With huge assets under management and a growing population of issuers and investors, the Islamic investment market is being taken increasingly seriously. Natasha de Teran looks at how derivatives are being used to create Sharia-compliant products.

Conventional investment and commercial banks have long been active in the Islamic market and have established footholds in some of the larger Islamic financial centres.

Until recently, they had a fairly easy time, developing investment products tailored to meet the requirements of Sharia-compliant investors. But the low interest rate environment and falling equity markets coupled with spiralling competition have forced them to become increasingly inventive. Fortunately, derivatives technology has lent them a helping hand.

David Ishoo-Mirzayoo, co-head of the derivatives and solutions group, EMEA, at SG CIB, estimates that total Islamic assets under management in the banking sector are about $200bn, $50bn of which is in the Middle East. Other estimates put the figure at $250bn and higher but the consensus is that the market is growing at 15% a year.

Bankers are taking a serious interest in the market. Mr Ishoo-Mirzayoo says: “The market is huge today, so banks like ourselves that have the derivative technology, expertise and relationships naturally take this market very seriously.” Islamic investors’ continued search for yield, the growth in Islamic funds, and the unfortunate market conditions have driven the move toward derivative-based and derivative-like structured products solutions, he says. “As a result, innovation in the area has been at its strongest in the past couple of years.”

Christian Kwek, global head of structured products marketing at BNP Paribas (BNPP), agrees. He recalls a period five years ago when BNPP introduced what it claims was the first derivative look-alike Sharia-compliant product. “At the time, most had thought such a solution was impossible. Now though, derivatives are increasingly being used in Sharia-compliant products – and the more you understand the way Islamic finance works, the clearer the adaptation process becomes and the easier it is to develop the appropriate solutions.”

Nizar Al-Shubaily, head of Deutsche Bank’s global markets Islamic finance group, says: “Things are really moving ahead with derivatives, particularly in the Gulf states. As a result, a lot of institutions are working on derivatives-based solutions for Sharia investors. Overall it is a very, very exciting time for Sharia investment products.”

Compliant products

There is nothing unusual about derivatives being used in Islamic products per se. As Usman Ahmed, a director responsible for Islamic finance in Citigroup’s fixed income business in London points out, the use of derivatives for yield enhancement purposes has been prevalent in the local markets for some time. Islamic products based on equity derivatives and offering capital-protected returns linked to baskets or indices have been extensively marketed and have been popular in the Middle East.


Usman Ahmed, Islamic finance director at Citigroup’s fixed income business, London 

However, in the past few years, the low rate environment has coupled with a growth in liquidity in the region as well as desultory equity markets to drive product innovation in other non-equity related areas. For instance, Citigroup has recently pioneered and successfully marketed the first Islamic-compliant credit derivative offering, says Mr Ahmed – though he coyly keeps the details of the product to himself.

Although that may be a first such product, Mr Ishoo-Mirzayoo says that in the past three years, credit-like pay-offs have been quite fashionable among the more aggressive Islamic banks in the Middle East; structures based on collateralised debt obligations (CDOs) and credit-linked note-like pay-offs.

“It took a long time to get the products approved and educate distributors and investors, and there was subsequently good appetite for the products. However, the recent tightening in spreads, coupled with the high annual costs typically involved in Islamic products has meant that these no longer made sense. Once spreads relax, we imagine there will be a return to these structures,” he says.

More recently, SG CIB has done a lot of real estate and commodity structures as well as some involved interest-rate like pay-offs, says Mr Ishoo-Mirzayoo – ideas that he describes as “quite simple but proprietary”.

Instrument scarcity

Jean Marc Riegel, head of the Middle East FIG and the Islamic banking units at BNPP, based in London, points out how the scarcity of available instruments compared with those accessible to conventional investors has pushed Islamic banks in two directions. “First, they have invested the main portion of their funding into money market murabaha deposits, through which they can achieve only regular market returns. And, second, for the sake of yield pick-up, they have invested their remaining assets on a longer-term basis than their liabilities, therefore exposing themselves to significant risks and maturity gaps,” he says.


Jean Marc Riegel, head of the Middle East FIG and the Islamic banking units, BNP Paribas, based in London 

Murabaha are basic Islamic contracts that are used in financing arrangements. In a murabaha transaction, a given financial institution purchases goods on the request of a client, who makes deferred payments that cover the cost and the agreed profit margin that is due to the financial institution.

BNPP recently took to market a product that attempts to overcome the shortfall in the split between the murabaha and yield pick-up trades, by combining and optimising the two strategies. “We came up with the Islamic equivalent of the dual currency option deposit (DCOD), which has been already very well received by conventional investors, outside the main Islamic regions”, says Mr Riegel.

A DCOD is a deposit with a boosted return whereby the redemption amount is payable as a function of the spot rate of a pre-agreed currency pair at maturity. Mr Riegel says: “Our Islamic version of the DCOD, the BNPP murabaha-plus, gives investors both short-term exposure and yield enhancement opportunities, as well as minimising the risk of longer-term investments.”

To create the murabaha-plus, which was marketed only recently, the bank replicated the same features in a normal DCOD but without using the instruments that would be prohibited under Sharia law. “As well as being a very transparent product, in which all the transactions are supported by Sharia-compliant confirmation documents, it is very flexible and can be fully tailor-made to fit investors’ particular needs,” says Mr Riegel. “Most Islamic products are currently structured across murabaha contracts, says Mr Ishoo-Mirzayoo. “Given the developments in the non-Islamic market and the volume of structured products that are being traded there with insurance companies, we believe it is likely there will be a move in the coming years towards using takaful contracts. There should be strong potential for growth in this market in the Middle East.”

Takaful contracts validate the concept of insurance in Islamic business by stating these are “voluntary subscriptions from participants to assist whoever needs assistance”. In practice, they are short-term, joint-guarantee contracts between a group of participants who agree to provide mutual compensation in the event of a defined loss. In the event of a catastrophe or disaster resulting in a loss or damage, the affected persons are assured of takaful benefits from the group. Mr Ishoo-Mirzayoo believes these might be a way to replicate the business that is currently conducted in the non-Islamic insurance sector.

Investment avenues

The financing needs of Islamic companies provide another avenue for Islamic investors as well as another potential income source for derivative experts. Mr Ahmed says that, recently, the use of derivative instruments as risk management tools in Islamic financing has been growing, primarily driven by the increase in scale and variety of transactions in the industry. “Issuers that utilise Islamic-compliant financing structures have the same hedging needs as conventional borrowers, since the financing is priced off conventional benchmarks. However, such issuers prefer to hedge rate risk on a Sharia-compliant basis, as do dedicated Islamic banks that cannot freely swap between fixed and floating rate exposures. This creates a need, which international banks like ourselves are able to address through our strong understanding of both Islamic financing principles as well as conventional derivatives products.”

Due to a number of banks working on methods to address these issues, Mr Ahmed says these remain closely guarded proprietary solutions. However, he is hopeful that there will be more open discussion in the future. “We hope that there will be a move toward standardisation. Ideally, innovation should remain strong, but there should be room for volume products and solutions to emerge. The International Swaps and Derivatives Association is working to adapt its master agreements for Sharia purposes and, although that is still some way from being concluded, it is a move in the right direction.”

Market drawbacks

Although opportunities in the Islamic market are plentiful, the banks that operate there do face a few difficulties. Mr Ishoo-Mirzayoo says that one of the particular considerations for banks developing derivative-based solutions is that it is not always possible to amortise the development costs of the products by distributing them through several different channels, as might be done elsewhere. “You cannot generalise in terms of risk appetites among the distributing banks, countries and investor bases. While one Sharia board might approve something, that is not to say another will. And while a product might work in Bahrain, that is not to say it will be acceptable in Saudi Arabia or elsewhere,” he says.

Mr Al-Shubaily admits that progress is slow, that the documentation and approval processes can be lengthy, but he also says that each solution tends to breed new applications. “The way the process often works is that as we solve one thing, so we are led on to solutions for other areas.”

In such an instance, Deutsche hopes to reapply its own technology that was first developed for an innovative forex option contract launched in March. In the coming months, it hopes to have a credit-linked solution on the market, which will be based on similar technology.

Mr Al-Shubaily is also hoping that the same technology will be applicable for giving investors a form of exposure to hedge funds without any direct investment. “Hedge funds are never acceptable to Sharia boards”, he says. “But the index-based methodology that we are developing, which still needs some fine-tuning, should be able to give them the same exposure. This is a very exciting development: the product’s success will mean that a whole new source of funds may eventually pour into the hedge fund industry that previously was not able to.”

Competition is high

The high stakes and concentration of expertise in the market has meant that competition is at an all-time high. All the banks canvassed are well-poised to thrive in the intense atmospheres, through their presence in the region and derivatives structuring capabilities. But, as Mr Al-Shubaily points out: “There are a lot of good ideas around but, in the end, it is getting a finished product approved and sold that counts.”


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