FEATURES IN THIS ISSUE

TRADING

Futures exchange warrants

Although conventional futures commodity exchanges do not usually comply with Shariah principles in relation to murabaha or similar structures, the ancillary delivery system they have created based on warehouse receipts, or warrants, can still play an important part. It is well known in Islamic banking circles that on-exchange futures trading is not generally suitable for Islamic finance structures. The uncertainty related to futures trading, which involves speculating on the price of commodities going up or down in the future, the interests embedded in the forward curves and the selling of material not owned by the seller at the point of sale (short positions: not holding the physical material to satisfy the delivery obligation) put exchanges off-limits under Shariah principles.
     Even so, part of the physical delivery—based on warrant or receipt creation and transfer of ownership—still plays a key role. Although commodity exchanges are not a natural source of physical material, they still need a mechanism of delivery of last resort (last possible option for delivery) for a number of reasons.
     First, commodity futures trading is based on contracts in the present to buy or sell specified quantities of assets on dates in the future.These contracts are mainly closed out financially, which means the parties are generally happy either to settle their obligations or to receive their rights by cash instead of transferring or receiving the real commodity. Nevertheless, delivery could still be a possibility and exchanges need to provide a system for such an eventuality.
     That delivery can take place in a futures market produces two further effects. It helps the so-called futures/physical price convergence, or to put it simply, it keeps financial and industrial market prices in line.

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INVESTMENT

Opportunities in emerging markets

The global financial events of the last two years have demonstrated to investors that emerging markets can prevail when confronted with the ultimate stress test—a widespread crisis caused by dislocations in the developed world as opposed to their own solvency issues. Despite the subsequent withdrawal of capital that ultimately put pressure on emerging market asset prices, many emerging market economies entered this downturn in a position of financial strength born of conservative leverage and sound policies.
With lower leverage, transparency and no speculation similar to the tenets of Islamic finance, risk-averse emerging market companies should appeal to the increasingly global Islamic investment community.
     In recent times emerging markets have re-emerged to regain, from their perspective, their rightful place in the economic world. Today, they account for more than 50% of global gdp, up from 38% in 1950, and are rapidly expanding their share. Numerous factors have contributed to the revival of these countries, including their ability to outsource to lower-cost economies in Asia, acceptance into the World Trade Organisation, strong commodity cycles, favourable demographics, implementation of conservative fiscal and independent monetary policies, and price stability and falling interest rates supporting domestic investments and consumption.
     Also important are the numbers joining the working population—a key driver of long-term growth potential. It is six times higher in emerging economies than in developed markets. Emerging markets are catching up at breakneck speed. Try typing “China overtakes” into Google and you will find headlines such as “China overtakes the us as largest auto market” and “China overtakes Germany in gdp, becomes third largest economy.”

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EDUCATION

Interest-free student loans

The most popular loan programme in the US, Stafford Loan, raised its borrowing limit from $23,000 to $31,000 last year. The us government essentially gave a green light to the colleges to increase their tuition up to 35% in the coming years. The University of Phoenix, the largest private university in North America, boasts that it “sets its tuition with the loan limits in mind”.
     Families in America typically save for their kids’ college through “529 plans.” There are two basic types: prepaid tuition plans and savings plans. Prepaid tuition plans enable families to pay for future tuition now in current dollars and prices and are an effective hedge against ever-increasing college tuition.
     The savings plans are nothing more than brokerage accounts where Wall Street-related entities “manage” the money. Calling them savings plans is a misnomer. They are investment vehicles where up to 100% of the savings could be at risk. I know of a family whose savings dwindled down to 30% of the amount actually deposited by the family in a 529 plan savings account.
     Middle and lower-middle class citizens in the us are the prime targets for consumer loans, including student loans. Riba, or interest, extends the duration of such loans and devours a significant portion of their hard-earned income for years, if not decades.

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FRANCE

Moral dilemma

The disposition of France towards Islamic finance has always been an anathema in a country that prides itself on laïcité, a legacy of the French revolutionaries who revolted against the Catholic Church. In a republican system of government, the dogma says there is no place for religion in anything related to government and, therefore, government-regulated finance. The dogma has been overlooked in special circumstances, such as in the early 20th Century when legislation was passed to accommodate Catholic worker associations, allowing them to set up their own financial institutions, better know as credit mutuels (credit unions), which benefited from government funds.
     So why has the French government shown sudden interest in Islamic finance? It is certainly not because—as government mouthpieces have declared—Paris will not cede the place to London as the centre of Islamic finance in Europe. Islamic finance conferences have been organised in Paris by very British entities such as Euromoney, and the plethora of Islamic finance conferences in Paris continues unabated. The real motive rests with the people who, as in the classic movie Casablanca, Captain Renault called “the usual suspects”.
     The French government has announced it intends to raise 152 billion euros to cover its budget deficit and other obligations, and it is keen on capturing some of the petrodollars destined for “recycling” in the Western economies. It has called on gcc sovereign funds to invest in French infrastructure under public/private partnerships, together with cash-strapped local governments. The format for this Islamic financing is, of course, sukuk. This has prompted the French authorities to rush enabling legislation through the Assembly in a coordinated action by the ministry of finance, the tax department and the central bank with unusually impressive haste and efficiency.

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SCREENING

Beneath the veneer

The sub-prime crisis presents a compelling window of opportunity for Islamic finance both to showcase the merits of asset-based or backed financial intermediation as well as to deploy savings into real investments. Islamic finance operates in the same macro “conventional” tax, regulatory and legal environment, and it has the same vulnerabilities of liquidity and confidence. Islamic banks—within their capacity of amanah (trust)—need to undertake a customised stress-test exercise consistent with the uniqueness of the home country.
     The methodology must not be seen as initiated or heavily lobbied by Islamic banks, as this will erode confidence and contribute to allegations of opaqueness. The stress-test must be transparent, comprehensive and flush out the impaired Islamic assets.
The test should apply to all Islamic commercial banks in the gcc and include takaful operators. A seal of approval would confirm the positive spin of cheerleaders of Islamic finance and objectively showcase that the model works better or differently in a crisis from its conventional counterpart.
     Has the industry been able to build on the success of other asset classes and positive (sustainability) screening? What about screening of the publicly listed companies in Muslim countries with stock exchanges?
     To date, we don’t have Islamic real estate investment trusts (reit) indexes or commodity indexes, and yet real estate is an important asset class for Gulf investors, and the latter provides the foundation for murabaha contracts. Despite the launch of an Islamic sustainability index in 2006, no funds, exchange traded funds, or structured products have been launched off it yet. Sustainability has become a powerful phenomenon in non-Islamic investing, hence, an ideal opportunity for building bridges.

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INDICES

Symbiotic relationship

The relative stability of Shariah-compliant investment products has not gone unnoticed. Owing to its lack of speculation, the industry is attracting new fans daily. The Islamic funds market has grown 20% per year since 2003, according to figures from State Street. Assets under management by financial institutions stand at more than $600 billion.
     Shariah-compliant indexes have helped significantly with this stability. The Dow Jones Islamic Market World Index was launched in 1999. Between 2006-2008, other large mainstream index providers, such as ftse, msci, and Standard & Poor’s, followed suit, offering healthy competition and different approaches. Islamic indexes have offered investors transparency, standardisation, investability, and low-cost solutions, and have also helped with the development of products such as exchange traded funds (etf), which are poised for major growth globally.
     Like any religion, Islam is multi-faceted and open to many interpretations, and conservative approaches to finance vary between the Middle East, South East Asia, and North Africa. While indexes may differ in part of their approach and their regional, country, and industry focuses, they are largely in agreement over debt ratios and financial screening, offering different perspectives on investment criteria and dividend purification.
     Financial screening is a key feature of a Shariah-compliant index. Generally, index providers prohibit investment in alcohol, pork, tobacco, weapons, gambling, pornography, and certain leisure and entertainment businesses. None invests in conventional finance.

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ANALYSIS

Contentious reference rate

The question of reference rates of returns for Islamic finance has plagued the industry for a long time and will continue to do so unless there is a viable alternative. The key contention of those who oppose the use of the London inter bank offer rate (libor) argue that utilising it as a reference rate for pricing Islamic instruments means that we are using a benchmark that is utilised to price money in the conventional financial markets, because libor usually represents the base rate of interest, on top of which a margin is added.
This, in their opinion, is forbidden.
      According to Islamic commercial jurisprudence, commodities such as gold and silver or currencies do not have any intrinsic value in and of themselves and are only measures of value. Therefore, earning an additional amount of money on the money invested based on libor or any other benchmark rate is considered forbidden by all schools of Islamic thought. However, the key difference with Islamic transactions is that they do not earn money on money.
     Rather, assets are bought and sold, leased or invested in to earn returns. That said, a large portion of corporate financing and sukuk issuances utilise the libor as a reference rate to price their financing, whether it is through an ijarah (lease) contract, a murabaha (full disclosure cost plus mark-up sale) contract or even a musharaka (profit sharing) contract.
     The opponents of such practice argue that this is like utilising the casino industry’s return on assets to price the expected returns from a halal (permissible) asset, say, a telecommunications company. This is clearly abhorrent at face value.
     However, according to some scholars, this practice is not necessarily haram (impermissible). They argue that pricing Islamic transactions utilising any benchmark does not make a transaction haram or halal. What matters is that the transaction itself must be Shariah-compliant and the underlying assets that are the subject matter of trade must also be Shariah-compliant.