Supporting Islamic finance: How custodians are facilitating the market’s growth

As demand for Shariah-compliant investment products and services grows, leading custodian banks are building innovative solutions to cater for the diverse requirements of Islamic financial institutions.

Now a $2.4 trillion market, Islamic finance is forecast to recover this year after suffering from a COVID-19 induced stagnation. According to RAM, Sukuk transactions reached $$152.6 billion in 2020, a significant increase from 2015 when issuances totalled $59 billion.1 Fuelling demand for these products are a combination of Islamic banks together with Shariah-compliant sovereign wealth funds [SWFs]; asset management companies; pension funds and family offices. In addition, a handful of global custodians and broker-dealers, whose own underlying clients comprise of major Islamic investors and institutional clients, are asking their sub-custodians to develop Shariah-compliant services as well, forcing providers to take note.

Navigating Islamic securities services

So what exactly do these Shariah-compliant services look like? Put simply, Islamic Securities Services broadly mirror the traditional model in that providers offer solutions such as custody; fund accounting; transfer agency; performance reporting; cash management; and foreign exchange  services. The fundamental difference is that all of these services need to comply with Shariah principles. Hence along with ensuring that the basic fundamentals are incorporated in the construct of these products they also need to ensure their offerings are certified as compliant, by a body authorised to do so.

In the case of Standard Chartered, it has a full-fledged Islamic bank within its ranks whereby there are teams of experts working on product management, operations, risk, controls, legal and compliance aspects. More importantly its Islamic Securities Services business is underpinned by Fatwas (certifications) which are issued by a permanent and an independent Shariah board, comprised of leading international scholars.

In markets like the UAE, Pakistan, Malaysia and Brunei, it is a regulatory requirement to have locally appointed Shariah boards in place to oversee business activities. Client agreements must be compliant with Islamic law. For instance, all contractual documents that the bank’s Islamic Securities Services arm signs with clients must be approved by a Global Shariah Supervisory Committee. The channels through which these services are provided and the linked reporting suites need to comply too.

Operating under Shariah law means the Islamic securities services model needs to fulfil a different set of requirements. For example, usury, which could be loosely translated as interest taking or giving, is forbidden. Traditional custody relationships envisage a cash link where these cash accounts provide interest; hence this solution can’t be used under an Islamic offering. Therefore service providers need to identify partners who can offer profit bearing cash solutions instead of interest bearing accounts.

In order to generate revenues off deposits, providers such as Standard Chartered utilise structures (called “commodity murabaha”) where there is a purchase and sale of select Shariah-compliant commodities (e.g. precious metals such as Platinum and Palladium) on an overnight basis. Profits are generated on the back of these secured trades and shared with the clients.

Islamic accounts also need to be clearly identifiable and Islamic and conventional assets can’t be co-mingled. Standard Chartered has implemented a fully segregated Islamic booking method that satisfies and is in line with these guidelines. Although quite complex logistically, custodians can also vet whether or not an Islamic institution is buying Shariah-compliant securities overseas.

From a fund accounting perspective, Standard Chartered leverages the AAOIFI (Auditing Organisation for Islamic Financial Institutions) accounting standards for Shariah-compliant entities, in addition to the traditional IFRS (International Financial Reporting Standard) and IAS (International Accounting Standard) models. It can also facilitate Shariah-compliant reporting and performance measurement on behalf of Islamic funds. This ultimately enables the bank to support Islamic institutions with their investment activities.

Network managers get to grips with Islamic finance

While Shariah-compliant financial solutions have been available for the last 50 + years, they have only picked up real traction, within the institutional market, relatively recently. Amid pressure from certain Middle Eastern and Asian SWFs and central banks, network managers at global custodians and broker dealers are starting to scrutinise the Islamic securities services capabilities of their underlying sub-custodians, and validate that these offerings are compatible with the Shariah mandates of their own clients. In terms of operational due diligence, this may require a network manager to ascertain whether a sub-custodian has a permanent Shariah board or committee in place, or if they are using a more ad-hoc solution. In addition, network managers will also need to ensure Shariah-assets and cash are fully segregated and that cash management practices at their sub-custodians comply with Islamic guidelines. For a number of network managers, Islamic finance will be a new concept. In order to overcome any lingering uncertainties or confusion, sub-custodians should educate network managers about Islamic finance and how it works.

Although some network managers may be unfamiliar with elements of Islamic securities services, the fundamentals are still the same. Take counter-party and operational risk, for example. Some markets will have their own domestic, standalone Islamic banks, who can provide local custody solutions. However, network managers do still have a fiduciary obligation and must ensure that client assets are fully protected at all times and held with institutions that come up to their appointment criteria. It is crucial therefore that they only work with providers which have strong risk management practices in place together with an excellent credit rating and robust balance sheet strength. At the same time, they should also only work with partners that comprehensively cover the complete ecosystem of their securities services, FX and cash related requirements.

Gathering momentum

Shariah-compliant finance is a rapidly expanding market, and the securities services industry is launching exciting new solutions and products in response. Similarly, network managers are also having to familiarise themselves with the intricacies of Islamic finance so that they can meet the requirements of some of their larger, Islamic institutional clients. By embracing Shariah-compliant financial solutions, the industry will be able to expand its market share across the wider Islamic world.

1 Global sukuk issuance in 2020 fueled by sovereign stimulus packages

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