By James Gavin
The Islamic finance market is growing at breakneck speed – the past year has seen the release of around 30 new Islamic derivative products alone, following on from Sharia Capital’s launch of the first Islamic hedge fund in 2006. Most of these products have been launched by western institutions moving into a rapidly expanding market, and not all Islamic experts are happy.
These developments have divided opinion among experts, some of whom fear a breach of the essential rule that you cannot sell what you do not own. A key ruling published in the International journal of Islamic finance services by the respected Pakistani scholar Mufti Taqi Usmani notes that “futures transactions are totally impermissible, regardless of their subject matter.”
This would seem to rule out Islamic hedging. But Yusuf Talal DeLorenzo, a leading US Islamic scholar who advised Sharia Capital on its fund, says that it achieves the economics while avoiding the actual mechanics of short selling.
These debates will continue even after the ‘bespoke’ sharia products currently on offer are eventually replaced with standard structures. Stella Cox, director of DDCAP Group, which provides sharia-compliant financial advice, says that companies have compelling reasons to protect their bottom lines by hedging themselves against changes in foreign exchange rates, interest rates, commodity and stock prices, which should be peripheral to their core business. “Historically, Islamic investors have not been able to protect their capital, as they have looked for ways of diversifying into a broader range of asset classes and yields, leading to the possibility of exposure,” she tells Emerging Markets.
Middle way
She recognizes that negative events in the global financial markets have caused the Islamic financial industry to limit its endorsement of hedging techniques. But she points to a middle way. “Sharia authorities will not endorse speculative activity. But solutions may be sought for genuine commercial needs related to underlying trade or investment transactions.” One way to avoid breaking the sharia is to exploit the fact that in most futures contracts, delivery and therefore possession is not intended. Transactions are settled through differences.
Two products currently marketed by DDCAP include Islamic profit rate and currency hedging. In both cases, an effect which would be achieved in conventional finance through a standard interest-rate swap is replicated by tying each side of the swap to the purchase of a commodity – and in this way managing risk without at any point speculating or selling what one does not own.
DDCAP has also developed an Islamic currency purchase undertaking instrument. Here, the customer pays an upfront fee to the bank. The bank then irrevocably undertakes to make a certain currency trade at the spot rate and on the date agreed between the parties. Once again uncertainty, speculation and interest play no part in the transaction.
A fourth instrument offered by DDCAP to its Islamic customers is the Arboun or “sale with revocation” instrument, also known as Islamic Capital Protection, which plays a role similar to that of an option. Here, the manager of a fund or capital-protected vehicle invests 95% of the fund in a morabaha transaction, which is set up to pay the capital payment obligation to investors on the deferred date. The remaining 5% is paid as advance down-payment on a basket of stocks, full payment of which must be made within the period up to the deferred date of the morabaha. If the manager chooses not to complete the purchase, he forfeits his down payment.
Controversial
While they are controversial, these types of short-term product have secured some degree of acceptance in the world of Islamic finance. Longer-term products may find it harder to win approval. “These transactions tend to be renewed rather than ‘rolled-over’ in a conventional sense on the interim maturity dates,” says Cox. “And that calls for a completely new supply of physical asset flow to support the transaction. The costs of this could have a negative impact on the cost and pricing of the product, but these tend to be managed within the context of the overall tenor.”
The driving force behind many of these innovations has come from the growing volumes of cross-border investment, and the much larger positions which Islamic investors are now able to take as more benchmark-sized Islamic investments come to the market.
When, in January 2006, Barclays Capital launched its first large equity-linked sukuk, a $3.5 billion bond for Dubai’s Ports Customs and Free Zone Corporation (PCFC), 80% of the investors were from the Middle East and just 20% from the international market, says Arul Kandasamy, head of Islamic Financing Solutions at Barclays Capital. One year and two similar-sized deals later, these percentages were reversed. The vast majority of investors in the $2.53 billion Aldar property sukuk, launched by Barclays in February 2007, were from the international market.
This has led to a huge increase in secondary trading, facilitated by institutions such as Barclays that have stepped into the role of market maker. “We undertake to create a secondary market,” says Kandasamy, who estimates that the bank’s volume of secondary trading now averages $20 million per day. “Trading volume has only one way to go,” he adds. “There will be more issues,” he tells Emerging Markets.
Kandasamy believes that sukuks can be “as competitive if not better than conventional instruments” from the point of view of the business raising the investment. “We price them on the basis of what a conventional issue would cost, but then you have conventional and Islamic investors,” he says. “So the universe is much bigger.”
For further coverage of Islamic finance, see "Takaful: a sure thing".