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Sunday, 9 August 2009

Moves to plug the gap in Islamic finance carry risks

The Islamic finance world is huge and growing hugely," says Chris Oulton, chief executive of Prime Rate Capital.

As yet, this upbeat description does not apply to money market funds, largely because the traditional short-dated instruments used in such funds are outlawed due to Islam's prohibition on interest.

But Prime Rate is endeavouring to help plug this gap by launching a Sharia-compliant money market fund, using Sharia commodity investments to mimic the characteristics of a Western money market fund.

The fact that Prime Rate's product will be just the second Sharia liquidity fund available in Europe, after last month's launch from the Bank of London and the Middle East, is testament to how slowly the Islamic asset management industry, as opposed to general Islamic finance, is developing.

Rushdi Siddiqi, global head of Islamic finance at Thomson Reuters, has a measured take on the situation. "This particular industry is young and there are growing pains." Questions of demand, performance and liquidity must all be resolved before Islamic asset management can be considered mature, he says.

An obvious question to ask is what Islamic asset management is, but finding an answer is not easy. While there is consensus on how to build a Sharia-compliant equity fund, extending that to other asset classes is not straightforward. For an equity fund, the manager simply needs to use a screen to exclude companies involved in activities deemed unacceptable such as alcohol consumption, gambling or pornography. Conventional financial stocks are excluded because of the prohibition on interest-bearing debt, which further precludes companies with too high a level of debt.

All of this is sufficiently well established that nearly $16 billion (Dh59 billion) was held in Islamic equity funds at the beginning of this year. "The key issue in terms of building out to other asset classes is going to be screening," says Siddiqi. "Equity screens don't work, so each vertical silo [asset class] requires its own screening proposition."

Sukuk, the Islamic equivalent of fixed income, for example, was rocked last year when a scholar on the Sharia committee of the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (Aaoifi) was reported as saying 80 per cent of current sukuk structures were not Islamic.

This is a striking example of what Siddiqi calls "Sharia risk," the danger that a product thought to be acceptable will be rejected by influential authorities.

"It comes down to whether you know the scholar," says Tim Harvey, head of sales in Europe, the Middle East and Africa at ETF Securities, which has six products that are officially Sharia compliant.

In this context, "officially Sharia compliant" means a board of Sharia scholars has decided the products are acceptable, and Harvey can show statements or fatwas from the Sharia boards of HSBC Amanah and Al Qalam, a UK-based Islamic bank, to that effect. Any Islamic institution using the products however, would have to submit them to its own Sharia board for approval, although the names authorising the fatwa may be authoritative enough to be fast tracked.

Although there is no central authority, the scholars on Aaoifi's board carry great weight. Largely as a result of the uncertainty surrounding sukuk's Sharia status, issuance in 2008 was less than a third that of a year before. While this year may see a return to the levels of 2006 - about $27 billion, according to Ernst & Young's annual Islamic Funds and Investment Report - this is still a far cry from the $47 billion of 2007.

Another challenge is that sukuk are not immune to the problems of the global financial environment. Two Middle Eastern issuers and one US-based issuer of Islamic bonds have recently been unable to meet their obligations. In Western terms, they defaulted, but since the concept of sukuk is relatively new, there are no established ways to work out what to do in the circumstances.

Siddiqui is optimistic: "That's the industry growing up." Once the restructurings are worked through, he predicts, there will be better pricing because the downside is clearer to issuer and buyer.

On the positive side, he says, due to the uncertainty some investors are selling off their sukuk holdings at a discount, thereby creating a buying opportunity for new sukuk funds, such as that of HSBC Amanah.

Asset managers wishing to offer sukuk funds to investors also face a lack of effective secondary market. Most sukuk are bought on issuance and held until maturity, leading to difficulty in finding assets to buy and in pricing assets held.

Such sukuk funds are open-ended despite the difficulty of managing a fund that investors can redeem at any time, yet for which there is no market for the underlying assets. To manage this issue, many of these funds have high minimum investments to restrict them to the institutional or private wealth market, as well as swingeing redemption fees.

Not all Sharia investment requires religio-financial engineering: ETF Securities' Sharia products are exchange traded commodities, investing in physical metals, not designed with the Islamic market in mind.

"We knew many Muslim asset managers who work in global capital markets who said to us 'these products are Sharia compliant'," says Harvey. "Eventually we thought we should do something with that."

The company asked Al Qalam to check the suggestion a couple of years ago, and last year HSBC Amanah issued a fatwa saying the products passed muster. Now, Harvey is fielding an increasing number of enquiries from investors in the Gulf.

(Financial Times)

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