There is both subtle and overt pressure for institutions to support Islamic finance. Stefanie Eschenbacher looks at the challenges of providing custody services for sharia compliant funds.

Perhaps the most important factor behind the potential for growth of sharia compliant funds lies in the fact that Muslims represent a quarter of the world’s population but, according to PwC, less than 1% of financial assets are held sharia compliant.

“There seems to be a disconnect here that is likely to be rectified in the coming years,” the consultancy states in a report, entitled Shariah-compliant funds: A whole new world of investment.

Albeit coming from a low base, in recent years the sector saw sometimes growth rates of between 15% and 20% a year. Many funds have failed to gather assets so far, making them not economically viable and dampening asset managers’ appetite for creating new products.

PRESSURE
However, a rising middle class in many Muslim countries and excess savings from oil do create opportunities for asset managers and asset servicers.

There is now “both subtle and overt pressure” for institutions to support Islamic finance, PwC writes, highlighting that there are a number of structural issues in the industry “that only time and persistence can resolve”.

Custody issues surrounding sharia compliant funds are complex. Although custodians do not have to operate in the manner of Islamic bank, they need to service these funds
in a way that does not violate sharia principles.

Asset managers providing these funds criticise that custodians do not usually have their own deposit accounts and that there is a lack of Islamic deposit facilities with automatic rollover.

Instead, excess cash has to be placed manually. This often turns into a time-consuming process that needs to be repeated daily and is therefore prone to human error.

Custodians typically sweep clients’ cash balances to be invested in one-day deposits using, for the ease of transaction, their own deposit accounts.

As sharia compliant investment prohibits deposits in conventional banking – owing to usury – excess cash often lies idle in current accounts, gaining zero income for investors.

Cheeping Yap, head of fund services Asia at Citi, says custodians can reinvest clients’ cash balances into short-term papers, although local regulations differ.

Indonesia, for example, has a prescribed list of securities that are sharia compliant and cash balance reinvestments can therefore be automated.

Whereas in Malaysia cash balance reinvestments need to be approved by a sukuk committee. “This committee will decide what is sharia compliant and what not,” Yap says. “In Malaysia, both asset managers and custodians need to be more flexible.”

Any change of holding needs to got through the committee, which will have at least two independent members.

While Yap acknowledges that this may result in an additional layer of cost, he says it is really about inefficiencies and the loss of opportunity.

Yap estimates that custody costs in Malaysia are between 10 and 15 basis points higher than in Indonesia.

Because the process is more prescriptive and simpler in Indonesia, it can be automated.

“I do not see Indonesian Islamic funds as being less efficient as non-Islamic funds because they allow reinvestment in securities,” he says. “The only difference is that they have to select their investments from a list of securities prescribed by the government. These tend to be conservative investments, safer papers with lower yields.”

With the approach being more flexible in Malaysia, reinvestment in investment grade is possible. “They have more freedom to generate higher returns,” Yap says.

In Indonesia the structure is fairly automated, but in Malaysia it is more flexible. “With a sukuk committee it can never be automated,” he says. “In that way, there is more room for human error.”

Stewart Adams, regional head for investors and intermediaries, transaction banking, at Standard Chartered, says most of these deposits are based on the murabaha structure. Murabaha structures require offer and acceptance between the parties at each rollover – as per sharia requirement.

ISLAMIC DEPOSITS
Usually, this process is not automated. However, Adams says Standard Chartered has developed an innovative one step murabaha based deposit product, which automates murabaha based deposit rollover.  

“Another possible solution could be to offer Islamic deposits based on other structures such as mudarabah/musharakah, but these are not popular among fund management companies as the return on such deposits are based on the performance of the underlying portfolios,” says Adams.

Jacqueline William, head of direct securities services for Deutsche Bank Malaysia, says Deutsche Bank’s custody business is backed by the bank’s Islamic window, which handles Malaysian ringgit products.

This means it can offer solutions or products such as murabahah to help maxminse returns on excess cash.

William says that, similar to any conventional contract, an Islamic contract becomes null and void after it has reached its maturity. In practice, clients are able to provide a standing instruction to their banker which allows a daily Islamic deposit facility to be automatically rolled over on the maturity date, she says, adding that this is evidenced in the new documentation, which is generated at every juncture of a new contract.

“However, based on our experience, most fund managers only retain a small portion in cash,” William says. “In addition, when an equity or sukuk fund is launched, the prospectus will clearly state the permissible investments allowed as well as the percentage of cash which the fund manager will retain.”

William says that, in order to address the different needs of clients, it also offers customised solutions.

Reinvestment of cash becomes more difficult if the sharia fund invests in different countries – for example Korea, the United States, Taiwan or Switzerland – where investments are denominated in different currencies.

Adams says while Standard Chartered does offer Islamic deposits in Switzerland, this does not extend to other markets.

“We would normally see less than 10% of the funds value retained in cash to meet liquidity requirements,” says Nik Azhar Abdullah, head of Islamic banking at Deutsche Bank.

“Nevertheless, where there is a need for an overnight deposit, the trend is to convert into a major currency, which is then deposited to enhance returns and manage currency risk.”  

Yap says Citi has received requests from Hong Kong and Singapore to link back into Malaysia.

“In reality, it is not possible to place spare cash in an Islamic deposit account in places like Korea, the United States, Taiwan and Switzerland because a lot of them have no Islamic investment committee,” Yap says, adding that this has been a challenge.

EXPLORATION
“We received enquiries from clients who had explored setting up Islamic funds in Asia, using financial hubs such as Hong Kong where we could potentially support by leveraging our Islamic capabilities in Malaysia,” he says. “We looked into it a couple of times but nothing took off because it was too difficult. It is impossible to find experts in other markets.”

Yap says that these do not have the same understanding of the market while setting up the link to the sharia team in Kuala Lumpur would be too costly.

“We have had a couple of conversations, but nothing materialised,” Yap says, adding that Citi is exploring potential growth opportunities in this segment.

PwC finds that while custody issues are already complicated by the lack of shareholder registers for many sharia compliant securities, in the post-Madoff era, custodians are wary of being held legally responsible for assets of which the existence is not completely ensured.

It concludes: “This demands an innovative approach to the fund-custodian relationship.”

HSBC Securities Services, JP Morgan Securities Services and State Street Global Services declined do comment on these matters.

©2012 funds global asia