Risk Islamic Finance 2006

Risk Islamic Finance 2006
AUTUMN 2006
Risk Islamic Finance: March 2007



Summary
• Comment
• Basel II
• Islamic bonds
• Secondary market
• Crude oil
• Structured products
• Profile

Comment
Sharia on the rise
Islamic banking is currently one of the most exciting areas of the financial markets. Given the steep rise in oil prices over the past couple of years, there is plenty of cash floating around the Middle East looking for a home - and investors want to invest that money in sharia-compliant products.
As a result, foreign investment banks are piling into the market. After being dominated by European institutions - the likes of BNP Paribas, Deutsche Bank, HSBC and UBS - US banks are looking to catch up, with some of the bulge-bracket firms now entering the market.
This investment banking expertise, combined with the ongoing participation of local institutions in the Middle East and Asia, has led to a surge in innovation in Islamic finance. Along with a sharp increase in Islamic bond - or sukuk - issuance (see page , a number of firsts have also emerged, with convertible bonds, profit rate swaps (a sharia-compliant interest rate swap) and a wide array of structured products and funds being launched into the market. There is even talk about creating synthetic sukuk, which will enable banks to repackage Islamic exposure synthetically for a wide array of investors.
At first glance, it is difficult to see how some of these concepts can comply with sharia tenets, which forbid the receipt or payment of interest, and usually require the products to be backed by physical assets. Dealers argue that, in theory, any product that exists in the conventional market can be made sharia-compliant, so long as an appropriate wrapper is used.
Nonetheless, interpretations of what is sharia-compliant can vary widely, not only between countries, but also between banks. The need to tailor products to comply with different banks' sharia boards can increase the costs of issuance, say bankers. In turn, some dealers say they err on the side of caution, preferring less complex products that stand a better chance of achieving wide appeal. Whether this will stymie innovation remains to be seen - from current evidence, it would seem not, with banks willing to swallow any additional costs in order to get access to this booming market.
Editor, Nick Sawyer

Basel II
The road to Basel II
The new Basel capital Accord is creating headaches for banks around the globe. However, Middle Eastern institutions that offer Islamic banking products have even more hurdles to jump
Europe is in the final stages of preparing for Basel II, set for implementation in January next year, while US regulators are still deciding how they want to apply the Accord to their financial institutions. For banks in the Middle East, however, particularly those engaged in Islamic finance, applying Basel II is a different story altogether.
The majority of Middle Eastern banks engage in both conventional and Islamic banking, so applying Basel II requires not only compliance with the core principals of the Accord, but also means working out how the concepts outlined in the framework fit in with Islamic law.
Different countries in the Middle East are at different stages of implementation. Bahrain, for example, wants its banks to comply with Basel II by 2008, as does Saudi Arabia. At a seminar held in Riyadh in May, Hamad Al-Sayari, governor of the Saudi Arabian Monetary Authority (Sama), said the country's banks are well on their way to implementation.
"We expect all banks operating in Saudi Arabia to implement the standardised approach for credit risk by January 1, 2008, and then continue to move towards more sophisticated internal ratings-based (IRB) approaches. For operational risk, all banks are likely to move to the standardised approach, with one or two banks experimenting with the advanced measurement approaches," he said.
Banks in Qatar, however, were set a deadline of this year to begin reporting under Basel II's most basic risk assessment approaches. Ahmed Abdi Sheikh, executive manager in risk management at Doha-based Qatar National Bank, says his institution has been complying with Basel II for almost a year, having worked closely with the monetary authority, the Qatar Central Bank, and the country's other banks to meet the deadline.
"The central bank put together a team of risk managers from the different banks in Qatar, along with a couple of people from the central bank itself, and in the past couple of years we've had frequent meetings to develop a strategy for Basel II implementation for the country," says Abdi Sheikh. "For almost a year now, we have been meeting our capital adequacy ratios in accordance with Basel II guidelines." He adds that the bank is, for now, sticking with the basic indicator approach for operational risk and the standardised approach for measuring credit risk.
Qatar National Bank now reports capital adequacy ratios to the central bank on a monthly basis. "The information is extracted from our banking systems and other applications, and it gets disseminated through the internet to the central bank," says Abdi Sheikh. The firm uses JP Morgan's Horizon system for managing operational risk, which lets its risk managers conduct self-assessment exercises and perform risk-event analysis. However, the bank has not yet purchased a system to manage credit risk. Abdi Sheikh argues that the firm does not need a sophisticated credit risk measurement system at the moment because it uses the standardised approach - where capital weightings for sovereigns, corporates and banks are based on ratings from external rating agencies such as Moody's Investors Service and Standard & Poor's. In future, though, it may need to buy a sophisticated model from a third-party vendor. "Even though the central bank doesn't require us to go to the foundation or the advanced IRB approach, we expect it to come to us in a couple of years and ask us to move to the next level. It is in our plan to prepare for that, and we have done a lot of work already internally," he says.
However, moving to the more advanced approaches could prove difficult for many banks in the Middle East, primarily because of the shortage of detailed historical default data. "The major issue in moving to the next level is the availability of quality data in order to produce the probability of default (PD) and the loss given default estimates," says Abdi Sheikh.
"PD data is the biggest stumbling block," agrees Riyadh-based Sam Tereblanche, a consultant employed by Saudi Arabia's Riyad Bank to implement its Basel II systems. "The pure concept of PD is not understood 100% here, although people are moving towards that." Banks in the region are so well capitalised and the deals so heavily collateralised that when defaults do occur, they have a negligible economic impact, he says. "And the economy here has been exceptionally good for the past five years, so there haven't really been any defaults."
As in other regions, steps are being taken to address the data issue. Saudi banks are working to create a national data pooling system for credit risk. In Qatar, there is a scheme to create a national database, and banks are also working on collecting their own historical data, says Abdi Sheikh.
Meanwhile, there has been some talk about creating a pooled data system at the multi-national level, specifically in relation to Islamic countries - although this is at an early stage. For smaller countries, such as Bahrain, a shared database would be especially helpful. "You need at least 2,000 corporate names for any database to work properly and generate adequate PDs, and in Bahrain we do not have that minimum," says Khalid Hamad, executive director of banking supervision at the Bahrain Monetary Authority (BMA). "We determined that a bank alone cannot generate realistic PD data on a stand-alone basis."
However, a number of issues must be resolved before a regional pooled database can emerge. "It is an idea, but it needs a lot of work and approval," adds Hamad. "To combine data, for example, from the GCC (the states that form the Gulf Cooperation Council) would require the relaxation of some confidentiality rules imposed by central banks on their banks. It would need the approval of all central banks involved, as well as the banks themselves, and to some extent, the approval of the corporates, because data on their exposures would have to be disclosed."
In the meantime, the BMA intends to let its banks use proxy data from the rating agencies. "Once the bank has established a rating engine, we will allow it to map its ratings to the ratings of two or three rating agencies. They will then be able to use the PDs associated with the rating agencies' rating," says Hamad. "For this, we have to have a dynamic mechanism for monitoring the reasonableness of the exposures. So we will be proactive with the banks in the first few years to make sure the PDs used are not lower or higher than they should be for our market."
Despite the fact the majority of banks in the region are starting with the standardised approach, many are intent on moving towards advanced approaches at some stage. "Almost every bank we have spoken to was very clear that it would go to the advanced approach sooner or later," says Andreas Raggl, Reuters' head of risk for the Middle East and Africa.
Using proxy databases potentially offers a route for any Middle Eastern bank to aspire to the higher echelons of Basel II reporting and compliance. But that still leaves the difficulty of collecting historical data on Islamic - or sharia-compliant - products.
In fact, a major challenge is how such products should be treated under Basel II. Under sharia law, banks cannot engage in transactions that could be deemed speculative, pay interest and involve contractual uncertainty. Transactions are also usually backed by assets. Murabaha, salam and istisna contracts, for instance, are based on the sale or purchase of an asset, while ijara contracts are based on selling the benefits of such an asset. Profit-sharing deals (musharaka and mudaraba) are also common, as is financing raised through the issuance of Islamic bonds, known as sukuk.
"A major issue for Islamic banks under Basel II is a clear understanding of the particular risk characteristics ofIslamic financial products. Are they loans and deposits, or are they to be treated as equity - or indeed, as loan/equity hybrids? What is the true nature of asset backing? Are the products equity-like profitand loss sharing products, or mark-up leases and sale and repurchase agreements?Are they bank liabilities, oris the bank afund manager?" asks Warren Edwardes, Basel II consultant and chief executive of Delphi Risk Management, a London-based consulting and training firm. "The answer to these questions will make a big difference to the capital backing required."
But steps are being taken to bring clarity to these issues. Last December, the Malaysia-based Islamic Financial Services Board (IFSC), an Islamic finance industry body, issued a paper called Capital Adequacy Standard for Institutions (other than Insurance Institutions) offering only Islamic Financial Services, which offers banks and monetary authorities a template for applying Basel II to sharia-compliant products.
"A strategy was developed and finalised. It went through a working group and then through a technical committee - which comprised the executive directors of supervision in all the member countries - and then it went to the governors of central banks who are members of the IFSC, who then approved it," notes the BMA's Hamad, who sits on the IFSC technical committee.
The IFSC paper breaks down how sharia-based transactions should be defined, measured and treated under Basel II. The guidelines cover minimum capital adequacy requirements based on the standardised approach for credit risk and the basic indicator approach for operational risk, and the measurement methods for market risk as outlined in the 1996 Market Risk Amendment. For example, the IFSC states that musharaka and mudaraba transactions are similar to an equity position in the banking book, as defined by Basel II, and therefore give rise to credit risk, except in the case of investments, normally short term, which are for trading purposes and are subject to market risk capital requirements.
Under mudaraba - or profit sharing - contracts, the holder of an investment account bears all the credit and market risk of the position, while the operational risk is borne by the bank. That's because the investor would hand over capital and take a share in any profits (rather than receive interest) generated by the enterprise or activity, but could lose all the investment if the market turns sour. However, if negligence, fraud or breach of contract can be proved, the bank is liable for the investor's loss.
The implementation of Basel II under the IFSC template requires that operational risk be explicitly recognised, but that a different, reduced, risk weight be applied to the exposure to calculate the capital requirement. As Hamad explains, traditionally Islamic institutions take an outstanding exposure, halve it, then multiply this figure by a risk weighting to come up with a capital adequacy figure. "Rather than take 100% of the exposure multiplied by the risk weight, Islamic banks always apply 50% because of the convention that the Islamic banks do not bear losses - it's a fiduciary relationship, and the loss is always borne by the customer," he says.
Under Basel II, banks have to hold an explicit capital charge for operational risk - under the basic indicator approach, this is 15% of annual average gross income. Given that this would have previously been implicit in the capital adequacy charge, the new formula (covering risks other than operational risk) has reduced the capital charge for banks. So, rather than take the full amount at exposure, multiply it by 50% and then multiply that by the risk weight applied to the exposure, the IFSC has decreed that that 50% figure should be reduced to 30%.
This is just one of the ways Basel II is being adapted for Islamic finance. Other issues remain to be resolved though. The guidelines only address the standardised and basic indicator approaches, and do not cover pillars II and III - the parts of the Accord covering supervisory review and market disclosure, respectively. However, a working group is currently looking at how Islamic institutions can apply IRB models. Other groups are working on the treatment of complex sukuk that have a combination of underlyings, while another team is examining how real estate projects, where the financing bank is a joint developer, should be treated.
The IFSC's guidelines, however, are not binding. Just as with Basel's rules, it comes down to how the national regulators apply the framework. "There'll be differences between different countries, and ultimately it is the central banks that decide the exact regulatory discretions that need to be applied," says JivanthaMendis,director of credit and capital at Toronto-based risk management technology provider Algorithmics, which is implementing Basel compliance systems in the Middle East.
Most people agree that risk management within Middle Eastern banks will take a massive leap forward as a result of Basel II implementation. "We viewed this project from a strategic point of view, so we didn't look at Basel II as a compliance issue alone," says Qatar National Bank's Abdi Sheikh.
"It will improve risk management because it is putting the emphasis on the right stuff, on proper risk management processes, on content and on procedures," adds Riyad Bank's Tereblanche.
One question, however, is whether the banks will benefit from a capital adequacy standpoint. In general, financial institutions in the Middle East are very well capitalised. Qatar's central bank imposes a minimum capital adequacy ratio of 10%, compared with 8% under the 1988 Basel Accord - but Abdi Sheikh says the banks are all well above that. Throughout the period 1992-2005, Saudi banks have maintained capital adequacy ratios of more than 18%.
In his May speech, Sama governor Al-Sayari said he expects all Saudi banks to remain highly capitalised. Given the expectations by regulators that bank capital should remain high, is there an incentive for banks to invest in IRB-compliant systems? "I don't know what the benefit of going to the IRB approaches is," says Tereblanche. Unless capital adequacy ratios are allowed to fall, with the freed capital put to more productive use, banks in the region may ask what the point of Basel II is.
John Ferry

Islamic bonds
Seeking sukuk
While Malaysia continues to dominate sukuk issuance, some mega-deals announced in the past two years point to bright prospects elsewhere in the Islamic world
Billions of dollars worth of sukuk bonds have been issued this year, indicating a continuing boom in the use of fundraising instruments that comply with sharia (Islamic law). High oil prices and greater customer awareness are driving demand from Islamic institutional and private investors for investments that avoid the prohibited areas of riba (interest), gharar (uncertainty) and maysir (gambling). Issuance has already reached $41 billion worldwide, and is growing fast. Abdullah al Muajel, head of the sharia control department at Al Rajhi Bank in Riyadh, expects this to rise to $150 billion by the end of 2010.
To meet this demand, the sukuk market (see box) will have to expand into new areas - and a few large and innovative sukuk deals this year may point the way. January 2006 saw the launch of the largest sukuk to date, an issue by the Dubai Ports, Customs and Free Zone Corporation (PCFC), arranged by Dubai Islamic Bank, and listed on the Dubai International Financial Exchange. Intended to raise funds for PCFC's takeover of UK port operator P&O, through its Dubai Ports World subsidiary, the sukuk was oversubscribed more than four times, receiving a total of $11.4 billion in bids. This demand led PCFC to increase issuance from $2.8 billion to $3.5 billion.
But it is not just the size of the PCFC sukuk that has attracted attention of Islamic financiers. PCFC, in anticipation of an initial public offering (IPO) at some point in the future, structured it as a convertible sukuk. Up to 30% of the sukuk can be redeemed into PCFC shares if an IPO goes ahead in the next two years - otherwise, the sukuk produces a higher yield at redemption, 10.125% a year rather than 7.125%.
The deal was based on a musharaka (venture capital) arrangement. The two partners in the musharaka structure were PCFC, which contributed $1.5 billion in kind, and a special-purpose vehicle (SPV), PCFC Development FZCO, which contributed the $3.5 billion raised by the sukuk. The key to the deal was the SPV's establishment of an English law trust over its right to share the joint venture's profits - selling the trust certificates gave investors a share of profits.
With the trust certificates came the option to convert into PCFC stock. Normally, such a transaction would raise issues of gharar, but according to PCFC's sharia board, as the strike price and the stock were set in advance, there was no uncertainty in the structure.
The PCFC sukuk was listed on the Dubai International Financial Exchange (DIFX), which opened for business in September 2005 - PCFC was the first sukuk to list there.
Aabar Petroleum, an Abu Dhabi oil exploration and production company, listed the second sukuk - a fully convertible bond - on the DIFX in June. Harris Irfan, Deutsche Bank's Dubai-based director of emerging markets structuring, whose bank acted as bookrunner and lead manager, explains: "Aabar is the first truly convertible sukuk that converts wholly into the shares of the underlying company. There are scenarios in which cash would be offered instead, but essentially it operates as a conventional convertible - if it is in-the-money, you get the equity, and if it is out-of-the money, you get par."
The Aabar sukuk raised $460 million, with a fixed profit rate of 6.894%, based on the four-year dollar swap rate at the time of pricing. It will mature on June 28, 2010. The conversion price is $1.0895; Aabar's stock is currently at 3.43 dirhams ($0.934).
Convertible bonds are not unique to Dubai - the Malaysian market saw its first issue in 2005 - but they have not, so far, been widely issued in any market. Market participants say this is not because of difficulties with sharia (even though equity options are widely regarded as being unreal instruments, or 'promises', rather than actual assets). Instead, it may be due to a simple lack of experience among the structuring banks.
"It is actually an extremely difficult instrument to structure. It requires a lot of different skill sets and resources and technology to make it work. So far, very few institutions have demonstrated that they are capable of structuring and executing these complex instruments from start to finish," says Deutsche Bank's Irfan. "I think it is probably the Western investment banks, ironically, that are best placed to do the complex transactions, rather than the local and regional institutions, even though traditionally Islamic instruments have been the preserve of the local Islamic banks."
In spite of the difficulties in structuring some Islamic financial instruments, the industry is growing fast. The obvious explanation for the growth is the five-year oil bull-run. The rise in oil prices, from $28 in January 2001 to a record high of $78.65 in August this year, means there's plenty of liquidity in the region, with investors keen to place their spare cash in Islamic investments. "Just by internal growth in the region, the assets under management should grow drastically. I don't think it will be growth from foreign investors - it is not about bringing back money invested elsewhere, it is about internal growth of the wealth they already have," says David Ishoo-Mirzayoo, London-based co-head of Societe Generale's (SG) derivatives and solutions group for Europe, the Middle East and Africa.
While much of the growth may be endogenous, investors outside of the Middle East have also been showing interest. Some high-profile sukuk issues have attracted significant proportions of non-Islamic cash - investors in the US and Europe bought 20% of the inaugural $600 million sukuk issued by the Malaysian government in 2002, and 70% of the $400 million 2003 Islamic Development Bank (IDB) sukuk, for example.
However, the Islamic finance business in general - sukuk included - has a disadvantage compared with conventional financing, say analysts. "In most cases, Islamic banks will be competing with conventional institutions, but Islamic products are less commoditised and require more tailoring and oversight, and this leads to substantial overheads," notes Adel Satel, an analyst at Moody's Investors Service in London. "As a result, it is difficult for Islamic (pricing) to compete with conventional market interest rates. In addition, in most markets where Islamic banks have been established, they are small institutions, even by local standards, and this puts further pressure on their cost base."
The additional cost associated with structuring customised Islamic bonds means only a handful of issuers outside the Middle East and Asia have issued sukuk. The finance ministry of the German federal state of Saxony-Anhalt issued the first European sukuk in July 2004. Although the issue raised its target of $100 million, the German authority has no plans for another sukuk issue - and few other European issuers have followed its lead.
By the end of 2005, only a handful of sukuk had been issued in Europe, and all were on behalf of Middle Eastern borrowers - a 2003 sukuk issued by the IDB used a Channel Islands-based SPV; the 2005 $26 million Al Safeena tanker financing was structured in London by ABC International Bank of Bahrain; Taib Bank of Bahrain issued a £143 million sukuk in London in 2005 to finance the purchase of a London office building; and a Jersey SPV, Caravan I, was used for the 2004 securitisation of a Saudi rental car fleet.

Edgar Kresin, head of the Saxony-Anhalt treasury office, says its sukuk issue was a success - but only because the government had more than financial objectives in mind. "We use it as a kind of marketing instrument for our region in the Middle East," he says, adding that a sukuk would only make sense for a European sovereign or sub-sovereign issuer if it hoped to reap indirect benefits. The region's economic ministry, responsible for promoting inward investment in Saxony-Anhalt, launched a push for Middle Eastern investment alongside the sukuk.
Without this push, there is no reason to use a sukuk rather than a familiar conventional instrument, Kresin says: "You need another target beside just funding. It doesn't make so much sense just from a funding perspective, but from a strategic way of thinking it may make sense for a state."
One of the hurdles to growth is the lack of standardisation in the Islamic market. Sunni Islam, the larger of the two major Islamic sects, contains four major schools of legal thought. Hanbali, the most conservative, is commonest in Saudi Arabia and the Gulf states; hanafi, the largest, is most common in south and central Asia and Europe; Africa is dominated by the maliki school; while Malaysia and Indonesia tend to follow the liberal shafi school.
This matters because each regulator, bank and institution has its own sharia board. And opinions on legally permissible structures vary not only from country to country, but also from bank to bank. However, not all banks are equal: a sukuk by the IDB, based in Jeddah in Saudi Arabia, may have opened the way for a new wave of non-ijara (sale/leaseback) sukuk, says Mohammed al-Sheikh, co-head of the Islamic finance unit at the law firm White & Case in Riyadh.
The sukuk, issued in July 2003, was the bank's first, and raised $400 million (up from $300 million after oversubscription). Previous sukuk, issued by the Malaysian and Qatari governments, had relied entirely on real estate sale/leaseback as underlyings. Other IDB sharia-compliant assets, such as murabaha (cost-plus sale agreements) and istisna'a (cost-plus production agreements) would not normally have been permissible, as they are undertakings to pay as opposed to actual assets - the murabaha and istisna'a deals themselves are sharia-compliant, but their securitisation would not have been.
But, al-Sheikh explains, IDB managed to push the envelope: "The novelty of the IDB was that their sharia committee, a very respected committee, said that as long as the ijara component was more than 50% of the portfolio, you could put whatever else you wanted in. That has really created a push toward more sukuk issuance. It is not a binding precedent, but it is a precedent that gives comfort."
In fact, the IDB deal left room for further flexibility, setting an absolute limit of 25% ijara "under specific circumstances and for very limited durations", below which the sukuk would be dissolved. In the event, the portfolio was 66% ijara.
However, the existence of a central decision-making body would add even more clarity to the process. Deutsche's Irfan comments: "I believe it is healthy to have sharia boards that act across schools of thought. We have a board of five scholars who may have divergent opinions, and that actually helps us sell the product, because investors say the most conservative views must have been applied to the underlying transactions here."
Standardised documents could also help develop the market for simpler transactions - Irfan suggests a profit rate swap as one example. In an Islamic profit rate swap, first developed by the Commerce International Merchant Bank (CIMB) of Malaysia in June 2005, the two legs are fixed- and floating-rate sale agreements, with the floating rate based on the Kuala Lumpur interbank offered rate (Klibor). A notional asset is sold for a notional sum, and then repurchased for the notional sum plus a fixed profit rate - effectively an agreement to pay the fixed profit rate. A similar sale/repurchase arrangement underpins the floating leg of the swap, and the result is a fixed/floating rate swap that is sharia-compliant.
Launching the product in June 2005, CIMB's head of Islamic banking in Kuala Lumpur, Badlisyah Abd Ghani, told Risk's sister magazine, Asia Risk, that the connection to an interest rate did not make the deal un-Islamic. "But in terms of a benchmark, this can be whatever is agreeable between the two parties. Klibor is just a mathematical formula. It is just a number. The act of charging money on money (is unlawful) but the number itself is just a number. Klibor is just a way to agree terms, and there is nothing wrong in using it."
But the complexity of the profit rate swap documentation - "like Tolstoy's War and Peace" compared with the brief International Swaps and Derivatives Association documentation for a conventional rate swap, according to Julian Candiah, Singapore-based director of structured products and debt-capital markets at BNP Paribas - means that more standardisation is needed.
Looking further ahead, SG's Ishoo-Mirzayoo suggests, the next step will be a move from cash to synthetic deals. "The cash market on the conventional world has been replaced by the synthetic market ... cash collateralised debt obligations (CDOs) moving to synthetic CDOs. Well, the Islamic market is moving in the same direction - we are able more and more to repackage synthetically Islamic exposure for investors."
Structuring such products while staying within the boundaries of sharia is not easy. Ishoo-Mirzayoo declined to give details of how the products would be structured, but notes they have been traded on a non-public basis since 2005. "We are trading these, and we are not the only ones," he adds.
In fact, some dealers argue that any product can be made sharia-compliant, so long as an appropriate wrapper is used. "A sukuk is nothing more than an Islamic wrapper on an underlying, and you will see more and more development of Islamic wrappers on different underlyings," says Ishoo-Mirzayoo. "It all depends how conservative the underlying investor is. Some people are just happy with the (Islamic) wrapper, as long as the flows are Islamic, regardless of the underlying product; some others need to be much more conservative."
Even interest-bearing loans could be acceptable as underlyings for some clients, so long as the structure itself follows sharia rules. "Some investors look just at the top layer, some look all the way down to the underlying," says Ishoo-Mirzayoo. "It all comes down to one thing - there is appetite for yield, and it is very difficult to find yield in traditional Islamic markets."
And Deutsche's Irfan predicts sharia instruments will move away from the lease-based type, or sukuk al-ijara, and more to traditional profit and loss sharing systems like musharaka (venture capital) and mudaraba (trustee investment).
"You will probably see two strands of sukuk ... simple corporate and sovereign bonds, and bonds that have a story behind them - structured project bonds for example," adds Ishoo-Mirzayoo. "The latter type of instrument may be required for project finance, and naturally those instruments will be more prevalent in areas that have huge infrastructure requirements and a decent credit story - an ability to repay."
Meanwhile, the next big market could be Indonesia. Infrastructure companies, such as the Indonesian Satellite Corporation, have already issued several sukuk, and the government plans to follow, with a launch planned for early 2007. Its proximity and commercial links to the heart of the sukuk business in Malaysia should prove an advantage. The state energy company, Perusahaan Listrik Negara, is planning a $1.6 billion sukuk to fund power station construction and has named UBS as the arranger. The archipelago's need for infrastructure investment is acute and, with better corporate governance rules making investment in the country less risky, using sukuk to funnel Gulf cash to Indonesian projects could be a profitable business.
WHAT IS A SUKUK?
A sukuk is often described as an Islamic bond or Islamic security. A sukuk is a tradable certificate, which represents an investment in an underlying asset of the issuer and carries a fixed or floating profit rate (the equivalent of a coupon on a conventional bond). The commonest form of sukuk remains the sukuk al-ijara, based on the sale and leaseback of the underlying asset, but sukuk can also use financial contracts as long as the majority of the underlying is ijara.
Three possible financial underlying contracts are:
- istina'a, an agreement in advance for production of goods at a certain time and price.
- murabaha, cost-plus sales in which payment is deferred (thus the equivalent of buying on credit).
- musharaka, a venture capital agreement in which profits from the joint enterprise are shared according to a prearranged rate rather than in proportion to the investment.
Islamic investors may also use a mudaraba arrangement. This is the equivalent of a trust, in which funds are deposited with an agent who manages their investment in return for a fee.
Alexander Campbell
http://www.risk.net/public/showPage.html?page=438758

Secondary market
Secondary thoughts
Global issuance of sukuk has grown rapidly over the past five years, but a secondary market has yet to emerge, with most of the paper being snapped up by buy-and-hold investors. Now, efforts are under way to kick-start secondary market trading. Gareth Gore reports
Sukuk are rapidly altering the investment landscape in Islamic countries worldwide. Global issuance of the bonds - structured so as not to contravene sharia, which forbids the receipt or payment of interest - is now in excess of $41 billion, according to Moody's Investors Service. That might seem a drop in the ocean compared with the estimated $15 trillion conventional bond market, but five years ago these securities didn't even exist. And issuance is growing fast - in the Middle East alone, the market grew by 45% year-on-year in 2005, taking the volume of newly issued sukuk to $11 billion.
Several jumbo-sized deals have emerged over the past year, including the $3.5 billion sukuk issued by Dubai Ports World to purchase the UK shipping monolith P&O, and the $550 million Wings issuance from Dubai-based airline Emirates as part of its plan to expand Dubai international airport into a global hub.
But while issuance has been steadily growing, relatively few global investment banks and investors have been able to gain exposure to the sukuk market. That's partly because of the small size of issuance, but is also due to strong demand from Islamic investors keen to put their cash to work in investments that comply with sharia. And with oil prices hovering around record highs, Middle Eastern investors have had a lot of cash looking for a home.
Demand is so great that when Dubai Ports World released what was initially a $2.8 billion sukuk, it was more than four times oversubscribed. The trouble is that most investors have had a buy-and-hold mentality, and calls for greater secondary market trading have so far gone unheeded.
"There is an imbalance in the market," says Ahmed Abbas, chief executive of Bahrain-based Liquidity Management Centre (LMC). The organisation was set up in 2002 by a quartet of regional banks - Bahrain Islamic Bank, Dubai Islamic Bank, the Saudi Arabia-based Islamic Development Bank and Kuwait Finance House - each with a 25% stake. Its mandate is to use its $200 million capital base to shore up liquidity in sharia-compliant instruments through short- and medium-term investments in the market.
"Illiquidity here is not your typical illiquidity as in the conventional markets," says Abbas. "If you look at the size of the market vis-a-vis assets, there are around $500 billion of Islamic assets and currently only around $11 billion in sukuk in the Middle East. When you say it is illiquid, normally it means you have stuff you cannot dump or dispose of. But here, it means you want stuff and you cannot locate it."
Building up a secondary market in sukuk has been a key focus of the LMC, says Abbas. Together with a handful of regional banks, it has been offering two-way pricing for 17 sukuk on its website, although the number of players offering quotes has been very low. As an indicator of demand outstripping supply, bids have generally been above or around par, but most of the trades have been relatively small - around $2 million-3 million on average. Still, the LMC executed $78 million of secondary trades in the first seven months of this year - well up on the $60.9 million of trades for the whole of 2005.
To boost liquidity further, the LMC - with the Bahrain Monetary Authority - hopes to issue a sharia-compliant repurchase agreement framework in the coming weeks. The two organisations were still hammering out the final draft of the agreement as Risk went to press, but both parties say they expect the first Islamic repo of a sukuk to take place before the end of the year.
"Under Islamic law, you need more than one counterparty - you need a middleman," says Khalid Bucheeri, chief operating officer at the LMC in Bahrain. "It's taken us more than a year to come up with this."
That's because under sharia, speculation in any kind of security is not allowed - and in effect, agreeing a future repurchase price amounts to speculation. Instead, the LMC will pay the par value of the sukuk to the bearer before transferring it to the repurchase counterparty at an agreed price. The cashflows will then be reversed at the point of repurchase, meaning no speculation or profit-making takes place. Other financial institutions will be able to act as agents, so long as all funds are transferred and securities delivered under the agreement, says Bucheeri.
A robust repo market will enable sukuk holders to free capital on their balance sheets for agreed amounts of time, either to invest elsewhere or gain regulatory capital relief. At the same time, smaller investors will be able to gain exposure - at a price - to the sukuk.
But the Middle East has some way to go before it catches up with Malaysia, where sukuk issuance is much more significant, at $30 billion. Secondary trading there now spans more than 40 names, with an average of around 100 trades a week of up to $50 million each - although the typical deal tends to be around $5 million.
Dealers say the Middle East could learn from the Malaysian sukuk market - in particular, in the use of standardised documentation. "A standardised legal document would aid a secondary market, definitely," says one head of an Islamic syndication desk in London. "If you look at the sukuk market in Malaysia, it is much bigger, much better standardised and, from a religious perspective, much easier than in the Gulf countries."
Malaysia has one regulatory body and a single documentation framework for all new sukuk. Added to that, the tax regime allows corporates to claim back expenses linked to sukuk issuance. By contrast, each new bond in the Gulf region must comply with the issuing country's interpretation of sharia - something that has led to the emergence of 14 different sukuk structures.
"The secondary market at the moment is not as liquid as the normal standard upfront market," says the syndication desk head. "One of the reasons is that sukuk differ very much in structure - some are asset-based, some are based on a profit-sharing agreement, others are based on something else. So it's not a unified kind of instrument that you can hold and compare it with, say, a five-year eurobond."
There have been some efforts by the Gulf states to iron out their differences, but little progress has been made to date. This has hampered the development of secondary market trading, with issuance in individual countries just too small to facilitate secondary market trading on a national level.
The buy-and-hold mentality of many investors has also prevented secondary market trading from emerging. Middle Eastern banks hold the vast majority of sukuk, and soaring oil prices mean the region's financial institutions have more cash than ever. According to Moody's, assets of banks in the United Arab Emirates (UAE) are more than 144% of GDP at $150 billion, while in Bahrain, that ratio climbs to 908% of GDP at $109 billion. Bankers say that means sukuk investors will be less likely to offload their current holdings on to the secondary market - they just don't need the cash.
"Many banks are flush with liquidity and are desperate for assets, so they would rather keep them in their portfolio instead of trading them," says Rami Falah, senior relationship manager at BNP Paribas in Bahrain.
Added to that, many regional banks are limited in what they can invest in, making sharia-compliant bonds an attractive - and permitted - investment. Even those regional banks willing to trade are thwarted by antiquated governance. "These banks have committees that decide to invest in those kinds of bonds and they buy them, put them away, end of story," says Steve McMillan, chief executive officer at broker group GFI in London, which recently set up a sukuk trading desk. "So if you actually want to go and buy a bond from that bank, it has to go back to the committee process and those committees meet once a month."
However, with more international banks and investors entering the market, more of a trading mentality could emerge, says McMillan. "When international investors get involved and the regional banks see what is going on, they are going to have to change how they interact with the market or they'll get left behind," he notes.
Most participants agree that increased issuance is the key to a secondary market taking off, and some issuers are actively trying to build in an element of tradability to the structure. Luma Saqqaf, head of Islamic finance at law firm Linklaters in Dubai, was part of the team that structured a $200 million issue for UAE cooling company Tabreed. Like all sukuk, the bonds are structured as equity investments in a special-purpose vehicle, which in turn holds the assets behind the bond. But the Tabreed sukuk was the first to be listed on the London Stock Exchange. The hope is that listing the issue will result in greater secondary market trading.
"Tabreed went into the international markets with the hope that it would see more trading and it hopes there will be," she says. "Actually, it was oversubscribed and Tabreed didn't want to put out an extra amount because it wanted to encourage a secondary market. Maybe in a year or two, there will be enough sukuk out there for a secondary market."
It may take time, but as more sukuk is issued, secondary market liquidity will inevitably follow, say participants. "It will take off," says the LMC's Abbas. "This is money, and money tends to remove obstacles whether you like it or not. Money is the force, and with enough issuance coming into the game there will be a secondary market."
http://www.risk.net/public/showPage.html?page=438759

Crude oil
Sweet and sour
The Dubai Mercantile Exchange has launched a Middle East-based sour crude oil benchmark, but it has been a long wait, given the importance of oil in the region. Pamela Tang reports
The lack of a sour crude benchmark in the Middle East has left a gaping hole in the futures landscape, one unfilled by established oil prices such as West Texas Intermediate in the US and Brent in Europe. These reflect the value of refined, sweet crude, but provide an imperfect hedge for the Middle East's unrefined, sour crudes.
But consensus in the Middle East is that the time is right for such a benchmark, and the Dubai Mercantile Exchange (DME) - set up this year - will launch an Oman-backed sour crude futures contract in the fourth quarter of 2006, which will be physically delivered (see box).
The exchange is a joint venture between Tatweer - a member of urban development group Dubai Holdings - and the New York Mercantile Exchange (Nymex), thus enjoying the backing of the Dubai government as well as Nymex's clearing infrastructure and global reputation.
Given that most of the world's remaining crude is heavy sour grade, few dispute the potential of a sour crude futures contract in the world's largest hydrocarbon region. But others trying to make similar moves have found themselves mired in a series of obstacles - such as lack of backing, poor credibility in the global trading market and lack of a clearing infrastructure - each one a potential deal-breaker, says a source familiar with the DME.
The market wants a robust and liquid price-discovery mechanism in the Middle East, says DME chief executive Gary King, and his exchange is answering that call. "We were told about a need for a new benchmark to help people manage price risk and have effective price discovery, especially in the forward curve," he says. "So we're providing a futures contract that is liquid and deep and provides price discovery in a regulated and transparent environment."
King believes the sour crude contract will supplement - not steal - liquidity from the other global benchmarks. There will be vigorous arbitrage and trading between the sweet and sour contracts, he says, allowing people to transfer their risk from one to another if their basis risk changes. (Basis risk is the risk that the price one is using to hedge a transaction does not move perfectly with the price one is trying to hedge.)
Middle East crude tends to be priced off Brent, which is sourced from the North Sea, off the UK's east coast, so the new benchmark will offer more accurate pricing. "Imagine there is a cargo of oil in the West priced off Brent and the owner wants to sell it into Asia - he can transfer his pricing into Oman pricing," says King. "You will see this transfer of basis risk as the Oman contract develops, and in five years, we hope to see this contract trading in equal - if not larger - sizes than existing contracts."
DME also plans to issue a jet fuel futures contract in 2007. "The industry says that's the next thing it wants to see, because it will allow refiners and airlines to hedge their risk," says King. "Let's not forget that the Middle East and Asia are some of the fastest-growing transport hubs in the world, so there will be a huge demand for jet contracts."
The evolution of capital markets in energy in the Middle East is a definite leap from the traditional equity markets, considering the sensitivity surrounding energy in the region, says the source. "This is a relatively small deal in the financial sense but one with far-reaching consequences," he adds.
It was on the strength of the partnership with Nymex that the DME convinced Oman to come on board, pulling off a coup where others have failed. The absence of a major oil producer had previously been a stumbling block.
Political sensitivities
Although it was an uphill struggle to transform mindsets in the Middle East, political realities have changed the landscape, says the DME source. "There is tremendous competition in the region to be the first one to get this right," he adds, "and it is obviously an advantage for the producing nation that has its crude become the benchmark rather than someone else's.
"There may be concerns, hesitancy and caution because having capital markets around energy is a relatively new concept in the region and, to a certain degree, some nations may feel this removes their ability to price their own crude oil," says the source. "But, at the same time, that is balanced with the realisation that the world is moving in this direction."
The exchange recognises the sensitivities of creating a new oil benchmark in the Middle East, says DME's King, "because these energy GDPs and sovereign oil revenues are people's bread and butter". The backing of Oman and Dubai are critical, because, without them, this would have been a different story. We created a sea change when it was first announced.
Oman's approval did not come easily. To allay fears and address concerns, a working group of senior professionals from Oman's Ministry of Oil and Gas, Ministry of Finance, Petroleum Development of Oman, Nymex and the DME was set up, and eventually got unanimous support from the steering committee after a few months of discussion.
The partners recognise the mutual benefits. For Nymex, the Middle East represents a relatively untapped pool of new liquidity, and having a first-mover advantage in a part of the world that has not fully embraced derivatives trading essentially raises the barriers of entry to competitors who enter the foray later, says the source.
And the partnership offers Dubai an opportunity to foster its brand, he adds. While Dubai has a strong regional brand in the Middle East and, to a lesser extent, in Europe, it is not so well known in the US. Such partnerships put Dubai on the New York City financial map.
The DME seems confident in its ability to attract liquidity, but is not targeting any group in particular. "We are reaching out to a broad audience of customers," says King. "Although hedge funds are playing a large part in the market right now, they will be treated like any customer we will be courting to bring liquidity to the marketplace."
However, this may not be the best approach, says the source, since hedge funds are prepared to trade and provide liquidity. "Nobody wants to trade on an illiquid exchange," he says. "It is a risky place to be for liquidity providers, and you have to motivate them to take that risk. You have to get the contract volumes up and attract different types of participants.
"There is a very small chance of success if the speculators do not participate, and I don't see this working out if the DME intends to run entirely on hedgers," says the source. "It is a very risky proposition if they are thinking that hedge funds will just show up anyway."
GETTING PHYSICAL
The Dubai Mercantile Exchange (DME) sour crude contract details were recently finalised and announced. The contract size will be 1,000 barrels, settled daily at the close of the Singapore trading day. The minimum position size for physical delivery will be 200,000 barrels, delivered from Mina al Fahal crude oil storage and loading facilities in Oman.
Physical delivery is an important factor for success, because it encourages market participation in the nascent stage of the contract. "Physical deliverability is the preferred method of trading energy, especially when launching contracts in new areas of the world that have not fully embraced derivatives," says a source close to the DME.
"It may not be critical for the average hedge fund, for example, though managers do like the underpinning of the market to be tangible," he adds. "Physical deliverability creates a certain comfort level, with the knowledge that arbitrage principles will ensure the future price equals the spot price on the delivery date."

Structured products
Building protection
A drop in Middle Eastern stock markets this year has caused some investors to pull their cash out of those markets, but demand for sharia-compliant principal-protected products has remained strong. John Ferry reports
Middle Eastern investors have shown greater interest in sharia-compliant structured products over the past two years. With energy prices soaring, real estate prices rising and local stock markets hitting record highs, cash-rich Islamic investors have been keen to place their funds in alternative investments that comply with sharia. Even the correction in local stock markets this year has done little to stem the tide, with investors turning more towards principal-protected products. "Islamic finance is the buzzword at the moment," says Mohamed Sammakia, London-based president of UBS's Middle East division. "There is huge demand for Islamic products."
Sharia-compliant investments are often based on established techniques in conventional markets, tweaked to conform with Islamic law. So, basic equity-linked principal-protected products are common, using a murabaha deposit to provide the guarantee and an arboun contract as a proxy for the option component.
A murabaha contract allows the investor to pay for an asset that the bank sells at a certain price on a deferred date. The investor then receives the assets at maturity, which are worth the same as the amount originally invested. An arboun contract lets the investor buy an asset at a fixed price at any point up to the contract's maturity - therefore resembling an options contract.
Constant proportion portfolio insurance (CPPI) products have also been popular. In a sharia context, the principal protection is achieved through investment in a murabaha contract, while the risky assets are usually Islamic stocks or funds. If the stock market heads upwards, a greater proportion of the fund's assets would be invested in the sharia-compliant equities; if the market falls, more of the assets would be invested in murabaha contracts, with the aim of ensuring that, at a minimum, the amount invested in the risk-free asset is sufficient to meet the principal amount promised at maturity.
However, some dealers point out that CPPI techniques are not really appropriate for highly volatile underlyings such as emerging market stocks. In volatile markets, the underlying equities are more likely to drop violently, leading to more of the fund's assets being invested in murabaha contracts. If the portfolio value hits the floor - the minimum level required to provide the guarantee - the investor would effectively be left holding a zero-coupon bond for the remainder of the product's life.
"A CPPI structure might not be the best to use in an emerging market," says Michael Gassner, an independent structured products consultant currently working in Jeddah. He adds that a number of CPPI products have not performed well this year because of the sharp drop in some Middle Eastern stock markets.
Recently, however, other innovations have started to emerge. Societe Generale Corporate and Investment Banking (SG CIB), for instance, is currently working on a product that will give investors exposure to a number of sharia-compliant Middle Eastern and North African stocks and funds, but will combine this with a volatility control mechanism. "In terms of structuring, it's similar to what we've done on the conventional side in the past," says Marc El Asmar, London-based head of sales for eastern Europe, the Middle East and Africa at SG CIB. "Nevertheless, given the fact that these would be Middle Eastern or North African underlyings with high volatility, this made it a difficult solution to address. But we have worked on a solution and we're about to come to the market with a product."
The volatility mechanism works by reallocating a certain proportion of the assets into sharia-compliant money-market-equivalent products if volatility increases. If market volatility drops back, the assets are reallocated again in favour of equities and funds. While the product does not offer a 100% capital guarantee, it should provide 90-95% principal protection (see box).
"It's very different in spirit, in implementation and in mechanism, to CPPI," explains Anthony Chamie, SG CIB's head of sales for the Middle East and Africa. "Basically, the constraint of CPPI is (that the product has)to guarantee capital, so it's a very constraining structure, and one that would probably push down exposure over time. Here, you're only investing in a mechanism that will control risk and volatility. It's a fully reversible mechanism that will allow you to go back to a specific exposure if volatility goes down."
In other words, while a CPPI investor could be locked into a zero-coupon bond investment during a sharp tumble in the equity markets - an unavoidable consequence of the CPPI formula, designed to ensure the investor receives 100% of principal at maturity - the volatility mechanism would allow the manager to increase exposure to the risky asset once the market environment improves.
Even the enhanced CPPI structures that have emerged over the past two years that offer investors a limited amount of rebalancing should markets recover, or set a limit on how much the product can de-leverage overall, would not be as optimal as the dynamic volatility mechanism, says Chamie. "Our product still has its full potential in terms of exposure when markets go down, whereas a CPPI that has lost most of its exposure will never get back to its initial level," he explains. "We've tried to find a structure that is adapted to a specific volatile market, rather than just applying what we did before as a CPPI, which we didn't feel was a good solution."
Regardless of the structure - murabaha and arboun, sharia-compliant CPPI or the new dynamic volatility mechanism - the correction in local stock markets this year has increased interest in principal-protected products among Middle Eastern investors. Saudi Arabia's Tadawul All-Share Index fell by 43.34% between April 8 and May 11, while the Dubai Financial Market Index dropped by 46.46% between April 5 and July 29. "Anything principal-protected is now more than welcomed by investors," says UBS' Sammakia.

Historical bias
Islamic investors have historically had a bias towards shorter-maturity securitised products. However, this is now starting to change, giving banks more scope to structure a wider variety of principal-protected products. "If you look over the past five years, there's either been a concentration at the very front end of the curve, up to 12 months, or you've had the medium- to longer-term seven- to 10-year products - either Islamic sukuk or Islamic real estate funds, or leasing and real estate products, which are all pretty illiquid," says Sammakia.
More products in the three- to four-year maturity range are now starting to emerge. In fact, UBS is currently working on a commodity-linked basket product that will give investors the ability to choose both the underlying and the maturity. Under sharia, investments in precious metals are prohibited, but base metals, oil and other commodities are allowed. "The note will be principal-protected and the investor can choose which index to link it to - whether it be copper, oil, zinc, and so on. Investors are also welcoming this because it caters for any type of maturity they may need, from one year up to 10 years," says Sammakia. The bank was awaiting authorisation from its sharia board at time of press.
However, one problem with Islamic banking products is the cost required to put them together. Legal costs can be high, and the product also needs to be approved by a sharia board comprising Islamic scholars - which also adds to the overheads. Shaun Wainstein, head of equity derivatives in London at BNP Paribas, says his bank is making an effort to offer smaller deals to a wider variety of Islamic clients in an effort to bring these costs down - the idea is to standardise the product, therefore spreading the cost of issuance. "We are trying to minimise issue-related costs to offer a more efficient, streamlined investment product," he says.
As with any market, attempts to standardise products, pricing or structuring techniques will increase liquidity, creating a virtuous circle of issuance and innovation. But another potential problem is whether investors in the region can keep up with the pace of innovation. "Demand for products has been increasing over the past 18 months, but that doesn't mean we are seeing more transactions," says SG CIB's Chamie. "The region is not yet fully ready in terms of understanding the products or in terms of regulation, so we are not seeing a rise in trades to match the rise in requests for trades."
Rather than focusing on products and how to make them sharia-compliant, issuers may have to put more effort into teaching the region's investors the ins and outs of structured note investment - for instance, how principal protection works and how leverage is used by structured product providers. These are the types of issues investors need to relate to, and they are the types of questions product providers need to make sure they answer.


THE VOLATILITY MECHANISM
The volatility control mechanism applied to Societe Generale Corporate and Investment Banking's (SG CIB) latest sharia-compliant product, which gives investors exposure to a range of Middle Eastern and North African equities and funds, has been used in conjunction with conventional investments for some time.
The usual way to add an element of safety to a structured product is to offer principal protection. With the volatility mechanism, however, rather than guaranteeing the initial investment, the structurer instead guarantees that the volatility of the underlying exposure will be capped at a certain level. To achieve this, the manager reduces exposure to the underlying stocks and funds if volatility spikes and invests the liquidated cash in sharia-compliant risk-free instruments.
The mechanism relies on the assumption that spikes in volatility are usually associated with declining asset prices. "There is a clear trend where you see volatility being low in a stable and growing emerging market, and you see very high volatility during periods of draw-downs," says Marc El Asmar, head of sales for eastern Europe, the Middle East and Africa at SG CIB.
Rather like constant proportion portfolio insurance (CPPI) products, it relies on leveraging and de-leveraging exposure to risky assets. However, CPPI is designed to guarantee the investor's principal. With this product, the only guarantee is that the volatility of the underlying portfolio will not exceed a certain level.
In this case, the volatility is capped at between 25% and 30%, with volatility measured as either the one-month or three-month annualised standard deviation. El Asmar says historical analysis shows that volatility for the underlying should generally be 15-25%, although the sell-off in emerging market equities earlier this year saw volatility spike at between 45% and 60%. "Today, you might have a market that is growing well with, say, 25% volatility, and it should continue to grow up to maybe 35% volatility. But above that, the probability of the market crashing is very high," says El Asmar.
By capping the volatility below this level, the probability of the investor making a loss on his or her initial investment is reduced. The mechanism therefore provides implicit, but not guaranteed, capital protection. The product should implicitly offer around 90-95% principal protection, adds Anthony Chamie, SG CIB's head of sales for the Middle East and Africa.

Profile
Widening the net
Consultancy firm Yasaar advises financial institutions on the development of sharia-compliant structured products. The company has recently opened an office in Dubai and is working with structurers to introduce sharia-compliant investments to the mass retail market
Malaysia is going head to head with Dubai in the Islamic finance market. But other financial centres, namely Bahrain, Singapore and London, are also joining the race to become the next hub for Islamic finance.
Yusuf DeLorenzo, Washington, DC-based director of Yasaar, a sharia compliance financial advisory company incorporated in the UK, believes that all financial centres will benefit from some form of sharia presence. It is only a matter of time before banks, asset managers and financial service providers worldwide introduce sharia-compliant versions of their existing products, he says.
"Conventional banks in the Arabian Gulf expect to lose between 25% and 40% of their clients to Islamic banks during the next five years," DeLorenzo says. "If institutions within the region are facing this kind of challenge, what about conventional asset managers in the US or UK?"
Established institutions such as Royal Bank of Scotland, Bank of Ireland, Societe Generale Corporate and Investment Bank, Barclays Global Securities and Prudential Asset Management have all turned to Yasaar for advice on sharia compliance, as have index companies and exchanges. "We worked with FTSE Group and the Singapore Stock Exchange to launch the FTSE/SGX Sharia Index Series in March this year," DeLorenzo says.
The FTSE SGX Sharia Index Series is designed to reflect the share performance of companies in Asia-Pacific markets whose business activities are conducted in accordance with sharia principles. The first index in the series is the FTSE SGX Asia Sharia 100 Index, which consists of a combination of 50 of the largest Japanese companies and the 50 largest companies from Singapore, Taiwan, Korea and Hong Kong.
To tap the growing demand for sharia-compliant products in the Middle East, Yasaar last month became the first sharia compliance financial advisory company to open an office in the Dubai International Finance Centre, which aims to rival the major global financial hub. Yasaar also operates in London and works with sharia scholars in the US, Bahrain and Malaysia.
All sharia-compliant products have to be certified by a recognised scholar via a fatwa. There are relatively few sharia scholars who provide financial institutions with advice on sharia-compliant structures, DeLorenzo says. But the lack of scholars has not hampered the development of sharia-compliant products or services, he adds.
Mass retail appeal
Although sharia-compliant structured products remain the preserve of high-net-worth individuals, increasing numbers are sold to the retail market. A number of domestic and foreign banks in Malaysia and the Gulf have already distributed sharia-compliant structured products to the mass retail networks. And more product providers are looking to tap this market. For example, Yasaar has advised Societe Generale Asset Management (SGAM) on a three-year principal-protected certificate launched in June and linked to a basket of 30 stocks selected from the Dow Jones Islamic Market Index.
Vincent Lauwick, SGAM UK's London-based sales director of structured products, says the certificate, called AlBaraka, is SGAM's first sharia-compliant investment aimed at the mass retail market. He declined to reveal which institutions are distributing the product, but says the certificate is targeted at the Gulf and Swiss markets. "We are still monitoring the response," he says. "It is too early to say whether we will be launching another one."
Hedge funds
Other banks in the Middle East have been distributing different types of structured products. Hedge funds are proving popular at the retail level as an underlying, and domestic banks such as the Commercial Bank of Qatar, Ahli United Bank, Emirates Bank and National Bank of Bahrain have all sold hedge-funds-linked products to retail investors.
Kamlesh Bhatia, director of relationship management at Man Investments in Dubai, says investor appetite for hedge-fund-linked products has grown steadily since 1996. The company has already launched sharia-compliant fund products, including Man-IP 220, a capital guarantee structure that has been sold by banks such as Ahli United Bank in Bahrain.
The structure offers enhanced exposure of up to 160% of assets to a portfolio comprising the AHL Diversified Programme, one of Man Investments' primary managed futures programmes, and the Glenwood Portfolio, a diversified fund of hedge funds portfolio. Man-IP 220 is offered in both dollar- and euro-denominated classes.
However, opinions are divided over the feasibility of manufacturing a sharia-compliant version of products such as these. "The reservations are based on the sharia prohibition against selling what is not known for certain, and what one does not own. Since short selling is the distinguishing feature of most hedge funds, it is predicated upon someone borrowing securities and then selling the same into the market," says Yasaar's DeLorenzo. "It is clear that hedge funds that employ short selling will not comply with sharia norms."
One solution suggested by DeLorenzo is to set up sharia-compliant hedge funds. Yasaar has developed a sharia-compliant short-selling mechanism that does not employ the short-selling techniques used by conventional hedge fund managers. "The sharia-compliant method replicates the economics, or the economic effects, of short selling," he says, declining to elaborate.
DeLorenzo has been working on two hedge fund products - Sharia Capital, set up in Connecticut, and Algo Capital, established in London. "These funds are designed to be funds of hedge funds, so the underlying managers agree to maintain separate managed accounts and submit to specialised sharia screening of the securities they trade," he says. In addition, the managers have agreed to work with a single prime brokerage whose documentation has been legally amended to accommodate the special arrangement required for sharia compliance.
When it comes to issuing sharia-compliant hedge-fund-linked products to the retail market, principal protection is key. However, there is scepticism in the Middle East about 100% guarantees in Islamic finance. This is because Islamic law encourages taking business risks in return for rewards.
"Protection of capital may be accomplished by different means. But most aim at protecting between 85% and 95% of the invested capital," DeLorenzo says. For example, a principal-protection programme has been developed specifically for Sharia Capital, which employs a market-neutral hedge fund strategy, and a wrapper is provided by Barclays in New York. The product is likely to be introduced to the market in early 2007, according to DeLorenzo.
Although both hedge funds have yet to be launched, DeLorenzo is confident they will grab the attention of Islamic investors once they understand the variety of investment styles. "I expect to work on many more hedge funds in the future as Islamic investors become aware of the benefits of investing in these products," he says.
The rewards
The Islamic finance market has always presented a challenge to many financial institutions. DeLorenzo believes there is considerable room for the market to expand, and no product or service provider is dominating the arena at present. "The exciting thing about modern Islamic finance is the rush to innovate with better and more efficient products that perform like conventional products while complying with sharia norms," he says.
Islamic finance is now beginning to prove its viability and profitability in nearly every financial field: property, private equity, asset management and alternative investments. "This was not the case 10 years ago," DeLorenzo says. "In fact, it was widely assumed that there were limitations in Islamic finance. There were things that Islamic finance would not be able to achieve while complying with sharia norms."
The important thing is that Islamic finance needs to offer a wide range of financial products and services to satisfy the particular requirements of Islamic investors, he says: Those with the vision and courage to enter this arena are discovering that there are ample rewards for their ideas and hard work."
Amanda Lee

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