Capital backing: A welcome increase in capital-protected instruments

As efforts to widen and deepen the pool of Islamic financial products continue, one area that has recently seen growth is capital-protected instruments. Both Dubai, and the UAE as a whole, have been keen to pursue this trend and boost choices among Islamic investors. One of the main challenges is the provision of sharia-compliant instruments for Islamic banks, insurers and asset managers to invest in, as such capital-protected products could be a major step forward.

MECHANISMS AND MARKETS: Capital-protected products have been around in conventional markets for some time. They typically consist of a certificate broken into two parts. The first is a zero-coupon bond – one that does not make periodic interest payments, but does guarantee a fixed sum on maturity from the issuer. The second part is an option that is linked to a particular market index, or an average of a group of indices, giving the product holder a percentage of any increases in those markets – and thus potentially higher returns than a normal bond if the market does well. The conventional version has been aimed at more cautious investors, who do not want full exposure to market risk, yet still wish to participate. The guaranteed part of the product ensures that such investors receive something back, even if the market index falls.

In the Islamic version, the requirements of sharia law mean the first, guaranteed part of the product is usually a variety of sukuk known as a murabaha. This is a cost-plus instrument, with a fixed profit for the seller, and similar to a zero-coupon bond. While this type of contract is not universally popular amongst sharia scholars, given its fixed margin and lack of profit and risk-sharing, it is widely accepted.

The second, option-linked, part of the product is more complex from a sharia perspective. Several alternatives have been developed for this, with the most popular being a wa’ad, or unilateral promise. This concept has been used to enable swaps of returns between baskets of assets, with this allowing, some sharia scholars concur, for tracking of market movements. The capital-protected product issuer in essence promises to give the investor a return linked to the performance of a particular index or indexes. This practice is not universally accepted, however, with some scholars expressing concerns over the indexes being tracked, which may contain equities based on haram products, for example, while there are also issues regarding buying and selling unilateral promises.

NEW TOOLS: This debate seems set to continue, yet for now, wa’ad is being more widely accepted. This has allowed financial institutions in Dubai and elsewhere to begin issuing more capital-protected Islamic products. In March 2012 Dubai-based Islamic insurer Takaful Emarat successfully launched such an instrument, which was a 90% protected product. The company said that it had raised some Dh4m ($1.09m) in the first two weeks of this offering. Two months later, Noor Islamic Bank followed suit, with two structured products. The first of these tracks volatility in the GCC stock markets, with a mechanism in place for exposure to be switched to other investments, should volatility breach a previously agreed level. The second product allows investors to choose, every six months, the contents of a basket of asset classes, with these then tracked.

Islamic capital-protected products thus already show a significant level of sophistication. While such products have been traditionally linked to the performance of particular stock indexes, moves towards incorporating different asset classes seem also likely to increase in the immediate future. Indeed, in late 2011, Abu Dhabi Islamic Bank launched a product linked to commodities, while Dubai Islamic Bank also offers a product linked to hedge fund performance.

The issue of guarantees on such products – which has been contentious with conventional capital-protected instruments since the financial crisis – can give rise to caution amongst investors. Yet, given the volatility of global equity markets and the huge demand and limited supply of normal sukuks, such products may well be a welcome answer to many Islamic investors’ needs.