The reason why the Middle East is such an attractive place for banks is that there is a huge reserve of liquidity. Because of an accident of geology, the Middle East sits on the world's largest supply of hydrocarbons and since people started pumping oil out of the ground, the nations who sat on the resources grew rich.

With the recent spike in oil prices, even more cash has flowed into Middle Eastern coffers. This has meant that a there are a lot of cash-rich individuals, companies and banks in the region.

Capital is a great thing to hold, but in the form of deposited cash, it is not working as efficiently as it should. The banks have something of a 'liquidity crisis' as they have lots of capital, but it is not being used efficiently. A bank cannot make money unless it lends money.

The regional governments have, in a sense, come to the rescue. It seems that large parts of the GCC are permanent building sites, as gleaming cities, grand developments, and thousands of miles of land reclaimed from the sea populate the Gulf.

But projects do not come free, and government run companies, as well as private enterprises, have been trying to raise capital to complete their grand designs. And this is where the banks have been able to ease their liquidity crisis.

In world terms the banks in the Islamic world do not have as long a heritage or the global punch of, for example, HSBC or Citibank, but what they do have is a philosophical understanding of the region and the wider Islamic world.

The most remarkable growth area has been Islamic banking. In the last five years Islamic banks have grown more rapidly than their conventional equivalents and a fledgling Islamic banking sector has begun to spread its wings with burgeoning confidence.

The Islamic banks have developed instruments that suit the cultural necessities of the Islamic world, and instead of financing these development projects with conventional Riba-bearing bonds, have developed a Halal alternative, the Sukuk.

The Sukuk market has been very active, and TejooriTejoori, a London-listed, Dubai-based investment company reckons that the global Sukuk market is worth approximately $15 billion, even excluding the Malaysian domestic and Central Bank of Bahrain Al Salam Sukuk issues. Of this $15 billion, approximately $6 billion of the issue is sovereign and $9 billion is corporate. It is not just the Islamic banks that have become involved in the Sukuk business. Conventional Middle Eastern and foreign banks, always keen to chase a new source of credit, have entered the Sukuk arena (see table).

In mature and conventional markets there is much arbitrage between different debt issues. In Sukuk, most credits are held until maturity. The main problem with Sukuk is liquidity. There is so much liquidity that there is a massive shortage of assets. Many Sukuk have been oversubscribed and once investors take hold of issues they cling onto them as long as possible, maintaining them in a buy-to-hold position. As a result there has not been a need to trade Sukuk in the secondary market.

Warren Edwardes is the chief executive of the London-based financial instrument innovation and risk management consultant, Delphi Risk Management. He has a number of client banks in the Islamic world, for whom he advises on risk, strategy and asset management.

He thinks that Sukuk is not mature enough to need a secondary market at the moment. He argued, "In an open economy, it is inevitable that Sukuk is benchmarked against conventional interest bearing assets."

He continued, "The massive liquidity in the Middle East has made a pressing need for a liquid secondary market somewhat academic. Despite the massive increase in issues, Sukuk are still oversubscribed but held as long-term investments rather than as liquid trading assets. But they still have to be priced fairly."

Despite massive market liquidity, nothing can last forever and with the level of Sukuk issuance from both the Middle and Far East as well as western markets, the liquidity will eventually be absorbed and arbitrage opportunities will start to arise. It is then, when the Sukuk market matures, that a secondary trading system will arise.

But even in what is an immature market, there is a fledgling broking community growing up. The US based GFI Group, one of the world's largest inter-dealer brokerages, has set up a trading desk in its London office to trade Sukuk. At the moment GFI has not seen very much trading, a fact that it ascribes to Sukuk being very new financial instruments, and that Islamic clients are not open to the concept of Sukuk trading. However, GFA would not have opened up a Sukuk trading desk if they did not see a need to do so. Julian Swain, the European managing director of GFI said that it opened up a Sukuk trading desk because, "we have had requests from our clients."

Chris Steer, head of GFI Group's Islamic finance desk in London, said that although the Sukuk market was still very new, it had great growth potential and that a secondary market would almost certainly develop at some point, assisted by GFI, given its experience and expertise in developing new markets.

Chris said, "If you look at the rise of Islamic financial services you will see that there is very strong demand, both from the retail and institutional markets, for Shari'ah compliant products. That's why we've opened an Islamic finance desk. We want to be involved as brokers right from the start."

GFI wants to be ahead of the game as although trading is very slow at the moment, they see the potential of there being a huge demand for secondary trading of Sukuk from Islamic institutions as well as the retail sector in the future, the lion's share of this from the GCC.

It is not just GFI who have seen the potential of a secondary Sukuk market. The Liquidity Management Centre (LMC) based in Bahrain was established to enable Islamic financial institutions to manage their liquidity mismatch through short and medium term liquid investments structured in accordance with the Shari'ah principles. HSBC and the EIIB also broker Sukuk.

The LMC is the one Middle East player that is committed to the creation of an active and geographically expansive Islamic inter-bank market which will assist Islamic financial institutions in managing their short-term liquidity. LMC's agenda, apart from making money as a business, is to accelerate the development process of the Islamic banking sector.

In addition, the LMC wants to attract assets from governments, financial institutions and corporates in both private and public sectors internationally and then securitise these sourced assets into readily transferable securities or structure them into other investment instruments.

Ahmad Abbas, chief executive of LMC and TejooriTejoori board member rages against the fact that there is not a more active secondary market in Sukuk. "At the moment, the global volume of Sukuk trading is no more than $50 million. Investors still hold to term and just do not trade and the $50 million volume meets requirements," he explained.

Ahmad continued, "But this is a lucrative business, it is not charity work, and more and more people are going to get involved and the profitability of the larger Sukuk issues means that people want to get into them, and as a result you can make a market."

However, the market remains a backwater, something that Ahmad blames on the fact that not many institutions feel comfortable in taking a position on Sukuk. Everyone buys and holds because the market is scared of taking risk. He says that many institutions will not risk buying a secondary Sukuk unless they already have a client order to pass it on to. Market making is an alien concept.

"The banks have to get over the freakiness of a holding mentality. They miss the forward value in the Sukuk. It is all about confidence. They do not seem to have the ability to acquire a Sukuk and then go out find a buyer," Ahmad complained.

He concluded, "We have to challenge the culture of ignorance. You cannot blame the Lehman Brothers of the world for having less confidence with Sukuk than with conventional bonds; it is not their field of expertise. But the root of the problem, and the group that should bear most criticism, is the local Islamic and conventional banks. They are the regional players and know the local markets. It is their fault that the Sukuk market is not maturing quickly enough. They sometimes look at what we are doing in Bahrain as though we were from Timbuktu. They just cannot see the forward value of the Sukuk market."

There is currently little evidence of active switching between cheap and expensive Sukuk or yield immunisation and arbitrage by Islamic bank treasuries and fund managers. This will come sooner rather than later so it is a very positive development that institutions are developing Sukuk secondary market trading operations. Edwardes warns that, "Even when Sukuk become liquid there is still a pressing need for shorter term Shari'ah compliant instruments to allow prudent and modern bank asset and liability and liquidity management."

With no slowdown in the pace of Sukuk issue, the development of a secondary Sukuk market might come sooner than later.

© Banker Middle East 2006

 

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