahawwuth (hedging) Master Agreement (TMA) and the success of modernizing Islamic banking in Malaysia should become a reference for derivatives development in Indonesia. Provided the operative principles of sharia derivatives transaction in the OTC market should be clearly articulated to ensure the consistency of application and how widely this instrument can be used. Lack of comparative work in other jurisdictions is the limitation of this study, as it would further clarify the way in which the modern Islamic derivatives system is evolving across jurisdictions, especially in the countries where a dual banking system has also been adopted such as Malaysia and MENA regions. Future research on empirical studies and tests relating to the Islamic derivatives in the OTC market, such as the relationship between the risk indicators of Islamic hedging and the financial stability of the banking system may attract greater scholarly attention and will be imperative for visualizing the use of Islamic derivatives instruments in Islamic Financial Institutions. Funding: This research received no external funding. Institutional Review Board Statement: Not applicable. Informed Consent Statement: Not applicable. Data Availability Statement: Not applicable. Acknowledgments: I would like to address special thanks to Maria Bhatti and Edward Mariyani- Squire for their constructive comments on this paper. Conflicts of Interest: The author declares no conflict of interest. References Agha, Syed Ehsan Ullah, and Ruslan Sabirzyanov. 2015. Risk Management in Islamic Finance: An Analysis from Objectives of Shari’ah Perspective. 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