Wednesday, January 19, 2011

The role of structured products in Islamic finance

Bloomberg reports that the International Islamic Financial Market (IIFM) is working on a master agreement for derivatives, according to the IIFM CEO Ijlal Ahmed Alvi. The article then goes on to describe Islamic structured products that are having some difficulty meeting international (as opposed to simply local) standards. Structured products combine a debt security with a derivative to provide, for example, returns based on an index performance combined with capital protection. These products are fairly common across the Islamic finance industry and financial institutions like their high fees, while investors may be attracted to the capital protection embodied in them.

However, I think they should be of limited use in the industry because they provide limited benefit to investors (although good returns to the financial institutions offering them in terms of high fees) and are, in my opinion, representative of the worst of financial replication of conventional products in Islamic finance. These products offer the promise of equity-like returns with debt-like risks. The risks of their debt characteristics is understated through claims of "capital protection"; generally these products will only be as safe as the debt offered by the institutions offering these products (or their counterparties in the commodity murabaha products that sit alongside the derivatives that provide the equity returns). It may be that the popularity of these products is due to the lack of debt-like alternatives (e.g. sukuk) for asset managers to diversify across asset classes. Instead of investing in (cheaper) sukuk funds, managers are forced to find quasi-debt investments that also give equity returns.

The reason that I find structured products objectionable is that they hide the risks of debt products with the "capital protection" (I believe they are generally unsecured debt), while generating high fees for the issuer, which can hedge the risks of paying out the upside gains through derivatives. They replicate the most cynical aspects of conventional finance (creating fancy products that generate high fees) with little benefit to investors except providing debt-like protection of capital. In my opinion, the investors would be better off using an equity investment like a mutual fund or managed portfolio of equities balanced with a fixed-income investment through a diversified portfolio of sukuk. However, it is difficult to compose a diversified portfolio of high-grade sukuk. Therefore the appeal of structured products.

Perhaps I am cynical about the rationale for structured products generally in finance. However, they don't seem to serve much purpose except where fixed income markets are lacking. For conservative investors, they would be better suited in lower-fee sukuk funds or deposit accounts at Islamic banks. Non-high net worth investors would be better served by a balance of either Islamic mutual funds or individual equities and sukuk funds. High-net-worth individuals have the resources to invest in diversified portfolios of both equities and sukuk (in addition to some alternative assets). Hiring managers within each asset class is surely a lower cost method of investing than structured products. This even omits the role that Islamic ETFs (if they were prevalent) could serve for investors just wanting to track the benchmarks with some diversification.

The IIFM has done some good work standardizing commodity murabaha contracts (the Master Agreement for Treasury Placements) and with the planned master agreement for asset-backed sukuk. Even the derivatives master agreement (Tahawwut) which has attracted criticism is valuable because Islamic banks, like other conventional financial institutions, need to hedge against currency and interest rate fluctuations (and other companies need to hedge commodity price fluctuations). However, tailoring standardized documents designed for structured products is not going to provide much benefit to the industry as a whole. It may lower costs, but that is unlikely to lower costs to issuers, but these probably will not pass through to investors who are charged high fees in conventional structured products as well.

As much as the sukuk structures are criticized for replicating conventional bonds, they at least serve a primary purpose in most, if not all, portfolios as fixed income replacement. The same cannot be said for structured products, which I suspect are favored by financial institutions for their high fees with little regard for whether they add much to the end client's portfolio.

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