Vol 7 Issue 28 14th July 2010

T h e W o r l d ’ s G l o b a l I s l a m i c F i n a n c e N e w s P r o v i d e r

ALERTSRegister now - It’s freeIn this issue

IFN Rapid ..................................................... 2

Islamic Finance News ................................ 3

Takaful News ................. .............................9

Rating News ................................................ 9

IFN Reports:A long way still for Islamic banking ......10

Bankers concerned on unhealthyliberalizing .................................................10

DTA doubles potential .............................11

Articles:Recent Islamic Finance Developments in Hong Kong ..........................................12

Thoughts on Sukuk and the Risk of Default ....................................................14

Legal Uncertainty in Islamic Finance .16 Challenges and Opportunities for the re-Takaful Industry................................. 17

Meet the Head ..........................................19Nick Barisheff, President and CEO of Bullion Management Group

Termsheet ..................................................20NBAD Ringgit-Denominated Sukuk under NBAD RM3 billion (US$937 million) program

Moves .........................................................21

Deal Tracker ..............................................23

Eurekahedge Funds Tables .....................24

S&P Shariah Indexes ...............................25

Dow Jones Shariah Indexes ....................26

Dealogic League Tables ...........................27

Thomson Reuters League Tables ...........30

Events Diary...............................................33

Company Index .........................................34

Subscription Form ....................................34

Hong Kong, one of the world’s leading international fi nancial centers and most densely populated areas, is not to be left behind in the advancement of Islamic fi nance. Apart from being a doorway to China, the special administrative region is taking the necessary steps to capitalize on its elevated fi nancial status and establish Islamic fi nance as a viable fund-raising and investment alternative. Our country report outlines the challenges and latest developments in this territory.

Sukuk, one of the more popular modern Islamic fi nancial instruments has its own set of challenges. The current debate on whether it is a type of bond or a debt instrument or not, is worsened by the notion that the structuring of Islamic fi nancial instruments is doomed for as long as Islamic fi nancial institutions operate within conventional or interest-based fi nancial systems. Our sector report looks at Sukuk and the risks associated in the event of a default.

Swiss Re takes us on a comprehensive analysis of the fundamentals required for the growth of the Takaful and re-Takaful industry in this week’s market report. It demonstrates the different hurdles faced by Takaful and re-Takaful practitioners, how to overcome them and turn them into opportunities.

Legal uncertainty is another facet of Islamic fi nance that needs to be continually overcome. By virtue of its organic and interpretative nature, Shariah law often leads to ambiguous and varying outcomes regardless of the contract in question.

We focus on The Investment Dar vs Blom Bank case as an example of how agreements

may not be upheld in the event of a dispute, and we list possible steps to take to avoid a similar fate.

If there is political will, there is a way, as demonstrated by Bermudan deputy prime minister, Paula Cox who recently led a delegation to Bahrain to cement relations and seal the double taxation agreement (DTA) signed between the two countries.

The DTA opens up a series of possibilities even as some see that the country may not be ready yet to welcome Islamic fi nance to its shores, as reported in one of our IFN reports.

Two countries testing the waters in Islamic fi nance are Albania and Libya, both of which are taking tentative steps to set up a semblance of Islamic fi nancial service offerings. The Islamic Development Bank looks to play a big part in the infrastructural development of Albania. Libya too has begun to open up to foreign and Islamic banking presence in the country. Read about them in our IFN reports.

Last but not least, we feature Nick Barisheff of Bullion Management Group, responsible for the BMG BullionFund, Canada’s largest Shariah compliant mutual fund and the second largest in North America.

As we go to press, the government of Indonesia has announced the appointment of Citigroup, HSBC and Standard Chartered as underwriters for the US$650 million Sukuk it aims to raise in October this year. Islamic Finance news reported last week on the potential appointment of the latter two banks.

Challenge begets growth

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Since the mid 70’s, the number of Islamic Financial Institutions (IFIs) has mushroomed to more than 300 in 51 countries. The rate of growth is impressive, approximately 20% to 30% a year. Research by McKinsey and Company suggests that assets of IFIs will exceed US$1 trillion in 2010. Ernst & Young in a report by Morgan Stanley estimated this number to exceed US$2 trillion. According to the International Monetary Fund (IMF), Sukuk is the most popular modern Islamic fi nancial instrument.

Sukuk shares some features with, and therefore often resembles, conventional bonds. But Sukuk has a different underlying structure and provision. It is the trust certifi cate, which gives its holder an undivided proportion of ownership in the underlying project/asset and right to receive cash fl ows from this underlying. Returns on Sukuk derived either from the performance of an underlying asset or the contractual agreement based on this asset.

The main principles underlying Sukuk issuance can be defi ned as follows: all rights and obligations should be clearly defi ned; the income from Sukuk should be related to the project, which was fi nanced by this issue; and Sukuk should be backed by real assets. Sukuk are issued through the special purpose vehicle (SPV), which serves as an obligor of the Sukuk issue. Returns on Sukuk should be calculated using expectation of profi t from the project, rather than based on market interest rate.

Compared with bonds, Sukuk has a very short history. The fi rst sovereign Sukuk was issued in Malaysia in 1995. Since then, Malaysia remains an active player in the Islamic capital market, marking 46% of the total value of issues according to the Collaborative Sukuk Report 2009. Although the GCC countries joined later, they have matched Malaysia in terms of the value of issuance, marking 49% of the total issue value as of September. Real growth in the Sukuk market started in 2003 when AAOIFI had issued a standard on investment Sukuk. According to Ernst & Young, the period between December 1996 and September 2009 witnessed 747 Sukuk issues with a total value of US$106.6 billion.

However, 2008 and 2009 were very diffi cult years for the Islamic capital markets. In October 2008, US$167 million East Cameron Gas Sukuk fi led for bankruptcy. Later, in May 2009, Dar Al Kuwait failed to meet its obligation on US$100 million Sukuk. Saudi Arabia’s Saad Group is another example of failing to meet Sukuk payments in June 2009.

The abovementioned defaults, as well as Nakheel’s troubles in meeting its Sukuk repayments, have generated a new wave of discussion. A series of questions relating to the robustness of the Islamic fi nancial system, and the Sukuk market in particular, have been raised by the conventional investors and the industry practitioners with limited knowledge of the Islamic fi nance.

Risk of defaultDue to fact that Shariah prohibits trading of debt, any rescheduling of debt for higher markup is forbidden under Sukuk. This prohibition makes risk of default higher for Sukuk compared with conventional bonds, since Sukuk issuers would be more inclined to default. Moreover, while conventional bonds represents a debt obligation,

Sukuk is a certifi cate of ownership, so in the case of default Sukuk holders have a very limited possibility to recover their initial investment.

The managers of Sukuk can bear responsibility for any Sukuk default only within the limits of their control and capabilities. Therefore, in case of default due to external factors, such as force major or global fi nancial crisis, all losses under Sukuk will be borne by Sukuk holders. However, some issues of Sukuk do not provide for legal ownership of underlying asset(s), but rather right of return, which is not Shariah compliant. In the same way, some types of hybrid Sukuk can be classifi ed as non compliant with Shariah due to the presence of debt-based instruments within their structure.

With regard to the risk of default, one should also mention the question of a guarantee of return of principal amount. Prior to the AAOIFI statement in 2008, Sukuk managers were promising to buy back underlying assets at the price equal to the face value of Sukuk. It can also be done by the third party, the government for example.

Some scholars think that such a purchase undertaking can be permissible, and until recently Sukuk Mudarabah and Musharakah were issued using this kind of guarantee. They believe that any guarantee of the principal amount is unlawful in Shariah, whether the originator of Sukuk acts as Mudarib (manager of the capital), Wakalah (agent) or partner.

The AAOIFI statement has classifi ed such a type of guarantee as non-compliant with Shariah. Under the new statement, underlying Sukuk assets should be bought at the end of Sukuk life either by the third party or manager of Sukuk at a market value of underlying asset. Thus, Sukuk holders bear a market risk when the underlying asset can be sold at a price lower than their initial investment.

Since there is no possibility to defi ne the market value of the underlying asset at the time of Sukuk issuance, the set of procedures to defi ne its fair market value can be agreed upon. The parties should also clarify the ways of defi ning the market value as well as procedures and valuation techniques. The Sukuk manager can pay the difference between the market value of underlying asset and face value of Sukuk, if the loss was occurred due to the manager’s poor performance. But the question is, how are we to defi ne the quality of Sukuk management? What are the criteria of poor versus good performance?

Hassan Hussein mentions the following actions as the manager’s misconduct and reasons for him/her to compensate the face value of Sukuk to investors: embezzlement and mismanagement of the capital; negligence in protecting the capital; committing gross errors in taking investment decisions; breach of the terms of contract. All these reasons require further clarifi cation in every individual case. The scholar claims that in a situation when loss occurs due to circumstances beyond the manager’s control, investors (Sukuk holders) should fully bear a risk of possible loss in the face value of an underlying asset.

Credit risk assessment is complicated by an absence of proper international rating of the most of Sukuk issues. Conventional bonds are rated by one of the major international rating agencies in order to

Thoughts on Sukuk and the Risk of DefaultBy Zhamal Nanaeva and Rauf Mammadov

continued...

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obtain access to the fi nancial markets. Sukuk issues often lack this requirement.

According to Ernst &Young (2009) only half of all Sukuk issues have been rated. Malaysian regulation requires the rating of new issues by the local agencies, while most of the GCC issues remain unrated. It is probably due to this that most of the recent issues were sovereign or quasi-sovereign. The government link was perceived as a guarantee and a substitute to adequate rating. These sovereign guarantees can explain the large size of recent issues in spite of the absence of issues’ ratings.

The other problem with the rating of Sukuk is the absence of Islamic rating agencies. Today Sukuk issuances are rated by conventional rating agencies using conventional rating methodologies. This is done in spite of the fact that the rating agencies are fully aware of the differences in structures of conventional and Islamic bonds. This kind of attitude can lead to incorrect rating results. For example, when rating Sukuk, the rating agency evaluates the guarantor’s credibility, rather than the risk of underlying asset.

In light of recent AAOIFI statements relating to guarantees of Sukuk, such rating can be highly inappropriate. An organization that deals with Islamic ratings — Islamic International Rating Agency, is established in Bahrain. It rates both credit risks and Shariah compliance of Sukuk. At this stage, both investors and regulators should coordinate their efforts to enforce use of Islamic ratings as a necessary pre-requisite for Sukuk issuance.

Managing the risksWhile conventional bond holders have a variety of instruments to manage their risks, IFIs lack this opportunity. For example, there is an on going discussion of permissibility of using options in Islamic fi nance. While most of derivatives are clearly prohibited by Shariah scholars, there are some options that can be attached to certain Islamic fi nancial instruments.

For example, call and put options can be used for hedging purposes. Scholars suggest an analysis of option by stipulation and option of determination as possible risk management instruments in Islamic fi nance. There is also the suggestion to use embedded options as a tool for Sukuk risk reduction. The argument is that Shariah, while prohibiting debt trade, allows its exchange for real goods, assets and services. Thus, Sukuk holders can have an option to exchange his “zero-coupon” Istisnah Sukuk, for example, to an apartment (after a certain period) instead of waiting for the Sukuk’s maturity.

There is also the possibility of using swaps of fl oating-rate Sukuk with zero-coupon-fi xed-rate-embedded Sukuk as a Shariah compliant instrument. Most academics argue that the options allow for decreasing excessive risk (Gharar), which should be avoided under Shariah ruling, but despite this are currently present at the highly volatile market. And while most academics agree that such detachable and non-trading options should be permitted in Islamic fi nance, and urge Shariah scholars to come up with collective fatwas, the latter seem to be reluctant to give such permission.

In 2007, Dubai’s Ports Customs and Free Zone Corporation issued the world’s fi rst convertible Sukuk allowing the conversion of initial Sukuk into common shares of the originator. In 2007 Khazanah Nasional

(Malaysia) issued exchangeable Sukuk with an option to exchange them for existing shares of one of subsidiaries of the originator. These issues attracted high interest both from investors as well as potential issuers of Sukuk as examples of risk reduction alternatives.

While fi nancial experts discussed the possibility of further innovation in Sukuk, such as mandatory exchangeable/convertibles, contingent-convertible Sukuk, reserve convertible Sukuk, and such, most of the scholars have forbidden these kind of innovations, due to their similarity with derivatives and excessive uncertainty.

Another recent discussion among scholars is about permissibility of third party guarantees in some Sukuk issues. Proponents of such guarantees, usually issued by governments, claim that there is no clear prohibition of such action in any Islamic source. Thus, according to this group, as long as the guarantor is fi nancially and legally independent from both contracting parties involved in Sukuk transaction, he can guarantee the entire investment or part of it without obtaining any fees for this operation. Opponents of such guarantee argue that it can open a possibility for riba and highlight the Shariah prohibition of any kind of guarantee of the capital. Hence, there is no common opinion on whether such guarantees can be used as a risk management instrument.

ConclusionIt is worth noting Sheikh Taqi Usmani’s statement that the system of Islamic fi nance should be based on principles of justice and equal distribution of fi nancial resources within a society. However, keeping in mind that IFIs currently operate within conventional/ interest-based fi nancial systems, scholars have allowed some fl exibility in the structuring of Islamic fi nancial instruments, provided that the banks gradually develop and adopt full Shariah compliance.

Unfortunately, the recent trend shows that new products and modes of fi nancing introduced by the IFIs tend to imitate conventional instruments, further distancing the industry from core Islamic principles. In the case of Sukuk, justifi cation for principal guarantee and fi xed returns was given by the fact that international rating agencies would otherwise not rate Sukuk properly. This reinforces the pressing need to develop and promote Islamic rating agencies.

It has been more than 15 years since the launch of the fi rst Sukuk. The valid question remains on whether Sukuk structuring should go back to its basics and follow the approved modes of fi nancing, or whether the market should go after the growing demand for Islamic fi nancial instruments and engineer new forms and structures.

Rauf MammadovDepartment of economic developmentGovernment of DubaiEmail: RMammadov@post.harvard.edu Rauf has 10 years of experience in Islamic banking and has authored several articles on Islamic fi nance.

Zhamal NanaevaIndependent researcherEmail: jnanaeva@gmail.com Zhamal has an MSc in Finance and Banking with a fi nal dissertation focusing on Sukuk.

Thoughts on Sukuk and the Risk of Default (continued)