Monday, February 28, 2011

An Islamic repo coming to market

The National Bank of Abu Dhabi announced that it will launch a murabaha-based Islamic repo (repurchase agreement) product in March. I believe this would be the first Islamic repo. The few details in the article suggest that it is similar to the structure proposed as most likely by the International Islamic Financial Market (IIFM) . That structure (and likely the NBAD structure) essentially create a secured commodity murabaha contract. The two parties engage in a commodity murabaha transaction (sale of a commodity with deferred repayment), but unlike a normal murabaha transaction, the borrower pledges a pool of sukuk to secure the repayment.

This transaction is not terribly innovative on its face. The main difference between this transaction and a commodity murabaha is the pledge of sukuk as collateral. There are other add-ons that could be part of the transaction. For example, the transaction could be structured so that the buyer (lender) can re-hypothecate the sukuk (i.e. use it for its own purposes, including by using it to engage in repos with other counterparties). This would differentiate the repo from commodity murabaha transactions because it ties up assets of the bank for the length of the transaction.

The downside of the repo transaction is that it further limits the potential for secondary market liquidity in sukuk because holders of sukuk will use the repo market as an alternative way to make their holdings liquid. Thus, they will be less likely to offer their sukuk holdings in the secondary markets that are already limited in the supply of sukuk being offered. The flip side of this is that it could benefit the primary markets for sukuk because investors (depending on the quality of the issuer) would be able to generate liquidity from longer-term sukuk than they can today. It could also reduce any illiquidity premium that is priced into current sukuk offerings, which would make sukuk more competitive with conventional bond offerings.

The one area of caution that the article raises is that repo transactions were used by Lehman Brothers to clean up (manipulate) its balance sheet at the end of each quarter (window dressing). By "selling" assets around the date when financial information is reported and using the proceeds of the loan (which was classified as a sale and thus not debt) to pay down debt, it was used by Lehman Brothers to reduce the level of indebtedness reported in its financial statements. This is certainly a possibility within Islamic finance, but the lending contracts are more cumbersome, raising the cost of repaying and reborrowing debt. However, the real lesson is that the practice (called Repo 105 and Repo 108 by Lehman Brothers) should be discouraged by regulatory bodies.

The details of the specific NBAD Islamic repo are not yet known, but can be guesstimated based on the IIFM paper on possible structures. Islamic repos--particularly if the pledged sukuk cannot be re-hypothecated--will not do much to reduce the reliance on commodity murabaha, but it can increase the liquidity management options available for Islamic banks, which should (given enough controls to prevent abuse) make Islamic banks more stable. One of the secondary effects could be a reduction in the spread between conventional bonds and sukuk, which could increase the appetite by issuers to choose sukuk. This on its own could help the secondary markets because investors might shed their hold-to-maturity outlook, at least those investors who maintain that attitude because of a shortage of replacement sukuk in either the primary or secondary markets.

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