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Three years ago, when the US sub-prime crisis exploded, GS Khoo was already testing the ground for fissures in other parts of the financial services landscape. Islamic finance was one of the areas he predicted would face issues.

Khoo was then group chief risk officer at a Malaysian financial conglomerate which owns an Islamic bank. Today, he is a director of risk with one of Asia’s biggest institutional investors and his concerns about Islamic finance are beginning to unfold.

At issue is whether the market for sharia products and services is outpacing its ability to manage the risks. Nakheel’s sukuk episode in late 2009 was a warning for investors. In November, Nakheel, a Dubai World company, requested a six-month debt standstill for its US$3.52 billion sukuk maturing in mid December 2009. The Islamic bond’s formal documentation had not specified the sukuk’s legal jurisdiction. Would it be the English legal or sharia system? The prospectus did not explicitly state the Dubai government’s support, in case of financial difficulty, although Dubai World is wholly owned by the state. Investors merely assumed that they would have legal recourse and the Dubai government’s guarantee.

Khoo’s concern for the developing Sharia investment market in Asia is of systemic risk: “There is no cohesive infrastructure in Islamic finance. A lot of attention is paid to the structuring, marketing and front-end of Islamic products, to make them sharia compliant. But little heed is paid to the back-end’s sharia compliance, including securities clearing and accounting. My research shows that often, the back-end is co-mingled with non-sharia products. If you cook halal food, you can’t use the same utensils as non-halal food. In financial terms, it works the same way.”

For example, a sharia-compliant treasury product using permissible commodities is becoming increasingly popular. There is sharia-related risk at every point of transaction, from the entry of trading codes to trade processing and clearing.

The risks can be broadly categorised into standardisation of contracts; interpretation and application of sharia principles; valuation and benchmarks; liquidity; and legal interpretation.

David Vicary Abdullah, global leader of Deloitte’s Islamic finance group and co-author of Islamic Finance: Why It Makes Sense, affirms that the industry has growing pains: “Overall, the infrastructure to support Islamic finance, such as legal structures, is not well developed. Investors need to pay attention to a finer level of detail to understand how risk is managed and the possible impact on their investment. Is the management competent? What is the quality of financial institutions supporting the product? Have you checked their balance sheet? Who signed off on the documents? Do investors understand the contract and do the sharia compliance people understand the contract? What are the market conditions surrounding the product? For example, the Dubai economy crumbled from over-dependence on real estate, which led to difficulties for Nakheel’s sukuk.”

Several sukuk defaults and restructurings have begun occurring in the last two years, which expose the complexity of legal jurisdiction and interpretation. Many sukuk fall under English law, with a sharia overlay. In cases of default or sharia disagreement, which legal system presides? Islamic finance specialists urge investors to state explicitly which is the governing system.

A recent case in the UK courts involved Bahrain’s Shamil Bank and Bangladesh’s Beximco Pharmaceuticals. The Islamic bank had provided a working capital facility to Beximco, under a murabaha contract, to comply with Islam’s prohibition of interest payments. In murabaha, the bank agrees to buy specified goods from Beximco and pays in instalments; the difference between the original price and the deferred price would be the bank’s profit. Beximco defaulted on the agreements and the case was brought to the courts. Beximco argued that the facility did not comply with sharia and hence they had no obligation to the contract. However, the agreement had a governing law clause: “Subject to the principles of the Glorious Shariah, this Agreement shall be governed by and construed in accordance with the laws of England.” The court decided that in this case, sharia was a guiding principle and not a governing legal framework.

Liquidity and valuation present risks too.

Brian Blanchard, head of asset servicing at BNY Mellon in the Middle East, observes: “The market is waiting for the deepening of liquidity. Most sukuk issues are oversubscribed but they are not traded much in the secondary market. The market can benefit from issuers such as the World Bank or Asian Development Bank to set benchmarks. Once there are widely accepted benchmarks, the market will benefit from its own steam.”

Ultimately, a liquid secondary market can only arise from greater variety of sharia-compliant investment instruments, regulation and clearer insight into the risks of these instruments, says Jamal Abbas Zaidi, former CEO of the Islamic International Rating Agency in Bahrain. The evolution of the conventional debt market suggests that there is no quick answer: “The process is gradual where the regulatory environment in the first place has to provide a level playing field for all the existing players in the market and then gradually, with evolution of new products and instruments, it has to keep pace with new developments,” says Zaidi.

Malaysia, one of the largest sharia financial markets worldwide, has begun to bridge the chasm between conventional and sharia legal frameworks for financial transactions. The Central Bank of Malaysia Act 2009 now recognises two financial systems in Malaysia: Islamic and conventional. 

Standardisation of sharia contracts and interpretation of sharia principles are another risk. Middle Eastern and Malaysian sharia scholars, for example, don’t always agree. In Malaysia, a contract called bai bithaman ajil was widely used for property loans. But it is rejected by Middle Eastern scholars, as cutting too close to being an interest-paying product. In bai bithaman ajil, a bank buys an asset on behalf of a customer and sells it to him at a profit. The proceeds are repaid in instalments.

Malaysia’s RHB Islamic Bank is phasing out this structure in favour of globally accepted sharia structures. Observers say the lure of cash from the Gulf Cooperation Countries (GCC) is nudging Islamic institutions to increasingly comply with the GCC’s sharia standards, which could lead to global standardisation. RHB Islamic, for example, recently structured a US$212 million GCC-compliant sukuk. Previously, the infrastructure financing deal would have used the bai bithaman ajil structures.

Sometimes, products previously regarded as sharia-compliant can be declared questionable by powerful sharia authorities. In recent years, several sukuk and murabaha structures suffered this fate. In 2008, the Islamic accounting body AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) published six principles for sukuks and declared - some say perceived to have declared - that 85% of existing sukuk structures didn’t comply. Even commonly used terms for product structures, such as ijara and mudaraba, don’t have universal interpretations.

“Knowledge is the best protection from uncertainties in an industry that is still developing. Before putting money into any investment instrument, both sharia and non-sharia, investors need to read the prospectus carefully and understand their specific risks. Do they understand the structure? They should invest only if they are comfortable with the proposition,” says Zainal Izlan Zainal Abidin, CEO of i-VCAP Management, a Kuala Lumpur-based Islamic fund management firm.

Investors need to be as vigilant with details as they are with conventional investment products, says Giambattista Atzeni, BNY Mellon’s business manager in the Middle East and North Africa region for corporate trust. Atzeni’s clients are the special purpose vehicles issuing sukuk and other sharia assets.

Having looked at the plumbing in a growing number of sharia products, Atzeni thinks investors should ask the following questions in their due diligence:

1.    Are key details about the investment product easily accessible both at the moment of issue and on an ongoing basis? Consider the cost of access.

2.    Is there full disclosure about the obligor and the guarantor, when applicable?

3.    What is the investor exposed to, the corporate issuer or the underlying asset? In cases of default, what is the recourse?

4.    Is the transaction in line with international best practices? For example, is there a third-party delegate whose responsibility is to represent investors’ interest and monitor compliance with the covenants during the lifetime of the deal?

5.    Which is the governing law?

“These would be the same questions you ask when you buy conventional bonds. Investors can get answers if they ask. The more questions they ask, the more the industry develops best practices. Don’t focus on the reports in the newspapers. Read the documentation made available through the official channels,” Atzeni says.

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