Islamic Financial and Capital Markets

Transcription

1 Islamic Financial and Capital Markets Hassanain, Khalifa M ISBN Islamic development Bank, 2016 King Fahd National library cataloging Publication Data Copy Rights Notice Islamic research and Training Institute 2016 All rights reserved. All parts of this work are subject to sole ownership of Islamic research and Training Institute (hereinafter referred to as Copyright Holder ) and remains exclusive property of the Copyright Holder. No part of this work may be copied, reproduced, adapted, distributed, modified or used in any other manner or media without prior written authorization of the Copyright Holder. Any unauthorized use of this work shall amount to copyright infringement and may give rise to civil and criminal liability. Enquiries and communications concerning authorization of usage may be made to the following: Islamic Research and Training Institute Member of the Islamic Development Bank Group P.O.Box Jeddah Kingdom of Saudi Arabia irti@isdb.org Disclaimer The content of these course have been developed solely for educational and training purposes. They are meant to reflect the state of knowledge in the area they cover. The content does reflect the opinion of the Islamic Development Bank Group (IDBG) nor the Islamic Research and Training Institute (IRTI). Acknowledgement This textbook was developed as part of the IRTI e-learning Program (2010), which was established and managed by Dr. Ahmed Iskanderani and Dr. Khalifa M. Ali.

2 Chapter 9 Tradability, Structures and Potential of Sukuk... 5 Chapter Introduction... 5 Tradability of Sukuk... 5 Pre-fixed Rate of Return on Sukuk... 7 Restrictions and Flexibility in Returns... 7 Other Issues in Sukuk Tradability... 8 Potential for Sukuk... 9 Examples of Sukuk Issues in the Islamic World Chapter Summary Chapter 10 Development of Islamic Money Markets Chapter Introduction Limited Scope of Islamic Money Markets The Need for Sharī ah-compliant Sources of Funds The Role of an Islamic Money Market The Negative Effects of Undeveloped Money Markets Legal Amendments to Develop Islamic Money Markets Sharī ah Issues in the Development of Islamic Money Markets Tax Issues in Developing Islamic Money Markets Instruments and Components of an Islamic Money Market Trends in Liquidity Management by IFIs Interbank Instruments Used by IFIs Chapter Summary Chapter 11 Monetary Operations in Islamic Money Markets Chapter Introduction Credit Facilities Offered by Central Banks Central Bank Deposit and Reserves Examples of Facilities for IFIs Market-based Financing Instruments Tradability of Sharī ah-compliant Instruments Supervising Liquidity Management Monetary Operations and Public Debt Management Factors in the Growth of Islamic Money Markets Policy Issues in Islamic Money Markets Developing Sharī ah-compliant Money Market Instruments Monetary Operations and Public Debt Financing Islamic Money and Foreign Exchange Markets Chapter Summary Chapter 12 Case Studies in Islamic Money Markets Page 2 of 64

3 Chapter Introduction Overview of the Malaysian IIMM Market-Based Instruments for Money Operations Processes of IIMM Instruments Sharī ah-compliant Alternatives to Forex Swaps Overview of Interbank Money Markets in Sudan Sudanese Markets and Monetary Operations Sudanese Payment Systems, Secondary and Forex Markets Overview of Money Markets in Bahrain Central Bank Facilities in Bahrain Market-Based Instruments in Bahrain Bahraini Payment Systems and Secondary and Forex Markets Overview of Money Markets in Pakistan Pool-Based Placement in the Pakistani Money Market Parameters for Pool-Based Placement in Pakistan Other Modes of Fund Placement in Pakistan Standing Facilities, Payment Systems and Forex Markets Chapter Summary Bibliography Page 3 of 64

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5 Chapter 9 Tradability, Structures and Potential of Sukuk Chapter Introduction Tradability, Structures and Potential of Sukuk. Tradability of Sukuk is vital because the usufruct of the underlying assets is a source of income for Sukuk investors. Practitioners and general public, who are interested in Islamic finance, should be wellinformed about the flexibilities and limits of each type of Sukuk so that the integrity of the system is not damaged. Though there has been an exceptional growth of Sukuk, there are few concerns that need to be addressed for sustained support for the emerging financial system. Sukuk can mobilise resources, benefit investors and fund users and provide liquidity and fund management. Before we proceed, note that various other aspects of Sukuk are covered in greater detail in the following chapters of this course: Chapter 6, Securitisation in Islamic Finance Chapter 7, Structure of Sukuk and Chapter 8: Categories of Sukuk On completing this chapter, you will be able to: Identify the factors determining the tradability of Sukuk in the secondary market, State the Sharī ah perspective and the AAOIFI standards on the rate of return in Sukuk, Explain the restrictions on and flexibility permitted for Mudarabah contracts and Sukuk issues with regards to returns, Describe the aspects that restrict tradability of Sukuk, Describe the emergence of Sukuk and potential for its growth as an important investment mode in Islamic finance and Describe the characteristics of four prominent Sukuk issues in the Islamic world. Tradability of Sukuk Tradability is an important feature that should be considered while issuing Sukuk and making investment. Page 5 of 64

6 Sukuk that signifies tangible assets or usufruct of such assets can be traded in the secondary market. This occurs depending upon the quality, risk and profitability of the securitised assets. If the Sukuk represents a share of ownership in the underlying assets or projects; it can be negotiable or tradable. However, it is not tradable, if it creates any debt obligations. Let us now learn about tradability of Sukuk in the secondary market with respect to Sharī ah as per the AAOIFI Standard. Mudarabah and Musharakah Sukuk are tradable at market price once the activity for which the funds were raised begins. Ijarah Sukuk based on freehold existing assets is tradable at market price. Ijarah Sukuk of existing assets subject to head lease are tradable at market price or at a price agreed upon at the date of redemption. Ijarah Sukuk based on future tangible assets are tradable at market price only after the asset is ascertained and leased. Sukuk based on existing specified services are tradable prior to sub-leasing of such services. Sukuk based on described future services are tradable at market price only after the source of the service is ascertained. Salam Sukuk are tradable only at the face value. Istisna a Sukuk are tradable if funds are converted into assets and handed over before sale to the orderer. Murabaha Sukuk are tradable prior to the sale of goods to the final buyer or if the receivables are less than 50%. It is tradable only at face value with resort, if the goods are sold and the inventory is not more than 50%. Page 6 of 64

7 Pre-fixed Rate of Return on Sukuk In the recent past, there has been an exceptional growth of Sukuk. However, there are few concerns that need to be addressed for sustained support for the emerging financial system. The first crucial issue is that of conclusively pre-fixed rates of return in all Sukuk, in some cases a provision for third party guarantee is absent. The profit rates in deferredpayment Murabaha and rentals in Ijarah are fixed. Nevertheless, there could be default in receipt of Murabaha receivables, and ownership-related expenses and default in receipt of the due rental may occur in leases. It may not be possible to provide fixed and guaranteed returns to Sukuk holders because the cost of funds cannot be recovered in Islamic finance and expenses are incurred by the lessor as the owner of the leased asset. This concern exists in sovereign Sukuk, as a guarantee by the sovereign itself gives rise to doubts about Sharī ah compliance. In the main contract, payment of rental is guaranteed through sovereigns. According to Sharī ah scholars, partners in contractual Shirkah-based modes should not provide any pre-fixed return or guarantee of the investment. Therefore, AAOIFI offers specific standard on Sukuk. It mentions that there should not be any clause in any of the certificate s prospectus stating that the issuer is liable to compensate certificate holders up to the nominal value in situations other than torts and negligence, or that the issuer guarantees a fixed percentage of profit. Such a guarantee can be provided by an independent third party for free of charge, subject to relevant conditions. However, the actual structure of Sukuk and the way in which it is marketed assures the subscribers and holders a fixed return rate, which is similar to other fixed income security in the conventional interest-based structure. Restrictions and Flexibility in Returns The financier partner or the bank can give returns to the client partners from its own profit or out of its own wallet, similar to the deposits kept on the basis of Mudarabah. However, the banks can accommodate the clients only up to a level of pre-agreed ratio. Page 7 of 64

8 Such arrangement of payment from the banks own profit may affect the sanctity of the Shirkah institution. In the case of Sukuk, the SPVs distribute the net proceeds of the business, in which the raised funds have been used, among Sukuk holders. In Ijarah, the rental rate can be fixed or floating and the lessor may be aware of his future expected receipts well in advance. However, the lessor may lose rental collection, if the lessee fails in timely payment, and may also lose his property because of systematic and unsystematic risks. It is important to provide Sukuk holders with a guarantee of investment and assurance of fixed income. To achieve this, the owner or lessor of the asset should provide assurance to the purchaser about the lessees performance. However, the Sukuk holder must be aware that in Ijarah Sukuk, the returns are linked to a benchmark, so they can be variable. This is similar to the case of IDB Trust Sukuk issued on the basis of a mixed portfolio of assets. In the case of Murabaha or other receivables, the SPV may have recourse to the institution that has engaged the underlying transactions. According to Sharī ah scholars, if the asset, which could be leased by the SPV, is destroyed without the lessee being negligent or at fault, the lessor or Sukuk holder should bear the risk. Also, if a fixed return is guaranteed for the investments made by Ijarah Sukuk holders, the requirement of taking up ownership-related risks has to be fulfilled. Other Issues in Sukuk Tradability Several issues are involved in the trading of a Sukuk. They are: Complexity in combining multiple contracts into a single Sukuk. Lack of transparency in documentations and rights and obligations of parties involved in a Sukuk. Over-reliance on Ijarah Sukuk and underutilisation of other Sukuk. Let s now learn about these issues in detail. Page 8 of 64

9 Complexity The inclusion of multiple contracts as independent agreements within a single arrangement of Sukuk poses a major issue in the tradability of Sukuk. There are six agreements involved in the Ijarah Sukuk issue with a sale and lease-back arrangement. If these agreements are integrated into the main contract, then the Sharī ah compliance is at stake. It is required to sequence these agreements because sequencing has an influence on the Sharī ah compliance. Inadequate Monitoring Most Sukuk documentation is available in the public domain and is transparent with respect to contractual conditions and rights and liabilities of various parties. However, adequate monitoring would enhance credibility of Sukuk and expand the Islamic finance market. The Sharī ah boards should approve the procedure of the issue and monitor the implementation of the project, including distribution of profit, trade and redemption of certificates, throughout its duration. Over-Reliance There is an over-reliance on Ijarah Sukuk and underutilisation of Shirkah-based and mixed portfolio Sukuk. Sukuk issued for public sector financing are not based on the best structures of Islamic finance except the Salam Sukuk in the Kingdom of Bahrain and few Shirkah-related certificates in the Islamic Republic of Sudan. Shirkah-based certificates of investment issued by corporate bodies have proved their suitability and profitability. Reliance on Ijarah Sukuk alone may not be sufficient to realize the securitisation potential of the industry and generate the support needed for realization of the market potential. Hence, in accordance with Sharī ah scholars, the procedures of Ijarah Sukuk should be refined. Potential for Sukuk As a part of the growing Islamic finance industry, Sukuk can mobilise resources and can be effectively used for the benefit of investors and fund users. Their growth enhances their potential for liquidity and fund management. In the Islamic Republic of Page 9 of 64

10 Sudan, central banks issue Sukuk for controlling liquidity. Sukuk are also used as a tool for monetary policy and open market operations. For short-term and medium- to long-term fund and cash management, IFIs relied on Tawarruq and Murabaha-based dealings in the international metals market and equity markets. However, Sharī ah scholars did not accept the method of operations of the transactions in the metals market. This is because the Murabaha conditions were not accomplished in letter and spirit. The emergence of Sukuk, particularly Ijarah Sukuk, along with the market makers and servicers facilitates IFIs in short-term fund placements with Sharī ah compliance. Until the recent past, Sukuk were stringently dealt with due to a shortage in the supply of such instruments with respect to the demand. This resulted in the absence of a secondary market. However, active trading of Sukuk has started only recently. The Dubai PCFC or Ports, Customs and Free Zone Corporation Sukuk has been traded with an average volume of USD 10 million a day since its launch. Similarly, there is a positive vibe from an active secondary market dealing in Nakheel Sukuk just after their issue in December According to one of the world s largest financial services firms, about 33 percent of investors in Muslim dominated countries prefer Sharī ah-compliant products and another 50 to 60% of investors use products conforming to Sharī ah tenets, if they are commercially competitive. In 2006, a leading investment bank from UAE issued a Sukuk of USD 800 million and around 40% of the investors came from Europe. Also, in the Nakheel Sukuk issue of USD 3.52 billion, 40% of investors were from Europe. A large number of European and Japanese corporations are planning to explore the Sukuk market to raise long-term funds. Numerous companies and institutions with Sharī ah-compliant products are shifting to public vehicles offering Sharī ah-compliant solutions to financial problems. This confirms the huge potential of Sharī ah-compliant certificates of investment. An enormous amount of funds is required for infrastructure projects in the Muslim world. If managed properly without compromising on the Sharī ah principles, this fund can be arranged through Sukuk. It could also act as a stepping stone for the development of these economies. To achieve this, Islamic countries should increasingly use Sukuk for financing their infrastructure and other development projects. Page 10 of 64

11 The development of Sukuk depends on a proper regulatory framework, Sharī ah compliance and convergence, the availability of trained market professionals and investors financial literacy and knowledge-sharing. Examples of Sukuk Issues in the Islamic World Let s now learn about few examples of Sukuk issued in the Islamic world. 1. Nakheel Sukuk issued by DP World 2. Ijarah Sukuk issued by government of the Islamic Republic of Pakistan 3. Ijarah Sukuk issued by WAPDA, Islamic Republic of Pakistan 4. Case study of Hanco Fleet securitisation in the Kingdom of Saudi Arabia DP World s Nakheel Sukuk Nakheel Sukuk offers extensive security package featuring: A mortgage on land, A pledge on shares in the operating company and A guarantee from Nakheel s parent company, Dubai World. The initial offering of Nakheel Sukuk was USD 2.5 billion. However, the final offering was USD 3.52 billion. The joint lead managers and joint bookrunners of the offer were Barclays Capital and Dubai Islamic Bank. The Nakheel Sukuk has a sale and leaseback structure, which was active for 3 years. The price of Sukuk was LIBOR plus 120 basis points or bps. Nakheel Sukuk is listed on the Dubai International Financial Exchange. Around 38% of the investors were from the Middle East, 40% from Europe and rest of the investors were from the other parts of the world. 55% of the deal went to banks, 35% to both fixed-income and convertible funds and the rest 10% to asset managers and wealthy individuals. Government of Pakistan s Ijarah Sukuk In January 2005, Pakistan s first Islamic Sukuk was launched. One of the leading credit rating agencies assigned a B plus rating for that Sukuk issue. An SPV, Pakistan International Sukuk Company Limited or PIS, was formed, which bought a highway land from the National Highway Authority and issued trust certificates. The land was then leased to the government of the Islamic Republic of Pakistan for a period corresponding to the tenor of trust certificates. The government makes periodic payments to PIS to pay the liabilities arising on the trust certificates. On completion of the term, the government will repurchase the land from PIS at an agreed price. This will enable it to redeem the Sukuk. Page 11 of 64

12 There were offers worth USD 1,200 million from 82 accounts, out of which USD 600 million were accepted. It was sold at par to yield 220 bps above 6-month LIBOR. WAPDA, Pakistan s Ijarah Sukuk The Water and Power Development Authority or WAPDA in the Islamic Republic of Pakistan works for the development of water and hydel power in the country. WAPDA issued Ijarah Sukuk to raise money for enhancing its power-generating capacity. An SPV, WAPDA First Sukuk Co or WFS was formed. WFS purchased WAPDA s ten Mangla Hydel power generation units for lease back to WAPDA for seven years. WAPDA pays semiannual rent to WFS to pay periodic rental to the Sukuk holders. On completion of the term, WAPDA will purchase the underlying assets by fulfilling its unilateral undertaking to purchase the turbines. This enables WFS to pay back the investment amounts to the Sukuk holders. The government of the Islamic Republic of Pakistan guarantees the payment obligation of WAPDA under the WAPDA Sukuk issue. This makes them eligible for maintaining a statutory liquidity requirement (SLR) by Islamic banks. The principal amount of the Sukuk is PKR 8000 million. The rentals are benchmarked against Karachi Interbank Offer Rate or KIBOR and the rental rate is 6 months KIBOR plus 35 bps. The issuance format is privately placed local currency or LCY floating rate notes. Hanco Fleet Securitisation in the KSA In the Kingdom of Saudi Arabia, a two-tier special purpose vehicle or special purpose company (SPV/SPC) structure was established to issue Sukuk certificates. The SPC was incorporated in a foreign country because of stringent Saudi laws. SPC issued Sukuk certificates for a motor fleet. The proceeds of the certificates are used by the SPV to fund the purchase of assets from the originator. As the owner of the assets, the SPV allows an agent to manage the assets. SPV deposits all the cash flows into an off-shore bank account managed by the SPC. In the case of lack of cash flow, the money in the bank account is used to fulfill any payment flow obligations. SPC pays the certificate holders and, at maturity, sells the assets to fund the redemption of certificate holders. Page 12 of 64

13 The principal amount of the Hanco Fleet securitisation is USD 27.2 million. With a periodic distribution of 6%, this Sukuk has a tenor of 3 years. The issuance format is privately placed LCY fixed-rate notes and the issuer is two-tier SPV/SPC. Chapter Summary You have completed the chapter, Tradability, Structures and Potential of Sukuk. The key points of this chapter are as follows: Tradability of Sukuk is vital because the usufruct of the underlying assets is a source of income for Sukuk investors. Sukuk representing a share of the ownership of underlying assets or projects are negotiable or tradable. However, it is not tradable, if it creates any debt obligations. Pre-fixed rates of return in all Sukuk raise concern. In some cases, it does not even have any provision for third party guarantee. Bank can give returns to the client partners from its own profit or wallet. However, such arrangement of payment may affect the sanctity of the Shirkah institution. To provide Sukuk holders with a guarantee of investment and assurance of fixed income, the owner/lessor of the asset should provide assurance to the purchaser about the lessees performance. The inclusion of multiple contracts as independent agreements within a single arrangement of Sukuk poses a major issue in the tradability of Sukuk. Most Sukuk documentation is available in the public domain and is transparent with respect to contractual conditions and rights and liabilities of various parties. However, adequate monitoring would enhance credibility. Lack of transparency exists in the documentation of a Sukuk issue and the rights and obligations of various parties involved in the Sukuk. There is an over-reliance on Ijarah Sukuk and underutilisation of Shirkah-based and mixed portfolio Sukuk. Sukuk can mobilise resources, benefit investors and fund users and provide liquidity and fund management. Development of Sukuk depends on a proper regulatory framework, Sharī ah compliance and convergence, the availability of trained market professionals, and investors financial literacy and knowledge-sharing. Nakheel Sukuk offers extensive security package featuring a mortgage on land, a pledge on shares in the operating company and a guarantee from Dubai World. In January 2005, the Islamic Republic of Pakistan s first Islamic Sukuk, worth USD 600 million, was launched. Page 13 of 64

14 The government of Pakistan guarantees the payment obligation of WAPDA under the WAPDA Sukuk issue making them eligible for maintaining a statutory liquidity requirement. A two-tier special purpose vehicle/special purpose company (SPV/SPC) structure, known as Hanco Fleet securitisation, was established to issue Sukuk certificates. The SPC was incorporated in a foreign country because of stringent Saudi laws. Page 14 of 64

15 Chapter 10 Development of Islamic Money Markets Chapter Introduction Development of Islamic Money Markets. The extraordinary growth in Islamic finance has led IFIs to compete with conventional FIs to appeal to both individual savings and institutional funds. Investors demand comparable liquidity and returns for their investments, which should be proportionate to the risks they take. Therefore, IFIs, acting as the fiduciary agent for the investor, are concerned with maintaining sufficiently liquid assets even as they earn adequate profits. The development of IFIs promoted the adoption of Sharī ah-compliant practices in other market segments such as Takaful and Islamic capital markets. The formation of these capital markets posed a challenge to the management of balance sheet liquidity due to the shortage of Sharī ah-compliant capital and money market instruments. The demand to manage liquidity better inifis compelled several countries such as Bahrain, the Islamic Republic of Iran, Malaysia and the Islamic Republic of Sudan to introduce Sharī ah-compliant instrumentssuch as short-term papers and long-term Sukuk, to meet the investment and liquidity needs. Central banks and securities commissions, which focus on the regulatory fundamentals and issuance of varied Sharī ah-compliant instruments, such as short-term papers and long-term Sukuk, are constantly striving to meet the investment and liquidity needs. Most of the descriptions of the instruments and infrastructure and money market practices across countries that have institutions offering Islamic financial services are based on the findings of a survey conducted by the IFSB. The main aims of the survey were to identify existing practices and infrastructures of various national Islamic money markets and to recommend measures to expand these. IFSB conducted the survey in several countries including Bahrain, Bangladesh, Brunei, Indonesia, the Islamic Republic of Iran, the Kingdom of Saudi Arabia, Kuwait, Malaysia, Pakistan, Qatar, the Islamic Republic of Sudan and theuae. Any reference to such countries or central banks means this group of countries or central banks of these countries. On completing this chapter, you will be able to: Explain why Islamic money markets have lagged conventional money markets in the volume of transactions, Explain the growing need for Sharī ah-compliant sources of funds for IFIs, Explain the role of an Islamic money market in effective supervision of IFIs and the stability of the Islamic financial system, Describe the four negative effects of undeveloped Islamic money markets, Page 15 of 64

16 Identify the legal amendments necessary to develop Islamic money markets, Describe the divergence in views and ways in which experts interpret the Sharī ah that affects the development of Islamic money markets, Explain the tax issues that hinder the growth of Islamic money markets, Describe the instruments and components of an Islamic money market, Identify the trends in liquidity management by IFIs and Describe the three main types of interbank instruments used by IFIs. Limited Scope of Islamic Money Markets According to the data provided by the authorities of various Islamic countries, the average daily quantum of interbank tradingamong IFIs, between IFIs and conventional banks and between IFIs and the country s central bank is low when compared to the volumes in the conventional money market. IFIs in Islamic nations, apart from the Kingdom of Saudi Arabia, tend to transact more with their central bank to meet their liquidity needs. The large difference in the rates of return between Islamic money market and conventional money markets signifies that the two markets are clearly segmented from the perspective of instruments used and their tradability and liquidity. In most Islamic countries surveyed, money markets and interbank markets for Sharī ah-compliant instruments have remained inefficient due to the unusual nature of instruments and the small number and size of IFIs. The prohibition of interest-based borrowing to meet the unforeseen withdrawals by depositors make managing mismatched asset and liability portfolios more complicated for IFIs. Nevertheless, the effect of mismatch on IFIs can be alleviated, as it is shared with the Investment Account Holders (IAH) under Mudarabah principles. Some of the measures implemented to encourage money market transactions among IFIs include placement or acceptance of funds on the basis of a Mudarabah or Commodity Murabahah or arrangements for compensating balances. IFIs have addressed the mismatch problem by maintaining excess reserve balances with the central banks. Thishas rendered the IFIs less profitable and less competitive. On an average, IFIs retain higher excess reserves at the central banks than the conventional banks. The reason is thatifis find it difficult to manage their liquidity positions due to the limited number of Sharī ah- compliant money market instruments in their countries. However, the amount of excess reserves of IFIs has dropped over the years, which indicates that more Sharī ah-compliant instruments are available to manage liquidity. The Need for Sharī ah-compliant Sources of Funds In order to perform investment and liquidity management, numeroussharī ahcomplaint money and capital market instruments have been developed in recent years. Oneof the attempts made by IFIs, central banks and governments was asset securitisation to build Sharī ah-compatible instruments that can be bought and sold. Page 16 of 64

17 However, these instrumentsare relatively few in number and are inadequate for flexible asset liability management by IFIs and monetary operations by central banks. Sharī ah-compliant instruments such as Mudarabah certificates, Musharakah certificates, securities based on Murabahah and lease-based financing have been issued by countries such as Bahrain, the Islamic Republic of Iran, Malaysia and the Islamic Republic of Sudan and by Islamic Development Bank or IDB. Most of these instruments are held until maturity rather than traded because of their attractive income and shortage in the market. This results in a lack of market liquidity, which is a major limitation for the growth of Islamic financial markets. While IFIs can use these instruments for both investing and managing liquidity, the central banks also require liquid money market instruments that can be used in monetary operations with IFIs to control or manage market liquidity. All these kind of operations need Sharī ah-compliant money market and government finance instruments that both IFIs and central banks can use. This would facilitate the central banks in both monetary and financial stability by managing market liquidity more effectively while also offering emergency liquidity assistance at a suitable price. By using such instruments, central banks can stimulate the growth of Islamic interbank money markets. These operations by central banks have still not expanded due to the lack of sufficient instruments and supporting infrastructure. The establishment of interbank Islamic money markets in each country with a significant numberof IFIs is a key element for short-term liquidity management and monetarymanagement and ultimately for the promotion of Islamic finance. In addition, Islamic banks can also invest in conventional banks that offer Islamic banking services, provided the conventional banks invest the funds on a Sharī ahcompliant basis. The Role of an Islamic Money Market The fast expansion in Islamic financial services has forced the need to develop an effective Islamic money market, which, in turn, is necessary for the effective supervision and management of risk by IFIs and the development of capital markets.the two ways in which a developed money market will enhance stability of Page 17 of 64

18 Islamic financial system are benchmarked rates of return and effective operations and better management of liquidity. Let s look at each one of them in detail. Benchmarked Rates of Return Establishing benchmark rates of return based on domestic financial conditions will facilitate the pricing of banking and capital market products. Currently, IFIs rely on London Interbank Offer Rate, or LIBOR, to make financing decisions. Although this benchmarking complies with the principles of Sharī ah, IFIs should link the price of these investment products and facilities to the rate of return on capital in their domestic markets, not on the opportunity cost of capital in dissimilar markets. However, the lack of a well-functioning Islamic money market and government borrowing instruments has hindered the establishment of benchmark rates of return in the domestic markets. In November 2011, the Islamic Interbank Benchmark Rate (IIBR) was launched in Bahrain, which paves the way for pricing Islamic financial transactions. IIBR has been established in cooperation with the Islamic Development Bank (IDB), Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), Bahrain Association of Banks (BAB), Hawkamah Institute for Corporate Governance and a number of major Islamic banks. IIBR uses the contributed rates of 16 Islamic banks and the Islamic finance divisions of conventional banks to provide mechanism for pricing Islamic instruments that is a dependable and essential alternative to the interest-linked benchmarks of conventional finance. Efficient Market-Based Monetary Operations Making market-linked monetary operations more efficient and managing market liquidity more effectively will enable the central bank to nurture deep and liquid national money markets and then integrate them into the international level. The extent of development depends upon market forces, synchronised development of the instruments and the essential national liquidity infrastructure. The Negative Effects of Undeveloped Money Markets Insufficient progress in the development of money markets has resulted in: Lack of appropriate interbank instruments. Insufficient utilisation of securitisation technique. Non-availability of risk management instruments. Lack of a comprehensive and integrated approach to the expansion of money and securities markets. In general, thesharī ah-compliant money markets are based on Mudarabah principles or linked to commodity markets and are inappropriate for interbank trading and government finance operations. However, there seems to be an avenue for further Page 18 of 64

19 progress due to the issuance of Islamic securities in domestic and international markets. The excess liquidity situation has discouraged commercial banks from using techniques of asset securitisation to manage the range of maturities and risks of assets and liabilities. Therefore, the lack of improvement in Islamic markets has dampened the incentives to securitise assets and manage risks by trading in such assets to balance the maturities and risks in the balance sheet. Risk management tools linked to hedging instruments are still limited for IFIs. The growth of Sharī ah-compliant hedging instrumentsrequires efficient active spot markets in commodities and hedging contracts that are both Sharī ah-compliant and economically feasible. Various legal, institutional and accounting issues need to be resolved to achieve this. Also, the development of Sharī ah-compliant hedging instruments requires that the limitations on risk management caused by the lack of Islamic money markets be removed. Lack of a comprehensive and integrated approach has hampered the application of asset securitisation to assist the growth of Islamic capital and money markets. This methodology has the potential to promote efficiency in Islamic money markets and the creation of benchmark rates of return based on central bank operations. An inclusive approach to nurture money and securities markets and alleviate risks is needed. Legal Amendments to Develop Islamic Money Markets Changes to the current regulations to incorporate the specifications of Islamic finance are very important for the development of Islamic money market. Most of the countries surveyed understand the importance of changes to their banking and securities regulations to enable their Islamic financial services industry to function better. The development of trust, security and debt laws are also considered necessary to encourage the planning and issuance of Islamic money and capital market instruments. According to the survey conducted by the Islamic Financial Services Board (IFSB), more than three-fourths of the Islamic countries had modified regulations related to central banking, banking, securities, insurance and anti-money laundering to incorporate the specifications of Islamic finance. But very few nations have altered regulations for trust and stamp duty to cater to Islamic finance. Sharī ah Issues in the Development of Islamic Money Markets The different perspectives of Sharī ah rulings or Fatawa on financial matters across various countries have led to different structuring methods and lack of validity of some contracts or practices in some countries. The survey indicated that the most imperative Sharī ah issues are the sale of debt to an independent entity and securitisation of receivables for debt trading (Bai`al-Dayn). Page 19 of 64

20 The Sharī ah permits sale and purchase of these agreements under very limited conditions. The survey also indicated that most of the countries accept revenue sharing contracts such as Floating Ijarah and Diminishing Musharakah as Sharī ah permissible. However,only half of the countries accept risk mitigation instruments, such as Islamic profit rate swap, foreign exchange swap, forward, forward foreign exchange, options, futures and Bai` al-istijrar as Sharī ah permissible. The survey revealed that the most urgent issues were options. Tax Issues in Developing Islamic Money Markets In general, taxes and tax incentives are vital for the expansion of the Islamic money market. Only few countries have provided tax breaks to encourage the growth of the Islamic money market and forex transactions. The survey showed that most of the countries levy similar tax structures on conventional and Islamic securities. This is a major disadvantage for the growth of the Islamic money market. It costs more to issue a new Islamic instrument than a conventional instrument due to the various contracts needed for fulfilling the Sharī ah conditions. However, very fewcountries consider the importance of costs involvedin money market and foreign exchange-related issuances and trading. On the other hand, the individual government s policy, not the central bank and supervisory authorities, determines regulatory and tax structures. Instruments and Components of an Islamic Money Market The diverse players in the money and foreign exchange markets include the central banks, banking and near-banking IFIs, Takāful operators and corporate end-users. The instruments of interbank money markets, in which central banks influence liquidity through their monetary operation, include unsecured interbank placements and transactions in various tradable instruments. The survey revealed that several Islamic countries have modified these instruments to meet the requirements of IFIs by designing Sharī ah-compliant variants such as Interbank Mudarabah deposits, Commodity Murabahah arrangements and short-term and long-term Sukuk. However, in most countries, Islamic money markets have low trade volumes and in few countries, interbank markets do not exist due to various reasons. Therefore, IFIs manage their liquidity by sustaining higher levels of excess reserves. Even though, the value of Islamic money market instruments is lower than that of the conventional money market instruments, the growth of Islamic money market has been encouraging. Page 20 of 64

21 Most of the Islamic countries have in place the key infrastructure components required to support conventional money and foreign exchange markets. Other components comprise microstructure of markets, payment settlement systems, public debt and financing arrangements and foreign exchange trading arrangements. The effective use of market-linked monetary operations influence the liquidity environment in the market, providing incentives for the participants to manage their liquidity risks, and contributing to the growth of Islamic money markets. Trends in Liquidity Management by IFIs Treasury operations of the IFIs increase the level of liquidity in the market. Conditional on the size of the IFIs, these operations can be executed in a centralised or decentralised arrangement. In most of the Islamic countries, liquidity and fund management, and cash flow and cash position forecasting are centralised for all business units. The instruments employed by IFIs to manage liquidity vary among countries and also among IFIs. Sharī ah-compliant money market instruments are neither easily nor uniformly available among different countries. Most IFIs use Commodity Murabahah interbank placement of funds under various profit sharing arrangements and Islamic mutual funds. On the other hand, most central banks use Islamic mutual funds, Islamic Government Investment Certificates and short-term Sukuk Al-Ijarah. Interbank Instruments Used by IFIs The dependence of IFIs on mutual inter-ifi arrangements, combined with restricted use of special arrangements with conventional banks, indicates segmentation of the interbank money market. This segmentation could bring challenges during the execution of monetary policy and for the expansion of Islamic money markets. Some of the instruments employed by IFIs for their inter-ifi transactions or with conventional banks are commodity Murabahah, interbank Mudarabah investments and compensating mutual balances. Let s look at each one of them in detail. Commodity Murabahah In a Commodity Murabahah, interbank funds are employed to perform a Murabahah transaction for a commodity, with the earnings after deducting commissions routed to Page 21 of 64

22 the bank supplying the money. The alternative is for banks with excess cash to buy metals, except gold and silver on thelondon Metals Exchange or other international commodity market and sell them on the same day for a deferred payment equal to the procurement price plus mark-up. This instrument is used by majority of IFIs in countries such as Bahrain, the Kingdom of Saudi Arabia, Qatar, Malaysia, Pakistan, Kuwait and UAE. This Murabahah, although standardised, cannot be traded undersharī ahrules. Commodity Murabahah are not adequately flexible for monetary operations because they carry market risk plus counterparty risks. Interbank Mudarabah Investments These are the investment facilities in which interbank placement of funds for a period ranging from one day to one year generates returns linked to a defined profit ratio with profit being estimated based on Mudarabah investments of one year or Mudarabah investments of comparable maturity in the bank receiving the interbank funds. Bangladesh, Indonesia and Malaysia use this type of instruments. The main features of interbankmudarabah investments are as follows. There is limited tradability. Profit calculation based on ex-post provides less clarity on indications of returns that can be used for monetary policy. Although the formula to estimate profit can also be used to determine the level of financing by the central bank, these investments are inappropriate for investment by IFIs with the central bank. Indonesia permits the receiving bank to issue these instruments, but they cannot be freely negotiated before maturity. Compensating Mutual Balances This instrument involves an exchange of interest-free deposits while ensuring that net balances average to zero in a specified period. The Kingdom of Saudi Arabia and Kuwait use this instrument. The main feature of this instrument is that the returns earned on fund placement or financing are not apparent. Chapter Summary You have completed the chapter, Development of Islamic Money Markets. The key points of this chapter are as follows: The average daily quantum of interbank trading among IFIs, between IFIs and conventional banks and between IFIs and the country s central bank are low when compared to the volumes in the conventional money market. Asset securitisation was one of the attempts made by IFIs, Central banks and Governments to build Sharī ah-compatible instruments that can be bought and sold. Sharī ah-compliant instruments have been issued by countries such as Bahrain, Iran, Malaysia and Sudan and by Islamic Development Bank or IDB The two ways in which a developed money market will enhance stability of Islamic financial system are benchmarked rates of return and effective operations and better management of liquidity. Page 22 of 64

23 The major consequences of undeveloped money markets are lack of wellsuited interbank instruments, insufficient utilisation of securitisation technique, non-availability of risk management instruments and lack of a comprehensive and integrated approach to the expansion of money and securities markets. The development of trust, security and debt laws are also considered necessary to support and encourage the planning and issue of Islamic money and capital markets instruments. The most imperative Sharī ah issues are the sale of debt to an independent entity and securitisation of receivables for debt trading (Bai` al-dayn). Few countries have provided tax breaks to encourage the growth of the Islamic money market and Forex transactions. The diverse players in the money and foreign exchange markets include the central banks, banking and near-banking IFIs, Takāful operators and corporate end-users. Most of the Islamic countries have in place the key infrastructure components required to support conventional money and foreign exchange markets. Other components comprise microstructure of markets, payment settlement systems, public debt and financing arrangements and foreign exchange trading arrangements. The treasury activities that are centralised for all business units are liquidity and funding management, and cash flow and cash position forecasting. The most commonly used instruments by IFIs in many countriesinclude Murabahah interbank placement of funds under various profit sharing arrangements and Islamic mutual funds. The instruments employed by IFIs for their inter-ifi transactions or with conventional banks are Commodity Murabahah, Interbank Mudarabah investments and Compensating mutual balances. Chapter 11 Monetary Operations in Islamic Money Markets Chapter Introduction Monetary Operations in Islamic Money Markets. The main goal of standing credit facilities of a bank is to provide a short-term liquidity either in the form of discount window or Lombard facilities. Central banks in all countries require IFIs to adhere to reserve requirements. But very few treat Profit-Sharing Investment Accounts (PSIAs) as liabilities where reserve requirements are applied. Central banks use two methods to determine reserves to be maintained during the reserve holding period. The first method is the period-average maintenance requirement and the second method is the same-level-each-day maintenance requirement. Page 23 of 64

24 Most of the central banks neither provide returns for reserves nor offer deposit facilities for Shari ah-compliant IFIs. The development of Open Market Operations or OMOs into Repurchase Agreements or REPOs and outright purchase or sale is essential to enable a central bank to run efficient monetary operations. In most of the countries, the central bank or government issues Islamic securities regularly. Some of the market based instruments that are required for the development of a liquid market include: Central Bank Musharakah Certificates, Government Musharakah Certificates, Government Investment Certificates, Government Investment Issues, Central Bank Participation Papers, Government Participation Papers, Central Bank Wadi ah Certificates, Central Bank (or Government) Ijarah Certificates, Sale and Buyback Agreements (Shari ah-compliant alternatives to REPOs), Government Islamic Investment Bond and Sukuk Al-Salam. Apart from banks, other FIs should be permitted to hold Sharī ah-compliant instruments that are strictly focused on a central bank s monetary operations. The supervisory authorities should provide an explicit set of liquidity management guidelines for IFIs so that the central bank can determine the short-term ability of the IFIs to match the differing maturities of their assets and liabilities. In addition, regular issuance of simple types of instruments will enable the development of a liquid market. Most of the descriptions of the instruments and infrastructure and money market practices across countries that have institutions offering Islamic financial services are based on the findings of a survey conducted by the IFSB. The main aim of the survey was to identify the active practices of Islamic money markets in countries and recommend measures for the growth of national Islamic money markets. IFSB conducted the survey in several countries including the Kingdom of Saudi Arabia, Qatar, Malaysia, the Islamic Republic of Pakistan, Kuwait, the UAE, the Kingdom of Bahrain, Indonesia, Bangladesh, the Islamic Republic of Iran, Brunei and the Islamic Republic of Sudan. Any reference to such countries or central banks means this group of countries or central banks of these countries. Page 24 of 64

25 On completing this chapter, you will be able to: Describe the features of credit facilities provided by Islamic central banks and the challenges involved in them, Describe how central banks determine the cash reserve requirements of IFIs during reserve-holding period, Describe the standing facilities provided to IFIs by the central banks across various Islamic countries, Describe various market-based instruments used by central banks and governments, Explain tradability of Shariah-compliant instruments in the Islamic market, Describe the need for liquidity management in IFIs and the methods followed by central banks in supervising liquidity management in IFIs, Describe how central bank instruments and government instruments promote the growth of the Islamic money market, Describe the factors influencing the growth of the Islamic money market, Describe the policy issues and strategies involved in the development of Islamic money market, Describe the need and features of Shariah-compliant money market instruments and the way to structure them to enable an active money market, Describe the development of an overall public financing management framework through the coordination of public debt and financing framework and monetary operations and Explain the strategies to be adopted to increase IFIs involvement in the money market and the foreign exchange market. Credit Facilities Offered by Central Banks Central bank credit facilities are always aimed at providing short-term liquidity for commercial banks. While doing so, they signal the position of monetary policy and limit the unpredictability in market interest rates. The standing facilities can be in the form of a discount window or a Lombard facility. A discount window is a credit provided by discounting a short-term paper or using a long-term eligible collateral. A Lombard facility is a short-term advance against collateral or based on REPOs for facilitating payment settlements. According to the survey conducted by the IFSB, many countries agreed that the central bank is the lender of last resort or LLR and that they are critical for the growth of the Islamic money market. The composition of such credit facilities also differs among countries. Page 25 of 64