Islamic finance: the next horizon

Islamic trade finance, far from being a mature industry, is nevertheless, faced with exciting prospects going forward especially in developing new product in structured trade finance, trade funds and trade receivable-related derivative. MUSHTAK PARKER reports

In the scheme of global trade flows, Islamic trade finance is a mere drop in the ocean but the potential is huge given that

the estimated trade of the 57 Muslim countries amounts to $0.5 trillion a year. But to Massoud Janekeh, director of Islamic capital markets at Bank of London & Middle East (BLME), it is a question of connectivity, or the lack of it, between Islamic banks criss-crossing various parts of the world.

For instance, if the larger Malaysian Islamic banks finance Malaysian trade with the UK, the natural inclination would be to use banks such as HS BC or Barclays as correspondent banks. The alternative would be to use one of the five Islamic banks in the UK. If these banks can capture that trade finance business flow, it would be a major boost for Islamic banking both in the UK and Malaysia. That is the connectivity which is still largely missing and which is essential for Islamic trade finance to flourish on a global basis and in a meaningful way.

“Global trade flow,” explains Janekeh, “is so large and Islamic finance is such a small element of it that there is plenty of headspace for Shariah-compliant structured, bilateral and derivative facilities to grow. Islamic trade finance relies on primary origination. For a fund you need the underlying Islamic trade transactions. In order to do that you need more active trade finance desks across all the Islamic financial institutions (IFIs). Such a level of activity has not yet reached critical mass.

“They say there are 300 Islamic banks but half of them are very young and small. They don’t have the network or the balance sheet to enter a mature and large market. In order for a bank on one side of the world to accept a paper from a bank on the other side you need to be rated, you need to have a balance sheet, you need to be recognised. Many of the Islamic banks do not have those features because they are mostly relatively young and small.”

But he, like many others, is confident that further down the line the market presence and franchise will develop internationally as the community of Islamic banks expands.

 

Trade finance should be a natural home for Islamic finance funded either through a Murabaha sale or a Tawarruqstructure. In jurisdictions such as the UK, for example, Tawarruq overcomes taxation issues such as VAT.

BLME focuses on small-and-medium-sized enterprises (SMEs) in the UK arranging short-term true Murabaha to cashflow and supply chain financing. In a credit crunch environment, BLME has built a competitive Islamic trade finance book business of more than £80m over the last two years.

Most Islamic bankers agree that many features of trade finance such as its liquidity (many trades have short-term maturity to less than one year, averaging 180 days) and asset-backed structure suit the industry.

To Neil D Miller, global head of Islamic finance at international law firm Norton Rose LLP, trade finance and related activities have long been an asset class in which Islamic firms should be more involved. In the mid-to-late Nineties, he contends, it was arguable that more of this type of activity took place but in the years leading up to the global financial crisis the returns available did not prove attractive enough.

“Now, we are beginning to see a slight up tick in interest in trade finance activities both as direct finance opportunities and indirectly though the means of Shariah-compliant trade finance funds. It is difficult to predict whether this will become a trend but Islamic financial institutions certainly do need to find a wider base of assets in the future if they are to create better balanced portfolios”.

New initiatives

In addition, there are already signs of new initiatives to boost connectivity. For instance, Bursa Malaysia a year ago launched its Bursa Suq Al-Sila’ platform, which claims to be the world’s first end-to-end Shariah-compliant commodity trading platform that facilitates commodity-based Islamic financing and investment transactions.

To underline the connectivity, some 23 Commodity Trading Participants (CTPs), which are usually banks, from Malaysia, the Middle East and Europe have already registered with Bursa Malaysia Islamic Services (BMIS), the operating arm of the platform.

In July 2010, the platform gained its biggest CTP when Alrajhi Bank of Saudi Arabia, the world’s largest Islamic bank in terms of balance sheet, signed up. Alrajhi Bank Group’s Murabaha book business is massive. Its investment held at amortised cost in the form of Murabaha with the Saudi Arabian Monetary Agency (SA MA) at end June 2010 alone stood at SR 27.5bn. Net financing for the same period also at amortised cost totalled SR 30.8bn in corporate Mutajara; SR 73.7bn in instalment sale; and SR 12.7bn in Murabaha.

“The admission of Al Rajhi Bank is further testament of the acceptance of the Bursa Suq Al-Sila’ platform and the structure of Tawarruq in facilitating Islamic finance. We hope that Al Rajhi’s entry will not only generate greater volume, but will also spur interest for more members to come in as Commodity Trading Participants and Commodity Supplying Participants,” explained Yusli Mohamed Yusoff, chief executive officer of Bursa Malaysia.

The platform is also generating connectivity in derivative products. The largest single transaction conducted on the platform in a single day to date was the RM2.4bn Malaysian Government’s Sukuk 1Malaysia. It was issued in June 2010 and structured as a Murabahah Sukuk using crude palm oil as the Murabahah commodity to be traded through Bursa Suq Al-Sila’.

The platform, according to Bursa Malaysia, operates as a hybrid market based on a fully electronic trading system coupled with the traditional voicebroking facility. It is an international platform that is able to facilitate cross border, multi-currency, commodity-based Islamic financing and investment transactions under the Shariah principles of Murabahah, Tawarruq and Musawwamah.

While 23 CTPs in the first year of operations sounds encouraging, in terms of the global commodity Murabaha trade, which has been estimated at more than $1.2 trillion, Bursa Suq Al-Sila’ still has a long way to go especially in terms of critical mass of contracts; range of contracts; a wider commodity type transaction universe and the number of participants.

Another recent Sukuk issuance of relevance in this context is the three-year $100m Wakala Sukuk issued in August 2010 by Istanbul-based Kuveyt Turk Participation Bank, in which Kuwait Finance House (KFH) has a controlling 62 per cent equity stake. The Sukuk has an asset pool comprising a mixture of Murabaha (49 per cent) and Ijara (leasing)(51 per cent) receivables.

Missing connectivity

The consensus amongst Islamic bankers is that the GCC bloc and Malaysia are both important trading nations. Generally, the most common route for trade is the bank route through documentary credits. Most companies and banks are used to dealing with these trade finance documents. But, unfortunately, the connectivity between the banks is still not there. This is where the next great leap for Islamic finance should be in creating a global trade finance industry and mechanism.

There are other reasons for being optimistic. According to the latest Trade Confidence Index by HS BC, Saudi importers and exporters seem to be the most confident about expanding foreign trade and their fears about the world economy in general are receding. Perhaps equally important is their perception of decreasing payment default risk and supplier risk, and the increasing use of local banks to facilitate trade finance and of export credit and political risk insurance.

A concrete manifestation of this is the decision in early August 2010 by Turkiye Finance, the Turkish participation (Islamic) bank, which is majority owned by Saudi Arabia’s National Commercial Bank, to increase the financing ceiling from $5m to $20m for Turkish companies importing non-oil products from Saudi Arabia under the Saudi Export Programme (SE P).

In fact, SE P’s sister organisation, the Saudi Exports Development Centre in early September 2010 was named as the winner of this year’s Islamic Solidarity Prize for the Promotion of Trade among OIC Member States, which is awarded by the Islamic Development Bank (IDB) and recognises the contri- bution of individuals or institutions in promoting trade among IDB member countries and providing export financing and guarantees.

However, there remain much room for improvement in terms of connectivity. BLME, for instance, operates in a European framework. For its trade finance facilities it works closely with ECGD under its export guarantee scheme, and uses the ECGD lines to take risk on some of the emerging markets. The Shariah-compliant alternative would be to use the facilities offered by the Islamic Corporation for the Insurance of Export Credit and Investment (ICIEC), which is part of the IDB Group. A further option would be to use an Islamic export credit insurer in a relevant market where there is one, such as Malaysia.

Many bankers in the Middle East would like to see the IDB group step up its role in facilitating the establishment of a truly global and mature Islamic trade finance industry. Massoud Janaekeh of BLME believes that this could be best done by the Dubaibased Islamic Trade Finance Corporation (ITFC), the dedicated trade finance entity of the IDB Group.

He would like to see the ITFC act as a catalyst to develop and expand the international Islamic trade finance market by providing the platform for Islamic banks to participate in trade. “I think they genuinely can be a market maker, and a truly significant one. They can ease the flow of transactions rather than underwrite all of them by bringing in participation from banks, As such, they don’t need the capital for underwriting. What they need is other Islamic banks committed to the cause,” he adds.

Innovation technique

ITFC provides particular scope in developing Islamic structured trade finance (ISTF), which has grown to $370m since 2008. The corporation regards ISTF as “an innovative commodity-based financing technique designed for developing markets, including difficult ones, and a new secured solution with high-impact, advanced risk management techniques implemented to meet the increasing demand for Islamic financial products”.

ISTFs, which are used in import financing and pre-export financing, are essentially an alternative to conventional payment guarantees – both government and bank guarantees. The focus of ISTFs is on transaction cashflow as a source of repayment and not the beneficiary’s financial strength.

The benefits of ISTF, according to ITFC, are that they are asset-backed; they are a more secure alternative to traditional lending; no government or bank or corporate guarantees are required; and they can help reach out to new clients or new markets, including difficult markets.

On a more technical note, they are Shariahcompliant thus giving the relevant customer satisfaction from that perspective; they involve tangible assets as opposed to notional assets; they involve identified cashflows as opposed to global cashflows; they have real-time ownership, transfer and valuation and are Basel II Compliant; and require less capital provision.

Perhaps it is no coincidence that Islamic banks are beefing up their trade finance departments or setting up specialised units. The global financial crisis was a wake-up call for all financial institutions to focus on proven business activity that has relevance to the real economy and which generates good, steady income, perhaps not as wild and exuberant as those returned by risky derivatives and their hybrids.

In the UK, one bank that is going back to basics is Gatehouse Bank, which recently recruited Irfan Afzal as its new head of structured trade finance and syndication. “The reason why Islamic structured trade finance has not worked in the past,” he explains, “has probably been the lack of mediumto- long term Shariah-compliant assets where this liquidity can be invested. If one were able to structure a Shariah-compliant mechanism, then there ought to be a lot of financial institutions to step in and intermediate between investors and those who require financing. At Gatehouse we are trying to fill that void. Up until now a lot of the assets have been short-term Murabaha transactions – a lot of the LME warrants. They are Shariah-compliant but is there really the underlying trade and flow of goods? That is debatable.”

Has there been an over-concentration on financing short-term commodity Murabaha mainly through LME warrants? Massoud Janakeh of BLME agrees but emphasises that this has been mainly to accommodate Tawarruq trade. In the GCC, where tax is not an issue, Tawarruq is not necessary for trade finance.

The challenge

However, Neil D Miller of Norton Rose says that the question of an over-concentration on LME commodity Murabaha is really a red herring in the context of the question of whether or not new lines of commodity-based trade finance will commence.

“The LME commodity Murabaha (whether used for deposit purposes or in its reverse format for lending purposes) is a different proposition to supporting genuine trade finance. However, where the real financial engineering skills remain to be developed would be to create products based on genuine primary trade finance that can also provide sufficient ‘flow’ to support secondary instruments that have the capability of eating into LME commodity Murabaha market share. This is not being achieved yet so far as I am aware.”

The challenge for banks such as Gatehouse is that they want to focus on actual real world trade flows, especially commodities in the oil and gas sector (crude oil or refined products); look at the actual production, export and sale of metals such as iron, copper, aluminium and steel; and the soft commodity sector – such as rice and sugar – that lends itself nicely to Shariah-compliant structures because of having a long warehouse intermediary stage that can be financed by taking ownership.

“We are very keen,” emphasised Irfan Afzal, “to bring these assets on the balance sheet. Whereas, in conventional banking, banks are trying to declutter and to deleverage the balance sheet – they don’t want assets that are on their balance sheets. Traditional trade finance requirements are not being met by the usual suspects in the conventional banking world. This is another reason why something urgent needs to be developed using a Shariah-compliant structure.”

However, some bankers warn that decluttering and deleveraging should not be a limiting factor for growing Islamic trade finance business. Developing a full suite of Islamic trade finance products – ranging from true Murabaha to cashflow and supply-chain financing, ISTF, trade funds and trade-related derivatives, which offer equivalent Shariah-compliant solutions to conventional products – is more prudent. These also include bonding facilities, performance or bid bonds and letters of guarantees.

It is true that there is fee-based income in trade finance that allows the banks not to use their balance sheets and that some of the exposure can be treated as contingent liability. But this can also be accommodated within Islamic finance structures.

“As far as I understand from the Shariah scholars,” explains BLME’s Janekeh, “we can use flat fees for services that we offer provided those services are meaningful and are commensurate with the work done. From an accounting point of view there is nothing in the AA OIFI standards that says we cannot effectively have contingent liabilities.”

However, some bankers believe that the issue is not necessarily the trade flow but the ticket size. An oil tanker could typically carry around $30m of oil. A sugar shipment on a dry bulk carrier could have $15m in value. According to BLME, many Islamic banks are not large enough to take such exposure by themselves and are not sophisticated enough to carry out these transactions on a club or syndicated basis. Hence the clarion call from Janekeh for the ITFC to act as market maker for the big Islamic trade finance deals.

Others point out that product development comes at a cost and that there is limited appetite amongst Islamic banks to incur the R&D spend that will be necessary to achieve it. Banks also need to be willing to change back-office systems in order to offer IT solutions and, in certain cases, to engage with indirect taxation authorities to remove tax hurdles that prevent these sorts of schemes and/ or make them inefficient because of the cashflow implications.

There is a consensus that there is a lot of liquidity amongst the Islamic financial institutions. At the same time, there is a lot of world trade that is going on that requires financing. Not surprisingly, the feeling is that the potential for Islamic trade finance is huge, but, to have any substitution effect, the service delivery has to match trade finance offered through conventional banks. Many Islamic banks are still relatively young and very few are more than five-years-old, and fewer still have an international footprint and correspondent banking relationships to offer true international trade finance.

Neil Miller of Norton Rose contends that “the effort involved in actually creating products, managing the inherent risks as well as the capital requirements etc are matters that demand sophisticated skills and experience. Whether all the necessary skills exist within pure Islamic financial institutions is something that it is difficult to assess and, as is the case with many potential financial products, strategic direction and commitment are both required to successfully undertake new business.”

Some banks see good possibilities through the Islamic trade fund route, which would bring on board the investor base and stimulate the growth of underlying trade finance transactions. But bankers such as Gatehouse’s Irfan Afzal are urging the sector to look at trade flows outside their usual geographies in the GCC, North Africa and South and East Asia. To him, Eastern Europe, other African markets and Latin America also offer good selected opportunities.

The preferred structure for the trade finance fund is to enter into a Wakala (agency) with the originator (eg the trade finance desk), and for the originator to invest in Murabaha transactions on behalf of the fund. Under this structure, the fund can appoint the originator to manage the day-to-day activities for procuring the investment, yet from an accounting perspective retaining an exposure to the underlying risk. However, other structures such as Mudaraba and Murabaha also have a role to play in trade funds.