The
January 2010 edition of the International Association of Hedge
Funds Professionals (IAHFP) newsletter
Dear
Members,
I
want to extend my best wishes for a safe, prosperous and blessed
year to all. I do hope that you will transform the difficulties
around into opportunities.
Today we will try to understand more about Islamic investment,
Islamic banking, Islamic finance, Islamic bonds, Islamic
structured products and securitization. All the professionals that
work in hedge funds and alternative investments should understand
the principles and the differences from traditional financial
services.
According to the International Monetary Fund's Working Paper
"Islamic Banks and Financial Stability: An Empirical Analysis",
institutions offering Islamic financial services constitute
a significant and growing share of the financial system in a
number of countries.
Since the inception of Islamic banking about three decades ago,
the number and reach of Islamic financial institutions worldwide
has risen
from one institution in one country in 1975 to over 300
institutions operating in more than 75 countries
(El Qorchi, 2005).
Islamic banks are concentrated in the Middle East and Southeast
Asia, but they are also present as niche players in Europe and the
United States.
Reflecting the increased role of Islamic finance, the literature
on Islamic banking has grown.
A large part of the literature contains comparisons of the
instruments used in Islamic and commercial banking, and discusses
the regulatory and supervisory challenges related to Islamic
banking (e.g., Sundararajan and Errico, 2002; World Bank and IMF,
2005; Ainley and others, 2007; Sole, 2007; Jobst, 2007).
The
Islamic Financial Services Board (IFSB)
is an international standard-setting organisation that promotes
and enhances the soundness and stability of the Islamic financial
services industry by issuing global prudential standards and
guiding principles for the industry, broadly defined to include
banking, capital markets and insurance sectors.
The IFSB also conducts research and coordinates initiatives on
industry related issues, as well as organises roundtables,
seminars and conferences for regulators and industry stakeholders.
Shari’a is
the comprehensive body of Islamic laws that should regulate the
public and private aspects of the lives of the Muslims.
The demand for
ethical-based financing has seen a
global rise. Islamic finance seeks to comply with the rules,
principles and parameters of Shariah whilst combining the
promotion of ethical and socially
responsible investment.
Investments in certain products (such as
alcohol and pork), certain industries (such as gambling and the
manufacturing of armaments) and certain investment strategies
(such as speculative or interest-related strategies) are
prohibited.
The Shariah monitoring function is
often split between a Shariah advisor
(conducting internal day-to-day monitoring to ensure the fund’s
compliance with Shariah investment guidelines) and an
external Shariah board (providing
guidance on investment guidelines, purification and undertaking an
independent audit on a periodic basis).
A
Shariah board (usually comprising at
least three scholars) undertakes an examination of the structure
and documentation of a proposed transaction or product to ensure
it complies with Shariah. The board often issue a
Fatwa (an Islamic juristic opinion)
in order to approve such
documentation or structure.
ISLAMIC FINANCIAL SERVICES BOARD
GUIDING PRINCIPLES ON GOVERNANCE FOR ISLAMIC COLLECTIVE INVESTMENT
SCHEMES
In December 2006, the Islamic Financial Services Board (IFSB)
issued its
Guiding Principles for Corporate Governance of institutions
offering only Islamic financial services (IIFS) – known as
IFSB-3.1
In order to further strengthen governance in the Islamic financial
services industry (IFSI) and promote soundness and stability in
the Islamic financial system, the IFSB Council, during its meeting
in Jeddah in December 2005, approved the proposal that the IFSB
develop a second tier of its governance standards by focusing on collective
investment schemes (CIS)
that are claimed to be
Shari’ah compliant.
Sometimes these are referred to as
Islamic unit trusts, Islamic mutual funds or Islamic investment
funds, depending on the jurisdiction.
In the interests of clarity and in accordance with internationally
recognised standards for investment funds, the IFSB has decided
that the term
“Islamic collective investment scheme” (ICIS)
is more appropriate and will be used in this document.
In line with this premise, where appropriate, the key
terminologies herein are defined and adapted accordingly.
As an ICIS is
primarily a capital market instrument,
this document marks a first prudential standard developed by the
IFSB in the area of Islamic capital markets. In this respect, the
document has a specific aim of complementing the internationally
recognised governance standards, by reinforcing international best
practices while addressing the specificities of ICIS.
The IFSB recognises that certain governance issues are of equal
concern to all CIS, whether Islamic or otherwise.
Therefore, this document will not attempt to “reinvent the wheel”
by proposing a wholly new governance framework for ICIS.
Instead, it will
seek to supplement and expand the relevant international standards
by focusing on the appropriate best practices identified by the
IFSB, particularly with regard to governance issues that are
specific to ICIS.
In this manner, this document seek to “add value” to the existing
international standards.
The IFSB has conducted its own survey on ICIS.
Its findings are consistent with the surveys conducted by the
IOSCO on CIS, namely, that – regardless of the diverse CIS
framework applied in different jurisdictions – they still share
many similar governance concerns, such as independence of
oversight of CIS operators, their conduct and execution of
fiduciary duties, the management of conflicts of interest,
transparency in disclosures of material information, etc.
In the case of ICIS,
the requirement to comply with the Shari’ah not only reinforces
good governance and integrity, but also influences the way
governance structures and procedures are implemented.
Accordingly, rigorous compliance with internationally accepted
governance best practices should be recommended.
Definition of ICIS
The diversity of legal requirements and regulatory frameworks
around the world, and not least in those jurisdictions offering
Islamic financial products, posed a major challenge to the IFSB in
resolving an appropriate definition for ICIS.
This problem is exacerbated by the ingenuity of those
engineering financial products.
The IFSB recognises the significance of “independence” of review
and oversight, as well as, of course, integrity and transparency,
which are the cornerstones of the relevant IOSCO recommendations.
However, it is felt that the efficacy of the governance systems
and, in particular, transparency requirements that are currently
in place cannot be judged solely on the basis of whether the ICIS
has been established as a separate legal entity, or on the
presence or absence of non-executive directors.
At this stage in the development of this type of fund, it is
important that these issues are looked at in the context of the
wider
picture.
A similar concern arises in regard to the definition that the IFSB
has adopted for an ICIS.
While the diversity of practices and products gives rise to a
peculiar degree of complexity, this document is particularly
concerned with those funds that have been securitised and are
dealt with in units.
It is further recognised that
some jurisdictions may impose different sets of regulatory
requirements between “private” and “public” funds –that is,
between funds offered to institutions and high net worth
individuals who are considered sophisticated investors, and those
which are offered to the general, retail investing public.
While this document does not expressly differentiate between the
two, as more often than not they share similar governance
concerns, the supervisory authority may wish to exercise their
discretion as to what extent these Guiding Principles shall
apply to private funds.
Consequently,
for the purpose of the Guiding Principles, ICIS is defined as “any
financial scheme which, fundamentally, meets ALL the following
criteria:
(i)
investors have pooled their capital contributions in a fund
(whether that fund is in a separate legal entity, or is held
pursuant to a contractual arrangement) by subscribing to units or
shares of equal value.
Such units or shares constitute, in effect, claims of ownership to
the undivided assets of the fund (which can consist of financial
or non-financial assets), and give rise to the right or obligation
to share in the profits or losses derived from those assets;
(ii) the fund is established and managed in accordance with
Shari’ah rules and principles; and
(iii) whether or not the ICIS is managed by the institutions that
established or sponsored it, it is separately financially
accountable from those institutions (i.e. has its own
asset-and-liabilities profile).”
Although in principle sukuk
schemes may fit into the above description, given that they
primarily serve certain economic purposes that are different from
the ICIS, they shall be excluded from the scope of this document.
Where appropriate, supervisory authorities may wish to apply
certain economic tests before imposing the governance structure
and
processes under the Guiding Principles on sukuk, bearing in mind
that they primarily serve as a Shari’ah-compliant alternative to
conventional bonds.
It may be helpful to set out some examples of structured funds,
which would, subject to what has been set out above in paragraph
6, be included within this definition.
Note, however, that these are only examples and the list is by no
means exclusive.
Amongst others, an ICIS may take the form of:
(i) open-ended funds that will redeem their
units or shares, whether on a continuous basis or periodically;
(ii) closed-end funds, whether those units or shares are tradable
(in regulated or unregulated securities market) or untradable;
(iii) a unit investment trust, whether on a contractual model or
that of a European UCITS model;
(iv) an individual fund, or an umbrella fund that comprises
various sub-funds; or
(v) a profit-sharing investment account (whether restricted or
unrestricted), which is pooled in the form of a CIS and whereby
each of the investment account holders (IAH) participate equally
in income (whether profit or loss) and is generally governed by
the same terms and conditions.
It is possible to identify funds that would not normally fall
within the definition that has been adopted in this document.
There is always the possibility, in the complex environment of the
financial services industry, of regulatory overlap even within a
single jurisdiction.
Consequently, for clarity, in this document the definition of ICIS
shall exclude:
(i) funds that are not pooled in the form of
a CIS;
(ii) funds established by Islamic insurance/takaful operators (if
they are attached to any Islamic insurance/takaful policy such as
retirement or education plans that are irredeemable until a
certain period of maturity), as they constitute a different
segment of the Islamic financial services industry and will be
addressed by the IFSB in specific standards for Islamic insurance/takaful
operators;11
(iii) pension funds, as they are arguably a different species from
ordinary CIS; and
(iv) investment accounts that are not divided into units or
shares.
Scope of ICIS governance
As highlighted by the IOSCO, the operation of CIS potentially
involves conflicts between the interests of those who invest in
CIS (CIS Investors) and those who organise and operate the CIS
(CIS Insiders or CIS Operators).
It must be borne in mind that the general goal is not to insulate
investors from suffering any market-driven loss, but rather
to enable them to understand the risks pertaining to investments
in specific CIS.
This would reduce the CIS Investors’ exposure to any loss due to
misleading, manipulative and fraudulent practices, as well as
malfeasance or negligence on the part of the CIS Insiders.
Indeed,
the Shari`ah itself clearly prohibits the abuse of a position of
privilege and promotes integrity and fair dealing.
Accordingly, CIS Governance, which is described in IOSCOPD no. 219
as "a framework for the organisation and operation of CIS that
seeks to ensure that CIS are organised and operated efficiently
and exclusively in the interests of CIS Investors (including both
resident and potential investors), and not in the interests of CIS
Insiders", is expected to reduce the risks
associated with conflicts of interest and robustly seek to ensure
that the interests of well-informed investors in CIS are well
protected and managed, through
appropriate oversight, control and review mechanisms, according to
traditional fiduciary standards.
In addition to the above definition, in the context of ICIS, good
governance should further encompass:
(i) a set of organisational arrangements
whereby the actions of the management of CIS Insiders are aligned,
as far as possible, with the interests of its stakeholders,
including the community (ummah), guided by the objectives (maqasid)
of the Shari`ah;
(ii) provision of proper incentives for the organs of governance
such as the Board of Directors/Governors (BOD), SSB and management
to pursue objectives that are in the interests of the stakeholders
and facilitate effective monitoring, thereby
encouraging ICIS to use resources more efficiently; and
(iii) strict compliance with Shari`ah rules and principles.
The IOSCO recognises that, save for minor details, CIS are
typically organised under two structures:
(i) Contractual Model – whereby the CIS as
an investment fund only exists as a trust or contract between the
operator and individual investors; and
(ii) Corporate Model – whereby the CIS takes the form of an
investment company, legally registered as a corporation.
In certain jurisdictions, a CIS that is a hybrid of these two main
models may be found; thus, it is prudent to include the Hybrid
Model.
However, in a number of the IFSB member jurisdictions, it has been
observed that the IOSCO’s assumptions in terms of management and
operation may not necessarily apply in the same manner as in
certain more developed jurisdictions, due to varying degrees of
clarity and sophistication, especially in the development of
fiduciary and trust law.
Among others, this would have an impact on the framework for
independent custodians or trustees, as well as in recognising the
status of special-purpose vehicle (SPV) companies.
It must always be remembered that ICIS operates within the legal
environment and much will therefore depend on the development and
sophistication of the legal system and, in particular, on the
existence of laws facilitating the establishment and management of
corporations and trusts, and the financial markets as a whole.
These and other considerations have led many supervisory
authorities to adopt an ICIS regime whereby IIFS play multiple
roles in the operation of the ICIS, including sometimes that of
administrator of the funds’ assets.
To mitigate the conflicts of interest in
such structures, it is a common practice for an independent
party to act as custodian/trustee.
Therefore, depending on the structural form, a number of different
entities, such as the regulators, investors, sponsors, managers,
auditors, broker-dealers, members of the BOD, trustees and
depositaries, SSB, self-regulatory organisations (SROs) and
insurers
can, and should, play a role in the ICIS governance.
However, each organ of governance can only be effective if they
collectively execute their roles well and recognise the importance
of complementing one another. In this respect, ICIS are expected
to view compliance with these regulations from a holistic
perspective.
THE GUIDING PRINCIPLES
Principle 1: The ICIS’s highest governing
body (GB) shall establish a comprehensive governance policy
framework which protects the independence and integrity of each
organ of governance, and sets out mechanisms for proper control
and management of
conflicts of interest and duty.
Principle 2: ICIS Insiders shall ensure that
disclosure of material information is not only done with
appropriate accuracy and timeliness, but also presented in an
investor-friendly manner.
Structure and Process
Financial reporting is a critical component
of good governance.
Those overseeing or involved in the financial reporting process
have unique responsibilities because financial reporting is a
public interest activity.
Just as shareholders commit their funds to companies in reliance,
in part, on the management’s representations and the auditor’s
opinion that a particular company’s financial statements fairly
reflect its financial position, the same goes for ICIS investors.
If ICIS investors cannot rely on the quality of information
provided to them, this would undermine their investment decisions.
Although, in practice, the ICIS investors shall not intervene in
the management of the investments made on their behalf, it does
not mean they should not have access to appropriate information in
order to monitor the performance of the ICIS and protect their
investment.
Without adequate disclosure, it would be difficult for ICIS
investors even to “vote with their feet” and simply withdraw their
investments.
It goes without saying that accuracy and timeliness of disclosures
play a significant role in ensuring market discipline and
efficiency.
In this respect, it is the duty of ICIS Insiders to present ICIS
investors with information that appropriately reflects the
investment profile of the ICIS, as well as the associated risks.
In particular, investors should, on a
continuing and regular basis, be informed of any risk
concentration to which the ICIS is exposed.
Insiders must be fully aware of their legal responsibilities in
the provision of such information and ensure that it meets the
requisite legal, regulatory and professional standards in terms of
accuracy, topicality, clarity and comprehensibility.
It has been argued that information asymmetries effectively
increase the cost of capital.
Past scandals have proven that when
investors question the integrity of financial information, they
become risk averse or risk avoiding, often to the detriment of the
local economy.
This is particularly true of financial institutions.
When markets lose confidence in the integrity of financial
information, or when they can no longer trust the issuer of
financial information, the negative effects can be dramatic.
Furthermore, effective and timely disclosure reduces the
opportunity for certain forms of misconduct, market abuse and, in
particular, insider dealing.
Therefore, it is appropriate that ICIS Insiders recognise their
responsibility to investors and markets. This will increase market
confidence in the ICIS. Some of the key issues for those involved
in the financial reporting process may include:
(i) ICIS managers must ensure that the
financial statements reflect economic reality and diligently
comply with the relevant accounting and reporting standards.
This is in the best interests of the ICIS – as well as investors –
because transparency has a direct impact on the cost of capital
and standing of reputation.
(ii) Auditors should follow appropriate
auditing standards, act with competence and integrity, and provide
a truly independent and diligent audit opinion.
(iii) The SSB should highlight any Shari’ah issues that might
impact on the financial position of the ICIS.
(iv) Regulators should design sound regulatory mechanisms, assess
compliance with appropriate standards, and have effective
enforcement mechanisms that are proportionate and reasonable to
the risks.
(v) Trustees, the SSB and other ICIS Insiders should in general
ensure compliance with the Shari’ah and, in particular, observe
that conflicts of interest are well managed and addressed and
integrity is advanced and maintained.
It follows that the methods of disclosure can be divided into
three categories:
(i) disclosure at the offering or
promotional stage of the investment (this takes the form of a
prospectus, placement memorandum, etc.), which is a mixture of
integrity and investment-related disclosure;
(ii) periodic and progressive disclosure (which takes the form of
quarterly reports, semi-annual reports and annual reports); and
(iii) timely or continuous disclosure (which sometimes may be a
non-financial disclosure relating to significant events) that
affects the governance evaluation of the ICIS.
33. In addition, ICIS’s GB shall include in its disclosure to the
supervisory authorities and the ICIS investors the status of its
compliance with these Guiding Principles in two components:
(i) In the first component, the ICIS’s GB
shall report how it applies these Guiding Principles.
The GB may determine by itself the form and content of its
disclosure based on its own governance policies in the light of
the Guiding Principles, including any special circumstances
applying to it which might have led to a particular approach.
(ii) In the second component, the GB shall either confirm that the
ICIS complies with the provisions of these Guiding Principles, or,
where it does not so confirm, provide a clear and adequate
explanation of the reasons for non-compliance.
Effective and efficient continuous and timely disclosure would not
only empower the ICIS investors to make informed investment
decisions, but would also lend credibility and cost efficiency to
the ICIS sponsors.
Principle 3: ICIS’s GB shall ensure that
appropriate systems and mechanisms for monitoring ex-ante and
ex-post Shari`ah compliance are in place, and are effective.
Principle 4.1: The ICIS’s GB shall ensure
that any movement of the ICIS’s funds or assets, to the extent
that such is lawful, will be carried out in conformity with the
ICIS’s investors’ objectives and their best interests and always
supported by appropriate and objective valuations.
To learn more: www.ifsb.org
Sukuk
(plural of sakk), frequently referred to as “Islamic bonds”,
are certificates with each sakk
representing a proportional undivided
ownership right in tangible assets, or a pool of
predominantly tangible assets, or a business venture (such as a mu
arabah).
These assets may be in a specific project or
investment activity in accordance with Shari`ah rules and
principles.
Sukuk differ from conventional interest-based securities or bonds
in a number of ways, including:
(a) The funds raised through the issuance of sukuk
should be applied to investment in specified
assets rather than for general unspecified purposes.
This implies that identifiable assets should provide the basis for
Islamic bonds.
(b) Since the sukuk are based on the real
underlying assets, income from the sukuk must be related to the
purpose for which the funding is used.
(c) The sukuk certificate represents a
proportionate ownership right over the assets in which the
funds are being invested.
The ownership rights are transferred, for a fixed period ending
with the maturity date of the sukuk, from the original owner (the
originator) to the sukuk holders.
Securitisation in sukuk
is broadly referred to as a process of
issuing sukuk involving the following steps:
(a) origination of assets (in conventional finance, these are
normally loans or other receivables, while in Islamic finance they
are Shari`ah compliant assets such as the subject matter of ijarah);
(b) transfer of the assets to a special purpose entity (SPE) which
acts as the issuer by packaging them into securities (sukuk); and
(c) issuing the securities to investors.
Sukuk structures
While it may initially appear that sukuk structures that
are not based on partnership interests (musharakah or mu arabah)
have real assets at their core, a detailed analysis of the
commercial terms and legal structure shows that, in fact, any one
of the three following situations may exist:
(a) An asset-backed sukuk structure
that meets the requirements for being an
asset backed structure as assessed by a recognised external credit
assessment institution (ECAI): this structure would leave
the holders of sukuk to bear any losses in case of the
impairment of the assets. The applicable risks are those of the
underlying assets, and these will in principle be reflected in any
credit rating issued by a recognised ECAI.
(b) An asset-based sukuk structure with a repurchase undertaking
(binding promise) by the originator:
the issuer purchases the assets, leases them on behalf of the
investors and issues the sukuk.
Normally, the assets are leased back to the originator in a
sale-and-leaseback type of transaction.
The applicable credit risk is that of the originator, subject to
any Shari`ah-compliant credit enhancement by the issuer.
The recognised ECAI will put weight, in determining the rating, on
the payment schedule of the repurchase undertaking
and the capability of the originator to make the scheduled
payments to the issuer (see paragraph 13). Such structures are
sometimes referred to as “pay-through” structures, since the
income from the assets is paid to the investors through the
issuer.
(c) A so-called “pass-through” asset-based
sukuk structure: a separate issuing entity purchases the
underlying assets from the originator, packages them into a pool
and acts as the issuer of the sukuk.
This issuing entity requires the originator to give the holders
recourse, but provides Shari`ah-compliant credit enhancement by
guaranteeing repayment in case of default by the originator.
Of the above three categories, this Standard focuses on the last
two, which are not explicitly covered in IFSB-2.4
In conventional securitisations, the structure is normally such
that the originator transfers the beneficial rights in or title to
the assets to the issuer on behalf of the investors, who do not
hold such rights directly but have beneficial ownership through
their legal relationship to the issuer.
The issuer is a SPE, which should be “bankruptcy remote” from the
originator in order to protect the rights of the investors in case
of the insolvency of the originator.
In many jurisdictions, however, including some in which Sukuk
issues may take place, there may be legal
obstacles to setting up an appropriate type of SPE which
can meet the conditions for the fiduciary responsibilities
mentioned above.
In such legal environments, it may not be possible to transfer
beneficial title in the assets to the investors, or to ensure that
the investors are able to exercise these rights (for example, to
repossess ijarah assets) in case of default.
In such cases, it is not feasible to create a structure for
issuing non-recourse asset-backed securities (ABS).
Shariah-compliant hedge funds?
To be honest, I
could never expect to see Shariah-compliant hedge funds, as under
sharia law, money is a tool for measuring value, not an asset in
itself, so trading money to make more money seemed impossible
under Shariah.
This
is what almost all my Muslim friends (that worked in the financial
sector in the Middle East) also believed.
I do not know if it
is possible. My personal opinion: It is not
correct according to Sharia. But, many Middle Eastern
investors and Wall Street financiers believe that there
is demand of having a Sharia hedge fund
product.
“There is demand for Islamic hedge funds, mainly from high net
worth individuals who already look at conventional hedge funds and
would have a preference for Islamic”
Geert Bossuyt,
Deutsche Bank’s head of Middle East structuring
Dear
members,
Write
in your CV, resume, websites etc. that you are members of the
International Association of Hedge Funds Professionals
(IAHFP)
Take advantage of the distance learning and online
certification program of our Association - at a cost that is unheard
of.
www.hedge-funds-association.com/Distance_Learning_and_Certification.htm
Best
Regards,
George Lekatis
President of the International
Association of Hedge Funds Professionals (IAHFP)
General
Manager, Compliance LLC
1200 G Street NW Suite 800, Washington
DC 20005, USA
Tel: (202) 449-9750
Email: lekatis@hedge-funds-association.com
Web:
www.hedge-funds-association.com
HQ:
1220 N. Market Street Suite 804, Wilmington DE 19801, USA
Tel:
(302) 342-8828
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