As global market volatility reaches extreme levels and most asset classes suffer heavy losses, bankers are engaged in the arduous work of finding sharia-compliant ways to offer companies and investors some protection. Writer Philip Alexander.
The period since the Malaysian government sold the first modern international sukuk (Islamic bond), in 2002, characterised by the rapid growth and rising sophistication of global Islamic finance, coincided with strong financial market performance worldwide. The shocks that have swept through the global financial system in 2007 and 2008 are, therefore, the first real test of whether Islamic finance can withstand a bear market and maintain its appeal to investors.
A central challenge for bankers in the field is that many of the conventional tools to achieve absolute return – such as swaps, options and short-selling – use techniques that contravene basic principles of sharia law. Interest (riba) is forbidden, which rules out conventional foreign exchange (FX) forwards, or paying repo to borrow stock for shorting.
It is not permitted for investors to sell something they do not own, placing a further obstacle to the short-selling of borrowed assets. Contracts should avoid uncertainty in outcomes (gharar), which raises questions over regular put and call options. And investors are required to share risk (sharik), so that seeking to generate returns while eliminating risk could be contrary to sharia.
However, Islamic scholars acknowledge the need for companies and long-term investors to manage their risks prudently, and are increasingly sympathetic to products that fulfil this purpose while adhering to sharia technically. “The essence is the need to share risks in any investment, and protection is possible in this context,” says Jacques Tripon, head of Islamic banking at BNP Paribas. “It is understood that an investor could not take credit exposure and FX risk on, for example, a project finance deal of 10 or 15 years, without any means of asset and liability management.”
Islamic structures cannot contain conventional interest rates so the basic building block, the murabaha, is a commodity sale transaction in which the commodities are paid for in advance at a fixed price plus an agreed profit rate – usually referenced to the London interbank offered rate (Libor). There is a general consensus among sharia scholars that using Libor as a benchmark is acceptable, as long as the investor derives no earnings directly from the interest rate itself.
Sulaiman Moolla, head of Islamic treasury sales at HSBC Amanah in Dubai, says: “We use murabaha trades in a similar way that zero-coupon bonds are used to build conventional structured products. In a volatile market, capital-protected products have become more expensive, and that affects the pricing available for other Islamic derivatives.”
Under the principle of maisir, any speculative trading akin to gambling would also struggle to receive scholarly approval. This has become an advantage in the current climate because it limits the potential for companies to take unnecessary derivatives positions that could result in heavy losses if the trade goes against them. The board of Kuwait’s Gulf Bank was forced to resign last October, after the bank was unable to pay margin on about $1.4bn in out-of-the-money FX derivatives trades.
“Sharia principles have a natural tendency to protect companies from taking excessive risks. If you have E100m in export receivables, then that is what you hedge in the market. In Islamic finance, over and above conventional finance, there has to be a real need for that hedge, otherwise it can be seen as putting on a speculative position, which is not within the realms of sharia,” says Mr Moolla.
At the leading edge of the market, bankers and lawyers are also developing Islamic equivalents to credit default swaps (CDS). “The most obvious way is an insurance-style product that will only pay out if the investors have suffered an actual loss, with a capped indemnity to remove the uncertainty that is not sharia-compliant. The other angle is protecting exposure on a sukuk. This has to be different from a conventional CDS because a sukuk is not a deliverable obligation like a conventional bond,” says Richard Tredgett, partner at law firm Allen & Overy in London.
Structural challenges
There are also three main mechanisms now in use to replicate conventional short-selling or call and put options. The first is the wa’ad, favoured by Dr Humayon Dar, chief executive of BMB Islamic in London, and his former employers at Deutsche Bank. One or both counterparties (the double wa’ad) can promise to deliver a given asset to each other at a set price if the other party exercises the option, but without entering into a binding contract that would include the uncertainty forbidden by sharia.
The second is the salam, based on an ancient financing structure that allowed merchants to buy crops at a fixed price before the harvest, to provide farmers with the advance funds for seeds. This technique is used by Newedge, the brokerage jointly owned by Calyon and Société Générale, in its sharia prime brokerage platform.
The third is the arbun, where the investor makes a deposit with the grantor of the asset to act as a downpayment for the purchase at a fixed price at a later date. The investor forfeits the deposit if the purchase option is not exercised on the delivery date. This structure was originally used for making advance payments on real estate that was still under construction. Shaikh Yusuf Talal DeLorenzo, chief sharia officer at Islamic investment boutique Sharia Capital in the US, is a leading advocate of this approach to creating financial market options.
None of these three structures is trouble-free or has universal acceptance among sharia scholars for every type of transaction. The 20 members of the sharia board of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) – created in 1990 to provide an international governance body for the industry – have not reached consensus on all aspects of Islamic derivatives. AAOIFI does not rule on individual products, but provides general guidance papers on each asset class.
Debate continues
There is debate over whether the wa’ad, as a promissory arrangement, is legally enforceable. And while its use in hedging, for instance as a cross-currency swap, is generally tolerated, scholars have given a much cooler reception to double wa’ad mechanisms that allow total return swaps on equities, sometimes including companies engaged in forbidden (haraam) activities such as sales of alcohol or pork products.
Shaikh Muddassir Siddiqui, head of Islamic finance at law firm Denton Wilde Sapte and a member of the AAOIFI sharia board, says: “The technicalities of a product can make a difference, but it must also keep to the spirit of sharia, which is very focused on the objective of a transaction. You cannot break the law and say you are right technically.”
Given its agricultural origins, the salam can be readily adapted to other commodities, but AAOIFI guidance has questioned its use for shorting equities. “In agriculture, salam was allowed because it served a purpose that was useful to the investor and the recipient. Now people are buying shares not hoping that the business will prosper, but that the price will go down – they are praying for someone else’s misery, which does not have the same objective as the structures allowed under sharia,” says Mr Siddiqui.
The arbun has achieved the widest acceptance in the Gulf states and Malaysia but Mr Siddiqui notes some individual transactions have moved beyond the AAOIFI guidelines. Moreover, there is legal ambiguity in the structure of an arbun.
“There is no legal or market convention on the size of the investor’s initial downpayment deposit, so there is room for disagreement between the investor and the grantor,” says Priya Uberoi, a senior associate at Allen & Overy in London.
Ms Uberoi is closely watching the outcome of a joint initiative between the International Swaps and Derivatives Association (ISDA) and the International Islamic Financial Market (IIFM) to develop master agreements for Islamic derivatives, with a first draft due for publication in April 2009. If widely adopted, such documentation could generate greater uniformity in the market and lower the product costs for investors.
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However, Dr Hussein Hassan, head of Islamic finance at Deutsche Bank in Dubai, cautions against expecting too much from the ISDA-IIFM initiative. “The inherent problem from a sharia scholar’s perspective is that you cannot necessarily link different conditions together. Each new element has to be reviewed to check that the whole product complies. This case-by-case approach is difficult to marry with the concept of master documentation,” says Mr Hassan, a Kenyan who returned to his family roots in Yemen to undertake sharia studies before entering banking. |
Alternative products
With such difficulties in building corporate hedging techniques, the process of developing absolute return products for investors is more complex, given the Islamic disapproval of excessively speculative activity.
Nonetheless, a growing number of providers have built alternative investment platforms that allow sharia-compliant investors to harness total return products equivalent to hedge funds. This approach could find favour with investors in a sustained market downturn. “It is always difficult to sell a hedge fund when a long-only position in the stock market is returning 40% a year, but that has changed now,” says Philippe Teilhard de Chardin, global head of prime brokerage at Newedge. The group launched its sharia prime brokerage service in October 2005, and has three live managers. The Amiri Equity Alternative Strategies fund-of-funds, with seed capital from private equity firm Olivant, will bring in a further four funds in 2009.
Trading began on the Al-Safi Trust, a joint venture between Sharia Capital and Barclays Capital listed on the Dubai Multi-Commodities Centre (DMCC) in January, with a sizable $200m seed investment from DMCC. Deutsche Bank launched Al-Miyar, an open architecture platform for listing Islamic certificates, in the same month. BMB Group, the parent of BMB Islamic, aims to launch a new alternatives product entitled Share (Sharia Alternative Return Evolution) in the second quarter of 2009.
Although the natural conservatism of Islamic products has added appeal in current market conditions, the Madoff fund fraud has inevitably undermined investor confidence in hedge funds as an asset class. “We thought of including a number of hedge funds on the Share platform but now we have changed our composition to managed futures programmes that have performed well,” says Mr Dar at BMB Islamic, who still hopes to roll out the platform on schedule.
Even so, there is agreement that the questions raised about highly leveraged banking and investment models will ultimately draw business towards sharia-compliant products, especially given their emphasis on commodities exposure.
“DMCC is a longer-term investor committed both to Islamic finance and to building a commodity-backed asset management business,” says Ahmed Bin Sulayem, executive chairman of DMCC. “Irrespective of prevailing market conditions, we believe in the managers we have selected and the funds that have been built around them. Consequently, we’re confident in their ability to generate positive returns in both rising and declining markets.”
“The timing is excellent,” says Dan Rice, portfolio manager of the BlackRock Global Resources and Mining, which joined Al-Safi in November – one of four funds listed on the platform.
“The darkest hour is always before the dawn. There is not so much visibility on the outlook at the moment, but markets will begin to discount renewed economic growth, which will lift the resources sector,” he says.
This assessment is shared by Mr Hassan at Deutsche Bank, who is preparing to list the first certificate on Al-Miyar. “This is likely to be a simple, safe, commodity-linked product, as investors look to lock in at current low commodity prices,” he says. “Now we have put the time and resources into building the infrastructure, we will focus on the distribution to potential issuers on the platform, and to investors.”
How to win investors
In contrast, Eric Meyer, chief executive of Sharia Capital, believes the distribution process needs to be built into the design, because of the challenges posed by the nature of the Islamic finance market. As scholars debate whether any of the available shorting and options mechanisms are strictly sharia-compliant, some investment products failed to gain traction among investors. UBS folded its Islamic investment products subsidiary Noriba back into the rest of the bank in 2006, just four years after its creation, and three fund managers have exited the Newedge platform since its inception.
Against this backdrop, Oracle Investment Management puts the total Islamic alternatives market at just $5bn, and some market participants believe this estimate is generous. This means the market is tiny compared with the $2000bn conventional hedge fund universe, or even the $70bn in outstanding sukuk issuance.
The reputation of scholars supporting a fund – often a three-member sharia board – is vital to winning over the Islamic investing public. The Jeddah-based Organization of the Islamic Conference Fiqh Council, a religious body that carries de facto legal authority, has approved the use of the arbun mechanism for securities trading used by the Al-Safi Trust.
The sharia board behind Al-Miyar is much larger than Deutsche Bank’s usual oversight, and includes five scholars with which the bank has had no previous contact. Mr Hassan hopes to expand the Al-Miyar board from 12 to 15 scholars, and to include more scholars from Saudi Arabia, who tend to take some of the strictest interpretations of sharia in Islamic finance.
Moreover, given the fragmented nature of the Islamic finance market, Mr Meyer emphasises the importance of establishing clear support from the financial authorities in leading Islamic finance jurisdictions. In addition to the DMCC investment in Al-Safi, Barclays can bring to the table its own major shareholders in Qatar and Abu Dhabi.
Deutsche Bank is in talks with the Bahraini and Malaysian central banks to replicate country-specific versions of Al-Miyar, especially to improve the range and liquidity of short-term investment products for Islamic investors in those countries.
Good governance
However, Mr Meyer also believes that the Islamic alternatives market as a whole has suffered from a lack of transparency among some participants. He is committed to making Al-Safi a good governance benchmark, asking: “Why should Islamic investors have to settle for lower standards of transparency, disclosure or reporting than everyone else?” In February, Al-Safi became the first Islamic alternative investment fund to publish its returns, available through ThomsonReuters dealing screens, and Mr Meyer is keen that investors should compare its performance to conventional as well as other Islamic hedge fund products. US law firm Skadden Arps carried out rigorous due diligence on Al-Safi, and custodial services are provided by Citco, one of the world’s largest fiduciary institutions.
Mr Suleyman emphasises that this combination was one of Al-Safi’s features that appealed to the DMCC. “There was a level of transparency and risk management we had not seen in another platform,” he says.
In the case of Deutsche Bank’s Al-Miyar, Allen & Overy built a structure that would allow listing in the UK and Luxembourg. “These products need to be robust enough to stand up under English and Luxembourg law principles. Then on top of that, sharia is an additional layer of compliance that you need to build into the structure so that Islamic investors are comfortable that you have abided by its core tenets,” says Allen & Overy’s Ms Uberoi.
The cost of compliance
This preparation is inevitably expensive. Mr Meyer says the set-up costs for Al-Safi, which he estimates at $10m, far exceeded his initial expectations. From an investor perspective, this can also translate into a lower-end return because product fees are high. “We want the tracking error between sharia funds and conventional funds to be kept to a minimum, so we have compressed those costs as much as possible,” says Mr Teilhard at Newedge. This affects profitability but it is a price worth paying to gain a foothold in the market.
Mr Hassan says the high set-up costs for Islamic fund products are precisely what should draw business to Al-Miyar, due to its open architecture approach. Several international investment banks are already expressing interest in listing their products on the platform. “It is a win-win situation, we will be able to offer a broad range, and for the other banks, they save on the money we have spent to develop technology that incorporates the latest sharia thinking,” he says.
As the market develops and Islamic products become more standardised, fees should begin to converge with conventional markets, although the frictional costs will remain higher due to the structural complexity necessary to be sharia compliant. There are already specialist Islamic finance investment consultancies such as Ratings Intelligence in the UK or US-based Failaka Advisors. For Mr Teilhard, the appropriate next step is for the leading global investment consultancies, such as Mercer, to begin assessing sharia-compliant asset managers alongside their non-sharia peers.
