The UAE Central Bank released more details about its Islamic CDs that it will offer "soon" according to Zawya Dow Jones. The sukuk will be murabaha, issued in UAE dirhams, US dollars and Euros, with maturities of between one week and five years. It will be likely limited to banks in the UAE as they are being issued as "a monetary policy tool for the Central Bank of the UAE" and "as a liquidity management tool for the Islamic banks".
The circular (PDF) from the UAE Central Bank describes in more detail the product. It will be a commodity murabaha where the banks (through the central bank as agent) purchase commodities in the spot market and then resell them to the central bank with deferred repayment but immediate delivery. The central bank will then resell the commodity in the spot market.
The one year and less maturity will be auctioned to banks daily with T+1 settlement and early redemption at the option of the banks. The method of the early redemption is that the bank requests early redemption and the central bank replies with an offer for "full proceed for the redemption through Reuters Dealing System". The reason this is done likely is for Shari'ah-compliance because a murabaha represents a receivable and therefore there is no early redemption discount permissible (accounting for just principal and accrued interest). This has been an issue in Malaysia where many Islamic mortgages are done via murabaha and in cases of prepayment, banks typically offer a rebate (ibra) representing the portion of the markup that has not accrued (based on an equivalent conventional mortgage) to equalize the outcome. Bank Negara Malaysia earlier this year issued a Shari'ah resolution that mandated ibra in murabaha financing.
As expected based on prior Shari'ah rulings, the sukuk will be non-tradable except at par ("due to Shariah limitations"). There will be no use of these securities at the central bank's repo facility "at the moment", which indicates a potential in the future for creating a repo facility based on the Islamic CDs.
The daily auctions of under 1 year maturity bills will be done for AED denominated bills and USD and EUR only "based on demand". Issuance of longer-term notes will be done "on bilateral arrangement".
In general, I think the new issuance is positive and it adds another country in the GCC (to Bahrain) whose central bank offers liquidity management tools for Islamic banks. Bahrain has offered limited issuance of salam and ijara sukuk with 3 and 6 month maturities, respectively. The CBB issues its sukuk monthly (compared to the UAE issuing daily) and the CBB sukuk are all denominated in Bahraini dinars, so the UAE Islamic CDs will offer the option of currency diversification for banks that have assets and liabilities with exchange rate exposure. In addition, the UAE Islamic CDs will have greater maturity diversification with 1 week and 1, 2, 3, 6, 9 and 12 month bills in addition to the 2, 3, 4, and 5 year sukuk. Both the CBB sukuk, which have been issued for several years, and the new UAE Islamic CDs are precursors to the International Islamic Liquidity Management Corporation (my thoughts on the ILMC) short-term sukuk, which will be issued in US dollars and Euros.
What will interest me is whether the ILMC sukuk will follow the murabaha model (used in the UAE) or salam (in Bahrain), both of which are not tradable in the secondary market except at par. The CBB sukuk al-ijara sukuk are tradable, although I don't know whether there is a market for them. The non-tradability of murabaha sukuk is a limitation in terms of establishing a pricing benchmark (my thoughts on an Islamic pricing benchmark) as an alternative for LIBOR, but if the ILMC were issued daily like the UAE Islamic CDs will be, it would reduce significantly the drawbacks of the murabaha model. The next 6 months should be interesting as information is released on the ILMC's methodology.
Showing posts with label ILMC. Show all posts
Showing posts with label ILMC. Show all posts
Thursday, November 11, 2010
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.
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.
Tuesday, October 12, 2010
Liquidity Management in Islamic Finance
Sorry for the lack of posting in the last week. I've had a cold that has put me on the sidelines.
What need does the ILMC fill?
The issue of asset-liability maturity mismatch has been a common one in Islamic finance, just as it is in conventional banking. However, in Islamic banking, the maturity mismatch has been accentuated by the lack of short-term, money market instruments that allow for managing excess liquidity and temporary liquidity needs. The solution until now has been interest-free deposits with central banks and bilateral commodity murabaha and wakala agreements where banks place excess liquidity with other banks in need of that liquidity. However, this setup is insufficient for the industry and the flaws of this method was demonstrated in the conventional banking industry in the latest crisis.
In the last crisis, the failure of Lehman Brothers led to a nearly complete freeze in commercial paper markets. Commercial paper is issued with maturities of less than 270 days (to get an exemption from some securities rules in the US). Commercial paper is issued by many corporations, but banks make up a large share of the total issuance. It is also a large portion of the investments held by money market funds. When Lehman collapsed, the purchasers of these securities pulled out of the market, fearing that another large CP issuer's collapse could impose significant losses on them. The market for CP did not return to vibrancy until the US government stepped in to support the market.
In Islamic finance, the current money market alternatives available resemble the commercial paper market (although being far less liquid than commercial paper). A bank with excess liquidity will find a counterparty with a short-term liquidity need and enter into a short-term commodity murabaha or wakala agreement. It will essentially loan its surplus funds to the other institution for a short period and generate a return on the surplus funds. However, these types of bilateral agreements leave the lending bank with exposure to credit risk that the counterparty will fail before it gets its money (with a return) back. In a liquidity crunch like the one following the failure of Lehman, Islamic banks (like the investors in conventional commercial paper) will be far less likely to lend out their surplus liquidity if they feel there is a chance it will be lost.
Because of the counterparty risk involved in these bilateral agreements, the Islamic finance industry is vulnerable to a crisis that could threaten the solvency of Islamic banks. If some banks with liquidity needs cannot find short-term financing through bilateral agreements, they may have to resort to asset sales, which will occur at fire sale prices, and the liquidity needs of the institution could turn into a solvency crisis. The fire sale of assets will deplete the bank's assets compared to its liabilities (which will remain mostly fixed) and for the balance sheet to 'balance', the difference will come out of the bank's capital.
There has not been much in the way of alternatives available to Islamic banks until recently (except on a country-by-country basis--with many countries having no Islamic short-term instruments issued by the government or central bank). The International Islamic Liquidity Management Corporation (ILMC), which was announced recently and will be launched on October 25 in Kuala Lumpur, Malaysia by the Islamic Financial Services Board members (mostly central banks and regulatory bodies).
What will come from the ILMC specifically is not yet clear, but it will be some form of short-term investment and the Malaysian central bank governor Zeti Akhtar Aziz says they will be "short term, and they will be, we expect, highly rated instruments". The fact that ILMC is being established by the central bank members of the IFSB will probably be the factor that makes them highly-rated. The high rating is important for the capital rules under Basel 2 (and soon Basel 3) for how banks classify their holdings of the securities. It is not clear exactly the degree of support the IFSB members will put behind the securities, but having central banks behind the issuer of these securities will also limit the degree to which a future liquidity crisis could lead to Islamic banks losing confidence in the ability of their counterparty (the ILMC) to make good on the obligation to redeem the short-term securities. I keenly await more details on the structure of the ILMC's products as well as details on the degree of explicit support from the IFSB members, but at this stage, it looks like the Islamic finance industry could take a big step forward with the establishment of the ILMC, which could start issuing bills regularly beginning "early next year".
UAE central bank's Islamic CDs
The news about short-term investments for Islamic banks does not end with the ILMC. The UAE central bank announced plans earlier this year for Islamic certificates of deposits (CDs) and new details are being reported on this front as well. Standard Chartered, which sits on the central bank's liquidity management committee, says the UAE central bank will use murabaha for its Islamic CDs. This is mixed news. It is certainly a positive for another country to offer short-term liquidity management tools for its Islamic banks for the reasons I outlined above. However, the use of murabaha for these does little to find a creative solution that does not entrench the industry in more commodity murabaha transactions.
The use of commodity murabaha transactions is common in Islamic finance and is accepted as legitimate by scholars (with some divergence from the OIC and the head of Shari'ah at the IFSB). In the end, it is a case of whether the perfect should be the enemy of the good. The benefits from the availability of short-term liquidity management tools surely outweighs concerns that commodity murabaha is 'too similar' to interest-based loans in the near term. However, the greatest skepticism about the Islamic finance industry is that its products do nothing but replicate conventional interest-based loans with different structures to receive approval.
As much as this criticism is valid--there are some products that do nothing but apply a 'Shari'ah wrapper' to conventional products--it overlooks the fundamental paradox in the prohibition of riba. To paraphrase, trade is like riba, but trade is permitted but riba is prohibited. I am certainly in no position to argue the theological points of the Qur'anic verse I paraphrased; that is, as they say, well above my pay grade (not to mention my qualifications). However, it is important from the level of consumer perception of the Islamic finance industry. At what point does a product which the scholars agree is Shari'ah-compliant become too close to an interest-based product for a consumer to accept it as preferable to an interest-based product.
I don't have an answer to the question and I don't think anyone in the industry does. However, it is a fundamental point for the industry's growth: if 'purity' in perception is the goal, products will likely be too unfamiliar to attract demand from enough people to be profitable (and the costs of those products will be too much higher to elicit much consumer demand). However, if (when) financial engineering is taken to its limit, the distinction between Shari'ah-compliant and conventional products becomes meaningless for enough consumers that the industry will have to compete almost entirely on price alone, which it will be hard pressed to do. Some middle ground is required and I think that some form of cost-benefit analysis can provide a guide and for the murabaha-based Islamic CDs, I think the benefits outweigh the costs and the product will benefit the industry.
Other Items
Reuters reports that according to the Assistant Secretary General of AAOIFI, a regional mandatory Shari'ah body is "years away". This is not surprising, but it is relatively new to have AAOIFI publicly acknowledge it.
I weighed in on my own views on the potential for Islamic finance to lead conventional finance by increasing the role of women in the industry (both conventional and Islamic finance industries are male-dominated). Rushdi Siddiqui adds his take on the issue.
What need does the ILMC fill?
The issue of asset-liability maturity mismatch has been a common one in Islamic finance, just as it is in conventional banking. However, in Islamic banking, the maturity mismatch has been accentuated by the lack of short-term, money market instruments that allow for managing excess liquidity and temporary liquidity needs. The solution until now has been interest-free deposits with central banks and bilateral commodity murabaha and wakala agreements where banks place excess liquidity with other banks in need of that liquidity. However, this setup is insufficient for the industry and the flaws of this method was demonstrated in the conventional banking industry in the latest crisis.
In the last crisis, the failure of Lehman Brothers led to a nearly complete freeze in commercial paper markets. Commercial paper is issued with maturities of less than 270 days (to get an exemption from some securities rules in the US). Commercial paper is issued by many corporations, but banks make up a large share of the total issuance. It is also a large portion of the investments held by money market funds. When Lehman collapsed, the purchasers of these securities pulled out of the market, fearing that another large CP issuer's collapse could impose significant losses on them. The market for CP did not return to vibrancy until the US government stepped in to support the market.
In Islamic finance, the current money market alternatives available resemble the commercial paper market (although being far less liquid than commercial paper). A bank with excess liquidity will find a counterparty with a short-term liquidity need and enter into a short-term commodity murabaha or wakala agreement. It will essentially loan its surplus funds to the other institution for a short period and generate a return on the surplus funds. However, these types of bilateral agreements leave the lending bank with exposure to credit risk that the counterparty will fail before it gets its money (with a return) back. In a liquidity crunch like the one following the failure of Lehman, Islamic banks (like the investors in conventional commercial paper) will be far less likely to lend out their surplus liquidity if they feel there is a chance it will be lost.
Because of the counterparty risk involved in these bilateral agreements, the Islamic finance industry is vulnerable to a crisis that could threaten the solvency of Islamic banks. If some banks with liquidity needs cannot find short-term financing through bilateral agreements, they may have to resort to asset sales, which will occur at fire sale prices, and the liquidity needs of the institution could turn into a solvency crisis. The fire sale of assets will deplete the bank's assets compared to its liabilities (which will remain mostly fixed) and for the balance sheet to 'balance', the difference will come out of the bank's capital.
There has not been much in the way of alternatives available to Islamic banks until recently (except on a country-by-country basis--with many countries having no Islamic short-term instruments issued by the government or central bank). The International Islamic Liquidity Management Corporation (ILMC), which was announced recently and will be launched on October 25 in Kuala Lumpur, Malaysia by the Islamic Financial Services Board members (mostly central banks and regulatory bodies).
What will come from the ILMC specifically is not yet clear, but it will be some form of short-term investment and the Malaysian central bank governor Zeti Akhtar Aziz says they will be "short term, and they will be, we expect, highly rated instruments". The fact that ILMC is being established by the central bank members of the IFSB will probably be the factor that makes them highly-rated. The high rating is important for the capital rules under Basel 2 (and soon Basel 3) for how banks classify their holdings of the securities. It is not clear exactly the degree of support the IFSB members will put behind the securities, but having central banks behind the issuer of these securities will also limit the degree to which a future liquidity crisis could lead to Islamic banks losing confidence in the ability of their counterparty (the ILMC) to make good on the obligation to redeem the short-term securities. I keenly await more details on the structure of the ILMC's products as well as details on the degree of explicit support from the IFSB members, but at this stage, it looks like the Islamic finance industry could take a big step forward with the establishment of the ILMC, which could start issuing bills regularly beginning "early next year".
UAE central bank's Islamic CDs
The news about short-term investments for Islamic banks does not end with the ILMC. The UAE central bank announced plans earlier this year for Islamic certificates of deposits (CDs) and new details are being reported on this front as well. Standard Chartered, which sits on the central bank's liquidity management committee, says the UAE central bank will use murabaha for its Islamic CDs. This is mixed news. It is certainly a positive for another country to offer short-term liquidity management tools for its Islamic banks for the reasons I outlined above. However, the use of murabaha for these does little to find a creative solution that does not entrench the industry in more commodity murabaha transactions.
The use of commodity murabaha transactions is common in Islamic finance and is accepted as legitimate by scholars (with some divergence from the OIC and the head of Shari'ah at the IFSB). In the end, it is a case of whether the perfect should be the enemy of the good. The benefits from the availability of short-term liquidity management tools surely outweighs concerns that commodity murabaha is 'too similar' to interest-based loans in the near term. However, the greatest skepticism about the Islamic finance industry is that its products do nothing but replicate conventional interest-based loans with different structures to receive approval.
As much as this criticism is valid--there are some products that do nothing but apply a 'Shari'ah wrapper' to conventional products--it overlooks the fundamental paradox in the prohibition of riba. To paraphrase, trade is like riba, but trade is permitted but riba is prohibited. I am certainly in no position to argue the theological points of the Qur'anic verse I paraphrased; that is, as they say, well above my pay grade (not to mention my qualifications). However, it is important from the level of consumer perception of the Islamic finance industry. At what point does a product which the scholars agree is Shari'ah-compliant become too close to an interest-based product for a consumer to accept it as preferable to an interest-based product.
I don't have an answer to the question and I don't think anyone in the industry does. However, it is a fundamental point for the industry's growth: if 'purity' in perception is the goal, products will likely be too unfamiliar to attract demand from enough people to be profitable (and the costs of those products will be too much higher to elicit much consumer demand). However, if (when) financial engineering is taken to its limit, the distinction between Shari'ah-compliant and conventional products becomes meaningless for enough consumers that the industry will have to compete almost entirely on price alone, which it will be hard pressed to do. Some middle ground is required and I think that some form of cost-benefit analysis can provide a guide and for the murabaha-based Islamic CDs, I think the benefits outweigh the costs and the product will benefit the industry.
Other Items
Reuters reports that according to the Assistant Secretary General of AAOIFI, a regional mandatory Shari'ah body is "years away". This is not surprising, but it is relatively new to have AAOIFI publicly acknowledge it.
I weighed in on my own views on the potential for Islamic finance to lead conventional finance by increasing the role of women in the industry (both conventional and Islamic finance industries are male-dominated). Rushdi Siddiqui adds his take on the issue.
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