The coming of age of Islamic structured products

Date: Monday, December 15, 2008
Author: Nick Ferguson, Finance Asia.com

Malaysia’s structured products market is benefiting from the development of a liquid Islamic capital market.

Islamic finance is coming of age. Today, for the first time, Islamic structurers in Malaysia and the Middle East are starting to create new financial products and infrastructure from scratch – developments that do not simply wrap their conventional counterparts in a Shar’iah structure but which are Islamic from start to finish.

Already this year, in its effort to develop a wholesale Islamic capital market, Malaysia’s Syariah Advisory Council has approved a Shar’iah-compliant commodity exchange and it has also given the go-ahead for securities borrowing and lending, which will support the creation and redemption of Islamic exchange-traded funds, or ETFs. The first Islamic ETF was launched in January this year.

A broad universe of Shar’iah-compliant underlyings is particularly significant for the structured products market, and most of all for equities structurers. Shar’iah-compliant underlyings often have no volatility market, which makes it difficult for providers to manage their risks, and they are typically illiquid, expensive and difficult to access.

Fixed-income structurers have an easier time of it. The increasing popularity of Islamic bonds has given them more to work with and, in fact, sukuk issuance is now starting to spread outside the Islamic world as borrowers learn to appreciate their value as a way to access new markets. A German state recently issued a sukuk and the UK is also considering one.

But the conventional structured products market in Asia is overwhelmingly dominated by equity and this is where the greatest development in Islamic products is focused.

It has taken a long time to get to this stage. Norfadelizan Abdul Rahman, the head of product development at Bursa Malaysia, describes the evolution of Islamic finance this way: adoption, conversion and, today, genuine architecture. “In the past, most Shar’iah product innovations were focused on adoptions – the study of conventional products and their Shar’iah justifications for use in the Islamic space,” he said at a recent forum on Shar’iah structured products in Kuala Lumpur.

The adoption phase led to the approval in Malaysia of warrants, crude palm oil futures and preference shares, starting in the mid-1990s. This process also allowed 85% of all companies listed on the stock exchange to be approved as Islamic stocks.

The next level of development involved taking conventional products that were not suitable under Shar’iah law and coming up with ways of converting or replicating them. Back in 1998, Islamic financiers created Shar’iah-compliant stock index futures and, more recently, Islamic real estate investment trusts and ETFs.

The global economic slowdown has affected Islamic markets as well, but Malaysian investors in general have not shared the bad experiences of structured product investors in Hong Kong and Singapore.

“Malaysia is protected in a sense, given the regulatory structure,” says Angeline Ong, head of structured products at Citi in Malaysia. “Malaysia has been sheltered from cases like the Lehman minibonds and so on – most of our products are quite conservative in nature and principal-protected by banks in Malaysia.”

However, some investors in equity and commodity products are expecting zero returns, so they are experiencing something of what the clients in Singapore and Hong Kong are going through, but to a much lesser extent.

Malaysian investors buy structured products in a variety of forms. Direct investment in derivatives-based products has only been allowed since 2005 and is still restricted to rich investors. The minimum investment size is either M$250,000 ($70,300) or M$100,000, though the lower figure is only for so-called qualified high-net-worth individuals.

“The first generation of Malaysian structured products will mature in the first half of next year, so it will be interesting to see the final performance of such products and how this will impact the market and investor sentiments,” says Aida Mastura, head of investor sales at Citi Malaysia.

Regular investors cannot buy structured products directly. Instead, they must buy them through structured deposits, which have a minimum investment amount of M$100,000, or through funds, which have been allowed to invest in structured products only since May 2006.

Structured deposits, which the securities commission prefers to call floating-rate negotiable instruments of deposit, are the biggest part of the market by far, making up about two-thirds of the total.

Risk sharing

Islamic structures are sometimes criticised as mere financial jiggery pokery – a clever dodge that lets Muslim investors achieve the exact same results as conventional investors. There are certainly some structures and products in the market that deserve such criticism, but Ahmad Chaudry, an Islamic finance specialist at Royal Bank of Scotland, argues that Islamic finance techniques can also offer very different solutions to conventional finance, which can appeal to Muslims and non-Muslims alike.

Islamic mortgages are a good example, he says. With a regular home loan, the would-be homeowner borrows money from a bank, invests it in a property and pays back the loan over time, plus interest. “The only circumstance under which the bank cares about the value of your property is if you default,” says Chaudry. “In Islamic finance, the bank buys the property with you – you share the risk.”

In this type of Islamic mortgage, the investor might buy 10% of the property, while the bank buys the rest. The investor reclaims equity stakes from the bank over time and also pays rent on the bank’s stake. Most important, the investor buys this equity at the prevailing market values, which means the bank is taking risk on changes in the value of the property over time. “This is something we don’t see in conventional finance,” says Chaudry. “The sharing of risk is something that is extremely central to Islamic finance.”

There are of course some contradictions that still vex conservative Islamic scholars and non-Muslim sceptics alike. If risk-sharing really is at the centre of Islamic finance, we might expect Islamic financial institutions to act more like venture capital firms than banks. But they do not – and for good (though not Islamic) reason. A banking system built on equity investing would be far too unstable, and so in practice, Islamic banks end up taking a very similar degree of risk as Western banks.

One of the key techniques to achieving this is the practice of benchmarking. In the mortgage Chaudry describes, for example, there is no Shar’iah-compliant way of determining the rent to be paid so it is simply benchmarked to interest rates, which is apparently acceptable to the Islamic scholars who sign off on these structures.

These sleights of hand are particularly important for creating halal equity structures because Shar’iah rules specify that the profit earned in a transaction must be agreed by both parties at the outset. This is clearly impossible in a product linked to the returns from an equity underlying, so Islamic structurers have come up with two techniques to solve the problem.

The first is an agreement known as a murabahah – or two agreements, to beaccurate. In a typical one-year trade, the first agreement runs for 364 days, in which the bank promises to pay back the investor’s money at par. Then, if the underlying index has appreciated during that time, the bank enters into a one-day agreement, promising to pay the investor the value of the index rise during those 364 days. This is the most common structure in Malaysian equity-linked products.

In the Middle East, Islamic structurers often rely on a form of benchmarking that is wrapped in an agreement called a wa’ad, whereby the bank promises to buy a portfolio of Shar’iah-compliant equities from the investor, plus a profit that is benchmarked to a conventional call option.

Even though these structures look very similar to their conventional cousins, they still present unique challenges for structurers. Shar’iah-compliant products are more expensive because there are more fees built into the structure – such as the cost of the extra legal work and the cost of getting scholarly sign-offs – and bid-offer spreads are much bigger on Shar’iah-compliant underlyings.

But one of the biggest problems is volatility. “You find with Islamic stocks that volatility is quite high, which means that to offer products with an Islamic underlying I need to be able to manage my risk,” says Chaudry. “But there is no volatility market.”

RBS’s solution is to manage the underlying at a fixed level of volatility by adjusting the exposure to it – for example, the investor is 100% exposed to the underlying when it is trading at the target volatility level and reduces his exposure when it is higher.

As the products and techniques on offer are becoming more sophisticated, so too are Malaysia’s investors, but, even so, the structured product market is still in its infancy. The country’s savings rate is 36% of its gross national product and even higher in the Islamic market.

“Islamic banks have too much cash and not enough assets to buy into,” says Lee Kok Kwan, head of treasury at CIMB. “There is always a lot of liquidity on the deposit side.”

This is one of the principal motivations for Malaysia to develop its Islamic capital market – to provide a way for all these deposits sitting in Islamic banks to find a productive use in the economy. The creation of new Islamic underlyings and a greater diversity of products should certainly help in that effort.

This story was first published in the November issue of FinanceAsia magazine.