Sunday, December 05, 2010

Islamic Commercial Paper

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The Banker has a fantastic article on the liquidity management tools currently available to Islamic banks.  At the end of the article, it briefly covers an effort by Geert Bossuyt, formerly the head of Islamic finance at Deutsche Bank now with Dar al-Istithmar, to establish an independent Islamic commercial paper (CP) facility for Islamic financial institutions.  The article offers few details about the CP plan he is developing, which is based on using a single SPV owned by a charitable trust (to make it independent) using a double-wa'd structure.

The Dar al-Istithmar website provides a little more details, although just in the form of a transaction diagram.  From what I can gauge, it is the same structure used by Deutsche Bank for their Al-Mi'yar platform (which I wrote about in a 2009 post).

Source: Dar al-Istithmar.

The structure uses the wa'ad Shari'ah wrapper, which has attracted criticism in the past, although depending on what returns are being swapped, it may not be as controversial as when it was used for generating returns from conventional hedge funds inside of a Shari'ah-compliant wrapper.  Here is my best guess on how the product works:

The independent issuer SPV is established and issues its CP certificates to the investors (Islamic financial institutions).  The proceeds of these funds are invested in a Shari'ah-compliant asset, whether that is a basket of Shari'ah-compliant stocks, commodity murabaha contracts or any other asset that is Shari'ah-compliant (the diagram says "Shari'a compliant shares", suggesting stocks).  The SPV then enters a dual wa'd undertaking with a counterparty to swap the returns of the Shari'ah-compliant asset (presumably) with the returns on conventional money market funds.  The dual wa'd would have to be structured to ensure that only one side of the dual wa'd will be exercised (otherwise it would run into Shari'ah-compliance questions).

At this point, the SPV generates a return that is equivalent to a conventional money market fund to pay to the holders of the CP certificates it issued.  The counter-party is receiving a stream of returns based on whatever the Shari'ah-compliant assets are invested in, which it can separately hedge using conventional hedging tools (unless it is an Islamic financial institution itself).  The investors can hold their CP certificates as long as they have surplus liquidity and if they need liquidity, they can sell the CP on to other investors, who will then receive the stream of money market returns from the SPV.

The risks to the investors and to the SPV is that its swap counterparties are unable to fulfill their side of the swap.  If one counterparty became insolvent, the SPV might have difficulty continuing operations because the payments expected by investors would have to be generated by the investments of the SPV.  This would likely have a destabilizing impact on the entire platform because it is likely that there would be some general financial market stress, which would lead to lower asset values for the assets held by the SPV.  This would probably be accompanied by greater cash needs for the investors in the Shari'ah-compliant CP (and a general desire to hold more safe assets with limited counterparty risk).

If doubts became widespread about the counterparties of the SPV, it could trigger a 'run' on the SPV to redeem shares (if that is possible) or at least pressure on the price of the CP in the secondary market, which would be akin to the problems facing the conventional money market funds that came close to 'breaking the buck' or falling below the $1 net asset value.   These problems could be mitigated if not entirely avoided if the counterparties to the platform were one or many central banks of countries viewed to be stable (US or EU for example), although any central bank that had access to the Fed swap lines during the recent crisis would probably suffice (or a multilateral institution like the Islamic Development Bank with a AAA rating and many member countries who could support the bank in its role as the dual wa'd counterparty).

There are always going to be risks that contagion develops for money market products unless they are somehow guaranteed by "reliable" sovereigns.  Developing a structure for money market funds will be a tricky business.  The current setup of ad hoc bilateral commodity murabaha also creates the same type of counterparty risk, so whether the replacement structure uses a  network of commercial counterparties or sovereign counterparties, the success of each product should be viewed on how cost competitive it is to conventional liquidity management tools, as well as how much it reduces counterparty risk over bilateral commodity murabaha.  Finally, there will also be an impact of the structure on how widely used it is.  The more controversial a structure, the less likely it will be to gain wide acceptance unless it offers something compelling on the other metrics.  What is undoubtedly positive is that liquidity management has moved the the fore for new product development.  This is probably the best legacy of the financial crisis for Islamic finance.

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