“Islamic banks continue to be awash with liquidity. The global supply/demand gap is expected to peak in 2014, amid strong demand for compliant investment products by Islamic investors and a need for quality products to meet regulatory demands. Global Sukuk issuance in 2013 fell 8.9 per cent from the previous year, totalling $119.7 billion. With demand for Shari’ah-compliant instruments so high, it’s the lack of effective liquidity management that’s holding back the growth of the global Islamic market.
“One of the key obstacles to investing in Islamic products is a lack of standardisation in terms of Shari’ah compliance. While there are some local auditors and regulators who control permissible transactions, these controls are not standardised, not only across country borders, but among different banks in the same country. In practice, this means that banks with excess liquidity often face difficulties investing in other banks that have different standards. Although Sukuk are the most common liquidity market instruments, they aren’t universally defined, and sometimes either the structure or the contract is not acceptable by the investor bank.
“A lack of standardisation also leads to higher operational costs, resulting in reduced profitability, as well as the absence of economies of scale and a learning curve.
“Another obstacle to liquidity management is that the Islamic secondary trading market is undeveloped. Sukuk are frequently traded over the counter and held until maturity, and what secondary market activity exists doesn’t operate through a trading platform on an overnight basis.
“A third obstacle is that since Islamic issuers frequently suffer from low risk ratings due to their small size, they’re either obliged to pay high rates to attract investment, or worse, are unable to attract investment at all. In addition, the high domestic demand for these products has kept yields low relative to their risk rating, contributing to their lack of cross-border attraction.
“A further issue lies with the structure of the products themselves. Traditionally, Islamic products have been designed by financiers from conventional backgrounds, who try to base them on conventional products. These products then become unnecessarily complicated when extra layers are added to achieve Shari’ah compliance. This lack of innovation in mimicking conventional products is paradoxically making Islamic liquidity products less appealing to non-Islamic investors.
“However, the good news is that there are some straightforward solutions to these issues. The most significant of these is setting common standards for Islamic investment products. This could be overseen by the Organisation of Islamic Cooperation or other Islamic international boards, which could provide a supportive role, as well as potentially guarantee banks wishing to sell liquidity products cross border. This would raise the risk rating of Islamic instruments, making them more attractive to conventional banks, which will in turn lead to the development of a secondary market.
“For this secondary market to develop, there also needs to be proper, standardised mark-to-market valuation and pricing for Sukuk and other Islamic banking instruments. This is very important as, without effective valuation, traders are unable to establish clear profit-making opportunities.
“Yet, standardisation can only do so much, and a more innovative approach is needed to realise the huge potential of Islamic finance. Instead of imitating conventional banking, the key to the long term success of the sector is to create new, risk free products. For instance, the securitisation of different types of financing could result in a more attractive, competitive product that could generate higher returns.
“Short-term issuance programmes could also be implemented more widely to support banks’ liquidity requirements and contribute to secondary market activity.
“In addition, with the vast majority of Islamic banks currently issuing in local currencies and only a few offering Eurodollar products, there should be more Islamic products issued in foreign currencies to build their cross-border appeal.
“As the Islamic finance industry moves on from the contagion effect of the Financial Crisis, its challenge will be to create both unique products and a market to exploit its liquidity. And, while the responsibility for standardisation lies with international boards, when it comes to innovation, it’s in the hands of the banks to act.”