Growth rate forecasts for the global Islamic finance market did not survive the economic downturn caused by a vertiginous drop in petrol prices. Nevertheless, with a new norm in the range of 5-7%, Islamic finance remains a fast-growing industry that offers great opportunities to the financial professionals who are acquainted with its specific products and services. There are, however, some challenges, as well. For instance, institutional investors are typically looking to invest in liquidity-generating products whereas the Sukuk market, unfortunately, is still a niche sector and depends mainly on private placement arrangements. It is a reasonably young market, spread across many different countries and jurisdictions and lacking a homogenous structure. MAURICE BAUER writes.
Transparency and standardization: Crucial elements for sustainable and Islamic finance
The critical mass required to ensure a minimum of liquidity has not yet been reached. There seems to be a lack of short-term Sukuk, in particular. Conventional investors nevertheless welcome the Sukuk as a diversification of their global fixed income portfolios and therefore adopt a ‘buy-and-hold’ strategy.
The asset-backed structure of Sukuk gives comfort to investors looking to lock into a medium-term investment instrument with minimal liquidity, without worrying about the intrinsic credit risk of the Sukuk. The market therefore attracts a very specific investor profile, unlikely to be deterred by liquidity matters.
There have recently been some efforts to increase the liquidity of the Sukuk and to encourage issuers to list these instruments on stock exchanges. It remains to be seen if this measure alone will have any positive impact on market liquidity.
A deeper analysis allows us to draw comparisons between the Sukuk market and the emerging sustainable finance market.
Increased and improved standardization
The lack of standardization is often considered worse than the lack of liquidity, potentially resulting in reduced institutional investor appetite for Sukuk or sustainable finance products.
It is crucial to learn from experience in other markets and push for increased standardization, a prerequisite for faster expansion of Islamic finance in general. Looking at the long history of the eurobond market, the standardization of contracts has proved to be a central element to the smooth development of the market.
The same trend can be noticed in the green bond market. The Luxembourg Stock Exchange launched the Luxembourg Green Exchange in September 2016; the platform is now displaying half of the world’s listed green bonds, but its development is strongly linked to the emergence of coherent and accepted standards at a global level.
The Sukuk market needs more and better standards, but with a balanced approach. One of the main characteristics of Islamic finance is that it is very flexible – too much standardization would limit this and risk hindering the market’s growth.
Ambitious market development targets are only achievable through a high degree of transparency and comparability. Evaluating market performance of Sukuk should not imply the need to study complex documentation. Information is a valuable asset and creates transparency. Transparency builds trust, which is the best recipe for investors to take an informed investment decision.
Another benefit of standardization is its positive impact on cost. It would make a big difference, especially in the retail investment area, where Shariah compliant funds are carrying higher compliance costs than their conventional equivalents.
A first step could be to create more uniform documentation. This would help in structuring products and lowering the cost for participants. Standardization is needed to give credibility and confidence to the market, but it has to emerge from the bottom up and not be imposed as a norm. Fintech and digitalization could be a game-changer, bringing automation and efficient processes.
Ensure a level-playing field with conventional finance
Both conventional and Islamic finance need a level-playing field internationally. Thus, Shariah compliant structures need to be included in the international treaty network, especially when it comes to avoiding double taxation.
The World Bank and the IMF support Shariah compliant products as a way of increasing the capital market culture in emerging countries. The converging elements between Islamic finance and sustainable finance can also support its inclusion on the radar screen of a wider range of target investors, contributing to its further development.
Islamic finance is not without risks. It requires further and deeper development. However, it is important to focus on elements such as risk management, investor compensation schemes, banking supervision or bankruptcy laws, while avoiding overregulation.
The drive for sustainability could help Islamic finance. The green bond market is growing fast and, therefore, promoting the issuance of green Sukuk could be a good way of boosting the sector.
The financial sector has a tremendous role to play here, providing funding and pushing forward the agendas. Finance has to become sustainable. Sustainable finance has to be the norm in the future rather than the exception, thereby acting as a further stimulus to Islamic finance.
Luxembourg has been active in Islamic finance for more than 30 years and was the first market to issue a euro-denominated sovereign Sukuk facility. The government and regulatory authorities support the Islamic finance industry. Building on a solid base of expertise in international finance, Luxembourg is well placed to develop a knowledge-sharing platform linking sustainable and Islamic finance.