An increasing number of financial institutions from international banks to local specialist players are developing sharia-compliant structured products, offering investors limited downside risk and high returns. But as the uptake for such products increases, so does the pressure of ensuring that they are 100% sharia-friendly.

For many retail investors, conventional structured products are already complicated enough. Therefore, the prospect of re-engineering them so that they comply with Islamic financial principles may seem to be adding an unnecessary layer of complexity. Yet, for the growing band of sharia-compliant structured investment providers, the attraction of these Islamic variants lies in their simplicity compared with conventional market-linked investments. Whereas conventional structured products have a reputation in the wider industry for complexity, sharia-compliant variants have the advantage of being more straightforward, say advocates.

“Islamic structured products are pretty transparent in the pay-off and sharia, by its nature, requires you to be transparent and clear so the structures also tend to be simpler,” says Jennifer Yong, head of structuring at Malaysia's CIMB Investment Bank. "What makes conventional structured products complex is when the pay-off is too exotic, or there is leverage in it. The fact that with sharia variants there can be no leverage makes it simpler.”

CIMB’s Islamic All-Stars Global structured product is the first Islamic equity-linked Malaysian ringgit-denominated structured product in Malaysia, and is explicitly developed to provide investors the assurance of capital protection together with the potential for high returns linked to 20 global multinationals.

Growing savvy

Appetite for Islamic structured products may not be as strong as for conventional products, but the growing savvy of the average Islamic investor has triggered greater awareness of the value that such products can provide as both risk mitigation tools and as a way of bolstering yield enhancement. International banks have deployed their franchise skills to increasingly strong effect in widening the product suite available to Muslim investors.

BNP Paribas’ Bahrain-based Islamic banking unit Najmah has develped a range of equity-linked derivative equivalents aimed at both institutional investors and high-net-worth retail investors in accordance with sharia principles.

Meanwhile, HSBC offers Islamic structured investment products that can cater for the requirement of smoothing out fluctuations in profit rates. This allows better planning and scheduling of expenses related to profit rates, and enables investors to lock-in future exchange rates for foreign currency purchase requirements. Profit rate swaps and cross-currency swaps are built using murabaha – cost-plus financing – commodity financing and investment structures.

The steadily widening array of sharia-compliant structured products delivered both through international banks and local channels has triggered a healthy debate about the validity of such products. Although sharia principles may run counter to many traditional option pay-outs – with the payments of interest and use of speculation regarded as 'haram' (forbidden according to Islamic norms) – banks have devised a series of coupon-paying structures that are broadly consistent with sharia principles.

Beneath the wrapper

Investors are increasingly being forced to pay attention to the nature of the underlying asset beneath the sharia-compliant wrapper. That means not only the asset underlying the structured product, but also the way that underlying is then structured. 

“Growing numbers of sharia investors have to ask themselves and their product providers – and they certainly have been – whether the products are sharia-compliant and are wrapped in the best way possible, have all the required approvals and have exchanged a number of assets that benchmarked themselves to the structured product,” says Ahmad Chaudry, director of custom indices and equity derivatives structuring at Royal Bank of Scotland's markets and international banking division.

The bank offers off-the-shelf products that are already set up, so that if a client comes in and likes what they see, they can buy those products. It also offers bespoke products for dedicated launches. RBS has been paying close attention over the past couple of years to engineering the underlying asset and structure to be as sharia-compliant or – in Mr Chaudry’s terms – as “sharia-friendly” as possible.

“A structured product is essentially a wrapper. You are taking an underlying and providing a wrapper to give some element of protection on it. What we at RBS end up doing is focusing on the underlying asset,” he says. “If the underlying asset of a conventional structured product is the Standard & Poor's 500, we look instead at a basket of 500 sharia-compliant stocks in the US market, which may not be in the S&P 500 but which are picked from the Dow Jones Islamic Market Index, for example.”

The process of ensuring the structured product is sharia compliant could be compared to peeling an onion in reverse, and the degree to which a structurer can be friendly to sharia in principle will vary across asset classes.

“We try wherever possible to engineer the underlying to be as sharia-friendly as possible and in some cases you can go a very long way. With equities you can ideally do those very easily by going to the market and looking at what the constituents for the Islamic indices are, or apply even stricter filters yourself. In other cases, however, you may not have 100% sharia-friendliness, for example with certain commodities. While you could remove things such as pork bellies and gold, many commodities are still traded via futures contracts [which have in-built speculative elements], so while they are in theory sharia-friendly they are not 100% there yet,” says Mr Chaudry. 

Ground up approach

CIMB has evolved its range of products substantially since entering the Islamic space back in 2007. A large number of its structured products have varying underlyings, ranging from profit rate structures – the Islamic equivalent of interest rate structures – to those linked to equity/commodity hybrids. 

“They can be sukuk-linked or any kind of combination. In terms of underlyings, we have moved quite far ahead, we have found that pretty much everything is available in the conventional space and that the pay-off can be made available in an Islamic way,” says Ms Yong.

Much of the debate around sharia-structured products is focused on whether they are essentially conventional products with an Islamic 'wrapper' or products that are devised as sharia compliant from the grassroots, and built up in a 'bottom-up' manner. Most banks have their own scholar supervisory committees whose job is to determine whether or not proposals for new transactions or products conform to sharia law, but much of the engineering is done by the bank teams themselves. Given that the Islamic structured product industry is still in its infancy, most products in the market are essentially conventional variants superimposed with an Islamic wrapper.

“Some of the risks that can come from bottom-up products can sometimes be quite difficult to manage,” says Abhishek Mishra, head of HSBC multi-asset structuring for Middle East and north Africa (MENA). “Mainly, so far our products have been Islamic wrappers, but there is nothing to stop us building an Islamic product from the bottom up.”

RBS tries to be as “wrapper agnostic” as possible, meaning that when it designs a product it does not do so with the intention of embedding it in a specific wrapper in order to tick all the requisite sharia boxes. “We try to take a bottom-up approach which means taking assets that are sharia-friendly, even if they are not 100% sharia-compliant, and then try and do something with those assets, for example, wrap it up into an index or some form of exposure which is also sharia-friendly and then finally add a wrapper on top of it to give you the final stamp,” says Mr Chaudry.

The agnostic approach does mean that when the team tries to feed through the product, there could be number of additional obstacles as there will always be something that will not be able to be engineered in an Islamic way. But the advantage is that it ends up pushing the envelope further and helping create something that is slightly more sharia-friendly in spirit. This then becomes a platform for further product innovation.

Local versus international

While their strong product teams and extensive distribution channels have given international banks an in-built advantage in pitching structured products to Islamic clients, Islamic-only banks in the MENA and south-east Asia markets have been increasing their product development in recent years.

However, the hedging of the products – the actual risk management process – is still largely the preserve of the leading international banks. Some Islamic-only institutions are considering setting up their own hedging programmes, but for the most part it is international players such as BNP Paribas, Deutsche Bank, RBS and HSBC that are able to market structured products through their Islamic windows.

“In terms of risk management, the idea of Islamic structuring is to be able to offer solutions within the Islamic space that can be suitably risk-managed by banks so that they can use their existing framework both for the product set-up and for its risk management,” says Mr Mishra. “For example, we recently built a certificate programme through which we can offer our clients asset-side Islamic exposures, structured investments which are sharia compliant.”

There are opportunities for Islamic-only banks to tap into their bigger rivals’ expertise and marketing prowess. In 2010, Dubai Islamic Bank (DIB) launched a two-year Islamic certificate linked to the RBS Crescent Dynamic Middle East 2 Strategy, a US dollar-denominated certificate with a minimum investment of $25,000. The structured product, distributed by DIB’s wealth management division, offered investors exposure to regional equity markets while minimising the potential downside risk and without locking away their capital.

Demand for structured products is springing from two main sources, according to Mr Mishra. He says: “The first is Islamic banks whose mandate is to do Islamic transactions and therefore they need to develop a wider product suite to make sure they can offer customers risk management solutions that are close to or on a par with the conventional product suite. The second is smaller corporate customers who have a strong preference in some cases for Islamic products. Based on these needs, we are able to offer risk management solutions for both.” 

Reducing risk, enhancing yield

The products themselves are not only intended to meet investors’ risk management requirements, but also to enhance yield. According to CIMB’s Ms Yong, typically the bank’s structured products tend to be more about yield enhancement than simple capital preservation. However, she says the bank’s structured product suite could also be deemed as risk management tools in the sense that most of the bank’s client base tends to go for structures with 100% principal protection at maturity.

“It limits the downside risk of the investment portfolio so in that way you can look at it as risk management as well, but most of them are looking at the products from the point of view of yield enhancement,” says Ms Yong.

It has not been plain sailing for the uptake of structured products in Muslim financial markets. The global financial crisis of 2008 affected risk appetites of Islamic investors just as much as in the conventional space, though since then demand has returned and the asset class’s compelling selling-point of 100% principal protection looks set to sustain their popularity in coming years.

“Investors with equity funds suffered a bit of mark-to-market principal loss during the crisis before coming back. This made investors realise the value of principal protection, so there is continued demand and we see it growing in markets such as Indonesia where the Islamic market is emerging,” says Ms Yong.

Islamic structured product delivery is also underpinned by consumer demand for more sophisticated financial instruments within the portfolio. Ms Yong says the supply of investable assets that are sharia-compliant is still limited, while the number of investors looking for such assets is growing. “Investors in each market are getting more sophisticated and looking outside their home countries so we are expecting to see a lot more demand coming out of areas such as the Middle East,” says Ms Yong.

Growing demands

This inexorable rise in demand will put added pressure on providers to focus more strongly on compliance issues. As investors’ comfort levels and awareness of structured products grows, they are likely to become increasingly discerning about the nature of the underlying exposures. Banks will come under greater pressure to make sure the wrapper is as sharia-friendly as possible in order to take their offering to the next level. Demographics are another key driver behind the appreciation of Islamic products.

“In the Muslim world right now you are seeing a big growth in educated consumers, either because of better quality of education in Muslim countries themselves or because of the rising numbers who travel to Europe and the US to get educated,” says Mr Chaudry. 

This growing band of savvy investors will drive innovation as they look to structured products to provide both capital protection and yield enhancement. And as HSBC's Mr Mishra notes, once they have gone Islamic, they tend not to go back to the conventional sphere.

“Customers within the MENA region prefer Islamic products. They would rather do a profit rate swap than an interest rate swap given the chance. And these things tend to be quite sticky; the next time they do it, they want to do it with an Islamic product again,” he says. 

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter