Special keynote address by

YBhg Tan Sri Zarinah Anwar
Chairman, Securities Commission Malaysia

2009 London Sukuk Summit,
3 July 2009


Innovating for the future: Challenges for Islamic capital markets


Two decades ago, the Shell Group in Malaysia was looking for a more creative way to meet its funding needs for a large project, and approached the country’s only Islamic financial institution then to explore possibilities. Islamic financing, based on the concept of participation and deferred payment sales, and predicated on profits rather than interest, was new to Shell then, and indeed to the world. The structuring team faced a daunting task, dealing with a vast number of issues, involving, then unfamiliar concepts. As a young lawyer in Shell at that time, working on that project, I remember well the extreme challenges and complications of structuring the legal documentations for which no precedent existed. We were truly sailing in uncharted waters. Little did we realise that what we were doing was breaking new ground in an instrument that would grow to become a significant global asset class over the next 20 years.


Ladies and gentlemen, it is a great pleasure for me to be with you here this morning. Since those pioneering days, Islamic finance is now for all intents and purposes viewed as part of the mainstream of global finance. This “mainstreaming” owes much, I believe, to the global development of the sukuk market. Malaysia’s own experience serves to illustrate this well. The Shell sukuk I just described was a milestone in many respects: it was the first sukuk to be issued in ringgit; it was the first ringgit sukuk to be issued by a multinational company; and importantly, it jump-started the Malaysian Islamic capital market.1


Previously, Islamic finance in Malaysia had been synonymous with banking; the advent of sukuk brought Islamic finance firmly into the realm of capital markets, enabling users to more effectively manage balance-sheet risks, diversify investments, lower the cost of funding and maintain capital adequacy through financial practices that comply with Shariah. As a result, what we have today is truly Islamic finance, in the broadest sense of the word.


The same, I believe, applies globally. There is now a broader geographical spread of issuers, ranging from corporates to multilateral agencies to governments.2 A similar pattern has emerged among investors3 where, encouragingly, non-Muslim investors typically have taken up a large proportion of issues.4 Servicing these users are an increasing number of providers operating out of various global centres of expertise, including London, Kuala Lumpur and Dubai, and potentially Tokyo, Hong Kong, Paris and Singapore. And their activities are now being guided by a number of global regulatory framework driven by international bodies like the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board.


Importantly, these developments have come with a raft of innovation that has opened up possibilities, allowing a wide range of financial needs to be met in compliance with Shariah. Taking Malaysia as an example, sukuk has been instrumental in financing, among other things, major national infrastructure and utilities, including the North-South Expressway, which links all major cities on the west coast of Peninsular Malaysia, and virtually the whole of the country’s mobile telecommunications network.

Sukuk has also facilitated balance sheet management of companies and banks through the securitisation of properties and mortgages.


Indeed if we think of innovation generally as the successful introduction of something new and useful, then perhaps the most important innovation in Islamic finance that we have seen recently is undoubtedly sukuk itself. In sukuk we have something that provides the flexibility of cash-flow financing structures with participation offered through equity; strengthens the link between investments and real assets; and addresses the ethical considerations underscored by Shariah.


But what has become apparent is that financial innovationincluding that which relates to Shariah-based financeis now facing a series of challenges arising largely from the credit crunch and financial climate we have found ourselves in.5 Risk aversion, although down from levels experienced at the height of the crisis, remains significantly higher than in the past. Unsurprisingly this has reduced the appetite for the more innovative forms of finance. On the supply side, product development has taken a back seat while banks and other financial institutions continue to focus on asset quality. Lastly, products themselves are undergoing much heavier scrutiny. In the Islamic finance space, it is not just the more exotic varieties of instruments that are being reassessed; scholars have been casting a fresh eye on more common structures for compliance with Shariah principles. Regulatory changes over conventional instruments could also impact on Islamic markets.6

Restoring faith in finance


Given these challenges, then, how much scope is there for future innovation in Islamic finance? I must say there is plenty. While Shariah principles have been with us for nearly 1500 years, modern Shariah-based finance has been in existence for only four decades. It is still a young discipline and one for which demand from financial institutions, insurance companies and pension funds across the Muslim and non-Muslim world will continue to grow.

But recent events have clearly shown us that in innovating for the future, Shariah-based finance needs to pay particular attention to three areas.


The first of these, concerns consumer interest. Users of financial products and services, whether conventional or Islamic, must be assured that the same regulatory principles apply to them. Malaysia emphasises a common regulatory approach for both Islamic and conventional products, based on the International Organisation of Securities Commissions’ objectives and principles of regulation.7 Indeed, an IOSCO task force chaired by the Securities Commission Malaysia in 2004 took the view that Islamic capital market activities were consistent with the objectives and principles of IOSCO. A 2008 working group conducted a deeper study and reaffirmed this, albeit recognising the need for specific provisions in some areas to ensure conformity with Shariah principles.


The second area that Shariah-based innovation must focus on is acceptability. We must make a greater effort to achieve clarity and consistency in pronouncing what is and what is not Shariah-compliant. Otherwise, we may breed scepticism about Islamic finance and ultimately this can jeopardise the ability of Shariah-based financing to meet the real needs of the market. We need to work more closely together to foster greater harmonisation in our approaches. It is a good sign therefore that Shariah scholars from different jurisdictions have been interacting more closely with each other to deepen their understanding of respective pronouncements. Malaysia and other Muslim countries as well as international Islamic institutions such as the IFSB and AAOIFI, have, and will continue to provide much needed platforms for regular high level intellectual discourse in this endeavour.8


While we work towards harmonisation in areas of mutual acceptance, we also need an effective way of managing differences. In my view a pragmatic, progressive and promising way forward is one that recognises these differences provided the supporting explanations and reasoning are made transparent. This will allow the richness of the Shariah to be fully explored for the benefit of the Ummah. Arguably this is consistent with the disclosure based approach to regulation which is premised on the important principle that issuers provide proper disclosure so that consumers are fully informed about the structures and the Shariah principles being adopted. Of course undeniably there are issues concerning reporting and accounting, as well as disclosure and transparency, that are still to be resolved.


In the case of financial reporting and accounting, although there is a call for a set of Islamic accounting standards to address unique aspects of Islamic finance, the view of Malaysia’s national Shariah advisors is that generally-accepted accounting principles are not in conflict with Shariah. As for disclosure and transparency, this still differs significantly across jurisdictions and types of products. For instance, while Malaysia’s sukuk guidelines require full disclosure over the use of proceeds, this is not common practice. As Islamic finance becomes more global, more frequent and intensive dialogues and engagements would go a long way in meeting the needs of Islamic investors.


The third area on which Shariah-based innovation should focus, relates to cost-competitiveness and efficiency. As key players in setting the development agenda for Islamic finance, we must not forget the importance of quality, cost-competitiveness and efficiency. At the end of the day, consumers will demand these of us. The long-term growth of Islamic finance therefore depends on how far we can address the needs of business (and business-minded) people on top of being a platform for meeting compliance with Shariah in practising finance. In this regard, the two important factors that promote cost-competitiveness and efficiency, in my view, are infrastructure and capacity. Allow me first to address infrastructure, by which I mean the frameworks and institutions that govern and support financial activity.


Innovation needs the support and involvement of governments and regulators in creating an enabling environmentwitness the recent announcements by authorities in London, Paris, Singapore, Tokyo, Korea and Hong Kong to name just a few. Malaysia’s growth has been driven by the government’s strong commitment since the 1980s to building and sustaining a fully-fledged system of Islamic finance; this was taken to the next level more recently through the establishment of the Malaysian International Islamic Financial Centre. Through the provision of a facilitative legal, accounting and tax framework, we have tried to achieve a level playing field between conventional and Shariah-based finance, and give appropriate incentives to encourage the further development of the Islamic sector. The government has also actively revised and adapted policies and regulations to meet changes in the domestic and international environment. For instance, the breakthrough in Malaysia’s sukuk market occurred when we decoupled sukuk from the conventional legal concept of debentures. This allowed the market to adopt a wider range of structures involving the element of equity participation.


Innovation also requires more capacity. Given the kind of growth we have seen in the industry, there is clearly a shortage of people with the right mix and level of skills. The issue we face is of finding the right people to run this fast-growing business; this requires financiers with cutting-edge knowledge of both mainstream markets and Shariah principles. The prevailing business model typically splits this work between trained finance professionals, who run the business and make the institutional decisions related to investments and other financial matters; and Shariah scholars, who supervise to ensure Shariah compliance. The majority of scholars are however trained in Shariah where the emphasis on finance may have been limited, while the financial practitioners, even those who are knowledgeable about Shariah principles, do not have the authority to rule on religious edicts.


Therefore ideally capacity-building programmes should target all groups involved in the value chain of Islamic finance. To enlarge the talent pool, fresh graduates including Shariah graduates must be enticed into the market; existing Shariah scholars must be provided with greater exposure through training and attachment with industry; as well as participation and debate at international forums.

The regulators must understand Islamic products and structures even if the approach to regulation is one that is based solely on disclosure. The Securities Commission together with our training arm, the Securities Industry Development Corporation, have introduced a comprehensive range of bespoke programs to address the training needs of the different groups. We have established the Islamic Capital Market Graduate Training Scheme for fresh graduates, regular product workshops for registered Shariah advisers and the annual Islamic Capital Markets Program for regulators and industry leaders. Additionally, the International Islamic Capital Market Forum provides Shariah scholars and market participants with an opportunity to learn about the latest products and structures in Islamic finance. We have just held our fourth Islamic Markets Programme recently, which attracted over 40 delegates from 15 countries, and later this month we will be hosting the third International Islamic Capital Markets Forum.9 Our efforts are complemented by those of the Central Bank and the universities in particular the International Centre for Education in Islamic Finance (INCEIF), the Kuala Lumpur based global university for Islamic finance.


Innovating for the future

Ladies and gentlemen


Having individually covered the three areas of importance for innovationconsumer interest, acceptability, and cost-competitiveness and efficiencyI should emphasise to you that the three factors are not mutually exclusive. Harmonisation of views, or at least clarity over the underlying justification of Shariah opinions, would promote the interest of consumers. At the same time, efforts at developing an enabling environment through the removal of legal uncertainty and other barriers would also contribute to wider acceptability of Shariah-based financial innovations. The requirement for higher standards of consumer protection would in turn demand a higher degree of professionalism and competency from industry players.


Ultimately, all this must feed into the innovative process and succeed in introducing something new and useful for the market. But where is innovation most lacking and needed? Allow me to offer three suggestions.


First, risk management. Writing nearly 15 years before the recent credit crisis, John Kenneth Galbraith stated that

“All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets … All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.”10


In the case of Islamic financial innovation, however, there is no doubt in my mind that strict rules on transparency, leverage and risk-taking contributed to the relative stability of Islamic financial markets and institutions during the recent global credit turmoil. True, the sukuk market has seen some consolidation of late: after growing by around 48% a year in recent years,11 sukuk issuance fell by more than half in 200812. But difficulty in raising money was inevitable as the extensive nature of the financial crisis led investors to shun all forms of capital-raising.


What is more of a concern, however, is a lack of tools for hedging for Islamic financial institutions and consumers of Shariah-based finance which would run a disadvantage to conventional financing in being less able to mitigate natural risks inherent in financial transactions. Hedging tools have their merits, but like many other things, they can also be abused. Shariah-based hedging instruments can be acceptable so long as they are properly regulatedfor instance, by having proper trading, clearing and settlement systems, so that transactions are done in a fair, orderly and transparent way. In Malaysia, we already have some Shariah-compliant hedging tools that work on the basis of real transactions or structured on real underlying assets13. However, we are continuing to develop a wider range of tools to meet market demand; including Shariah-compliant regulated short-selling. These may not be very sophisticated compared to some of the more complex derivatives available (or not as the case may well be by now), but they certainly have the capability to hedge a number of Shariah-based transactions.


The second focus for future innovation needs to be on fund-raising. At present, Malaysia and the United Arab Emirates are said to account for three-quarters of global sukuk issuance, while in 2007, Saudi Arabia reportedly issued a fifth of the global sukuk. Large markets with predominantly Muslim populations remain largely untapped, especially in Asia. But as I had mentioned earlier, Shariah-based investors are not confined only to Muslims. So clearly, the sukuk market remains a strong growth prospect.


However, we should remember that while sukuk brought Islamic finance into the realm of capital markets, Islamic capital markets are not confined only to sukuk. Indeed, the equity market is an area where there are strong opportunities, enabling issuers to expand their potential funding pool through the Islamic equity market. This year, Xingquan, a China-based company seeking to list on the Malaysian stock exchange, also applied for and received pre-IPO Shariah-compliant status for its shares. This will thus make the company eligible for inclusion in the investment portfolio of individual and institutional investors seeking Shariah compliant investments.


Equities offer a wide scope for innovation. Instruments such as Shariah-compliant exchange-traded funds, real-estate investment trusts and structured products are attracting strong interest. For instance, there is a large demand for REITs and in Malaysia, there is strong prospects for Shariah-compliant REITs-so much so that a conventional REIT has recently converted from a conventional structure to one that is Shariah-based.


This brings me to a third area of innovation: investment. Shariah-compliant financing instruments have proven themselves to be commercially-viable and effective in mobilising investment assets to finance productive economic activities. We must now set our sights higher. Asian and Middle Eastern economies have large surpluses; at the same time they require substantial investments to drive their growth. Clearly, there are opportunities for Islamic finance to strengthen its role in intermediating surplus savings into economic development.


Investment management products are therefore a strong growth prospect. Despite Malaysia being home to more than 140 Islamic funds of great diversity, we believe there is still much potential for developing Shariah-based investment management. In attempting to tap this potential we have completely liberalised the Islamic fund management industry.


But markets and innovation cannot thrive in isolation. Right now, pools of Islamic liquidity remain fragmented and this makes it difficult to tap opportunities. What we need is to build more links between our economies and markets to promote the growth of Islamic financial markets worldwide; connectivity is key. The mutual recognition agreement between the Securities Commission Malaysia and the Dubai Financial Services Authority is one example of this. The sector needs more partnerships of this nature.



Ladies and gentlemen: Innovation has been a hallmark of the development and growth of Shariah-based finance at least over the last 20 years. But in the past 18 months, the global financial sector has had to face some of its biggest challenges in a very long time. And while the momentum of Islamic capital markets appears to have slowed, we thankfully escaped the worst of the credit crisis. There are some concerns, however, that the impact of a shift away from financial innovation as a result of the crisis will do irreparable damage to the prospects for Shariah-based finance. I do not share that view. Financial innovation will return, albeit in a slightly modified wayand most likely for the better.

With more attention given to consumer interest, acceptability, and cost-competitiveness, the Islamic capital markets will be in a strong position to benefit from the global recovery and meet the demands for risk management, investment and fund-raising. And if you should have any doubts about this, I leave you with some words from Muddassir Siddiqui, (former member of the Shariah Board of AAOIFI) which I am sure should inspire us all:

“Innovation will never stop. God will not create a genuine human need within society and not give a genuine means to fulfil that need…”

Ladies and gentlemen, thank you very much for your attention.


That issue, in 1990, raised RM125 million or about US$46 million (end-1990 exchange rate). In 2007, ringgit sukuk issuance amounted to RM44.2 billion (US$13.4 billion).


In addition to those from Asia and the Middle East, companies in the United States, Britain, Germany and Korea, as well as from multilateral agencies have issued sukuk. Ringgit issuers in Kuala Lumpur have included the International Finance Corporation sukuk (2004), World Bank sukuk (2005), AEON Credit Services (2007), Tesco Stores (2007) and Toyota Capital (2008).


For instance, the Malaysian sovereign sukuk (US$600 million) had 30% of its issuers from Asia, 15% from Europe, 4% from the US and the rest from the Middle East.


Dubai Ports sukuk (US$3.5b) placed over 50% with conventional investors; the German state of Saxony-Anhalt (€100 million)placed the majority of its sukuk with conventional investors; the Qatar Global Sukuk(US$700 million) placed 48% with conventional investors; the US$500mil IDB sukuk placed 70% with conventional investors.


See for instance “Innovation: Downturn temporarily blunts inventiveness.” Financial Times. May 5th 2009.


“Islamic markets fret as regulators revamp bank rules.” Reuters. June 24th 2009.


For instance, Kuala Lumpur’s provisions require Islamic unit trust funds to have true-to-label disclosures and Shariah advisers to ensure operational compliance with relevant aspects of Islamic principles. Similarly, in the area of sukuk offerings, issuers are required to have Shariah committees to advise them on the compliance of structures and must make appropriate disclosures on the particular structure being adopted for an issuance.


Recognising that the fragmented global body of fatwa is a hurdle to these efforts, the Securities Commission Malaysia is working on a project to compile the fragmented global body of fatwa into a single source: comprising three volumes, it will cover rulings concerning Ijarah, Murabahah, and Musharakah and Mudharabah. We have also appointed several international Shariah advisers and industry leaders to the International Advisory Committee of the Islamic Capital Market Development Project.


For more information on the IICMF, see https://www.sc.com.my/wp-content/uploads/eng/html/icm/iicmf/iicmf_2009.pdf.


A Short History of Financial Euphoria. By J.K. Galbraith. Penguin (Non-Classics). 1994.


Average annual growth of sukuk issuance in billions of US dollars, 2003-2007. Source: International Financial Services London, Securities Commission calculations.


Source: International Financial Services London.


These include profit rate swaps, foreign exchange and cross-currency swaps, palm oil futures and single-stock futures.