The Islamic Development Bank (IDB) plans to create the first-ever Islamic currency swap by raising $263 million in Malaysian ringgit bonds and swapping the proceeds into another currency, a bank official said.
Interest payments, banned under Islam, are an integral part of conventional swaps which allow two parties to exchange specific amounts of different currencies, with one often paying a fixed interest rate and the other a floating exchange rate.
Swaps have hitherto not been used by the Islamic finance industry, which caters to devout Muslims who want to follow Shariah, when investing.
But Mohammad Tariq, treasurer of the Saudi-based IDB, said the bank was studying ways to adapt the swap mechanism to one of the world's fastest growing niche financial markets.
One option is to use the Islamic concept of salam which covers a payments made in advance for goods delivered at a later date, he said.
"We are confident that a mechanism will be found. It is a forward deal and we have submitted several mechanisms, one of them is 'salam'," Tariq told Reuters in an interview late on Sunday.
Salam is also being used to develop other risk management instruments such as Islamic options.
"There is no Islamic objection to risk management," Tariq said.
"If we can hedge the currency under a swap agreement, we can raise money in ringgit and bring money to the IDB in a different currencies which are used by the borrower, usually dollars or euros," he said.
Tariq said the IDB would issue five-to-10-year bonds worth up to 1 billion ringgit ($263.2 million) in Malaysia, home to one of the world's best developed Islamic finance markets.
"Then we have the benefit of swapping ringgit into IDB currencies, either dollars, euro, yen or pound sterling."
Unlike the Malaysians, Gulf Arabs have been slow to develop a secondary market for sukuk, or Islamic bonds.
Tariq said the IDB could raise up to $500 million in local currencies over the next few years to try to deepen the market for sukuk, which hardly ever change hands between issue and maturity.
The sukuk market is currently worth about $16 billion and could reach $25 billion this year, Tariq said.
But Tariq said the IDB would likely not tap its $1 billion, five-year floating rate note programme this year. The bank issued a $500 million tranche under the programme last year.
Tariq said the bank would likely win approval at this week's shareholder meeting in Kuwait for a $2 billion increase in capital over the next five years to help fund an increase in lending.
"We are quite flush with cash now," he said.