Sukuk investors eye on-exchange trading
Like conventional bonds, Sukuk are traded overwhelmingly over the counter (OTC). This pattern has been established since the first Sukuk issuances nearly 15 years ago. However, efforts to provide investors with attractive alternatives are well underway, including initiatives by several exchanges to bring trading on to their platforms. I believe that on-exchange trading will steadily become more popular in coming years, as it offers several clear advantages over the OTC model.
This will not happen overnight, and to see why it is worth looking at the reasons that commentators usually give to explain the current dominance of OTC trading. The static nature of the sector is one explanation; buy and hold institutional investors dominate in the primary market, just as with conventional bonds, and the appetite for either selling or buying in the secondary market is limited. But this argument is at least partly circular. In the absence of a satisfactory framework for trading, of course investors’ appetite for doing so will be limited. But if the framework is improved, the desire to trade will increase. Another reason that is sometimes put forward is that whereas comparing equities is an apples-to-apples type of exercise, comparing fixed income issuances is more like apples-to-pears, given the different structures and terms of each issuance. This makes it harder to attract investors into the market, as it is harder to understand, runs the argument. But as research tools improve and investors become more sophisticated, this reason too is becoming less persuasive.
The on-exchange opportunity
A shift towards trading on exchange will involve much more than an adjustment of procedures and technical behaviour. It will amount a shift in culture and mindset. This is always required when new markets are set up and it explains why they can take time to succeed. But the benefits of trading on exchange are so clear cut that I believe it is only a matter of time before it becomes widespread. Prominent among these advantages are:
Transparency: Moving trading on-exchange will lift it out of the silos in which it currently resides in the fragmented OTC market, which is operated by a large number of broker dealers and financial institutions. Instead prices, volumes and market depth will be freely available on a single screen, visible to everyone who wants to trade, or who wants to understand the market in order to decide if they want to take part in it. This will raise awareness of the opportunities that exist.
Price discovery: In the opaque OTC market, investors are often uncertain about the true value of particular Sukuk securities. This can limit their participation in the sector. On-exchange trading will immediately remove this doubt, just as it does for equities, by shining a light on market sentiment and instantly tracking its fluctutations.
Liquidity:There is enormous potential for volumes to soar when on-exchange trading gains critical mass. A virtuous circle of activity will be created, driven by a unified market place where everyone is engaging openly with everyone else.
Risk mitigation: On-exchange trading can mitigate risk by also providing a central counterparty, as this eliminates the danger of an individual party failing to honour a transaction. This framework is especially important for Sharia'a-compliant products such as Sukuk, given the emphasis placed by Islamic finance on promoting financial responsibility and providing a safe environment for investing.
A number of exchanges in the Middle East, East Asia and Europe have already created on-exchange trading platforms for Sukuk. Some are likely to grow, others will not. The usual criteria that apply to the success of any trading platform, such as trading fees, trading hours and robustness of trading technology will also apply to Sukuk. So too will the efficiency and reliability of clearing and settlement mechanisms. Particularly critical will be the number and quality of Sukuk available to be traded on a particular exchange. Exchanges that are most successful in attracting new Sukuk listings will have a clear advantage.
An international consensus in favour of expanding on-exchange trading for multiple asset classes has been growing since the global financial crisis struck more than five years ago. There is broad recognition that it is safer for the financial system as a whole, as well as for individual investors. It was OTC trading, after all, that lay at the centre of the crisis. This mood gives a fair wind to a movement towards on-exchange trading of Sukuk that I believe will soon gather pace. I do not expect that it will entirely replace OTC trading. But it will give investors a choice about how they wish to participate in the market, to the benefit of the entire Sukuk sector.
About the author
Chief Executive Officer, Nasdaq Dubai
Mr Ali was appointed Chief Executive Officer in July 2013, after serving as Acting Chief Executive Officer since August 2012. He previously served as Executive Director of Nasdaq Dubai from 2006 to 2008. His experience includes serving as Chief Operating Officer of DIFC Authority and most recently as Executive Director at the Dubai Knowledge & Human Development Authority.
Mr Ali played a key role in the development of the Dubai Strategic Plan 2015 and participated in number of strategy development exercises. These included Nasdaq Dubai’s strategy in 2006 where he had the role of overseeing the implementation of the Market of Markets strategy expanding the exchange’s activities beyond the equity and debt markets into derivatives and other sectors.
Mr Ali holds an Executive MBA from London Business School, a B.Sc. in Applied Computing from Leeds Metropolitan University, and a Master Certificate in Project Management.