The launch of an International Islamic Liquidity Management Corporation is a step to resolving a long-standing weakness of Islamic finance, but there is still much work to be done. Writer Philip Alexander

The International Islamic Liquidity Management Corporation (ILMC), announced jointly in October 2010 by the Islamic Financial Services Board (IFSB), Islamic Development Bank (IsDB) and 11 central banks from jurisdictions with an Islamic banking presence, aims to tackle a long-standing problem of the Islamic Finance industry. Conventional banks derive short-term liquidity from the interbank markets, or from central bank instruments. They place their own excess liquidity on the interbank markets, in short-maturity government and high-grade corporate bonds - commercial paper (CP) - or in central bank deposits.

All of these instruments are interest-bearing, and therefore forbidden under sharia principles that prohibit interest (riba). This has left Islamic banks with the unpalatable alternative of placing surplus cash on deposit at the central bank or with counterparty banks, earning zero interest. And while interest rates in most major economies are very low today, once they start to rise this would place Islamic banks at a more severe disadvantage. In addition, there are few options for sharia-compliant banks to obtain short-term liquidity when needed.

Well structured

"It is well-known that there is a dearth of liquid instruments in Islamic finance. But if you look at Islamic banks, they tend to be characterised by loyal customer deposits - more so than conventional banks. Secondly, Islamic banks are less involved in leveraged or derivative markets, where they would have a lot of contingent risk for the posting of collateral. So Islamic banks' core structural liquidity tends to be good," says Mike Kennedy, head of risk management at Europe's largest fully sharia-compliant bank, the Bank of London and The Middle East (BLME).

This inherent structural liquidity should be just as important as having a pool of liquid assets held as a reserve in case of emergency. But in practice, greater focus has been placed on liquidity management since the financial crisis, both by the architects of the emerging Basel III regulations and by individual national regulators. BLME is subject to the Individual Liquidity Assessment operated by the UK Financial Services Authority (FSA).

Limited assets

At present, the most commonly used tool for liquidity management is a commodity-based murabaha (sale and repurchase) agreement. Such contracts are becoming more standardised, but this approach still involves taking on counterparty risk because there is no central clearing, and placing funds by a series of individual agreements, which is not cost-efficient. They can also be expensive to exit early, which defeats the purpose if they are intended to manage surplus liquidity in an accessible way.

To reduce counterparty risk, many regulators would ask banks to hold at least some top-rated assets. In the UK, all banks must hold 10% of their reserve liquidity in AAA rated government or multilateral bonds. For Islamic banks, only one asset qualifies - the IsDB sukuk.

"Sukuk trading volumes are lower than for conventional bonds because there is so much demand and many banks hold the sukuk to maturity. The FSA also imposes a higher haircut on the IsDB sukuk than on UK gilts, because it is not issued by an OECD [Organisation for Economic Co-operation and Development] country and it is denominated in dollars rather than sterling," says Nigel Denison, executive director of markets at BLME.

Wider asset pool

The sukuk industry has only just scratched the surface. Larger, more liquid sukuk are traded on a regular basis, but still not to the same degree as benchmark conventional bonds. Issuance is slow, but oversubscription is heavy, which shows that there is a lot of untapped demand

UK Islamic banks have lobbied the country's government to start a sovereign sukuk programme to diversify the pool of liquid assets available, but the UK Treasury is naturally focused on whether this will be beneficial for the government's own cost of borrowing. Only Malaysia has a frequent programme of sukuk issuance, which is mostly denominated in local currency, so not suitable for use elsewhere. The international market really needs a wider pool of available assets, says Harris Irfan, head of Islamic products at Barclays Capital.

"The sukuk industry has only just scratched the surface. Larger, more liquid sukuk are traded on a regular basis, but still not to the same degree as benchmark conventional bonds. Issuance is slow, but oversubscription is heavy, which shows that there is a lot of untapped demand," says Mr Irfan.

International co-operation

In a number of countries, central banks have sought to build liquidity by developing Islamic equivalents to traditional monetary policy tools. Barclays Capital is advocating an Islamic repo facility, which would also give central banks a tool equivalent to that used for managing the liquidity of the conventional financial system.

"The underlying trade contract is a collateralised reverse murabaha transaction, and the repo asset is a sukuk rather than a conventional bond," says Mr Irfan.

At present, Qatar operates a points system that does not offer banks a return on surplus liquidity, but does at least allow them to draw liquidity from the central bank provided they are no longer in debit at the end of a set period. Malaysia offers banks a return on deposits at Bank Negara via sharia-compliant 'gifts' for providing funds to the central bank, and has an asset-backed lending system to act as lender of last resort for Islamic banks. Bahrain is the most advanced, with regulatory support for liquidity pooling to compensate for the small size of many Islamic banks, and an Islamic treasury-bill programme.

"These are 90-day government bills backed by aluminium or oil murabaha contracts, but the price is not negotiable - they must be held to maturity, so they cannot be sold to provide overnight liquidity," says Simon Archer, a professor of finance and consultant to the IFSB.

They are also for use solely in Bahrain, whereas an international facility would clearly be beneficial to increase the depth of liquidity available. This is where the ILMC plan comes to the fore.

But as yet, the facility has no staff - the indications are that it will draw heavily on the resources of Bank Negara Malaysia, whose governor, Zeti Akhtar Aziz, has been a driving force behind ILMC. Nor has a particular product been devised for distribution via the platform. Mr Archer believes ILMC will draw on an earlier plan for the IsDB to issue sukuk under its AAA rating, backed by assets originating from the 11 countries that have so far signed up to the proposal.

This plan is not without drawbacks. Already, it is noticeable that Bahrain has not signed up to ILMC. While the Central Bank of Bahrain has not officially explained its non-participation, there is long-standing rivalry between Bahrain and Malaysia as Islamic financial centres.

Geert Bossuyt, CEO of Islamic finance boutique Dar Al-Istithmar

Geert Bossuyt, CEO of Islamic finance boutique Dar Al-Istithmar

Single platform

In addition, Bahrain has a high investment grade sovereign rating. This means there is less upside for the Bahraini authorities to pool their assets into an IsDB/IFSB-led sukuk programme than for ILMC participants such as Nigeria, which has speculative-grade sovereign ratings, or Sudan, which is unrated. Geert Bossuyt, CEO of Islamic finance boutique Dar Al-Istithmar, hopes ILMC will use its international backing to be more ambitious in its plans than using only IsDB-wrapped issuance.

"Ultimately, what you have created with that is only one new issuer. I think the aim should be to have multiple new issuers of very short-term paper in the market," says Mr Bossuyt.

He is seeking to set up a Luxembourg-registered Islamic CP facility, open to bank (conventional or Islamic) and corporate issuers using standardised legal and sharia documentation based on the double-waad (promise) structure, as an alternative to interbank commodity murabaha deals. At the moment, he is discussing the initiative with six central banks, and hopes to finalise the platform's licence and network in the first quarter of 2011. This channel could both provide liquidity for issuers, and give Islamic banks with surplus cash a natural market to invest in without tying money down in a way that hampers liquidity management.

"Instead of each issuer using a separate special purpose vehicle, we are looking to get all CP issuance channelled through one platform, which has economies of scale, takes a lot of hassle away from the issuer and distributor, and should create a fungibility of assets because of the standard documentation. An investor should not need to make separate checks with their sharia board or back-office settlement systems to see if the bank can handle each asset," says Mr Bossuyt.

He anticipates a cost to issuers of about two basis points per year, which compares very favourably with commodity murabaha deals that are often renewed every month, costing about three basis points per month. In addition, Islamic CP would avoid the use of the reverse tawarruq (deferred payment purchase) contracts that are the building blocks of murabaha transactions. These contracts have attracted criticism from some sharia scholars who find that they are too close to conventional borrowing with interest.

We are looking to get all CP issuance channelled through one platform, which has economies of scale, takes a lot of hassle away from the issuer and distributor, and should create a fungibility of assets because of the standard documentation

Independent strength

Mr Bossuyt was previously the head of Islamic finance at Deutsche Bank, where he helped to build an issuance platform called Al-Miyar. This was originally intended to be a liquidity provider, but issuance through Al-Miyar is largely conducted by Deutsche Bank itself. Mr Bossuyt says he moved to Dar Al-Istithmar partly because he felt that it would require an independent smaller firm, rather than a bank, to create a platform that gained universal acceptance. His proposed scheme would be owned by a charitable trust, highlighting the independence of the vehicle even from Dar Al-Istithmar itself.

"For any individual bank, a CP platform that they launched could be seen as a rival by other banks, and central banks would worry about being seen to favour one bank over others," he says.

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