Chapter 18
The Role of Capital Markets in Providing Shari’ah-Compliant Liquidity
The effectiveness of any capital market, including Islamic capital markets, depends to a large extent on its depth and liquidity and the extent to which it can provide liquidity to the constituents of the financial services sector in its economy. Liquidity is the vital lubricant to ensure safe, sound, and efficient operations and sustainable growth of various participants in the Islamic finance industry. Islamic financial institutions are not very different from the conventional financial institutions in this respect, as they share similar obligations towards their clients and counterparties and hence a similar need to manage their risk profiles.
1. LIQUIDITY AND ITS IMPORTANCE TO THE ISLAMIC FINANCIAL SYSTEM
The critical importance of liquidity to sound and efficient functioning of the Islamic finance sector is better appreciated now than in the past, given the lessons learnt from the global financial crisis. Although the Islamic finance sector was not affected to the same extent as the conventional financial system by the global financial crisis, the lessons learnt by the conventional finance industry have highlighted the critical role of adequate liquidity in the overall safety and growth of various constituents of the Islamic finance sector. The need to develop a robust liquidity supply infrastructure has been widely accepted among the leading thinkers of the Islamic finance world as an essential prerequisite for strengthening the stability and resilience of the Islamic finance sector. Given their integrating role and capabilities, capital markets are in the best position to provide the required liquidity supply to the broader Islamic finance sector.
Adequate liquidity in the financial system is essential to reduce the cost of intermediation and bring down the cost of capital for the wider economy. Adequate liquidity in Islamic capital markets (ICMs) will also enable Islamic financial institutions (IFIs) to manage their risks effectively by providing a range of funding options and risk management tools. Availability of a strong liquidity supply infrastructure materially enhances the capabilities of IFIs to survive liquidity stresses. Most jurisdictions with potential for growth in Islamic finance lack such a strong liquidity supply system, leaving the IFIs operating in those jurisdictions at a disadvantage.
Essentially, there are two main facets of liquidity required by financial institutions—funding liquidity and asset (or market) liquidity. Funding liquidity refers to the availability of funds for consumers of capital or savings, ranging from borrowers for business, borrowers for investments, issuers of equity capital for business enterprise, and so forth. Asset liquidity refers to the equally important facet of ability to buy or sell assets in their marketplace without material adverse impact on pricing arising only due to the occurrence of the transaction. This essentially means that the markets have to be deep enough, with an adequate number of players with adequate financial capacity, so that any desired trade can be executed successfully and in particular without causing a material impact on the pricing. Lack of adequate liquidity in asset markets would result in trades affected by inefficiencies in price discovery, wider bid–ask spreads, and higher volatility in prices causing greater uncertainty to the market participants. All of these would contribute to reducing the attractiveness of such illiquid markets to participants.
In the broader financial services sector, almost all the players and market participants are affected by both facets of liquidity—the funding and asset liquidity—the notable exceptions being the entities at both ends of the financial intermediation chain. The savers who supply capital find illiquid markets for their investments unattractive, as they are inefficient in trading and do not provide finer pricing. This affects the investors both during initial investment of their capital and during disposal of their investments to raise cash, whenever required. Similarly, the ultimate users of capital for business or personal needs—industrial corporates or individuals—are affected by illiquidity in markets, which crimps their ability to raise funds for any capital or current expenditure. In the rest of this chapter, we will analyse various aspects of liquidity and their impact on viable operations of financial services in terms of both funding liquidity and asset liquidity.
2. TRADITIONAL ROLE OF CAPITAL MARKETS IN PROVIDING LIQUIDITY TO FINANCIAL SYSTEMS
Capital markets play a crucial role in the sound and efficient functioning of a country’s financial system by being the primary provider of liquidity, a vital ingredient for sustainable growth and sound functioning of the financial system. The crucial role of capital markets in providing the essential element of liquidity to any financial system highlights the need for deeper and broader capital markets. The global financial crisis highlighted the critical need for a sound capital market infrastructure that would be capable of meeting the aggregate liquidity needs of a financial system. Capital market infrastructure in this respect refers to a comprehensive set of structural elements, including but not limited to products, players, and market infrastructure.
In general, capital markets refer to the platform that brings together the investors and issuers who are the suppliers and seekers of liquidity and all the enabling infrastructure elements required for effective functioning of that platform. There is ample evidence pointing to the adverse impact of weak or underdeveloped capital markets on the performance and growth capabilities of the financial systems or jurisdictions of which they form part.
The development of deep and liquid capital markets helps reduce reliance on bank financing and leads to greater diversification of the sources of funding for a variety of market participants, from nonbanking financial firms, corporate entities, sovereign, and subsovereign entities. Well-developed capital markets with appropriate elements of market infrastructure attract a wider set of investors and bring more investable resources to the market, by virtue of their ability to provide the best prices and efficient completion of trading processes. As a result, such markets provide higher levels of liquidity and contribute to the sound operation of the financial markets in their country, ultimately leading to a more efficient allocation of resources. For example, reliance on banks for funding may also result in currency and funding mismatches for projects with long gestation periods, which are particularly relevant for infrastructure financing.
Robust capital markets can provide the much-needed source of stability, particularly during periods of financial stress. Deeper and highly evolved capital markets are capable of ensuring liquidity under most scenarios of market stress, thereby enabling market participants and the financial system to continue to perform and carry out their business. Shallow or underdeveloped capital markets often witness bouts of poor liquidity and are unreliable in terms of enabling participants to complete their transactions or fulfil their needs efficiently.
While the mismatches mentioned above are manageable during periods of stable market operation, such mismatches may be aggravated during periods of instability in markets. Hence, there is a need for strengthening capital markets, medium- to long-term debt markets in this case, to provide alternative sources of funding to match the needs of investment projects and to mitigate potential mismatches. In the short-end of the maturity spectrum, the money markets are integral to the safe and sound operations of banks, in providing IFIs with the tools and avenues for managing any funding gaps and for investing their short-term surpluses. The development of capital markets is a challenging process and may take a considerable amount of time.
3. CAPITAL MARKETS—STRUCTURE AND ANALYSIS
A systematic analysis of the contribution of each of the structural elements of a capital market towards ensuring adequate liquidity will enable us to identify the critical success factors for ICMs and the required enhancements in ICMs.
3.1 Suppliers of Liquidity
In the classical context of capital markets, individuals and corporate entities that have investable surpluses bring liquidity to capital markets with their savings available for financing an investment need of some sort. Often, the investable surpluses from savers are brought to the capital markets by financial intermediaries of different kinds, who provide access to capital markets combined with advice on investment options as a service to their investor clients. In addition, the liquidity in capital markets is amplified by the actions of individuals or entities that participate in market activity for a variety of reasons, ranging from mere speculation to systematic exploitation of risk-free profit opportunities, for example, arbitrageurs in stock markets. The financial intermediaries that are referred to include banks, capital market brokers, sponsors of collective investment funds, or other such investment vehicles.
In a similar vein, investors with surpluses and financial intermediaries providing access to them supply liquidity to ICMs, in terms of both funding liquidity and asset liquidity. Investors in ICMs essentially include primary investors, who bring their investable surpluses in search of a stated risk-return trade-off, and financial intermediaries, who provide access to primary investors of different types and sizes. The financial intermediaries are Islamic banks, investment funds of different flavours, brokers who facilitate execution of investment transactions in Shari’ah-compliant securities, and Shari’ah-compliant asset managers who manage assets of investors on a fiduciary basis. All of these intermediaries play a crucial role in bringing liquidity from the primary investors onto Islamic capital markets.
Islamic banks perform intermediation in a manner very similar to that of conventional banks, though they differ in terms of the risk-return opportunities they present to their investors. Essentially, Islamic banks end up channelling a sizeable portion of investable savings from their customers onto Islamic capital markets to provide liquidity. Islamic banks contribute to the generation of funding liquidity as they channel investable savings from their customers and generate asset liquidity by participating in secondary-market activities to manage their investment portfolio or to facilitate their client’s trading.
Shari’ah-compliant brokers contribute to asset liquidity by providing access to Islamic capital markets and facilitate acquisition or sale of investments by Shari’ah-compliant investors. The presence of Shari’ah-compliant brokers contributes, though indirectly, to the generation of funding liquidity by giving the investors the confidence that there is adequate means and capabilities to sell and realise the value of their investments without significant transaction costs.
Islamic asset managers and Islamic fund sponsors facilitate the flow of investable surpluses to Islamic capital markets by providing suitable and reliable investment management services and products, including mutual funds. These asset managers do not guarantee the performance of the investments that they recommend to their clients, but they commit to providing fiduciary care and diligence in managing the assets of their customers, as well as leveraging their skills and expertise in identifying investment potential. In some cases, IFIs, particularly banks and brokers, also perform the role of market makers in Islamic capital markets, thereby contributing to the generation of liquidity.
3.2 Demand for Liquidity
The demand for liquidity arises from potential investors looking for liquid Shari’ah-compliant securities and various types of IFIs, who face the need to manage liquidity risk arising from their business operations. This also includes corporates from nonfinancial enterprises who are committed to carrying out their business in a Shari’ah-compliant manner and hence look for options to meet their liquidity needs from Shari’ah-compliant sources. However, in this chapter we are confining our focus primarily to the liquidity needs of Shari’ah-compliant financial institutions (IFIs). The liquidity demand from IFIs has increased due to the introduction of Basel III liquidity rules, which require all financial institutions, including IFIs, to maintain higher levels of liquidity.
Underdeveloped capital markets with poor capacity to provide liquidity to the financial system are often characterised by a narrow investor base and, more particularly, investors with similar risk-return profiles and investment horizons. Such conditions entail investors adopting buy-and-hold strategies with very limited secondary trading, which hampers development of liquidity.
3.3 Structural Factors Essential for Adequate Liquidity
Various segments of capital markets should ideally be endowed with appropriate levels of market depth and liquidity in order to effectively address the divergent liquidity needs of various types of financial institutions and industry participants. The liquidity needs are spread across a range of dimensions, maturity, product type, and size. But the most widely recognised dimension on which capital markets are segregated is the maturity spectrum, with the normal classification being short-, medium-, and long-term markets.
The level of liquidity in any capital market segment is directly dependent on the extent and nature of participation from issuers who demand liquidity and the investors who supply the liquidity for investment in those securities. To attract a wide range of investors and issuers to achieve strong liquidity, it is essential to ensure a robust regulatory framework and a fair price discovery process that builds trust and confidence among issuers and investors. The causes of inadequate growth in capital markets or in some specific segments are often diagnosed as including a relatively underdeveloped regulatory framework, inefficient market infrastructure, and absence of a wide range of instruments.
4. ROLE OF ISLAMIC CAPITAL MARKETS IN PROVIDING LIQUIDITY
The role of the wider capital markets in providing liquidity and funding support to conventional financial institutions of various types, the pivotal nature of that role, and the concomitant benefits to financial institutions in general are equally applicable to ICMs in relation to Shari’ah-compliant financial services. The rationale for deep and developed capital markets and the structural elements for driving liquidity as described above are very relevant to ICMs. Therefore, the foregoing discussion about capital markets in general sets the framework for describing the current state of ICMs and analysing their capabilities to provide liquidity to IFIs.
A well-developed ICM would offer several additional benefits for issuers, investors, and other market participants committed to the Shari’ah-compliant financial services sector:
- Reduce financing costs for borrowers and helps in more efficient allocation of savings in Islamic finance system.
- Bring a wider set of investment options to facilitate portfolio diversification and help match investment horizons for investors with long-term liabilities.
- Facilitate investment flows by enhancing investor confidence with transparency and market regulations.
- Help achieve improved pricing efficiency with robust disclosure requirements.
- Enable IFIs and other Shari’ah-compliant issuers to manage their risk exposures by providing access to risk management tools.
Most of the major Islamic finance markets are in emerging market countries expected to achieve sustainably high economic growth rates over the next few decades. This raises the need for greater local and foreign investments to fuel their high-growth economic engines and specifically to fund large-scale infrastructure projects. Consequently, the size and depth of ICMs in these emerging markets in particular, are expected to grow materially during this high-growth period in order to attract the required investments. In Gulf countries, the demand for capital or funding is supplemented by the demand for Shari’ah-compliant securities from investors whose investment outlays have been expanded by sustained high energy prices and resultant generation of investable surpluses over the past few years.
While the strength of the underlying economic need for growth of ICMs is encouraging, the current status of the ICMs leaves much to be desired in terms of their ability to support and facilitate the expected level of growth. The ICMs in many of the countries with a large Islamic finance potential are yet underdeveloped in terms of their size, depth, sophistication, and ultimately their appeal to investors and other market participants. Many of the structural elements of ICMs required to generate liquidity continue to be rudimentary and hence are scarcely liquid. This leads to inefficiencies in funding the Islamic finance sector in the normal course of business, and potential exposure to adverse effects of systemic risk during times of distress. As a result, these markets lag far behind the banking system and the equity market in their countries as a source of funding for economic growth.
Even in developed countries with well-developed capital markets, their ICM segments are yet in a relatively nascent stage and share many of the characteristics of ICMs in emerging markets. So, in general, the potential of ICMs to attract savings from investors looking for Shari’ah-compliant investments remains untapped in almost all the major economies, except in Malaysia. ICMs in general are characterised by a limited supply of quality instruments from issuers and an absence of benchmark-size issues, with small issues hampering the development of liquidity in the secondary markets.
The short-term segments of ICMs are relatively illiquid, primarily owing to the dearth of credible securities or investment products and the absence of effective market infrastructure. Although the lack of adequate market participants for both supply and demand for liquidity can be cited as a reason for the illiquidity, it is a derivative of the two primary reasons mentioned above. Any improvement in terms of products and market infrastructure will lead to increased numbers of market participants and drive liquidity. The short-term Islamic capital markets face a shortage of easy-to-trade investment securities with relatively low credit risk and stable though low returns. The relatively young stage of evolution of the Islamic finance sector, and a tendency to use conventional instruments for short-term markets, have resulted in this situation. The absence of the necessary market infrastructure in terms of trading platforms, reliable clearing and settlement systems, pricing benchmarks, and evolved industry practices, has further aggravated the illiquidity in the short end.
Illiquidity in the market for Shari’ah-compliant securities continues to pose major challenges for risk management by IFIs, in general. The particularly high levels of illiquidity in short-term money markets poses a challenge to robust liquidity risk management by IFIs. Availability of a liquid market in Shari’ah-compliant securities would allow Islamic banks with surplus liquidity to fund the Islamic banks with liquidity deficits, thereby maintaining an effective market required to promote stability in the system. With a poor supply of liquidity and low volumes in secondary market trading, the market continues to suffer from consequences of trapped liquidity pools, as seen in high transaction costs and pricing inefficiency. The instruments currently used as standard tools for managing short-term liquidity are characterised by structural deficiencies, which preclude wider acceptance as the market grows. These inadequacies result from their design and operational issues, including expensive trades in underlying commodities or metals and their high propensity to suffer operational risk losses.
The problems faced by IFIs due to weak liquidity supply from capital markets is compounded by the fact that in most countries with substantial Islamic finance activity, sovereign debt markets have not yet evolved to an adequate degree, for various reasons. Sovereign debt markets with low risk perception and easy tradability are traditionally seen as instruments that are most amenable to liquidity management purposes in the short-end of the maturity spectrum. The lack of liquidity in the secondary market for Shari’ah-compliant securities is largely due to the buy-and-hold investment strategy adopted by the majority of the investors participating in these markets. The majority of investors participating in current ICMs are essentially long-term investors looking for fixed returns over the long-term, which limits their motivation to participate in secondary market trading.
Issuers in developing markets, which tend to have ICM activity, are not big enough to go in for benchmark-size issues, and that has restricted secondary market liquidity in many ways. These include inability to attract market makers and unavailability of quality issues, both of which may encourage the investors to hold the securities until maturity.
Market infrastructure surrounding the trading of Shari’ah-compliant securities is also not sufficiently well developed to promote their liquidity. The trading systems are inadequate in many countries with material presence of IFIs and Shari’ah-compliant business. These markets are also often too inefficient to encourage market participants to actively trade Shari’ah-compliant securities. For example, some electronic trading platforms do not have a market-making facility, while others are not linked to the clearing and settlement system. In addition, the inefficient price discovery process in many Islamic capital markets makes it difficult for investors to trade Shari’ah-compliant securities. These market infrastructure issues are particularly acute in respect of “fixed-income-like” instruments such as sukuk in most of the countries.
Other factors that contribute to lower liquidity include a narrow investor base, low market transparency, and a lack of timely information on Shari’ah-compliant issues. Liquidity is not only a challenge faced by ICMs in their effective operations, but is an ongoing concern for their sustainable growth.
4.1 Specific Characteristics of the Islamic Finance Industry
The most significant idiosyncrasy of Islamic capital markets is the limitation on trading of debt obligations arising from Shari’ah issues. This limitation constrains the tradability of some sukuk structures in secondary markets, particularly those sukuk in the short-end of the maturity spectrum. Longer-term sukuk structures are usually structured to qualify for secondary market trading on a Shari’ah-compliant basis. Another characteristic peculiar to ICMs, which impacts the level of liquidity, is the need to cover Shari’ah-compliance issues as part of the disclosure requirements for the products.
The acceptance of short selling in Islamic capital markets is under doubt, which limits its role in driving trading liquidity. Innovation in developing Shari’ah-compliant structures to enable short selling for hedging purposes is required to achieve the contribution towards liquidity. This aspect is particularly relevant to improving asset liquidity levels in equity capital markets, which is essential for improved portfolio management and risk management by various participants in the Shari’ah-compliant financial services sector.
5. ENHANCEMENTS TO THE CRITICAL DIMENSIONS OF ICM TO IMPROVE ITS ABILITY TO PROVIDE LIQUIDITY
A detailed analysis of the structural components of capital markets and their ability to support growth and liquidity sets out the key dimensions to assess the ICMs and to identify the areas that need improvements. The primary developments required to improve ICMs in general (and specifically to improve their ability to provide liquidity) include, but are not limited to, a robust and wide suite of credible Shari’ah-compliant products, stronger market infrastructure, measures to attract a wider set of investors, steps to reduce uncertainty on market practices and instruments, and efforts to achieve a robust and reliable regulatory framework. It is worthwhile to emphasize here that these elements mutually reinforce their intended impact on improving the overall strength of ICMs. For example, measures to improve efficiency in market operations are also likely to contribute materially to attracting new, uninitiated investors from conventional market segments to ICMs. The International Organization of Securities Commissions (IOSCO), as part of its work on ICMs, has identified the key drivers for enhancing liquidity in ICMs as a wide range of products, lower transaction costs, development of professional expertise in markets, strong regulatory framework, consistent and predictable Shari’ah compliance, Shari’ah convergence across national markets, and investor education.
The following sections focus on elaborating the extent and nature of improvements required in respect of each of these issues.
6. PRODUCTS
The availability of a strong and wide range of Shari’ah-compliant products is a fundamental prerequisite for healthy growth and adequate levels of liquidity in Islamic capital markets. The introduction of a wide range of investment products and material benchmark-size issues from different categories of issuers will support the establishment of a viable and liquid secondary market in Shari’ah-compliant investments. It is also essential that the investment products are credible and reliable in terms of consistently delivering the risk-return profile they promise to the investors. To achieve this, it is essential to achieve a high level of standardisation, to implement regulatory standards requiring better disclosures, and to introduce measures to minimise uncertainty in legal and Shari’ah aspects. A wider range of products is also a significant attraction for new market participants, thus indirectly deepening market liquidity.
In this section, we try to assess the various key-product and business segments that create the demand for and supply of various products in Islamic capital markets, in terms of their ability to contribute to market liquidity.
6.1 Sukuk
Sukuk (the plural of sakk, meaning “certificate”) are financial instruments representing an interest in an underlying asset that can be designed using a range of different structures. In the case of “asset-backed” structures, the interest is a type of ownership interest, while for “asset-based” structures it consists of rights to cash flows from the underlying asset. Given the level of success enjoyed so far, sukuk as a product is best positioned to have the maximum impact on growth and generation of liquidity in ICMs.
To realise the potential of sukuk in driving growth in ICMs, a few key issues and risks need to be effectively addressed. In the past, Shari’ah compliance of some of the sukuk structures was put under doubt by fatawa from some Shari’ah scholars. Uncertainties of this kind around the performance of the investment products are not appreciated by investors and consequently lead to material squeezing of liquidity for the affected securities or class of securities. Sukuk structures are the most amenable for various types of issuers of varying credit quality to raise capital for their needs, particularly at medium- to long-term maturities. The initiation of sovereign borrowing programmes by many of the primary Islamic finance markets like Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) is a positive development in terms of widening the product range available to attract investable capital.
6.2 Infrastructure Financing
The importance of developing credible Islamic finance products in this segment is underlined by the need to attract investable resources to finance the rapacious demand from the infrastructure sector, given the rapid growth outlook for infrastructure in most of the emerging markets. This argument is particularly relevant to almost all the key Islamic finance markets, where infrastructure demand will continue to be driven by sharp growth in population and high levels of economic growth. More importantly, the risk-return profile and specific characteristics of infrastructure financing closely match that offered by the fundamental Islamic finance concepts. The emphasis on asset-backed or -based financing, risk-sharing, focus on equity or partnership modes, and absence of exposure to structural interest rate risk are the main concepts of Islamic finance, which endear it to infrastructure financing. The congruence in key concepts and the wider ideological emphasis on socially responsible investments makes infrastructure financing a suitable business opportunity for the Islamic finance sector. However, the share of Islamic finance in funding infrastructure projects in the past has been very low, particularly compared to the potential available. The reluctance of Islamic financial institutions of various kinds to participate in infrastructure financing deals is primarily caused by the paucity of credible products and Shari’ah-compliant market participants who will be interested in participating in such deals. These factors are accompanied by relatively under-developed market infrastructure elements in causing asset liquidity issues in secondary markets for those investments.
In a large majority of the structures, the future return flows can be securitised and traded at negotiable prices, as long as they are structured to represent the returns from physical assets backing them. The most appropriate form of Islamic financing for infrastructure projects is issuance of sukuk. The different types of sukuk that can be effectively used to finance infrastructure projects while contributing the overall liquidity of long-term segments of ICMs are asset-backed sukuk, which are issued against physical assets or their usufruct, and equity-based sukuk, which are based on profit- or output-sharing contracts. The latter may also be structured so as to be asset-backed, where the underlying assets might be, for example, the royalties from mineral or hydrocarbon extraction.
6.3 Asset-Backed by, or Asset-Based on, Mudarabah or Musharakah Contracts
Instruments are based on securitisation of Shari’ah-compliant contracts, such as mudarabah and musharakah partnerships. The underlying asset may be a business venture or an asset, such as an ijarah lease or a murabahah or salam receivable (note that in most jurisdictions the latter are not considered negotiable in secondary markets and so must be held to maturity; hence, they command no liquidity for secondary trading). Even in the case of negotiable instruments, the trading volumes are very thin and hence they do not lend themselves to effective liquidity management by IFIs.
6.4 Risk Management and Hedging Instruments
Shari’ah-compliant hedging instruments, used as part of the primary tool kit for risk management, should form a significant share of the activity in ICM, as in the case of conventional capital markets. Successful adoption of Shari’ah-compliant hedging instruments is likely to play a big part in driving liquidity in various segments of Islamic capital markets. The growth of these instruments implies a growing presence of market makers or dealers, which are the financial institutions producing these instruments. Such financial institutions would face the need to hedge the exposures they assumed while producing these instruments by seeking counterparties with opposite exposures, or by packaging the risks and selling them to an entity that can absorb such risks. Either of these approaches would result in additional liquidity to capital markets in general.
Islamic financing structures are seen by issuers as more complex and consequently more expensive to execute. Often, lack of depth in Islamic capital markets is cited as a reason for the relative distaste for sukuk among issuers. This apparent conundrum can be clarified with the systematic assessment of ICMs using the essential building blocks as outlined previously. A lack of reliable products that deliver the promised risk-return profile without any uncertainty in their performance is one of the fundamental issues facing Islamic capital markets. In the case of sukuk, the uncertainties associated with their tradability and liquidity have hampered their emergence as a successful benchmark financing structure and have consequently hindered their ability to drive liquidity growth in ICMs.
In addition, the questions surrounding the enforceability of Shari’ah-compliant contracts in jurisdictions that do not have supporting Shari’ah law also give rise to indifference among potential issuers and/or bankers. The primary uncertainty in this regard includes varying Shari’ah interpretations of scholars within and across national boundaries as well as over time. It is essential to work towards convergence of Shari’ah standards and interpretations to ensure reliable products for investors in Islamic capital markets across national jurisdictions.
Apart from idiosyncratic elements of each of these products, a steady stream of primary issues of products, sprinkled with adequate levels of benchmark size issues, is essential for achieving a deep and liquid secondary market. There is a need for sukuk and other types of Shari’ah-compliant investments of varying tenors from 3 months to 30 years, all of which can together form a benchmark yield curve, for issuers of a specific risk level. The developments in sovereign sukuk markets are encouraging in terms of providing the necessary elements to form a benchmark sovereign yield curve. In this regard, it is essential to understand the importance of other factors, like legal and regulatory frameworks, to attract adequate numbers of issuers, and a market infrastructure to be able to handle the resultant volumes.
7. PLAYERS
Islamic capital markets also suffer from inadequate depth and diversity of market participants. This is equally applicable to investors of various types who bring investable savings to the market and for intermediaries who are in the market, as part of performing various roles in the Islamic financial services industry. Given the emerging nature of the Islamic finance industry, the number and range of participants is limited in every segment of the ICMs. The issue is exacerbated by the early stage of development of the financial sector in most of the dominant Islamic finance markets, like those in Middle East.
The absence of a range of market participants with differing risk-return profiles is a material limitation on the attractiveness of ICMs as source of funding liquidity for issuers and projects, particularly those with unique risk-return profiles. ICMs lack a diverse set of market participants who are differentiated by the normal range of tenor in which they seek or deploy their funds. For example, the absence of adequate number of pension funds and family-takaful companies results in a reduced appetite for long-term financing instruments and consequently limits funding liquidity in long-term markets, which provide financing for infrastructure projects.
The issue is particularly worrying in the case of long-term capital markets and infrastructure financing. Liquidity in ICMs and specifically in equity and long-term segments is limited by an inadequate presence of institutional investors. The takaful industry and the Shari’ah-compliant asset management industry are yet in early stages of evolution and consequently do not command the capability and expertise to contribute to liquidity growth in ICMs. Takaful and pension funds, which are normally expected to generate liquidity at the long end of the maturity spectrum, are yet in the process of evolving, and hence in short supply, in most of the major Islamic finance markets.
Although Islamic banks and investment companies have proliferated, their ability to drive liquidity in their local markets is limited by their size and passive strategies for investment and risk management. Islamic brokerages and investment companies are limited to executing trades for their clients on an agency basis or trading for their own account. But, such firms are rarely involved in making a market for any Shari’ah-compliant investments by offering two-way quotes, which is an essential ingredient for higher asset liquidity in secondary markets.
It is important to communicate the various positive developments in the sphere of Islamic capital markets to potential investors and issuers, so as to attract them to participate in Islamic capital markets. Such an effort should emphasise the asset-based transactions, lack of speculative or risky trades, and rapid growth in capital available for Shari’ah-compliant investments.
The ability of various types of Islamic financial institutions to contribute to liquidity in ICMs is further hampered by the lack of skilled and experienced personnel who can develop and implement the active investment or risk management strategies that invariably result in accessing capital markets for execution of such strategies. The absence of an adequate number of skilled personnel also limits the capabilities of investment banking businesses in providing attractive Shari’ah-compliant structures for potential issuers, thereby limiting growth in liquidity. Most of the Islamic financial institutions are limited to performing passive buy-and-hold strategies for their investment portfolios, which crimps asset liquidity. This issue is particularly relevant for markets in short-term securities and fixed-income investments.
The contribution of market participants to driving liquidity growth is hampered in many significant Islamic markets by the absence of the government sector’s efforts to come to the market with innovative instruments for resource mobilisation. This would provide the market with a wider range of instruments with divergent risk-return profiles, attracting investors looking for such investments. The presence of the government sector not only helps the government at various levels of sovereign, quasi-sovereign, and municipal entities to raise resources for their investment needs, but also provides low-risk investments that can facilitate risk management for IFIs, particularly in the short end of the maturity spectrum.
There is a need to attract investors and issuers who are not mandated to be Shari’ah-compliant as part of efforts to deepen Islamic capital markets. The challenges involved in achieving this illustrate the interrelated nature of all the drivers for growth of liquidity in ICMs. It is difficult to attract market participants of all stripes as long as the markets are not deep and liquid, and most of these investors being new to Islamic finance would look for reliable investment products or securities without any uncertainty associated with the investment’s risk-return profile.
8. INFRASTRUCTURE
The different components of market infrastructure required to drive trading volumes and liquidity in various segments of Islamic capital markets include regulatory standards, dedicated market places, accounting standards, and standardisation in products and documentation. The most important development in this area relates to development of a viable secondary-market-trading platform, particularly for nonequity investment products. This will significantly improve the asset liquidity and enable Shari’ah-compliant investors to manage their liquidity profile as well as to implement their overall risk management strategies. The supporting infrastructure required for deepening ICMs includes efficient clearing and settlement system and price information providers.
An example of the kind of innovation required to drive asset liquidity within the confines of Shari’ah is the development of an Islamic alternative to stock borrowing and lending to facilitate regulated short selling in Malaysia. Innovative facilities like this in the ICMs are often necessary to continue to provide all relevant tools and products for market participants to manage their investments and risk on their portfolios. The alternative to stock borrowing and lending is made possible within the Shari’ah framework by rendering the gharar (uncertainty) element irrelevant. In respect of standard documentation, the International Islamic Financial Market (IIFM) and the International Securities Dealers’ Association (ISDA) are involved in an effort to create a master agreement for Shari’ah-compliant securities.
The enhancements required to drive efficiency gains in market operations should broadly include: smooth and reliable legal and regulatory framework for the issue of securities, reducing the time to market; and standardized documentation for the common set of products and functionalities in the market that facilitate accuracy and reliability in pricing. Issuance in securities markets typically involves authorisation by the issuer, documentation process (including prospectus review), registration or approval by the regulator, and offerings to the market, among other factors. This issuance process may prove to be challenging for many issuers, as they may be subject to an onerous and time-consuming issuance process, usually attributable to inefficiencies in the approval framework. For example, multiple authorities may be involved in the registration or approval of the issue, resulting in duplication of processes. These issues are compounded by inadequate proposals or issue documentation from issuers, and probable lack of adequate skills with the regulator. It is imperative, therefore, that the regulatory processes relating to new issues in ICMs are developed adequately to ensure that time to market is optimized, while ensuring compliance with regulations.
The measures aimed at a more robust market infrastructure should include measures to improve trading efficiency in terms of lower trading costs, reduced bid-offer spreads, ensuring availability of adequate market makers, and establishing reliable and accurate pricing benchmarks. A robust market infrastructure should also include various critical infrastructure entities essential for completing pre- and post-trade processes in an efficient manner.
An important enhancement target required is to ensure certainty and to facilitate clarity and understanding on the terms of the product and assurance that investors will be treated fairly. The key measures to achieve this enhancement should include strengthening legal, regulatory, and supervisory frameworks, robust disclosure standards in terms of their quality and timeliness, and an investor protection framework that infuses confidence in potential investor groups. To address the uncertainties surrounding the treatment of Shari’ah-compliant structures based on Shari’ah law and to enforce those contracts in a consistent manner, it is essential to establish a legal framework that protects the interests of all stakeholders in a predictable manner.
It is essential to ensure that the markets deliver reliability in price discovery, efficiency in terms of trade execution, and price transparency. In order to achieve the expected improvements cited above, it is not adequate to rest with establishing the relevant and necessary regulations. It is important to ensure that the improvements are actually felt by the investors in their market activities. This can only be achieved by effective implementation of regulatory standards and intensive risk-based surveillance and supervision of the markets. In addition, ancillary factors to be addressed to achieve improvements in widening the investor base include removal of regulatory obstacles, which impede the participation of some groups of investors in Islamic capital markets, and initiatives to reduce uncertainty in relevant tax rules. These improvements would make a big contribution to ensuring predictability in regulations and their implications for transactions.
9. MARKET SEGMENTS
Section 9 analyses the key market segments in Islamic capital markets in respect to their stage of evolution and the enhancement opportunities they present.
9.1 Short-Term Money Markets
One of the crucial lessons learnt from the financial crisis was the shattering of the myth that wholesale short-term funding from interbank markets is reliable. Currently, IFIs are reliant on wholesale markets to a great extent, particularly for their short-term funding needs, given the lack of adequate liquidity supply from capital markets in that segment. In fact, this observation is equally attributed to other segments of the ICM as well.
Short-term segments of ICM are fairly illiquid and have so far failed to serve the interests of the wider Islamic financial services industry in many countries. The critical aspects of short-term Islamic money markets that need to be strengthened to achieve the required level of liquidity include credible short-term Shari’ah-compliant securities and effective infrastructural components of the market. Improvements in these structural aspects of the market segment would attract and retain the interest of a wider section of market participants, both from investors and issuers, irrespective of their proclivity towards religious considerations.
This approach has been successfully employed in Malaysia, which has achieved a high level of success in creating and sustaining a short-term money market in Shari’ah-compliant securities. In Malaysia, the Islamic Inter-bank Money Market (IIMM) was introduced as an intermediary structured as a platform offering a range of short-term Shari’ah-compliant investment securities. This facilitated the strong growth of the Islamic banking sector in Malaysia by enabling such IFIs to fulfil the funding requirements effectively and efficiently. The IIMM platform included a range of Shari’ah-compliant instruments from mudarabah-based investment options and bonds, negotiable instruments of deposit, securities issued by Bank Negara Malaysia (the central bank) and Malaysian government, and funds acceptance under al wadiah contract and murabahah-based bills. The development and growth in activity of the IIMM has been possible due to the active involvement of the Malaysian government and BNM, which is also the lender of last resort. As seen in other segments of the Islamic financial services industry, Malaysia has been fairly innovative in leveraging the various Shari’ah-compliant contracts and the underlying Shari’ah principles to introduce new products and sustain a high level of liquidity in markets.
9.2 Long-Term Markets
The medium and long-term segments of ICMs are also characterised by the same deficiencies discussed above in the context of short-term ICMs. Although there had been a steady and growing stream of supply of Shari’ah-compliant securities in this segment over the past decade, the liquidity in the secondary markets has continued to be poor. This has limited the utility of the available Shari’ah-compliant securities in enabling IFIs to effectively manage the risks on their balance sheet. The risks faced by IFIs range from asset–liability mismatches, structural profit rate risk (if any), to credit risk exposures associated with investments on their balance sheet.
Poor liquidity in secondary markets also adversely affects the attractiveness of ICMs as a source for infrastructure financing, though the essential characteristics of Islamic finance make it eminently suitable for infrastructure financing. Given the emphasis on asset-backed or asset-based structures, risk sharing, and the preference for socially responsible investments in the Islamic finance sector, infrastructure financing offers appropriate Shari’ah-compliant investment opportunities. A variety of Islamic contracts are available for primary financing of an infrastructure project, ranging from istisna’a to murabahah, to provide debt funds for construction of the project. Equity funds are provided by way of musharakah or mudarabah contracts. In addition to these, sukuk of both asset-backed or -based and equity varieties can be used for raising funds for infrastructure financing.
As already noted, sukuk structures based on contracts used for debt financing (murabahah, salam) generally do not provide tradability in secondary markets for reasons of Shari’ah–non-compliance. Although sukuk based on other forms of contract issued to finance infrastructure projects can be traded in secondary markets, there is in fact very little appetite for doing so. Such sukuk are invariably held to maturity and attempts to sell them usually involve material discounts that affect the return proposition on the investment. Absence of deep and liquid markets proves to be a significant deterrent for wide use of sukuk in infrastructure financing, thereby failing to connect the suppliers of funds with those in need of funds. This exemplifies the failure of Islamic capital markets in one of their fundamental roles, and hence efforts to bring in liquidity should receive utmost attention in order to maintain the competitiveness of ICMs and to achieve growth. Having emphasized the importance of generating liquidity, it is fair to recognise the fact that generating liquidity in fixed-income markets, including conventional ones, is a tough challenge and has been successfully achieved in very few jurisdictions.
The trading liquidity of sukuk has also been adversely affected by uncertainty surrounding their Shari’ah compliance. The Shari’ah issues that have affected sukuk in the past were related to the guarantee of initial capital by originators, buy-back of assets underlying sukuk at predetermined selling price, and certain practices of smoothing returns to sukuk holders. So, measures to improve the asset liquidity of sukuks, particularly in secondary markets, are essential to achieve growth in ICMs and to enhance overall market liquidity. One of the suggested ways is to improve the attractiveness of sukuk to investors by including embedded options in sukuk, including a convertibility option.
10. CURRENT TRENDS AND WORK IN PROGRESS
In spite of the weak economic growth trends in most of the developed financial markets, inflationary pressures, elevated levels of sovereign risk, and heightened risk aversion among investors, ICMs are expected to witness sharp growth over the medium to long term. This accelerates the need to establish and implement the structural elements for a robust liquidity supply infrastructure to support the expected growth in Islamic finance activities.
In the short-term market, various key contributors to the growth of Islamic finance are already at work. An evolutionary trend in this area was triggered by the establishment of a high-level taskforce on liquidity management by the IFSB, which was mandated to develop a liquidity infrastructure to facilitate and offer liquidity solutions to IFIs with the objective of supporting their growth and enhancing their liquidity risk management. Successful work by this taskforce has led to the incorporation of the International Islamic Liquidity Corporation (IILM), an international institution dedicated to design, implement and operate an international liquidity management framework for IFIs.
The incorporation of the IILM in October 2010 represented a significant milestone in the development of supporting infrastructure for the global Islamic finance industry. The IILM is expected to play a crucial role in facilitating liquidity management, including for cross-border IFIs. The structure of IILM raises expectations of the effective fulfilment of its objectives, given the close involvement of a group of central banks in its operations. The current members of the IILM include 12 central banks and regulatory authorities, and two multilateral development institutions; membership is open to central banks, financial regulatory authorities, and relevant multilateral organisations.
The IILM is mandated to issue short-dated high-quality Shari’ah-compliant financial instruments in major reserve currencies on a regular basis, in a cost efficient manner. The IILM intends to establish a wide array of high-quality Shari’ah-compliant instruments as well as a platform to support the issue and trading of those instruments to address the challenges related to liquidity supply in Islamic capital markets and hence to facilitate liquidity management in IFIs.
Shari’ah-compliant instruments issued by the IILM are expected to merit a high credit rating, as they are supported by the credit strength of its shareholders. This should enlarge the pool of instruments that can qualify as collateral for collateralised short-term money market borrowing/lending and for central bank funding. The nature of constitution and the likely high credit quality is likely to enhance the acceptability of IILM’s securities for secondary market trading among IFIs within and across different jurisdictions. The IILM is also mandated to make a qualitative contribution to the development of ICMs and their ability to provide liquidity by providing a platform for interaction among its members regarding potential innovations and evolving practices in Islamic liquidity management.
The short-end of Islamic capital markets also saw a notable development in 2011, in the initiation of Islamic Interbank Offer Rate (IIBOR), which is expected to serve as a benchmark for pricing Islamic finance transactions. The benchmark will provide the reference for pegging the profit rates on transactions and is designed to be determined on the basis of bid-offers provided by a set of 12 large IFIs. The development of such a benchmark is very valuable for growth of the short-term segment in ICMs, given the difficulties and uncertainties faced by IFIs in pricing their transactions with benchmarks, which were seen as potentially Shari’ah–non-compliant.
Despite all the issues raised earlier in respect of long-term Shari’ah-compliant instruments, their supply continues to grow gradually. In particular, the issuances of sukuk from non-Muslim countries like Germany, China, and Japan are attracting rising interest. Quasi-sovereign entities from nontraditional Islamic markets have realised the benefits of accessing ICMs to raise long-term funds. Over the recent past, the asset-backed nature of certain sukuk and the relative credit quality of the large corporates issuing sukuk, particularly those in GCC countries, have attracted investors in a climate of uncertain credit quality in conventional fixed-income markets. The increasing product supply is complemented by a gradually widening range of investors from insurance companies, pension funds, and long-term savings organisations. The geopolitical trends observed in 2011 in the Middle East/North Africa (MENA) region spurred the policy makers in that region to implement strategies aimed at facilitating long-term savings and ensuring long-term risk cover for their constituents. These strategies have already resulted in initiatives like National Bonds Corporation in the United Arab Emirates, government pension funds for social security measures, and promoting private pension schemes for the welfare of the public. In addition, the improving trend in the quality of risk management employed by financial institutions in major Islamic finance markets, notably insurers, has led to their increasing participation in long-term Islamic capital markets. These trends, on their own and in combination with other initiatives, have contributed immensely to the gradual enhancement of the Islamic capital markets’ capability to provide all aspects of liquidity to the wider Islamic financial system.