A lack of common standards in Islamic custody and fund administration can lead to costs and delays in launching products. Setting up a sub-fund on a sharia-compliant platform could be a quicker alternative. George Mitton reports.
In Islamic finance, you cannot make money on money. This simple principle presents problems for those who offer custody or administration for sharia-compliant funds.
So forbidden is the concept of interest, riba in Arabic, that any mention of it in a service provider’s books can undermine the Islamic character of the whole fund.
To overcome the problem, service providers typically segregate Islamic from conventional assets and provide fund accounts that are clean of interest and the mention of interest.
It is important that they do. Without these measures, Islamic scholars tasked with certifying funds as sharia-compliant may decide the fund does not meet the necessary standards.
But within this general framework, it seems there is room for manoeuvre.
Some scholars are less strict than others.
Meanwhile, a new method of launching sharia-compliant funds is coming into play that could change the market – sharia-compliant platforms.
Nick Angio, managing director at Apex Fund Services, says about a third of the funds he services are sharia-compliant. “There isn’t always consistency across the requirements of various clients in Islamic finance. Some will be very strict and will want all accounts to be held within a fully Islamic bank. Others are happy with a conventional bank that has an Islamic window. It depends on how conservative the sharia scholars are.”
Perhaps surprisingly, Angio says some of his sharia-compliant fund clients are even happy to have conventional cash accounts with a conventional bank, provided the accounts do not bear interest.
“Those who are not too strict in their own requirements are fine to open an account with a conventional bank. It’s case by case. And it turns out to be like that for just about every question when servicing sharia assets, there’s rarely a standard.”
But if there is rarely a standard, how are service providers to know what measures to take when serving Islamic clients? As with much in Islamic finance, the answer depends on the specific individuals appointed to the fund’s board.
Every sharia-compliant fund has a board of scholars who decide whether the fund is acceptable for observant Muslims to invest in. They adjudicate on the investment strategy to ensure the fund does not invest in speculative financial instruments, which are forbidden, or un-Islamic industries such as arms or alcohol.
The sharia board must also decide whether custody and fund administration are being done in a sharia-compliant manner. If the scholars are diligent and conservative, they may require more than just segregation of assets and the removal of interest.
One aspect that comes into play for some custodians of Islamic assets is a post-trade check, says Shikkoh Malik, regional head of products, investors and intermediaries, Standard Chartered, Middle East and North Africa.
A post-trade check is a safety net provided by the custodian to ensure the client does not try to settle the trade of an un-Islamic security, such as an equity not included in their universe of sharia-compliant stocks.
“As a part of its compliance monitoring responsibilities, the custodian needs to monitor and verify whether the securities the client is trying to settle form part of the sharia-compliant universe or not,” says Malik. “This responsibility is totally different from that of a conventional custodian.”
Custodians may also need to consider entitlements for the investor, such as coupon payments from bonds or dividend payments from equities. Although a company’s stock might have been deemed sharia-compliant, that company may receive revenue from non-compliant sources, rendering part of the entitlement received by the investor as non-sharia-compliant.
In these situations there is a process to “purify” the dividend or coupon payments coming from the offending security. It is the custodian’s job to perform this purification process, which, like the post-trade check, is not needed for conventional assets.
Islamic custody “demands more resources, carries different risks and puts additional responsibilities on the custodian,”, says Malik.
“Obviously, the pricing for a sharia-compliant service would be slightly higher than the conventional product,” he adds.
Sometimes, a custodian may fail to appreciate the complexity of certain Islamic investments. This can happen with some of the more esoteric Islamic structures such as sukuk, which are instruments that replicate the coupon payments of a conventional bond. Although sukuk are generally regarded as Islamic bonds, they are structurally somewhat similar to equities and must be serviced appropriately.
“You could have a service provider who has not adapted its infrastructures to reflect properly Islamic instruments, sukuk being a good example,” says Francis Dassou, senior business manager, Islamic solutions, HSBC Securities Services. “The sukuk cash flow structure could appear to be similar to a bond, but a sukuk is a combination of an equity for the ‘ownership’ aspect and a bond for the capital raising method. A sharia-compliant fund promoter would require you to reflect sukuk like sukuk, not like a bond.”
It is perhaps understandable if there is sometimes confusion. Dassou says there are 14 different sukuk types, though only three or four are commonly used.
With all this to consider, it is not surprising that some sharia boards can take a long time to issue the fatwa that will certify a fund as sharia-compliant. If a sharia-compliant fund is at all unusual, or its service providers are seen to be untested, discussions may drag on for weeks. These delays can be both time-consuming and expensive, since Islamic scholars often charge high fees for their services.
Emerging Asset Management, based in New York, is working on an alternative system that could make it quicker and cheaper to launch sharia-compliant funds. The firm is building a sharia-compliant platform, domiciled in Bermuda, that provides the legal support and infrastructure needed for a new fund.
Jerry Gil, managing director, says the firm’s sharia board will soon issue a fatwa for the platform.
Once the fatwa is gained, clients will be able to launch their own products as sub-funds on the platform, “piggy backing” on the fatwa that already exists. Gil says launching a sharia-compliant fund on the platform will cost between $20,000 and $25,000, including legal fees, administration costs and the fatwa. In contrast, set-up fees for an independent fund from a newly established asset manager could run to $100,000 in legal costs alone, he says.
It will take between four and eight weeks to launch a sharia-compliant fund on the platform, says Gil – significantly quicker than the launch time of a typical independent fund.
“Getting the fatwa is quite painful,” he explains. “Fund companies want to minimise the time they have to put into that. Getting legal advice and all the infrastructure is difficult.
We’re taking on the burden of making this happen for them.”
By making it simpler to gain the fatwa needed to launch a sharia-compliant fund, and streamlining the administration process, Emerging Asset Management could make it quicker and easier to bring Islamic funds to market.
As the lack of common standards in Islamic finance continues to cause complexity and delays for asset managers and custodians, such short cuts could prove to be valuable.
©2013 funds global mena