Sukuk market development

As I was finishing up my weekly newsletter, I had a few extra thoughts to add to what I included in the newsletter.  Here's a portion of the newsletter (sign up on the right hand side of the blog, old issues of the newsletter are available at the Sharing Risk website) for context: 

I ran across a presentation from 2005 where the head of IIFM, Ijlal Alvi (PDF) lays out a broad prediction for sukuk markets (with a few recent relevant news items added):  

• Increasing demand from issuers to tap sukuk markets (South Africa is planning to issue sovereign sukuk) IFIs want tradable sukuk with fixed income profile
• Development of sukuk funds followed by growing demand for sukuk, causing issuance to “surge exponentially” (Indonesian sukuk fund managers want to expand fund size, but fear demand for sukuk will outstrip supply.  This is also true in Malaysia).  
• Sukuk will be used for liquidity management and as a money market instrument.  (IIFM held a meeting on collateralized murabaha with sukuk as collateral, which is rapidly becoming the standard alternative for unsecured commodity murabaha in inter-bank lending markets)

The items for the sukuk market to develop laid out by Mr. Alvi 7 years ago seem to be falling into line quite well, after being interrupted by the financial crisis.  There is however, a key item missing in the sukuk markets across the items above: tradability is possible, but it remains limited.  

What surprised me is how well articulated the needs for the sukuk market have been over several years when the global economy and financial markets have gone through significant changes.  The problem for Islamic finance is not necessarily that the problems are not articulated, it is that there are so many different factors in play, and the sukuk market is not a unified market, so different markets around the world have a different set of items to change that have moved to the top of the list for stakeholders.

For example, the GCC is largely dominated by sovereign (and government-related entity) issuance, which probably mitigates some of the risks to coporate sukuks that are more common in Malaysia, but the GCC sukuk markets are relatively illiquid and dominated (in terms of size) by fewer, larger sukuk.  The Malaysian market is more liquid, with a larger number of issuers, particularly corporate issuers, although there are a number of very large government- or GRE-issued sukuk (the difference is that the secondary market is better developed).  

From the top-down perspective, the GCC would be served by a greater diversity of issuers, while Malaysia is attracting more buyers chasing the available sukuk that causes the market to become relatively more illiquid if holders of sukuk don't wish to part with their holdings in fear of not being able to find another sukuk to replace it.  The discussion above itself is mostly from a high-level, and there are many other nuances that distinguish aspects of the sukuk markets in these regions and across the countries in the GCC.  

However, with different needs in different markets, it is difficult to address the underlying difficulties to even accomplish and agreed-upon goal: creating an Islamic repo product.  This is being adopted, using a collateralized murabaha structure, in both the GCC and Malaysia (the latter in part to provide GCC-connected banks with acceptable short-term liquidity management products as a substitute to the domestic inter-bank market which those banks won't use).  

An Islamic repo product in order to remain viable even in periods of financial stress, need to have highly-rated and liquid collateral (an equivalent to US Treasuries for conventional repos).  There is a shortage of this collateral, which is in part what the IILM will provide (if an inaugural sukuk is ever launched), will have to be issued in large enough supply and with enough diversification across the short end of the yield curve and across different currencies to get a secondary market developed. Otherwise, issuers will be forced to pick and choose from among the sukuk outstanding, which could lead to increased pricing distortions in the yields between liquid and illiquid sukuk as banks bid up the liquid sukuk to use for repo transaction. 

So, while individual markets will have their own challenges to address, it is important for the Islamic finance industry to find areas where there are similar challenges--and solutions--to tackle in a cooperative way.  One of these challenges is liquidity management and the solution, which is on the right path even if it is taking far too long, is the IILM. 

A few items that slipped through the cracks

There have been a lot of articles sitting in my feed reader and I won't have time to write more in depth on the topics, but here are the links with quick summaries.  

Size of Islamic finance industry
The City UK released its latest annual report on the Islamic finance industry showing the industry has $1.3 trillion in assets.  I hope to have more detail on this in another post when I have time to read it.

The Malaysian Islamic finance banking industry reached 22.4% of the country's total at the end of 2011.  Despite only having 15% of the outstanding USD-denominated sukuk issuance, it has one of the best developed (i.e. liquid) sukuk market, based on a lot of domestic MYR-denominated sukuk, but still showing that size isn't everything. 


Shari'ah standards
A conference participant suggests that investors and advisors should do their own Shari'ah research instead of waiting on a Shari'ah board to provide a fatwa.  Not much chance of happening, but interesting to see new perspectives. 

Goldman Sachs
Reuters gives the latest update on the Goldman Sachs murabaha sukuk which has attracted a lot of criticism, saying that the Shari'ah advisors have signed off and the ball is in Goldman's court.   I offered my perspective on the trading issue with a murabaha sukuk in an earlier post. 

IIFM-ISDA
The ISDA press release is available here for the new Mubadalatul Arbaah master agreement.

Australia
The National Bank of Australia is considering a $500 million sukuk issuance, the first from the land down under, as Islamic finance begins to develop in the country.

Hong Kong
HK returns to its work on attracting Islamic finance.  Despite expressing a desire to become an Islamic finance and sukuk hub, Hong Kong has not progressed far with the only issue coming from RMB500 million ($79 million) sukuk from Khazanah. 

Indonesia
The Indonesian government issued its first 4 series of project-based sukuk, although only the 30 year sukuk received bids accepted by the government.   Out of a 2.18 trillion rupiah ($237 million) in total bids, only 355 billion rupiah ($38 million) was accepted, all for the PBS0004 issue due 2037.

Microfinance
A microfinance product that offers a deposit product and interest-free loan program rolled into one.  When will Islamic finance get behind Islamic microfinance in a big way?

Profit rate swap master agreement

The International Islamic Financial Market (IIFM) and the International Swaps and Derivatives Association (ISDA) announced their newest master agreement for a profit rate swap (mubadalatul arbaah).  This is a good development in my opinion because it provides a lower cost way for Islamic financial participants to hedge against fluctuations in the interest rates that are used to determine the cost of Islamic financial products. 

The idea of Islamic derivatives have been controversial because they are often viewed as instruments for speculation, which is viewed as not being in the spirit of Islamic finance.  Speculation financed by Islamic financial products (e.g. in the Dubai real estate market before the crisis) somehow escapes the same level of scrutiny as derivatives.  Other objections have focused on the synthetic nature of Islamic derivatives as being just copies of conventional products done in a way that is Shari'ah-compliant, and is somewhat condescendingly described as not being used to finance 'real economic activity'.

However, profit rate swaps are quite easily used for legitimate hedging transactions that doesn't necessarily shift risk from one party to another at least entirely (a criticism that could be more aptly pointed at talk of developing Islamic credit default swaps).  Hedging is viewed as permissible, where speculation is viewed in a negative light (again with a somewhat double standard). 

Take, for example, a situation where an Islamic bank financing a widget factory through a murabaha.  The bank only offers the company a floating rate loan.  However, the managers of the widget factory don't want to be exposed to the risk that the financing costs increase over the term of the murabaha because it could lead to additional cost that complicates their planning for the business. 

The manager of the company may then approach an investment company to lock in the financing costs, to make its finance costs predictable over the life of the murabaha.  A fund approaches the company with the offer of  a profit-rate swap that locks in the financing costs for the widget company through a profit-rate swap.  The fund receives a stream of fixed rate payments in exchange for paying a floating rate, which it expects to benefit its investors. 

The master agreement facilitates this process by lowering the costs compared to the participants having to custom build a profit-rate swap.  Without the master agreement, there would be fewer transactions, which would make an impact on the 'real economy' because fewer companies would have the opportunity to fix their financing, and effectively shift the management of interest rate fluctuations to institutions that have a focus on managing those changes. 

The one criticism I have of the profit rate swap is that it is an over the counter (OTC) swap.  The benefits of the profit-rate swap come with the cost of counterparty risk by adding a third party into the original murabaha, which exposes the widget to the company that it will lose its fixed rate protection if the counterparty in the swap cannot fulfill the terms of the contract.  However, creating an exchange for swaps is a whole different challenge that can (and probably will) wait for another day (likely well into the future). 

Indonesia inter-bank money markets

It is difficult to tell exactly how the inter-bank money market will work (described in an article from Bisnis Indonesia).  The article describes:  

 "According to him [an unnamed source at Bank Indonesia, the central bank], the underlying asset in the money market may be in the form of sharia commodity futures. Moreover, collateral may use government’s sukuk.

Taking apart the parts of this sentence, I would imagine that the "sharia commodity futures" refer to using a commodity market (for cocoa, cashew or arabica coffee, as the article suggests later) to back commodity murabaha between Islamic banks in Indonesia.  A commodity murabaha is a common inter-bank money market instrument in the GCC and Malaysia.  The latter has set up an exchange, Bursa Suq al-Sila, to connect palm oil producers with financial institutions that want to use palm oil to back commodity murabaha transactions.


The difference between most commodity murabaha inter-bank lending and the Indonesian plan, from my reading, is that the inter-bank commodity murabaha would be collateralized using government sukuk.  Bank Indonesia announced in the first half of 2011 that it planned to issue 3-, 6- and 12-month Sharia T-bills and was scheduled to issue the first 6-month T-bills in early August. 

Collateralizing inter-bank commodity murabaha transactions is a good move from a risk management perspective, where lack of confidence by counterparties can lead to withdrawal of inter-bank lending and turn a liquidity crisis at a bank to a solvency crisis.  If the inter-bank lending is collateralized, the counterparties to a bank that runs into a perception that it is in trouble will be less hesitant to withdraw funding to that bank (although they will certainly not be patient for ever).  This is the reason that repurchase (repo) transactions have become a large source of short-term funding for many banks (with the caveat that the security of repo transactions is only as good as the credit of the collateral; the European debt crisis shows that even seemingly solid sovereign credit can lose their value as collateral very quickly).


The difficulty with developing this type of collateralized inter-bank lending is from a Shari'ah-compliance perspective.  The issue of collateralized commodity murabaha was one of the proposals considered by the International Islamic Financial Market (IIFM) (see my initial comments here). It is still not necessarily widespread, but it is a promising way to make inter-bank lending more secure (which prevents funding from drying up as quickly and gives time to deal with troubled banks).  However, there are obstacles--about which I cannot speak with authority---that make it more difficult to ensure it is widely accepted as Shari'ah-complaint.  But, it adds to the forthcoming International Islamic Liquidity Management Corporation (IILM) as a new source of inter-bank liquidity management tools that will strengthen the Islamic finance industry. 

In the end, we will have to wait and see what the final regulations around collateralized inter-bank Islamic lending from Bank Indonesia.  However, I think that the development is positive and could help Indonesia be an area of growth for Islamic finance and banking in 2012 (more in terms of being rapidly growing; not necessarily having a large quantitative impact on the size and growth of Islamic finance as a whole).  One area where it does not have much impact is in moving Islamic finance away from murabaha.  However, it is probably better for Islamic banks and financial institutions to move other parts of their balance sheets away from murabaha and towards profit-and-loss sharing instruments before the inter-bank money markets are shifted away from murabaha.

The rise of istithmar sukuk

From my newsletter:

On June 20, 2011, the Malaysian central bank, Bank Negara, unveiled its newest liquidity management product, although few details were offered. In the first auction on the following day, Bank Negara sold RM500 million.($165 million) of the 1- to 3-year sukuk. The product itself is based on the istithmar structure, which combines other receivables from murabaha as well as ijara transactions. In general, under AAOIFI rules, the portfolio must have at least 33% ijara sukuk in order to be tradable, although in many cases, a more conservative interpretation is used where 51% of the portfolio must be ijara.

It is always interesting to see new Shari'ah-compliant liquidity management products come out with different structures (istithmar, commodity murabaha, salam and ijara are the ones I have run across). However, beyond the liquidity management space, the istithmar structure is becoming more widely used with institutions like the Islamic Development Bank. The International Finance Corporation used a similar wakala (agency structure) which securitized a portfolio of other contracts.

The thing that I find about this interest in istithmar sukuk is that it (and/or wakala) have potential to replace mudaraba and musharaka sukuk, which were used (and misused) extensively before the financial crisis and the AAOIFI ruling clarifying the rules around the buyback clauses used at maturity of those sukuk. There may be less concern about misusing structures (or misapplying their rules) in an istithmar sukuk (compared with a mudaraba or musharaka) because the former type is designed to be specifically an investment portfolio, where latter is commonly associated with venture financing (either providing financing from one party in mudaraba or through a joint-venture financing in a musharaka).

It will remain to be seen how much uptake their is in the istithmar sukuk structure but they are likely holding many ijara and murabaha assets on their balance sheets that could be securitized. It will likely depend on whether they have sufficient ijara assets to match up with murabaha to get to the threshold to make their sukuk tradable.

As I re-read the newsletter, it occurs to me that the entire area of securitization has largely passed Islamic finance by, although it would be a natural source of new sukuk were Islamic banks to pass on their risk and return to investors. However, the likely reasons for the absence of securitization (with a few exceptions) is the absence of standardization of the contracts for securitization, as well as the collapse in the securitization market that occurred just as the sukuk market was reminded of the rules around mudaraba and musharaka sukuk, which had been widely used (and as I mentioned, misused).

Now that the securitization market is coming back to life in the conventional market, it would be a good time to look towards pure securitization. It has the "ideal" structure (in the eyes of many) of making investors participate in both the risk and reward, would allow for the relatively quick creation of a lot of new sukuk in a market that has been coming back strongly from the credit crisis and the istithmar and wakala structures are much better vehicles, at least on a high-level view view, than mudaraba and musharaka, which were somewhat co-opted for creating sukuk based on a pool of financial assets.

There are, of course, some caveats. The first would be to find and address the reason why Islamic banks are reluctant to securitize their assets. Perhaps they believe that they will be more highly rewarded by holding the assets themselves, although that creates additional risk within the system as a whole. Or, perhaps, the infrastructure for creating cheap securitizations does not exist. Compared to the first possibility, this would be the best case. The International Islamic Financial Market (IIFM) is already reported to be working with Hawkamah on a standardized contract for ijara sukuk.

There is also the ever-present risk to investors that Islamic banks will securitize their bad assets and keep the ones they believe will perform the best. Given the ability of some Islamic banks (Gulf Finance House is the best known name) to use questionably ethical business models, the potential for Islamic banks to dump risky assets into securitized sukuk risks creating Subprime (v.Islamic). Perhaps the Western Islamic banks could take the lead in developing the infrastructure for Islamic securitizations.

An Islamic repo coming to market

The National Bank of Abu Dhabi announced that it will launch a murabaha-based Islamic repo (repurchase agreement) product in March. I believe this would be the first Islamic repo. The few details in the article suggest that it is similar to the structure proposed as most likely by the International Islamic Financial Market (IIFM) . That structure (and likely the NBAD structure) essentially create a secured commodity murabaha contract. The two parties engage in a commodity murabaha transaction (sale of a commodity with deferred repayment), but unlike a normal murabaha transaction, the borrower pledges a pool of sukuk to secure the repayment.

This transaction is not terribly innovative on its face. The main difference between this transaction and a commodity murabaha is the pledge of sukuk as collateral. There are other add-ons that could be part of the transaction. For example, the transaction could be structured so that the buyer (lender) can re-hypothecate the sukuk (i.e. use it for its own purposes, including by using it to engage in repos with other counterparties). This would differentiate the repo from commodity murabaha transactions because it ties up assets of the bank for the length of the transaction.

The downside of the repo transaction is that it further limits the potential for secondary market liquidity in sukuk because holders of sukuk will use the repo market as an alternative way to make their holdings liquid. Thus, they will be less likely to offer their sukuk holdings in the secondary markets that are already limited in the supply of sukuk being offered. The flip side of this is that it could benefit the primary markets for sukuk because investors (depending on the quality of the issuer) would be able to generate liquidity from longer-term sukuk than they can today. It could also reduce any illiquidity premium that is priced into current sukuk offerings, which would make sukuk more competitive with conventional bond offerings.

The one area of caution that the article raises is that repo transactions were used by Lehman Brothers to clean up (manipulate) its balance sheet at the end of each quarter (window dressing). By "selling" assets around the date when financial information is reported and using the proceeds of the loan (which was classified as a sale and thus not debt) to pay down debt, it was used by Lehman Brothers to reduce the level of indebtedness reported in its financial statements. This is certainly a possibility within Islamic finance, but the lending contracts are more cumbersome, raising the cost of repaying and reborrowing debt. However, the real lesson is that the practice (called Repo 105 and Repo 108 by Lehman Brothers) should be discouraged by regulatory bodies.

The details of the specific NBAD Islamic repo are not yet known, but can be guesstimated based on the IIFM paper on possible structures. Islamic repos--particularly if the pledged sukuk cannot be re-hypothecated--will not do much to reduce the reliance on commodity murabaha, but it can increase the liquidity management options available for Islamic banks, which should (given enough controls to prevent abuse) make Islamic banks more stable. One of the secondary effects could be a reduction in the spread between conventional bonds and sukuk, which could increase the appetite by issuers to choose sukuk. This on its own could help the secondary markets because investors might shed their hold-to-maturity outlook, at least those investors who maintain that attitude because of a shortage of replacement sukuk in either the primary or secondary markets.

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.

IIFM releases report on Shari'ah-compliant repurchase agreements (repos)

Conventional borrowers in the GCC are moving away from sukuk following the Dubai debt crisis. It is not said whether they are moving away from sukuk, which often have higher structuring costs, because of the structures or because the additional costs of structuring sukuk for issuers and a higher illiquidity premium makes it not cost competitive. Despite this there were 98 sukuk issued globally for $13.7 billion in the first half of 2010, up from $7.1 billion in the same period of 2009. S&P provided comments with their data release.

The IIFM released a paper on the possibilities for Islamic Repo transactions (I'aadat Al-Shira'a). You can download the paper from IIFM's website after going through the registration process. I hope to put up a post once I have a chance to read the document.

Other News

• Rushdi Siddiqui takes on the misguided "anti-Sharia" groups in the US who view Islamic finance as a threat.
  
• There is a video of my presentation at the UFANA conference in March in Toronto. It begins at about the 3:50 mark of this video and concludes at the beginning of this video.
  
• In a blog post on Monday I suggested that an article from Bloomberg describing falling yields on sukuk in the GCC was somewhat misleading and now Bloomberg's article that is similar to their earlier article is titled: "Persian Gulf Sukuk Yield Premium Widens on Fourth Default".
  
• Kazakhstan will issue a sukuk after cancelling a conventional bond sale.
  
• The American Prospect interviews Frank Vogel, who co-authored the book Islamic Law and Finance: Religion, Risk and Return with Samuel Hayes, both professors at Harvard University.
  
• A short video of a speech by the governor of Malaysia's central bank, Bank Negara, Zeti Akhtar Aziz.
  
• Khazanah Nasional is raising funds through 5- and 10-year sukuk to finance its bid for hospital operator Parkway Holdings Ltd.
  
• Indonesia's planned global sukuk will be smaller than the $650 million initially expected because the budget deficit is smaller than expected. An unnamed foreign bank is planning an Islamic banking service in Indonesia in the second half of 2010 according to the Head of Research, Development, and Sharia Banking Management of the central bank.
  
• Two Islamic banks in Pakistan became the first merger of two Islamic banks in the country. Emirates Global Islamic Bank and Al Baraka Islamic Bank will merge. The new bank will be called Al Baraka Bank (Pakistan) and will have combined assets of $582 million.
  

Thursday bullets

• The UK courts threw out the case brought by the Investment Dar against Blom Bank, which relieves some questions regarding the ex post enforceability of Shari'ah-compliant contracts where one party claims Shari'ah-non-compliance.
  
• Nakheel will issue the sukuk to its largest trade creditors in mid-July according to a large contractor.
  
• Oxford Analytica has an article about the ISDA-IIFM Tahawwut Master Agreement for Shari'ah-compliant hedging.
  
• Bermuda wants to be an Islamic finance hub and may launch its first Islamic bank or takaful company by the fourth quarter. the Bermuda Stock Exchange wants to see the first sukuk listed on the exchange later in the year as well.
  
• Sumitomo Corp is working on the first Islamic financing deal in Japan. This follows the announcement about Nomura's $100 million sukuk being issued in Malaysia.
  
• AmIslamic's musharaka sukuk received a AA3 rating from RAM Ratings.
  
• Barwa Real Estate received murabaha financing from Qatari Diar.
  
• A Malaysian fund, HwangDBS Investment Management had the top performing sukuk fund in the past year.
  
• Khazanah may increase the size of its planned sukuk to $1 billion if it increases its offer for the hospital operator Parkway Holdings.
  

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.

Friday night bullets

• A London-based healthcare organization may be the first corporate issuer of a sukuk, according to reports. The sukuk is expected to be GBP50 million ($76 million).
  
• Nakheel has asked for information on the identities of 2010 sukuk and bond holders, which may be an indication that they may want to restructure those obligations.
  
• The Saudi mortgage finance law is expected to increase the demand for Islamic banking services although there are concerns about the diminished liquidity if banks add illiquid Islamic mortgages to their balance sheets.
  
• Gulf Finance House continues to work through its debt deal and is close to a deal of another $100 million in debt coming due soon.
  
• The IIFM, now with a new website, released a sukuk report, which looks to focus on case studies, although I have not yet read it.
  
• The Philippines is considering its first sukuk issuance for about $500 million.
  
• Sukuk issuance is expected to be $31 billion globally, with $10-15 billion coming from the Middle East according to Bank of America Merrill Lynch. Deutsche Bank sees sukuk issuance being 'weaker' in 2010.
  
• Standard Chartered's Malaysian Islamic banking subsidiary Saadiq is planning on offering new products targeted at small-and-mid-sized businesses. Standard Chartered will also begin offering Shari'ah-compliant hedging contracts.
  
• Arcapita is cutting workers to control costs.
  
• HSBC named William Ross as a co-head of Islamic finance at the bank. HSBC's chairman Stephen Green says that London can expand its financial business by offering more Islamic banking products.
  

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.
  

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.
  

Standardization may support innovation, says Sheikh Nizam Yaquby

Sheikh Nizam Yaquby, a prominent Shari'ah scholar, commented on the controversy about whether standardizing Shari'ah-compliance in some ways harms the future of the industry. In contrast to the Shari'ah board of AAOIFI which criticized calls for standardization as detrimental to ijtihad, Sheikh Yaquby said: "In Islamic law we encourage debate, research, scholarship and it is an ongoing process which cannot be stopped by anybody. However, for the purpose of standardisation, it is important to have certain prudential rules and basic contracts especially repetitive ones to be accepted among a group." I have had the pleasure of hearing Sheikh Yaquby speak a few times and he always provides an interesting counter-argument to the conventional wisdom. I have frequently said that using Shari'ah scholar's time for approving the same contract over and over is not a valuable use of their time and it reduces the amount of time they can spend working on innovative products. I hope that his comments on this subject will start a fresh discussion about the merits of standardization in some areas and Shari'ah board review of individual contracts in other areas.

The International Islamic Financial Market (IIFM) is working on its second standardized contracts following the Ta'Hawwut Master Agreement (for treasury placement): I'aadat Al Shiraa'a Master Agreement (repurchase). The IIFM has also now thrown its support behind the AAOIFI Shari'ah board's refusal this year to allow repurchase agreements as a positive development for the industry in the future.

Sukuk issuance continues to struggle in 2008 compared with previous years because of the credit crisis. The reduced level of issuance and reflection on the dominance of ijara sukuk has led to suggestions that the sukuk issuance process should be reexamined.

The Aston School of Business in Birmingham, UK is planning to have a program in Islamic finance if it can find the necessary financing. Brimingham, the second largest city in the UK has a significant Muslim population and is home to the Islamic Bank of Britain, the Islamic retail bank. The Islamic Bank of Britain recently announced low cost home finance that could help spur the use of Islamic home finance by non-Muslims. The UK government sees Islamic finance as a way to promote greater inclusion of Muslims in the U.K., although many Muslims remain wary about whether the Islamic banking industry in the country is 'Islamic'.

A new website provides information about Islamic finance in France (available only in French).

Islamic finance at risk from fall in prices in the real estate market; CGAP study on Islamic microfinance released

My fears that the credit crisis in conventional financial markets is spilling over to Islamic finance are becoming to be realized. The primary mechanism I identified in my blog (and in greater detail in a forthcoming opinion piece for Business Islamica magazine) for transmitting a crisis through the Islamic banks was falling property prices in the GCC countries that had mostly escaped the direct fallout from the subprime crisis that began in the United States. Although the prices have not fallen as dramatically as in Western countries, they are beginning to fall and this has an effect on Islamic banking because these assets are the underlying physical property used in many Islamic financing deals. From a Gulf Daily News article: "Falling prices in mainly Muslim countries in the Middle East and Southeast Asia are likely to affect the Islamic finance market due to heavy reliance on such assets to support deals." A senior analyst at Zawya, Alexandra Tohme, adds her opinion on the link between Islamic financial institutions and the global credit crisis.

The Dinar Standard has an interesting article about the potential for Islamic banking in Europe.

The Financial Times has a Q&A on the basics of Islamic finance, as do a number of newspapers in the U.S. and there is also an article on finance based in Christianity.

Islamic finance could still grow by 20-25% a year despite the financial crisis according to Rushdi Siddiqui, the Global Director of the Dow Jones Islamic Market Indexes, but "Islamic banks should diversify their investments to generate revenues from different areas."

Hedge fund managers are targeting Muslim investors in the Middle East by developing Shari'ah-compliant hedge funds, but is it too late for them to attract investors given their often poor returns during the past couple of years.

The DIFC has lent its support to the new Master Agreements for Treasury Placements (MATP), the standardized contract from the International Islamic Finance Market (IIFM) that was recently announced.

Zurich Financial Services Group has launched a joint venture takaful company with the Abu Dhabi National Takaful Company to expand their operations in the GCC region.

The Consultative Group to Assist the Poor (CGAP), a multi-lateral effort to promote microfinance and based at the World Bank, released a study of 125 Islamic microfinancial institutions.

IIFM standardized murabaha document finished; sukuk market an alternative to the conventional?

The International Islamic Financial Market (IIFM) announced that it had finished the creation of a standardized agreement, the Master Agreement for Treasury Placement (MATP). The standardized document is primarily used for Shari'ah-compliant deposit products using commodity murabaha. The commodity murabaha product is a somewhat controversial way to replicate a short term loan and is used to address Islamic banks' liquidity management challenge. The move towards standardized documents for common products like murabaha will provide a way to maximize the value of Shari'ah scholars' scarce time by allowing them more time to review innovative or controversial new products.

The secretary general of ASEAN says that companies finding difficulty tapping the conventional credit markets have been turning to sukuk, although issuance is down sharply this year. An article describing why Islamic finance does not allow short selling morphs into a reminder about performance of Islamic banks.

Malaysia's central bank governor says that the reliance on profit-and-loss sharing agreements has insulated Islamic finance from the credit crisis. Because most products are not profit-and-loss sharing in form, it seems to me that the insulation of Islamic finance is provided mostly by continuing strong economic growth in the areas with the most Islamic finance, the GCC and Malaysia.

Islamic funds continue to receive good publicity in the U.K. Islamic finance and banking continues to lag in Egypt while booming in Bangladesh and encouraged in Japan through changes in the regulatory environment. Indonesia continues ahead towards issuing a dollar-denominated sukuk.