Sunday, July 08, 2012

Sukuk market development

As I was finishing up my weekly newsletter, I had a few extra thoughts to add to what I included in the newsletter.  Here's a portion of the newsletter (sign up on the right hand side of the blog, old issues of the newsletter are available at the Sharing Risk website) for context: 
I ran across a presentation from 2005 where the head of IIFM, Ijlal Alvi (PDF) lays out a broad prediction for sukuk markets (with a few recent relevant news items added):  
  • Increasing demand from issuers to tap sukuk markets (South Africa is planning to issue sovereign sukuk) IFIs want tradable sukuk with fixed income profile
  • Development of sukuk funds followed by growing demand for sukuk, causing issuance to “surge exponentially” (Indonesian sukuk fund managers want to expand fund size, but fear demand for sukuk will outstrip supply.  This is also true in Malaysia).  
  • Sukuk will be used for liquidity management and as a money market instrument.  (IIFM held a meeting on collateralized murabaha with sukuk as collateral, which is rapidly becoming the standard alternative for unsecured commodity murabaha in inter-bank lending markets)
The items for the sukuk market to develop laid out by Mr. Alvi 7 years ago seem to be falling into line quite well, after being interrupted by the financial crisis.  There is however, a key item missing in the sukuk markets across the items above: tradability is possible, but it remains limited.  
What surprised me is how well articulated the needs for the sukuk market have been over several years when the global economy and financial markets have gone through significant changes.  The problem for Islamic finance is not necessarily that the problems are not articulated, it is that there are so many different factors in play, and the sukuk market is not a unified market, so different markets around the world have a different set of items to change that have moved to the top of the list for stakeholders.

For example, the GCC is largely dominated by sovereign (and government-related entity) issuance, which probably mitigates some of the risks to coporate sukuks that are more common in Malaysia, but the GCC sukuk markets are relatively illiquid and dominated (in terms of size) by fewer, larger sukuk.  The Malaysian market is more liquid, with a larger number of issuers, particularly corporate issuers, although there are a number of very large government- or GRE-issued sukuk (the difference is that the secondary market is better developed).  

From the top-down perspective, the GCC would be served by a greater diversity of issuers, while Malaysia is attracting more buyers chasing the available sukuk that causes the market to become relatively more illiquid if holders of sukuk don't wish to part with their holdings in fear of not being able to find another sukuk to replace it.  The discussion above itself is mostly from a high-level, and there are many other nuances that distinguish aspects of the sukuk markets in these regions and across the countries in the GCC.  

However, with different needs in different markets, it is difficult to address the underlying difficulties to even accomplish and agreed-upon goal: creating an Islamic repo product.  This is being adopted, using a collateralized murabaha structure, in both the GCC and Malaysia (the latter in part to provide GCC-connected banks with acceptable short-term liquidity management products as a substitute to the domestic inter-bank market which those banks won't use).  

An Islamic repo product in order to remain viable even in periods of financial stress, need to have highly-rated and liquid collateral (an equivalent to US Treasuries for conventional repos).  There is a shortage of this collateral, which is in part what the IILM will provide (if an inaugural sukuk is ever launched), will have to be issued in large enough supply and with enough diversification across the short end of the yield curve and across different currencies to get a secondary market developed. Otherwise, issuers will be forced to pick and choose from among the sukuk outstanding, which could lead to increased pricing distortions in the yields between liquid and illiquid sukuk as banks bid up the liquid sukuk to use for repo transaction. 

So, while individual markets will have their own challenges to address, it is important for the Islamic finance industry to find areas where there are similar challenges--and solutions--to tackle in a cooperative way.  One of these challenges is liquidity management and the solution, which is on the right path even if it is taking far too long, is the IILM. 

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