Saudi- Shariah-compliant repo - a key development 

(MENAFN - Arab News) The execution last week "of the GCC's first ever Islamic equivalent of the conventional repo (repurchase contract) product" is potentially an important development in the Islamic finance industry especially for short-term liquidity management and bank reserve management by central banks. The National Bank of Abu Dhabi (NBAD) and Abu Dhabi Islamic Bank (ADIB) claim to have completed the first Shariah-compliant equivalent of a conventional repo based on a collateralized Murabaha transaction.

A statement from NBAD stressed that the two banks concluded a one week maturity deal valued at 20 million against Malaysian and Abu Dhabi government-related entity sukuk. "NBAD and ADIB jointly embarked on this initiative to formalize the Master Collateralized Murabaha Agreement (MCMA), thus enabling Islamic banks to utilize their holdings of sukuk. The MCMA offers a Shariah-compliant alternative to the repurchase arrangement, which conventional banks and financial institutions (FIs) use to lend and borrow at extremely low risk," explained the statement.

Both banks are confident that the MCMA will provide Islamic financial institutions with an efficient and cost effective tool to manage short and medium-term liquidity. According to Mahmood Al-Aradi, general manager financial markets division, NBAD, "this type of transaction will set the stage for future collateralized Murabaha trading in the sukuk market, which will greatly boost this segment and the secondary market." His colleague, Mark Pritchard, head of Islamic institutional coverage, NBAD, is even more bullish about MCMA's fit with the flourishing sukuk market. "With global issuance of sukuk this year to be around 25 billion to 30 billion, the MCMA will be of significant benefit to the Islamic financial market participants who, up to now, haven't been able to fully maximize their holdings of sukuk whilst still maintaining ownership."

In fact, UAE central bank governor, Nasser Al-Suwaidi, sees liquidity management in the Islamic finance industry as a major challenge for the industry going forward. In a keynote speech at the WIBC Asia conference in Singapore in June 2011, he strongly hinted about a forthcoming solution, namely the MCMA. "Another challenge is the short-term liquidity management at Islamic banks and other financial institutions. This is not a straight forward issue and has been under discussion between Islamic banks and central bank of the UAE. There is now a reasonable proposal to advance a solution for this issue," he added.

The MCMA structure is in fact a repo equivalent which accepts UAE Central Bank Islamic certificates of deposits as collateral against cash, thus enabling liquidity to be freed up. According to the UAE central bank, at end April 2011, banks in the UAE were holding some AED12 billion of these Islamic certificates of deposits.

It is not clear whether the product is related to the I'aadat Al-Shira'a (IS) - the Islamic alternative to repo product being developed by the Bahrain-based International Islamic Financial Market (IIFM), which published a reference paper on it in July 2010.

Liquidity management and managing reserves and capital held by Islamic banks at central banks is a major challenge for the sector. There are no cross-border products available in the market, although the mandate of the International Islamic Liquidity Management Corporation (IILM) which was established last year is just that. It would be interesting to see whether the IILM also becomes interested in the MCMA or whether it will stick to its position of creating a pool of AAA rated sukuk whose certificates can then be actively globally traded to release liquidity.

The most common money market instrument to manage liquidity hitherto used by Islamic financial institutions and central banks include the commodity Murabaha, which has an implicit disadvantage in that it is not tradable under Shariah principles and may carry some market, commodity price, counterparty, credit and even Shariah risk. There is also the interbank Mudarabah investments in Malaysia, Indonesia and Bangladesh where the interbank placement of funds from overnight to 12 months produces returns based on agreed profit ratio.

In Saudi Arabia and Kuwait, Islamic financial institutions (IFI) also use interbank compensating mutual financing facilities within the profit-sharing framework. This involves the exchange of interest-free deposits with arrangements to ensure that net balances average to zero in a defined period. Other liquidity management instruments used by central banks and governments are central bank deposit facilities, required IFI reserves and excess reserves; Central Bank market-based instruments for open market operations (OMOs) and government financing instruments. Other instruments include standing central bank credit facilities based on Murabaha or tied to Mudharabah deposit rates of banks receiving credit, or through buyback arrangements for specified Sukuk held by banks.

Market-based instruments used by Governments and Central banks include government and central bank Musharaka certificates (Sudan); government investment certificates (Sudan and Pakistan); government investment issues (Malaysia); government and central bank participation papers (Iran); central bank Wadiah certificates (Bahrain, Indonesia, Malaysia); government and central bank Ijarah certificates (Sudan, Malaysia, Bahrain, Brunei); sale and buyback agreements (Islamic alternatives to repos) (Malaysia); government Islamic investment bonds (Bangladesh); and Sukuk Al-Salam (Bahrain).

The IIFM's I'aadat Al-Shira'a (repurchase) project in fact also explores the concepts and structuring possibilities of an Islamic alternative to repo and collateralization based on the Murabaha. Bankers stress that repos are important tools in cash and liquidity management; in creating liquidity in the underlying instrument; in financing and leveraging the investment; in credit enhancement and greater volume; in playing a role in other structured products (derivatives, swaps etc); and in oiling the wheel of the bond market. The objectives of the I'aadat Al-Shira'a (repurchase) project, according to IIFM, include the funding the positions of sukuk and other instruments; better asset, liquidity and cash management; assisting in Sukuk credit and yield pickup and increasing secondary market liquidity in sukuk; a useful tool which can be used by central banks to control money supply and to better fulfill reserve requirements.

The project's leader, Ismail Dadabhoy, head of Islamic finance at UBS, explained at the time of the launch of the reference paper that "finding a solution for repo alternative product that satisfies Shariah while also being acceptable to the general market has been a real challenge. As an ex repo trader, I know how important this product is to the short term and fixed income traders. I am convinced wider use by the market of I'aadat Al-Shira'a will add liquidity in the system in terms of cash funding and liquidity float of sukuk. It will 'oil' the wheels for efficiency and be a boost for sukuk".

In the conventional sense a repo, according to IIFM, is a simultaneous purchase and sale of a security at a pre-agreed time and price. The agreement is between two parties, whereby one party sells to the other party a security at market price. In terms of the Shariah, this is acceptable. However, there is a commitment to buy the same security back at a later date for a pre-agreed price. This presents a major Shariah issue.

In a classic repo, the transfer of title takes place but ownership is maintained. The economic benefit is not transferred which means interest or dividend is paid to original owner. Mark to market and margin mechanism is allowed. In a buy and sell structure, there is a complete transfer of all rights and benefits.