New frontiers of replication in Islamic finance

Reuters reports that QIB-UK is planning a new capital-protected note based on a sukuk issuance, rather than murabaha.  The typical structure for capital protected notes involve funds being invested in a murabaha, and the originator then entering into a Shari'ah-compliant wa'd to generate the returns from another asset class.  They have been used to synthesize the returns from relatively uncontroversial asset classes, as well as more controversial asset classes like conventional hedge funds (a public critique by Sheikh Yusuf DeLorenzo of the latter use is a good read [pdf]). 

I have no idea the exact structure of the QIB-UK product (but if anyone has a better idea, please email me), but I ran across an analogous product (I think) from the conventional space that turned out poorly for investors.  The product, originally issued by Wachovia in 2005 before it was bought by Wells Fargo, (described in a NY Times article) had the mouthful of a name Floating Rate Structured Repackaged Asset-Backed Trust Securities Certificates, Series 2005-2 (called STRATS) provided an investment opportunity for retail investors in a trust preferred security issued by JP Morgan that could not be redeemed unless there was a change in tax laws or bank capital levels.  

With the financial crisis occurring after issuance and before redemption, the regulatory termination clause was triggered and investors ended up taking quite a haircut: nearly $11 on a $25 par value security went to terminating the swap agreement, which was in place to provide variable returns between 3% and 8%.  The NY Times describes the effect: 

An investor who owned this security since it was created in 2005 collected about $6.70 in interest per share, and had a capital loss of $10.31 from an investment that was pitched as offering a modest but safe yield.

This STRATS security is far different from whatever structure will be used by QIB-UK, but the similarities are that 1) the return is based on an underlying quasi-bond investment; 2) the returns to investors will be generated through a swap agreement (in the case of the QIB-UK product, it will most likely be a swap of returns based on a yet-to-be-issued sukuk); and 3) the complex structure required will almost certainly necessitate high fees for the originator. 

It might not end up in a loss for investors; it will be a whole different investment, and details are so far sketchy.  However, the question remains: why is it necessary to produce extraordinarily complex structured notes to give investors exposure to a sukuk?  In part, it is because there are too few sukuk being issued to meet demand, but that can't be the only explanation because there are many other structured notes out there offering capital protection with no reference to sukuk. 

More likely, the continued push within Islamic finance to sell structured notes (including capital-protected notes) is based on the incentive structure for Islamic financial institutions that want to offer fixed-income-like instruments that generate high fees when they are sold.  That is not something unique to Islamic finance, by the way, but a transfer of the rules of conventional finance into Islamic finance.  It is another reminder that Islamic finance largely plays within the rules set by conventional finance that puts profit against the best interest of investors.  

UPDATE (9/25/12): Source of the news regarding the capital-protected note updated to Reuters.