Sukuk and Islamic Investment
By Rose Anderson

Islamic finance govern by Shari’ah law , as per Shari’ah law interest is strictly restricted in Islam.Free debt help is allowable without taking any interest, or these can be treat as to help anyone, without taking any interest from the lender. As interest is against the Islamic law bond market not develop in the Islamic world. Most of the Petroleum exporting countries are investing there surplus amount in the US free debt help bonds and they not taken interest on investment. Sukuk is invested to protect the religious value and also to increase the Muslim investment market.Malaysia is the largest issuer of the sukuk bonds ,sukuk is not only famous in islamic market but also some European and American countries issued sukuk bonds to get the islamic investment of rich middle east countries.Sukuk is also consider as a portfolio investment to diversify the investment.

A major challenges facing Islamic financial products like sukuk bonds are the lack of liquidity.According to S&P, there are more sukuk listed in Dubai than any other else, but the secondary market is virtually non-existent. Further, the bulk of sukuk are over-the-counter instruments,with listed sukuk accounting of only 20-255 of outstanding sukuk is issued worldwide; that is, $10-15 bn so far, says the rating agency. Zeti contends that creation of persistent supply of Islamic papers and instruments that would upgrade the secondary trading of instruments and greater depth of the market is the hour. According to her, another factor that could help futher expand the market for Islamic finance products would be to bring in greater diversity in the market for Islamic financial institutions and portfolio manager to manage their funds effectively. Pricing issues also pose significants challenges to the unhindered growth of the market. There is the need for developing a relevant benchmark for efficient and credible pricing. For example , if sukuk is issued based on the Ijarah principle, and if it uses the property as its underlying assets then actual rate of rental may be explored to be used to determine the rate of return on the instrument. However, it may then fluctuate depending upon the demands and supply for that property. Shari’ah experts, who have a full understanding of the mechanics of sukuk, should play an important role in ensuring its proper pricing as well as governance, she suggests.

Taking Islamic finance products global is another challenges as it requires harmonization of standards and practices between those of regional Islamic finance and international standards. Zeti suggests that full support has to be accorded to the international standard setting organizations such as Islamic Financial Service Board (IFSB) and to the Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) to formulate appropriate standards that would strengthen the Islamic Financial system.The Malaysia based IFSB has already formulated the prudential treatment for sukuk investment by the Islamic Financial Institution s as specified in the Capital adequacy standards and has also undertaken a set of initiatives to strengthen the framework and practices in the Islamic money market.

Also, lack of rating is another major issue. Given the complex legal structure, it adds to the cost and complexity of rating. Further rated instruments are almost non-existent in the Middle East.
However, global rating agencies such as S&P, however, feel that there is a way out. “the provisions of Islamic debt instruments may add level of complexity to rating analysis long stading methodologies and rating scales are sufficiently broad so far to incorporate the varied features of Islamic debt financing,”It said in recent report. Islamic finance largely centers on assets-backed approaches and sometimes involves a degree of risk-sharing more commonly born by equity investors.In practice,however,as illustrate d in the sukuk that Standard & Poor’s has rated, binding guarantees and other contractual obligations can place transactions firmly in the debt category.

R. Anderson is a financial writer .She is the Community Member of "Debt Community" and has been contributing her suggestions to the Community . She has also made notable contributions through various articles written on different subjects related to debt industry.

Coming of age
Past challenges, future opportunities
By Dr. John Lee and Anita Menon (KPMG Malaysia)

Last year may go down in history as the watershed year for the financial services industry. However, as Dr. John Lee and Anita Menon explain, while Islamic finance was not entirely unscathed by the vagaries of the economy and the contagion effect of the conventional finance sector, the industry still recorded compounded annual growth rates of 28 percent from 2006 to 2009. Islamic banks also recorded an increase in assets by 28.6 percent in 2009 to US$822 billion.¹

This in itself is interesting, as a couple of years ago at the height of the previous growth cycle for Islamic finance, many felt that the true test of the resilience of the system would be when there was a shock to the system, and when the liquidity in the Middle East dried up. However, skeptics would also claim that this was due to Islamic institutions general investment prohibitions which meant that they were less exposed to subprime assets.

2009 also saw the entrance of a number of new players which indicate that interest in this burgeoning sector is as yet, unabated. As at end 2009, there were 1,124 Islamic financial institutions globally.² While issuance of sukuk³ dropped in 2009 on the back of tightening liquidity and concern on possible defaults, the demand for quality sukuks continued to be there and issuance increased by 40 percent for the first 10 months of the year, as compared to the corresponding period in 2008.⁴ Saudi Arabia led the issuance followed closely by Malaysia; with one of the largest issuances by Malaysia’s national oil and gas company Petronas totaling US$1.5 billion.

Figure 1 - Total Sukuk Issuance by Country in 2009
Source: S&P’s Europe, Middle East, and Africa Markets Outlook 2010, January 2010.

Outlook for the rest of this year and into 2011

The outlook for the remainder of 2010 remains positive with some analysts saying⁵ that Saudi Arabia is expected to continue to lead issuance, although investors are expected to be somewhat spooked by the recent Dubai World crisis, sukuk defaults and the problems seen to be encountered by some of the institutions in the Middle-East. Dar-Al Arkan, Saudi Arabia’s largest property developer by market value, successfully issued a sukuk in February this year raising US$450 million and analysts believe that the number of issuances for the rest of 2010 is likely to grow to pre-crisis levels.

KPMG in Malaysia’s analysis indicates that the Islamic finance market is steadily growing both deeper and wider, with the emergence of new Islamic finance markets such as the Maldives, Korea, Kenya, Nigeria and also stronger interest from EU countries like France and Italy. Korea for instance, is currently working on amendments to its legislation that may see the first Korean sukuk being issued as early as 2010 or 2011. In Malaysia, the interest continues to grow and, among the recent liberalization measures is the issuance of two new Islamic banking licenses to foreign players; with a paid-up capital of at least US$1 billion, along with two family Takaful licenses towards the middle of this year. Malaysia continues to be a leading market outside the Middle East with assets of almost 11 percent of the global market and with Islamic assets making up almost 19 percent of the banking and finance market in Malaysia. However, the UK is emerging as a key market holding close to 2.5 percent of global assets.⁶

Within the Asia-Pacific region, relative newcomers such as Singapore and Hong Kong have expressed their desire to also become centers, while the most populous Muslim nation – seen by many as the next big growth zone – Indonesia has still a long way to go if estimates of asset size are anything to go by. Bank Indonesia, the central bank of Indonesia, has indicated that shariah assets are projected at US$7.6 billion as at end 2009, which places the nation’s Islamic finance assets at 2-3 percent of the total banking assets.⁷ This is attributed to the nascent infrastructure and regulatory system for Islamic finance. While there is a new law which was set to be effective in April 2010 that would remove the double-taxation on some Islamic banking transactions, there are still issues around this area that hold back the otherwise huge untapped potential in this country.

Figure 2 - Total Banking Assets & Islamic Banks by Country in 2009

Source: The Banker, The Pew Forum, Bank Negara Malaysia, FSA, Central Bank of Bahrain, November 2009.

The global Muslim population is continuing to grow faster than the non-Muslim market; recent estimates place the Muslim population at 1.57 billion, 23 percent of the global population.⁸ There is also a large Muslim population in the Asia-Pacific region - China for instance has more Muslims than Syria; while Russia has more Muslims than Jordan and Libya combined. This translates to immense opportunities for shariah compliant finance in as yet untested markets. The potential for Islamic finance continues to be enormous. The only impediment to its growth may be that the conventional regulatory structure is currently unable to support the introduction of Islamic products.

Through the adoption of a progressive face as opposed to an overtly religious tone, in countries such as Malaysia, the Islamic finance industry has continued to make inroads in the non-Muslim market. This may also be the approach adopted in countries such as India and certain African countries with large Muslim populations, but, where the projection of an Islamic face would be anathema to the political regime.

Islamic finance is also gaining acceptance where it is seen as an ethical alternative to the conventional system, bridging the gap between socialism and capitalism. According to the Vatican’s official newspaper Osservatore Romano in its March 2009 issue, “The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service.” Ethical investors also are drawn to the principles that underlie Islamic financial transactions. Therefore growth is expected to come from this segment of consumers as well who are not necessarily attracted by its faith-based appeal, but more from its socially responsible outlook.

The future of Islamic finance

The ongoing debate on whether products are shariah compliant or shariah based and the lack of standardization, continues to be an issue. Additionally, other major hurdles that remain or have become more apparent with the recent financial meltdown include:

• the need for robust risk management practices that would be able to drive product innovation and development;
• the need for a legal and regulatory framework for dispute resolution, especially on cross-border transactions;
• the ongoing requirement for trained practitioners in this field that have a strong understanding of shariah requirements, but are also in tune with market and consumer demands.

Notwithstanding that, many Islamic institutions are expected to undergo a transformation in their approach and strategy, and more importantly in their business models as well. This will enable them to encompass more of the ideals of shariah principles and to move away from the predominance of debt-based structures as in the past. When Islamic finance was first introduced into the market, the approach was to adopt products that were familiar to the generation of consumers and clients brought up on conventional financial products. Therefore, Islamic financial products were shariah compliant mirrors of their conventional equivalents. Furthermore, the initial target market was retail customers who are generally risk-averse and therefore, fixed rate products were more appealing to this segment of the market.

Increasingly however, a radical shift from the current norms will be required and this would fuel the anticipated growth in Islamic finance. The pursuit of social objectives would gain emphasis alongside the pursuit of commercial objectives; since Islamic finance is meant to be the antithesis of the previous conventional financing norms – where excessive risk-taking led to the ultimate downfall of many players. The financial crisis has heightened the interest in Islamic finance and it’s future; the concepts of risk-sharing should be ingrained further through the development of more profit and risk sharing mudaraba and musyaraka products. This would require a shift in banking business models as well. Increased product sophistication and market awareness-building would also need to go hand-in-hand with the advancement of the financial and legal infrastructure.

Over the next 18 months Islamic finance institutions are expected to come of age

ISLAMIC FINANCE 2010
by IFSL RESEARCH

OVERVIEW

The global market for Islamic financial services, as measured by shariacompliant assets, is estimated by IFSL to have reached $951bn at end-2008,25% up from $758bn in 2007 and three quarters up on the 2006 total(Chart 1). However, 2009 may have seen a pause following strong growth ofprevious years. Commercial banks account for the bulk of the assets withinvestment banks, sukuk issues, funds and takaful making up the balance.

Key centres are concentrated in Malaysia and the Middle East including Iran,SaudiArabia, Malaysia, Kuwait, UAE and Bahrain (Chart 2). Islamic financeis also developing in Asian countries such as Bangladesh, Pakistan andIndonesia, as well as North African countries such as Sudan and Egypt. TheUK, in 8th place, is the leadingWestern country and Europe’s premier centrewith $19bn of reported assets, largely based on HSBC Amanah. Assets inother Western countries are currently small but a number of countries,particularly France, are looking to develop a presence in Islamic finance.

While the Islamic finance industry initially has been less affected by thefinancial crisis and global economic downturn, there are ongoing challenges,particularly for the sukuk market and for some Islamic banks. The sukukmarket fell back in 2008, but despite recovery in issuance to $20bn during2009, is being tested by its ability to deal with several defaults. A $10bn loanby Abu Dhabi staved off the threat of a potential default by Dubai World onits repayment on the Nakheel $4bn sukuk in December 2009. Quality issuersof sukuk continue to attract demand from investors.

Islamic banks have not been immune to the effects of the financial crisis anddownturn: some have suffered a higher rate of non-performing loans thanconventional banks, mainly due to their exposure to falling real estatemarkets. Revenue and profitability has suffered in both 2008 and 2009 andliquidity is a significant restraint for some banks.

Islamic banks have not been immune to the effects of the financial crisis anddownturn: some have suffered a higher rate of non-performing loans thanconventional banks, mainly due to their exposure to falling real estatemarkets. Revenue and profitability has suffered in both 2008 and 2009 andliquidity is a significant restraint for some banks.

- 22 banks including five that are fully sharia compliant, more than in anyotherWestern country. Two Islamic banks were granted licences in 2008.
- 20 Sukuk issues raising $11bn listed on London Stock Exchange,exceeded only by Dubai Nasdaq.
- Seven sharia compliant exchange-traded funds (ETFs).
- 20 law firms supplying services in Islamic finance.-
- Advisory services provided by Big Four professional service firms.
-Institutions offering educational and training products in Islamic finance.
- Off-exchange trading in commodity-based agreements linked to LMEcontracts.

GLOBALMARKET FOR ISLAMIC FINANCE

As mentioned in the overview, IFSL estimates that the global market forIslamic financial services, as measured by sharia compliant assets, isestimated to have reached $951bn at end-2008, 25% up from $758bn in 2007(Chart 1). Assets have grown from about $150bn in the mid-1990s. Islamiccommercial banks accounted for 74% of the assets, investment banks 10%,sukuk issues also 10%, funds 5% and takaful 1%.

Assets that can be allocated to individual countries from The Banker’ssurvey of 500 organisations reveal that the leading countries for shariacompliant assets are Iran with $293bn, Saudi Arabia $128bn and Malaysia$87bn (Table 1). These are followed by other Gulf states including UAE,Kuwait, Bahrain and Qatar. The UK, in 8th place, is the leading Westerncountry with $19bn of reported assets, largely based on HSBC Amanah.Countries with most of the 302 firms reporting to The Banker’s surveyinclude Malaysia with 37, Bahrain 34 and Kuwait 30. Iran, Sudan, SaudiArabia and Indonesia each have between 20 and 23 firms supplying Islamicfinance (Table 1).

Broadening geographical customer base for Islamic services The market iscurrently most developed in Malaysia, Iran and the majority of countries thatform the Gulf Co-operation Council (GCC). However, Islamic finance ismoving beyond its historic boundaries in these countries into new territories.Markets where Islamic finance is developing include:

- Other countries in the Middle East and North Africa such as Turkey,Sudan, Egypt, Jordan and Syria.
- Other Asian countries such as Indonesia, which has the largestindigenous Muslim population in the world, as well as Hong Kong,Singapore, Bangladesh, Pakistan and China.
- Western countries in Europe and North America. Countries such as theUS, France, Germany and the UK each have indigenous Muslimpopulations of between one and five million, although Russia has muchthe largest in Europe with 30m. The customer base in Western countriesis not necessarily restricted to Moslems: other customers may beattracted by the ethical and environmental basis of Islamic finance.

Following the lead set by the UK, otherWestern countries, such as Japan andFrance, are looking to make the appropriate regulatory and legal reforms thatwould facilitate provision of Islamic financial products. London is seeking toconsolidate its position as the gateway to Islamic finance in Western Europe.Providers in London are likely to focus on services that complement thoseavailable in other centres. Government strategy for the development ofIslamic finance in the UK is set out on page 7.

Sharia compliant financial services

Banking and sukuk - the issue of Islamic notes - represent the forms ofIslamic finance that are most well established, although takaful (insurance)and funds are also evolving. Products that may be the subject of innovationinclude private equity and private wealth management.

Banking Islamic banks have been perceived favourably since the onset of thefinancial crisis in 2008 as they have been less exposed to losses frominvestment in toxic assets. However, they have not been immune from theeffects of the crisis and the subsequent economic downturn. Some Islamicbanks have suffered a higher rate of non-performing loans than conventionalbanks, mainly due to their exposure to falling real estate markets. Revenueand profitability has suffered in both 2008 and 2009 and liquidity is asignificant restraint for some banks.

In its World Islamic Banking Competitiveness Report 2009/10 McKinsey &Company recommended that many Islamic banks need to take action in anumber of core areas in order to:

- Enhance and diversify their business mix, by tapping into new businesslines such as personal finance asset management and various areas ofinvestment banking.
- Upgrade risk management in order to address credit and liquidityconstraints. This would also include avoiding excessive exposure to realestate.
- Reduce operational costs and improve service quality to maintaincompetitiveness.
- Explore growth opportunities in the international markets, especiallywhere any excess capital can be better deployed in underdevelopedmarkets.

Islamic banks compete not only with each other but also with all other banksoffering conventional finance, particularly those that have establishedIslamic ‘windows’. In the Banker’s survey, balance sheet assets of shariacompliant banks rose 29% from $622bn in 2007 to $800bn in 2008, of which$701bn were in commercial banks and $99bn in investment banks.

In the UK, five fully sharia compliant banks have been established putting itin the lead in Western Europe (Table 2). The Islamic Bank of Britain (IBB)became the first stand-alone retail Islamic bank in the country in 2004 andwas followed between 2006 and 2008 by The European Islamic InvestmentBank (EIIB), The Bank of London and The Middle East (BLME), EuropeanFinance House and Gatehouse Bank. IBB is the only bank with a high streetpresence having eight branches and around 50,000 customers. EIIB providesinvestment banking services including trade finance, private equity and assetmanagement. BLME offers Sharia compliant investment, corporate andprivate banking to businesses and high net worth individuals globally.European Finance House offers a range of investment products and servicesto clients that include companies and wealthy investors. Gatehouse Bank is awholesale investment bank operating in capital markets,institutional wealth management, Treasury business andadvisory services.

In addition to the five sharia compliant banks, there are anestimated 17 conventional banks that have set up windows inthe UK to provide Islamic financial services (Table 2). HSBCAmanah is the only conventional bank with an Islamicwindow to report to the Banker’s survey: its assets of $16.5bnaccount for 85% of the UK’s identified assets, with a further6% from BLME and 4% from the HSBC parent bank.

The 22 Islamic banks in the UK substantially exceeds that in anyother western country or offshore centre (Table 4). The UK market forIslamic mortgages has grown to about £500m, some 0.3% of the total UKmortgage market.

Sukuk are issues of Islamic notes that represent an alternative toconventional bonds. Issuance of sukuk increased rapidly from $1bn a yearin 2002 to $34bn in 2007 (Chart 3). In common with the broad-basedslowdown in global capital market activity, sukuk issuance fell awayduring 2008 to $15bn, as a result of a decline in asset valuation, a lack ofliquidity and a lack of market confidence. The ruling from the Accountingand Auditing Organisation for Islamic Financial Institutions (AAOFI) thatquestioned the sharia compliance of some sukuk structures also acted as abreak on issuance in 2008.

Sukuk issuance rose from the low point of Q4 2008 to reach $6bn in eachof Q3 & Q4 2009, resulting in an annual total of $20bn, up by 30% on 2008.Most issuers in 2009 have been government or quasi governmentorganisations. Uncertainty has arisen from the financing problems at DubaiWorld, resolved for the time being by a $10bn loan fromAbu Dhabi. This hasbrought concerns about settlement of sukuk defaults into focus with keyissues set out in the side panel. In the meantime, quality issuers of sukuk arecontinuing to attract demand from both Islamic and non-traditional investors.

Malaysia is the main country in the global market, but Indonesia andSingapore have come into the market more strongly in 2009. According toIslamic Financial Information Service (IFIS), the main factors hinderingrevival of the sukuk market in the GCC are troubled Kuwaiti investmentcompanies, the real estate market in the UAE and the availability of credit inSaudi Arabia.. There was one sukuk listing in Nasdaq Dubai and two on theLondon Stock Exchange in 2009. This has brought the Dubai total atend-2009 to 21 listings totalling $18bn and to 20 listings in London worth$11bn.

Long term prospects for sukuk are positive, with three factors having a rolein fostering growth in demand when market conditions improve:

- There is a commitment to a substantial programme of infrastructureinvestment in the GCC totalling up to $1,000bn over the next ten years,some of which will be financed through Sukuk.
- Recent years have shown that there is an appetite and demand forinvestment in Sukuk that goes well beyond Islamic investors amongstthose investors that wish to gain exposure to diverse but high qualityassets.
- Governments and regulators in a variety of countries have recognised theimportant role that Sukuk can play in capital markets and have beengiving priority to developing their countries as Sukuk centres. Inaddition to Dubai and the UK, these include Bahrain, Hong Kong,Malaysia, Japan, Pakistan, Singapore and South Korea.

Islamic funds The market for Islamic funds has been expanding steadily.Eurekahedge estimates that the total number of sharia compliant fundsreached 680 funds by end-2008 having risen more than threefold from around200 in 2003. Ernst & Young estimates that the total value of these funds has grown from $20bn in 2003 to $44bn in 2008 (Chart 4). Equity funds accountfor the largest segment: 40% of funds, with fixed income 16% and real estate& private equity 13% (Chart 5). Cash, commodities and other funds make upthe balance. Over half of funds, 58%, are invested in a portfolio covering theMiddle East and Africa. A further 20% are in a global portfolio, 15% in Asia,6% in America and the residual 1% elsewhere.

The bulk of Islamic funds are small scale with two thirds being less than$100m and many of these having attracted only $10m to $15m. The domicileof funds is heavily concentrated with nearly two thirds of the total number offunds being in five jurisdictions: Malaysia 23%. Saudi Arabia 19%, Kuwait9%, Luxembourg 7% and Bahrain 6%. Cayman, Ireland and Indonesia eachaccount for a further 3-4% each, but the remaining 25% is divided between afurther 23 countries, including 1% in the UK.

Eurekahedge estimates that the average return on Islamic equity funds was22% in 2009, recovering from an average drop of 28% in 2008. This wasclose to the return on the global equity index, up 25% in 2009 following a fallof 37% in 2008. The largest Islamic equity funds, according to Failaka, arethe US-based Amana Funds, which it estimates account for 95% of Islamicfunds in the US totalling $2.3bn in 2009.

There has been a substantial decline globally in the number of new fundlaunches since the 2007 peak. In the UK new offerings in 2009 haveincluded:

- BLME launching a sharia compliant money market fund, the first of itstype to be launched in Europe.- Qatar Islamic Bank
- European Finance House launching its GlobalSukuk Plus Fund.G
- atehouse Bank and DDCAP announced the launch of a fund in early2010 to invest capital in structured trade finance transactions. DDCAP isa wholesale Islamic market intermediary company.

This followed a more active year in 2008 when four exchange traded funds(ETFs) were listed on the London Stock Exchange. Other offerings in 2008included a fund of equity funds, the first of its type globally by SEI; the firstsharia compliant retail capital-protected equity fund in the UK by Alburaq;and the launch by FTSE Group of the FTSE Bursa Malaysia Hijrah ShariaIndex, in association with Bursa Malaysia.

Takaful, similar to mutual insurance, is a risk sharing entity that allows forthe transparent sharing of risk by pooling individual contributions for thebenefit of all subscribers. The global market remains at an early stage ofdevelopment and is estimated at $8.3bn in 2008, up from $6.6bn in 2007(Chart 6). Iran, where takaful is the compulsory form of insurance, is thelargest market, with assets totalling $2.6bn (Table 1). It is followed byMalaysia, with premiums of $2.1bn, UAE $1.0bn and Saudi Arabia $0.8bn.Together, these four countries account for over three quarters of the globalmarket. Smaller markets for takaful with annual premiums of over $100mhave developed in Kuwait, Bahrain, Qatar, Sudan and Indonesia. Penetrationof takaful is nevertheless low in these and other countries with Islamicmajorities. Takaful represents a strong growth opportunity, particularly withregard to life insurance, as sharia compliant products are developed.

The takaful market in the UK remains at an early stage of development.Principle Insurance, authorised by the FSA in 2008, was the first shariacompliant independent takaful company in the UK, but it stopped taking newbusiness in 2009. The remaining takaful available in the UK is restricted toHSBC Amanah’s home insurance offering. Prudential was given approval in2006 to launch a takaful business in Malaysia in partnership with BankNegara Malaysia.

Other financial products The range of products generated by Islamic financehas broadened steadily. In the UK in 2007 Merrill Lynch structured the firstsharia compliant credit default swap for a UK power company involvingGCC investors. In 2008, Barclays Capital and Sharia Capital Inc. of the USlaunched the first Islamic fund of hedge funds. Sharia compliant publicprivate partnerships (PPP) are also under consideration.

The UK has a successful record as a trading centre for Islamic products ascommodity-based LME contracts are traded off exchange. This has been akey mechanism for Islamic financial institutions to manage their assets andliabilities. In 2008 ETF Securities launched a sharia compliant precious metalexchange trade commodity platform, based on platinum, palladiumsilver, gold and a basket of other metals.

Law firms The UK is a major global provider of the specialist legalexpertise required for Islamic finance, with 20 major law firms providinglegal services in Islamic finance (Table 5).

Professional service firms The Big Four professional services firms -PricewaterhouseCoopers, KPMG, Ernst & Young and Deloitte - have eachestablished an Islamic finance team in London providing specialist servicesincluding advice on tax, listings, transactions, regulatory compliance,management, operations and IT systems.

Education and training There is a growing demand for skills as Islamicfinance expands and UK institutions are at the forefront of providingqualifications for the global industry.

Courses in Islamic finance are offered by the Chartered Institute forSecurities and Investment (CISI), Chartered Institute of ManagementAccountants, Association of International Accountants, Cass BusinessSchool and the Institute of Islamic Banking and Insurance. These courseshave been key to the development of Islamic finance qualifications in theUK. One new development in January 2010 has been the launch by AstonBusiness School of an Islamic Finance and Business Centre.

In a separate initiative, the Islamic Finance Council UK has developed apioneering ‘Scholar Professional Development Programme’ in conjunctionwith the CISI. The objective of the course is to teach conventional finance toShariah scholars worldwide. Partners for this programme include the CentralBank of Bahrain and the International Shariah ResearchAcademy for IslamicFinance (ISRA) that is backed by Malaysia’s Central Bank.

Beyond Islamic finance, the UK education offering that majors in Islamspans the full range of qualifications starting from 16 year-old school levelthrough vocational and career-based qualifications as well as undergraduateand postgraduate degrees.
GOVERNMENT STRATEGY FOR DEVELOPMENT OF ISLAMIC FINANCE IN THE UK

London has been providing Islamic financial services for 30 years, althoughit is only in recent years that this service has begun to receive greater profile.An important feature of the development of London and the UK as the keyWestern centre for Islamic finance has been supportive government policiesintended to broaden the market for Islamic products for both shariacompliant institutions and firms with ‘Islamic windows’ (see side panel).

A key aspect of supportive government policy has been the establishmentsince 2003 of an enabling fiscal and regulatory framework in the UK forIslamic finance. There have been a number of initiatives which are intendedto form part of a continuing process:

The removal in 2003 of double tax on Islamic mortgages and theextension of tax relief on Islamic mortgages to companies, as well asindividuals.- Reform of arrangements for issues of bonds so that returns and incomepayments can be treated ‘as if’ interest. This makes London a moreattractive location for issuing and trading Sukuk.- Initiatives by the Financial Service Authority to ensure that regulatorytreatment of Islamic finance is consistent with its statutory objectivesand principles.

Following a review into the case for issuing sharia compliant governmentbonds, the UK Government announced in November 2008 that this would notoffer value for money at the present time. The situation has since been keptunder review by the Government. Investors would welcome a UKGovernment sukuk as it would provide more liquidity in the secondarymarket and act as a benchmark for UK companies that might considerissuing sukuk.

During 2009 the UK Government has been following through on otherinitiatives designed to support the UK as a centre for global finance and toensure conventional and alternative finance are treated on the same basis.Specifically, it has been undertaking a consultation on the legislativeframework for those alternative finance investment bonds (AFIBs) or sukukthat are structured to have similar economic characteristics to conventionaldebt instruments. Following this consultation, the Government announced on21 January 2010 that it intends to introduce measures to provide ‘clarity onthe regulatory treatment of corporate sukuk, reducing the legal costs for thesetypes of investments and removing unnecessary obstacles to their issuance’.

BARRIERS TO DEVELOPMENT OF ISLAMIC FINANCE

The global development of Islamic finance requires that further progress ismade in addressing a number of barriers. These may be broadly groupedwithin the following headings including: taxation and regulation;standardisation; awareness; and skills. More details on these barriers aredetailed in the The December 2008 UK Government paper on ‘Thedevelopment of Islamic finance in the UK: the Government’s perspective’.

DERIVATIVES AND ISLAMIC FINANCE

Muhammad Ayub
(The writer is Senior Joint Director, Islamic Banking Department, State Bank of Pakistan Karachi.)

The conventional options, swaps and futures stem from debts and involve sale and purchase of debts/liabilities. As a group, products such as interest-rate swaps, stock options and futures, currency futures etc are called derivatives i.e. instruments derived from the expected future performance of the respective underlying assets. These are very complex and risky contracts having present market value of trillions of dollars over the world. According to an article published in the Economist, some $ 128 trillion of over the counter derivatives were outstanding in June 2002, a 28% increase over a year earlier. It has been observed, however, that global financial market is becoming increasingly fragile as more and more derivatives and ‘hedging’ instruments emerge.

Just to introduce the terms to common readers, an option to buy a commodity is known as ‘call option’ while the option to sell a commodity is known as a ‘put option’. An option has a nominal size, this being the amount of underlying asset that the option holder may buy or sell at the strike price, the price at which the holder may buy or sell the underlying asset upon exercise of the option. If the price moves favorably, the option is exercised and the commodity is bought/sold at the agreed price. If the price moves unfavorably, the buyer of the option simply abandons it. Thus an option contract confers the right but not the obligation to enter into an underlying contract of exchange at or before a specified future date (the expiry date). The buyer of that option pays a price (the premium) to the seller (the writer) of the option.

We can explain the options trading with help of an example. A call option purchase at a price of say Rs 5 on bond or stock ‘A’ provides a right to Mr. M to purchase the stock at price of Rs 50 three months from now. If as per his expectations the price of ‘A’ increases to Rs 60 on the maturity date, then the buyer of the call has a net gain of Rs 5 (on an investment of Rs 5). This is what the seller or the writer of the call would lose. But if the price of the stock falls below Rs 50 on the maturity date, say to Rs 40, the buyer would allow the option to expire without exercising it since he can buy from the market at a lower price. His loss would amount to Rs 5 or hundred percent with the call. This Rs 5 would be what the seller of the call would gain on zero investment. In the game, the buyer and seller have diametrically opposite expectations. The possibility of risk and returns are magnified, the gains of the buyer being equal to the losses of the seller and vice versa.

The institutions dealing in derivates and hedge funds claim that diversity of hedging products protect their clients against market volatility and provide a larger spectrum of risk management to the benefit of the society. But, actually volatility is caused by their activities when they trade in derivatives as a part of rip-off factor and the clients are sold nothing for something – protection against a danger that never needed to exist in the first place. They may produce huge profits for financial institutions at the cost of others. But these profits are not necessarily indicative of productive efforts. Mr. Warren Buffet, Chairman Berkshire Hathaway says: Derivatives are financial weapons of mass destruction mainly due to opaque pricing and accounting policies in swaps, options and other complex products whose prices are not listed on exchanges; Credit derivatives and total return swaps that are agreements to guarantee counterparty against default or bankruptcy merit special concern.”

The macro-economic arguments for their existence are also not convincing – they are for minimizing risks which do not need to exist as described earlier. The global foreign exchange market as at present is more or less an unproductive pursuit in that it exists because of an unnecessary monetary expansion. It would be better to structure the financial system such that it does not suffer from continuing volatility. What we are seeing in the Western world is the emergence of financial products that are a symptom of a system that has gone wrong. For a more efficient economy, we must promote systems in which people work in productive pursuits rather than unproductive ones. Change the system to relate it with real sector activities
and all those clever dealers who earn huge profits out of thin air could become doctors, industrialists, business people and teachers instead! As such, Islamic financiers who look at the products of this system as a paradigm seem to be at mistake.

Study of the behaviour of the Derivatives market reveals that it has the potential to cause a serious breakdown in the financial system. The degrees of leverage that are afforded by option contracts can be so high that large unpredictable market moves in underlying prices may one day lead to the insolvency of a major financial institution. Liabilities cannot be perfectly hedged even if that is the intention, and some traders deliberately do not hedge their option portfolios because such action would limit the potential for high returns. The case of Long Term Capital Management in the United States, rescued by a Federal Reserve bail out in 1998, demonstrates the degree of risk that can be incurred. The question is whether the central bank or other authorities would be able to move quickly enough, or in large enough measure, to prevent failings.

For example, Collateralized Debt Obligations (CDOs) are sophisticated type of derivatives and clever way of exploiting anomalies in credit ratings. A number of loans or debt securities payable by various companies are put into a pool, and new securities are issued which pay out according to the pool’s collective performance. The new securities are divided into three (or more) levels of risk. The lowest, equity tranche, takes the first loss if any companies in the pool default. If nough losses eat that up, the next, mezzanine level suffers. The most protected level, the senior tranche, should still be safe, unless the collective pool has severe losses. It takes only a couple of defaults in a pool of 100 companies to destroy the equity tranche. Downgrades of investment-grade corporate bonds in America were a record 22% in 2002, according to Moody’s and it recorded bond defaults of $ 160 billion worldwide. The equity and mezzanine tranches of many CDOs have suffered severe losses; some have been wiped out. Even senior tranches, usually rated AAA, have been downgraded because losses may yet reach them. Thus, the whole concept of CDOs as in vogue refers to absolute risk and exploitation.

According to the concept of Option (khiyar) as we find in Shariah literature, the informationally disadvantaged party at the time of entering into the contract has the option to cancel the contract within a specified period. A person has also the right to undo his purchase if the seller specifically allows as part of the terms of the sale. All such forms of option are in the nature of rights embedded in a contract. In the term khiyar as used in Fiqh books we do not see any analogy that would lead us to acceptance of the structure of modern option contracts. These are independent financial contracts traded for a price that do not have any clear-cut parallel in the classical Islamic theory of contracts. Khiyar relates to a halal contract of exchange that has already taken place, whilst a modern option relates to an exchange that is yet to take place. In the case of khiyar, the exchange of one or both counter values is effected immediately while in the case of the modern option contract, future delivery applies to both the payment and the underlying asset. In addition, uncertainty as to the materialization of the exchange exists with the modern option contract but not in khiyar. A resolution of the Islamic Fiqh Academy of the OIC asserts, “Option contracts as currently applied in the world financial markets are a new type of contracts which do not come under any of Shariah denominated contracts. Since the subject of the contract is neither a sum of money nor a utility or a financial right which may be waived, the contract is not permissible in Shariah.

Most of the derivatives incorporate gharar (absolute risk), gambling and interest and support speculative activities. Islamic legal rules, particularly the ban on Gharar and on the sale of debt for debt, do not allow transactions devoid of real/productive activities. Derivatives involving such financial contracts which themselves are prohibited in Shariah (Riba based bonds & forward foreign exchange where mutual exchange is not simultaneous, for example) are clearly un-acceptable according to the Shariah principles. In case the underlying assets are equities and commodities it would be seen whether or not Riba and Gharar are involved. Experts are of the view that even in case of acceptable forms of underlying assets, a key valuation element in arriving at the fair value of an option contract remains the rate of interest. The Black-Scholes formula proposes that since an option can be perfectly hedged through constant trading in the underlying asset, the option position should be riskless and hence earn the buyer the risk free rate of interest on the premium that was paid for it. (In reality, constant trading of the underlying asset to achieve the perfect hedge is unattainable, and so option prices behave in ways that are not entirely predicted by Black-Scholes.) For the unhedged option, the contract becomes one of pure uncertainty. Neither party knows whether the option would be exercised, as it is dependent upon the condition of the market at a future date.

According to some writers ‘Arbun'can become a basis for developing some kinds of Shariah compliant options – contract by which one party buys the right to purchase from the other party specified goods for a specified price on a certain date. ‘Arbun’ is a void contract according to a Hadith and the three schools of Islamic law. Only Hanabalah uphold ‘Arbun’ with the condition imposed by some of them that time should be stipulated for the option. The OIC Fiqh Academy has also endorsed ‘Arbun’ but only if time limit is specified. Even if ‘Arbun’ is accepted as valid transaction, most of the derivatives current in the market would still be unacceptable from Shariah angle due to involvement to Gharar and Riba. A Call Option can be considered near to Bai al Arbun in the sense that the seller does not return the premium or advance payment to the buyer in case the latter does not exercise the purchase option and the buyer loses the option premium even if the option is exercised and the contract is confirmed. In case of Bai al-Arbun, however, the option premium is adjusted in sale price when the contract is confirmed. However, this subject of derivatives needs extensive research.

Samuel L. Hayes, after detailed discussion on derivatives concludes, “There are no effective derivates of Islamic debt contracts which replicate conventional risk-hedging and leveraging contracts such as swaps, futures, and options. Similarly, in the equity security sector, there are no risk-hedging or leveraging contracts in Islamic finance truly comparable to available conventional derivatives….. With respect to commodities and other goods, the Salam contract is an imperfect Islamic substitute for a conventional forward contract. The related Istisna contract for goods being manufactured for a buyer provides another partial Islamic proxy for a forward contract. It is also possible to construct an Islamic contract which partially replicates a conventional futures contract, via back-to-back Salam contracts”.

Derivatives in Islamic Finance

During the late 1980's an opportunity came my way to become an option dealer in the London capital market. At that time I was not a practising Muslim and, given that the pay in this line of work could be enormous, I accepted without a second thought. As the years went by, it occurred to me that the size of my pay packet bore little relation to the benefit enjoyed by society as a result of my work. Others had misgivings of their own. Accountants complained of the hidden risks that banks were taking 'off balance sheet' and, from time to time, government ministers would make a scapegoat of the derivatives market when other excuses were not forthcoming. Regulators scrambled to recruit staff who could understand what the traders were doing but offerred low rates of pay and, therefore, sufferred from a persistent lack of qualified staff.

As the derivatives booty trickled down in ever greater quantities, the financial establishment began to seek a wider economic justification for the existence of this market. The business schools, progenitors of modern option valuation techniques, were only too happy to help. The increasing diversity of hedging products provided a more complete spectrum of risk management tools and was therefore of benefit to society, they told us. But we in the market saw a different story unfolding. XYZ bank would lure the poorly paid treasury manager at the Kingdom of Somewhere-Or-Other into a complex swap deal that only a PhD in Nuclear Physics could properly value. So the bank would book a multi-million dollar profit the very day the deal was closed and the Kingdom's officers would never know any better. Derivatives departments began to swarm around corporate clients like bees around a honey pot.

Of course the scam couldn't last forever. By the early 1990's, Bankers Trust traders were caught discussing the size of the "rip-off factor" on a Procter and Gamble derivatives deal. We know this because the episode was taped and made public on behalf of the company. It was one of many large derivatives losses accrued by clients that had acted on the eager encouragement of their bankers. Soon Orange County and Metallgesellschaft would fall into the same trap at a cost of hundreds of millions of dollars more.

"We can protect you against market volatility" the investment bankers tell their clients. But the market volatility is caused by the activities of those very same investment bankers, and so the clients are sold nothing for something. Protection against a danger that never needed to exist in the first place. Sadly, the world learned little from the derivatives explosion. By the time the internet boom collapsed, a new generation of clients was learning about the motivations that really drive bankers and advisors. The clients tend to be offerred the products that provide financial institutions with the highest profit margin.

What if every country had pure gold coins as its currency? Then what would be the point of the foreign exchange market? What would be the point of exchanging one ounce of American gold for one ounce of Japanese gold? Who would need currency derivatives? Who would need to pay commission on foreign currency transactions? We see very quickly where this idea leads. An end to a trillion-dollar-a-day market that produces huge profits for the financial establishment. But of course profit is not necessarily indicative of productive effort. Theft is a good example of this principle. If we want to achieve a more efficient economy, we must promote systems in which people work in productive pursuits rather than unproductive ones. The foreign exchange market is an unproductive pursuit in that it exists because of an unnecessary monetary convention. Change the convention, in other words adopt a different monetary standard, and all those clever dealers can become doctors and teachers instead!

But back to options. Modern option contracts have a variety of features in common that can be summarised as follows. An option is a right not an obligation to enter into an underlying contract of exchange at or before a specified future date (the expiry date). The buyer of that option pays a price (the premium) to the seller (the writer) of the option. The option may give its holder the right to buy a specified asset (the underlying) from the option writer, gold for example, such being a call option on gold. Or the option may give its holder the right to sell the underlying asset to the option writer. This would be a put option. Every option has a strike price, this being the price at which the holder may buy or sell the underlying upon exercise of the option. And every option has a nominal size, this being the amount of underlying that the option holder may buy or sell at the strike price. A 15 December 2001 European call on gold at $400 per ounce in 100 ounces gives its holder the right to buy 100 ounces of gold from the option writer at $400 per ounce on the 15 December 2001, if the holder so wishes.

If we exclude those financial contracts which are of themselves haram (bonds and forward foreign exchange for example), then we are left with a set of underlyings such as equities and commodities upon which a derivative contract may be based.

Curiously, even where acceptable forms of underlying such as these are concerned, a key valuation element in arriving at the fair value of an option contract remains the rate of interest. The Black Scholes formula proposes that since an option can be perfectly hedged through constant trading in the underlying, the option position should be riskless and hence earn the buyer the riskless rate of interest on the premium that was paid for it. (In reality, constant trading of the underlying asset to achieve the perfect hedge is unattainable, and so option prices behave in ways that are not entirely predicted by Black-Scholes.) For the unhedged option, the contract becomes one of pure uncertainty. Neither party knows whether the option will be exercised, as it is dependent upon the condition of the market at a future date.

The first problem with the standard option contract from a Shari`ah perspective is that a contract of exchange in which both payment and underlying are deferred is widely held to be prohibited. The second problem is the uncertainty that exists with regard to whether or not the option will be exercised. Thirdly, if the option contract is judged to be halal, the question then arises as to whether that option can itself be sold to a third party, as is the case in the market for warrants for example. Fourthly, by buying a put option and selling a call option, a trader can replicate a short position in an underlying asset. Where these options are cash settled, the trader can be seen to achieve the same cash-flows as a short seller of that underlying. Shari`ah scholars have agreed that selling what one does not own is a prohibited commerical activity, and the possibility that such an activitiy can be synthesised through the use of options must therefore call into question their validity under Shari`ah. There is a fifth problem that pertains to more complex option contracts where the strike price itself varies according to an agreed formula. Such is the case with a serial option. For example, a one month 'at-the-money' serial call with daily resets gives the holder a series of one day call options whose strike price is the price of the underlying asset at the previous day's close of trading. As this price is unknown in advance, the strike price itself cannot be known. This represents further gharar.

Under Bay al-Urban, a deposit is paid on an item that a prospective buyer may purchase at a later time. Should the buyer not complete the purchase, the deposit is lost. This contract has been used as a justification for Islamic options by some writers who argue that the deposit can be seen as the premium paid by the buyer of a call option. The problem is that the scholars do not widely allow bay al-Urban. According to Ibn Rushd in Bidayat al-Mujtahid:
Within this topic is the sale of the urban (sale with earnest money). The majority of jurists of different regions hold that it is not permitted, but it is related from a group of the Tabi'un that they permitted it, among them are Mujahid, Ibn Sirin, Nafi ibn al-Harth and Zayd ibn Aslam. The form it takes is that a person puchases a thing and delivers to the seller part of the price on the condition that if the sale is executed between them this earnest money will form part of the price of the goods, if it is not executed the buyer will forgo it. The majority inclined toward its prohibition, as it is from the category of gharar, mukhatara and the devouring of wealth of others without compensation. Zayd used to say, "The messenger of Allah (God's peace and blessings be upon him) permitted it". The Ahl al-Hadith said that this is not known from the messenger of Allah (God's peace and blessings be upon him).

Under Khiyar, which is allowed by the jurists, the buyer of an item has the right to undo his purchase if the seller specifically allows as part of the terms of the sale. This is in other words an option to cancel a previously agreed sale. All buyers have a right to cancel a sale following purchase but before leaving the presence of the seller (khiyar al-majlis). This right is different to that expressly given by the seller to the buyer under sale with an option (bay al-khiyar), where the buyer may leave the presence of the seller for a specified period of time before returning to cancel the sale and take back the money that was paid.

Ibn Rushd in Bidayat al-Mujtahid comments:
Permissibility of option is upheld by the majority, except for al-Thawri and Ibn Shubrama, as well as a group of the Zahirities. The reliance of the majority is on the tradition of Hibban ibn Munqidh, which contains the words "and you have an option for three days", and also what has been related of the tradition of Ibn Umar: "The parties to sale have an option as long as they have not parted, except in sale with an option". The reliance of those who prohibit it is (on the argument) that it constitutes gharar and that the basis of sale is that it is binding, unless definitive evidence is produced for the permissibility of sale with an option from the Qur'an or authentic sunna or ijma. They also said that the tradition of Hibban is either not authentic or it is specific to the case of a person who complained to the Prophet (God's peace and blessings be upon him) that he was deceived in sales. They said that the tradition of Ibn Umar and the words in it, "except sale with an option", have been interpreted through another version of this tradition in which the words "that he says to his counterpart: 'Choose'," have been recorded.

In khiyar it is difficult to see any analogy that would lead us to the acceptance of the modern option contract as described above. Khiyar relates to a halal contract of exchange that has already taken place, whilst a modern option relates to an exchange that is yet to take place. In the case of khiyar, the exchange of one or both countervalues is effected immediately. In the case of the modern option contract, future delivery applies to both the payment and the underlying asset. In addition, uncertainty as to the materialisation of the exchange exists with the modern option contract but not in khiyar.

Disagreements among traditional scholars in the matter of khiyar arise in minor details, such as the length of time for which the buyer has the option to return the goods, or who is liable for any damage to the goods whilst the buyer is in posession of them during the option period. These scholars do not seem to have disagreed upon those fundamental principles which distinguish khiyar from the modern option contract.

It is my view, having been involved in derivatives dealing, that the potential exists in this market to cause a serious breakdown in the financial system. The degrees of leverage that are afforded by option contracts can be so high that large unpredictable market moves in underlying prices may one day lead to the insolvency of a major financial institution. Liabilities cannot be perfectly hedged even where that is the intention, and some traders deliberately do not hedge their option portfolios because such action would limit the potential for high returns. The case of Long Term Capital Management in the United States, rescued by a Federal Reserve bail out in 1998, demonstrates the degree of risk that can be incurred. The question is whether the central bank or other authorities will be able to move quickly enough, or in large enough measure, to prevent future failings.

When looked at from the Islamic perspective, as with so many other Islamic financial products, it seems that theory needs to be stretched in order to justify an Islamic option contract. The macro-economic arguments for their existence are of dubious merit, based as they are on minimising risks which do not need to exist in the first place. Better to structure the economic system such that it does not suffer from continuing volatility. If there was no such thing as interest, there would be no such thing as interest rate options. The same with foreign currency. What we are seeing in the Western world is the emergence of financial products that are a symptom of a system that has gone wrong. Islamic financiers who look at the products of this system as a paradigm are making a big mistake.