Banking & Finance: Sukuk succour
11 June 2007
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It’s not just pro-Muslim sentiment that is fuelling the emerging Islamic finance market, Government legislation is lending a helping hand too. By Farmida Bi
As law firms and investment banks stampede into the Gulf, the UK Government continues to legislate to support the City’s claim to be the international centre for Islamic finance. But against the competing claims of Dubai and Malaysia, it is worth asking whether Islamic finance is here to stay or if it is a short-term phenomenon, driven by the high price of oil and pro-Islamic sentiment that has followed 9/11.
Until recently Islamic finance was a niche practice area and financing structures focused mainly on commodity-trading murabaha transactions. It has been primarily the issue of international sukuk (Islamic bonds) that has given it its high profile, although Islamic financing techniques are now used in many sectors, including residential and commercial property, insurance and retail products.
The first international sukuk was issued by the Government of Malaysia in 2002 and in January 2006 part of the acquisition of P&O by Dubai Ports World was funded by a $3.5bn (£1.76bn) sukuk by Dubai’s Ports Customs and Freezone Corporation (PCFC), suggesting that the sukuk had become simply another product in the armoury of bankers.
Sukuk structures have evolved rapidly in response to the demands of issuers and investors, from simple sale and leaseback (ijara) structures, such as the $1bn (£502.54m) Dubai Department of Civil Aviation sukuk issued in November 2004, to the $2.53bn (£1.27bn) trust finance sukuk structure issued by Aldar Properties in March 2007, demonstrating the flexibility of Islamic finance principles.
The rise of the sukuk
It is expected that the number of sukuk coming to the market will continue to increase, both from the traditional Islamic finance regions of the Gulf and Malaysia and from new regions, including the West. Thus far, the only non-Islamic issuer has been the German state of Saxony-Anhalt, which tapped the sukuk market with its e100m (£67.78m) issue in August 2004.
The UK Treasury has repeatedly passed legislation to ensure that Islamic finance is on an equal footing with conventional finance to encourage, for example, the development of an Islamic mortgage market, and the Financial Services Authority (FSA) has authorised the Islamic Bank of Britain and the European Islamic Investment Bank to operate in the UK.
Most recently, the UK Finance Bill 2007 seeks to remove the tax penalties for a UK sukuk issuers, so it will be intriguing to see which UK issuer will come to the market first. It could even be the UK Government, since Ed Balls, the Economic Secretary to the Treasury, has said that the Treasury is examining whether the Government should issue a sukuk in order to support the City’s position as a leading centre for Islamic finance.
There has certainly been pressure on the UK Government to issue a sukuk, perhaps linked to the 2012 Olympic Games. The US has already seen a $165.67m (£83.26m) domestic sukuk issuance by East Cameron Partners, linked to offshore gas property assets near Louisiana.
Widening the net
In addition to a wider group of issuers, the potential pool of investors in Islamic finance products is now much bigger than the initial group of devout Muslims based in the Gulf and South East Asia. Investors in Europe, Asia and even the US, who are keen to participate in the exuberant markets of the Gulf but are limited by rules restricting foreign ownership, see sukuks as no more than asset-based securities that give them exposure to markets in the Gulf that they would otherwise be unable to access.
Recent large sukuk issues have been placed mostly outside the Gulf region and it is expected that this trend will continue and may well expand to include the large institutional investor base in the US. Many of the issuers to date have been sovereign issuers or corporates created by sovereigns, with a ’sovereign halo’, which have accessed the market in order to raise their profile.
It is likely that in the future, increasing numbers of corporates with no links to government and with a real funding need will access the market. The popularity of convertible and exchangeable issues, with guaranteed allocations of shares, including in some cases in future IPOs, are also likely to continue in the Gulf and are becoming increasingly popular in Malaysia.
Islamic securitisations are seen as the next frontier for the development of the sukuk market and a number of transactions are currently being structured and are expected to come to the market this year. These transactions are raising novel issues, such as how to effect tranching without offending the sharia principle of treating all investors equally, which need to be addressed by the sharia scholars issuing the relevant fatwas.
Increasingly, clients also want to replicate conventional structured products in a sharia-compliant way so that a broader range of products can be offered to Islamic investors. This includes capital-protected products and products that give investors exposure to underlying hedge funds, which are considered unacceptable by some sharia scholars.
The move into structured products has been boosted by the International Swaps and Derivatives Association (ISDA) and the Bahrain-based International Islamic Financial Market (IIFM) signing a Memorandum of Understanding in October 2006 to produce a sharia-compliant Master Agreement based on the 2002 ISDA Master Agreement. A draft is currently being produced by a working group established by the ISDA and IIFM that, when it receives its approval by the Sharia Board of the IIFM, may kickstart a market in Islamic derivatives similar to the impetus that the publication of the original 1992 ISDA Master Agreement gave to the conventional derivatives market.
However, this is not a sector without its problems. The main issue that concerns market participants is the lack of standardisation in the market. There is no single authority capable of stating what is acceptable under Islamic law and each transaction requires a fatwa to be issued by a sharia scholar or sharia supervisory board, even if it replicates a previous transaction. This can add significantly to the cost and timing of a sharia-compliant transaction.
A related concern is the shortage of appropriately qualified scholars who can issue fatwas. There are a number of initiatives, such as the ISDA/IIFM Sharia Master Agreement, to jointly develop standardised contracts and market practice for sukuk, although it is harder to address the lack of appropriately qualified scholars in the short term.
Many economists expect the price of oil to remain high because of increased demand from emerging economies such as China and India, so the liquidity in the Gulf region, which has supported the expansion of Islamic finance, is likely to continue. This liquidity is being used to finance infrastructure development and to diversify the local economies away from oil and into, for example, tourism.
The pro-Islamic sentiment that was discernible in the aftermath of 9/11 is of less relevance now as the financial community as a whole embraces Islamic finance. The cashflows from oil and the huge interest now shown in Islamic finance, combined with the investment made in the sector by investment banks and professional firms, suggests that Islamic finance is here to stay.
•Farmida Bi is a partner at Denton Wilde Sapte.