Banks devise a range of sharia-compliant products

19 Oct 2007

Alternative investment is viewed as relatively safe after the summer’s credit crisis Investment banks are making as many of their structured product programs as possible sharia-compliant in a bid to attract Islamic and traditional fixed-income investors into a growing sector.


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Sukuk issues, July – August 2007

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The sub-prime fallout this summer has contributed to the surge in Islamic structured finance volume, because sharia-compliant products provide a relatively safe haven for investments.

The products have some of the same high returns of conventional structured products but with higher transparency of processing, and lower credit risk, because they trade only in physical commodities, not those whose price is derived from its credit rating, such as corporate bonds.

Making a product sharia-compliant involves ensuring a financial transaction or investment adheres to laws based on the Koran. An investor would not be allowed to profit from investments that derive profits from alcohol or cigarettes. And once a bank structures a product, a Muslim scholar specializing in sharia compliance checks and signs the transaction to make sure it adheres to Islamic financial laws.

An investment bank source said: “It is easier to make as many structured products as sharia-compliant as you can, because it is more efficient and turns over more transactions.”

Barclays, Deutsche Bank and HSBC are among the leaders in integrating their Islamic financing business into their mainstream investment pool. Folding sharia-compliant operations with other parts of their business has made it easier for banks to turn over large sharia-compliant trades.

Popular structured Islamic products like sukuks, which resemble traditional bonds, and murabahas – a contract of exchange on a physically owned commodity usually between two banks, such as a swap – and bilateral contracts from Islamic and non-Islamic investors are seeing a surge in sales. This has resulted in record benchmark transactions worth up to $2bn (€1.4bn) and $500m, respectively.

Nigel Denison, head of markets at the Bank of London and Middle East, said: “Large sukuk transactions above $500m are usually bought by a mixture of conventional and Islamic investors, rather than solely by investors seeking sharia-compliant investments. Islamic investors account for 30% to 40%.”

Sharia law forbids the payment of interest. A fundamental aspect of sharia compliance is that the investor can only profit from the ownership of an asset rather than receiving a return from a lump sum with an applied interest rate.

Since sharia compliance has to go through a rigorous process of documenting, it provides a higher level of transparency. Moreover, all trades involve the physical ownership of a commodity, for example sugar or wheat, and the investor, structurer, brokers and dealers are informed of every transactional detail throughout the process.

In July and August sukuks raised $7.6bn, exceeding this year’s first-quarter’s $4.5bn, according to the Islamic Finance Information Service. Walkers, a global off-shore law firm, recently worked on large sukuk programs, including a $1.5bn sukuk program, by NIG, part of the Royal Bank of Scotland group, and Gulf Finance House’s $1bn sharia-compliant structured funding program.

Robert Varley, a partner at Walkers’ Dubai office, said: “You can see the growth in Islamic structured finance by the size of the products. A few years ago, a typical corporate sukuk might be in the range of $100m; 12 months ago the region of $200m – $500m was normal, but only government or government-related sukuks went over that.

“Now we are seeing billion-dollar-plus corporate sukuk programs. Islamic structured finance has attracted a lot of interest from the conventional banking world, and the products clearly stand up to technical scrutiny like a conventional medium-term note program. It is a transparent, properly documented and watertight product.”

Barclays Capital has integrated sukuk inquiry and execution into its debt capital market program, including its medium-term notes, which allows a more regular and higher turnover of Islamic structured products.

Arul Kandasamy, head of Islamic finance at Barclays Capital, said: “We arrange sharia-compliant products, such as sukuks, by structuring a product under our traditional MTN program, which is fully integrated with our Islamic financing. We focus on convergence.

“We don’t just target Islamic investors, our sharia-compliant products are targeted at everyone. We make most of our regularly sold structured products sharia-compliant as most of these products can be replicated, such as bonds and convertible equity notes.”

In the wake of the sub-prime fallout, investment banks are targeting their catalog of sharia-compliant structured products at the traditional fixed-income network in addition to their traditional Islamic investors.

Denison said: “Following the credit crisis in the summer, investors are demanding much greater transparency particularly in structured transactions. By its nature Islamic finance provides this to a great degree, which is part of its appeal. Investors therefore know exactly what assets they own and what risks they are taking.”

Last week, Deutsche Bank and Dubai Islamic Bank issued a significantly large $500m “profit collar swap”. A typical transaction involves a commodity owner leveraging the price of their physical asset by widening the margin, and entering a contract with a counterparty who agrees to buy the commodity at that leveraged price. The “collar” provides a minimum and maximum return for the investor.

Meanwhile, sharia-compliant funds have enjoyed a surge in volume. Eurekahedge’s Islamic fund database, which contains more than 458 sharia-compliant funds, representing 95% of the market, reported assets under management in Islamic funds were hovering between $50bn and $70bn.

All of the funds are spread across equity, fixed income, real estate and private equity asset classes.

This may only be a small percentage of the overall fund market but much like the Islamic structured product market, it is expanding steadily, despite the credit market volatility.

Varley said: “Eventually, Islamic structured finance will no longer be seen as a novelty or niche arena but as a regular component in all global investment strategies, and of course this will be a very positive development.”

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Graphic: Sukuk issues, July – August 2007


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