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Fri 1 Jun 2007 12:00 AM

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Competing or complementary?

As Islamic financial instruments develop, they need to decide what they want to be when they grow up.

Anyone working in the Middle East finance industry must be aware that Islamic products have been developing at a rapid pace. Almost everything that can be done with conventional financial instruments can now be done through Shariah compliant means, and the gaps are quickly being filled. There are even recurring claims that Islamic hedge funds might soon be possible, although they would require some kind of credit swap to avoid exposure to the high levels of debt and short selling strategies often used by such funds.

As this issue's cover story shows, sukuk are becoming more inventive, and more complicated. New issues may be convertible to equity after a certain period of time, or they may include securitised elements.

Such innovation is impressive, but it also raises two important questions.

Firstly, is there any point in producing an Islamic imitation of a conventional product? Shariah compliant instruments that do something new or unique have a place in world finance. However, Islamic products that try to emulate a conventional product probably do not. Why not create something to meet an investment need that cannot be fulfilled conventionally?

Secondly, are such products moving away from their roots? If an investment has only a tenuous link to an asset, some would say that it is not truly Islamic. Even if it were possible to produce a hedge fund and find someone to certify it Shariah compliant, should it be done? Already there is a debate among sukuk experts over whether securitisation is Shariah compliant, as it could be viewed as a way of guaranteeing future income.

Issues like this could create serious divisions in the Islamic finance industry, which is already split on jurisdictional lines.

The industry may be growing rapidly, but compared to the conventional finance world it is tiny. If the Islamic finance industry goes head-to-head with the conventional finance industry, it probably will not win. Conventional finance products are standardised and generally understood, so there is no need for issuers to offer a premium.

The same cannot be said of the complex new Islamic instruments that are emerging.

Shariah compliant finance should instead be looking for niche opportunities that conventional finance cannot fill. As a rival, it cannot hope to beat conventional finance at its own game, but as a complementary set of instruments targeted at a different kind of investor it has a place in the global market.

Islamic finance is at a crossroads, and its champions need to decide where it should head: to tackle conventional finance head-on, or to look for a less crowded area, perhaps with a smaller pool of investors, where it can flourish.

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