Sharia-compliant investing and structured products are two of the largest and highest margin growth areas for investment banks. Both are born out of specialist structuring teams, rich with fiscal and regulatory experts, so it is almost inevitable that compliant structured products are fast becoming voguish. Natasha de Terán explores the market.
Hussain Hussan, a director in the structuring team at Deutsche Bank in Dubai, estimates that about $6bn- $7bn-worth of sharia-compliant structured products have been issued to date. That is a minuscule amount compared with the amount of conventional structured products that have so far been issued, or even when considering that the Islamic investment market is estimated to be worth more than $400bn, but the sector is growing exponentially.
Almost all the major conventional banks are interested and involved in developing this segment of the market alongside their wider Islamic finance offerings – and Mr Hussan reckons that related revenues are expected to grow at 18%-20% until 2010.
Banks and distributors have been gearing up to offer products to investors in Western markets, as well as in the traditional Islamic regions. But of the geographical areas that are likely to grow the fastest, Mr Hussan says: “The Malaysian and Far East markets tend to be more sophisticated because the infrastructure is more developed there and because some of the sharia interpretations there are quite liberal. But the Middle East region is catching up and developing enormously fast and will probably become the most important market for sharia-structured products very soon.”
Fast-paced innovation
The concentration of interest in developing investment and financing instruments for Islamic investors has resulted in a wealth of recent issuance and innovations. Aside from a surge in sukuk (Islamic bond) issues, there have been sharia-compliant hedge funds debuts, and sharia-compliant prime brokerage and managed account units have sprung up.
The attention that expert investment banking structurers have lent the nascent Islamic structured product market has also resulted in a wealth of recent innovations. Mr Hussan says that in the past 12 months, sharia structuring techniques have become much more sophisticated. “These innovations have opened up new asset classes and pay-offs, which, in turn, have resulted in a notable jump in issuance.”
Shaun Wainstein, head of London equities and derivatives at BNP Paribas, says: “There is a massive amount of potential for this market. So far we have mainly been working on equity-linked structured baskets, in which the stocks are specifically selected to be sharia-compliant. But we have also looked at developing some similar commodity-based products and we have also done a lot of work on sharia wrappers, which allow for a lot more flexibility in product development.”
Innovative products
Among the recent innovations are one from UBS and several from Deutsche Bank. Last September, UBS launched a sharia-compliant, commodity-linked structured product – an investment certificate aimed at the bank’s wealth management clients. The principal- protected, two-year certificate offers investors a fixed minimum redemption of the invested principal, with a maximum redemption amount capped at 150%. The amount of redemption on the certificate is determined by the performance of an equally weighted basket consisting of oil, copper and nickel. The product was developed by the bank’s wealth management team in tandem with its global Islamic finance unit.
Mr Hussan claims Deutsche Bank has scored several firsts in the past six months, offering new forms of sharia-compliant exposures to hedge funds and collateralised debt obligations (CDOs), as well as to hybrid exposures of all kinds. The hedge fund product is particularly noteworthy, he says. “The market had been trying to come up with a method of offering sharia-compliant hedge fund investments for a long time. The innovation we introduced gave exposure to conventional hedge funds in a sharia-compliant way.”
Different structure
Deutsche Bank’s investment structure is essentially the sharia equivalent of a total return swap (TRS) that gives exposure to a hedge fund’s performance. A conventional TRS is non-sharia compliant whereas Deutsche’s technique, which has the same economic result as a TRS, is structured differently. Rather than being based on a typical swap agreement, it is based on the Islamic system of wa’d (promises).
It works as follows: the bank arranges for the client to invest in liquid sharia-compliant assets (equity shares, for example) and swaps away the return of these assets in exchange for another return (for example, one linked to a hedge fund’s performance). Because the client’s investment is sharia compliant (because they only invest in sharia-compliant assets) and the swap transaction is also conducted in a sharia-compliant method, the bank has found a sharia-compliant method of making traditional hedge fund exposures and derivatives pay-offs available to the market without needing to redesign the underlying. This contrasts with others’ efforts to establish sharia-compliant hedge funds from scratch.
Mr Hussan says: “Our experience was that only a very few investors need to have sharia-compliant structures put around sharia-compliant investments – for the majority of them sharia wrappers around conventional investments can be sufficient.”
The new mass market
Mr Hussan believes that banks now have most of the tools necessary to roll out the full spectrum of traditional structured products to Islamic investors, and thinks it is unlikely that there will be much more in the way of innovation. “Instead, the products and processes we have already developed will be refined, and greater efficiencies and standardisation will be introduced to the market,” he says.
Geert Bossuyt, managing director, regional head of Middle East structuring at Deutsche Bank, agrees. “The market may already be at a turning point with innovation: structuring techniques are now sufficiently developed that they can be applied to develop almost any sort of product. We will see existing products being more widely applied and sold and far less conceptual innovation occurring,” he says.
The International Swaps and Derivatives Association, the body behind the $385,000bn over-the-counter derivatives market, is not ignoring these developments. It is working fast to develop documentation that can underpin the derivatives contracts that are widely used to construct sharia structured products.
Developments like this, the growing familiarity of Western bankers with sharia principles and the expected greater standardisation of what should be accepted as being sharia-compliant should all help to spur the market’s growth. Mr Hussan says that systems, staff and infrastructure will all have to be expanded and improved to facilitate more mechanical, industrial-size issuance of these products, but he says there are already widespread moves under way to allow for this. If he is correct, the future for sharia structured products could hardly be brighter.
