The growing significance of Islamic finance has brought into sharp focus the similarities and the potential for convergence with respect to market practices between conventional modes of financing and the market for Shariah-compliant instruments. Can the market for Islamic Finance and instruments maintain its momentum without emulating the more standardised approach associated with the conventional market? But might that convergence do violence to some of the fundamental principles of Islamic finance?
The growth of Islamic capital market securities (Sukuk) has been a particularly notable market development by any measure; and it is in relation to the Sukuk market that we are seeing a particularly lively debate on the pros and cons of standardisation and harmonisation. The growth of the Sukuk market has been made possible by the compatibility of Shariah law with traditional common law tenets. Although investors will need to be satisfied that a particular transaction is compatible with Shariah law precepts, the Sukuk documentation itself will be governed by Western law, typically the laws of England; the remedies available to any party, and the situs for dispute resolution will therefore depend on traditional legal procedures. Expressed another way, the enforceability of terms and conditions depends on the governing law of an Islamic finance contract; there is no provision for the choice or application of a non-national system of law, such as the Shariah. The scholars opinion on the compatibility of the transaction with Shariah law will not typically be incorporated into the underlying documentation.
The conventional international bond market has been characterised by an inexorable process of standardisation and harmonisation of market practices. This process became necessary due to the increasingly rapid time frame within which conventional bond issuance takes place. The speed of the process was given a major impetus by the use of global debt issuance programmes starting in the mid 1980s. The virtue of such issuance in “shelf” format was both speed and the accessibility of base documentation to investors and underwriters. Debt programmes are now an established feature of the international capital market.
In looking at the role that participants in today’s Islamic capital markets can play in developing well functioning market practices, it may be instructive to look at what happened in the Eurobond market in the mid 1980s. This was a period when the fabric of the Eurobond market was under threat. There was a lack of discipline among underwriters: new issues were sold at deeply discounted prices as underwriters competed to unload their unsold positions. Few banks committed adequate capital to the secondary trading of bonds. The cult of innovation was strong, but frequently, as in more recent times, the most innovative instruments were the ones that left investors nursing the biggest losses. There was no standard Eurobond documentation. European corporations barely raised any funds in the debt capital markets; reflecting concerns about disclosure requirements, a lack of credit research and the limited availability of ratings.
Senior industry figures recognised the need for a collective initiative to establish a trade association; one which could provide guidance to its members in the interest of creating a more stable and predictable setting within which issuers, investors and underwriters might operate. This resulted in the creation of the International Primary Market Association (IPMA) in 1984. From the start, the IPMA relied on its members for the drafting of its recommendations, which acted as a code of conduct and source of standard documentation for the Eurobond market. IPMA’s recommendation crystallised the experience of the leading market participants, and promoted good market practices. From the start emphasis was placed on the issue of investor protection, with emphasis on the importance of the underwriters responsibility for carrying out “due diligence”. Due diligence is the process by which underwriters satisfy themselves that a borrowers representations as to its financial condition are accurate. Due diligence came to the Eurobond market initially through the global medium term note programmes which American banks dominated in these early years, bringing well established practices from the United States. The ability to introduce well-established features from other markets remains a characteristic of the international capital market.
Over time the IPMA played an increasing important role in acting as a conduit between underwriters and issuers. Issues arise where a single firm may not wish to jeopardise its relationship with an issuer by taking an opposing viewpoint on a particular aspect of market practice. For example, a leading US issuer wanted to include a special clause in its bond documentation; this clause would give it the option to cancel any bond issue after launch if any related swap transaction had failed for any reason. This option could have operated against the interest of any investor in the bond. No single underwriting firm was able to persuade the issuer not to adopt this clause. However, IPMA was able to do so, acting on behalf of the industry as a whole.
Would the Sukuk market benefit from a similar process of standardisation and harmonisation? And if so, how might it be achieved? The conventional bond market has clearly benefited from the contribution of trade associations such as the IPMA and its successor body, the International Capital Market Association (ICMA). Would the Islamic capital market benefit from the existence of a similar organisation, able to exercise some degree of guidance to market participants, and provide a forum for engagement between market participants and the industry’s standard setting bodies? And could the establishment of such a self-regulatory organisation be reconciled with the mandate of the existing standard setters?
Generally speaking host governments have not seen it as their role to promote standardisation in Islamic finance. Take the example of the United Kingdom. The United Kingdom has taken a number of steps to position itself as the global partner of choice for the provision of Islamic financial services, including the development of strong partnerships with other centres of Islamic finance. The U.K. Financial Services Authority (FSA) has expressed its support for the development of common standards by existing organisations such as the IFSB and AAOIFI. There is a strong awareness among these organisations that there remains a key practical consideration to address in the Islamic finance market, namely that Shariah law will continue to be interpreted differently across different areas and cultures. A lack of certainty remains as to whether a product developed in one jurisdiction may be Shariah compliant in other jurisdictions. This reality has heightened the importance of recent deliberations between AAOIFI Shariah scholars and market participants. In recent months scholars have expressed their concerns in relation to the Shariah compatibility of “commodity murabaha” and the fixed price repurchase provisions in “mudaraba” and “musharaka” transactions; in addition there is a greater focus on the precise title and repurchase provision in sukuk al-ijarah transactions.
There remains a strong onus on leading market participants to ensure that their, or more precisely their Shariah scholars, reading of Shariah law is concordant with local beliefs. But there is awareness in the Islamic finance world that there are a limited number of qualified religious scholars available for instruction. Is it possible that in areas where the industry’s expansion is particularly rapid, that the Malaysian model be adopted, where a single national Shariah board is overseen by the government rather than individual banks?
Returning to the matter of Sukuk, this instrument is well accepted by a majority of scholars as reconciling the concept of securitisation with the principles of Shariah law. In a typical Ijarah Sukuk transaction, a Special Purpose Vehicle (SPV) holds title to the assets, which are leased back to the originator in return for rental payments on the Sukuk. The majority of global Sukuk have been governed by English law. The UK Government’s declared interest in the idea of wholesale Sukuk issuance has attracted significant interest. The UK Government has shown its desire to create a level tax and regulatory playing field between conventional and Islamic finance. In terms of taxation of Islamic financing the UK Government’s primary aim has been to remove uncertainty in tax legislation, while applying ordinary tax rules where possible. The Pre Budget Report in November 2008 detailed the Government’s commitment to address remaining issues relating to stamp duty and capital gains tax on Sukuk (aka “alternative finance investment bonds”).
A number of sovereign governments have been keen to promote the development of Islamic capital markets within their jurisdictions. Malaysia is a notable example of a country which has championed the development of an indigenous Sukuk market. It is estimated that Malaysia accounts for about two-thirds of the global Sukuk market in terms of outstanding issuance. The growth of the Malaysian Sukuk market has been made possible by market infrastructure development but also by specific actions in relation to the regulatory framework. The Kingdom of Saudi Arabia has also given an impetus to the development of an Islamic capital market without creating a specific regulatory regime for Shariah compliant financing instruments. So we see similarities here in the United Kingdom where the approach is analogous, with a focus on the elimination of legal or regulatory barriers to the development of Islamic finance but not on the taking measures that would tilt the playing field in either one direction or the other.
The existence of different opinions, either within or across national borders on the permissibility of specific financial instruments, is a reality that confronts any attempt to establish commonly accepted standards for products and practices in Islamic capital markets. The enthusiasm of non-Muslim investors for Sukuk investments adds another dimension. Conventional investors place a high value on predictability and will be particularly concerned if a modification of a particular interpretation of the Shariah discourages Muslim investors from holding a particular security, resulting in downward price pressure. These factors reinforce the imperative for the industry to standardise products and practices to the fullest extent possible. A higher level of standardisation would reduce transaction costs, raise documentation standards and improve the transparency and overall level of confidence in Islamic financial instruments. In the conventional Eurobond market, a more standardised approach has raised the level of co-operation and mutual understanding between market participants and the quality of dialogue between issuers, investors and underwriters.
There are three recognised international Islamic standard setting bodies. In some jurisdictions market participants are required to observe the standards adopted by the standard setting body, which is recognised in that jurisdiction, most notably in the case of AAOIFI.
The AAOIFI was established in 1990 and is registered and located in Bahrain. As an independent international organisation, AAOIFI is supported by institutional members (155 members from 40 countries) including central banks, Islamic financial institutions, and other participants from the international Islamic banking and finance industry, worldwide, AAOIFI’s standards are now adopted in Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria. AAOIFI’s standards currently cover: accounting (using international financial reporting standards as the basis); auditing; corporate governance; capital adequacy and ethics. Future standards will include corporate social responsibility and presentation and disclosure.
The Islamic Financial Services Board (IFSB) based in Malaysia, was established in 2002 and currently has more than 150 members, including regulatory and supervisory authorities, the World Bank, the IMF, the Bank of International Settlements, the Islamic Development Bank and the Asian Development Bank. IFSB has issued five standards and guiding principles for the Islamic financial services industry, focusing on risk management, capital adequacy and corporate governance, supervisory review processes and transparency, and market discipline.
The International Islamic Financial Market (IIFM) was founded with the collective efforts of the central banks and monetary agencies of Bahrain, Brunei, Indonesia, Malaysia, Sudan and the Islamic Development Bank based in Saudi Arabia, as an infrastructure institution with the mandate to take part in the establishment, development, self-regulation and promotion of Islamic capital and money markets.
The Islamic Development Bank, due to its unique position in the Islamic finance arena, is also able to exert significant influence in market development. In 2005 the Islamic Development Bank and the IFSB initiated a 10-year master plan for the markets. The launch of this master plan coincided with efforts to re-invigorate work of the IIFM on standardisation and product innovation aspects of Islamic fiancé, including a proposal by IIFM for a “Shariah supervisory board with universal acceptability in the global market”. The IIFM also launched a formal collaboration agreement with the ICMA on the development of a set of common standards for the market in Islamic bonds. A memorandum of understanding between the IIFM and the ICMA set out some clear objectives, including the development of primary and secondary market practices for Sukuk, an Islamic repo-type agreement based on the ICMA global master repurchase agreement and a trade matching and reporting system for Islamic finance instruments.
Such joint efforts will contribute to increasing the market acceptance of Shariah compliant products. As confidence in the sector increases, the industry will expand its presence and develop more products; as more products are offered and more trust is placed in them, more are taken up, creating a virtuous circle.
As the world’s leading financial centre, the City of London is well placed to act as a catalyst in the further development of Islamic capital markets. The FSA’s paper “Islamic Finance in the UK: Regulation and challenges” provides a concise assessment of the challenges and opportunities facing the Islamic finance industry. The United Kingdom has a strong Islamic finance educational and training proposition with offerings such as the Securities and Investment Institute Islamic Finance qualification. Durham University and the Cass Business School are taking the lead in improving skills and forging links with counterparts in the Muslim world. The UK based Institute for Islamic Banking and Insurance delivers training, sets qualifications and works towards the harmonisation of standards and the interpretation of Shariah principles. A recent Standard & Poors study concluded that London “has the capacity to become a hub for Shariah compliant financial flows that seek recycling in Europe”.
In conclusion we can see that governments need to ensure a level playing field for Islamic financial products within their existing legal framework, just as the UK Government is doing in terms of tax law and the FSA in terms of prudential supervision. But a place remains for self-regulation as exemplified by the co-operation between the IIFM and bodies such as ICMA or the International Swaps and Derivatives Association (ISDA) as just one example in the Islamic financial market. Thoughtful self-regulation still offers the best chance for effective market development. Good practices should be allowed to develop naturally before their use becomes standardised. Information exchange in the Islamic financial market should be encouraged, through publications, educational courses and mutual co-operation. At the end of the day there will be opportunities for the Islamic and conventional finance to reinforce each other; particularly in areas such as risk management and corporate governance.
The author would like to express his appreciation to Dr. Habib Ahmed, Sharjah Chair in Islamic Law & Finance, Institute of Middle Eastern & Islamic Studies, Durham University for his review of this article and helpful comments.
About the Author
Robert Gray joined HSBC in May 1994 as Chairman of HSBC Markets Limited, with particular responsibility for developing HSBC’s capital markets capabilities worldwide. He was appointed Vice Chairman, Client Development of HSBC Investment Bank plc in September 1999, and to his current position in March 2001.
Prior to joining HSBC, he was head of J P Morgan’s capital markets activities in Europe. Previously he was President and Tokyo branch manager of J P Morgan Securities Asia Ltd. Robert also headed J P Morgan’s worldwide loan syndication group and was later responsible for their eurobond underwriting business.
He is Vice Chairman and Chairman of the Regulatory Policy Committee of the International Capital Market Association and a former Chairman of the International Primary Market Association, a predecessor body. In addition, he serves as Chairman of HSBC Saudi Arabia Limited and as a Board Member of British Arab Commercial Bank and HSBC Bank Egypt. Robert graduated from St John’s College, University of Cambridge with an Honours degree in History.
