The vision of making Dubai the financial centre of the Middle East and the wider region rests on the twin pillars of the DIFC and DIFX, and Islamic banking is a vital component of the DIFC.

What does the DIFC do to encourage the growth of Islamic banking?
We have established the Islamic Finance Advisory Council, made up of the CEOs of leading Islamic institutions of Dubai and other experts in the field. The concept is that this group would become a 'think tank' for the sector, and provide strategic guidelines for the Islamic finance aspect of the DIFC, by coming up with a road map of where the industry is going and wants to go.

The council has already had a couple of sessions, and identified a number of projects that it thinks will help the entire Islamic financial industry with its continued growth. Three of those projects have been decided as short-term priorities for the industry.

First of these is increasing the size of the primary Sukuk market, which in turn will lead to the growth and liquidity of the secondary market. With the ultimate aim of developing the secondary Sukuk market, we are working closely with the Liquidity Management Centre (LMC) and Aref Kooheji, the CEO of Dubai Islamic Bank's Investment Banking Group and chairman of the Sukuk task force.

The second project the task force deals with Murabaha transactions. Murabaha make up the predominant share of the Islamic finance assets these days, but are currently being done out of London, because of the availability of infrastructure there. All the necessary people are there. Also, the Murabaha has been operational under English law for some time, so people feel comfortable with it.

We want to bring Murabaha transactions under the DIFC 'time zone', as it is appropriate for the region as well as the borrowers and the lenders. The second task force has been formed to work towards bringing the Murabaha transactions to the DIFC. The recently announced launch of Dubai Mercantile Exchange (DME), a 50/50 partnership between DIFC and NYMEX to start a commodity exchange, will play a significant role in this process.

The third project is to create a database of all the Islamic instruments and securities in existence and do a Shari'ah compliance assessment on them. We would set up an agency that would eventually provide a Shari'ah compliance rating on all Islamic transactions. For example, if a company has some investments in non-Shari'ah approved activities because there is a certain percentage allowed by the Shari'ah scholars, then it should not rank the same as the fully Shari'ah-compliant investment. If it is 100% Shari'ah compliant, it should get a higher rating than a company that is 15-20% involved in non-Shari'ah-compliant dealings. The Shari'ah rating might go from a completely compliant institution to a less-compliant one.

This is an idea that the industry itself has suggested. When they look at an instrument, security or investment vehicle, they want to know what the level of Shari'ah compliance is. If we can create such a rating body, it would provide an incentive to Islamic fund managers as well as the investment community to look at the Shari'ah rating along with the usual measurements of risk.

We are currently working on these three areas, and hope that we will achieve some results this year, and complete them at the latest by next year. All these projects will help promote the growth of Islamic finance in DIFC and the region.

And aside from these three initiatives?
On the industry side, we are working closely with the major players, and working towards bringing them together, and forming a joint effort in promoting the growth of industry. We are of course trying to attract Islamic financial institutions to come to the DIFC, and we are already seeing some prominent Islamic players set up presence here.

We have a two-pronged approach to our objectives in Islamic finance. The first is purely business development related, where we are trying to attract more companies to establish a presence in the DIFC, and the second is working with the industry in providing the infrastructure for helping the growth of the Islamic financial community.

We hope that one of the objectives we will achieve is to encourage the governmental bodies in Dubai and the UAE, to become the issuers of Shari'ah-compliant debt and other securities. The project finance requirements of Dubai are in excess of $200 billion, and we want to play a conduit role in financing those projects in a more Shari'ah compliant manner. This is also the preference of the investment community.

Ultimately, we hope to bridge the gaps between the Islamic financial institutions operating here, and the governments that are trying to raise finance for their infrastructure projects around the region.

What is your take on the other financial centres in the Middle East?
Bahrain clearly has an excellent reputation as an offshore banking unit. Most of the institutions registered there do not actually have a major presence there. Their onshore business is limited because the size of Bahrain's economy compared to that of the UAE is around 1/10 in terms of GDP.

There is, therefore, very little onshore market in Bahrain. However, Bahrain has done an excellent job in both attracting offshore banking business as well as developing a unique set of rules and regulations promoting the Islamic finance industry. There are now over 30 major Islamic financial institutions registered in Bahrain, for which the credit goes to the BMA. They have been pro-actively supporting start-up Islamic financial Institutions as well as authorising branches of others.

However, we feel that their niche is still in commercial banking. Qatar, on the other hand, has the niche market for hydrocarbon-based financial industry. Any big company that has an energy department, like Morgan Stanley, Goldman Sachs or Merrill Lynch, is likely to set up an office in the Qatar Financial Centre, to be close to where the business is.

Thus we believe that Bahrain's niche is in commercial banking and Qatar's niche is in hydrocarbon based financial services. However, DIFC and particularly in Islamic finance, wants to focus on the capital markets, project finance and the investment banking side of financial services industry. This focus would help feed the project finance sector, not just in the UAE but across the Middle East. We think that some of the major Sukuk issuance will be from the DIFC in the future, and will also be supported by an integral part of the DIFC, the DIFX.

The DIFX provides the platform for companies to list here, list their funds, securities, and other instruments.

This would then create a secondary market for these securities, as well as other opportunities such as GDRs.

The combination of the stock exchange and the focus on capital markets and project finance is our focus in the region. We therefore do not see the development and growth of Bahrain and Qatar as competition. We think of them as financial centres complementing each other for the good of the growth of Islamic finance industry in the region.

We want the major players to come and carry out their capital markets and investment banking activity out of the DIFC, and that is what the rules and regulations are geared towards. We are not a retail centre with a focus on the consumer banking sector nor are we focused on one segment of industry alone.

Surely, the vision behind the DIFC and the DIFX is larger than solely focusing on the capital markets? To become the overall financial centre of the entire Middle East?
We want to create a platform for a world-class financial centre in Dubai. The overall focus is much wider, but in the context of Islamic finance, banking and insurance, the sector that differentiates us from other centres is the wholesale aspect. We are going for the high end of the market with high end of financial activities, such as mergers and acquisitions, debt and equity financing, institutional or corporate banking and global cross-border transactions.

The oil-exporting countries now have around $500 billion in their current account surpluses, and that liquidity has to find its way somewhere. We believe that Dubai has taken the lead in offering the asset classes and the opportunities for the excess liquidity to be invested. I think that the DIFC will play a very significant role in leading the region by offering international standards, regulations and a robust platform for doing business.

Most domestic centres are still working with home-grown regulations, whilst the DIFC has done its homework, worked with many international law firms, and come up with the laws, rules, regulations and policies that are 100% compliant and compatible with international standards.

The fact remains that the Morgan Stanleys and Goldman Sachs of the world have always been aware of the opportunities in the region, but didn't set up their shop here before.

Despite some strides in the right direction, there are still a lot of problems fitting together Sukuk and capital market regulations and laws?
This is a sensitive area of Islamic finance, because one of the basic ingredients missing in Islamic finance is that it does not have its roots in a conventional legal system. So who has the final authority to rule in case of a dispute? The Shamil Bank vs Bexhimo case clearly proved that it is the law of the land that prevails in the end. There is no final regulatory body for Shari'ah interpretation and rulings, which is a clearly a missing element in Islamic finance.

So far, if an international firm dealt with a Bahraini, Qatari or Saudi firm, they decided to be under the jurisdiction of English or US law, in the event of a dispute. This means that when the dispute arose, both parties had to file cases in the UK or US Courts. The DIFC now offers the legal framework as well as the court system, so if there is a dispute, both parties can refer to the DJA Courts where the cases will be judged under the common law system.

But is the jurisdiction always clear? For example, some Sukuk SPVs might be based in Guernsey, have an underlying asset in the UAE, and have English, US and Saudi investors.
There are always underlying assets attached to a Sukuk, where the title transfers to the SPV, otherwise it wouldn't be Shari'ah compliant. But inevitably, these assets are based in a country where foreigners are limited in their rights to own assets, and this is where the problem arises. In many of these cases, there is a guarantee from the government, such as the Sovereign issues from the BMA. In all cases therefore, the investor effectively takes a clean risk on the issuer's credit worthiness.

One of the reasons why there have been few Sukuk issued in Saudi Arabia is that foreign investors cannot have access to the assets in the country. However, the CARAVAN I Sukuk was done through a very complex structure involving Bahrain, through which a Saudi SPV was created in Bahrain, but ownership was independent, and which could then have access to the assets in Saudi. But partly due to this complex and untested structure, the vast majority of that Sukuk is still sitting on the books of Shamil Bank, the underwriter, and never got distributed to a wider investor base.

The legal aspect and the access to assets in jurisdictions where foreign ownership is restricted remain key issues for Sukuk, but we hope that these will be resolved soon. There is clear momentum towards this, and even Saudi Arabia now allows foreigners to buy and sell securities on the Tadawul. But there is still some resistance to changing too quickly.

The Sukuk's legal structure remains untested because so far, not a single Sukuk failure has been referred to the courts. In general, Sukuk are in high demand, and have so far been offered with short maturities, generally for 5-10 years; the investors feel comfortable with the instrument and sit on it until maturity.

Further it is not really the quality or security of the underlying asset that matters, but the credit worthiness of the issuer that drives the investor appetite.

Qatar Gas did an 18-year Sukuk some time ago, and now more long-maturity Sukuk are coming in. In addition more innovative structures such as the convertible PCFC Sukuk for Dubai Ports have hit the markets with roaring success.

Sukuk are also a lot more complicated to issue than conventional bonds?
If you were to compare a Sukuk to a conventional bond, the risk is essentially the same, and the investor understands and appreciates that the reason you are using the Sukuk structure is to comply with the requirements of Shari'ah law. However, the credit risk remains the same, as you are taking the risk of the issuer as recourse.

In our discussions with some potential issuers, we come across the objection that in order to raise debt financing using Sukuk, they need to have appropriate tangible (not financial) assets which qualify. Further, Sukuk issuance involves complex legal documentation and the layer of Shari'ah approvals which all add to the costs. So why should they go through all these Shari'ah requirements and additional legal costs when they could raise the same financing via a straightforward medium-term note or bond relatively cheaply?

And they're right. From a cost and practicality perspective, it is easier to issue conventional debt rather than to go down the Sukuk route. This reality is not going unnoticed though within Islamic finance industry and both legal and Shari'ah scholars are making efforts to develop standard templates to lower costs involved in Sukuk transactions.

Why is the development of the secondary Sukuk market so vital?
If you make the comparison between the traditional bond market versus the equity markets, you see that bonds provide the fund managers, asset managers, investors and financial institutions a way to balance their portfolio in fixed-income securities as well as variable return securities like equities. You thus have the ability to balance your portfolio with both equities and debt. Appropriate asset allocation models, therefore, rely heavily on availability of fixed-income securities like bonds.

In Islamic finance outside Malaysia, this isn't the case. There is no debt or Sukuk market as such. If a fund manager has to invest and balance its portfolio, they either have to run the risk of keeping the money in the equity markets, or retain some of it in cash, which would be unproductive. They therefore resort to the commodity Morabaha transactions where the returns are money market-linked and lower than bond yields.

You cannot give your investors a good rate of return by investing in money market operations alone.

In Islamic finance, investors are somewhat disadvantaged because they don't have the appropriate asset classes available to diversify risk. To overcome this, we have to come up with a secondary market where Sukuk are traded, so people can come in and add debt to their portfolios.

The establishment of secondary Sukuk market is also important if you want to build the long-term pension industry in the region. The insurance industry is also linked to that, as it would not want to invest long-term in the equities market alone. It needs long-term investments in the more predictable fixed-income instruments. Whereas they are available with conventional bonds, they are not so in Islamic finance.

One of the reasons why the Takaful and reTakaful industry, and therefore the Islamic fund industry, is not really developing as fast as it could is because the choice of asset class available to them is severely limited.

Malaysia offers a good model. They have long-term Sukuk there, as well as a secondary market with sufficient liquidity. There are about $22 billion of Sukuk traded on the Malaysian bourse, and most of their domestic bond issuance is now Shari'ah compliant, as that is where the investor demand is. One of the reasons they have managed to move so quickly is because of how liberal and realistic they are in their interpretation of Shari'ah principles. The similar views have not found favor with GCC scholars yet.

Is differing Shari'ah interpretation a major problem?
Shari'ah convergence has to happen. If the industry wants to move forward, convergence, standardization, and having a legal platform to merge the different opinions together, is vital.

Some convergence is already taking place, and a closer 'meeting of minds' is happening. Further, 'globalization' of Shari'ah scholars is emerging. For example, the Malaysian scholar Dr. Daud Bakar is now represented on the Shari'ah boards of GCC institutions, and Sheikh Nizam Yaqoobi from Bahrain represents the Shari'ah boards of GCC banks that now operate in Malaysia.

There is still polarity of opinion, but there are some elements that are starting to converge, and once this momentum builds up, we will see more unanimity in Shari'ah acceptance of different products and services.

For me, it is a question of a number of factors. Shari'ah scholars now understand financial products and systems much better than before, and the more they understand, the more flexible they become. Secondly, Islamic finance has been an offshoot of the conventional system, and has not come up as a parallel or completely independent system. The conventional system has been in existence for over 300 years while Islamic Finance is relatively young; only around 30 years old. Islamic finance has therefore, analysed conventional product components and adapted them to comply with Shari'ah principles.

There is also an ideological difference even inside the GCC, between those who want Islamic finance to adhere as closely as possible to the strict religious aspects, and those who want Islamic finance to be practical and pragmatic. Malaysia has moved further towards conventional finance in many respects, and as our own markets mature, I think that this will happen here also. But whilst convergence is happening, it will take time, and you can never truly bring all the different Muslim schools of thought together. Assuming that Islamic finance will smooth out the differences between various Shari'ah schools of thought is like operating with only a hammer in the toolkit and assuming that all issues and problems are like nails.

What can regional governments do to stimulate the Sukuk market?
It is very important that regional governments become active in issuing Sukuk. We have to give a lot of credit to Bahrain in this regard, as the BMA started issuing a lot of the sovereign Sukuk, which is one of the factors that triggered the growth of Sukuk in this market. All the governments need to enter this market, but so far we have only seen Qatar, Bahrain, Malaysia and Pakistan issuing Sovereign Sukuk.

We need governments to enter the market, not only as issuers but also as regulators, and make laws and rules more friendly for the creation of the secondary market, for instance by providing a window for discounting Sukuk and being able to do repurchase agreements (repos).

In order to kick-start some markets, the respective governments should not be going into the Sukuk market for profit, but be loss-leaders for some time, until the markets gain momentum and the industry starts to build up and mature on its own. These are essential pre-requisites. Otherwise the markets will not develop as fast.

© Banker Middle East 2006

 

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