With trade growing in countries with large Muslim populations, and innovation happening on the product side, Islamic trade finance is looking set to expand. Ben Poole reports.


Islamic trade finance is benefitting from the increasing trade activity among member countries in the Organisation of the Islamic Co-operation (OIC). According to the Islamic Centre for Development of Trade’s annual report, trade between OIC countries and the rest of the world increased from US$3.9tn in 2011 to US$4.1tn in 2012, up 6.2% year-on-year, while OIC countries accounted for 11.3% of total global trade in 2012.

Even more importantly for the purveyors of Islamic trade finance products, the trade volume purely between OIC countries is also on the rise. This figure rose to US$742.5bn in 2012, compared to US$681.6bn in 2011. This is a year-on-year increase of 9%.

“The increase of trade flows to the east and within emerging economies, combined with growing interest in Islamic finance, means that Islamic trade finance is now a serious alternative,” says Ashar Nazim, partner at Ernst & Young’s Global Islamic Banking Centre of Excellence. “A constant challenge for business leaders is to anticipate and interpret how global trade is changing, while understanding the opportunities and risks it creates. Boards and management of Islamic banks must take note. Trade, technology, culture, labour and capital will integrate at different rates across these markets and need to be anticipated when transforming the financial institution’s trade finance operations.”

Countries such as Turkey, Indonesia, Malaysia, Saudi Arabia and the UAE are developing into key countries for global trade. The trade links that these countries already have with Islamic finance markets can help drive the usage of Islamic trade finance instruments.

“Middle Eastern countries are trading increasingly with other rapid growth markets, reflecting the faster growth in demand from these countries,” says Gordon Bennie, Mena financial services industry leader at Ernst & Young. “Banking, insurance and other financial services sectors in these countries will grow as the economies mature and the middle classes expand, offering new opportunities for trade. Demand for more sophisticated financial services is already growing rapidly as wealth levels rise,” Bennie adds.

The focus on trade in Asia, the Middle East and Africa is also something that multinational corporates will have to factor in to their own trade activities. Being able to do business through Islamic trade finance methods may be a requirement that increases for exporters as their client base in these markets grows.

“It makes business sense for global organisations that operate in and trade with many of these rapid growth markets, especially those that are in the OIC or have strong links to the bloc, to seriously look at Islamic trade finance,” says Ernst & Young’s Nazim.

Islamic instruments

While Islamic trade finance instruments share similarities with those available via conventional finance, they of course must adhere to Islamic principles. This means that areas such as interest payments and debt trading are off the agenda. Instead, trade is more focussed on financing, rather than borrowing and lending.

“The most widely used instrument is the letter of credit (LC) with a slight modification to make it an Islamic LC,” says Bana Akkad Azhari, head of relationship management in the Middle East and North Africa for treasury services at BNY Mellon. “The bank opens the LC on behalf of the corporate and guarantees payment to the supplier. In turn, this is settled between the buyer and the bank through a profit sharing agreement, which is within the spirit of Islamic finance and the muharaba concept.”

One of the reasons for the popularity of this instrument is that it is relatively easy to use. It bears many similarities to a conventional LC. There are also some slightly more complex Islamic finance trade instruments that are based on the murabaha concept. In this case there is a transfer of ownership, where the intermediary (usually a bank) holds on to the ownership of the goods until they are paid for. There is also some trading on an open account basis that adheres to Islamic principles as it promotes greater transparency.

“Many people in the Mena region would always like to use shariah-compliant products,” says Rajai Ayyash, client executive and country manager for the UAE, Oman and Kuwait at BNY Mellon. “The question is whether there are enough shariah-compliant products and instruments for their needs. This is where the challenge lies for banks today, to come up with instruments and solutions to meet the demand.”

Role of the banks

Islamic banks cannot earn any interest on the dollar balances that they have. However, they can take these balances and invest them overnight in commodities and then get a good return.

In order to support the growth of Islamic trade finance products, many banks are looking at how they can drive greater efficiencies and cost savings into the process in a way that still sticks to the Islamic principles of finance. This has improved over the past decade, but there is still a long way to go before they meet all of these demands. As a result, there are still importers, exporters and investors that will use conventional banks due to the limits on what Islamic banks can offer from a shariah-compliance perspective.

“There has been a lot of innovation by the banks to improve their Islamic trade finance offering and processes,” says Azhari. “This has minimised the difference with conventional instruments in terms of processing time and cost, though the process is more complex from a documentation perspective.”

Some of the differences that exist between the two product sets cannot, by their very nature, be removed in the drive for efficiency. “What we are finding is that if customers are offered like-for-like terms by conventional and Islamic trade finance instruments, they will choose the Islamic instrument,” says Ghazi Naqvi, global head of Islamic origination and client coverage at Standard Chartered. “The clients that are adopting this are doing it on their belief systems.”

Market innovation

For Islamic trade finance providers to truly use the growth of OIC trade as a catalyst for an increase in product use, they need to demonstrate innovation in delivering products that are simple to understand and use while remaining within the clear remit of Islamic law.

“From my perspective, I am seeing some development on the insurance side,” says Naqvi. “There are more banks in the market that are offering purely Islamic products. They are looking for counterparties purely on an Islamic basis, which is another driver of growth, in terms of acceptance of the product.”

Another important factor is regulatory and the market support. “If you look at the key markets, the regulators are actively promoting Islamic banking,” Naqvi adds. “This has resulted in a greater awareness of the solutions available. You have customers who would prefer an Islamic solution wherever possible. Then there are customers who are looking for a solution-based approach.

Pakistan has been supporting Islamic banking, and it is very new if you look at the regulations introduced in that market. Then there are organisations, such as the International Islamic Trade Finance Corporation, that have been promoting Islamic trade. This has given Islamic trade finance a boost in the Mena region.”

Challenges to progress

The trade finance offerings from Islamic banks have to align with global common practices in order for corporates to consider them as a viable alternative.

These banks will need to demonstrate how the products that they offer are not just shariah-compliant, but are also capable of adding value to their clients. It is true that in some cases clients will only want Islamic financial instruments and will take whatever their institution can rustle up for them, however inefficient it may be.

However, to truly capture the opportunity presented by the high percentage of Muslim populations in rapidly growing markets, Islamic institutions need to present a compelling proposition to persuade corporates to move over from conventional finance.
Banks that are based in the Mena region also have to improve their global connectivity and offer solutions to their clients that can go beyond domestic deals.

As many Islamic banks are quite local in terms of their scale, there is a challenge for them to offer trade finance tools that can link deals across different countries or regions.

Another key challenge is the relatively small pool of Islamic scholars and experts that can oversee and confirm that the trade instruments being used are indeed shariah-compliant. Talent management is a key concern for Islamic banks, both in terms of keeping the current practitioners within the sphere of finance, and also in terms of identifying and promoting new talent as demand for Islamic trade finance services grows.

“The road to Islamic trade finance is not one without obstacles,” says Nazim at Ernst & Young. “But if the correct framework is used and awareness about shariah-compliant initiatives continues to grow, Middle East and North African markets will be able to strengthen their trade focus on the growing Muslim populations in emerging markets. These initiatives have the potential to significantly increase the value and volume of trade of these expanding markets.”

With the positive trade growth statistics being provided by the OIC nations, both Islamic and global banks will be focussed on increasing the scale and scope of their Islamic trade finance solutions.