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An Introduction to Islamic Finance:

Analysing Alternative Benchmarks to be Used in Place of LIBOR in the Islamic Financial System

Nov 2014

Contents

1. Background 3 1.1 Introduction 4 1.2 Principles of Islamic Finance 5 2. Modes of Financing 6 2.1 Capital Markets 8 2.2 Principles of Islamic Equity Funds 10 2.3 Background to Islamic Equity Indices 11 2.4 Empirical Studies 12 2.5 Principles of Islamic Debt Funds 13 2.6 Criticisms of Islamic Benchmarks 14 2.7 New Benchmarks 15 3. Methodology & Data 16 4. Empirical Findings and Commentary 17 5. Conclusion on Study 18 6. Looking to the Future 19 7. Conclusion – Framework for a New Benchmark 20 Truncated Appendix 21 Bibliography 24

1. Background

London Interbank Offering Rate is one benchmark currently used in many Islamic finance transactions. However under Islamic law the use of interest is prohibited so any apparent resemblance to interest should be avoided. This study seeks to identify other suitable benchmarks, which could be used as an alternative to LIBOR, and LIBOR equivalents. In this analysis the LIBOR 3month USD index was evaluated against other benchmarks, which seem relatively stable, widely accessible and provide a good indication of the prevailing rate of return in the economy. These alternative benchmarks included various Islamic equity indices namely; Dow Jones Islamic market Index (DJIM), DJIM 100 Titans Index (IMXL), FTSE SGX Islamic Index (SGS100) and the Jakarta Islamic Index (JII). Additionally the Dow Jones Citigroup Sukuk Index (DJSUKUK) was evaluated for its suitability as a benchmark. The period analysed was between 2006 and 2009, in order to incorporate the suitability of LIBOR and alternatives, as a benchmark in times of financial turmoil. In assessing the volatility of the financial historical data the existence of any volatility clustering and heteroscedasticity was initially determined through the ARCH Lagrange Multiplier tests. This then provided an insight into the properties of the different benchmarks and enabled the use of various advanced ARCH models to determine the levels of volatility. These preliminary tests reflected that the Dow Jones Citigroup Sukuk Index was homoscedastic, thus the use of any advanced ARCH models would not be appropriate in modeling its volatility. From applying the GARCH, TGARCH, and EGARCH models on the indices which exerted levels of heteroscedasticity, it was found that the LIBOR 3 month USD index was the most susceptible to short term persistence, characterized by frequent spikes in returns. Additionally the Islamic equity indices displayed high levels of long term persistence, indicating the shocks will be incorporated into the conditional variance for a long period of time. However the LIBOR 3 Month Index met the condition of integrated GARCH, which indicates a non-stationary conditional variance. We have provided a brief outline of the Sharia Market and its various structures (Sections 1 & 2), for the benefit of our readers who are new to this topic. Sections 3 & 4 deal with data, and in-depth empirical findings, for which we have provided an executive summary, if you require the full data analysis, methodology and findings, please contact us and we will provide the full report. Our aim is to introduce the topic of Sharia Pricing Benchmarks, while at the same time raising the profile of Islamic Finance and alternative Islamic financial solutions.

1.1 Introduction

Islamic finance has made significant progress in recent times, and is estimated at growing at 15-20% per annum. Even with this rapid expansion, Sharia compliant assets are close to $1,500bn, and only 12% of Muslims bank according to Sharia principles. The challenge remains that an Islamic financial system is being gradually integrated into a much larger conventional system. Thus consequently the Islamic financial system is required to adopt certain practices, which are dictated to them from the wider market which are controversial. Still yet, other Islamic finance practitioners engage in Sharia arbitrage models – mimicking conventional modes of finance and taking advantage of legal loopholes. One practice which is contentious is the common use of London Interbank Offering Rate (LIBOR) as a reference rate for many Islamic financial products and transactions. Islamic banks justify the use of an interest-based benchmark as it provides an accurate indication of the prevailing rate of return in an economy and there is no equivalent Islamic alternative. Thus LIBOR is used as a measure of mark-up to price assets and analyse portfolio performance, because no other suitable alternative exists. No doubt, the use of an interest rate index for determining the rate of return on Islamic financial instruments cannot be considered desirable as interest is prohibited under Islamic Law. In addition to providing an indicator of the prevailing rate of return in the economy Islamic finance practitioners also state that LIBOR rates are very stable. However from Sep 2008 – Jan 2009 there was great volatility in the short term LIBOR market when credit risk was deemed high and thus lending between banks became restricted. This permeated all aspects of capital markets, as there was a huge disconnect between implied short term interest rates in various money market products and the rate of return in the real economy. In this context, can LIBOR (or any of its derivatives) be used to price capital – in an Islamic Financing scenario? Though the credit crisis in 2008 was, and is detrimental to the global financial system, analysts such as, Adnan Yousif, CEO of Bahraini based Albaraka Banking Group state the affects on the Islamic financial system are limited (Al-Hamzani 2008). However that begs the question, if spikes in LIBOR do not affect Islamic Economies, why use it as a benchmark for Islamic products? Surely one must use a benchmark that is reflective of the current state of the Islamic economies. There is no doubt that the crisis would have been avoided in an economic system based on Sharia principles. Many of the catalysts that precipitated the crisis, simply would not have existed, for example excessive leverage which is prohibited in Islamic financial structures. There are also other safeguards, such as Islamic financial structures placing greater reliance on collateral and underlying assets. This therefore provides the Islamic financial system the opportunity to enhance and develop its own model and move away from the debt based system, and specifically away from using a debt based reference rate. This point has been continually reiterated by various heads of Islamic states.

1.2 Principles of Islamic Finance

Islamic finance provides financial services, which adhere to Islamic law or Sharia. Sharia refers to a code of law or divine injunctions that regulate the conduct of human beings in their individual and collective lives and has sets the basic framework for an Islamic financial system. The primary sources of Sharia law are the Quran and the teachings of the Prophet Muhammad also known as the Sunnah. Beyond these sources clarification and rulings are sought from scholars who have the juristic expertise (ijtihaad) to provide solutions to emerging problems and issues. These verdicts can be based on consensus (ijma) among scholars, or analogical verdicts (qiyas) based on the Quran or Sunnah. Islamic finance defines a complete system that prescribes a specific pattern of social and economic behaviour for all individuals, with the over-riding objective of the system to promote social justice and fair income and wealth distribution. Main Principles of an Islamic Financial system

1. The prohibition of usury or interest (riba) The literal translation is “to increase, to augment or to practice in usury”. This term was understood by classical scholars such as Ibn Arabi, Mujahid, Tabari, as an increase which has no wealth corresponding to it (Ibn Arabi) or as a reward for waiting (Mujahid) or something which accrues to the lender on a deferred payment because of an extension in the actual period of a loan (Tabari) (Iqbal et al 2007) 2. Profit & Risk sharing Sharia stipulates that earning a return on capital is only legitimized by engaging in economic activity which involves taking a risk. Most economic activities involve some commercial risk and bearing this risk ensures the validity of any profits. It is important to note that it is permissible by Sharia to mitigate risks through risk management or due diligence, so risks are mitigated but not totally eliminated. 3. Money is NOT classified as capital Money is not considered to have any value itself rather it is used as a medium for exchange. Money is considered as potential capital rather than capital. Therefore money only becomes capital when invested in an enterprise. 4. Contracts have to be free from informational uncertainty/ambiguity or Gharar Gharar refers to any uncertainty that arises through a lack of information or ambiguity in a contract. Sharia considers gharar on the basis of quality, quantity, recoverability or existence of subject matter in a contract. Thus gharar can usually be eliminated by stating the object and the price of the object to be sold, eliminating ambiguities. In certain cases jurists or scholars will assess the extent of any uncertainty and may nullify the contract if the uncertainty is excessive, whereas smaller levels of uncertainty are accepted. 5. Speculative behavior and gambling is forbidden One of the implications of prohibiting gharar is that any speculative behaviour or gambling is forbidden. Such behaviour will involve asymmetric information, excessive uncertainty, excessive risk and a lack of control. Initially the permissibility of equity trading was questioned as it was equated to speculation, however this was resolved as equity trading integrated various technical, fundamental and performance analysis which would incorporate different economic variables into tits trading strategy. Thus it could be said that equity trading is subject to reasonable uncertainty and not pure speculation. 6. Sharia compliant activities Any investment which involve, alcohol, gambling, pork, or anything that goes against the tenets of Sharia is forbidden.

“Those who consume interest cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, "Trade is [just] like interest." But Allah has permitted trade and has forbidden interest. So whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allah . But whoever returns to [dealing in interest or usury] - those are the companions of the Fire; they will abide eternally therein.” (2:275)

2. Mode of Financing

1. Partnership (Musharakah) Musharakah is a partnership arrangement where two or more parties provide capital towards financing the business and thus become partners. Every partner will have a share in the profits which is to be determined as a proportion or percentage, however no fixed amount can be determined as this hinders the profit-risk sharing relationship which underlies Sharia law. Additionally losses are borne by the partners according to their invested capital. Musharakah contracts are flexible to different situations, and are one of the least contentious forms of financing. 2. Profit sharing (Mudaraba) Mudaraba is a special partnership where one party provides the capital and the other party manages the capital and invests the capital into real economic activities. Formally a mudaraba contract is a partnership between the investor (rabb ul mal) and an entrepreneur (mudarib) who Acts on behalf of the investor. Profits are shared between the different parties but the losses are borne by the investor exclusively. 3. Cost plus mark up (Murabaha) Murabaha is a type of cost plus financing method. Murabaha takes place when the seller declares to the buyer the price at which they have bought the commodity and then stipulates a profit margin; either as a percentage costs or a fixed amount. Murabaha in its original context is a sales transaction and not a mode of financing, where a trader would purchase a product as required by an end user and then sell the product with an agreed mark up. Thus in its original context Murabaha can be used as a form of asset acquisition. Consequently many banks take the role of traders and will purchase assets as requested by a client and sell back to them with a stipulated profit mark up. Murabaha has now been deemed an acceptable mode of financing by contemporary scholars, contingent on certain conditions being met (Usmani, 2005). Currently with the increasing role of banks as financial intermediaries, the traders' role as financier has been taken over by the bank. The banks can also act as an intermediary between the client and trader, combining both the selling and trading aspects as done typically in the market for over-the counter-derivatives. Thus a typical murabaha would take place between an Islamic bank, the trader or the original seller of the product and the client agreeing the product. With similarities to the over-the-counter derivatives market murabaha is commonly used to structure Sharia compliant financial derivatives, and are a contentious issue. Commonly the profit or spread used in pricing or structuring these products involves the use of the LIBOR. Below is an example of a commodity Murabaha being incorporated into a sukuk structure:

1. Sukuk (Trust Certificates) 2. Cash 3. Cost Price (spot payment) 4. Commodities (spot delivery) 5. Mudaraba commodities (spot delivery) 6. Deferred price (cost price & profit) 7. Return from deferred price

ORIGINATOR – as purchaser

COMMODITY SUPPLIER

ISSUER SPV – as Trustee & Rab al Maal

INVESTOR

3

4

5 6

2 1 7

6. Leasing Ijara A contract of ijara is a sales contract which is based on the sale of usufruct for a specified period of time. All terms in an ijarah contract must be clearly stipulated such as the asset being leased, the rental amount, schedule of payments and the purpose of use for the asset. One of the major advantages of ijarah is it resembles a conventional lease agreement and only has a few differences. Through this it has become prevalent for banks to purchase assets such as buildings, machinery, and equipment and lease them to clients. Ijarah contracts have great potential for developing advanced financial instruments to meet the growing demands of investors. However issues remain on this form of financing as many ijarah contracts use an interest rate as a benchmark in determining the amount at which an asset is leased.

4. Deferred payment sale (Bai Muajjal) This type of contract allows for the sale of a contract on a deferred basis through lump sum payments or installments. 5. Forward sale contracts (Bai Al-Salam) This is a type of forwards contract where the buyer pays the spot rate for the specific product, which the seller delivers at a future date.

Efficient capital markets facilitate the flow of capital in both the primary and secondary markets providing liquidity, price assets based on riskiness (by determining risk premia) and provide market participants with opportunities to theoretically eliminate their unsystematic risk through portfolio diversification. Importantly the success of the Islamic financial system relies on how the Islamic capital markets satisfy these factors. Conventional capital markets use both the security markets for debt trading and stock markets for equity trading. Islamic involvement in the equity markets took speed in the early 1990s when it was stipulated that equity investments were permissible contingent on certain conditions being met and certain practices being avoided. Activities to be avoided include: short selling, speculative trading, the use of margin accounts, investing in companies whose activities go against Sharia principles. Thus the equity markets could provide a source of liquidity and form an integral part of the Islamic financial system. However debt and FX markets do not conform to sharia principles where the creation of capital through debt contravenes Sharia principles. This brought forth the concept of Sharia compliant asset based securities or sukuks. 2.1 Islamic Bonds or Sukuks A sukuk is a type of Sharia compliant bond, but maintains some distinct differences to a conventional bond. Firstly, it should be noted that with interest prohibited under Sharia, pure debt securities such as conventional bonds are strictly forbidden. However, an obligation which is linked to the performance of an asset is deemed acceptable and consequently sukuks are semi-collateralised against an underlying asset and derive a return based on the performance of this asset. The majority of sukuks are asset based as opposed to asset backed. As a result sukuk holders are deemed to be owners of the underlying assets and share the risk and returns associated with the cash flows generated by the underlying asset. Furthermore, a conventional bond creates a lender borrower relationship whereas a sukuk relationship depends on the nature of the underlying contract or transaction which underpins the sukuk. Additionally the returns on sukuks vary in line with the underlying contracts and are either fixed or floating rate. Some of the different sukuk structures are mentioned below 1. Ijara sukuks: These are based on an ijara or lease contract but is subject to certain conditions to qualify for securitization. This includes that the underlying lease must conform to Sharia principles, the leased asset must be productive in order to derive 'lease payments from its users and the leased asset must be fully compliant to Sharia. Consequently the sukuk relationship will be between lessee and lessor. 2. Muqaradah bonds: These bonds are based on mudaraba contracts where capital is provided by investors against the bond for a particular project undertaken by an entrepreneur (mudarib). In return the bond is backed up by revenues generated by the project. This has been a common undertaking in public finance projects and investors have shared revenues generated from government backed development and infrastructure projects.

2.1 Capital Markets

7

10

ORIGINATOR – as Managing Agent

ORIGINATOR – as Obligor under purchase undertaking and under

sale undertaking

9 8 12 11

ORIGINATOR – as Partner MUSHARAKA

ISSUER SPV – as Issuer and Trustee

INVESTOR

3 5

1

2

4

6

1. Sukuk (Trust Certificate) 2. Cash 3. Cash Contribution 4. Contribution in cash or in kind 5. Share of profit & loss 6. Share of profit & loss 7. Periodic distribution amounts 8. Sale of Musharaka unit 9. Exercise price 10. Dissolution amount 11. Appointment as managing agent 12. Inventive fees

3. Musharaka bonds: These are based on partnership and profit and loss sharing contracts and are similar to aforementioned muqaradah bonds. But in this case the entrepreneur (mudarib) takes up dual roles and acts as a partner and agent with the investors. Other sukuks include murabaha sukuks, salam sukuks, istisna sukuks etc, The current sukuk industry has been hugely popular in recent years, with 2014 being a landmark for a variety of sukuk issues in virgin territory. It popularity as a mode of financing transcends demographic and geographic boundaries. However challenges remain. Firstly the secondary market activity is limited and as such investors tend to hold sukuks until maturity. There have been improvements in secondary market liquidity in recent years through the issuance of more investment grade sukuks and standardization of sukuk contracts. However secondary market activity will remain as such until we have development of Sharia compliant hedging instruments and far more sophisticated modes of risk managing in institutions which hold sukuks. Example of a Musharaka Sukuk below:

Islamic equity funds are similar to mutual funds which invest in equity or stocks. A majority of the scholars stipulate that share ownership is different to a partnership agreement (musharaka) in an Islamic context. This is because in a partnership all decisions are attributed to the partners in the company, whereas in a listed company only majority shareholders can influence decisions. As such if a company is generally in compliance with Sharia law but holds some money in an interest-bearing account receiving small levels of interest income, it does not render all the business activities of the company unlawful. If the shareholder does not personally agree to such activities, it is deemed acceptable to invest in the company. The construction of an equity fund will require screening and filtering stocks. The following principles are used for screening and filtering stocks which are to be included in an Islamic equity fund:

2.2 Principles of Islamic Equity Funds

1. Sharia compliance of business: The main business of the company should conform to the principles of Sharia. This constraint eliminates all companies dealing with the financial services industry operating on interest, companies manufacturing, selling or offering alcohol and pork products, and businesses that are involved in gambling, night clubs, etc. 2. Interest income: Fund managers will avoid stocks where companies generate a high level of income from interest bearing instruments. However if the interest income is small, the proportion of that income received in the dividend must be given to charity. Additionally shareholders are required to express their disapproval for such dealings in interest bearing instruments.

3. Existence of debt: Companies who are highly leveraged as determined by debt ratios are eliminated. However scholars have set a level of tolerable debt; anything below 33% debt to equity is permissible, though this varies from fund to fund. Shareholders are encouraged by scholars to cite their concerns regarding the use of debt in financing. 4. Negotiability of shares: Stocks are only negotiable if the company owns some illiquid assets. Although there is no fixed tolerable level a ratio of 51 percent is cited as preferable. The reasoning behind this constraint is that if all the assets of the company are in a liquid form i.e. in the form of money, shares cannot be sold or purchased except at par. This is because the shares represent the companies money and under Sharia money cannot be sold or purchased except at par, where any excess above or below par would be classified as interest or riba.

Until the early 1990s, there were major uncertainties about whether investing in the stock market was acceptable by Sharia law. However a verdict was given by a leading Islamic authority which stipulated that equity investments were permissible if certain conditions were met. This created clarity over the issue and led to the establishment of Islamic equity funds. By the mid-1990s many Islamic equity funds grew rapidly and in 1996, estimates showed a total of 29 Islamic funds, and by March 2002 the number of Islamic funds increased to 129, valued at $3.324 billion (Siddiqi 2002). Islamic equity indices In response to the increased demand in Islamic equity investments the FTSE Global Islamic Index Series (GIIS) was launched at the end of 1998. This was then followed in February 1999 with the launch of the Dow Jones Islamic Market index (DJIM). These Islamic equity indices act as benchmarks that track the performance of stocks which are consistent with Sharia law. In addition to the DJIM and FTSE GIIS Indices many other Sharia compliant indices have been launched. One notable index is the Kuala Lumpur Sharia Index (KLSI) which was launched in April 1999, in order to meet increasing demands from investors who were seeking to invest in Sharia compliant equity and securities. Additionally the Jakarta Islamic Index (JII) was launched in July 2000 for similar reasons. More recently in 2006, the FTSE Sharia compliant product range was initiated. This product range includes the FTSE SGX Asia Sharia Index which comprises of various Sharia-compliant stocks from the many Asia- Pacific markets including; Japan, Singapore, Taiwan, Korea and Hong Kong. Generally Islamic equity indices will have Sharia committees that comb through the stocks that make up the index, and companies whose business activities contravene Sharia will be excluded from the index on the basis of certain principles which include interest income, company debt levels, line of business etc. Additionally these committees will provide periodic reviews of the stocks, with the aim to add or remove companies who no longer meet the recognition criteria. Since their introduction Islamic equity funds have expanded and now include different regional, sector and other subgroup variations. Essentially these variations in the index provide investors with diversification for their investment portfolios. This variety can be exemplified through the DJIM Index which is a detachment of the Dow Jones Global Index (DJGI) Group, and includes stocks from 34 countries, 10 economic sectors, 18 market sectors, 51 industry groups and 89 subgroups defined by the Dow Jones Global Classification Standard (Hussein, 2005).

2.3 Background to Islamic equity indices

Even though Islamic equity indices and funds have seen rapid expansion, empirical studies on the subject are limited. Hakim and Rashidian (2004) examined the risk and return relationship between different indices specifically; DJIM Index, Wilshire 5000 Index (W5000) and 3 month US Treasury Bill for the period 1999-2002. They concluded that the Islamic index was similar to other indices as its movements over time were random. Through the cointegration analysis no distinct link was found between the DJIM Index and W5000, and similarly between the DJIM Index and the 3 month US Treasury Bill. It was suggested that the Islamic index was influenced by factors independent from the broad market or interest rates. Additionally the findings indicated that the Islamic index presented a unique risk-return opportunity, as the Islamic index was observed to maintain lower risk than the W5000. This was especially surprising as the Wilshire 5000 is considerably more diversified than the DJIM. Thus the filtering criteria can be cited as effective, this point was also mentioned by Hussein (2005) who states that the filtering process can detect signs of corporate troubles and preemptively remove these stocks. A notable example includes the case of WorldCom, where their stocks were removed from the DJIM Index a year before their collapse, as their debt equity ratio exceeded the limit of 33%. At removal from the DJIM, the WorldCom shares were trading at $14, but six months later they had lost their entire value. Hashim (2008) specifically looked at whether the Islamic index yielded adequate returns for the level of risk undertaken. In his analysis he compared three different indices namely; FTSE Global Islamic Index (GIIS), FTSE All-World Index and FTSE4Good (socially responsible fund). This study concluded that the FTSE GIIS outperformed the socially responsible FTSE4Good Index even though the later was well diversified. However the Islamic index showed higher risk than the market index but it's realized returns were considered fair and it undertaken. This study was very similar to one done earlier by Hussein (2004) who also compared these three indices but for the period July 1996 to August 2003. The results were identical where the Islamic index had a lower beta than the socially responsible fund and a higher beta than the market index. Though it was concluded that the FTSE GIIS performed as well as the FTSE All World Index, where the Islamic index exerted superior performance during a bear market and inferior performance during a bullish market.

2.4 Empirical studies of Islamic Equity Indices & Trends

Another study conducted by Hussein (2005) sought to examine the effects of Islamic equity screening, comparing Islamic equity indices against conventional indices. He analysed whether returns in the DJIM and FTSE Global Islamic Index were significantly different from those of the Dow Jones World Index and FTSE All-World Index for periods of 1996 to 2004. The analysis was broken down into three segments; bull period 1 from December 1993 to December 2000, bear period from December 2000 to September 2002, and bull period 2 from September 2002 to December 2004. It was noted that in bull period 1 the Islamic indices yielded significant abnormal returns, and in the bear period and bull period 2 underperformed against the market indices. Another similar study by Hassan and Antoniou (2002) provides an insight for these results. Through their study they found that Islamic equity indices bias towards including technology stocks proved beneficial during a bullish stock market (January 1996-March 2000) but has a detrimental affect on the performance of Islamic equity investments during a bear stock market (April 2000 to March 2003). This would explain why Hussein (2005) found that Islamic indices outperformed against their counterpart indices in bull period one (December 1993 — December 2000) and underperformed in the bear period (December 2000-September 2002). Ultimately these studies both concluded that the Sharia screening process did not have an adverse impact on the performance of Islamic equity indices. General trends from these studies suggest that the Islamic index may maintain lower levels of risk than some other well-diversified indices. Additionally it cannot be assumed that conventional equity indices will outperform Islamic equity indices as the risk and return characteristics have not been consistently one-sided. The level of growth and development in Islamic equity indices will largely depend on the extent of innovation. Active investment strategies and robust risk management tools in additional to the current screening and filtering process will ensure growth and development is sustained in the future. During the credit crisis Islamic equity indices had an inherent advantage that excess leverage and debt was filtered out at the outset.

Islamic debt funds generate revenue by investing capital into murabaha and ijara type contracts which involve debt and a fixed level of income. The debt in these contracts is collateralized against assets and therefore the permissibility of the debt fund depends on the nature and maturity of the underlying assets. The revenues generated from these contracts are predetermined so the net income received for the fund, after a management fee payment to the investment manager (mudarib) is known with reasonable certainty. Thus the fund is similar to a conventional debt fund but the income generated is interest free and is generated in a transaction which involves a physical asset. Sukuk indices Two notable sukuk indices which have been launched include; the Dow Jones Citigroup Sukuk Index and the HSBC/DIXL Sukuk Index. The Dow Jones Citigroup Sukuk Index was launched to measure the performance of global Islamic bonds or sukuks. This index was introduced in 2006 and is based on the same design principles and calculation assumptions of Citigroup's fixed income indices. The sukuks included in the index possess the following characteristics; fixed rate and floating rate coupons, minimum maturity of one year, minimum issue of $250 million and are all investment grade sukuks (rated to at least BBB/Baa3 by major credit rating agencies.) Additionally the calculations of the index are updated daily and the index is reviewed monthly. The Dow Jones Citigroup Sukuk Index is screened to maintain Sharia compliance which is consistent with the Dow Jones Islamic Market Index and is based upon three other principles:

2.5 Principles of Islamic Debt Funds

(i) sukuks included must be certified by a recognised Sharia Supervisory Board, (ii) the sukuks must meet the standards issued by the Auditing and Accounting Organization of Islamic Financial Institutions (AAOIFI) in 2004

(iii) the underlying assets to be securitised in the sukuk must be in compliant to Sharia principles. The HSBC/DIFX Sukuk Index was launched by HSBC in collaboration with the Dubai International Foreign Exchange. Similar to the Dow Jones Citigroup Sukuk Index, the HSBC/DIFX sukuk index also tracks the performance of international sukuks but adheres to a slightly different screening process. The main differences include; only one Middle Eastern Sharia scholar is required to authorise the sukuks included, any low grade rated sukuks can be included with the only requirement that the sukuk is not in default, and minimum sukuk issue size for inclusion is $100 million. A bond market implies maturing capital markets, and the establishment of a Sukuk market implies a convergence, where all (Islamic and non-Islamic) issuers, investors and traders can raise money, invest and trade as long as the rules of Sharia are adhered to. This is no doubt a positive development. However due to its relatively recent introduction there is a lack of empirical studies on sukuk indices, specifically in the period from 2006-2009, and thereafter.

Islamic law stipulate clearly that the Sharia prohibits interest. However El Gamal (2002 & 2009) states that this statement is paradoxical in light of the actual practices of Islamic financial service providers over the past three decades. Many transactions within the Islamic financial system involve either; cost plus mark up sales (murabaha) or lease to purchase transactions (ijara), where similar embedded mark up is designated as rent. The mark up most commonly used to determine the return on such transactions is the London Inter Bank Offering Rate (LIBOR) or its local proxy. Ultimately the practice of using interest rates to determine the profits or the cost of capital is not desirable and should be scrutinised. The use of an interest-based reference has been an area of great contention, though this practice is defended by scholars on the basis that it is only used as a benchmark. The analogy used is that if you are a soft drink vendor, you can use an off license’s profit mark up techniques. LIBOR essentially represents the opportunity cost of capital – capital in the Western definition - for a select panel of banks. It is quoted in all major currencies and for maturities up to 12 months and therefore has global accessibility. In addition to having different maturities, the rates are also frequently quoted which provides flexibility to the user. From some of the aforementioned points, and the fact that LIBOR is widely recognised as the rate of return in the economy or “price of money” particularly in the short term, suggest why LIBOR draws suitability as a benchmark in Islamic finance. We appreciate that LIBOR has different connotations now, and in effect LIBOR represents the credit worthiness of a bank in relation to another. For example both HSBC and RBS are LIBOR setters, however given the pitiful state of the latter, it is likely borrowing rates will be higher for them. A unique factor of derivatives pricing pre-crisis was the total lack of comprehensively taking into account credit risk. This issue still haunts financial institutions today, especially in the GCC who are still not adequately accounting for counterparty and collateral risks. To justify the use of LIBOR as a reference rate many practitioners cite Usmani (2005) where he states that if a murabaha (cost plus mark up) transaction fulfills all other conditions, the use of an interest rate as a benchmark for determining profit cannot render the transaction invalid as the deal itself does not contain interest. However it is important to note that he goes onto say that Islamic banks and financial institutions should get rid of this practice as soon as possible as the use of an interest rate benchmark does not advance the basic philosophy of an Islamic economy. This opinion is also cited by a number of leading Sharia scholars. A type of financial instrument where LIBOR may be typically used is a floating rate sukuk which is often linked to the 3-month or 6 month LIBOR index (e.g. 3m LIBOR + 0.5%), so any movements in the LIBOR rate will influence the price and demand of the sukuk. This clearly reinforces the fact that interest or riba is present and shapes the transaction. Indeed the latest 5 year UK sukuk issue was priced FLAT to 5 year Gilt rates. Consequently such transactions are being likened to interest bearing transaction at least in appearance, and keeping in mind the prohibition of interest, even this apparent resemblance should be avoided as much as possible.

2.6 Criticisms of Islamic Benchmarks

While in recent times Islamic finance has made significant progress, the need for a suitable benchmark has continued to be a low in priority. However we, and a growing number of other practitioners have reiterated the need to develop an alternative benchmark. There are inherent differences between an Islamic financial system and a conventional system, thus there is a need for alternative benchmarks to be used in Islamic finance. While it is fairly straightforward to create a pricing mechanism on a project by project basis, there needs to be deeper understanding and most importantly a desire to develop a suitable nation based benchmark, efforts will be required by all parties concerned namely; economists, bankers; policymakers and Sharia scholars if this is to be achieved. At the movement, and particularly pre 2009, interest-based benchmark were used to determine mark ups, price assets and evaluate portfolio performance because of the absence of a suitable equity-based benchmark which conforms to Sharia principles. Simply put, this practice exists because there is no other suitable alternative. This point has also been mentioned by Sharia scholars. Benchmarks or reference rates remain important for all types of businesses and their relevance is determined according to the sector, industry or market where a particular business operates. The availability of an efficient, frequently quoted and globally accessible reference rate for pricing assets and a benchmark for evaluating portfolio performance is vital to the success of today's financial markets. Islamic financial markets are no exception to this and their growth and development are similarly dependent on an efficient and stable benchmark. The lack of alternative debt pricing models since 2009 is a disappointment In recent times Islamic finance has made progress in developing Islamic equity indices which have been used to evaluate portfolio performance such as the Dow Jones Islamic Market Index and FTSE Global Islamic Index. However the development of debt based benchmarks is limited. Benchmark evaluation The benchmarks to be evaluated will include both Islamic equity indices and sukuk indices. The suitability of using an equity based benchmark while analysing data from 2006-2009 was apt especially given that excessive leverage and debt had been at the epicenter of the international credit crisis. No doubt equity markets where affected by this global crisis however the leverage and debt level restrictions give Islamic equity indices an inherent advantage over conventional equity funds as well as debt based reference rates. The fundamental criterion for any benchmark to be used in Islamic finance is stability, meaning the benchmark should not exert undue and excessive volatility. Volatility is essentially a stochastic process where extreme values may be exerted by particular time series. Thus to evaluate the suitability of a benchmark various financial econometric analysis techniques will be used to assess the levels of volatility. Many previous studies suggest that financial time series data exert heteroscedasticity; where the variance is constantly changing. This indicates that for the purpose of this study, econometric technique which incorporate autoregressive conditional heteroscedasticity (ARCH) will be useful in capturing volatility within the different financial time series.

2.7 Benchmark Evolution

3.1 Data Description* Data for the daily returns or yields (excluding non-trading days) where obtained from Bloomberg in USD for the following indices; Islamic equity indices - Dow Jones Islamic Market Index (DJIM), DJIM Titans 100 Index (IMXL), Jakarta Islamic Index (JII) and FTSE SGX Sharia Index (SGS 100). Islamic bonds/sukuk Index - Dow Jones Citigroup Sukuk Index (DJSUKUK). This index was introduced in 2006 and historical data obtained was limited to 04/05/2006.

3. Methodology & Data

Libor Index - LIBOR 3 Month USD Index (LIBOR3M). The LIBOR 3 month rate is commonly used in Islamic finance and will be used as a proxy in this study. Data on the different indices will be compared in order to determine whether or not the underlying index is a suitable benchmark. The period under observation will be 4/05/2006 - 2/24/2009. As mentioned prior, the reasons for this is to look upon the suitability of Islamic benchmarks pre-crisis and during the crisis. The inclusion of the Jakarta Islamic Index (JII) and FTSE SGX Sharia Index (SGS 100) will provide an insight into geographical variations in Islamic indices, especially in emerging markets. Additionally the inclusion of the DJIM Titans 100 Index (IMXL) will analyse the effect of any sub group variations. The Dow Jones Citigroup Sukuk index, will provide an insight into sukuk indices in general, as previous empirical studies are rare. For a full explanation of methodology, models and definitions used please request access to the Extended Appendix which accompanies this report.

*For the full transcript and explanation of the section named ‘Methodology & Data’, please request a copy of the Extended Appendix which accompanies this report

Both these indices can be associated with emerging markets, with the Jakarta Islamic Index directly belonging to one, and the FTSE SQX Asia Sharia Index including many Sharia compliant stocks attributable to companies operating in Asian-Pacific emerging markets such as Taiwan and Korea. Through the Jarque-Bera (JB) test the normality of each index was assessed. From table 1a it can be seen that none of the indices met the conditions for normality with all yielding a high kurtosis co-efficient and with all indices inducing a strong negative skew. In figures 2a-f, a bell shaped normal distribution and student-t distribution curve has been imposed onto the distribution charts for all the indices. This provides a visual insight into the normality of returns and shows the distribution of returns are all peaked around the mean and have relatively fat tails. From these properties it can be concluded that these distributions are leptokurtic. This indicates that the indices will encounter large positive or negative returns more regularly than they would under a normal distribution. One explanation why the normality assumption was rejected could be because all the indices encountered extreme values, which skewed their distributions and produced relatively fat tails. This point can be illustrated from observing the skewness and kurtosis statistics in table 1a. Furthermore this non-normality could also be due to volatility clustering and time varying variances. From a visual observation of figures 1a, 1b, 1c, and 1d it strongly appears that volatility is not constant. Volatility seems to be clustered, where there is a tendency for large movements in the daily returns to be followed by other large movements in random directions. This suggests that the time series data involves some level of heteroscedasticity or time varying variances. Further tests proposed will gauge whether or not heteroscedasticity exists among all the indices examined.

4. Empirical Findings & Commentary

*For the full transcript and explanation of the section named ‘Empirical Findings’, please request a copy of the Extended Appendix which accompanies this report

Statistical properties* A summary of the mean, median, standard deviation, maximum values, minimum values, skewness, kurtosis, Jacque-B era for the log return series are given in table 1a. From hereon in, when returns are discussed, the log returns series is being examined. Table 1a (Truncated Appendix) shows the highest daily mean returns were attributable to the Dow Jones Citigroup Sukuk Index (-0.00011) and the lowest daily mean returns were attributable to the LIBOR 3 Month USD Index (-0.00091). The Dow Jones Citigroup Sukuk Index also had the lowest standard deviation (0.002946) and figure 1f illustrates how this particular index endured a prolonged period of stability until October 2008 upon which large movements were experienced. These large movements coincided with the global financial credit crisis which saw Lehman Brothers go bankrupt and other institutions face severe problems. One of the implications of this crisis was the restriction of capital and this not only affected the Dow Jones Citigroup Sukuk Index but also had an impact on all the other indices under observation. This reflects why all the indices displayed negative skews and negative mean daily returns. The strongest negative skew was aligned to the Dow Jones Citigroup Sukuk Index (-19.505). The Sukuk index is most sensitive to moves in credit risk, and therefore this result is expected. From analysing figures 1a-e together with the minimum values in table 1a it can be seen that all the indices experienced their most extreme movements during this period which highlights the adverse implications of this crisis on all the indices under observation. Table 1a also shows how the DJIM Titans 100 Index, a subset of the Dow Jones Islamic Market Index outperformed the later with both a higher daily mean return and lower risk. From table 1a it can also be seen that the Jakarta Islamic Index obtained the highest standard deviation (0.011616) and was seconded by the FTSE SQX Asia Sharia Index (0.007513).

Results The objective of this study was to analyse different possible benchmarks which could be used in place of LIBOR (and its equivalents) in the Islamic finance system and assess their suitability. In order to do this the volatility of each benchmark was modeled and evaluated on the basis of what was exhibited. From the basic statistics, it was concluded that all of the indices were non-normally distributed and were leptokurtic. This was not only due to the existence of some extreme values which took effect during the global financial crisis, but also due to the existence of heteroscedasticity among some of the Indices as was reflected in the ARCH Lagrange Multiplier test. We purposely evaluated data including and surrounding the Lehman’s crisis of late 2008, as we felt it necessary to include the effects of stressed events on the suitability of an index. For the indices that displayed signs of autoregressive conditional heteroscedasticity, different enhanced forms of the ARCH model were used as an evaluation tool in assessing the volatility. Results from the GARCH models demonstrated that the LIBOR 3 Month USD Index had the highest levels of short-term persistence through higher parameters and the Islamic equity indices maintained the high levels of long-term persistence through a higher parameter. In addition to having the lowest long-term persistence parameter, the LIBOR 3 Month USD Index was also the only index which surpassed unity or integrated GARCH which indicates it has a non-stationary conditional variance. The Dow Jones Islamic Market Index and DJIM Titans 100 Index were marginally off attaining unity, which implies any shocks experienced will be incorporated into the conditional variance for a much longer period, noting that when unity is obtained persistence remains inevitably. From this it can be concluded that the LIBOR 3 Month USD Index would be the most volatile benchmark in the short term which suggest reactions to shocks will be intense. This is exemplified by sharp hikes in the conditional variances in figure 11 (Truncated Appendix) where the LIBOR 3 Month USD Index reacts the most intensely from all indices. Additionally through its non-stationary properties any persistence from shocks will have an infinite effect. Through the TGARCH and EGARCH models it was evident all the indices were asymmetric, that is they would induce different levels of volatility following positive or negative shocks. Specifically the Islamic equity indices would induce higher levels of volatility following a negative shock than if a positive shock was encountered. Aziz and Kumiawan (2006) also found such asymmetry when analysing stock returns for the Jakarta Islamic Index and Kuala Lumpur Sharia Index. However the LIBOR 3 Month Index showed opposing attributes where positive shocks induced higher levels of volatility. Consequently the Islamic equity indices and the LIBOR 3 Month USD Index will react in contrasting manners indicating a negatively correlated relation, which is supported by the correlation coefficient in table 9a. This indicates that using Islamic equity indices in place of LIBOR would be questionable as they are negatively correlated and will be unable to respond to shocks consistently. Though these Islamic equity indices did fare well against the LIBOR 3 Month USD Index in terms of Islamic equity indices did fare well against the LIBOR 3 Month USD Index in terms of persistence, but these asymmetric relationships suggest an equivalent debt based reference rate is a desirable substitute. As such the Dow Jones Citigroup Sukuk Index can be cited as a good substitute. According to the ARCH Lagrange Multiplier test it was suggested the index was homoscedastic where the variance is invariably constant. This combined with the fact that it maintained the lowest standard deviation enhances its creditability as a contender.

5. Conclusion on Study

Sukuk indices do face many challenges, which need to be addressed in order for sukuk indices to become more prominent and credible as benchmarks. Firstly from a juristic point of few, the sukuk indices needs to include more fixed rate sukuks or use a different reference rate other than LIBOR to determine coupon rates. If sukuks are included in the index, which use LIBOR and LIBOR proxies (and there are many) to determine the coupon, this undermines the use of the sukuk index as a benchmark because it is still based on LIBOR, and LIBOR equivalents. Pricing of sukuks since 2009 seems to not have progressed much unfortunately, and recent “landmark” issues, such as the first Sukuk issue by the UK Treasury (a 5 year sukuk), was priced flat to 5 year Gilt rates. Secondly there are few sukuk indices in the market which limit the flexibility of financial engineers in utilising them as benchmarks. Heed must be taken from Islamic equity indices, which have expanded rapidly developing various regional, sector and other subgroup variations. This can manifest through sukuk indices based on government sukuks, real estate sukuks, investment grade sukuks etc, which provides flexibility and may be more meaningful, where a government sukuk issue can use the government sukuk index as the base rate for its coupon. This has been done in recent times this has been done. But sukuks continued to be asset based, as opposed to asset back furthermore at times, and even the pricing seems spurious - the recent 5 year UK sukuk issue is a case in point (supposedly it was based on a pool of real estate assets, and yet it was priced flat to 5-year gilts). Surely there should be a greater correlation to the rate of return of the asset – which if it were prime real estate for example, would comfortably be higher than 5%. Unfortunately there continues to be a malaise in the Sharia financing world were Sharia arbitrage opportunities are exploited and easiest solutions are created regardless of the long term implications for the industry. In addition to this some scholars state that correct compliance is not occurring with certain types of sukuks namely; musharaka sukuks and mudaraba sukuks. Another alternative, is using a basket of indices in order to derive an Islamic benchmark, though as mentioned some of equity indices react oppositely as compared to LIBOR. Studies on an Islamic Pricing Benchmark There is a plethora of classical books that discuss pricing in a Sharia context, including, Nihayat al-Ratibah fi Talab al-Hisbah (Ibn Nasir), Adab al-Hisbah (al-Malqi), al-Turuq al-Hukmiyya fi al-Siyasah al-Syariyyah (Ibn Taimiyyah), and others. Furthermore there are a number of contemporary works in Arabic on pricing mechanism and permissibility in a Sharia context including works by Al Ya’kubi, Dr Muhammad al Salih and Dr Aud Mahmud al Kufrawi, the later focusing on cost and profit rate in a Sharia context. Among the contemporary works in English on pricing benchmark from Sharia perspective the seminal work on the topic is an Introduction to Islamic Finance (Muhammad Taqi Usmani), while the Malaysians have done some fantastic work in this regard also. Further work can look into other potential benchmarks, where Bursa Malaysia is initiating commodity-based murabaha transaction based on crude palm oil. This as a primary export of Malaysia does indicate the level of economic activity but its success will rely on the stability of crude palm oil industry. Similarly, the primarily export or source of returns, in other countries can be used as a benchmark. However the danger is that for many Muslim countries, the primary source of revenues are primary products which are notoriously volatile themselves. Additionally Hague and Mirakhor (1998) attempted to derive a rate of return in the economy based on the profit sharing concept. They proposed the use of a Sharia compliant equity based index as a benchmark for issuing government paper. Overall studies on Islamic pricing and cost of capital are scarce, however the time is now ripe – with the boom in Sharia compliant assets – to take huge leaps forward and create holistic solutions, as opposed to making do with broken solutions.

6. Looking to the Future

There are a few studies on Islamic pricing benchmark but they are in early stages. Our studies, measures the suitability of current benchmarks and proposes alternative methods of calibrating future solutions without the need to resort to interest based pricing models. Omar, Noor & Meera et al (2010) proposed a framework in which to base an Islamic Pricing Benchmark. We agree with the spirit of the proposal, though disagree with some of the parameters. Below is a set of refined parameters – based on their original proposal – in which we believe a Pricing Benchmark should be created: 1. The Benchmark should be used as an indicator and a guide to pricing capital within a specific asset class. 2. The factors for creating a pricing benchmark should be free from non-Sharia compliant activities, such as inclusion of interest rates models, non-real economic activities such as indices of financial derivatives products. 3. Time value of money is a misnomer. Money has no value unless converted to capital, therefore there should only be reference to the “opportunity cost of capital” 4. Pricing should be asset specific, therefore benchmarks should vary according to asset class. 5. Indices must be accurate objective and transparent. 6. Islamic banking activities are more comprehensive relative to conventional banking, including being a trader, partner and wakeel. As such, the pricing benchmarks/mechanisms should not be based solely on financial intermediary functions. 7. The creation of granular inflation indices to monitor price movements. 8. Real macroeconomic conditions need to be taken into consideration when determining macro-benchmarks or risk-free rates. Ultimately capital were priced in accordance with the asset class it belongs to. For example the price of funding a real estate project in London should be based on real estate Indices which captures that market. However as the price of capital (particularly in the previous 5 years) has always been higher than LIBOR this has then it has meant that Sharia models of financing are more expensive, therefore pricing Sharia financiers out of the market. Despite this, such a method is a more holistic and viable long term pricing mechanism. LIBOR and LIBOR proxies will always lack credibility amongst the populace. We have demonstrated that such benchmarks are cannot be used in times of volatility due to the fundamental disconnect between the real economy and interbank markets in which credit risk is hugely multiplied. We have proposed a revised framework on which to create new benchmarks, there are precedents set within the early books of jurisprudence. This was time when Islamic merchant capitalism was at the forefront of world economics, constantly innovating and creating new products. The spirit of the age needs to be revived in order to lead the world in new innovations.

7. Conclusion : Framework for a New Benchmark

Truncated Appendix

Figure 1 – Log Return Graphs for all Indices

Figure 2 – Distribution histograms for all Indices

DJIM GARCH(1,1)IMXL GARCH(1,1)JII GARCH(1,1)SGS100 GARCH(1,1)LIBOR3M GARCH(2,1)

Figure 11 – Comparison of modeled conditional variances using GARCH(p,q)

Table 1a - Descriptive and Normality test statistics.

Index Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera

DJIM -0.00026 0.000213 0.0314 -0.0406 0.006380 -0.842 10.656 1689.73

[0.00]

IMXL -0.00021 0.000114 0.0343 -0.0347 0.006009 -0.550 10.371 1527.33

[0.00]

JII -0.00024 0.000448 0.0635 -0.0751 0.011616 -0.757 10.269 1515.93

[0.00]

SGS100 -0.00034 8.20E-06 0.0443 -0.0446 0.007513 -0.647 10.340 1527.55 [0.00]

DJSUKUK -0.00011 7.32E-05 0.0033 -0.0679 0.002946 -19.505 432.205

5107815 [0.00]

LIBOR3M -0.00091 0 0.0432 -0.0687 0.007264 -2.290 26.157 15324.17 [0.00]

DJIM IMXL JII SGS100 DJSUKUK LIBOR3M

DJIM 1.000000 0.981052 0.488126 0.519177 0.046871 -0.062115

IMXL 0.981052 1.000000 0.415404 0.448259 0.035359 -0.036358

JII 0.488126 0.415404 1.000000 0.638189 -0.016070 -0.110577

SGS100 0.519177 0.448259 0.638189 1.000000 0.057415 -0.123557

DJSUKUK

0.046871 0.035359 -0.016070

0.057415 1.000000 0.027546

LIBOR3M -0.062115

-0.036358

-0.110577

-0.123557 0.027546 1.000000

Table 9a - Correlation coefficient

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