Where is the Islamic ETF growth?

One of the puzzles of Islamic finance is why Islamic ETFs have not seen a corresponding growth to the rest of the Islamic finance universe.  A Reuters article tackles the subject and suggests that it is the incentive structure in how financial products are distributed in the GCC, the largest market for Islamic finance.  Reuters describes:

In the Gulf, institutional investors are usually catered to by placement agents and fund marketers, not financial planners. These agents, who charge commissions on their sales, prefer to sell private equity, hedge funds and real estate, where margins are higher for them - a hedge fund can charge a 2 percent management fee and a 20 percent performance fee.

That is, the distribution of financial products are run much more along a brokerage model, which is how financial products were overwhelmingly distributed in the the US, and still are to some degree.  However, the rise of investment advisors, who are not reliant on commissions for determining investments, and a general growth in discount brokerages (which has made many investors more cost conscious) has made the relatively cheap, passively managed ETFs more popular.  The investment advisor model is not as prevalent in the Gulf, but Tariq Al Rifai of Dow Jones Indexes says "At some point it will take off...Give it another three years."

However, one of the areas that Reuters only mentions in passing is:

"One attraction of ETFs is that they can provide investors with access to themes that have a low correlation with equities markets. But Islamic ETFs focused on asset classes other than equities have yet to appear, even though major index providers offer large families of sharia-compliant indexes."

Many of the ETFs that provide investors with alternative investors, whether those are hedge funds, individual commodities, and a number of other asset classes (e.g. the VIX index) do not hold the underlying assets themselves, but instead use swaps and other derivatives to gain exposure, either as ETFs or Exchange-Traded Notes which expose the holders to the credit of the issuer and provides return based on the performance of an underlying index. 

The asset classes beyond equities represented by ETFs and ETNs have attracted controversy (ETFs, ETNs) because they are not doing what a normal fund would do--hold a diversified portfolio of investments directly in the fund.   They would also be more difficult to create Islamic versions of, so it is neither clear whether there would be a demand for these products or if they would provide a valuable product for Islamic finance to endeavor. 

In particular, many are leveraged products, and all are designed to be trading vehicles, since they tend to decay in their underlying values regardless of the performance of the underlying indices.  Encouraging extra leverage and frequent trading is likely to not be something that will get favor from Shari'ah scholars approving these products. 

As for plain-vanilla equity ETFs that actually own a portfolio of equities, they may have their day, but it is clearly not upon us yet. 

Could there be an Islamic whale?

I think of myself as one of the last people who would suggest that Islamic finance is inherently superior to conventional finance, because I think there is a lot more than just the Islamic label that will determine such a value judgment.  For example, is Islamic finance inherently superior if it is more expensive than conventional finance without offering anything different (e.g. without any change in the rights and responsibilities of the two parties which could offer a fairer deal that could offset the additional cost). 

However, since the news of the JP Morgan loss was announced, and the actual losses have piled up (potentially rising to $5 billion at last count), and reading through the excellent coverage on the FT Alphaville blog on how the trades might have actually been constructed, I came to the conclusion that Islamic finance might actually prevent some of these types of trades. 

Underlying the whole JP Morgan story is that the bank would turn into a massive liability on the government balance sheet if it were to fail, notwithstanding that the current losses are tiny relative to the bank's overall capital.  Then there is the issue of the Volcker Rule, which is more of a weakened form of Glass-Steagall, the Great Depression-era law that separated commercial banking, which would allow investment and commercial banks to operate within one corporate structure, but would limit their ability to speculate using their capital.  As it stands, with the size of JP Morgan, it is somewhat toothless since they could probably find something, somewhere on their massive balance sheet that would make all of the bits of the bad trades hedges of something. 

Most of this story (too-big-to-fail, combining investment and commercial banking and exposure to derivatives markets) could happen in Islamic finance, even if the potential today seems slim.  The relevant question, for Islamic finance then would be in the oversight process of the trading operations of the Chief Investment Office, the part of JP Morgan which seems to have shifted from risk management to just another profit center for the bank.  Here it is where an Islamic bank would have the trouble getting into the specific situation that people think the bank is in. 

JP Morgan's losses have come primarily as corporate credit markets deteriorate as the Euro crisis flares up again.  And, they are facing losses which seem outsized, even based on the description of the trader who entered the trades as the London Whale.  A bank, conventional or Islamic, would expect to take losses as the market for corporate credit hits a rough patch, but the losses should be coming from the banking operations, not from the risk management/hedging department.  Whether through mismanagement of a trade or just a bad call with a trade that was intentional, JP Morgan ran into a situation that would be difficult for an Islamic bank to replicate because:

• The loss on the derivatives are moving in the same direction as the bulk of the bank's balance sheet; and, 
• It appears the derivatives were designed to provide enhanced leverage to the bank on the trades.  

These two would be very hard for an Islamic bank to replicate because there would be (at least hypothetically) another layer of oversight from the internal Shari'ah audit department over the derivatives and one specific question they would ask would be for evidence that the derivatives transactions were entered into for hedging purposes (and not for speculation or to increase leverage).  Ex ante, it would be harder for the traders to enter into the trade.  In the JP Morgan example, the trade will make them a lot of money if it moves in one direction, and will cost the bank a lot of money in the other direction, but in a conventional bank, even with the Volcker Rule, the traders will be able to use the hedging excuse because it would come ex post, and they have a huge balance sheet to dig through to find the other side.  

An Islamic bank, if things work correctly, will have internal Shari'ah auditor whose job is to force the determination that the trades are hedges ex ante, which should limit these types of trades in the first place.

Islamic derivatives

While writing the post yesterday on the new profit rate swap master agreement (mubadalatul arbaah), I explained the reasons why I think the master agreement can help make a difference in developing Islamic finance and providing a product that can help 'real economic activity' by providing certainty in financing costs for companies that have floating rate financing. 

However, there is an issue with Islamic derivatives in general that has been raised multiple times about the participation of 'speculators' versus those participants who are involved in 'legitimate hedging transactions'.  This is a tricky issue, and one that is very hard to even define (since what transaction doesn't involve some elements of speculation. 

In the context of derivatives, there will likely be some profit to be made and in general, it will be a profit that, if you view the transaction in the abstract will be gain for one party at the expense of the other.  This is generally viewed as akin to gambling (maysir) in Islamic finance because the gains from one party will come at the expense of the other. 

In the profit-rate swap example, viewing the transaction in the abstract misses some key elements that differentiates a profit-rate swap from others (such as, for example, a credit default swap).  In a profit-rate swap, assume that the company has a two-year $100 million floating rate ijara, with a floating rate starting at 5% annual rate, which is set at the end of year 1.  The ijara is structured so the cash flows are:

T=0: Company sells assets worth $100 million to the financier, which it will rent with rental payments adjusting, but beginning at $2 million a year (benchmarked to an interest rate that starts at 5%).  The first payment is made.
T=1: Company pays rent benchmarked to an interest rate
T=2: Company pays repurchases the asset for $100 million

At T=0, the company enters into a profit-rate swap to exchange the rent in T=1 for cashflows of $2 million at T=1 for a floating rate based on the same benchmark with a spread (through two separate commodity murabaha).  At T=1, the murabaha are paid, with the company paying $2 million and the counterparty paying $100 million * (R+e), where e is the spread paid.

Looking just at the transaction, no net payments are made when the benchmark rate is (5-e)%.  If the benchmark rate is higher than (5-e)%, then the company makes the difference between the rate and (5-e)%.  If the rate is lower, than the swap counterparty makes the difference between (5-e)% and the benchmark rate. 

For the transaction alone, the components of the transactions are common.  There is an ijara and, separately, the company enters into two murabaha with another party.  However, the murabaha transactions result in the outcome of a win-lose scenario.  An increase in the reference rate benefits the swap counterparty, while a decrease benefits the company, in equal amounts.  The criticism of this transaction is that it is not financing any 'real economic activity', and also that the counterparty is merely speculating on the direction of the reference rate (the company is hedging its exposure to changes in the reference rates, which would be viewed as legitimate hedging activity). 

There would be in most cases, a clear economic benefit of the transaction because the company would be able to lock in the cost of financing the asset it purchased.  Armed with the certainty of its costs, the company wouldn't have to incorporate the uncertainty around its financing costs in its financial planning, and could devote the resources that might be held back in case the rate increased to expand its business.  The counterparty would assume the risk of changes in the reference rate (in expectation of a lower rate or to hedge itself against its own fixed rate liabilities (most financial counterparties would be likely able to show enough fixed rate liabilities to justify its participation on the grounds that it is hedging, even if it were speculating). 

As I mentioned, the fact that the contract is executed on an OTC basis adds some risk that the counterparty cannot meet its obligation, which would moot some of the benefits to both parties of resources freed up by hedging its profit-rate exposure.  There won't be many issues with whether the parties are legitimately hedging (it is probably easy enough for the Islamic financial institution to speculate while being able to at least nominally show that it is hedging some exposure on its balance sheet).  However, it will be difficult to convince the doubters of profit-rate swaps that the transaction adds value overall and is different from a transaction like a CDS. 

Most arguments in support of the profit-rate swap assume that Islamic finance institutions are involved in liquidity transformation, just like conventional banks, but using Shari'ah-compliant contracts.  The criticism of Islamic derivatives are mainly (but not entirely) from people who believe that Islamic financial institutions should be based entirely on profit-sharing contracts.  It is difficult to offer a counter-argument, because a pure profit-sharing bank would not need to worry about liquidity constraints because it would not transform short-term liabilities into long-term assets (rather, it would, but it could pass off any losses directly to depositors). 

This is how a typical mutual fund works (the fund manager acts as a mudarib or wakeel), but it is not how Islamic banks work.  If an Islamic financial institution is working in a bank-like role (taking deposits and making loans) in an environment where pricing is based on interest rates (because the Islamic bank is competing with conventional bank), then there will be a role for instruments like a profit-rate swap.  Arguments against profit-rate swaps are mostly shifting the discussion into a theory versus practice argument.  At this point it usually turns into a discussion where people from two different perspectives are talking past one another.  

There are two different things to consider, which are entirely different, when considering profit-rate swaps:

• Should Islamic financial institutions work within the regulatory system that exists today?  Or should they try to change the regulatory environment to allow pure profit-and-loss sharing for Islamic banks?
• If Islamic banks work within the current banking regulations, should they be permitted to hedge their exposure to fluctuations in their profit rates which may be exposed to fluctuations determined by changes in interest rates?  And does the profit rate swap contribute to an underlying economic activity?

These are two different arguments and it is important to separate them.  If Islamic banking operating under a conventional regulatory system is problematic, then that is the issue, not whether a profit-rate swap is beneficial or not.  However, if the presumption is taken as given that Islamic banks work within a system that evolved around a conventional banking system, then the discussion around Islamic derivatives should be focused on whether it contributes to underlying activity and stability within the Islamic financial system, and is done in a Shari'ah-compliant way. 

Where I stand is that Islamic banking does operate in a regulatory environment that was designed for conventional banking and that providing a standardized way for Islamic banks to hedge against profit-rate risk will lead to a more stable banking system (counterparty issues still unresolved) and will provide a benefit to the non-financial who enter into profit-rate swaps to fix their costs as a part of their financial planning. 

Derivatives trading in Islamic banks

I was reading through an article from a few weeks ago from Reuters about Kuwaiti banks involvement in derivatives trade in a way that might put depositors' money at risk and which lies (as I read it) outside of the central bank's regulatory oversight.  The banks concerned are the National Bank of Kuwait and Kuwait Finance House. The former is a conventional bank that has an Islamic window, while the latter is an Islamic bank with a long track record in Islamic banking.  The statements from the banks were:

Bank 1: "[The bank] does not engage in any derivative trading at all and has no exposure whatsoever to these instruments"
Bank 2: "[The bank] is fully committed to the laws and regulations of the supervisory authorities and all the procedures governing banks, and has no dealings that violate or circumvent the supervision of the Central Bank of Kuwait"

Can you guess which bank is which?  I would imagine that most readers would pick Bank 1 as KFH because derivatives (in their conventional form) are not permissible, but most readers (and me to be perfectly honest) would be wrong.  Bank 1 is NBK.  The bank providing an evasively unspecific response was KFH. 

The Islamic finance industry has developed Shari'ah-compliant versions of derivative products, as they should, to deal with interest rate (profit rate) risk, currency fluctuations, commodity fluctuations, but the idea often given for why Islamic banks are better than conventional banks is that by the nature of the Shari'ah standards they adopt, they should be more transparent, and should adopt simpler products to perform their role as financial intermediaries. 

Regardless of whether KFH uses derivatives (they probably should be since they have operations in Kuwait, Turkey, Malaysia and elsewhere), statements like what KFH provided do nothing to provide outside observers such as this blog with any confidence that they are transparent in how they operate.  That more than anything is increasingly important when competing with a conventional financial industry that has lost the public's trust due to hidden liabilities. 

The well known financial commentator from the UK in the mid 1800s Walter Bagehot pointed out that when a bank is arguing over its solvency, it has already proven to the public that it is not solvent (and in the days before deposit insurance) this usually led to a run on the bank.  Today, while bank runs do happen, they are much less of a risk.  The issue at the heart of Bagehot's argument was that once a bank loses confidence of the market or its customers, it is impossible for it to convince people to restore that confidence.

In today's world of Islamic banking, the issue of confidence is much more concerned with the bank's reputation as an "ethical" institution.  There have been many examples of that confidence abused and punished (Gulf Finance House comes to mind).  KFH should not tread down the path where it cannot come out unequivocably and state that it either does not use derivatives (like NBK) or that, while it does use (Shari'ah-compliant) derivatives, these are done for the purpose of risk management and in full compliance with its regulatory requirements.  KFH took the third way of not acknowledging whether or not it uses derivatives but stating without clarification that it acts in compliance with regulatory requirements. 

This is the "trust us" path that asks for confidence without refuting the allegations against it.  In a climate where banks are suspect and Islamic banks try to keep above the fray by deferring to their "ethical" underpinnings, this is a risky strategy.  Evasion does not often win friends or confidence. 

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.

Tahawwut slow to catch on in the GCC, Nakheel/Dubai World face trade creditors' claims

Lack of familiarity with derivatives products in the GCC has hampered the adoption and use of the Tahawwut Master Agreement for Shari'ah-compliant derivatives. There is also some skepticism that the implementation of the product is Shari'ah-compliant because the Master Agreement is just a template and not a specific product.

Although Nakheel has offered to pay trade creditors 40 percent in cash with the remainder in a tradable sukuk yielding 10%, several of Dubai World's trade creditors have taken their claims to the Dubai World Tribunal set up at the DIFC. Nakheel needs 95% agreement in order to issue the sukuk to pay the deferred portion of the amounts owed to trade creditors. One of Nakheel's trade creditors, Construction Delivery Group filed suit with the tribunal claiming it is owed Dh 50 million (13.6 million) for a construction management contract.

Other News

• Mushtak Parker provides a good assessment of an IMF report that found that Islamic banks fared better during the financial crisis.
  
• A study from Deloitte found that 79% of executives believe Islamic finance is growing. 66% believe the industry is under-regulated.
  
• Indonesia may issue a global bond or sukuk for $650 million in the first quarter of 2011. Jordan formed a committee to study the changes needed to be able to issue sukuk and a statement from a government official stated that the government is "serious about using Islamic sukuk to provide funds for carrying out vital and top priority projects.
  
• Citigroup, which co-managed the Kuveyt Turk sukuk says it is in talks for more corporate sukuk issuance in Turkey. AmIslamic Bank in Malaysia issued RM550 million in 7-year sukuk.
  
• The governor of the Kuwaiti central bank says that with five Islamic banks, the market for Islamic banking is saturated.
  
• RAM Islamic projects that the sukuk market in Malaysia will continue to grow.
  
• Qatar First Investment Bank and Gulfmena Alternative Investments are launching an Islamic asset management firm. Allfunds Bank launched an Islamic Services Unit to provide a B2B fund platform of Shari'ah-compliant funds.
  
• Luxembourg will host the 8th Annual Summit of the Islamic Financial Services Board (IFSB), the first time it has taken place in the EU. Luxembourg is the only EU member country that is a member of the IFSB.
  
• Zawya and the Ethica Institute of Islamic Finance announced a partnership for Islamic Banking certification and training.
  
• Pakistan, Afghanistan and Senegal see Islamic banking as a way to bring underbanked people into the financial system. Bloomberg updated its list of planned and expected sukuk.
  
• The Central Bank of Bahrain's 6-month sukuk al-ijara was heavily oversubscribed with BD62 million (US$164 million) in subscriptions received for the regular BD10 million issue.
  

DIFC Investments, Other News

JP Morgan said the government of Dubai may have to convert its $1 billion loan to DIFC Investments into equity, as well as make an equity investment in the company. The report also upgraded DIFC Investments' $1.2 billion mudaraba sukuk maturing in 2012 from "underweight" to "neutral" based on "improved asset coverage". Other analysts believe the rally--the sukuk rose in price to 79.15 (yielding more than 13%) --has gone to far in DIFC sukuk, as well as other Dubai-related sukuk.

Other News

• Gulf Finance House was able to roll over $100 million in debts for two years, with an option to extend it by another year.
  
• Standard Chartered is expanding its Islamic finance business. The bank recently launched a product that will allow for hedging against fluctuations in commodity prices.
  
• Bloomberg has a list of upcoming sukuk. Many new sukuk are coming from Asia including Hong Kong and Singapore, although regulatory challenges remain.
  
• The Houston Chronicle interviews Monem Salam on the Amana Funds.
  
• Moody's placed Dar Al-Arkan's credit rating (and the rating on its sukuk) on review for possible downgrade.
  
• Islamic finance has become as closely watched as celebrities, according to Lahem Al-Nasser.
  

Future growth in Islamic finance, sukuk news

Future growth in Islamic finance
An article in the National newspaper provides a good summary of the growth areas in Islamic finance, as well as the areas of controversy which remain in these areas. The largest focus is on whether creating Shari'ah-compliant hedging contracts is a help or hindrance for the growth of the industry. In some aspects I can see how it reinforces the view that Islamic finance does nothing but mimic conventional financial products. However, as the article notes, longer term financing like what would be necessary for project finance, would be largely absent were there not a way to hedge against currency, commodity price or interest rate fluctuations.

The article also discusses the lack of Islamic microfinance. Moinuddin Malim, the CEO of Mashreq Al Islami, is quoted as saying "We have not yet reached our real audience. We need to develop microfiannce to enable communities to thrive in their own right and bring living standards to them". I would disagree with his characterization of "bringing living standards to them" and replace that with bring affordable, Shari'ah-compliant financial alternatives, but it is definitely an underserved area of Islamic finance. The CGAP competition which recently closed (and I advised two groups who submitted proposals) is a good effort because it focuses on providing seed money to develop sustainable financial institutions (either non-profit or for-profit). However, outside of this and a few efforts by a couple small efforts by (mostly) global financial institutions in Islamic finance, there has been not much more than lip service paid to the need for Islamic microfinance.

There is a lot more to Islamic finance than just structured products that mimic conventional finance for large corporations and sovereigns. Islamic retail banking fills some of the need with a reach towards a larger number of Muslim consumers, but there are many Muslim (and non-Muslim) 'unbanked'. This is the consumer base that the Grameen Bank was formed to serve and it has now attracted a lot of attention from larger financial institutions. The same need is present for the Islamic financial industry to fill and it should be a quicker transition for Islamic financial institutions to recognize this need (and potential) now that conventional microfinance is well established with participation from the larger financial institutions. It is also ideally suited to the underlying ethics behind Islamic finance, which should feel a greater need to promote economic empowerment based on its ethical foundations.

Another article describes the re-emergence of innovation within the Islamic financial industry which has largely been absent during the recession. There are areas--like liquidity management--where innovation can be a positive development to increase the available investment opportunities (particularly short-term and overnight). However, there are also a lot of 'innovations' during the 2005-2008 period in structured products and especially real estate, where 'innovation' can turn into 'high fees with little other benefit'. One example of this that has been described in detail was Gulf Finance House, which was described in a recent paper by Mohammed Khnifer.

The issue of standardization remains contentious. The debate, however, depends on what standardization means, which Debshis Day of Clifford Chance pointed out, is unclear. "Standardization, what does that really mean? It is very difficult for everybody to agree on one thing. People need to understand that even in a conventional market there is not pure standardization". I would agree with him that complete standardization is neither possible nor probably desirable. There are certain areas (like the ISDA-IIFM derivatives standard and the IIFM standardized murabaha agreement) where standardization can be beneficial by reducing costs associated with replicating the same structure. However, these standardized contracts are not, nor should be, mandatory. There are numerous areas where improvements can be made and leaving the door open to new products or new variations of existing products makes sense for the industry as a whole.

Sukuk News
Unicorn Investment Bank and Standard Chartered report they have mandates to work on issuance of $6 billion in sukuk this year. Reportedly, over $4 billion of this amount will be advised by Standard Chartered. An executive at HSBC, Mohammed Dawood, says that issuance of dollar-denominated sukuk may reach $5 billion, matching the previous year's total. The total issuance may be $8.5 billion, about last year's level, but far below the pre-crisis levels in 2007 and 2008. However, due to the Greek crisis and Ramadan, most issuance will be pushed into the third quarter. Al Rajhi Bank, which has been largely absent from the sukuk market due to concerns by its Shari'ah board over the compliance of the sukuk in the markets, plans to launch a sukuk with Cagamas, the Malaysian housing finance agency, in June. Indonesia recently sold $467.5 million in sukuk to the government-managed Hajj fund.

U.S. issuers could make up part of the issuance in the second half of this year or in 2011. GE Capital, which issued a $500 million sukuk last year (my summary of that sukuk) is planning a 'benchmark' sized sukuk in late 2010 or 2011, which is generally over $500 million. In addition, Unicorn Investment Bank, which has a U.S.-based private equity subsidiary UIB Capital, is working on a $250 million sukuk for a U.S.-based company. The only two sukuk issued by U.S.-based companies so far have been the East Cameron sukuk, which ended with investors owning the underlying asset after the issuer entered bankruptcy, and the 2009 GE Capital sukuk.

Another rare issuer coming to market is Malaysia, which will likely offer its first international sukuk since 2002. The sukuk, expected to be an ijara sukuk with a 5-year tenor is said to be backed by government hospital assets. The issue is reported to be a $1 billion, however, it has not been formally announced and is expected to be announced at an Islamic economic forum in Kuala Lumpur.

Robin Amlot writes an interesting review of an e-book published by Euromoney, written by Parvez Daruwalla and Shahzad Siddiqui, in Islamic Business & Finance. The e-book talks about whether the sukuk structure, and in particular sovereign sukuk, could be done better.

Article by the CEO of Gatehouse Bank

Richard Thomas, the CEO of Gatehouse Bank, an Islamic wholesale bank in the UK, has an article about Islamic finance. While in general, he speaks to the general outlook for Islamic finance globally, he makes two notable points. First, he does not fall into the "Islamic finance is immune from the crisis" trap and secondly, he acknowledges the overlap between Islamic finance and ethical/sustainable finance. He writes:

"Islamic finance has, however, been met with enormous challenges. It has not escaped the global downturn despite Islamic banks being safeguarded by the nature of their Shariah principles against exposure to subprime mortgages and the other toxic assets that have hurt the balance sheets of so many of the world’s biggest financial institutions. "
[...]
As it is, a substantial amount of business transacted in an ethical or sustainable format may qualify as Sharia compliant. This demand for products and investments, while primarily fuelled by the world’s 1.3 billion Muslims, is supporting interesting crossover products that benefit from the same ethical criteria."

Other News

• Golden Belt Sukuk holders approved the dissolution of the sukuk trust, making the sukuk holders unsecured creditors of Saad Group.
  
• The Central Bank of Bahrain's sukuk al-ijara issue was oversubscribed by 230%. The sukuk has a maturity of 182 days.
  
• Dana Gas reset the conversion rate on its sukuk according to JPMorgan Chase & Co., the calculation agent.
  
• South African investment management firm is planning on launching its products outside of its home country including within Europe.
  
• Aston Business School will launch an MSc and PhD program in Islamic banking with sponsorship from the CEO of Dubai-based Surgi Tech.
  
• Al Rajhi Steel Industries, a Saudi rebar manufacturer obtained a $196.5 billion Shari'ah-compliant bank loan to finance construction of a new plant in Jeddah.
  
• The Iraqi bank Ashur Bank is exploring offering an Islamic banking window, for which it submitted an application six months ago to the Central Bank of Iraq. 7 of Iraq's 42 banks are Islamic banks.
  

Nakheel repays its sukuk, FT Special Report

The Nakheel restructuring discussions continue as Nakheel repays the Nakheel Development 3 sukuk for $980 million (Thursday) with assistance from the Dubai Financial Support Fund. The trade creditors of Nakheel are close to approving the deal which would pay them 40% in cash with the remainder in a "publicly traded security with a 10 percent per annum return". Previous reporting said the security would be a sukuk, which is not mentioned in the latest news. AFP reports that 50% of trade creditors have agreed to the plan; 65% approval is needed for it to be approved. One interesting piece of information contained in the article that I had not seen explicitly mentioned was that upon the approval of a restructuring plan, Nakheel would no longer be part of Dubai World and would instead be owned directly by the government of Dubai. The repayment of the Nakheel sukuk is described as a part of the debt restructuring plan for Dubai World.

The Dubai World debt restructuring is an extremely complex process with many different stakeholders with different goals. However, it appears that there has been differential treatment of various parties without regards to their seniority (excepting the initial Nakheel Development sukuk). The first Nakheel sukuk provided sukuk investors with a mortgage over the underlying (undeveloped) properties, but the trade creditors, investors in Nakheel Development 2 and 3 sukuk and the other debt holders are all unsecured creditors of either Dubai World or one of its subsidiaries. In general, a restructuring should (in my opinion) treat all unsecured creditors equally if the debt restructuring for all entities (with the exception of excluded business like DP World) is done at once. In the current deal, all investors are theoretically being repaid at par but sukuk holders receive their payment upon the scheduled maturity dates while trade creditors receive 40% cash payment with the remainder paid in the form of a tradable security and other creditors have maturities extended with a 1% interest rate being offered.

There are good reasons for some of these developments--the Dubai government recognizes that trade creditors receiving cash on their claims (at least on a portion) will help the local economy. Paying sukuk holders on the near-term maturity will avoid default. However, it is troubling for the Islamic finance industry as a whole because it could create a perception problem for the industry. In general, the products used in Islamic finance are created to mimic conventional bonds, but their robustness in cases of default is unproven. A default by Dubai World on sukuk could have ripple effects because it was viewed (incorrectly) as a quasi-sovereign issue. However, on-time repayment of the sukuk while other creditors see the maturity extended and the interest rate dropped could make companies less likely to consider sukuk.

The rationale is somewhat convoluted, but I will try to explain it. A company that uses both conventional and Islamic forms of debt finance brings a conventional unsecured, senior bond to the market. Before that bond matures, the company issues an unsecured, senior sukuk (equal in seniority with the conventional bond) to diversify its funding sources that makes up a relatively small share of the company's total debt. When the time comes to roll over the conventional bonds, the investors balk at the debt pointing to Dubai World and asking "If you run into trouble, will the sukuk certificateholders have de facto seniority over the bond holders? Will they be repaid while we wait for a debt resolution?". The prospects for the issuance of sukuk by a conventionally financed company to create investor concerns among conventional bondholders could make such a company think twice about issuing the sukuk in the first place. This would deprive the Islamic finance industry and sukuk markets of a large group of potential issuers and will slow the growth of a portion of the industry, but not just investment banks who work on the sukuk issuers. Takaful companies, for example, will see the shortage of sukuk accentuated if potential issuers do not issue sukuk for this reason.

The Financial Times has a special report on Islamic finance. Rather than try to summarize each article, I will just list the articles and recommend them all:

• "Derivatives: 'In need of robust architecture'"
  
• "Rich potential in emerging markets"
  
• "Products: Industry 'strays too far from its roots'
  
• "Hedge funds: Industry once more at centre of attention"
  
• "Malaysia: Ahead of the game in local contest
  
• "Sukuk: Sustained recovery expected in second half of the year"
  

Other News

• Differences in interpretation and the lack of enforcement powers by standardization bodies like AAOIFI could be hindering the Islamic financial industry's growth.
  
• Bahraini Islamic investment bank Elaf Bank was appointed to arrange sukuk for two Indonesian companies.
  
• Dubai Islamic Bank approved a wakala agreement with the Ministry of Finance. The wakala agreement converts a $1 billion deposit by the government that was part of efforts to shore up local banks in the wake of the debt troubles at Dubai World.
  
• An article in the UK looks at Islamic ETFs from iShares available in the UK.
  

ISDA-IIFM Ta'Hawwut Master Agreement described by K&L Gates

K&L Gates, an international law firm based in London, released a comprehensive summary of the new ISDA-IIFM Ta'Hawwut (hedging) Master Agreement. The full description is recommended reading because it raises a number of issues with the contract's implications based on the differences with a standard ISDA derivatives Master Agreement. I will put a few quotes here, but the full article, which was released March 16, 2010, is available from K&L Gates' website.

One point of note for ISDA Master Agreements generally (from Wikipedia) is:

The ISDA Master Agreement is a bilateral framework agreement. This means it contains general terms and conditions (such as provisions relating to payment netting, tax gross-up, tax representations, basic corporate representations, basic covenants, events of default and termination) but does not, by itself, include details of any specific derivatives transactions the parties may enter into. The ISDA Master Agreement is a pre-printed form which will not be amended itself (save for writing in the names of the parties on the front and signature pages). However, it also has a manually produced Schedule in which the parties are required to select certain options and may modify sections of the Master Agreement if desired. The Master Agreement would be modified to the extent the modification is mentioned in the Schedule.

The K&L Gates article describes the general need for Shari'ah-compliant derivatives:

"Although these [Shari'ah] restrictions may make a Shari'ah-compliant derivative seem like a contradiction in terms, OTC derivative transactions are not necessarily repugnant to Islamic finance principles if carefully drafted and appropriately limited in purpose. Islamic finance, just like conventional finance, has a need for hedging against unexpected changes in exchange rates and commodity prices. Surprisingly, hedges are also needed in some transactions against changes in interest rates, despite the prohibition on interest in Islamic finance, because Shari'ah-compliant transactions often use published interest rates as a benchmark for pricing Islamic financial products.

They provide an analogy to conventional derivatives to demonstrate that some can be viewed as speculation while others are legitimate needs for hedging. The ISDA-IIFM Master Agreement specifies that the derivatives transactions must be used for legitimate hedging activities only:

"One analogy is of an Islamic participant being (a) a conventional investor who holds a bond and buys credit default protection on that bond versus (b) an investor who buys a credit default swap on a bond he does not own. The latter position is not Shari'ah-compliant as it is pure speculation not based on any ownership of an underlying asset."

The removal of interest in the contracts may change the incentives in cases where counterparties default:

"The absence of interest may also affect the behavior of parties in a default situation. A defaulting party may potentially raise legal objections and elongate the process knowing that default interest is no disincentive. Equally, a non-defaulting party may prefer to continue with a transaction under a mechanism that has a premium attached rather than be left with a liquidated amount which carries no interest."

K&L Gates describes the basis for the transaction which includes two wa'ad (promises), one is a promise to enter into a murabaha transaction on certain terms and the other is a promise to enter into a musawama, which is like a murabaha except that the cost to the seller does not have to be disclosed to the purchaser:

"The absence of interest may also affect the behavior of parties in a default situation. A defaulting party may potentially raise legal objections and elongate the process knowing that default interest is no disincentive. Equally, a non-defaulting party may prefer to continue with a transaction under a mechanism that has a premium attached rather than be left with a liquidated amount which carries no interest."

Finally, the Ta'Hawwut Master Agreement covers Shari'ah compliance. K&L Gates describes:

"Therefore a party is only obliged to confirm that the transaction is Shari'ah-compliant as far as it wishes or is required to do so. This may lead to further discussions between the parties as to each other's stance on such issues. If a non-Islamic party is concerned, then it could attempt to exclude this representation. Due to the varied interpretations of Shari'ah law, users may also want to involve their Shari'ah advisers in approving the Ta'Hawwut Agreement."

This reliance on the two parties to determine Shari'ah-compliance is both a strength and a weakness in my opinion. It allows for different Shari'ah standards to be incorporated for the underlying transactions and also for these standards to change over time (at least as far as they don't affect the Master Agreement. However, they also present a risk not unlike the Shari'ah risk that characterizes other products. In general, the transactions are governed by a secular law (in the Ta'Hawwut it allows the choice of New York or English law). A party should not have grounds to object to the transaction after the fact based on its Shari'ah-non-compliance. However, the TID v. Blom Bank case involving a wakala agreement adds another risk factor: that an Islamic bank will claim that it is, under its corporate charter or under another national law, unable to enter into contracts that are not Shari'ah-compliant. In the TID case, the courts cast doubt on the claim, but did not dismiss it altogether. This case should provide a good indication about whether institutions which are specifically prohibited from entering into non-compliant transactions can use this as a defense under the idea of ultra vives that could allow them to void a contract after it is signed even if the company's Shari'ah board approved the contract at the outset. It will be an important decision, and the judge who wrote the decision indicated that the ultra vives defense is unlikely to be allowed in the end when it required TID to pay the principal amount from the wakala to Blom Bank in order to be able to file an appeal.

The K&L Gates article covers many more issues than I could quote in this short blog post and I would recommend reading it in full.

Tahawwut derivative contract, Islamic finance and Nakheel, BBA, Publications on Sukuk

The Tahawwut master agreement that establishes a Shari'ah-compliant derivative framework was released today. An article in Risk magazine does the best job of describing the process in detail. One of the sticking points that delayed the release was the inclusion of the murabaha contract in the agreement as well as the procedures for close-out netting of derivatives exposure. This allows parties to close out derivatives positions with offsetting contracts between counterparties. The result is that the close-out netting is allowed in jurisdictions where national law allows it, which excludes many Muslim-majority countries that do not have laws governing this. There was also probably a discussion among Shari'ah scholars about the permissibility of offsetting debts (like murabaha). In general, there are restrictions on this because it is viewed as trading in debt (bai' al-dayn), which is restricted outside of Malaysia. However, it is generally allowed where the debts are equal (i.e. exchanged at par). The standard was backed by other banks including Standard Chartered, which recently announced its own Shari'ah-compliant derivatives products. In an earlier post, I wondered whether Standard Chartered's product would be able to be competitive with an ISDA-IIFM tahawwut product based on a master agreement that could spread costs across many financial institutions.

Westlaw Business has a few quotes from a roundtable discussion they held of Islamic finance recently that mostly focus on the Dubai World/Nakheel situation. It highlights that the investor base was sophisticated and should have (and probably did) know that the sukuk were not legally backed by the government. One omission I see in the discussion (and the quotes are just selective, so it may have been raised in the discussion) is the inclusion of fully perfected mortgages over the properties backing the sukuk. While the structure was a transfer of beneficial interests in a long-term lease to the SPV, there were also mortgages granted to the SPV over the underlying properties. This should have provided investors with recourse to the land if the sukuk was not redeemed using funds provided by the government of Abu Dhabi and two government-owned banks in Abu Dhabi. There are all kinds of potential problems investors would have faced to turn those mortgages into actual ownership in the underlying lands (in part because the land was in Dubai and the sukuk used a trust structure based on English law and the concept of a trust is not recognized in the local jurisdiction). In discussing sukuk generally, this point is not necessarily relevant because most ijara sukuk do not contain mortgages on the underlying asset and the investors are generally provided with just an unsubordinated, unsecured claim against the issuer if the issuer can not or does not repurchase the asset in case of a default. An article summarizing a discussion at the recent Reuters Summit on Islamic finance looks at the Dubai World/Nakheel situation in a different light, with participants suggesting that the problems with the Nakheel sukuk highlight the need for greater product diversification in Islamic finance to allow portfolio managers to have greater opportunity for diversification.

Affin Islamic Bank, a Malaysian Islamic subsidiary of Affin Bank, says it will continue to use the bai bithamin ajil (BBA) contract, despite criticism. RHB Islamic said earlier it stopped using the BBA contract to adopt global Shari'ah standards reflecting the more stringent requirements, particularly in the Gulf. The primary difference between a BBA and murabaha contract is that in a BBA, the client makes a deposit to the seller and then transfers the rights to acquire the property to the bank which then sells it back to the client on a cost-plus basis in installments. In a murabaha, the bank buys the property and then sells it to the client on a cost-plus basis with repayment in installments. The criticism of BBA is its reliance on bai' al-inah (sale and buy-back). In contrast to the murabaha contract the transaction is executed between only two parties and therefore is viewed as a hidden (conventional) loan. The murabaha, in contrast, separates the purchase (from the third-party seller) from the sale (to the client) and is more widely viewed as legitimate.

Islamic Finance Resources has four links to recent reports on sukuk. The links are to the Zawya Collaborative Sukuk Report, the Guide to Issuing Sukuk in the DIFC, a guide to issuing sukuk from Bank Negara Malaysia and the Malaysian Securities Commission, and the description of several types of sukuk from the Malaysia International Islamic Financial Centre.


Other News

• Deutsche Bank received an international Islamic banking license from the Malaysian central bank, Bank Negara, that allows it to provide services in foreign currencies.
  
• The Central Bank of Bahrain's Sukuk al-Salam sukuk was oversubscribed with a bid-to-cover of more than 4 times with BD56.8 million in subscriptions for the BD12 million issue.
  
• An experiment in Islamic microfinance in Pakistan described in brief.
  
• Israeli fund managers are offering investment products that comply with the prohibition of interest (ribbit) as well as other prohibitions, which shows how the prohibition of riba in Islam is mirrored in other Abrahamic faiths.
  

Reuters Islamic finance summit, AAOIFI Shari'ah review

An article in the Kipp Report describes some of the issues facing Islamic finance if it wants to move forward. The areas are primarily focused on regulation and transparency, which are key areas for the Islamic finance to develop to ensure future growth.

AAOIFI provided a timetable for its review of the Shari'ah-compliance of Islamic financial products. They will begin the process in June and begin screening products in the second half of 2010. This is an interesting expansion of AAOIFI's traditional role of setting standards for the Islamic finance industry, but it is important that the industry remain some degree of consistency in the product's adherence to a common set of overarching Shari'ah standards. The one thing that will be vital to ensure that the industry is engaged in a positive way with the Shari'ah review is for AAOIFI to provide a transparent process to evaluate products' Shari'ah-compliant.

Reuters Islamic Finance Summit

Islamic banks in Indonesia have been and expect to produce returns on equity twice that of conventional banks. The additional return on equity is likely due, at least in part, to the rapid growth of the industry in Indonesia. One area which is somewhat concerning is that Beny Witjaksono, president of Bank Mega Syariah Indonesia, who said that the profitability was in part due to the finance fees being about twice that of conventional financial institutions. This is concerning because the Islamic finance industry needs to remain competitive with conventional financial institutions. It should not be financing growth and profitability at the expense of customers above the cost of finance offered by conventional financial institutions.

The ta'hawwut standardized Shari'ah-compliant derivatives contract's launch (being developed by ISDA and the IIFM) is "imminent" according to Simon Eedle, managing director of Islamic banking at Credit Agricole CIB. I wrote a comment on the FT Alphaville blog (who graciously linked to this blog):

The idea of a Shari'ah-compliant derivative is not necessarily a contradiction in terms. Islamic finance, just like conventional finance, has a need for hedging against unexpected changes in exchange rates, commodity prices, interest rate (which affects the industry through its use as a benchmark for pricing financial products).

However, the tricky part about derivatives from the perspective of Shari'ah-compliance is how to create them so that they can provide the necessary hedging (a transaction that in one way can be thought of as altering the risks and returns between different parties) without providing a way for investors to speculate. For example, the difference between a conventional investor who holds a bond and buys credit default protection on that bond, versus an investor who buys a credit default swap on a bond he does not own.

There is an additional problem from the Shari'ah-compliance perspective (as I understand it, and I am not qualified to give anything more than my opinion on the subject) is that by its very nature, a derivative (whether an option, swap or other product) involves one person gaining at the other's expense, which is viewed as close to gambling and on the face of it, would not be something that Islamic finance should get into. However, creating ways for Islamic investors to hedge risks is something that is useful to the productive running of the economy (why make manufacturers who export goods also be currency market experts?). This could be the reason for the delay.

Alliance Takaful is in talks on a sukuk issue. In part, the move is described as encouragement for the issue of more high-grade corporate issues that takaful companies need to invest in to fill the asset side of their balance sheet to match the longer-term liabilities. The article does a very good job explaining one of the manifestations of the asset-liability maturity mismatch facing other Islamic financial institutions including takaful providers. In addition, the CEO of Allianz Takaful, Abdul Rahman Tolefat, describes the difficulty in competing with banks for new sukuk issues, particularly in sovereign sukuk. He suggests that issuers allocate a percentage (10-15% was his number) of the new issue to takaful providers to allow them to subscribe to high-grade sukuk that they may not otherwise get access to if the issue is significantly oversubscribed.

Standard Chartered is about to launch an Islamic commodity derivative for clients to be able to hedge against the price of various commodities, something they say they have been working on for 15 months. It will be interesting to see how the new product interacts (particularly in terms of acceptance from clients) if the ISDA-IIFM product is launched shortly. The long development process could be a detriment to Standard Chartered based on the price they are able to offer to clients when competing with standardized derivatives under the ISDA-IIFM master agreement. The new products will each have to incorporate the development cost in their product's cost. Standard Chartered undertook the product development cost on their own and absent a subsidy from other areas of the bank, the cost of their Shari'ah-compliant derivative will incorporate additional cost that financial institutions using the ISDA-IIFM master agreement will not necessarily have to bear. That being said, the availability of a number of different products to accomplish the same goal of hedging against external risks is a positive for the industry by forcing industry participants to determine which is the best product and this will ensure that future development is done in a competitive environment.

Sonya van de Graaff, a partner at Brown Rudnick, offered some good commentary on the Islamic finance industry at the Reuters summit which are summarized in an article. She points to the Nakheel sukuk debacle as providing investors with a reminder that the sukuk structure was complex and overlapped several legal systems. I have discussed the Nakheel sukuk in depth in other posts. The article ends with a quote from Ms. van de Graaff that I think should have been recognized by the industry far earlier than it was

"There was sometimes the impression during the crisis that hit western economies from 2007 that the stretched loans-to-value at the root of the problem could never happen in Sharia finance because of restrictions on leverage limits. Well, they did"

There were two other articles from the Reuters summit, one on Bank of London and the Middle East and one on the prospect of asset sales by Gulf Finance House.

Other News

• The new product from Australian bank Westpac is described in a little more detail and there is a link to the government study of Islamic finance (pdf).
  
• The Central Bank of Bahrain's al-ijara sukuk issue was oversubscribed by 200%.
  
• ThomsonReuters launched their Islamic finance gateway.
  
• Indonesia cancelled a 1 trillion rupiah ($107 million) in sukuk it was offering, without specifying a reason. An analyst quoted in the article suggested that the investors demanded returns higher than the government was willing to pay.
  

IIFM-ISDA Shari'ah-compliant hedging agreement, KFH investment in US real estate

Shari'ah-compliant hedging

The International Islamic Financial Market (IIFM) held a meeting of Shari'ah scholars in Dubai to discuss the Tahawwut (Hedging) Master Agreement. The Tahawwut Master Agreement, developed in partnership with the International Swaps and Derivatives Association (ISDA), has not been described in significant detail, in particular what types of hedging activities it would cover. There are certainly areas where hedging could be useful in the Islamic finance industry, and a standardized agreement could provide some standardization and a starting point for more discussions about the place of Shari'ah-compliant hedging products in the industry.

The difficulty with many hedging products in Islamic finance is that there are so few and each hedging transaction must have a counterparty to assume the hedged risk. For example, if an Islamic bank hedges against its foreign exchange or interest rate risk, there must be a counterparty that is essentially unhedged, which would probably be characterized as speculation. There could be a central counterparty that enters into enough transactions to be able to be relatively hedged itself, but this is not yet the case. Alternatively, a conventional bank could step in and act as the counterparty in the transaction. In this case, that bank would then go into the conventional swaps/derivatives markets to hedge its own risk.

This raises the question of whether the Shari'ah-compliant hedge was beneficial to anyone except the counterparty. If an Islamic bank hedges its risks with a conventional bank, which then hedges itself against the same risk, who benefits except for the conventional bank which inserts itself into the middle and presumably collects fees?

To some degree this problem occurs in other Islamic finance transactions. However, the nature of derivatives as opposed to other investment products, highlights this problem. In the best case, the IIFM-ISDA Tahawwut Master Agreement will provide a transparent and simple way for hedging transactions to be structured that will lead to the development of a common counterparty that only acts in Islamic derivatives. There are similar institutions in emerging market currency hedging. The scope of the problem would be large enough to probably require some assistance from a multi-lateral institution like the Islamic Development Bank.

KFH real estate investment in the U.S.

Kuwait Finance House made a $242 million investment in a real estate project in Chicago, Illinois which is currently under construction and is expected to be completed in 2011. The building will be a 40-storey Ritz-Carlton Residences, a condominium tower and $137.5 million of the project will be debt financed from German landesbanks Helaba.

Helaba recently arranged its first Shari'ah-compliant real estate deal in the U.K. with Gatehouse Bank, so the debt for the Chicago project may be Shari'ah-compliant. If it is not, it is likely to be separated from the equity using an ijara-istisna'a structure which has been used internationally over the past decade.

Other News

• Saudi Hollandi Bank issued a $193 million subordinated, callable sukuk.
  
• The Islamic Development Bank saw its AAA rating affirmed by Standard & Poor's.
  
• Bursa Malaysia may allow individual investors to invest in sukuk. Following Dubai World's debt crisis and the multitude of questions asked regarding the ability of investors to have recourse to the underlying assets, it would seem that opening sukuk secondary markets up to individual investors could create the potential for problems down the road.
  

Regulation in Islamic finance, Questions remain about Dubai GREs

Malaysia's prime minister Najib Razak said that the Islamic financial industry needs strong regulation to ensure it avoids future crises. This has been an area where the industry has been slow to recognize its susceptibility to a similar financial crisis that occurred beginning in 2007 in the conventional financial industry. For too long, there were many articles talking about how the Islamic financial industry was 'immune' to crisis because of the way it operated. I have been pointing out that there are some aspects of the Islamic financial system (including lack of deposit insurance and a true 'lender of last resort') that could even make Islamic finance more vulnerable to a crisis if there was a serious loss of confidence in one or a few large Islamic banks. It is good to see that there is a greater recognition of the need for regulation to prevent either poor risk management or damaging innovation from creating a situation where there could be a crisis. Now, all that needs to happen is for these regulations to be adopted. That could take a while, although the Islamic FInancial Standards Board has begun discussing liquidity standards that would address one potential area of systemic risks in Islamic finance caused by the difficulties of Islamic banks in managing liquidity and asset and liability maturity mismatches.

Some of the proceeds from the recent Dubai sukuk, which raised $1.93 billion, will be used to pay the maturing $1 billion sukuk from the Dubai Civil Aviation Authority, which matured today. The UAE said that the timing of the issue of a $10 billion bond planned by Dubai that may be used to redeem the Nakheel sukuk maturing next month will "depend on the needs at the time" according to the Minister of Economy. In a contrary development, ratings agency Moody's Investor Service downgraded five government related entities (GREs) because the government after the Dubai finance department relinquished its obligations to cover the entities' debts. Although the GREs are not part of the government and do not have a government guarantee, they are closely tied to the government and any defaults would likely have repercussions on the Emirate's perceived creditworthiness.

Other News

• Amlak and Tamweel, the two large Dubai-based Islamic mortgage firms will be merged beginning in January with their investors owning one-third of the resulting bank.
  
• Gulf Finance House is planning on converting into a commercial bank from an investment bank and will issue $100 million in a convertible Islamic instrument. GFH issued Macquarie Bank with a $100 million convertible murabaha earlier this year.
  
• The ISDA-IIFM template for Shari'ah-compliant derivatives will be released either this year or early next year.
  
• The IFC listed its $100 million sukuk on the Bahrain Stock Exchange and NASDAQ Dubai.
  
• The U.S. is selling the building in which its embassy has resided in London to Qatari Diar, which recently began the process of issuing sukuk to fund its European acquisitions. Al Salam Europe, the European unit of the Bahraini firm is also planning on expanding its investments in Europe with real estate and private equity investments planned by January.
  
• Islamic finance could continue its rapid growth and see total assets of $4 trillion in 8-10 years according to the CEO of Doha Bank in a speech recently.
  

Sukuk markets recovering, IFC sukuk listed in Dubai and London, Islamic asset management faces a 'chicken-or-egg' problem

The sukuk market is expected to recover following signs that Nakheel will avoid default and GE Capital Corporation, which has a joint venture with Abu Dhabi-based Mubadala, was reported to be considering issuing a sukuk. The recovery in Nakheel's sukuk have come following the $10 billion in bonds issued by Dubai and the prospect for the Emirate to issue $6.5 billion in bonds and sukuk. The sukuk-reported to be $2.5 billion of this amount-are reported to be priced near 6%. The funds from the bond and sukuk issuance are expected to be administered by the Dubai Financial Support fund, which has provided some assistance to Nakheel.

With the listing of the World Bank Group's IFC sukuk, NASDAQ Dubai expects the sukuk and bond markets to pick up before the IPO market. The sukuk will be listed on both NASDAQ Dubai and the London Stock Exchange and is rated Aaa by Moody's.

The Islamic asset management industry faces a 'chicken-or-egg' problem as the industry has a shortage of investments to choose from, particularly in the fixed income area, while there are few investments available because of questions about the strength of demand. The increasing involvement by governments is a double-edged sword, notes an article from Reuters. Governments can provide a source of issuers willing and able to issue sukuk, but could crowd out other issuers, particularly lower-rated issuers. So far this year, roughly 80% of sukuk have come from government issuers and many of the others were issued by high-grade corporate issuers.

Emirates Business 24/7 has an interesting article about the debate over standardization in Islamic finance. There are many views on how standardization should happen, whether it should be a goal at all and what aspects of the industry should be standardized.

Other News

• The International Swaps and Derivatives Association (ISDA) is expected to release guidelines on Islamic derivatives, and these could come by December. The standardized agreement, being jointly developed by the ISDA and the International Islamic Finance Market (IIFM), would provide a standardized contract for Shari'ah-compliant hedging products.
  
• The opening of the country's first Islamic bank led German paper Das Spiegel to write a good article that provides an overview of the industry's development.
  
• Tamweel, the troubled Dubai-based Islamic mortgage company, made a periodic payment on its sukuk due in 2013.
  
• The Irish Revenue Service has clarified its rules on the taxation of Islamic finance products and a summary is available from Arab News.
  
• The CIO of CIMB-Principal Islamic Asset Management Dr. Zeid Ayer believes that Brunei should open its sukuk up to international investors to broaden the base of investors. The sultanate issues sukuk despite large oil reserves and little need to raise financing as a way to promote the growth of its Islamic finance industry.
  
• The results of an Islamic Finance Perceptions survey are summarized in an article.
  
• As Malaysia issues RM3 billion ($888 million) in sukuk, it has also extended the tax exemption on Islamic financial products to 2015 that have helped the industry grow rapidly in the country.
  

Malaysia leading in sukuk, CBK appoints monitor for TID, Nakheel sukuk rises on comments, derivatives framework by year end, Islamic finance in France

Malaysia remains the largest issuer of sukuk representing 45% of total issues followed by Saudi Arabia with 22% in the first 7 months of 2009 according to a report by Standard & Poor's. The largest issuer was Saudi Electric Company which issued a $1.8 billion sukuk. 20% of the sukuk issued were denominated in US$, up from 10% in 2008. 3/4 of all new issues were from sovereign issuers. In another report, the Securities Comission of Malaysia reported that through August 2009, more sukuk had been issued than all of 2008 which amonted to 58.2% of the total issuance of sukuk & bonds in the country through July (p from 57% in 2008).

The Investment Dar, whose sukuk is in default, has not filed its 2008 financial statements yet and will be monitored by a temporary monitor appointed by the Central Bank of Kuwait.

Troubled property firm Nakheel saw its sukuk rise over par in secondary market trading after Shaikh Mohammed bin Rashid Al Maktoum, ruler of Dubai, said he was not worried about either the $1 billion in maturity debt for the Emirate or the $3.52 billion maturing Nakheel sukuk. Speculation has been rising that Dubai will bail out Nakheel using the $20 billion it raised recently with half coming from the UAE Central Bank. I wrote a summary of this sukuk earlier this year when it was trading at a substantial discount to par.

The International Islamic Financial Market (IIFM) will finalize a master agreement for Islamic derivatives by the end of the year. The agreement, called Ta'Hawwut may be based on Arbun, which has been used to replicate call options in a Shari'ah-compliant way. Derivatives like options and swaps have have attracted some significant criticism for simply replicating conventional products. I recently wrote a blog post on whether all innovation is necessarily beneficial within the Islamic financial industry.

France wants to attract Islamic finance, but concerns remain about how well Islamic retail institutions would fit in with the country's strict separation between religion and state. The author of the article in Reuters has a blog post at the website providing additional insight behind the article.

An Australian newspaper has an article on the MCCA co-operative that recently offered a retail Shari'ah-compliant mortgage interest fund. It's an interesting article about a product that is not available in much of the world in Shari'ah-compliant fashion. However, it is available to some extent in the U.S. and Canada also in the co-operative model. However, one of the significant limitations of the co-operative model is that it often faces a shortage of capital to fund the home purchases for the members because it cannot access capital markets by securitizing the mortgages or, in the U.S., by using funding provided by Freddie Mac.

Other News

• The government of the Indian state of Kerala plans to set up an Islamic bank according to the region's finance minister.
  
• Two Bahrain-based Islamic investment firms, Inovest and Tharawat, are investing $32 million in a water filter production company.
  
• An article on the recovery includes what I think is an important reminder that "'Islamic Finance's immunity is a myth which is brought up persistently', says Fares Mourad, Managing Director and Head of Islamic Finance at Swiss private bank Sarasin."
  
• Does Islamic finance need more supervision?
  
• Malaysia's state-owned body which owns transit assets priced RM2 billion ($573m) in 15- and 20-year sukuk.
  
• Kuwait Turkish Participation Bank, majority owned by Kuwaiti firm Kuwait Finance House, received approval to conert its commercial office in Mannheim into an Islamic banking institution by the end of 2009 or early in 2010.
  
• Abu Dhabi's Tourism Development & Investment Company may raise $1 billion in sukuk.
  
• A $125 million syndicated secured ijara facility from a Kuwaiti issuer may have helped the market for other syndicated ijara facilities.
  
• Qatari Diar is raising $962 million through a syndicated Islamic facility to fund investments in Europe.
  

Illusions of the 'immunity' of Islamic finance hinder growth and innovation

The governor of Bank Indonesia, during a speech, made the claim that because of the Shari'ah screens, "if implemented properly, we can say that sharia economy and banking pose no risk of a crisis. Amid the ongoing global crisis, the presence of sharia banking is actually a hope." Although there are benefits in reduced risk created by the restrictions on gharar and maysir, the use of Islamic financial products cannot be said to be entirely free of risk of crisis. Islamic finance is still a tool used to finance purchases, including assets that can be inflated in a bubble (see Dubai's property market) and claims that asset price bubbles cannot happen when using Shari'ah-compliant financial services distracts from the real benefits from using these financial products and could, in the extreme, be detrimental if there is a general belief that crisis cannot happen.

One immediate outcome of a focus on the 'immunity' of Islamic finance from crisis is that it distracts attention from a much needed focus on real risk management, particularly whether and what types of derivatives and forwards could be judged permissible to provide a way to hedge exposure to some of the risks that Islamic banks face. In general, derivatives are not permitted because they are judged as gambling, but there is a valuable place for some hedging products to offset the lack of liquidity of some Islamic financial products, the maturity mismatch between assets and liabilities on banks' balance sheets and the lack of an interbank lending market (outside of Malaysia) that could keep a crisis from spreading by providing a buffer against illiquidity becoming insolvency.

The sukuk market shows no signs of improving despite there being over 100 sukuk issues planned because there are doubts about whether there will be buyers. Also, the AAOIFI ruling on sukuk from February 2008 has led to a greater proportion being ijara sukuk, depriving many issuers without the assets needed for the sale-leaseback transaction. Despite this, there are a few companies raising funds to purchase sukuk in the expectation that the lack of demand has made the future returns greater.

Other News

• Asset managers in India are becoming more interested in offering Shari'ah-compliant services. The equity markets in India are deeper than in other countries with larger Shari'ah-compliant asset management companies like Malaysia and some managers expect that over 60% of the total market capitalization in India pass common Shari'ah screens.
  
• Assets under management by Shari'ah-compliant asset managers in Kuwait fell 45.5% in the second half of 2008 to $4.4 billion, a similar percentage fall as seen by conventional fund managers.
  
• Abu Dhabi Islamic Bank will receive AED2 billion in a capital infusion from the government. The government will receive a sukuk paying 6% semi-annually. The structure of the sukuk is not clear.
  
• The merger of Islamic mortgage lenders Amlak and Tamweel into Emirates Development Bank is being rethought and the companies may be nationalized according to an analyst at EFG-Hermes.
  
• Malaysia's central bank, Bank Negara, will issue Ringgit 400 million ($110 million) in ijara sukuk next week.
  
• The size of a Malaysian bank's Gulf aviation fund may be cut in half as a result of the economic downturn.
  
• The State Bank of Pakistan is developing guidelines for Islamic financial products for the agricultural industry.
  

Do Islamic financial institutions avoid high leverage?

The Bank of London and the Middle East (BLME) is launching three new funds, a fixed income fund, a distressed real estate fund and an equity fund. If these funds are well capitalized, they could benefit greatly from the economic difficulties created by the credit crisis and provide another avenue by which the Islamic financial industry gains prominence. I did find one sentence in the article to stretch a little (emphasis mine): "BLME will capitalise on an increasing appetite for Islamic finance, which protects investors from the risk of excess leverage and prevents exposure to toxic assets, short selling as well as derivatives, amid a collapsing global financial system." In general Islamic finance should protect investors from excess leverage, however, as I commented in recent post, this has not always happened: one of the factors mentioned in S&P's downgrade of Arcapita Bank was that they "view[ed] Arcapita's leverage as high".

Kuwait's Islamic financial sector is helping support the country's financial system as the conventional financial institutions run into trouble. However, there are still concerns about lax regulatory oversight in the Islamic financial industry in the country and The Investment Dar requested $1.1 billion from the government to help it refinance its short term debt and may sell part of its 50% stake in Aston Martin, purchased in 2007. The government of Kuwait has announced it will issue a sukuk backed by the banks' assets to support the banking system. In a difficult economic climate and following the developments in the financial system last fall, it strikes me as puzzling that Kuwait's financial sector is healthy with concerns over transparency in the industry while it is requesting $1.1 billion from the government and selling recently investments that it announced with great fanfare (I saw a presentation that included music from a James Bond movie along with the first slide of the presentation which read 'Bond, Islamic bond', a reference to Bond's preference for Aston Martin cars) less than two years ago. Also, two directors quit Boubyan Bank, which is partially owned by The Investment Dar, without providing explanation.

Other News

• Indonesia issued its first sovereign sukuk, which will yield 12%
  
• Despite being of relatively similar sizes, Malaysia's bond market receives less attention, according to an article in The Star. The share of sukuk in the entire bond market has risen to 36.2% from 28.9% in 2005.
  
• After its rating was confirmed by S&P (although the outlook fell to negative from stable), Gulf Finance House says it is looking at making acquisitions.