Matt Smith explores how sharia-compliant repo-like structures can support liquidity management in Islamic financial markets, and considers the structural, regulatory, and legal factors that need to be addressed to facilitate the further development and take-up of such instruments.
Islamic finance is steadily increasing its use of sharia-compliant alternatives to repos, helping the industry better manage liquidity and enabling sukuk holders to increase returns from their holdings.
Yet doubts over whether such structures are truly Islamic and a lack of standardisation has slowed take-up of these instruments, also posing fundamental questions as to whether the sector should be seeking to simply emulate conventional finance or trying to create a truly alternative approach.
“The starting premise is the same for most challenges in Islamic finance – that of trying to square a circle,” says Khalid Howladar, managing director and founder of Dubai’s Acreditus, a boutique risk, ratings, fintech and sukuk advisory practice.
Central banks use repos to control money supply, while commercial banks use them to manage short-term fluctuations in their cash holdings, and they are essential to the smooth functioning of financial markets. In conventional finance, holders of government securities will sell such assets to investors, agreeing to repurchase them for a predetermined price, usually the following day with the asset itself used as collateral.
Such structures effectively involve paying interest and so are haram, or forbidden, under Islamic law, while the sale-and-buyback aspect of a repo is also unacceptable.
For the past decade, Bahrain’s International Islamic Financial Market (IIFM) has been working with the Islamic finance industry to create a product that would be close to a conventional repo.
“Banks are trying replicate the economic aspect
These difficulties have slowed the development of Islamic capital markets, especially as Islamic scholars differ on their interpretation of what is and is not allowed, while Basel III rules have made improving liquidity management a more pressing concern for Islamic banks.
“You need repos for cash and liquidity management, financing, structured products or more exotic investments such as derivatives and swaps, which are a complex, underdeveloped part of Islamic finance,” says Bashar Al Natoor, global head of Islamic finance at Fitch Ratings. “It’s an industry that’s still trying to develop aspects that are essential to its operations.”
He cites the example of having the ability to place excess liquidity at central banks, which until three to four years ago was not possible in many countries such as Saudi Arabia and the UAE. Now, these capabilities have helped banks better manage their cash.
“Some of the industry’s essential components are still not in place – Islamic capital markets are not yet well developed,” says Al Natoor.
That many Islamic banks possess excess liquidity highlights “the importance of having alternative sharia-compliant liquidity management instruments,” says Dr Bello Lawal Danbatta, secretary-general of the Islamic Financial Services Board (IFSB), a Malaysian standards-setting body.
“The development of Islamic repos would require a deep and developed Islamic money market where sharia-compliant securities are sufficiently available in various features including tenors, prices, liquidity characteristics,” he says.
IFSB has issued various standards that attempt to address the challenges that Islamic banks face regarding liquidity management.
“Given the varying practices in Islamic banking, and diversity of sharia opinions on the subject, the IFSB has so far stopped short of offering a specific model for an Islamic repo mechanism, leaving that to individual jurisdictions and the approval of relevant sharia boards and the regulatory authorities,” says Dr Danbatta.
Centralised sharia boards, especially in the Gulf, are not sufficiently developed to approve repo-like structures, notes Fitch’s Al Natoor. “Once you have standardisation it will give banks more flexibility,” he says.
There are two aspects to standardisation: the structure itself and the legal documentation.
“In terms of structure, the sharia principles are already available. In terms of legal documentation, I wouldn’t say it’s standardised, but it’s harmonised to the extent that legal enforceability is intact,” says Maya Marissa Malek, chief executive of Dubai’s Amanie Advisors Ltd, a specialist Islamic finance advisory firm.
The UAE has launched a centralised sharia board, which has asked Islamic banks to comply with sharia standards from Bahrain’s Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), another standards-setting body.
Malaysia has several instruments available based on Wadiah – the safe custody of the depositor’s funds – and Rahn, in which an asset is used as collateral in order to obtain debt, as well as sale-and-buyback facilities based on an underlying sukuk. Saudi Arabia has yet to introduce a centralised sharia board.
“Each jurisdiction is moving at its own pace,” says Fitch’s Al Natoor. “As we see development in sharia capital markets and sukuk, the repo side will also develop. It won’t happen in the short term, it’s more of a medium-term development. The industry is still growing in terms of liquidity – development of the more exotic instruments like repos and derivatives has been slower.”
In 2014, IIFM created an alternative standard based on using collateral in order to remove the need for a binding sale-and-buyback agreement. Transaction volumes are not available, but several central banks including those of Malaysia, Bahrain and the United Arab Emirates have approved IIFM’s Collateralized Murabaha Standard as a liquidity management tool. Financial institutions in several jurisdictions use it; Murabaha is a cost-plus-financing arrangement that is common in Islamic finance.
“This works well and enables the financial institutions to manage their liquidity and investment requirements by using sukuk or Islamic securities portfolio,” says Ijlal Ahmed Alvi, IIFM chief executive.
“The Islamic finance industry mostly utilizes sukuk as collateral. Local regulations also come into play in shaping how quickly the collateral can be realised in case of default to fulfil the obligation under the agreement.”
Yet such workarounds do not solve other problems relating to repos. Some jurisdictions lack sufficient sharia-compliant securities to use as collateral in an Islamic repo-like structure, notes Dr Danbatta.
Counterparties are also often sceptical as to whether the repo-like structures are truly Islamic, warns Amanie’s Malek, while the risk that the terms differ depending on the specific instrument makes them significantly less liquid than conventional repos, says Acreditus’ Howladar.
“We’re trying to get both the economics of a repo, which is already a challenge, and then have it legally equivalent to conventional ones from a risk and regulatory standpoint,” he says.
“Fundamentally, there are some things that can’t be done in Islamic finance and perhaps some things that shouldn’t be done. Islamic banks are already pretty profitable. Do they need to go further in replicating every single interest-based structure of conventional banking? I don’t think it adds value.”
A few banks – mostly the Islamic windows of conventional banks – offer sharia-compliant alternatives to repos.
“We’re working with a number of banks to structure Islamic repos and reverse repos as well as alternatives to securities lending. The demand for such products is very encouraging – it’s not a question of demand, but more of supply,” says Amanie’s Malek.
“As well as demand from the GCC, there’s also a need for sharia-compliant liquidity in the UK and South East Asia because of the growing number of Islamic banks and Islamic windows – the demand for these products is always high.”
In July 2018, Borsa Istanbul launched its Committed Transactions Market of Sukuk (CTM), which aims to enable trading of repo-like products that use sukuk – known in Turkey as lease certificates. Approved by Turkey’s Islamic banking advisory board, CTM activity began in earnest in June 2019, when $25.9 million of contracts changed hands. July turnover ballooned to $892.1 million, while the first 15 days of August generated sales of $532 million, bourse data shows.
Enabling the widespread use of repo-like structures would also help expand the secondary sukuk market, which is typically dominated by buy-and-hold investors.
“Repos would allow banks to free up liquidity and stimulate the secondary market, allowing investors to purchase and re-sell on a collateralised basis,” says Fitch’s Al Natoor.
Yet asset growth among Islamic banks has slowed, while liquidity is increasingly scarce.
“Sharia alternatives to repos offer Islamic finance market players a way to monetise the sukuk they hold on their books,” adds Malek. “It’s a very useful way to get cheaper funding.”
This article features in the Middle East and North Africa Securities Finance Guide 2019. Download the full guide here.
Interested in learning more about the MENA markets? Attend Global Investor’s MENA Asset Management and Trading Summit in Dubai on November 6, 2019.