Technology Aids Sharia Compliance for Islamic Finance's Rise

Islamic finance is the fastest growing segment of the global financial system. With an increasing Muslim population and a reputation for being more resilient to crisis than conventional finance, the Islamic financial sector is now facing great demand worldwide for schemes and products responding to the criteria set by Islamic laws, or Sharia. By Marina Daras

After the global financial crisis, some western investors sought restricted exposure to the types of assets that brought the world's economy to its knees. And more crucially, the number of Muslim investors requiring that their investment activities comply with the Islamic moral code, known as Sharia, is growing. These factors have brought about an increase in Islamic banking activity, and have drawn attention to the Islamic finance sector. This rise in prominence has left an opening for technology vendors looking to gain a foothold in a niche market with unique requirements and restrictions.

Sharia mandates that losses and profits be shared by both parties; receipt or payment of interest is not allowed; and the practices of short-selling, gambling, and taking risky, speculative, or uncertain positions ─ known as Gharar in Islamic laws ─ are formally forbidden. Islamic finance is generally considered to represent an ethical system, but means most derivative contracts are considered invalid because of the uncertainty involved in the future delivery of the underlying asset.

Sharia mandates that losses and profits be shared by both parties; receipt or payment of interest is not allowed; and the practices of short-selling, gambling, and taking risky, speculative, or uncertain positions ─ known as Gharar in Islamic laws ─ are formally forbidden.

The Islamic financial sector is still considered a relatively new and underdeveloped part of the global capital markets, which could be an advantage, if it means firms practicing Islamic finance can develop more reliable trading systems by only adopting the best-of-breed technology already tried and tested by the traditional markets.

Its growth cannot be understated: The sector had an estimated $1.6 trillion under management as of the end of 2012, and will have a forecasted $6.5 trillion under management by the end of 2020, according to a report by the Kuwait Finance House entitled Overview of the Islamic Financial Landscape. To ensure the industry has the scalability to meet this demand, while staying in line with the ethical standards of Sharia, specialized, cutting-edge technology is needed that can decipher the complexity of the market structure, and monitor and manage business and reputational risks in a restricted but fast-evolving environment.

Compliance
The first challenge in Islamic finance is Sharia compliance. This means being able to trace and monitor, on an historical and a real-time basis, the entire trade lifecycle, as well as the compliance of every third party involved in the process. Before electronic trading, when bankers knew their customers and counterparties personally, this wasn't difficult. But as trading activity has migrated to computers and gone global, this has become impossible.

In order to respect ethical restrictions ─ meaning no investments in business involving gambling, alcohol, pornography, and non-halal products ─ asset managers must rely on analytics to delve into huge volumes of trading-related data. Sayd Farook, global head of Islamic capital markets at Thomson Reuters, explains that aside from covering the basics that asset or fund managers in all markets have to go through, there is a layer of additional due diligence to ensure the Sharia compliance of an investment.

"To search and collect all the data you need in order to assess the compliance of each investment instrument represents a lot of work, time, and money," Farook says. "And the process is different for each asset class. So the challenge for technology providers is to facilitate a platform that can understand this process and provide all the information within that same platform."

Taking advantage of this rise in popularity, in 2010 Thomson Reuters launched its Islamic Finance Gateway, a global platform and directory that aggregates news and information for Islamic finance participants. Reuters Messaging is embedded within the platform to facilitate communication among users.

In 2011, Bloomberg debuted its ISLM platform, designed to provide analytics tools such as real-time pricing data, historical data and graphics. It aims to maximize investment performance and manage the Sharia compliance cycle. It also contains databases of publicly listed and Sharia compliant securities, Islamic financial professionals, Sharia scholars, and the products they have endorsed as compliant.

"As the market began to grow, Bloomberg recognized the need for a comprehensive platform that provides in-depth data, transparency, and gives users the ability to customize data across countries and asset classes," says Kamel Hajri, business manager for Islamic finance at Bloomberg.

Harmonization
Despite a push from regulators and central banks in South East Asia and the Middle East to implement harmonized standards on a global scale, the Islamic market is still fragmented. A board of scholars, experts on Islamic laws, determines the interpretation of Sharia and is responsible for endorsing (or not) partnerships with companies when they launch new products. As each financial institution has its own Sharia board, standards can vary from one region to another, from one country to another, and even from one bank to another within the same country, depending on the origins of the scholars, their personal and collective interpretation of Sharia, and the bank's strategy.

This fragmented nature of Islamic finance makes it difficult to evolve beyond local markets. But according to Hajri, technology can help iron out those discrepancies by building the necessary filters to adopt the different conventions and terminologies.

An Educational Purpose
Path Solutions, a technology provider to the global financial industry with a specific focus on Islamic finance, has been around for more than 20 years. Reflecting on the industry and the challenges facing technology providers, Jacob Zachariah, executive vice president of operations and global support for the iMAL platform at Path, says that the vendor's clients are not always fully aware of all the concepts and challenges Islamic finance can bring. "We also give them full support during and after the implementation, to make sure they have the right foundation in place to start their business," Zachariah says.

As most participants come from a conventional finance background having studied or started their career within the industry, it is important for them to be able to collect and analyze data to better inform themselves about the specifics of the instruments' structure and be comfortable with the investment decisions they make.

Flexibility
Implementing a standardized terminology describing Sharia-specific financial instruments and practices is one thing, but as the market develops across borders, firms also need highly flexible systems that can cater to all changes within countries and regions, but also within conventional and Islamic business.

Geneva-headquartered banking solutions provider Temenos has developed its T24 banking platform to suit the requirements of Islamic banking, within a single core banking software system that handles Islamic financial services in tandem with non-Islamic ones. Fadi Yazbeck, product manager of the Islamic banking sector at Temenos, explains that the vendor's strategy is to offer a flexible system to handle all types of variations and future growth strategies, both in terms of assets and geographies. "We allow high levels of flexibility within the T24 system so that it can suit any bank's requirements and can be implemented in Europe, the Middle East, Africa, or even Asia and Pakistan, which all follow different schools of culture, apply different rules of Islamic finance, and offer different products. It all depends on the flexibility and the level of parameterization you offer around your product," he says.

Reputations
As Waters' editor-in-chief Victor Anderson wrote in August, technology firms' images and their reputations play an integral role in their healthy functioning. Due to the ethical and religious aspects of Islamic finance, it is even more important for firms to mitigate various risks and preserve their reputations if they want to attract clients.

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), a Bahrain-based regulator, has teamed up with professional services provider Ernst and Young to help technology vendors negotiate the compliance minefield of Islamic finance. The partnership allows them to issue certification of financial software products and core banking systems for the Islamic banking industry.

"The AAIOFI provides the Sharia review process, while Ernst and Young goes into the technical details," says Majd Bakir, financial analyst at the AAIOFI. "Banking and financial information technology vendors can utilize this program to properly incorporate AAOIFI standards in their products and systems. Technically, by securing an AAOIFI-certified status, IT systems in Islamic financial institutions can boost their operations and mitigate risks of Sharia non-compliance."

According to Bakir, there is a lot of pressure on vendors to stay on the right track from a Sharia perspective, as their customers are concerned about their reputation. "The aims behind offering a certification are to bring some standardization across the industry and to harmonize the practices within the third-party technology vendor industry," he says.

The certification process is lengthy and subject to ongoing review, so vendors don't always renew their certification, as is the case for Path Solutions' IMAL. Instead, Path's product management team monitors all the market requirements and Sharia-compliance issues to ensure they can address those stipulated by central banks and other regional regulatory bodies. "The product management team is responsible for analyzing clients' specific needs and requirements to make sure the system answers their own business needs and is in accordance with the Sharia laws," says Zachariah.

Mitigating Risks
The restrictions Islamic laws impose on the market are a double-edged sword: Although its risk-averse model has made the Islamic market a safe haven for investors, it is constrained to the extent that investors often experience "concentration exposure" to specific stocks in their portfolios, due to lack of diversification. "When it comes to investment banking or derivative products, there is no product specifically restricted in Islamic laws," says Yazbeck. On paper, the restrictions exist to ensure that there is no gambling, excessive risk, or non-halal investments, and that every investment is being made for hedging purposes, he explains.

But although it is aimed at reducing operational risks for the banks rather than restricting investment instruments, the practical result is different, and the Islamic market remains narrow and under-developed. As the market evolves, it will have to develop deeper liquidity to become a real force, and that process has already started. Islamic financial institutions are tiptoeing around trading activities, looking for a more diversified landscape in which to participate.

Following that trend, Bloomberg's ISLM platform has been working toward the delivery of trading tools to facilitate and assist firms with their growth. "Initially, we started by providing cross-asset-class data over a ticker, historical performance data and equity screening tools, as well as structured diagrams and fatwas mainly for Islamic bonds, or sukuk. Now, as the market keeps growing, we have to follow demand and move from offering basic information-driven functionality to providing trading tools," says Bloomberg's Hajri.

Thanks to its attractive structure that reduces risk and poor investments, the Islamic finance sector is playing catch-up with the more traditional markets. Developing the best data-driven technology system to ensure the ethics and principles of Sharia are respected while working on making it sustainable on a bigger scale, is a process already in place.

The next step for the Islamic market is to become more mainstream by growing its spectrum of investments and building competitive trading venues. Since UK prime minister David Cameron announced at World Islamic Economic Finance Forum in London the future issuance of a bond-like sukuk worth £200 million ($322 million), it seems to be on the right track.

Salient Points

• As the Islamic financial industry continues to develop, it offers technology vendors an opportunity, as Islamic firms are dependent on data-collection and analysis tools for their trading activities.
• The Islamic finance sector needs to work toward a more standardized and harmonized system before it can become a true global player. Having to cater to a fragmented market, IT systems need to be highly flexible and support parameterization within core banking solutions to allow firms to develop outside their traditional countries or regions.
• To be competitive and sustainable, the market needs to work on the establishment of Sharia-compliant trading venues and trading instruments.

Waters Technology