Offshore centers are poised to benefit from the enormous growth forecast in Islamic finance over the next few years, says Ogier’s Head of Banking and Finance in Asia.
The combination of increasing appetite for Islamic finance products, new variations on existing products and an increased interest in the role of offshore centers in Islamic finance point to a developing area with huge potential, according to Anthony Oakes, who leads the banking and finance team in Ogier’s BVI and Cayman-focused Hong Kong office.
Islamic finance is based on the prohibition of interest (Riba), excessive uncertainty (Gharar) and gambling (Maysir or Qimar), which makes certain financial products, including interest-bearing instruments and derivatives, and practices like short-selling and leveraging, noncompliant with Islamic law.
As such, Islamic finance relies on real economic transactions such as trade and investment based on profit sharing rather than interest-based and speculative financing practices. It integrates Islamic principles such as social justice and kindness to create products and financial markets that are ethical and sustainable.
Research by the International Shariah Research Academy for Islamic Finance estimated the total value of global Islamic finance at around $900 billion in 2009 – that figure had reached $2.4 trillion by 2015, with forecasts reaching $3.4 trillion in 2018 and $5 trillion by 2020.
“The traditional market in the Middle East remains strong, but we are also seeing growth in Asia, Malaysia and Indonesia. At the same time, the industry is developing new products – we are seeing more Shariah compliant retail and corporate banking and trade finance products coming online,” said Oakes.
“A further interesting development is happening in non-Islamic countries, where access to Islamic capital markets is being sought – a good example is the sukuks issued by the Hong Kong government in 2014 and 2015.”
A sukuk is a form of bond that is structured to be “shariah compliant” by not paying interest. This is generally achieved by giving the investor partial ownership in a tangible asset, for example in a sale and leaseback transaction. Instead of interest and coupon payments, the investor will receive rent payments, which end when the sukuk expires.
In May 2015, Hong Kong sold a $1 billion five-year sukuk at a spread of 35bp over U.S. Treasuries. The government of Hong Kong is currently holding investor meetings in Asia, the Middle East and Europe ahead of another potential U.S. dollar sukuk offering.
Oakes, who recently published a chapter on Islamic finance in the Cayman Islands in The Islamic Finance and Markets Review, said “offshore centers, and particularly Cayman, are well-positioned to take advantage of this growing area because of their flexibility and efficiency, and because their underlying legal systems are based on the trusted, well-established and familiar English legal framework.”
Cayman exempted companies are typically used as the issuer, often described as the trustee, in many Islamic financing transactions, including sukuk, wakalah, an agency or service contract, and ijarah, a lease to purchase or lease to own transaction.
In these arrangements, the Cayman company is often set up as an “orphan” special purpose vehicle because it is formed solely for the financing transaction. The SPV is referred to as an orphan because the beneficial interest in the shares of the SPV, rather than being held by a parent company, are held by a trustee such as a charitable trust or Cayman STAR trust, Oakes noted in the Islamic Finance and Markets Review article.
In this way, the SPV is unlikely to be considered an asset of the borrower in case of an insolvency, and “bankruptcy remote” because it is prohibited from undertaking any activities other than the financing transaction, making the SPV unlikely to be liquidated.
The typical sukuk structure involves the issuance of certificates to investors by a Cayman SPV. The invested funds are used to buy an asset that is then leased back to the borrower. For the duration of the sukuk, the borrower pays rent to the SPV, which distributes the coupon and principal payments on the certificates to the investors.
“If specific events of default occur, the borrower is obliged to repurchase the asset at a certain exercise price so that the SPV may redeem the certificates,” Oakes explained.
Islamic funds are another area in which the Cayman Islands is used for investment purposes.
The majority of Islamic funds tend to be close-ended private equity or property funds, which are structured either as exempted limited partnerships or exempted companies.
Since Islamic funds are established in compliance with shariah principles, they can invest only in industries or properties that comply with Islamic law, but they will use structures similar to a conventional fund.
The Cayman ELP is one of the most commonly used investment vehicles both for Islamic and non-Islamic funds, Oakes noted.