The sukuk market is going from strength to strength, buoyed by Middle East investors' appetite for fixed income products following the local equity market's decline and the continuing rise in oil prices. With secondary market liquidity on the rise and a full pipeline of primary issuance from jumbo borrowers as well as smaller corporates, it is natural for market participants to ask if, and when, a derivatives market will emerge to complement the cash sector.
"Only a year after consolidating our Middle Eastern credit trading business in Dubai we are trading 100-plus Islamic and conventional issues, with pricing available to investors 24 hours a day," says James Milligan, head of HSBC's Dubai trading desk, established in August last year. "Many local institutions are now involved, with several having recently hired specialists from various international centres who are driving the pace of change. The Middle East credit markets are definitely moving in the right direction for further innovation."
For many, it is received wisdom that derivatives are incompatible with Shariah. The terms gharar - meaning uncertainty or speculation, and maysir - meaning gambling, are often applied to products seen in the mainstream credit-derivatives market and some observers doubt that the most liberal interpretation of scripture could accommodate Islamic versions.
"At least one European bank has been marketing derivative structures to Islamic investors, but it hasn't sold any yet," says one senior official at a Western bank based in the region. "It is feasible that the market might never take off if enough scholars disagree with it, but even if there is sufficient support, it will take a long time for standard documentation to be agreed. There is no doubt, though, that demand exists for hedging products."
Some derivative products already exist in the Islamic finance market, in the form of interest rate and foreign exchange swaps launched by Kuwait Finance House last year. Innovations in those markets often presage change in the credit sector, leading some to feel optimistic.
"The key about these structures is that, like other Shariah-compliant funding, they are asset-backed," says Anouar Hassoune, credit analyst at Standard & Poor's in Paris. "It's not just a question of swapping cash flows, as in the mainstream market, and at least three parties are required - brokers in the middle choose commodities to replicate cash flows. Although more complex than what we see elsewhere, the principle is the same."
There has also been derivatives activity in equities, another sector that anticipates developments in credit, says Jean-Christophe Durand, regional head of Gulf Cooperation Council countries in Bahrain. "While the credit side is subdued, we have seen some equity derivatives and investors are investing in a capital-protected basket of shares, which makes the structures compatible with Shariah - we did one at the beginning of the year for a large client in Switzerland, and have done others."
Options are more problematic under Shariah because, unlike with a swap, the two parties have asymmetrical pay-offs - although the use of embedded options in convertible issuance is permissible as payment is made in shares rather than cash.
"The closest thing to an option in Islamic finance is known as urboun, which consists of a down payment for the pre-purchase of the right to acquire an asset, although this instrument has not attracted a wide level of acceptance yet," says Hassoune.
That "yet" is significant, as Islamic scholarship is not static. In particular, the concept of istihad, or mental effort, is crucial. "It represents the constant discussion and re-evaluation in Islamic jurisprudence and is increasingly important in the field of finance, so structures that were considered non-compliant a few years ago are possible now," says Khalid Howladar, vice-president in Middle Eastern and Islamic structured finance at Moody's in London. "Tranching used to be difficult due to the risk and return share applying pro rata to the capital invested, but tranched Islamic capital structures are on the horizon for 2007."
Given the mutable nature of Islamic scholarship, the number of active and respected theologians dictates the pace of change. Islamic scholars need to be fluent in finance, English, Arabic and Islamic jurisprudence, a demanding set of skills.
"The bench of expertise will grow deeper, improving future capacity to handle growth, but at the moment the market's development is hampered by a lack of human capital," says Howladar. "Some scholars sit on up to 20, 30, or even 40 boards, giving rise to questions about how much time they can spend with the Shariah board of each institution."
This lack of expertise aside, investors who do not need to observe Islamic law are already taking advantage of Shariah-compliant credit derivatives. "Several Middle Eastern credit default swap trades have been transacted in recent months, where conventional investors have entered into trades which have Shariah-compliant bonds or loans as the underlying reference obligation," says Milligan at HSBC, which is part of an International Swaps and Derivatives Association working group (see box).
"These conventional investors who go long the credit by selling protection give purchasers the right to sell Shariah-compliant bonds if a credit event occurs. While this in itself does not present a problem, it is still a grey area as to whether investors governed by Shariah law can take delivery of a conventional asset following a credit event. Arguments have been made that this should be acceptable given that in the event of a default the conventional asset would be trading flat of interest anyhow."
Room to grow
In mainstream markets the CDS sector is worth multiples of the cash business, and Milligan is happy to point out that this is yet to become the case in the Middle East. "Savvy investors wanting to diversify their risk and take exposure to Middle Eastern names are already starting to look seriously at the CDS market. Given that this is still a developing sector, it is very difficult to come up with the overall size of the Middle East CDS market to date."
"We have already seen the emergence of a conventional CDS market on particular names where sukuks, among other debt instruments, are used as cross-defaulting obligations as well as deliverables," says Jean-Claude Issa El-Khoury, head of global markets for the Middle East and North Africa at JPMorgan in Dubai. "There is no technical reason preventing further development of that trend."
Anouar Hassoune at Standard & Poor's agrees that there is nothing to stop mainstream investors writing credit default swaps on sukuk, and believes that this is not inevitably incompatible with Shariah, as it could be seen as insurance rather than as a speculative swap.
"There are still Shariah strictures applying to insurance, or takaful, which need to be negotiated, and no takaful companies are involved in the market yet, as they are too small to sell protection at this stage," he says. "Shariah-compliant synthetic CDOs, based on credit derivatives, are being developed by a few managers, like the asset management arm of the French insurer Axa, which is very innovative but still underdeveloped."
Jean-Christophe Durand at BNP Paribas, while acknowledging that there is no technical reason for conventional investors not to experiment with CDS, says the bank makes its money in other ways.
"There is nothing to stop conventional investors writing protection on sukuk," he says, "but we haven't seen that so far and investors are more likely to wait for the cash market to mature. A lot of new corporate borrowers are waiting to issue and we expect secondary market trading to pick up before long. Credit derivatives are not taking a front seat."
Trading in intangibles is generally prohibited, with obvious implications for the use of derivatives to hedge risk - looking at the letter of Shariah law, some say that derivatives are gambling and therefore not permitted. But others believe that if the differences between speculative derivatives and those structured simply to remove, or limit, risk can be established, the sector could fit within the jurisprudence.
"Shariah focuses on the tangibility of assets, making asset-backed finance as close to the Islamic ideal as you can get," says Howladar at Moody's. "Islamic derivatives should incorporate asset flows. For the moment, I can't see how you could reconcile that with derivatives as we know them."
Observers agree that Islamic CDOs would be difficult, because the underlying would be non-Islamic and couldn't be made halal simply by packaging it. More sukuk issuance and a resolution to the question of tranching might change matters, but the central question with derivatives is a theological one.
"A very important concept in Islam is that of niyyah, or intention," says Howladar. "Combined with that of istihad, this means that while some structures today may not be perfect in the opinion of some scholars, they represent interim efforts in the evolution towards a fully equipped Islamic capital market, and hence may be acceptable."
Western institutions are looking to formalise documentation for a derivatives market in line with Shariah principles. Last September, the International Swaps and Derivatives Association (Isda) and the International Islamic Financial Market (IIFM) agreed to co-operate in the development of a "master agreement for documenting privately negotiated Shariah-compliant derivatives transactions".
The two groups established a working group in pursuit of this aim, which meets every four to six weeks. Peter Werner, Isdas New- York based policy director, says a draft of the master agreement is already being discussed and that a final version should be submitted for approval by scholars in late summer. The documentation is intended to apply to South-East Asian as well as Middle Eastern states - the former are thought by some to be more liberal in their interpretation of Shariah.