United States: Liquidity And Secondary Markets In Islamic Finance

Previously published in Islamic Finance news, Volume 9 Issue 27, July 11, 2012

When it comes to liquidity Islamic finance faces the perennial problems of a lack of assets in which to invest and the absence of a secondary market for those assets. DOMINIC HARVEY and BARRY COSGRAVE explore.

Liquidity and the secondary market, or the lack thereof, in the world of Islamic finance, has been an issue of much debate for many years among industry professionals. It has arguably been the single largest factor in pushing down yields on Sukuk recently and also in slowing the long-term growth of the industry. Moves by certain central banks to create a liquidity platform, such as that of the Central Bank of Bahrain's Bai al Arboun program, have been welcome attempts to address this issue but problems persist.

However, there are many opportunities available to the industry as the Middle East, in particular, moves on from some of the more distressed scenarios of the past few years. With oil prices still far higher than they were even five years ago, plenty of capital remains available to be developed. The challenge for the industry will be to create products and develop markets to tap into that liquidity. The increasing rise of infrastructure projects in Islamic countries is great cause for hope.

Sukuk and the hold to maturity culture Sukuk have traditionally been the asset class of choice for Islamic asset managers seeking to deploy the capital at their disposal. However, there are simply too few Sukuk in the market and those that have been issued have traditionally seen their investor class comprised of a majority of conventional and not Islamic investors. The logical outcome of this must surely be that Islamic investors are unable to purchase enough Sukuk. With this supply/demand imbalance, Sukukholders feel unable to trade out of a position for fear of not being able to find another Sukuk in which to invest. As a result the prevailing culture amongst Sukukholders in the Middle East is to buy and hold to maturity. The problems this causes with liquidity are obvious and the sort of vibrant secondary market for Sukuk that exists for conventional bonds is sorely lacking.

This is a purely market-driven issue as scholars have been more than accommodating to issuers that seek to provide the option of trading in and out of a holding of Sukuk. Scholars have taken a pragmatic approach to the value of assets required to underpin a Sukuk which is intended to facilitate secondary market trading.

A Sukuk is a certificate of ownership representing a pro rata interest in certain assets. Buying and selling a Sukuk is the equivalent of buying or selling those particular assets and as such, the tradability of Sukuk should not be in doubt. Clearly there are arbitrage opportunities in such trades but this is akin to the arbitrage opportunity in buying a limited edition car in the belief that its value will appreciate over time. It is therefore clear that secondary market trading is possible but the chief culprits preventing this are lack of supply and incorrect valuations.

By not considering trading as an option, marked to market (MTM) valuations have not been considered to be a requirement of risk management for Sukukholders. As balance sheets became distressed over the past few years and options to restructure were being explored, one of the factors that caught a number of restructuring advisors from conventional markets off guard was this lack of MTM valuation. This led to difficult conversations with certain creditors when 'hair-cuts' were being discussed.

A lack of MTM valuation also impacts secondary markets as it does not establish any sort of profit-making opportunity for traders. Without effective valuation of Sukuk there is no way to establish a market and as a result trading does not happen.

Uncertainty and legal risk

Barriers to secondary market trading are not the result of a lack of effective valuation alone; there are also other considerations relating to differences of opinion among scholars as to the acceptability or not of certain structures. It is possible that certain investors shy away from secondary market trading because of a lack of clarity as to the acceptability or not of the transaction structure employed. Were a scholar to rule against a particular structure, and a secondary market trade to be sought to be unwound, it would cause huge complications both on a practical level and from the point of view of market reaction.

Allied to this is the continued legal risk that pervades the Sukuk market. It is only in the US (with the East Cameron Sukuk) and the UK (with the Shamil Bank case) that any sort of legal precedent has been laid down in relation to Islamic finance transactions in particular when things do not go according to plan. There is still no clarity in many jurisdictions as to how a dispute will be resolved nor is it clear what level of ownership of assets (if any) has been achieved. Further, the tax laws in many jurisdictions do not yet accommodate Islamic finance transactions where, for instance, there can be a double charge to stamp duty or similar land transaction taxes in the case of a property financing. Many jurisdictions have either taken steps to address this (such as the UK) or are going through the law making process to address such matters (such as Tanzania).

Lack of variety

However, even within the Sukuk market there is far too little variety for investors. There are too few options for short-term commercial paper instruments. A notable exception to this particular rule is the Central Bank of Bahrain (CBB)'s Sukuk al Salam program which leverages off Bahrain's aluminum supply to provide a platform for short-term investment for banks in the kingdom. The program offers a three-month Sukuk al Salam which, for the Sukuk maturing in August 2012, had a subscription level of 178%. Similarly, and again in Bahrain, the CBB also offers 182-day maturity Sukuk al Ijarah which, for the November-maturing installment, had a subscription level of 175%. However, perhaps the success of this initiative serves to highlight the comparative lack of effective liquidity management tools elsewhere in Islamic investor environments.

Structured products both in the form of structured investments and risk management tools are too scarce in the Islamic sphere and it is not possible for a secondary market in Sukuk trading or for effective liquidity management programs to be put in place without the commensurate development of such products. Sukuk should not be the only asset class available to investors but at present that seems to be the case. Many investors that bought into Sukuk pre-2008 were convinced that it was a product almost immune from default. Much was written in support of this idea but this has proven not to be the case as many high-profile examples have shown. Declining balance sheets and declining asset valuations will always result in a loss irrespective of the asset-backed versus asset-based debate.

Any investment, whether it is a conventional credit derivative or an asset-backed true sale Sukuk, carries the risk of financial loss as well as gain. This sort of risk is a central tenet of Shariah and cannot be ignored. What is more important however, is for those with excess liquidity looking for investment opportunities to be provided with such opportunities through a wide variety of products that provide a real variation in risk profile as well as products that can manage that risk and therefore provide diversity. No portfolio should be over-reliant on one asset class and Shariah-compliant portfolios are no different.

Growth opportunities

Sukuk to fund infrastructure are becoming more common, with Malaysia exploring one such issuance to fund development of the urban mass rapid transport system (MRT) in Kuala Lumpur – a project that is currently predicted to require RM36 billion (US$11.25 billion). Other infrastructure and project financing opportunities continue to present themselves in Africa and in Asia. Infrastructure lends itself particularly well to Islamic financing as there are assets either in place or in the process of construction. Infrastructure assets such as the proposed Malaysian MRT are also revenue generating assets which are ideally suited to Islamic structures.

What has also become noteworthy in the past 12 months is the willingness of non-Islamic institutions and corporates to consider Islamic finance as a source of funding.

The lack of supply has created a bottleneck of demand which has pushed down yields much to the delight of issuers. This has led a number of conventional institutions that have chosen Sukuk ahead of conventional bonds as a result of such pricing pressure.

As the sophistication of investors grows, so should the availability of more structured investment products. Sukuk should not be the only asset class available for investment and both structured deposits and Shariah compliant swaps should provide opportunities for investment in new products. A Shariah compliant total return swap or price return swap structured through a Musawwamah are examples of products that could address this gap in the market. Such products are particularly useful when overcoming investment hurdles such as foreign ownership restrictions. They are also a useful means by which investors who find themselves in a long position vis-à-vis a particular stock option incentive scheme or similar can try to unlock liquidity opportunities. However, in order to achieve this, products need to be created which specifically address the needs of Islamic investors.

Conclusion

Islamic finance faces the same problem it has faced for many years when it comes to liquidity: a lack of assets in which to invest and a lack of a secondary market for those assets.

The success of Bahrain's short-term liquidity programs are clear evidence that such initiatives are needed and well received and it is hoped that similar products can be offered by other sovereigns in the future.

The growing familiarity with Islamic finance means that Sukuk should not be as focused on the property market as they once were with infrastructure projects now coming to the fore. This familiarity also leads to a wider geographical diversification with countries from Brazil to Japan seeking to issue a sovereign Sukuk.

However, Sukuk cannot be allowed to be the only asset class for Islamic fund managers and as such a greater diversification must be achieved in order for such funds to be properly managed. The Islamic finance market has come a long way but there is much still to do in order for it to truly rival its conventional equivalent.

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