Tuesday, November 02, 2010

More thoughts on the ILMC

There are still few details about the International Islamic Liquidity Management Corporation that was established in Kuala Lumpur, Malaysia by the members of the Islamic Financial Services Board (IFSB). One new piece of information is that the ILMC will issue short-term papers in international reserve currencies (starting with the US dollar and Euro). I don't have any source for other than my own intuition, but I would suspect that the short-term issuance will be based on commodity murabaha (perhaps using the facilities at Bursa Suq Al-Sila'). The Bursa Suq Al-Sila was established in late 2009 as a Shari'ah-compliant trading platform in crude palm oil in Malaysia to facilitate Islamic financial institutions' liquidity management. That platform has already been used by international Islamic banks like Al Rajhi Bank's Malaysian subsidiary, which became a Commodity Trading Participant in August.

The use of commodity murabaha (if this were the choice made for the short-term issuance) would provide some benefits, but it would be outweighed in some areas by the costs of using the murabaha structure. First, the benefit is that commodity murabaha is globally recognized as being Shari'ah-compliant and therefore would sidestep any potential debate about whether the Shari'ah standards used were globally recognized. Even without using the commodity murabaha product, the difference in Shari'ah opinions is somewhat overstated as it relates to the ILMC because it would follow a well established trend for Islamic finance institutions to have a diverse Shari'ah board to command global respect for their rulings. Recently, Al Rajhi Bank worked with Cagamas, the Malaysian housing agency, to develop the Sukuk ALIM to be acceptable in both Malaysia and the GCC. And long before that sukuk, the Dow Jones family of Islamic indices was launched with a Shari'ah board composed of scholars from many regions, including both the GCC and Malaysia. In addition to the Shari'ah-compliance issue, using murabaha would be familiar to bankers who currently use inter-bank murabaha to manage liquidity. The ILMC would formalize this and reduce the counterparty risk associated with short-term interbank lending.

While the benefit would be substantial of using a structure that everyone accepts, even if there is debate about the appropriate level of reliance on murabaha by the industry as a whole, it would impose costs. The largest cost would be that the short-term bills are generally not tradable, except at par, because they represent a debt from the issuer and do not provide the investor with ownership of an asset that would be the basis for any secondary market trading. I recall (although I may be misremembering) that these bills would be issued with maturity of up to 1 year and therefore the absence of a mechanism for their secondary market trading would deprive the industry of a benefit from having a global, multi-currency short-term issue. This is not a problem that would be unique to the ILMC; in addition to its short-term ijara sukuk, the Central Bank of Bahrain issues sukuk al-salam, which have a similar limitation. The cost of not having secondary trading is that the ILMC would miss the opportunity to provide a reference rate of return that--by virtue of its shareholders being central banks and regulators--would be close to a risk-free rate of return on which other pricing could be based.

While it is easy to offer a criticism of the ILMC if it were in fact to choose commodity murabaha as the structure for its short-term bills, it would be difficult to develop an alternative that addresses the concern. First, it would have to probably be either a wakala, mudaraba, musharaka or ijara contract to be tradable and thus offer a reference pricing benchmark for other short-term financing. From these structures, there would have to be an easy, and relatively costless, way to issue short-term financing to attract widespread usage. All four of these contracts raise issues for which I don't have an easy answer for. The wakala structuure would benefit from using a structure that is relatively common in inter-bank liquidity management. However, with one of the parties (the one borrowing money by issuing sukuk) being a multi-lateral institution owned by central banks and regulators, there would have to be some use of the funds that would generate a return to pay for the wakala return or else the structure would raise issues of Shari'ah-compliance (with the ILMC acting as agent for the provider of funds, the return would have to be based on some activity). The mudaraba and musharaka would raise similar issues: what activity is being financed by the ILMC that generates the return paid to investors in the short-term sukuk?

The ijara structure would be easier to structure because their returns can be based on the rental of property or some other good. However, the ILMC is expected to be located inside the Petronas towers in Kuala Lumpur and would therefore not have sufficient assets on which to base the ijara sukuk. Even if the ILMC owned assets like its headquarters building, it is hard to see how it could have sufficient assets to issue the level of sukuk necessary to fill the demand for short-term sukuk. Every increase in the demand for the short-term sukuk would require the expansion of the assets held by the ILMC (not to mention the expansion necessary if they were wakala, mudaraba or musharaka sukuk). This would increase the cost and limit the demand for the sukuk, which would defeat the stated goal of providing liquidity management products to Islamic banks. With the alternatives posing difficulties, it seems likely that the ultimate structure will be commodity murabaha and despite the issues raised with this structure, it is the 'least costly' setup for creating better liquidity management tools, and the need for the product makes accepting the limitations of a commodity murabaha structure.

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