Introduction to Islamic Money and Capital Markets

1. Introduction to Islamic Money and Capital Markets By Azahari bin Abdul Kudus Director – Treasury & Capital Markets 10th March 2008

2. Section 1 ISLAMIC FINANCE

3. Islamic Finance & Fiqh al-Muamalat • Islam is a way of life which covers all aspects of human life, amongst others, economic and financial aspects. • Islamic finance is the provision of financial services on a basis that is compliant with the principles and rules of Shariah. • Fiqh al-muamalat is a branch of Shariah in relation to the financial activities. • The focus of fiqh muamalat is on contracts and it lays down types of contracts which are permissible or impermissible. • Islamic finance should be free from prohibited activities such as riba (usury / interest), gharar (uncertainty), maisir (gambling), khiyanah (fraudulent act), etc..

4. Riba’ Riba* Riba’ al-Nasi’ah (Riba’ due to deferment of one countervalue) Riba’ al-Fadl (Riba’ due to exchange Of two similar ribawi Items with different Countervalue) *Modern definition: The stipulation for the additional premium to be repaid in loan transaction which is made upfront Source: Dr Mohd Daud Bakar, Lecture Notes MBA UIAM Nov 2002/03

5. Riba’ Al-Nasiah • The debtor borrowed money to be paid in certain time, and the amount payable is more that the amount borrowed • Additional amount charged on the expiry date due to extension of period of loan. • Arising out of exchange contract, a buyer must pay a consideration. If he failed to settle on time, the period will be extended by increasing the amount (principle + interest).

6. Riba al-Fadl • Involved ribawi items based on the saying of the Prophet: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt, like for like, hand to hand, in equal amount; and any increase is riba’”. • These commodities can be classified under two main categories: i- medium of exchange (currency): Gold and Silver ii- Staple foods: Wheat, barley, dates and salt • Any other items, even though not mentioned in the hadith but serve the same purpose will be considered as having the same illah by way of qiyas (analogy)

7. Riba’ In Conventional Financial Transaction • Riba’al-duyun in loans or any types of advances. • Riba’ al-buyu’ mainly in exchange of currencies

8. Basic Difference between Islamic and Conventional Modes of Finance Conventional Money Bank Client Money + Money (interest)

9. Goods & Services Money Basic Difference between Islamic and Conventional Modes of Finance Islamic Bank Client • Islamic financial products and services are contracts based. • Money is medium of exchange and not a commodity. • As such, money cannot be used to increase the money by lending it to others with interest (riba).

10. Transactional Contracts Intermediation Contracts Real sector transactions that include exchange, trade and financing of economic activities To facilitate an efficient and transparent execution of transactional contracts Two broad types of contract Islamic Financial System Profile of Contracts Combined to offer a set of instruments with varying purposes, maturities and degrees of risk to satisfy a diverse group of economic agents

11. Modern Islamic Finance comprises three key segments… Islamic Banking • Islamic banking provided foundation for development of modern Islamic finance. • Takaful industry emerged as a mutual protection provider. • Islamic Money and Capital Markets facilitated mobilisation of funds. Islamic Money & Capital Markets Takaful

12. Section 2 ISLAMIC MONEY MARKETS

13. INTERBANK MONEY MARKET • Usually as regarded including financial assets that are: - • Short term • Highly marketable • Low Risk • High Degree of Liquidity • The importance of interbank market as an integral part of the financial system are as follows:- • A market for short term funds • Minimising risk exposure • Channel for transmission of monetary policy by a central bank

14. Milestones in the development of Islamic Money Market in Malaysia 2004 and forward 1983 1993 1994 • Islamic Banking Act (IBA) was enacted for Islamic Banking to exist side-by side with conventional banking • Bank Islam Malaysia Berhad (BIMB) was established on 1 July 1983 • The Government Investment Act 1983 was also enacted to empower the Government to issue Government Investment Issues (GII) • Interest Free Banking Scheme was introduced, and was subsequently replaced by the Islamic Banking Scheme in 1998). • More Islamic financial products and services were offered • The Islamic Interbank Money Market (IIMM) was introduced on 3 January 1994 • Provides Islamic financial institutions with facilities for adjusting portfolios over the short-term. • Serves as a channel for the transmission of monetary policy. • Islamic Treasury bills. • Dual-market bonds. • Islamic hedging • Islamic Market Maker • Islamic Reference Rate • Entrance of foreign banks • Major Currencies – USD, EUR, GBP

15. The Birth of IIMM • Trading of Islamic financial instruments mainly based on debt trading principle • Instruments – Government Investment Issue, Bank Negara Negotiable Notes, Islamic Acceptance Bills, Islamic Debt Securities Islamic Money Market Trading of Financial Instruments • The Islamic Interbank Money Market (IIMM) was introduced on 3 January 1994. • All Islamic MM instruments are approved by the Syariah council prior to implementation • Provides facilities for adjusting portfolios and funding purposes to Islamic banks and conventional banks Mudharabah Interbank Investments • Tenor – overnight, one week, one month, three months • Placement and acceptance of funds based on Mudharabah principle – profit sharing concept.

16. The Players • Central Bank • Authorized Dealers • Money Broker

17. 3 3 2 1 2 1 BANK NEGARA MALAYSIA • BNM influences the Islamic money market via several instruments,:- • Money Market Operations • Wadiah Interbank money tender • Mudharabah Interbank Investment • Bai al Inah funding • Open Market Operations • SBBA and reverse SBBA • sales and purchases of securities • issuance of BNNN and GII BNM Government Conventional Money Market Islamic Money Market The government, which holds large deposits at BNM, also affects the money market through deposit movements between BNM and commercial banks BNM money market operations affect the real economy through its effect on deposit rates, lending rates and its effect on the yields and prices of bonds and equities in the capital market Deposit Rates KLIBOR & Lending Rates Bonds & Equities Prices

18. AUTHORISED DEALERS Active players in the Islamic Interbank Money Market • Alliance Bank Malaysia Berhad • Citibank Berhad • HSBC Bank Malaysia Berhad • Malayan Banking Berhad • OCBC Bank (Malaysia) Berhad • Public Bank Berhad • Southern Bank Berhad • Standard Chartered Bank Malaysia • Berhad • Al Rajhi Banking & Investment Corporation (Malaysia) Berhad • Affin Islamic Bank Berhad • AmIslamic Bank Berhad • Bank Islam Malaysia Berhad • Bank Muamalat Malaysia Berhad • CIMB Islamic Bank Berhad • EONCAP Islamic Bank Berhad • Hong Leong Islamic Bank Berhad • Kuwait Finance House (Malaysia) Berhad • RHB Islamic Bank Berhad

19. Global Islamic Banking & Finance Industry : Size & Composition • Size: • Current: 300+ institutions – US$ 700 billion • Expected: US$1.4 trillion industry by 2010 • Composition: • Islamic financial institutions US$ 178.5 B • Conventional banks’ Islamic window US$ 200 B • Islamic capital markets US$ 300 B • Takaful assets US$ 20 B • Non-banking financial institutions US$ 9-12 B Source: The Islamic Financial Services Industry - Ten Year Master Plan (2006-2015) by IFSB, IRTI and IsDB IFSB: Islamic Financial Services Board, IRTI: Islamic Research & Training Institute, IsDB: Islamic Development Bank

20. Money Brokers • A licensed company involved in the business of arranging transactions between buyer or borrower; and seller or lender in the money or foreign exchange markets with brokers acting as an intermediary in consideration of brokerage paid. • Money Broker do not act as principal in a transaction

21. Money Market Instruments • Central Bank • Interbank Players

22. Wadiah Interbank Acceptance • Acceptor of funds is viewed as custodian and there is no obligation to pay returns. However, the acceptor of funds may give return on a discretionary basis in the form of hibah (gift). • The instrument gives flexibility for the Bank to declare dividend without having to invest the funds received. • However to ensure acceptability by the inter bank participants, the dividend will be declared based on Islamic Inter bank Weighted Average Rates. • This instrument will have a maturity profile ranging from overnight up to three months. Central Bank of Malaysia The Central Bank absorb funds from IB via Wadiah Inter bank Acceptance Islamic Bank (IB)

23. BNM BNM BANK BANK Bai Al Inah Funding Facility • CONTRACT 1 • CONTRACT 2 BNM sells asset to BANK @ RM X + profit, but the payment is deferred (forward value date) Contract 2 is preceded by Contract 1 BANK sells asset back to BNM @ RM X for Value Today

24. Securities Funds SBBA – BNM Sells Asset and Buys Back on Maturity Date First Leg of SBBA SBBA Seller SBBA Buyer SBBA Asset is returned to BNM Second Leg of SBBA On maturity, the SBBA Seller pays back the cash amount with SBBA profit

25. MUDHARABAH INTERBANK INVESTMENT (MII) • MII refers to an arrangement between two banks where surplus bank acts as a capital provider to deficit bank on the basis of Mudharabah (profit sharing) • Period of investment shall be from o/n to 12 months • The minimum amount of investment for the MII shall be RM50,000 • The rate of return shall be based on the rate of gross profit before distribution from investment of 1 year of the “receiving” bank Price quotation • Translate to indicative rate • Bid 90 => 0.90 x Minimum benchmark rate • Offer 92 => 0.92 x Minimum benchmark rate • Assume minimum benchmark is 4.00% p.a. (expected dividend rate on GII is 3.50% p.a. + a margin of 0.5% p.a.) • Indicative rate (bid) 3.60% p.a. / 3.68% p.a.

26. The Determination of profit rate depends on market forces and the return of Acceptor • The rates represent the Islamic Financial institutions gross rate of return termed as R rate. • The rates are will be used to determine the Profit Sharing Ratio (PSR) to be shared between the investor and the acceptor • Price quotation Translate to indicative rate Bid 2.50% Offer 2.70% Assume R rate of Maybank is 5.00% Therefore if the 1 week rates concluded at bid side i.e 2.50, therefore the PSR will be fixed at 50:50 The PSR will remain fixed throughout the tenure. However the R rate of Maybank will fluctuate depending on the profitability of Maybank. Assuming the R rate of Maybank changed from 5% to 6% therefore the final profit rate will be 3.00% instead of 2.50%

27. COMMODITY MURABAHA DEPOSIT-i • A Murabahah InterBank Deposit product • provides a pre-agreed deposit rate via the buying and selling of the underlying commodity. • A Murabahah InterBank Placement product • provides a pre-agreed net yield rate of return via the buying and selling of the underlying commodity.

28. Terminology • Principal Amount of the deposit or placement • is the Purchase price of the commodity. • The Net Yield • is the stated or agreed profit known to both the buyer and seller is expressed in term of percentage. • Payment methodology agreed:- • Deposit/placement – cash or spot basis • Settlement for the Selling Price – deferred to a specified future date.

29. Commodity Murabaha – Typical Structure Commodity User of Funds Funds Deferred Settlement Acting as Principal • Agent’s Confirmation • Principal Acknowledgement Funds Spot Settlement Commodity Funds Spot Settlement User of Funds Commodity Trader II Acting as Agent Funds Spot Settlement Commodity Commodity Trader I

30. WAKALAH-BASED PLACEMENTS Shariah-approved transactions 1. Appoint as Wakeel and provides funds 4. Invests funds 5. Expected profit less agency fee Bank A (Muwakkil) Bank B (Wakeel) 2. Undertaking that it will invest funds into transactions that are expected to generate a certain expected profit 3. Waives profit above the expected profit and gives to Wakeel as incentive fee

31. GOVERNMENT INVESTMENT ISSUE • An interest free bond issued by the Government of Malaysia • Issuance is governed by the Government Investment Act 1983 • Since 1983 until June 2001, the issuance concept is Qardul Hassan (benevolent loan) • Return is not predetermined or promised • Government is accountable to repay the principal amount borrowed • Dividend, if any, be paid but strictly on discretionary basis • Formula: (# days from last dividend date/ 365*expected dividend*100)+100 • As there is no secondary trading, BNM provides a window for banks to sell or purchase GII. • The price is determined by BNM based on expected dividend. • In order to develop the IMM, a tradable GII was introduced in Jun 2001….. • After careful consideration and approval from the Syariah Advisory Council, the issuance concept was changed from Qardul Hassan to Bai Al Inah(BAI). • The concept requires the sale and purchase of Government asset between the Government and the Banks. • Through the above process, a debt is created and subsequently being securitised via the issuance of GII. • The GII is traded in the IMM secondary market based on Bai ad Dayn (debt trading). • Also used as a monetary policy instrument Government Investment Issues

32. GOVT GII Certificate of Govt. Assets Islamic Banking Institutions GII – The Structure 4 Through the sale and purchase transaction, a debt has been created. This debt is securitised through the issuance of GII 1 Subsequently, GOVT will buy back the Certificate of GOVT assets at par value (100.00) to be paid on credit term (above 1 year) 3 Identify Assets Sell assets on a tender basis 2

33. BANK NEGARA NEGOTIABLE NOTES (BNNN) Bank Negara Negotiable Notes • Introduced in October 1999, BNNN is issued by Central Bank as a monetary policy instrument to manage liquidity in the Islamic Money Market • A short-term instrument (less than 1 year) issued via Bai al Inah concept • The issuance modus operandi is similar as GII except that the asset is owned by Central Bank • BNNN will be traded based on Bai ad Dayn • As at October 2001, the outstanding amount is RM1.0 billion Islamic Debt Securities

34. BNM BNNN Certificate of BNM assets Islamic Banking Institutions BNNN – The Structure Through the sale and purchase transaction, a debt has been created. This debt is securitised through the issuance of BNNN 4 1 Subsequently, BNM will buy back the Certificate of BNM assets at par value (100.00) to be paid on credit term (i.e. 91, 182 or 364 days) 3 Identify Assets Sell assets on a tender basis 2

35. SUKUK BANK NEGARA MALAYSIA IJARAH (“SBNMI”) • The Islamic banking industry in Malaysia has undergone full liberalisation in 2004 with the award of Kuwait Finance House, Asian Finance Bank and Al-Rajhi Banking and Investment Corporation, comprehensive licenses to conduct Islamic banking business in Malaysia. • The entrance of these international Islamic banking players have, to a large extent introduced innovations in Islamic financing and new concepts as well as different interpretations of Shariah. • The difference in Shariah interpretations adopted by these global Islamic financial institutions results in these institutions having limited investment opportunities in terms of Shariah-compliant papers. • Bank Negara Malaysia (“BNM”), the central bank of Malaysia realised this issue and took a laudable gesture by initiating the issuance of SBNMI which is based on the Ijarah concept taking into account the acceptability of SBNMI to these institutions.

36. SBNMI – The Structure Sells beneficial interest in assets 1 Rental payment Leases the asset 2 4 BNM Sukuk Berhad Issuance of Sukuk Rental distribution 3 5 Investors Source: Bank Negara Malaysia

37. SUKUK BANK NEGARA MALAYSIA IJARAH (“SBNMI”) • SBNMI only addresses the placement of excess liquidity in Islamic financial institutions. Investments of Islamic financial institutions need to be liquid enough to be managed efficiently. Therefore, the use of collateral account (“K-Account”). • K-Account This is a collateral account of financial institutions maintained by BNM for the purposes of intraday credit with BNM. The amount of intraday credit will be determined by applying the margin percentage to the market value of the securities collateralised. Settlement by 3.30 p.m daily after Can call for cash subject to liquidity requirement FI Place SBNMI or any other securities as collateral

38. Sukuk BNM-Ijarah and BNNN…a comparison

39. Negotiable Islamic Debt Certificate (NIDC) • NIDC is a debt instrument issued under the concept of Al Bai Bithaman Ajil (deferred payment sale) and Bai Al Dayn (debt trading) • Investor purchases asset from the Bank on cash basis • Investor re-sells this asset to the Bank at higher price on credit basis • Bank issues NIDC to the investor • Bank settles this credit to the investor upon an agreed future date • The debt arising from the Al Bai Bithaman Ajil can be traded in the secondary market based on the principle of the Bai Al Dayn, and is subjected to guidelines for Islamic Negotiable Instruments issued by BNM • It is similar to the conventional short term NCD

40. Section 3 ISLAMIC CAPITAL MARKETS

41. CAPITAL MARKETS • Instruments with longer term to maturity • Instruments include government, corporate and municipal bonds; • corporate stocks; and mortgages • Bonds in Islamic Capital Markets are mostly sukuk

42. SUKUK: DEFINITION “investment sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of a particular projects or special investment activity, however, this is true after receipt of the value of the sukuk, the closing of subscription and the employment of funds received for the purpose for which the sukuk were issued.” Definition by AAOIFI

43. MALAYSIAN ISLAMIC CAPITAL MARKET • Several significant milestones were achieved in 2006 , whereby 27 out of 64 Sukuk approved by the Securities Commission were based on Mudharabah, Musyarakah, Istisna’ and Ijarah, which are globally accepted • Malaysian Sukuk account for two-thirds of the total Sukuk issued in the global Sukuk market Source: Malaysian ICM Bulletin March 2007

44. MALAYSIAN ISLAMIC CAPITAL MARKET • Popularity of the Sukuk as a debt instrument continues to increase on the back of strong demand. • Coupled with fiscal incentives to ensure Sukuk is competitively priced. Source: Malaysian ICM Bulletin March 2007

45. INTERNATIONAL SUKUK MARKETS Selected Global Sukuks • The international Sukuk market began in 2002 with a USD600 million issuance by the Government of Malaysia - it has grown rapidly since • Recent trends in the Middle East have encouraged development of the Sukuk market • Corporate expansion, both organic and M&A related • Increase in international investment • Perceived reduction in geopolitical risk for the GCC region • Economic diversification away from hydrocarbon • As the product has gained visibility, demand for Sukuk assets has increased, leading to significant oversubscription of transactions • Estimated USD250-300 billion of Islamic funds available for investment • Conventional funds now form the bulk of benchmark size Sukuk investors • Traditionally, Sukuk issuance has been dominated by corporates, however, today major Islamic banks and non-Islamic/non-Mid East players are also using Islamic finance structures Source: Bloomberg, IFIS, Central Banks, KFH

46. GLOBAL SUKUK MARKET: DEVELOPMENT & POTENTIAL Global Local Currency & Dollar Sukuks by Country(as at 28th Mar 07) Global Sukuk Issuance Trend (2000-2006) Composition Structure of Global Sukuk by Value (2006) • Global Sukuk Issuance Trend - 2004 : US$7.2 billion, 2005 : US$12.1 billion, 2006 US$26.8bil, 2007F: USD35bln-USD40bln • 2006 Sukuk issuances were dominated by Malaysia 55%, the UAE 31.5%, Kuwait 3.7%, Saudi Arabia 3.0% and Bahrain 2.9% • In terms of local currency & dollar Sukuks issued & outstanding, Malaysia & GCC have the largest Sukuk market in the world • Global Sukuk outstanding is expected to reach USD150bln by 2010 from current USD47bln Source: Bloomberg, IFIS, Central Banks, KFH

47. Wider Geographical Acceptance • Increasing number of mutual funds, pension managers, financial institutions and central banks are holding Sukuk paper as part of diversification strategy • The recent geographic distribution of Islamic Development Bank USD1.0bln Sukuk reflects a move away reliance on Europe & Middle East • For the first time for a GCC promoted Sukuk, Asian investors outstripped investors from Europe & Middle East – Asia 35%, Middle East 32%, Europe 26% & Supranational 7% Source: KFH

48. Tendering Method Tendering via Fully Automated Tendering System (FAST)… • Competitive tendering exercise through the Principal Dealers’ network and Islamic banks • All bids are to be submitted based on yield • Allotment to the successful bidders will be based on the yield ascending order (that is from lowest to highest rate). • Rental rate will be determined based on the weighted average yield of all the successful bidders.

49. Section 4 CASE STUDY

50. Introduction • You, as a Treasury Dealer, saw an opportunity to purchase a sukuk as part of your investment or trading activity. • The above activity would require you to: - • Fund the purchase of the sukuk • Hedge the floating rental return, if you choose to fund the investment by borrowing the same currency. • Hedge the FX risk, if you choose to fund the purchase with a different currency • Above all, all the activities above must be done in a manners that are acceptable to shariah.