Bank Indonesia (BI) extended its reverse repo operations to government sukuk on December 1st. The structure of the transactions are not clear, but based on another article and a BI regulatory document (which is not available in English, so I had to rely on GoogleTranslate) it looks like a wa'd-based repo transaction. In the past, the sukuk issued by BI were based on ijara (mitigating concerns about the Shari'ah-compliant of trading at prices different from par if it were repo on sukuk based on commodity murabaha).
However, the repo concept has been tricky to synthesize in a Shari'ah-compliant way, so the BI reverse repo would be a novel transaction. It appears that the structure is based on wa'd, a unilateral undertaking to purchase or sell. In the repo transaction (which the article said would be with a 1 month maturity, although that may only be used as an example), BI would sell a sukuk to a bank for the market value (assume for simplicity this is par, 100). The bank would make a unilateral undertaking to sell the sukuk bank to BI in one month for 100 plus a spread based on a repo rate of 4.6% annualized.
I think, although I am not familiar enough with the Shari'ah-compliance rules on wa'd to say for certain, that because it is only a unilateral promise, it is permissible to specify a price for the transaction in the future. If there were two unilateral promises (one by the bank to sell and one by BI to purchase), it would not be permissible. Presumably since BI is originating the transaction and is the central bank, it is virtually assured that it would purchase the securities without needing to give a binding promise.
One area where difficulty would arise is if the sukuk rose in price during the repo, for example to 120. The rules for the reverse repo transaction stipulate that if the bank decides not to honor its unilateral promise to sell, BI will charge the bank a penalty of the difference between the market price (i.e. 120) and the amount that the the bank bought the sukuk (i.e. 20). This appears to me to be a sticky point for Shari'ah-compliance, although it could be mitigated if the penalty were stipulated to be donated to charity. Anyway, with the penalty being stipulated as being the profit the bank would realize by not honoring its unilateral promise (removing the financial incentive for the bank to default), it is unlikely that this would ever occur in practice.
I think this is an interesting idea and I would like to see more documentation about how it works and also the logic by which it was approved by the Shari'ah board advising BI. I would appreciate any reader comments on the structure, since I am trying to piece together the structure from limited information, some of which I had to base on imperfect translations.
Showing posts with label wa'ad. Show all posts
Showing posts with label wa'ad. Show all posts
Friday, December 23, 2011
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 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.
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.
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.
Sunday, September 12, 2010
Malaysia as a primary legal jurisdiction for Islamic finance, Islamic finance news
Malaysia wants to become a hub as the country where Islamic financial contracts are governed. Currently, most Islamic finance contracts are governed by English laws, because of its predictability. While Malaysia has a unique position having a Shari'ah advisory council at its central bank and could therefore provide governmental legitimacy to the process of litigating whether certain contracts were or were not Shari'ah-compliant, it would likely run into difficulty because the country's Shafi'i interpretation of Shari'ah is viewed as more liberal than the Hanafi and Hambali interpretations used in the GCC. Therefore, it may be unlikely that an Islamic finance institution would submit to the jurisdiction where a different interpretation of Shari'ah is prevalent.
The Shari'ah Advisory Council of Bank Negara Malaysia gave the go-ahead for wa'd (unilateral promise) to be used to hedge against currency fluctuations as long as there is no compensation paid for the wa'd, which would make it a bilateral wa'd. The promise is binding on the promisor.
Rusdhi Siddiqui's latest article tackles the area of Islamic finance news, which I agree does have too little depth behind it. Bloomberg articles (not to pick on them alone) give the bullet points and then re-spout market statistics with too little context. Other news outlets just string together a few quotes with generalities about "Islamic finance is designed to avoid interest, etc". If this blog does anything, I hope it provides a current and critical look at the Islamic finance industry. It certainly has an inherent bias towards the Islamic finance industry, but I have also been critical of the "party line" talking point (for a while at least) that Islamic finance was not harmed by the credit crisis. And thankfully, there are other reporters out there who take stands against things that are either ridiculous Panglossian ideas or products that too cynically avoid the restrictions that are the heart of the Islamic finance industry. However, it is always a good time to remind oneself to think critically.
Other News
The Shari'ah Advisory Council of Bank Negara Malaysia gave the go-ahead for wa'd (unilateral promise) to be used to hedge against currency fluctuations as long as there is no compensation paid for the wa'd, which would make it a bilateral wa'd. The promise is binding on the promisor.
Rusdhi Siddiqui's latest article tackles the area of Islamic finance news, which I agree does have too little depth behind it. Bloomberg articles (not to pick on them alone) give the bullet points and then re-spout market statistics with too little context. Other news outlets just string together a few quotes with generalities about "Islamic finance is designed to avoid interest, etc". If this blog does anything, I hope it provides a current and critical look at the Islamic finance industry. It certainly has an inherent bias towards the Islamic finance industry, but I have also been critical of the "party line" talking point (for a while at least) that Islamic finance was not harmed by the credit crisis. And thankfully, there are other reporters out there who take stands against things that are either ridiculous Panglossian ideas or products that too cynically avoid the restrictions that are the heart of the Islamic finance industry. However, it is always a good time to remind oneself to think critically.
Other News
- Kiplinger has an interview with Monem Salam and Nicholas Kaiser of the Amana Funds.
- Details about the Dubai World restructuring are coming and I expect more to come out as the process of implementing the restructuring proceeds.
- Mushtak Parker wrote an article about the growth of Islamic ETFs.
- Pakistan's government plans to sell sukuk by the end of the month. The sukuk are expected to carry a maturity of less than on year.
- Despite many suggestions that Islamic finance could become viable in Russia, there are few Islamic financial institutions in the country.
Thursday, April 02, 2009
Comments from a scholar and legal rulings in Malaysia on Islamic finance products wa'ad and BBA
A Malaysian Shari'ah scholar says that a promise (waad) made in an Islamic financial transaction is not legally enforceable but said that the other party may be entitled to compensation for the unfulfilled promise. Waad are used in the context of several different products like murabaha and istisnaa. The scholar, Abdulazeem Abozaid, also criticised the Malaysian stock exchange plans to allow Shari'ah-compliant short selling. He said, "First of all, you are selling things that you don't own. Secondly, you're borrowing shares and in return for borrowing, you will be charged some money so it's a conventional loan." A Malaysian appeals court also ruled that the controversial financing product bai bithaman ajil (BBA) is valid. The contract is widely used in Malaysia but is viewed as a disguised loan in many other regions.
Badlisyah Abdul Ghani, CEO of CIMB Islamic Bank, continues his call for increased regulation of the Islamic finance industry to protect it against further problems and deal with 'internal contradictions' caused by standards that vary widely across jurisdictions.
Other News
Badlisyah Abdul Ghani, CEO of CIMB Islamic Bank, continues his call for increased regulation of the Islamic finance industry to protect it against further problems and deal with 'internal contradictions' caused by standards that vary widely across jurisdictions.
Other News
- The Sacramento Bee has an article about Islamic finance that is interesting although some of the claims that Islamic finance could prevent the recession are questionable, as I have described in previous posts.
- HSBC Amanah received approval from the Hong Kong Monetary Authority to issue sukuk.
- University Bank in Michigan received a cease-and-desist order from the FDIC relating to compliance issues at the bank that the bank says have already been addressed. None specifically mentioned the bank holding company's Islamic banking subsidiary.
- The Islamic Bank of Britain is attempting to broaden its client base outside of the group of clients who will be drawn by their faith by describing their product's price competitiveness. The commercial director at the IBB describes: "The bank is open to customers of all faiths, so my call to UK homebuyers and homeowners is to put any misapprehensions to one side and come and find out how a Home Purchase Plan from IBB can really make a difference to your pocket."
- Fitch cut its rating on Kuwait Finance House due to its exposure to other GCC investment banks. Other investment banks, including a few Islamic banks, have run into trouble in the economic crisis.
- The latest Central Bank of Bahrain al-salam sukuk was significantly oversubscribed.
Saturday, February 02, 2008
Stir over Islamic finance study in Canada, criticism of commodity murabaha
Reuters has an article that describes the success of Islamic finance in growing rapidly with a discussion of some of the challenges it faces in the next few years. The main challenge, which has been enumerated many times, is the shortage of skilled practitioners in the field, particularly Shari'ah scholars who are instrumental in adding legitimacy to the industry by certifying products as Shari'ah-compliant.
One area which is not as frequently mentioned is the need to spread awareness of the industry as it moves out of majority Muslim countries in the GCC and Asia into Western countries where Muslims are in the minority. This challenge has been accepted by the Institute of Halal Investing, which is working to demystify Islamic finance globally, with a particular focus of spreading knowledge and understanding of Islamic finance within the United States. The Reuters also mentions an informal poll of Islamic finance practitioners who pick Indonesia, Pakistan and the U.K. as the next significant growth opportunities for Islamic finance.
A further challenge to the industry is the wide use of murabaha, particularly commodity murabaha, by Islamic banks to invest surplus cash. Recent criticisms from within the Islamic finance industry have focused on repurchase agreements in ijara sukuk but Ruggiero Lomonaco, of ABN Amro and Aznan Bin Hasan, an assistant professor at the International Islamic University Malaysia both made strong criticisms of commodity murabaha at the recent Islamic Finance Forum in Dubai.
Mr. Lomonaco suggested that because the commodity murabaha often doesn't involve the delivery of the metals involved, it may reduce the legitimacy of Islamic finance and could "cause the fall of the industry in a very short period of time". Mr. Bin Hasan, in addition to criticizing the practice, suggested that where other options are not available, Islamic financial institutions could use commodity murabaha out of necessity. One alternative, using a wa'ad swap where the returns are determined by external benchmarks that was suggested by Mr. Lomonaco was the subject of a forceful criticism in a paper by Sheikh Yusuf DeLorenzo, a prominent Shari'ah scholar.
Moody's warns that Islamic financial institutions face significant risk if they are not seen as being fully Shari'ah compliant. In addition, the use of new products with different risk profiles from conventional financial products makes it difficult for Islamic banks to know the true risks. The presence of Islamic finance predominantly in emerging economies also means there is greater systemic risk to the industry as a whole because regulatory systems are less developed than in Western nations.
Disagreements over whether Islamic finance is beneficial to Muslims in Canada has lead to open disagreement over a Canadian Mortgage and Housing Corporation study about Islamic banking. Critics like Tarek Fatah, founder of the Muslim Canadian Congress call Islamic finance a "con job". Islamic financial institutions like UM Financial, headed by Omar Kalair, disagree and say that Islamic finance is not being forced upon Muslims in the country and provides a valuable tool for those Muslims who would not otherwise participate in the financial industry or purchase homes because of the interest charges in conventional mortgages. The Canadian Mortgage and Housing Corporation, stuck between the opposing groups, says the study is needed to understand the growing industry. CMHC vice president in charge of policy and planning Douglas Stewart says that the CMHC "wanted to get a better understanding of the nature of this type of lending and what some of the implications might be for the Canadian housing system."
Despite the credit crunch spreading across the world financial system, most bankers and analysts in the Islamic finance industry expect a similar volume of sukuk issues in 2008 as 2007, about $12 billion.
The growth of Islamic finance outside of the GCC along with it reaching 'critical mass' in places like Dubai is a significant development for the industry says Majid Dawood, the CEO of Yasaar Research, Inc.
Yasaar Research recently worked as independent Shari'ah consultants for the FTSE Shari'ah Indexes. The new indices, in addition to being overseen by an independent Shari'ah organization, are also using financial ratios calculated using total assets, rather than 12 month trailing market capitalization. The use of the latter as the denominator in the financial ratios has attracted criticism that it forces Shari'ah-compliant investment managers to buy high (when the market capitalization is large enough to drive the ratio lower) and sell low (when falling market capitalization increases the value of the ratios above the level allowed by the Shari'ah screens.
In another development for indices based upon religious and ethical principles, Dow Jones Indexes, the creator of the Dow Jones Islamic Market Index, one of the most commonly used benchmarks for Shari'ah-compliant funds, has launched the Dow Jones Dharma Indexes. The Dharma indexes use screens that aim to appeal to Hindus, Bhuddists, Jains and Sikhs. Briefly, the screens exclude companies that create violence and do not promote sustainable stewardship.
The Harvard Business Review included a paper on Islamic finance in its list of breakthrough ideas for 2008.
A website critical of the World Bank and IMF has a description of how the multilateral organizations approach Islamic finance.
The Islamic Development Bank is moving forward in the development of an anti-poverty fund called the National Islamic Fund. The board of directors are scheduled to meet in Tehran on February 17th.
One area which is not as frequently mentioned is the need to spread awareness of the industry as it moves out of majority Muslim countries in the GCC and Asia into Western countries where Muslims are in the minority. This challenge has been accepted by the Institute of Halal Investing, which is working to demystify Islamic finance globally, with a particular focus of spreading knowledge and understanding of Islamic finance within the United States. The Reuters also mentions an informal poll of Islamic finance practitioners who pick Indonesia, Pakistan and the U.K. as the next significant growth opportunities for Islamic finance.
A further challenge to the industry is the wide use of murabaha, particularly commodity murabaha, by Islamic banks to invest surplus cash. Recent criticisms from within the Islamic finance industry have focused on repurchase agreements in ijara sukuk but Ruggiero Lomonaco, of ABN Amro and Aznan Bin Hasan, an assistant professor at the International Islamic University Malaysia both made strong criticisms of commodity murabaha at the recent Islamic Finance Forum in Dubai.
Mr. Lomonaco suggested that because the commodity murabaha often doesn't involve the delivery of the metals involved, it may reduce the legitimacy of Islamic finance and could "cause the fall of the industry in a very short period of time". Mr. Bin Hasan, in addition to criticizing the practice, suggested that where other options are not available, Islamic financial institutions could use commodity murabaha out of necessity. One alternative, using a wa'ad swap where the returns are determined by external benchmarks that was suggested by Mr. Lomonaco was the subject of a forceful criticism in a paper by Sheikh Yusuf DeLorenzo, a prominent Shari'ah scholar.
Moody's warns that Islamic financial institutions face significant risk if they are not seen as being fully Shari'ah compliant. In addition, the use of new products with different risk profiles from conventional financial products makes it difficult for Islamic banks to know the true risks. The presence of Islamic finance predominantly in emerging economies also means there is greater systemic risk to the industry as a whole because regulatory systems are less developed than in Western nations.
Disagreements over whether Islamic finance is beneficial to Muslims in Canada has lead to open disagreement over a Canadian Mortgage and Housing Corporation study about Islamic banking. Critics like Tarek Fatah, founder of the Muslim Canadian Congress call Islamic finance a "con job". Islamic financial institutions like UM Financial, headed by Omar Kalair, disagree and say that Islamic finance is not being forced upon Muslims in the country and provides a valuable tool for those Muslims who would not otherwise participate in the financial industry or purchase homes because of the interest charges in conventional mortgages. The Canadian Mortgage and Housing Corporation, stuck between the opposing groups, says the study is needed to understand the growing industry. CMHC vice president in charge of policy and planning Douglas Stewart says that the CMHC "wanted to get a better understanding of the nature of this type of lending and what some of the implications might be for the Canadian housing system."
Despite the credit crunch spreading across the world financial system, most bankers and analysts in the Islamic finance industry expect a similar volume of sukuk issues in 2008 as 2007, about $12 billion.
The growth of Islamic finance outside of the GCC along with it reaching 'critical mass' in places like Dubai is a significant development for the industry says Majid Dawood, the CEO of Yasaar Research, Inc.
Yasaar Research recently worked as independent Shari'ah consultants for the FTSE Shari'ah Indexes. The new indices, in addition to being overseen by an independent Shari'ah organization, are also using financial ratios calculated using total assets, rather than 12 month trailing market capitalization. The use of the latter as the denominator in the financial ratios has attracted criticism that it forces Shari'ah-compliant investment managers to buy high (when the market capitalization is large enough to drive the ratio lower) and sell low (when falling market capitalization increases the value of the ratios above the level allowed by the Shari'ah screens.
In another development for indices based upon religious and ethical principles, Dow Jones Indexes, the creator of the Dow Jones Islamic Market Index, one of the most commonly used benchmarks for Shari'ah-compliant funds, has launched the Dow Jones Dharma Indexes. The Dharma indexes use screens that aim to appeal to Hindus, Bhuddists, Jains and Sikhs. Briefly, the screens exclude companies that create violence and do not promote sustainable stewardship.
The Harvard Business Review included a paper on Islamic finance in its list of breakthrough ideas for 2008.
A website critical of the World Bank and IMF has a description of how the multilateral organizations approach Islamic finance.
The Islamic Development Bank is moving forward in the development of an anti-poverty fund called the National Islamic Fund. The board of directors are scheduled to meet in Tehran on February 17th.
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