Islamic financial instruments continue to evolve, but their growth is facing numerous challenges, including stringent requirements for Shariah law compliance that restrict the source and purpose of funds, a new report finds.

According to Fitch Ratings’ Islamic Finance Survey 2025, liquidity management and funding constraints pose the biggest challenges to the further development of Islamic finance.

Investors face several barriers to investing in the sukuk market, including the limited availability of quality sukuk and their low liquidity.

The fragmented landscape of issuers also limits investor choices and market flexibility. Frequent issuers, including Malaysia, Saudi Arabia, and Indonesia, launch the majority of sovereign sukuk, but activities are muted in countries such as Oman, Nigeria, and Jordan, Fitch says in the report.

Relying on a few frequent sovereign issuers puts the market in a tough spot, especially when sukuk vary in Shariah interpretations, thereby restraining investors who insist on strict Shariah compliance from purchasing sukuk with a more flexible approach.

“Many Gulf Cooperation Council Islamic banks do not invest in Malaysian government investment issuances because the murabaha-based contract has tradability restrictions and currency risk,” the report explains.

Sukuk’s liquidity is also likely to suffer from the regulated flow of funds between Islamic and conventional banks. Bank Negara Malaysia, the country’s central bank, has barred Islamic financial institutions from transferring funds to conventional counterparts, while Oman also has similar regulations in place to maintain Shariah compliance.

Bolstering market liquidity

In a bid to bolster Islamic finance, several Islamic jurisdictions have sought ways to increase liquidity in the sukuk market. According to the Fitch report, several regulatory initiatives “are underway for providing Islamic banks with opportunities to seek funding and invest their additional liquidity”. The aim is to standardize and harmonize regulations to enhance market development.

Malaysia is one of the countries shaping the Islamic finance agenda. Bank Negara has released the Islamic Collateralized Funding Policy Document to provide clarity on Islamic financial instruments. This includes the collateralized murabaha, which allows a client’s asset to be sold if the obligation is not repaid, and “sell and buyback” agreements, which resulted in Islamic interbank repo transactions tripling to US$10 billion, according to the report.

Similar moves were seen in Bahrain, where the central bank launched a Shariah-compliant commodity murabaha facility last year.

The market could also benefit from technological advancements. “Use of technologies such as tokenization, collateralized digital assets, blockchain-based repos, AI-driven interbank operations, and smart contracts could also support Islamic banks’ liquidity management by potentially enabling real-time settlement, enhancing transparency, supporting fractional ownership, and market liquidity,” says the report.