FINANCE - IILM - Retooling Liquidity Management

Islamic repos, or repurchase agreements, provide a new tool in creating and managing liquidity in the Islamic interbank money market. SCOTT WEBER identifies what instruments are available in the market and the extent to which they are being utilized.

Islamic repos aim to provide Islamic financial institutions with an additional avenue to source their funding requirements, providing banks with relevant tools to effectively manage their liquidity needs allowing the banks to finance its asset inventory.

In an Islamic repo agreement, the borrower sells securities outright to the lender while at the same time agreeing to buy the equivalent securities from the lender at a specified price at a later date. These transactions are usually secured by a Sukuk issuance in order to limit risk to the lender in case of a default.

Most repo transactions are conducted to manage short term liquidity needs, utilizing assets to guarantee short term loans. Conversely, excess liquidity can be invested in order to generate yield. The International Islamic Financial Market (IIFM), a body established by the central banks of Bahrain, Indonesia and Malaysia, released a reference paper to provide solutions to aid Islamic banks’ liquidity requirements. The IIFM reference paper provides a guideline on the necessary frameworks to create and structure tools to further manage their funds and boost trading in the Islamic money markets.

However, a section of Shariah scholars view repos as un-Islamic and say that repo rates (a replacement for traders posting securities as collateral for cash and agreeing to buy them back at a specified date and price, or paying the difference as interest) contravene the ban on borrowing and lending on interest.

Tooling up

An approved Islamic repo will allow banks a new weapon in their arsenal to create and manage liquidity, freeing up their balance sheets and allowing the extra liquidity to be utilized in keeping the markets buoyant, driving further growth. While repos are being actively pushed by the central banks of Bahrain, Indonesia and Malaysia, it will take key Islamic banks and investors to come forward in both creating and driving demand for such products. Yvonne Phe, managing director — markets division at AmBank Group, while speaking at the Global Islamic Finance Forum (GIFF) 2010 promoted the benefits of utilizing Islamic repos, mentioning: “If you look at the interbank market, everyone would like excess liquidity at the short end of the curve, especially on short term parking and funding.” Phe added that “such structures would help deepen the available liquidity in the Sukuk market, even sovereign benchmarks”.

Also voicing his concerns on the Islamic money markets and their lack of capable instruments at GIFF 2010 was Dr Aznan Hassan, Shariah scholar and assistant professor at the International Islamic University Malaysia (IIUM). Aznan suggested that there are currently underutilized Islamic instruments available in the market to maximize surplus liquidity and deficits while managing risk, including Islamic repos.

War chest

Malaysia currently has its Sale and Buy Back Agreement (SBBA), an instrument akin to conventional repurchase agreements that has been modified to comply with the National Shariah Council principles and approved for use by Bank Negara Malaysia. In the Malaysian SBBA model, the seller puts up securities for a spot sale in cash to the buyer. Both parties then enter into a secondary binding agreement under which the buyer promises to sell the securities back to the seller at a later date.

The Central Bank of Bahrain (CBB) believes that the Malaysian model falls short of its standards and that it only mirrors conventional repurchase agreements. The central bank’s model utilizes a third party agreement in order to satisfy the demands of Shariah.

This means that a broker serves as the intermediary between the debtor and the obligator. The model is also supported by a real time settlement system in order to maintain these complex tripartite transactions.

Both structures are only workable at country level and are specifically tailored to domestic requirements and local Sukuk issuances. As for cross-border transactions, a number of issues need to be addressed in order for it to become universally acceptable.

Also within the liquidity management space, we see collateralized Murabahah where a bank can develop their securities portfolios to create the lending aspect of the transaction while utilizing a Sukuk portfolio to serve as collateral for the repayment, thereby producing similar results to an Islamic repo. In this instance, if the Sukuk value increases or diminishes significantly, challenges would arise in selling or re-hypothecating the pledged collateral.

The IILM reference paper also poses two further models for Islamic repos; the first is similar to the bilateral structure with a government stepping in to serve as the counterparty. However, its double Waad based structure raises many Shariah issues, according to the report. A fifth structure is still under discussion.

A major benefit of conventional repo transactions is that the lender has the choice to sell its security and buy an equivalent at maturity, thus creating liquidity. Issues for Islamic repos arise from the wide spreads given to Sukuk between bidding and offer, resulting in increasing costs to the lender and limiting resale opportunities.

Ultimately, Islamic repos are a new product in a developing market. They require a robust banking infrastructure in which to prosper, meaning they are currently limited to small scale implementation in the Bahraini and Malaysian money markets.

As the repurchase structures develop and mature in tandem with the returning Sukuk market, we should see banks utilizing these structures to greater effect. This increase in trading should spur larger banks to observe the possibilities of repos as seen with Barclays’ recent entry to the marketplace.

Source : http://www.islamicfinanceasia.com/18-fea-repo.php - Nov 2010