In the newsletter, I wrote:
"I have not yet had time to read over the IIFM report on Shari'ah-compliant repurchase agreements (repos). However, I am sure it will be viewed negatively in some respects with an argument made that the repos are just another example of Islamic finance replicating conventional financial products. The argument is valid in some respects. In a repo transaction one party borrows money by selling a debt with an agreement to repurchase at a higher cost at some specified point in the future. The transactions are generally short maturity debts, even if the underlying bond being sold and repurchase is of longer maturity (usually Treasuries or some other highly liquid investment).Having had a chance now to read the report, I think that my comments were correct. It could be viewed as an attempt to replicate repos in a Shari'ah-compliant structure, but the benefits from making short-term tools like Islamic repos available will ultimately benefit the Islamic financial industry. The report covers four concepts that were described and alludes to a fifth that is currently under discussion.
By that definition, there would seem to be several issues that are worked around that would make a repurchase agreement not Shari'ah-compliant. There is trading in debt, interest payments, and a forward contract on a debt at a specified price; all of which would make a traditional repo agreement not Shari'ah-compliant. The new structuring will likely replicate the outcome through a different Shari'ah-compliant structure. In the past with other transactions, that usually leads to criticism."
"The criticisms usually neglect the difficulty of developing an alternative to conventional finance working within a financial, legal and regulatory system that was developed with only the conventional financial system in mind. As such, it is hard to create an industry that competes with conventional finance and works within the financial system and so replication of conventional products--while not necessarily desirable long-term--do provide the Islamic financial industry with a starting point and as it develops further there will be changes that seek to improve it."
"The argument that product replication is desirable is not clearer in my view than for the case of repos and other short-term liquidity management tools. These allow banks to invest more of their capital (rather than holding it in cash), which makes them more competitive with conventional financial institutions while also increasing the stability of Islamic financial institutions by increasing the liquidity of their balance sheet. So long as their counterparties in repo transactions believe they are solvent, they will be able to manage withdrawals of deposits without being forced into a firesale of their assets. There are always potential areas where problems can arise like the Lehman Brother's Repo 105, which manipulated the bank's assets to make it look more healthy than it was and this could become a problem with Islamic repos. However, as long as sufficient controls are put in place by regulators, the benefit from greater ability for banks to manage liquidity will outweigh the criticism of just another highly structured conventional product with a structure that makes it Shari'ah-compliant."
The first concept is a bilateral repo (I'aadat Al-Shira'a or 'IS'). It is the closest to a conventional repo. Two parties agree to a sale by one party in the spot market with a repurchase of an identical (although not necessarily the original) security at a later date at a set price. The set price (not dependent on the market price at the time of repurchase raised issues of riba with the Shari'ah considerations with the scholars they asked. The use of an identical (part of the same offering) rather than the original security was generally accepted as avoiding the problem of debt trading (bai' al-inah).
The second concept changed the purchase undertaking to a wa'd (unilateral undertaking to purchase or sell), but raised more Shari'ah issues that the authors said would be "difficult to overcome". As a result of the difficulties associated with bilateral repos ('IS'), the third concept abandoned the bilateral structure for a three-party structure, which is different from the conventional tri-party repo.
The three-party structure inserted a third party in between the two parties with a sale to the third party by the 'borrower' and a purchase from the third party by the 'lender'. There was also a purchase undertaking for a specified price between the 'borrower' and the 'lender' to return the securities for a pre-specified sale price at maturity of the repo agreement.
The issues in the three-party repo were covered more extensively than in bilateral repo, which suggests that the three-party repo is a more preferable model, at least from the perspective of the report's authors. There remain significant financial and accounting issues concerning margin calls, overcollateralization, accounting treatment of the repos. From a Shari'ah perspective, there are issues with the purchase undertaking, specifically whether it can be exercised by the lender (to force repurchase by the borrower) or whether it is a unilateral promise (wa'd) by the borrower to the lender.
In my opinion, the issues highlighted by the authors are valid and it will be difficult to create a three-party repo that has the substance of a repo transaction (and be acceptable to both parties, regulators and accounting bodies) while avoiding the pitfalls mentioned from the Shari'ah perspective. The sale and purchase transaction at the outset is in the spot markets and is probably acceptable (although if the transaction were overcollateralized, there might be issues). However, the purchase undertaking for securities raises issues that are much more difficult. If the purchase undertaking were unilateral (not binding on the borrower), then it would in essence be a call option, which would not be acceptable for the lender. If the values of the securities fell, the borrower would just abandon them to the lender (let the call expire) and the lender would be left with a loss. In the conventional setting, most repos are conducted using highly secure and highly liquid bonds (like US Treasuries) and the use of overcollateralization or haircuts can mitigate this risk to the lender (as can the enforceability of the repurchase agreement). However, these are not possible in the Islamic repo transaction.
The final concept outlined is one that is essentially a modified commodity murabaha transaction. As in a commodity murabaha transaction, the lender buys a commodity and sells it with deferred repayment to the borrower. Unlike a straight commodity murabaha, the repayment obligation is secured by the sukuk held by the borrower (and overcollateralized to cover fluctuations in the value of the collateral). If the repayment is made on schedule, the sukuk are not sold and is returned to the borrower. If there is a default, the lender takes possession of the sukuk and can sell them to recoup the unpaid repayment. There are a number of issues that were encountered in the three-party repo (margin maintenance, accounting treatment and Shari'ah issues) as well other issues as whether the securities held as collateral could be re-hypothecated (i.e. used by the bank holding the collateral in its own business).
The final concept uses the most similar structure to Islamic short-term liquidity management instruments used today, but if re-hypothecation were allowed, it would be the most 'replicated' product structure. The addition of transfer of securities as collateral (without compensation) on top of the use of commodity murabaha would raise the most objections, I believe, on grounds that the product is cynical and does nothing to really help the industry develop new products. With the three-party repo at least, there would be a purchase and sale of the securities and the obligation created by the wa'd (purchase undertaking) would be based on another purchase of securities, however difficult the Shari'ah and financial issues it presents are.
None of the four proposed methods are perfect and as I described in my newsletter, that was likely from the outset. However, by providing an overview that describes the benefits and the limitations and Shari'ah-compliance issues involved with each, I think that the authors of the IIFM report have done a great service. Not only were the issues laid out, they were done so publicly. While it may receive criticism as being an exercise in replication of a conventional product for the Islamic financial industry, this degree of transparency can only serve to start debate about what alternative structures could be used. For example, would it be more worthwhile for other central banks to follow the lead of the Central Bank of Bahrain and begin issuing short-term (non-tradable) securities like the sukuk al-salam? Is the Malaysian example instructive (it is probably a non-starter on Shari'ah grounds in the GCC)? However, now that four suggestions have been laid out, the burden is on the critics to propose a solution that addresses the need by the Islamic banking industry, moves away from commodity murabaha and wakala and offers a better solution than has been proposed. With the level of talent working in Islamic finance and a shared desire to create a better liquidity management tool for the Islamic financial industry, I believe this is just the first step on the road to a solution to the problem at hand.