Successful innovation efforts focus on supporting sustainability initiatives and uplifting marginalized communities
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Islamic finance, an industry known for its distinctive fusion of ethical principles and financial services, is witnessing a significant evolution, particularly in the realm of treasury and investment products. While traditional structures like Sukuk continue to dominate, successful innovation efforts have also focused on supporting sustainability initiatives and uplifting marginalized communities. However, the market is not without its challenges. The very principles that define Islamic finance also impose unique constraints, particularly in terms of liquidity management.
Traditional Islamic financial instruments often lack the flexibility and immediacy offered by their conventional counterparts. This limitation poses a significant challenge, especially in a rapidly evolving global financial landscape where agility and responsiveness are crucial. As Islamic finance evolves, technology holds the key to unlocking the full potential of Islamic treasury products and shaping a more robust and efficient financial ecosystem for the global economy. A focus on fostering a more integrated Islamic interbank market will be key to future success and growth.
Improving access to liquidity
While the Islamic finance market currently inhabits 80 countries and is predicted to reach $4.94 trillion in value by 2025, growth could be limited by a number of factors. Continuing double digit growth would be dependent on addressing some critical issues, including improving access to liquidity. With strict prohibitions against interest-earning (riba) instruments, Islamic banks have fewer Shariah-compliant alternatives than traditional banks to manage liquidity.
Currently available treasury products take longer to mature and trade at lower volumes, making them less attractive to investors seeking quick access to cash. With fewer participants buying and selling, banks may also find it difficult to settle a transaction quickly and at a fair price.
To ensure liquidity, Islamic banks in Western countries will eventually need to move from the ‘lone wolf’ approach to an integrative collaborative environment. If a big bank in one region cannot fund their operations due to lack of liquidity in their bespoke Islamic finance structures, offering Shariah-compliant instruments to banks with surpluses can support liquidity requirements, while also balancing the ecosystem across Islamic banking.
Seizing market opportunities in derivatives
Many Sharia scholars believe derivatives do not belong in Islamic banking as an asset. And so, the penetration of conventional derivative structures in the market remains low. Fitch Ratings reported that over 30% of Islamic banks did not use derivatives in 2022. However, most Islamic banks in the GCC, Malaysia, and Turkey use Islamic derivative hedging structures, such as profit-rate swaps, forward foreign-exchange contracts, cross-currency swaps, forward-rate agreements, and options.
Jigar Dedhia, Senior Manager, Treasury and Capital Markets, Middle East and Africa, Finastra
The Islamic derivatives market is characterized by cautious innovation. New structures are being explored to ensure compliance with principles like risk-sharing and underlying asset ownership. One study suggests that adapting traditional forward contracts to fit the muwaada concept – which means bilateral promises, i.e. two parties performing two unilateral promises on the same subject – is a potential solution, though scholars remain divided. Additionally, Sukuk Ijarah, with embedded options or warrants have been proposed, allowing investors to back underlying assets without breaching the prohibition on interest.
Innovation, coupled with a growing middle class in Muslim-majority countries, has led some to believe that derivatives in Islamic finance are on the rise. As the market continues to mature, it is expected to attract a broader range of investors seeking ethical and risk-hedging instruments that align with Islamic values.
Collaboration also has the power to expand Islamic finance through the development of new Shariah-compliant finance instruments specifically designed for liquidity management. Cooperation across regions leads to a larger pool of capital and innovation, making it easier to create new financing structures with shorter maturities that will trade at higher volumes.
Technology, and APIs in particular, can facilitate this level of collaboration by uniting banks needing liquidity with those holding excess funds and identifying opportunities in real-time. Simultaneously, straight through processing (STP) facilitates secure and swift electronic document exchange between banks, brokers and clients.
However, Deloitte reports that most traditional banks rely on outdated technology to run the treasury, leading to redundant data reconciliations and multiple intermediaries. The need for Sharia compliance within Islamic Finance adds an additional layer of complexity in light of the same technology deficiencies.
For one thing, the disconnect between treasury workflows impacts servicing of treasury products. Pricing, for instance, requires accurate and up-to-date data. When Islamic banks are required to gather information manually — a time-consuming task — treasury departments run the risk of operating with outdated pricing structures. Conversely, automating the process results in real-time insights that lead to faster and more accurate decision-making. This holds true whether the bank is servicing clients or hedging risk.
Automation to minimize risk
STP can also facilitate risk management in other ways. Achieving streamlined and more accurate workflows begins by automating verification of key details up front, such as commodity type, quantity, and pricing. With STP, compliance checks can be built into the process to more accurately and efficiently ensure adherence with Sharia principles. However, the lack of global standardization across regulations and product structures can reduce the effectiveness of some technology implementations.
While individual banks will realize the added benefits of STP, regional differences in governance and product structures can inhibit banks’ efforts to raise capital across borders. Since STP relies on pre-defined data fields and mapping to specific regulations, regional variations can impede electronic data flow across a global financial system. It may also utilize conditional logic to make decisions based on specific criteria, such as those that define compliance with Shariah principles.
Variations in regulations make it more difficult to automate the process effectively in an interbank environment. While leading technology providers are adept at building workarounds, it is necessary to standardize or harmonize the rules, laws, approaches, and product structures within Islamic banking to facilitate increased digitalization and compel growth across the sector.
Embracing digitalization and standardization
To fully harness the benefits of digitalization, a concerted effort towards harmonizing Islamic financial laws and standards is essential. This will not only facilitate smoother interbank transactions and cross-border capital flows but also expand the reach of Islamic finance to underserved regions, such as Africa. By embracing digitalization and standardization, the Islamic finance industry can achieve sustainable growth, better serve its ethical principles, and contribute more effectively to the global economy.
The writer is Senior Manager, Treasury and Capital Markets, Middle East and Africa, Finastra
