In the sharia investment marketplace, global best practices are just beginning to surface in back-office functions such as custody and fund accounting. Often, the global service providers do not have a separate team or service window for sharia products, as it remains a small niche business for them business. But that position is changing.
Bill Rosensweig, Managing Director at Brown Brothers Harriman, based in Hong Kong, says, “Sharia products are a rapidly growing part of our business. As volumes increase, we continue to evaluate market requirements for a one-stop shop, including a sharia adviser and other facilities. Currently, we leverage our existing infrastructure to support sharia products. However, as our business in this area evolves, we will continue to tailor our services to the unique requirements of sharia funds. One potential area to do so is compliance monitoring, as our flexible rules-based system can be configured to meet the unique needs of sharia funds.”
Rosensweig foresees the need for compliant accounting and compliance monitoring approaches suitable for the major fund domiciles like Dublin and Luxembourg, which host 20% of Islamic funds each, outside the Middle East. BBH currently serves as custodian to asset managers and sovereign funds in East Asia, including Japan. “Sharia services are a natural extension for many of these clients and as such BBH intends to expand its capabilities in this area,” Rosensweig explains.
Institutions that want to serve the Islamic market might also need to adjust their operating hours, Rosensweig suggests: “Investors in certain Islamic markets work on Saturdays and Sundays, so will require support regarding fund administration and custody, which over time may require an extension of our global service model.”
Investor protection standards and ownership structures vary from one jurisdiction to another. The Islamic dimension adds another layer of complexity. Sukuk transactions, in particular, have differing standards across the globe. In Europe and the Middle East, the special purpose vehicle administering the investment can also be the trustee, says Giambattista Atzeni, strategic business development manager at BNY Mellon Global Corporate Trust. In Malaysia, a third-party trustee is required. “The third-party delegate is crucial, especially when you have to retract the transaction or when there is a breach of covenant. The delegate acts on behalf of investors’ interests,” he says.
When a few sukuk defaulted recently, one of the first things Atzeni identified was that these sukuk didn’t have independent trustees. “If a third-party trustee had been involved, maybe they could have identified steps to avoid default. They might have put in place agreements to restructure the payment schedule, for example. In a post-default scenario, a third-party trustee would have considered the position of the investors, exercised any security taking and filed claims on their behalf, and represented their interests in the insolvency proceedings,” Atzeni says.
Transaction protocol and automation are other areas under development. SWIFT started a pilot for commodity murabaha in October 2009. The pilot includes a dozen financial institutions in the UK, the Middle East and Malaysia, says Franck de Praetere, head of Southeast Asia at SWIFT.
Ching Liran, SWIFT’s senior manager for securities markets, says, “Initial feedback from pilot institutions has been positive, with many expecting to move to live use of SWIFT for Murabaha in the first quarter of this year.”
Murabaha was selected for the pilot because about 60% of global sharia transactions are in this category, Liran explains. It is also a complex and manually intensive process with little standardisation currently.
Commodity murabaha is a treasury product that involves numerous parties transacting almost simultaneously. To keep sharia’s principle of minimal uncertainty, the commodity’s future price must be agreed upon on the spot, without leaving room for fluctuations. Moreover, the transaction must not result in any interest payment.
A common transaction involves four simultaneous parties: A bank buys a commodity contract from a supplier. The bank then sells the contract to a client at cost plus profit. To get cash, the client immediately sells the contract to a purchaser at a price equivalent to the bank’s cost. The client pays the bank on a deferred or instalment basis. All prices must be determined almost simultaneously.
The multiple steps and lack of standardised documentation opens up operational risks at every juncture, where agreements between parties must be secured and documented, and sharia compliance must be established. Many sharia-approved commodities are traded on conventional markets such as the London Metal Exchange, where prohibited commodities are also traded. For sharia-compliance, SWIFT is developing standardised codes to identify the two types of commodities.
Automation will also trim transaction costs. Two forces favour the growth of back office services for sharia-compliant products. One, the sharia-compliant financial services market is at the cusp of the US$1 trillion mark and is growing at 15% to 20% annually. Two, common belief says that Gulf Cooperation Council (GCC) institutions and wealthy families still have cash to invest, unlike many developed nation investors. Naturally, a growing number of asset managers, banks and other financial institutions, both Islamic and non-Islamic, are waking up to the profit possibilities in the sharia-compliant market.
Rolf Bachner, vice president at BNY Mellon Asset Servicing in Luxembourg, says, “Until the end of 2008, we were primarily servicing institutions issuing sukuk in the Middle East and Southeast Asia. At the end of 2008, we saw new demand for Islamic fund services; they were from fund managers in the Middle East, Southeast Asia and the West. The managers from the West are large fund houses creating Islamic funds to reach Islamic constituents in Europe, the Middle East or Africa.”