Working Paper Series 010

CREATING AN EFFECTIVE
AND EFFICIENT REGULATORY
FRAMEWORK FOR THE ISLAMIC
CAPITAL MARKET

By

Dr Wan Nursofiza Wan Azmi

2007

Creating Dynamic Leaders

 Creating an Effective and Efficient Regulatory
Framework for the Islamic Capital Market
TABLE OF CONTENTS
Abstract
Introduction 2
Development of Islamic Capital
Market
The Need for an Effiective and
Efficient Regulatory Framework
Global Challenges
Conclusion
Page 2
2 Abstract
The development of the Islamic capital mar-
ket is the outcome of the progression in the
growth of the Islamic financial services in-
3
dustry. The pressing needs for liquidity man-
agement from Islamic financial institutions
5
prompted the introduction of new Islamic
11 financial instruments and the promotion
of financial engineering. A proper enabling
12
environment that is facilitated by a robust
and efficient regulatory framework as well
as the adoption of international standard of
best practices are, however, crucial for fu-
ture growth of the Islamic financial services
industry.
Introduction
The Islamic financial services industry has recorded im-
pressive growth worldwide. From humble beginnings
in the 1970s, the industry has grown in both size and
significance in more than 75 countries. Today, the in-
dustry has gained considerable interest as a viable and
efficient alternative model of financial intermediation as
a result of the growing awareness of and demand for
investing in accordance with Shariah principles.
The Islamic banking industry, which is an integral part
of the Islamic financial system, is poised to continue
registering an average growth of 15% per annum over
the next decade. With more than US$250 billion worth
of deposits hold by 300 Islamic financial institutions,
this industry represents an attractive investment op-
portunities. The growth of Islamic banks and takaful in-
Creating Dynamic Leaders
 stitutions has given rise to the need of products for
the management of balance sheet liquidity. The de-
velopment of the Islamic capital market is therefore
the outcome of a natural progression in the growth
of the Islamic financial services industry.
The Islamic capital market provides a stable and
viable source of long-term funds for financing large
investments and development projects as well as for
capital and business expansion. The Islamic capital
market also ensures greater diversification of risks
emanating from asset and liability mismatches fac-
ing Islamic financial institutions. The market has a
pivotal role in ensuring the overall stability of the
Islamic financial system through its contribution
to the enhancement of a resilient and robustness
Islamic financial system in withstanding financial
shocks.
Thus, developments and innovation in Islamic capi-
tal market products transpired in response to the
growing needs of the Islamic financial industry. At
present, a wide selection of Islamic capital market
products and services are available in the market
to meet the needs of those who seek to invest in
accordance with Shariah principles which includes
Shariah-compliant stocks, Islamic bonds, Islamic
funds and Islamic risk management products.
Nonetheless, the strong growth for Islamic finance
products is not only driven by increasing demand
from those who want to invest in instruments that
are Shariah compliance so that they are able to
meet their religious obligations but also by non-
Muslims who find some of the risk-return features
attractive, or by those investors who subscribe to
ethical investment philosophies.
Even though the Islamic financial services indus-
try is currently experiencing a double digit growth,
the industry is still in its infancy compared to the
conventional financial system. The backbone of the
Islamic financial system is a well developed Islamic
capital market. Developing a robust and efficient
Page 3
Islamic capital market requires the concerted ef-
forts from the regulators, market participants, Sha-
riah scholars and development institutions. As the
market regulator, one of the many challenges we
encounter is creating an effective and efficient legal
and regulatory framework which is essential for the
functioning of a modern Islamic capital market.
For a rapidly growing market like the Islamic capital
market, market regulator plays an important role
in ensuring that an enabling and conducive regula-
tory environment exists to adequately regulate the
Islamic capital market. Based on this notion, this
paper seeks to deliberate on the role of the regula-
tor in creating an effective and efficient regulatory
framework for the Islamic capital market.
The further growth of the Islamic financial services
industry and its successful response to the challeng-
es of promoting systematic stability and economic
development depends crucially on the creation of a
proper enabling environment that is facilitated by a
robust and efficient regulatory framework and the
adoption of international standard of best practices.
This paper primarily reviews role of the regulator
in creating an effective and efficient Islamic capi-
tal market. The paper also addresses the need for
global integration of Islamic capital market.
Development of the Islamic Capital
Market
As outlined earlier, the development of an Islamic
capital market was the result of the pressing need
to address liquidity management of Islamic finan-
cial institutions. During the 1980s and1990s, Is-
lamic financial institutions were able to mobilise
their deposits by investing in a handful of financial
instruments which were dominated by trade financ-
ing. Activities on the asset side of these institutions
included cost-plus-sale, Islamic leasing, trust fi-
nancing and equity participation.
Creating Dynamic Leaders
 Creating an Effective and Efficient Regulatory
Framework for the Islamic Capital Market
However, the asset composition of Islamic financial
institutions remained fairly static and was heavily
focused on short-term instruments, mainly com-
modity financing due mostly to the lack of liquid
assets. Hence, the management of balance sheet
liquidity became a major challenge facing the Is-
lamic financial institutions owing to the scarcity of
Islamic capital market instruments. This gave rise
to the demand for the introduction of new Islamic
financial instruments and the promotion of financial
engineering. The development of the Islamic capital
market can be seen through the development of a
wide range of Islamic capital products that are be-
coming widely available such as the Shariah-com-
pliant stocks, Islamic funds, Islamic bonds and Is-
lamic stock broking services.
Development in the Islamic financial system
prompted countries like Malaysia, Bahrain, Kuwait,
Sudan and Iran to introduce Islamic bonds to fa-
cilitate the management of assets in the Islamic
banking system, which was already fairly mature.
The first successful issuance of Islamic bonds was
initiated by the Malaysian Government in 1983 with
the issuance of the Government Investment Issue
or GII (formerly known as the Government Invest-
ment Certificate or GIC).
Another aspect of the early development of the Is-
lamic capital market was the need to establish clear
guidance on the types of equities that comply with
Shariah requirements. One of the measures taken
was to ascertain that the review and identification
of Shariah-compliant stocks are guided by specific
criteria set out by Shariah scholars. In Malaysia, the
initial efforts to provide a list of Shariah-compliant
stocks were undertaken by Bank Islam Malaysia Bhd
in 1983. Following this, the Securities Commission
of Malaysia introduced a list of Shariah-compliant
stocks in June 1997 to guide the investing public.
This development in the capital market facilitated
the establishment of Islamic indices. The first Is-
lamic equity index was introduced in Malaysia by
Page 4
RHB Unit Trust Management Bhd in May 1996. This
was followed by the launching of the Dow Jones
Islamic Market Index (DJIM) by Dow Jones & Com-
pany in February 1999, the Kuala Lumpur Shariah
Index (KLSI) by Bursa Malaysia in April 1999 and
the FTSE Global Islamic Index Series by the FTSE
Group in October 1999.
Although these indices have since been published
worldwide, Islamic indices remain in their infancy
and play a limited role in Islamic financial markets.
Consequently, this led to the establishment of Is-
lamic stock broking services. They operate within
the same institutional and regulatory framework as
that of stock broking with the exception that their
activities must comply with Shariah principles. As
per se, they are allowed to participate in the origi-
nation, trading and distribution of Shariah-compli-
ant stocks only.
Hence, in the periods between the early 1980s and
late 1990s, the Islamic capital market experienced
two distinct developments. First is the introduction
of equity funds which were compatible with Shariah
and second is the launch of Shariah-compliant as-
set-backed securities or Sukuk. The development
of the Sukuk market was primarily driven by the
demand of the Islamic financial institutions to ex-
tend the maturity structure of their assets beyond
the typical short-term maturities provided by trade-
financing instruments.
Today, the global market for Sukuk has reached an
impressive size of US$30 billion within a short span
of less than five years. As part of the initiative to
enhance the international profile of the Islamic cap-
ital market in Malaysia, the Malaysian government
launched the world’s first sovereign Islamic bond
in June 2002. To date, the Islamic bond market in
Malaysia has continued to register strong growth
of 22.9%. In 2005 alone, about 71% of new bond
offerings approved valued at RM43.3 billion were
Islamic bonds. A significant development in the Is-
lamic bond market in Malaysia was the issuance of
Creating Dynamic Leaders
 a RM700 million ringgit-denominated Islamic debt
securities based on bai’ bithaman ajil by a multilat-
eral financial institution.
This was the spill-over effect of the liberalisation of
the Foreign Exchange Administration Rules which
facilitated multilateral development banks, multi-
lateral financial institutions and multinational cor-
porations to raise ringgit-denominated bonds in the
Malaysian capital market. Other landmark issuance
include included the first domestic Islamic corpo-
rate bond based on the ijarah concept amounting
to RM160 million and a five-year US$350 million
global sukuk ijarah.
Another recent development in the Islamic capital
market in Malaysia is the amendment of the Gov-
ernment Investment Act 1983 in June 2005 which
was renamed the Government Funding Act 1983.
With the amendment of the legislation, the govern-
ment is now accorded greater flexibility to source
funds from the capital market through the issuance
of lease-based and asset-based Islamic financial
instruments. In February 2006, Bank Negara Ma-
laysia issued a new Islamic monetary instrument,
Bank Negara Malaysia Sukuk Ijarah, with an issue
size of RM400 million. This issuance adds to the al-
ready diversified liquidity instruments in the market
and serves as a benchmark for other short-term to
medium-term Islamic bonds.
The Need for an Effective and Effi-
cient Regulatory Framework
Islamic capital market is supposed to perform all
the functions of conventional capital markets but
with justice and equitable distribution of benefits.
The Quran and Hadith has given clear guidance on
moral rules and obligations, prohibition of interest,
and the prohibition of obtaining others property by
wrongful means. Based on these guidelines, an Is-
lamic capital market should function without inter-
est as well as without malpractices tantamount to
Page 5
grabbing others’ property by wrongful means. An-
other aspect of Islam is that it prescribes to the
compulsory financial obligation of zakat.
The Quran prescribed that the purpose of zakat is
“so that the wealth does not circulate only among
your rich folk” (Al-Hashar 59:7). In this sense, if
the capital market is not growing to allow for the
increase in wealth and economic growth or if the
growth results in the concentration of wealth to few
groups of individuals, this indicates that there ex-
ists some weaknesses in the system and corrective
measures need to be implemented by the regula-
tory authority. Hence, the regulator of an Islamic
capital market has a distinctive task of developing
the market with Islamic orientation and growth ob-
jectives.
In the conventional financial system, an ideal ef-
fective and efficient regulatory structure is said to
promote financial markets that are: (1) liquid and
efficient where there exist free flow of capital and it
is allocated properly given the underlying risks and
expected returns; (2) transparent and fair where
information must be reliable and relevant and must
flow in a timely and fair-handed manner to all mar-
ket participants; and (3) ethical and sound where
market participants must act with integrity and in
accordance with principles of unassailable conduct
as they make capital transactions and other elated
activities. The success of regulators in this case is
seen in terms of the extent to which they can build
investor confidence in the integrity and fairness of
transactions in capital market and the extent to
which they are able to develop the markets in the
direction of better transparency, greater competi-
tion and hence greater efficiency.
In contrast, the Islamic framework of finance con-
sists of three institutions, namely ukhuwah (broth-
erhood), adl (justice) and ihsan (benevolence).
Under the institutions of ukhuwah or brotherhood,
Islam unites all individuals in the bond of universal
brotherhood as if they were members of a single
Creating Dynamic Leaders
 Creating an Effective and Efficient Regulatory
Framework for the Islamic Capital Market
family. Each individual within the brotherhood is en-
titled to equal social status.
The main implication of brotherhood is cooperation
and mutual help. Seen in this perspective, the fi-
nancier and clients are members of one brotherhood
and rules out any relationship in which the financier
acts from a position of power and strength and the
client acts from the position of socially weak. This
motivation affects demand and supply forces of the
financial market in the most favourable way where-
by both parties understand each other interest and
through fair dealing focus on favourable synergies
which facilitate greater use of risk-sharing modes
of financing.
The institution of adl (justice) plays a key role in
realising the goals of social balance because it pro-
vides legally enforceable measures specified in the
contract. The fulfilment of contract roots out any in-
justice and exploitation. Islamic fiqh has developed
a comprehensive code for making contracts which
regulate the role of both parties and emphasises
that all contracts should be honoured in accordance
to the terms stipulated. Hence, adherence to the
principles relating to financial contracts minimises
the possibility of fraud and deception.
The institution of ihsan essentially means foregoing
one’s rights for the sake of others. This is an act
which is considered to be a virtue of higher order
and consistent with the Islamic concept of rational-
ity. The individual displaying benevolence under-
stands that Allah will compensate him for his sacri-
fices. Islamic teachings call upon both the financier
and the client to be kind, honest, accommodating
and generous. In fact, ihsan contains set of values
that give rise to professionalism, high ethical con-
duct and the concept of trust the by-product which
is good governance. In Islam, elements of good
governance that is trust, accountability and ethical
conduct are the way of life.
Although the Islamic system has the potential of
Page 6
introducing market discipline in the Islamic finan-
cial system, this does not eliminate the need for
regulation and supervision. The role of regulation is
more towards ensuring strong investor protection
through effective surveillance and enforcement as
well as enhancing the level of competition in the
marketplace and facilitating product innovation.
Furthermore, given that the Islamic capital market
is still in its infancy, market discipline in the market
requires a system of laws, rule and standards to
discriminate in favour of companies with high stan-
dards of corporate governance and disclosure and
to exact penalties on companies that manipulate
the market. In this sense, the functions of the reg-
ulatory authority of the Islamic capital market are
fairly similar to those regulating the conventional
capital market.
The basis for most conventional regulation is the
efficient capital market hypothesis (ECMH). The
ECMH is an economic model which assumes that
the market is comprised of a large number of ra-
tional participants and that information is fully and
quickly available to them. What constitutes an ef-
ficient and effective capital market? Efficient capital
markets can be defined as being ethical, transpar-
ent, and provide adequate investor protection.
In the conventional finance literature, much has
been studied on capital market efficiency. These
studies essentially examined the notion of how
much, how fast, and how accurately available infor-
mation is incorporated into security prices. West-
ern financial economists often classify efficiency
into three categories based on what is meant by
available information, i.e. weak, semi-strong, and
strong forms.
Weak-form efficiency exists if security prices fully
reflect all the information contained in the history
of past prices and returns. If capital markets are
weak form efficient, then investors cannot earn ex-
cess profits from trading rules based on past prices
Creating Dynamic Leaders
 or returns. Thus, stock returns are not predictable,
and so-called technical analysis (analyzing patterns
in past price movements) is useless. Under semi-
strong form efficiency, security prices fully reflect
all public information. Thus, only traders with ac-
cess to non-public information, such as some cor-
porate insiders, can earn excess profits.
Under weak form efficiency, some public informa-
tion about fundamentals may not yet be reflected
in prices. Thus, a superior analyst can profit from
trading on the discovery of, or a better interpreta-
tion of, public information. If market is semi-strong
efficient, it reacts so quickly to the release of new
information that there are no profitable trading op-
portunities based on public information. Finally, un-
der strong form efficiency, all information (even ap-
parent company secrets) is incorporated in security
prices. In this case, no investor can earn excess
profit trading on public or non-public information.
Why does informational efficiency matter? The cap-
ital markets channel funds from savers to firms,
which use the funds to finance projects. Informa-
tional efficiency is necessary if funds, allocated
through the capital market, are to flow to the high-
est-valued projects. Moreover, efficient capital mar-
kets make it easier for firms to raise capital because
the markets determine the prices at which exist-
ing and potential security holders are willing to ex-
change claims on a firm’s future cash flows.
A related reason for having an interest regarding
efficiency is that investors who do not have the
time or the resources to do extensive analysis will
be more willing to invest their savings in the mar-
ket if they believe that securities traded are accu-
rately priced. This, in turn, helps the capital market
to perform its function of translating savings into
productive projects. Finally, there are policy impli-
cations of evidence on market efficiency. If capital
markets are efficient, then the regulator’s role in
capital markets should be very limited. If security
prices do not accurately reflect fundamentals, how-
Page 7
ever, there might be a case for regulating both the
operation of the securities markets and the capital-
allocation process itself.
If market is efficient, then why do we need to have
a regulatory framework in place? The goal of regu-
lation is to ensure the fair, efficient and transparent
operation of the Islamic capital market while at the
same time protecting investors. A truly competitive
capital market must inspire investor confidence in
the market, confidence on the Shariah-compliant
process, confidence that Islamic products are truly
Shairah-complaint, must be fair and most impor-
tantly must be perceived to be fair.
It should be noted that regulations cannot prevent
investors from losses, nor should regulations at-
tempt to do so. Furthermore, laws and regulations
should not discourage risk-taking, but regulations
should make sure that investors have reliable infor-
mation on which to base their decisions. Hence, the
role of the regulator is to ensure that strong inves-
tor protection is in place through effective surveil-
lance and enforcement as well as enhance the level
of competition in the marketplace and facilitating
product innovation. Rather than slowing the devel-
opment of the Islamic capital market, an optimal
and efficient level of regulation will bolster investors
demand for Islamic securities.
Hence, the growing significance of the Islamic capi-
tal market requires the development of an effective
and efficient regulatory framework to provide the
enabling environment to support the development
of the Islamic financial services industry. It is also
necessary to promote the efficient operation of the
capital market and its institutions for accelerating
the development of the capital market.
However, regulation should not be so rigid and com-
prehensive that it raises compliance costs unbear-
ably and also strangulates innovation and creativity.
The trade-off between stability and efficiency should
not be lost sight of. Furthermore, the need for the
Creating Dynamic Leaders
 Creating an Effective and Efficient Regulatory
Framework for the Islamic Capital Market
Islamic capital market to have the necessary regu-
latory, supervisory and self-regulatory framework,
which is at par with international best practices, will
ensure that Islamic business activities take place in
an efficient, prudent and sound manner.
Given that Islamic capital market has yet to reach
a mature stage, the regulator plays an important
role as the promoter of product innovation and in
developing a wider range of financial services and
products that are Shariah-complaint. Furthermore,
the development of new products that suits the dif-
ferent kind of issuers and investors of varying char-
acteristics is one of the ways that can contribute
to the increase in the share of Shariah-complaint
products in the aggregate market. Nonetheless,
product development and its market acceptance is
a complex issue which needs to be addressed.
Learning from the experience of product develop-
ment in Malaysia and other countries such as Paki-
stan and Sudan, several distinctive lessons should
be pointed out. First, it is important that the issuer
remains active in refining the products and that the
regulatory framework provides an environment that
is supportive to innovation and retracting of older
products. Secondly, education of investors and the
general public is very crucial towards creating a de-
mand for the product and making informed invest-
ment decisions. Thirdly, a slight change in the stan-
dard terms and conditions can have a significant
effect on the liquidity of the product. Therefore, an
important consideration in product development is
the implications of new features of the product on
its liquidity.
A robust and effective regulatory framework pro-
motes efficiency of the Islamic capital market by
working to correct information asymmetries that
may possibly result in market failures and subop-
timal allocation of funds. Most often, these failures
arise when there are significant disparities between
the quantity and quality of relevant information ac-
cessible to market participants. Regulation should
Page 8
be designed so that investors are able to adequate-
ly gauge the risks and potential returns on the in-
vestments.
However, this is not to say that the purpose of regu-
lation is to have full disclosure of information, but
the aim should be rather on reducing information
asymmetries to the point that benefits of disclosure
still outweigh the costs of compliance. This is what
constitutes an effective regulation which will ulti-
mately result in a more efficient Islamic financial
system.
The importance of transparency and disclosure re-
quirements for the Islamic capital market cannot
be overstress. For the regulators, a fine balance
between enhancing the growth of the industry and
ensuring safeguards to protect investor interests
needs to be of top priority when designing regu-
latory framework for the market. Although timely
and relevant information are expected to increase
market discipline, it is necessary that the disclosure
of such information be matched with the ability of
market players and investors to effectively utilise
the information.
Complementing the need for investor protection is
effective risk management systems. In this regard,
risk management infrastructure must be put in
place to facilitate the identification, measurement,
monitoring and control of all inherent risks that ex-
ists in Islamic products and instruments so as the
specific risks that entails in these instruments can
be effectively managed.
As discussed earlier, an effective regulatory frame-
work enhances investors’ confidence and in the
case of Islamic finance, it should enhance investors’
confidence in Shariah-compliance products where
investors are truly confident that all Islamic capital
products which are labelled as Shariah-compliant
fully reflect the Shariah framework. The role of the
Shariah advisory board at the regulatory level plays
a crucial part in ensuring a high level of investor
Creating Dynamic Leaders
 confidence in the quality, consistency and reliability
of the Shariah-compliance process. In Malaysia, a
strong regulatory structure is already in place.
The regulators rely on a two-tier approach to regu-
late the provision of Islamic financial products and
services. In the first-tier regulation, all issuers if
Islamic financial products must comply with the
general conventional capital market requirements
and disclosure standards derived from statutes and
listing requirements. These include complying with
disclosure requirements relating to prospectuses or
trust deeds, disclosure of interests in the provision
of investment advice and the segregation of client
monies in trust accounts.
The Islamic capital market products must also com-
ply with Shariah requirements by virtue of being
an Islamic product, i.e. the second-tier regulation.
However, in practice, wherever feasible, the addi-
tional requirement for Shariah compliance is added
on to the existing first-tier regulations. These ad-
ditional requirements relate to the appointment of
a Shariah committee or adviser and specific report-
ing requirements, among other things. Therefore,
unlike conventional financial securities which are
governed by investor protection, Islamic securities
are governed by both investor protection as well as
Shariah-compliant.
Over the years, much have been debated and dis-
cussed on the issue of corporate governance fol-
lowing the Asian financial crisis in 1997 and most
recently corporate scandals in the US and Europe
have shown how the lack of good corporate gover-
nance has exacted a heavy toll on the market and,
as a result depleted investors’ confidence. Enhanc-
ing corporate governance involves a collective re-
sponsibility amongst regulators, professional bod-
ies, corporate leaders, investors and shareholders.
There is a wide array of definitions of corporate
governance. A complete and widely used definition
is the one given by the OECD:
Page 9
“Corporate governance is the system by which busi-
ness corporations are directed and controlled. The
corporate governance structure specifies the distri-
bution of rights and responsibilities among different
participants in the corporation, such as the board,
the managers, the shareholders and other stake-
holders, and spells out the rules and procedures for
making decisions on corporate affairs. By doing this,
it also provides the structure by which the company
objectives are set and the means of attaining those
objectives and monitoring performance”.
This definition highlights the broad scope of cor-
porate governance’s meaning since it concerns all
the participants from both inside and outside the
company. Good corporate governance practices are
expected to increase the profitability of the com-
pany by enhancing the credibility of the company
which in turn ameliorates the confidence of the in-
vestors and to a certain extent lowers the cost of
capital. On the other hand, poor corporate gover-
nance practices may lead, as it has been observed
in the recent corporate scandals, to fraud and put
corporations in financial distresses.
One of the distinctive features of Islamic finance
is the existence of the Shariah board in the corpo-
rate governance structure of Islamic financial insti-
tutions. The role of the Shariah board can conse-
quently be divided in two parts: (1) retrospective
and (2) prospective. The retrospective part consists
of verifying that all activities executed by the Islam-
ic financial institution have been done in accordance
with the Shariah Law.
This could be assimilated to a Shariah audit of the
Islamic financial institution’s activities. The second
part of the Shariah board’s task more specifically
concerns the future of the Islamic financial institu-
tion in the way that the Shariah board also has to
give advice and even take decisions on the activi-
ties that the institution wants to undertake. That is
why it is important that the Shariah board be an
independent decision body from the management
Creating Dynamic Leaders
 Creating an Effective and Efficient Regulatory
Framework for the Islamic Capital Market
and the board of directors. Indeed, since the Sha-
riah board is expected to conduct a Shariah audit
of the Islamic financial institution’s activities, the
Shariah board members must not feel any influence
from the management or from the board of direc-
tors on their task.
In order to ensure that each Shariah board of the
Islamic financial institutions do not make deci-
sions independently, the National Shariah Advisory
Council (NSAC) was set up to supervise the deci-
sions taken by different Malaysian Shariah boards.
The NSAC is considered to effectively play its role
of harmonizing the decisions taken by the various
Shariah boards.
Whenever the Shariah board members of an Is-
lamic financial institution are not able to answer a
question, they refer it to the NSAC who will have to
take a final decision on the raised issue. Also, the
Shariah boards will have to ask the approval of the
NSAC for every new Islamic financial product they
wish to offer except if this type of Islamic financial
products has already been launched by other Is-
lamic financial institutions. The same structure has
been chosen at the level of the regulatory authority
as what we have seen in the case of the Shariah
board of Islamic financial institutions.
Hence, one cannot over stresses the fact that an
effective and efficient regulatory should also pro-
mote and encourage the participation of conven-
tional issuers and investors in the Islamic capital
market. The Islamic capital market would be highly
inefficient if it were to develop as a closed system in
which only Islamic financial institutions participated.
A strategy of openness is essential in order to cre-
ate an international Islamic capital market that is
characterized by both liquidity and effectiveness in
serving the needs of both conventional and Islamic
financial institutions. In this regard, coordinated
initiatives will need to be undertaken to promote
participation in the Islamic capital market among
major international issuers and investors.
Page 10
The challenge to regulators is to consistently be
abreast of and track new market developments in
order for there to be an effective and timely for-
mulation of standards, guidance or best practices
where necessary. In this regard, there is a need for
the Islamic capital market to have the necessary
regulatory, supervisory and self-regulatory frame-
work that is at par with international best practices
so as to ensure that Islamic business activities take
place in an efficient but prudent and sound manner.
If an adequate and effective regulatory framework
of legislation, supervision, market surveillance,
law enforcement and penalties is put in place, this
will lead to improvement in corporate governance,
transparency and disclosure standard.
When it comes to creating an effective regulatory
framework, balance is the key. The idea behind reg-
ulation is to find the appropriate balance between
the competing concerns of investor confidence and
protection versus business interests. Striking a bal-
ance requires a consideration on the economic im-
plications of ones actions.
For example, excessive regulation slows innovation,
imposes needless costs on investors and stifles com-
petition. But at the same time, regulators must not
engage in a regulatory race to the bottom, seeking
to eliminate necessary safeguards for investors in a
quest to reduce costs. The right regulatory balance
should marry high standards of integrity and ac-
countability with a strong foundation for innovation,
growth and competitiveness. This is the daunting
task of any regulator.
As the industry is constantly facing a rapidly chang-
ing financial landscape, regulators continuously
have to rethink their approaches towards the over-
sight of the capital market. The objectives of pre-
serving confidence by maintaining fair, transparent
and efficient market have not changed; but the
methods of achieving these objectives are being re-
fashioned.
Creating Dynamic Leaders
 Greater emphasis is now being placed on discipline
within the market and by the market. At the same
time, there has to be adequate financial infrastruc-
ture to enable the players in the Islamic capital
market to conduct their business efficiently realised
that a successful Islamic financial centre cannot de-
pend on low cost alone but much depending on the
overall efficiency in the delivery system. Most im-
portantly, regulation must adapt to the changes in
the economy and the pressure of globalisation and
it needs to be engaged in a healthy partnership,
protecting capital and investors while at the same
time allowing fair competition among the financial
providers and the markets.
Global Challenges
The introduction of new Islamic capital market in-
struments will continue to be an uphill task if re-
views are not made to the existing framework and
structures governing the issuance of global Shari-
ah-complaint products. Fervent structural changes
as well as judicial consciousness are imperative for
the Islamic industry to survive the currents of glo-
balisation and change. High transaction cost is still
regarded as an issue and this stems from the dif-
ferences in the regulatory and listing requirements,
different trading platforms and trading rules, lack
of support institutions for cross-border transactions
and a range of Shariah compatible criteria.
Even though Malaysia have already in placed a ro-
bust regulatory structure, the challenge ahead re-
mains on how to bring convergence on regulatory
structures across national borders. As discussed
earlier, the Islamic capital market needs to be
opened and accessible to all investors be it Muslims
or non-Muslims. But in order to attract big players
into the market, we need to understand what global
institutions look for when exploring the world’s cap-
ital markets. Above all, they seek familiarity with
the financial systems and regulations as well as cer-
tainty that justice will be upheld by the rule of law.
Page 11
Hence, this creates the challenge of developing ho-
mogeneity in the Islamic capital market.
Given that the current Islamic capital market prod-
ucts are segmented across countries, a system of
Islamic Depository Receipts (IDRs) is proposed in
order to expand the market for Islamic products.
Such as system of depository receipts have evolved
in the conventional emerging markets under the
similar difficulties involved in cross-listing whereby
instruments such as Global Depository Receipts and
American Depository Receipts have emerged.
A depository receipt is a negotiable an transferable
instrument that is traded on the stock exchanges of
a country but represents a stock that is listed and
issued by a firm in another country. Given that at
present cross-listing possibilities exist only across
few Muslim countries, IDR offers a good alternative
to start with. Hence, a system of IDR on Shariah
compatible products has the potential to expand the
market size of the Islamic capital market, investor
base and the liquidity of the product and market.
Another advantage of IDR is that it will eventually
lead to regulatory competition amongst jurisdiction
as each jurisdiction will be constantly trying to im-
prove investor protection as well as Shariah compli-
ance.
The end result would be the much needed conver-
gence of product standards and Shariah applica-
tions. For example, given that IDR is governed by
investor protection and Shariah compliance, if the
investor demands certain degree of corporate gov-
ernance as well as Shariah compliance in the un-
derlying asset of the IDR then those who do meet
the required levels will not benefit. This forces the
individual firms to improve corporate governance
and the regulators to amend regulations towards
more converging views. Hence, it important that we
study this aspect from the operational side as well
as to come up with Shariah and market rules for
such an activity.
Creating Dynamic Leaders
 Creating an Effective and Efficient Regulatory
Framework for the Islamic Capital Market
Another issue facing the development of the Islamic
capital market is the lack of convergence of Shariah
interpretations. Different Muslim countries have ad-
opted different practices in relation to various Is-
lamic capital market product and services which is a
result of the varying interpretation on various Sha-
riah issues across jurisdictions due to the different
school of thought among Shariah scholars.
This may have implications for cross border flows in
relation to investment and trading of international
Islamic instruments. Convergence of Shariah inter-
pretations will facilitate higher level of issuance of
globally accepted Islamic capital market products
and services in the international market. Arguably,
the harmonisation of Shariah interpretations could
lead to the creation of more homogeneous Islamic
capital products and services that in turn will in-
crease investor’s demand and enhance the overall
growth of the Islamic capital market.
Furthermore, standardised practices among market
players in the market should result in a reduction in
transaction cost as well as risks. Differing Shariah
transactions may also impact the enforceability of a
transaction, as differences in interpretation would
affect the recognition of legal rights and liabilities of
parties to a transaction, particularly in a cross-bor-
der transactions and listings. In order to expand the
market for Islamic products and make them avail-
able at global level, efforts have been underway to
cross-list Shariah compatible products across mar-
kets.
In the development of the Islamic capital market,
regulators must recognise the need for innova-
tive Islamic products to meet the demand of both
Muslim and non-Muslim investors; the need for an
active primary and secondary trading to generate
market liquidity; whilst at the same time ensuring
that investors are adequately protected and an ef-
fective regulatory framework is in place to promote
financial stability of the Islamic capital market. In
the environment of rapid changes, innovative solu-
Page 12
tions are required to meet the changing and more
complex customers’ needs.
Product innovation is crucial in the process of deep-
ening and broadening the Islamic financial industry
and thus a critical factor in the development of the
Islamic capital market and finance. For Islamic cap-
ital markets to remain competitive, attractive and
innovative; indigenous Islamic financial products
must be introduced to meet the risk-reward profiles
of investors and issuers, fulfilling all the tenets of
the Shariah while remaining sufficiently cost-effec-
tive and competitive vis-à-vis conventional prod-
ucts. By confining product development to mere
evaluation and adaptation of products in the con-
ventional markets, the Islamic capital market will
have to play a perpetual catch-up game with the
conventional financial system. There will also be a
continuous reliance on the expertise within the con-
ventional market to take the Islamic capital market
forward.
Conclusion
An effective regulatory framework for the Islamic
capital market should promote transparency of
price data; promote transparency of relevant issuer
information; be designed and enforced to maintain
and enhance market credibility, openness and in-
vestor confidence; and ensure a level playing filed
in trade execution for all market participants. All
these will foster efficient Islamic capital market by
permitting investors to make well-informed deci-
sions and provide issuers with lower capital costs.
Self-regulation is also promoted in the market be-
cause it encourages market participants to “buy-in”
to the purpose and meaning of regulation.
As the regulator, our role is to develop an effective
and efficient regulatory framework which provides
an enabling environment to support the develop-
ment of the Islamic financial services industry. In
Creating Dynamic Leaders
 this regard, the purpose of an effective regulation is Overview of the Malaysian Islamic Capital Market,
to ensure the fair, efficient and transparent opera- Quarterly Bulletin of the Malaysian Islamic Capital
tion of the Islamic capital market while at the same Market, May 2006 Vol. 1 No. 1.
time protecting investors.
M. Umer Chapra and Tariqullah Khan (2000), “Regu-
Such regulations should also inspire investor con- lation and Supervision of Islamic Banks”, Occasional
fidence in the market, confidence on the Shari- Paper No. 3, Islamic Development Bank, Islamic
ah-compliant process and confidence that Islamic Research and Training Institute.
products are truly Shairah-complaint. Challenges
facing the Islamic capital market at the present are
product innovation; attracting conventional players
to participate in the Islamic capital market for man-
aging the liquidity as well as investment purposes;
and the integration of Islamic capital market glob-
ally. All these issues need to be addressed by all
participants in the market, including regulators.

References:

Iqbal, Zamir and Abbas Mirakhor (2002), “Devel-

opment of Islamic Financial Institutions and Chal-
lenges Ahead,” in Simon Archer and Rifaat Abdel
Karim (eds.) Islamic Finance: Growth and Innova-
tion, Euromoney Books, London, UK.

Salam Syed Ali (2005), “Islamic Capital Market

Products: Development and Challenges”, Occasion-
al paper No. 9, Islamic Development Bank Group,
Islamic Research and Training Institute.

Islamic Capital Market Fact Finding Report, July

2004, Report of the Islamic Capital Market Task-
force of the International Organization of Securities
Commissions.

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Creating Dynamic Leaders