term rates) and (2) providing risk-hedging tools for issuers and investors. Well-functioning derivatives markets complement cash markets in price formation across a broad spectrum of maturities, providing, for example, references on market expectations for changes in long-term interest and foreign exchange rates. Derivatives can also support market development by improving risk management capability for issuers and investors willing to hedge against interest rate, currency fluctuations, or even credit risk exposures.<sup>33</sup> Conventional derivatives meet the needs of only a portion of the sukuk investor base, and thus development of Sharia-compliant swap structures is needed. Ensuring the availability of both conventional and Sharia-compliant derivative instruments is important to support sukuk market development. Standard-setting institutions such as the IIFM have made progress in developing standards for certain types of derivatives transactions and have a pipeline of derivatives standards under development. The acceptability of certain derivative products is still under consideration as scholars forbid most conventional derivative products because of their speculative nature.<sup>34</sup> The challenges in finding broad acceptance may put Islamic investors at a disadvantage as compared with conventional investors who have more tools available to hedge and manage risks of their investments through the use of conventional derivatives.

Active policies to build derivatives instruments for sukuk market development will yield better results after progress in other areas is observed. Cash and derivatives markets are closely interconnected, but the development of cash markets usually comes first. Progress in critical areas such as money markets and the construction of a reference curve would facilitate implementation and growth of derivative products.

# **VI. ACCESSING INTERNATIONAL SUKUK MARKETS**

To fully exploit the potential of sukuk as vehicles for development, a holistic approach is needed to facilitate access to international sukuk markets and the development of domestic sukuk markets. Agendas for conventional debt instruments tend to concentrate on domestic markets. In the case of sukuk, both international and domestic capital markets should be analyzed. While countries with pools of Islamic savings are natural candidates to develop domestic markets given the domestic Islamic financial ecosystem, many countries have found that the international markets are more accessible given the critical mass of Islamic investors. This is also true even for some countries with a significant Muslim population. For issuers from non-Muslim majority countries, the international sukuk market holds high potential to tap for funding for strategic areas such as infrastructure development.

Although many common issues are related to the development of domestic sukuk markets and in accessing international sukuk markets, their emphases are different. Some elements such as the need of a credit rating are more critical in international capital markets, whereas others such as the tax and legal framework need to be analyzed as a complement to the jurisdiction chosen to issue and distribute global sukuk.

> 33 The preconditions, advantages, and challenges for developing derivatives markets in support of local currency bond market development are discussed in IMF, World Bank, EBRD, and OECD (2013). The document is part of an action plan to support local currency bond market development, endorsed by the G-20.

> 34The Islamic principle of _gharar_ prohibits speculation and trades that are considered excessively risky.

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