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Wednesday, 25 July 2007

Rise of the sukuk

The Islamic bond market is taking off, not only in the Middle East but across the globe. Are there specific technology challenges related to these and more complex Shariah-compliant instruments? A niche product until recently, issuance of the global sukuk, an asset-backed, Shariah-compliant trust certificate or Islamic bond, will top $100 billion by the end of the decade, up from some $70 billion at the end of 2006. According to estimates from Standard & Poor’s, the growth of the sukuk is part of the overall explosion of the Islamic market, as Shariah-compliant assets worldwide total close to $500 billion reflecting growth of more than 10% a year over the past decade. S&P predicts that Islamic finance will continue to expand, both geographically and in terms of products offered, and newly created Shariah-compliant instruments are set to rival product offerings at conventional banks. In response to the growing market, last year Dow Jones and Citi launched the Dow Jones Citigroup Sukuk Index, the first Islamic bond index. To be included, a sukuk must comply with Shariah law and the Accounting and Auditing Organisation for Islamic Financial Institutions, the main standard setting organisation based in Bahrain. Western banks, including HSBC, Deutsche Bank, Barclays Capital and Citi, are getting in on the action. BNP Paribas has recently completed the second largest bond issue in Saudi Arabia for the Saad Trading Contracting and Financial Services Company. BNP Paribas acted as sole managing underwriter for the $650 million, 5-year bond issue, in sukuk format, which was also the first sukuk issued in Saudi Arabia for a private business. And more are following their wake: “In Europe and America, there is a large myth about these millions of unbanked people who keep their money under the mattress – if only there was an Islamic bank in the neighbourhood. So there have been one or two Islamic institutions formed and certainly regulation has changed in a few different Western countries,” says Nicholas Brewer, Temenos strategy manager. This includes the UK. London has recently joined the list of major financial hubs to handle Islamic transactions, becoming the sole non-Muslim competitor of natural Islamic markets in Dubai, Kuala Lumpur and Bahrain, according to S&P. The UK government demonstrated its commitment in the 2007 budget by introducing new measures for sukuk, enabling them to be issued, held and traded in the same way as corporate bonds. Mohammed Amin, tax partner at PricewaterhouseCoopers, says that previously it was impractical for UK companies to issue sukuks because they wouldn’t get tax relief on the payments that would be made to the investors. “The tax law is being changed so that in future, from the date of the Finance Bill becoming law, UK companies will be able to issue sukuks with obvious, very concisely controlled definitions and they will be able to get tax relief on the payments they make to investors. Similarly it is quite clear how UK investors will be taxed if they buy and sell sukuks.” The UK government itself is carrying out a study as to whether it should issue a sukuk, which will have “a big effect in terms of making everyone sit up and take notice,” believes Amin. According to Celent’s 2007 report Socially Responsible Investments: Shariah-governed investing, sukuk is the first foray into security instruments to broadly take hold in the marketplace. Because of the Islamic ban on riba, or interest, sukuks follow a structure similar to revenue bonds –they are structured in tandem with a physical asset. The underlying revenue streams from toll roads, airports, seaports, utilities, new buildings, power plants or oil facilities are used to pay a profit on the sukuk. Currently most sukuks are bought and held – there is not an active secondary market. Although it sounds relatively simple, the actual issuance of the bond is more difficult than conventional bonds due to the fact that Shariah is an interpretive law that has variance among countries and people – and this has an impact on the technology. Jamil bin Hassan, principal consultant on Islamic banking practice, i-flex solutions, says: “Buying and trading sukuk is not a problem. The problem is the issue and creation of sukuks. No one had come up with good system to originate sukuk because the market is still small and there has not been the volume to justify the spend on technology.” Vittorio D’Orazio, principle research analyst at Gartner, explains that there is a problem with standardisation: “It is a problem for the IT provider to configure [technology] around the current regulation in each country and around a specific request of the Islamic board, which is a separate entity from the bank board and supervises the delivery of Islamic banking project. The IT providers develop some products, they show the Islamic board how the product works and the board must approve it or they must make changes. Very often, the board is not unanimous because mostly they are just three people and discuss endlessly around specific theological points.” Shariah-compliant products must be approved by a Shariah scholar certified for issuing a fatwa (Islamic decree). There are fewer than 20 scholars with such skills worldwide, increasing approval times and leading ultimately to a “manpower crunch”, he says. In Gartner’s Market Trends: Islamic banking worldwide 2006, D’Orazio examines 15 IT service providers and 27 core banking systems providers of Islamic banking applications. The research found that the back office is the most affected area, with 80% of it being actively involved in changes by the Islamic banking implementation. This is largely a result of the need to replace not only the software but also the way the products are managed across the back office systems. Middle office is also heavily affected (63%), especially regarding the reporting issues that must be related to the Shariah calendar and practices. “Technology providers see that the banking world has long been convinced that it should go for a packaged approach where it can – buy a commodity when it can and bespoke if you need to,” says Brewer. “Where there is not this commonality or commoditisation of the instruments and processes, then it becomes harder to adopt a truly packaged approach because you can’t say that everyone does this 80% this way and I will make my package fit and add the extra 20% if, in fact, the 80% commonality isn’t there. It is quite hard to adopt a packaged approach.” He says that Temenos has packaged as much as it can and the rest it has constructed a modern technology framework around it which means that “you can carry out more customisation both during implementation and afterwards then perhaps you would normally want to do with a package for other types of banking.” Peter Sherriff, technical architect at Charles River Development, Asia Pacific, agrees that the different interpretations create a problem, but that the solution lies in being flexible. “From the systems perspective, we already equip the system with a lot of the guidelines around Shariah compliance, and around other ethical type investment strategies, which gives people a head start in terms of being able to very quickly deliver Shariah compliant products. Those products can differ between the different Islamic scholars, so you need to be able to slightly modify and tweak those rather than go back to the first principles or do it completely from scratch. So the key is to have a framework which is flexible, automatable and which can handle the complexity of the requirements.” Gartner’s D’Orazio found difficulty in drawing a definitive map of the technology providers providing Islamic banking products worldwide for a number of reasons: they are embedded into a generic core banking system deal/replacement; they are developed internally and not publicised with a public offer; and they happened mainly in emerging countries where information is not that easily tracked. Also they do not use system integrators. “If you are Temenos, Misys or any other and you want to implement the Islamic banking solution for your customer, you typically do not go to Accenture to do the implementation because the main work to do is on the parameters – so they hire some local provider and experts.” Samir Safa, business development manager, Misys, argues that these limitations force Islamic banks to be more innovative. Misys has recently signed an agreement with Bahrain’s Albaraka Banking Group to implement Misys Equation (Islamic) so the bank could improve the retail and Islamic services it provides its customers, plus enable it to expand into new territories. Such as moving into derivatives, perhaps? In this area there is a debate that has yet to be resolved. Celent believes that a nascent Shariah-compliant derivatives market is developing. In the hedge fund industry short selling is a common strategy that cannot be used under Shariah because you cannot sell something you don’t own. Derivatives are difficult to structure because Shariah committees generally state that money should be lent only on physical assets and bar speculation – a central characteristic of derivatives. Yet last September the International Swaps and Derivatives Association and the International Islamic Financial Market signed a memorandum of understanding as a basis for developing a master agreement for documenting privately negotiated Shariah-compliant derivatives transactions. But that doesn’t mean that it is clear sailing ahead. PwC’s Amin says: “There is a lot of debate about derivatives. I have seen lawyers who are experts in terms of standards stand up in conferences saying there is no such thing as Islamic derivatives, while others are setting up funds to transact derivatives. It is a grey area. The challenge is that to the extent that people have these structures, they regard these structures as proprietary and therefore they don’t publish or write about them, so it is very hard for other people to unpick them and evaluate whether they really are Shariah-compliant or not.” The notion of Islamic derivative may currently be a grey area, but the same was said of Islamic bonds until relatively recently, and in the form of the sukuk, they have plainly arrived. It seems only reasonable to assume that some form of Shariah-compliant derivative product will soon emerge, and bring with it a whole new set of challenges. Shariah law overview: In its 2007 report Socially Responsible Investments: Shariah-governed investing, Celent outlines the high level guide to the principles of Shariah:
□ no interest (riba) may be charged or paid; one may not benefit from another’s uncertainty (gharar) – in investment terms this includes the trading of risk or sale of something not yet obtained;
□ where income is involuntarily received, the investment or portfolio must be purified – the income may be given as a donation (zakat) to charity;
□ certain investments are not religiously permissible (halal) – including investments in alcohol, hotels/restaurants that serve alcohol, tobacco, pork, gambling, weapons, and entertainment such as films; and
□ no investments in companies that do not meet specific financial parameters in relation to debt to equity ratios (no more that 33% of enterprise value), interest income (no more than 5% of income attributable to interest). - (Banking Tech, July 2007)
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