While the debut issuance of a $490m sukuk in August was a significant milestone for Islamic finance, it will barely dent the industry’s short-term liquidity management issues, which are hampering growth.

The Islamic finance industry has made great strides since the onset of the global financial crisis. Assets have passed the $1000bn mark, profits have risen sharply and the industry has been feted for pushing into new markets and sectors. Yet it continues to be dogged by one recurring question: when will it address the short-term liquidity management of Islamic financial institutions on a global basis?

To date, the industry’s expansion has been noticeably hampered by a shortage of highly liquid, investment-grade financial instruments that Islamic banks can trade to manage their short-term funding needs. So the long-awaited debut $490m sukuk issuance in August 2013 by Malaysia International Islamic Liquidity Management (IILM) Corporation – a body backed by central banks from the Middle East and Asia – marked a significant milestone, while setting several records in the process.

The three-month Islamic bonds comprise the first tranche of the IILM's approved $2bn short-term programme, assigned an A-1 credit rating by international rating agency Standard & Poor's, to create US dollar cross-border liquidity instruments.

Landmark issuance

The sukuk constitutes the first sharia-compliant US dollar-denominated short-term rated financial instrument in the market and the first money-market instrument backed by sovereign assets in the form of sukuk. 

“It’s a path-breaking sukuk,” says Humayon Dar, founder of UK-based Islamic finance advisory firm Edbiz Consulting. “Now that this has been issued, I expect more to follow. Liquidity management can only be improved by having an increased number of sukuk in the marketplace.”

The issuance was on the cards from when the IILM was established in October 2010, but was delayed several times due to technical obstacles and divergent views among its multinational board members. After repeated false alarms that issuance was imminent, there were growing concerns over the credibility of the IILM, whose mandate is to create and issue short-term Islamic financial instruments that can be traded to enhance cross-border liquidity flows, international linkages and financial stability.

“This sukuk is definitely a step in the right direction,” says Ashar Nazim, a partner at management consultancy Ernst & Young and leader of its global Islamic banking centre. “The industry and stakeholders recognise that there are bottlenecks, so through this issuance, the IILM hopes to accelerate the issuance of similar instruments in the marketplace. To date, banks have had to rely on synthetic instruments such as multi-murabaha.” 

Indeed, currently many Islamic banks place their surplus funds with conventional banks by means of bilateral murabaha transactions based on goods, for example, commodities or metals, and services not connected to the underlying business of the financed party under the principles of the murabaha. This huge market today dominates many other Islamic transactions.

The $490m sukuk was auctioned off to seven banks drawn from Asia, the Middle East and Europe: Kuwait Finance House, Albaraka Turk, KBL Private Bankers, Malayan Banking (Maybank), National Bank of Abu Dhabi, Qatar National Bank and Standard Chartered. These banks are now going to serve as primary dealers in selling the sukuk onto Islamic banks and institutions with the aim of creating an international market in Islamic financial instruments. 

“The sukuk was fully subscribed on auction day, which is significant as the IILM’s toughest issuance was always going to be the first one,” says Leon Koay, head of global markets and co-head of wholesale banking at Standard Chartered Bank Malaysia. “I’m not at liberty to disclose specific details of other banks, but I can say that for ourselves, the take-up was immediate and has already been absorbed.”

More instruments needed

While the IILM’s $2bn programme definitely marks a step in the right direction, a programme of this size is barely going to make a dent in addressing the vast cross-border liquidity management challenges facing the industry. 

“We expect that the IILM is probably going to try to make another issuance within the next six to nine months,” says Mr Koay. “The challenge now is to devise more instruments given how much liquidity is currently parked with murabaha. The IILM’s initiative is a good start, but we need to see other instruments.” 

Mr Nazim agrees that there needs to be an increased issuance of instruments. “Islamic banks have had to rely on synthetic instruments – mainly multi-murabaha – and so the focus now needs to be on coming out with new papers in the market.”

The IILM’s current shareholders comprise nine central banks from Indonesia, Kuwait, Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Turkey and the United Arab Emirates, as well as the Saudi Arabia-based Islamic Development Bank. Iran is also a member of the IILM but not a shareholder.

In April 2013, the Saudi Arabian Monetary Agency, the Saudi central bank, unexpectedly withdrew from the IILM, depriving the body of a key industry player – home to the world’s second largest pool of sharia-compliant assets ($227.2bn) and some of the largest Islamic banks. For now, it is not clear whether it will ever return but its current absence is likely to limit trade participation in the sukuk by Saudi institutions.

“Clearly, the long-term aim is to bring other central banks into the domain,” says Mr Dar. “[Among] other Islamic bodies... the Islamic Financial Services Board currently has about 20 central banks sitting on its board and I see no reason why the IILM can’t build up to 20 central banks.”

Mr Dar also believes that the IILM and other bodies can learn from the conventional banking industry. “Co-operation between conventional and Islamic banks is always healthy,” he says. “Liquidity management technology is very well developed in conventional markets – we cannot completely ignore it. Islamic banks are small in both number and size, whereas conventional banks are the dominating force in nearly all markets so I think we can and should learn from them in our efforts to create new, credible liquidity tools.”

To participate in the international sukuk market, Islamic financial institutions need to achieve certain prerequisites such as global connectivity, sukuk structuring and trading expertise, as well as balance sheet strength.

“The challenge is how do you originate quality assets when there are serious constraints on the supply side,” says Mr Nazim. “If we look at the private sector, it is clear that Islamic banks are unable to fill this vacuum because they still lack global connectivity across markets and investor classes, plus their balance sheets are rather modest, preventing them from underwriting a large number of sukuk.”

Increasing demand

Worldwide demand for sukuk is forecast to grow threefold from $300bn to $900bn by 2017 due to an exponential rise fuelled by double-digit growth in the Islamic banking industry and the increasing appetite for credible, sharia-compliant liquid securities, according to a report published by Ernst & Young’s Global Islamic Banking Centre in August 2012. However, the report noted: “We believe that the industry is not yet ready to fully capitalise on this demand potential, and the supply of sukuk may well fall short of the $900bn demand over the next five years.”

Mr Nazim says a call to action is required for leading Islamic financial institutions and multilateral institutions to work in a collaborative manner to bring out quality sharia-compliant short-term paper for the market. A more liquid market that can entice smaller investors can only happen when larger, more established institutions are actively involved. “Unless three or four major initiatives are launched by large institutions in key jurisdictions such as Qatar, Dubai, Malaysia or Saudi Arabia, we won’t see this challenge going away,” he says.

Indeed, in a speech given in July 2013 in Kuala Lumpur, Zeti Akhtar Aziz, the governor of Malaysia’s central bank, said: “A key area for co-operation that is being advanced relates to the provision of a robust liquidity management infrastructure for Islamic finance. This is an important imperative to ensure the resilience and stability of the Islamic financial system.”

Interbank financing

The recent global financial crisis demonstrated how quickly and dramatically interbank lending can decline. If Islamic banks were to become concerned about the solvency of other Islamic banks, then the supply of their interbank financing could dry up quite rapidly. Furthermore, the need for improved liquidity management tools has also been brought into focus by the new Basel III regulations, which will start to be implemented in March 2018.

The Basel III liquidity requirements, in particular the liquidity coverage ratio, stipulates institutions hold a sufficient buffer of high-quality liquid assets to cover liquidity outflows for a one-month stress period. With their current limited range of short-term instruments, this requirement places Islamic institutions in a somewhat compromised position.

It is as yet unclear how successful all seven of IILM’s primary dealers have been in selling on their portion of the $490m sukuk, but this is something that industry participants will be watching closely.

Clearly, sukuk issuance alone is not enough to overcome the current liquidity management problems. IILM’s sukuk and others that follow in its path need to be actively traded by Islamic banks, rather than held to maturity and potentially rolled over thereafter – a course of action favoured by the market’s mainstay investors of specialist sukuk funds and private wealth managers.

Indeed, one of the biggest constraints to sukuk market development has been the instrument’s lack of secondary market liquidity. While secondary market trading has been improving noticeably in the past few years, helped by global Islamic players such as HSBC Amanah, Malaysia’s CIMB Islamic and Dubai Islamic Bank – who are actively involved in the trading of sukuk papers – regular issuances are needed to meet the demand of both short- and long-term market players. 

“The number of sukuk trading on the secondary market has definitely improved over the past seven to eight years and will continue to improve,” says Mr Dar. “Pre-2005, there was virtually no trading in secondary market papers. Today, leading Islamic banks are now trading in sukuk with increasing volumes – we are seeing daily trading taking place on the Dubai and Kuala Lumpur stock markets, while monthly trade volumes are also becoming quite significant.” 

A lack of assets in which to invest and a lacklustre secondary market for those assets are perennial problems facing the industry. Finding solutions to these problems is integral to improving market liquidity and ultimately enabling the overall development of an integrated Islamic financial system. The continued promotion of efficient and effective market liquidity management through a coordinated approach to introducing more short-term liquidity instruments is crucial to ensuring both the long-term growth and health of the industry in the years to come.

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