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Islamic finance needs its own efficient price indicators

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Points of Essence:

  • The author suggested an Islamic reference price indicator for Islamic financial instruments and securities. The heavy reliance on  the prevailing interest based benchmarks i.e the London Interbank Offered Rates (LIBORs), will only implicate the Islamic securities from any movements in global interest rates.

Azrul Azwar Ahmad Tajudin, senior economist at Bank Islam , the second-biggest Islamic bank in Malaysia by assets, considers the need for an efficient price indicator for Islamic finance instruments.

KUALA LUMPUR, Oct 14: Sharia compliant assets have emerged as a viable alternative asset class as part of the strategy to diversify portfolios of investors.  The outperformance of a number of global Islamic indexes in the medium-to-long term should encourage investors to consider allocating a portion of their portfolios to Islamic investment vehicles. To conform to sharia requirements, Islamic products will have to avoid elements of riba (usury), gharar (ambiguity/uncertainty/ misinformation or deceit/fraud), maisir (gambling) and zulm (oppression), among others. Although the obligation to eliminate riba may result in complex structures for Islamic financial instruments, I believe the prohibition of other elements as mentioned above in Islamic contracts and in strict adherence to sharia rules and principles, should help assuage many investor concerns.

Whatever it is, a product structuring or innovation exercise should comply with sharia requirements in substance and in spirit.  In the absence of reference price indicators specific for Islamic finance, the Islamic financial services industry still relies heavily on interest rate-based benchmarks such as the London Interbank Offered Rates (LIBORs).  Without a viable sharia compliant alternative, the industry will still have to use these quoted market rates as a basis to price Islamic financial instruments and securities. As such, it’s a fallacy to think that movements in global interest rates will not have any implications for Islamic securities although the impact may be limited to those that are pegged to observed interest rates, especially LIBORs.

On the other side of the coin, the use of common global benchmarks for both Islamic finance and conventional finance could help facilitate the integration of Islamic finance into the global financial system.

Nonetheless, there is an urgent need to initiate the introduction of an alternative efficient price indicator for Islamic finance instruments to reduce reliance on the prevailing interest rate-based benchmarks. For a start, we may perhaps consider the actual rate of rental of Ijarah-based instruments with property as their underlying asset, which fluctuates according to the market supply and demand as a benchmark for pricing purposes.  Market liquidity can be defined as the ability to transact over a relatively short period without exerting material impact on prices.

Since market liquidity is closely related to investor confidence and investor creditworthiness, securities with high market liquidity generally command low risk premiums as investors are confident in their ability to perform market transactions quickly while risks are quantifiable.  Rational investors would prefer securities with excellent market liquidity, which should enable them to exit the market easily, in particular during times of market turbulence.

Market liquidity, or the lack of it, for Islamic financial markets in the majority of countries, remains one of the thorny issues dogging Islamic Finance as there appears to be more willing buyers than sellers. It reflects the tendency among investors to hold Islamic financial instruments or securities until maturity given their limited supply, especially of good-quality ones. (RTRS) Given the benefits of greater market liquidity for securities in general, such as more efficient price discovery process and effective market transactions, the Islamic finance industry will need to step up efforts to strengthen the depth and breadth of the secondary markets for Sukuk and Islamic Treasury products.

By Azrul Azwar Ahmad Tajudin



Written by Suapi Shaffaii

October 15, 2008 at 10:38 pm

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