REGULATORY ISSUES FACING SUKUK AND ISLAMIC CAPITAL MARKETS
By Hari Bhambra

I t is possible for capital market regulations based on international standards, which may have originally been prescribed for conventional markets, to apply to Islamic capital markets. They would be subject, however, to appropriate modification to reflect the specific features of Islamic capital markets that can only be achieved with a clear understanding of Islamic products.

When considering the application of best practices and codes of governance that are promulgated by international standards, there is an assumption that these may not be applicable in the Islamic finance context. However, when examining the standards and codes propagated by such international bodies, one will find that they are not inconsistent with Islamic principles. In fact, many are totally compatible. Take good and ethical conduct as an example. Such conduct is expected in all capital markets, conventional or otherwise. A perception shift is also required in order to encourage practitioners to be more receptive to integrated regulatory standards. Indeed, there is a consensus that international standards relating to the regulation of capital markets can apply to Islamic capital markets, including Sukuk. The Dubai Financial Services Authority (DFSA) is an example of a regulatory model that has achieved this balance.

The comments in this article are summed up well by the words of Governor Zeti Aziz of Malaysia (as endorsed by the 10 year Masterplan for the Islamic Financial Services Industry): the need to integrate both regulation and practice will become more pronounced the more Islamic finance continues to transcend geographical boundaries. Islamic finance emerged in the Middle East, but has stretched across to the West and Far East as can be seen with the phenomenal flow of Sukuk. Such globalisation will further raise the debate to standardise and integrate Sukuk and other Islamic products into the international financial system, and to avoid, or minimize to the extent possible, unwarranted differentiation in regulatory standards that could adversely affect the Islamic financial services industry.

The Dubai Financial Services Authority (DFSA) is an integrated regulator for the Dubai International Financial Centre (DIFC), which is a financial free zone in the Emirate of Dubai, and is home to the world' s largest Sukuk market.

The DFSA was in the privileged position of developing a regulatory regime on a blank slate and, from the outset, devised its integrated risk-based regime with both conventional firms and Islamic ones in mind. The DFSA clearly had the advantage of not having to modify legislation, or bolt on Islamic Finance to an established conventional financial system. The DIFC began with the creation of a legal system based on common law, inclusive of a specific trust regime. In respect of the regulation of Islamic finance, the DFSA has taken steps to create an enabling regulatory framework for, among other things, the Islamic financial services industry by creating clearly defined, international regulatory parameters but within an environment that is conducive not only to the cross-sectoral features of Islamic Finance but also the pace of innovation in this industry.

Mindful of the differences in opinion in Shari' a interpretation, the DFSA has implemented a Shari' a systems approach to regulation. Islamic firms operating in the DIFC must implement systems and controls to ensure that the firm operates in compliance with Shari' a. This includes the appointment of a Shari' a Supervisory Board ( SSB ) in accordance with guidance provided. In addition to the obligation on firms to have Shari' a systems and controls, the DFSA requires enhanced disclosure for Islamic transactions. Transparency and disclosure is an obligation of authorised firms and is particularly relevant in respect of Sukuks.

The Shari' a scholars' approval process and confirmation of the Shari' a validation relating to the underlying structure. This is further supported by the requirement to make any relevant structure-specific disclosures promulgated by AAOIFI' s Shari' a Standards.

The DFSA also demonstrates

The Dubai Financial Services Authority clearly had the advantage of not having to modify legislation or 'bolt on' Islamic Finance to an established conventional financial system.

The DFSA regime prescribes regulations for the offering and holding of Sukuks as investments. In the latter case, the prudential requirements, which are based on international standards but duly modified for Islamic finance, will apply, including the specific risk weights prescribed for Sukuks. With respect to the offering of securities, the DFSA requires the following initial and ongoing disclosures to be made:

• details of the SSB that has undertaken the Shari'a review for the offer;
• the opinion of the SSB as to whether the offer is Shari'a compliant;
• description of the underlying structure of the transaction;
• any applicable disclosures prescribed by AAOIFI Shari'a Standards;
• any subsequent changes to the SSB.

With respect to Shari'a law, the issuer is under the obligation to ensure that the necessary approvals have been sought.

The DFSA' s approach clearly focuses on providing clear and relevant disclosure in respect of its overall commitment to disclosure and information sharing through its relationships with other regulatory agencies. The DFSA recently concluded a Mutual Recognition agreement with the Securities Commission Malaysia whereby Shari' acompliant DIFC domestic funds will be capable of distribution and sale into Malaysia. This is the first agreement of its kind for both agencies and a model that is capable of application to other product areas including Sukuk. Such collaboration and co-operation is encouraged by IOSCO, and in the field of Islamic Finance indicates the regulators' willingness to seek to create an enabling regulatory environment for Islamic Finance.

Hari Bhambra is Senior Manager of Supervision at DIFC' s Dubai Financial Services Authority in the UAE. For more information, visit www.dfsa.ae.