Wednesday, March 09, 2011

Considering the possible IILM liquidity tool structures

The International Islamic Liquidity Management Corporation (IILM) announced that it plans to issue the first short-term liquidity management instruments by the end of 2011. This is disappointing because the products are needed, the sooner the better. However, it is usually better to get it right than just to get it out there quickly. The size of the first issue will likely have a minimum size of $300 million, depending on demand, which is tiny compared to the volume of commodity murabaha contracts used for liquidity management which is estimated at $1.2 trillion.

No structure has been announced yet for the IILM, but it would likely not be commodity murabaha, which is not tradable. An article from Bernama describes (citing Mohd Razif Abudl Kadir, the deputy governor of Bank Negara Malaysia): "the main function of the IILM is to issue high quality papers as the shareholders are the central banks, which recognise it as eligible papers that can be traded among the players". Commodity murabaha (all murabaha) is not tradable on the secondary market outside of Malaysia except at par because it represents a debt receivable, subject to restrictions on trading in debt (bai al-dayn). He added that the maturity can be short-, medium- and long-term and gave the specific example that "it can be an avenue for the Malaysian government to tap global funds for the Mass Rail Transit mega-project". The Mass Rail Transit mega-project is a nearly 10 year project to put in 150km of rail in the Kuala Lumpur area by 2020 that is estimated to cost RM36.6 billion ($12.1 billion).

From this point, it is only speculation what the IILM product will look like, there are a few established and developing liquidity management tools (described well by Simmons & Simmons in a document from 2008 [PDF]; they are the basis of the descriptions I provide of the products):

Wakala/Mudaraba: In a wakala, two Islamic financial institutions (IFIs) enter into an agreement where one places funds with the other, who invests it on their behalf. The party placing funds (the lender) bears responsibility for losses. This could be a viable option for the IILM, but only on a short-term basis (unless a secondary market developed quickly). The IILM could provide an "indicative" rate of return, but is non-binding and is not a guarantee. However, the IILM would face a credibility problem if it did not meet the "indicative" rate of return. Central banks undoubtedly want to avoid losses, even if they are less concerned with generating a profit. Once the funds are placed with the IILM, they would have to be invested in something which generates a return that meets or exceeds the "indicative" return investors expect.

The advantage of this structure is that it could provide perpetual sukuk (or sukuk that were issued in equal amount as they matured), so long as the IILM is able to find things to invest in to generate a return sufficient to meet the "indicative" return (adjusted for changes in interest rates; the indicative return may even be calculated as a spread over a benchmark like LIBOR or KLIBOR). This would define the focus of the IILM. Instead of rotating assets from member banks to use as backing for, say, ijara sukuk, the IILM could focus on generating a return with the funds and on facilitating the secondary market.

However, this strength would also create a weakness. It would force the IILM to compete with the Islamic Development Bank and would also limit the size of the tradable market to the amount of funds the IILM could invest in quality projects to generate a return sufficient enough to make profit payments to the holders of the certificates. This is less of a hurdle than it appears at first. If the figure above were only for overnight liquidity management (i.e. the same amount was created and redeemed each day), it would represent just under $5 billion in certificates (i.e. $1.2 trillion divided by 250, the rough approximation of business days in a year). Assuming that the demand for these certificates increase 20% per year for the next 10 years and only 1/2 of the outstanding certificates trade in a given day, that would allow $60 billion in certificates in ten years to replace the equivalent of $7.5 trillion in commodity murabaha contracts. [Note: my assumptions for this calculation is by no means realistic, but used as an exercise to put the $1.2 trillion of commodity murabaha into context]

While the wakala/mudaraba structure seems like it is viable as a structure (there are many asset managers with more than $60 billion in assets), it would be difficult to create the liquid market for the certificates. Pricing would be relatively easy if the IILM is able to garner a credit rating at least as good as its member states (for comparison, the Islamic Development Bank has a AAA rating).

Wadiah: The two IFIs agree that one will place funds with the other and the one receiving the placement invests the funds like in the wakala. However, the placing institution does not have the right (although the receiving institution can voluntarily make profit-sharing payments) to any profits, but is entitled to a return of capital in the full amount, regardless of the performance of the investments made with the funds placed. This has the benefit that the IILM could use it as a way to get certificates into the market. However, it would be more likely to incur losses in adverse market environments. This is unlikely because although the IILM would be forced to pay out deposits in full (in contrast with the mudaraba/wakala), in both situations it would be expected to incur these costs to keep its credibility.

The benefit of the wadiah for the IFIs would be that even though they give up the legal right to a share of profits, they are entitled to their deposit back in full. Given the way markets and institutions operate, the IILM is likely to pay out profit-sharing payments in the good times and make good on deposits in bad times. However, this introduces a new risk to IILM member central banks. Under wadiah, they are obligated to make full payment of deposits on request even if the investments turn out to be unprofitable. It is definitely a "tail risk", but it is worth considering with the hindsight of the experience in the US with Fannie Mae and Freddie Mac, which operated under implicit government guarantees from the US government that were called upon following the US financial crisis. In wadiah, the guarantee would be explicit, while under mudaraba/wakala it would remain implicit.

Accrued Notes: An accrued note works like the wakala product but allows the IFI to either reinvest the profits or take them out in specified intervals. This would allow the IILM to underake longer-term projects with its capital because instead of paying out profits every period (month or quarter), it would issue new certificates to investors who reinvest the profits. Depending on the percentage of certificates held for a longer term (e.g. cash held by money market funds), this would both require less capital to be held in liquid form (i.e. cash) if new certificates could be issued for the same par value as the outstanding certificates. Longer-term investments have the potential to generate higher yield but are also have more risks, which would introduce a greater likelihood of a 'tail event'.

Capital Protected Products (including multi-currency products): In a capital protected note, there is a combination of a commodity murabaha and a wa'd-based swap of returns from a specified index. This is an unlikely structure for the IILM because trading would be difficult because of the commodity murabaha to create the capital protection. It would also be relatively unnecessary if the IILM were able to get a high rating that I would expect (i.e. similar to the Islamic Development Bank). If the IILM is operating on a global scale, it would be able to issue multi-currency certificates and the wa'd-based multi-currency feature would be better served by the Islamic window at a conventional bank, which could limit its currency risk by using conventional hedging tools.

Tradable Sukuk: Besides the wakala/mudaraba and wadiah, this is the most likely product. In fact, it might be more likely because of the relative familiarity that the market has for sukuk. The biggest problem in sukuk markets besides lack of supply is liquidity. Where the wakala/mudaraba product needs both a new market for the certificates and sufficient liquidity, an IILM sukuk issuance needs only a liquid marketplace. The central bank members of the IILM might not have the assets needed to issue a large volume of sukuk, but the comment in the Bernama article that the IILM would consider short-, medium- and long-term products and could use the funds for domestic projects suggest that other assets that are not directly owned by the central banks could be used to back sukuk.

The risk from IILM sukuk being used to fund national projects (like the Malaysian rail project mentioned in the article) is political. How will the assets be selected to back IILM certificates? Even with an IILM guarantee, the certificates would not be identical. You could buy a sukuk that was backed by the transit system in Malaysia (which has Ringgit exposure) or the one in Luxembourg (which has Euro exposure) and your sukuk might be denominated in dollars. It would be preferable to reduce external factors by having the certificates backed by a large number of diversified assets.

This could be accomplished either by the use of wakala or murabaha contracts or by the IILM issuing sukuk using mudaraba or wakala as the underlying contract. Reflecting on the description of what is created with mudaraba or wakala certificates, I think I was essentially describing sukuk certificates. In my opinion, an IILM wakala or mudaraba sukuk is the most likely structure.

Sukuk repos: This is an unlikely product for the IILM because it would duplicate the efforts of the IIFM (which is on the first stages of a difficult road towards a repo master agreement) and would step on the member central banks' toes because one of the primary uses of repos is for monetary policy. It also requires a larger supply of sukuk than exists today (particularly higher-quality sukuk) for it to become feasible.

I would hope that more details are released as we see the IILM develop and the next opportunity for further announcement is coming up when the IFSB holds a seminar on liquidity management in Islamic finance in Istanbul, Turkey on April 6th and 7th.

No comments: