Islamic financial institutions have long relied on conventional interest-based benchmarks such as the Emirates interbank offered rate (Eibor), the London interbank offered rate (Libor) or the Euro interbank offered rate (Euribor).
These benchmarks are used to price short-term treasury and financing instruments such as murabaha (cost plus), wakala (agency contracts) and mudaraba (shariah-compliant equity financing), as well as retail financing products and other transactions.
‘Guidance from sharia scholars will be instrumental to adopting an Islamic benchmark’
As Libor is being phased out globally in favour of benchmarks such as the secured overnight financing rate (SOFR) by the US Federal Reserve and the sterling overnight index average (Sonia) in UK banks, there is an opportunity for Islamic finance to establish its own indigenous benchmarks, says Noor Suhaida Kasri, director of Islamic economy at Malaysia’s ISRA Research Management Centre at INCEIF University.
Rate adoption
However, migration to shariah-compliant benchmarks has been slow. One reason is that some Islamic scholars have issued rulings allowing the continued use of conventional benchmarks on the basis that substitutes are not available.
Their complexity, transition cost and lack of standardisation have hindered a transition to sharia-compliant benchmarks, says Zul Hakim Jumat, a researcher at Qatar’s Hamad Bin Khalifa University, compared to local currency benchmarks that are impacted by local monetary supply.
‘Guidance from sharia scholars will be instrumental to adopting an Islamic benchmark,’ Kasri says.
Innovation
Malaysia’s central bank, Bank Negara Malaysia, has sought to address the lack of a local, shariah-compliant benchmark with the launch of the landmark Malaysia Islamic overnight rate (Myor-i), the world’s first transaction-based benchmark rate for Islamic finance, in May 2022.
Malaysia’s Myor-i is calculated as the volume-weighted average of unsecured overnight ringgit transactions between banks in the interbank market. It includes Bank Negara Malaysia’s Islamic overnight monetary operations such as commodity murabahah tenders and direct placements, but excludes standing facilities.
The creation of Myor-i is part of Malaysia’s efforts to transition away from Libor to alternative reference rates and to spur the development of innovation in sharia-compliant financial products – an industry projected to be worth nearly US$5 trillion by 2025.
The standard is largely applicable to all interbank institutions in the country, and replaced the Kuala Lumpur Islamic Reference Rate, which was discontinued in 2022.
Contractual certainty
Even as supranational Islamic banking organisations have laid out additional principles and guidelines, the transition from conventional benchmarks such as Libor is impacting Islamic banks, says Ben Charoenwong, assistant professor at the National University of Singapore Business School.
Islamic finance products need to meet the standards of gharar, or contractual certainty, to be sharia-compliant. Yet benchmarks like SOFR and Sonia do not satisfy this principle. Compounded SOFR, whereby interest is calculated at the end of a period rather than being set from the very beginning, goes against the concept of gharar.
Any alternative to Libor will also require approval from shariah scholars in terms of how it can be applied to common Islamic finance instruments, such as murabaha financing and ijara (sale and leaseback) agreements. This may require different operational approaches.
Islamic financial institutions also need to adhere to standards set by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). Potential benchmarks would have to comply with AAOIFI guidelines, which complicates the transition for Islamic finance institutions.
‘Expanding the scope of benchmarks can support innovation in Islamic financial products’
Changes in rate characteristics and transitioning away from Libor can involve Islamic finance institutions having to make substantial adjustments to their operational systems, Kasri says. She adds: ‘The new rates may not offer the same level of predictability and planning capability that Libor provided, which is a core component of risk management strategies in financial operations.’
Charoenwong points out that, without a global regulatory authority for Islamic finance, no single authority can compel Islamic banks in different countries to uniformly adopt benchmarks.
Islamic finance benchmarking will likely pivot towards data-driven, transaction-based methodologies, according to Charoenwong. ‘Malaysia’s approach [with Myor-i] for a transaction-based measure in its local currency is more analogous to the updated SOFR used by conventional banks,’ he says, adding that these methods of calculating reference rates are more transparent.
The development of Islamic pricing benchmarks can go beyond just interbank rates to other sectors such as retail financing, says Kasri. Benchmarks could factor in the environmental and social impact metrics of underlying assets.
Sustainable business
Islamic finance is attracting global interest because it overlaps with growing ESG principles, especially for investors interested in ethical and responsible investing.
‘Existing coordination between different Islamic finance stakeholders in the area of sustainable finance is viewed as a great opportunity and ought to be leveraged as it overcomes shared challenges,’ says Kasri.
The sector is projected to expand 8% in Southeast Asia over the next three years, according to a 2022 estimate by S&P, with long-term growth, particularly in Malaysia and Indonesia – the two countries currently hold 96% of total Islamic banking assets in the region.
‘Expanding the scope of benchmarks can support innovation in Islamic financial products,’ says Kasri. ‘Integration of sustainability and ESG considerations into Islamic benchmarks, in line with the industry’s increasing focus on green and socially responsible finance, is a good case to start with.’
