Treasury Products for Islamic Financial Institutions

By Mark J Lynch and Khalfan Abdallah.

A challenge for all new banks lies in providing a full range of competitive treasury products which help manage not only a bank’s liquidity and hedging positions but also its business divisions and client requirements.

This becomes more challenging when the breadth and complexity of products offered by established financial institutions is considered alongside the Shariah principles that Islamic banks operate by.

However, many have argued that the complexity and lack of transparency of these treasury products played a part in the credit crunch.
Islamic treasury products are required to be transparent and non speculative.

In recent years Islamic banks have invested heavily in product development, particularly in relation to treasury. This article provides a summary of the more frequently used products, their basic structures and what they mean to treasury.

Liquidity management products

1. Commodity Murabahah (Tawarruq).
Based on the Murabahah (trust financing) structure, this has developed to become one of the main short term liquidity management tools used by treasuries. When completing a Commodity Murabahah, commodities are purchased in order to create liquidity. A bank would buy a commodity for US$100 spot and sell them to a client for US$110 on deferred payment terms. The client then sells the commodities back into the market for US$100 to realize the liquidity it requires.

Most Shariah scholars prefer the use of non-precious metals such as those used on the London Metals exchange. With the current low rates in the market, the use of Commodity Murabahah for short-term deals of less than one week has decreased as the cost of purchasing and selling a commodity is prohibitive.

2. Wakalah Investments.
This is a useful liquidity tool between Islamic banks as it operates under the principle of agency agreement and does not have the
added costs of commodity purchase/sale involved. For this reason it is especially cost effective in very short term transactions. This structure is mainly used to mobilise funds from the market for investors whose risk profile prefer lower investment risks. It is also used to manage excess liquidity of Islamic banks.

3. Foreign exchange
Foreign exchange (FX) products such as Spot, FX Forwards, and Swaps are vital for a functioning Islamic treasury. These can be used to manage customers requirements, the banks own liquidity or FX risk.Spot FX (Sarf) is a straightforward product used throughout the industry involving the exchange of one currency for another at an agreed rate for immediate spot delivery. However, the use of FX Forwards in Islamic markets is less prevalent. FX Forwards can be achieved by the use of a Waad (unilateral promise) structure where one party (the promisor) agrees to enter into a Spot FX transaction on a pre-agreed date in the future at a pre-agreed rate.

To complement the growing number of products, Islamic financial institutions have implemented technology solutions that dovetail with services such as foreign exchange. For example, BLME launched an online foreign exchange platform that allows clients to access FX markets over the internet. Speculation and short selling is prohibited in order to comply with Shariah principles.

Another useful FX product is the FX Swap (structured using Waad concept) which allows the bank to effectively fund themselves in one currency using another currency. Forward FX also makes use of the Waad in order to achieve the forward delivery of one currency versus the other.

Additional liquidity management products.

Repo.
‘Repo’ (short for repurchase) involves the sale and buy back of securities in exchange for cash on pre-agreed dates at a known cost price. This product has not been approved by all Shariah scholars but is considered an important development in Islamic markets. The IIFM in 2014 completed to develop a standard for Islamic repo products that will be fully Shariah compliant. A standard contract template for collateralised murabaha transactions, aiming to boost use of a sorely needed liquidity management tool for Islamic finance institutions. The standard will serve as an alternative to repurchase agreements, which are common money market tools used by conventional banks but are largely absent in Islamic finance. In the United Arab Emirates, the first collateralised murabaha transaction occurred in 2011 between National Bank of Abu Dhabi and Abu Dhabi Islamic Bank.

Collateralised murabaha is a cost-plus profit arrangement where by the financier buy the asset at market value and immediately sell the asset to the customer for a mark-up on a deferred payment basis.Because the mark-up price is agreed up front by both parties, this addresses the element of ambiguity, or gharar, a key principle in Islamic finance.

Transactions can be secured by any sharia-compliant assets, including equities and sukuk (Islamic bonds). The standard expressly forbids rehypothecation. The IIFM has previously launched standard contract templates for sharia-compliant profit rate swaps as well as hedging and treasury transactions.

It is acknowledged across the industry that there is a dearth of liquidity management products for Islamic fi nancial institutions. It is critical that Islamic fi nancial institutions have access to high quality liquid instruments such as government issued Sukuk. Without access to such quality liquidity, the requirements laid down by the regulators inthe UK that banks hold a liquid assets buffer adds an expensive burden on Islamic banks. This is not so for the conventional banks. A number of the more established Islamic centres already have regularly issued short term government papers. In the UK, despite some positive steps and encouraging noises from HM Treasury we are still waiting.

Islamic treasuries are under pressure to provide competitive rates against the offerings of Islamic peers and conventional banks. It is vital that Islamic fi nancial institutions have a competitive offering, not only to attract clients per sé but also to be seen as a viable alternative to conventional financing.

Netting
An important development for Islamic treasury departments has been that of netting relationships. Netting agreements allow treasury to offset the payables against the receivables for a specifi c counterparty. This has mutual benefi ts for both parties to the agreement. Netting agreements are permissible for Islamic banks under the Shariah principle of Muqasah (offset of debt).

Islamic Funds.
Traditionally treasuries would not be directly involved in investment funds – whether they be money funds, equity, or property funds however there is a place for liquid money market funds, such as BLME’s $ Income Fund. Money market funds can provide a treasury department with a return better than money market rates with the additional benefi t of being able to access the liquidity at short notice.

Managed account structures.
This product is used by Islamic fi nancial institutions to manage liquidity and is offered to clients as a liquidity management tool. Generally the managed account invests in Islamic products such as a Sukuk with specific risk and return parameters which are set internally or by the client.

Conclusion
The above are a small selection of tools available to the Islamic treasury but collectively they have a huge bearing on a treasury’s
ability to run effi ciently and effectively.

Islamic treasury products have developed tremendously in the past five years as customers demand more sophisticated ways of managing their investments and liquidity. Technology continues to evolve with products now being made available to a much wider, international audience.

Standardization will come but the industry is still nascent and banks continue to use the structures and documentation they created and cater to the needs of their specifi c clients. As the industry matures there will be more cross-fertilization of products, structures and documentation.

After the world economic events of the last three and half years, and amid calls for banks to hold ever more high quality liquidity, it is vital that all countries ensure they provide their banking fraternity with the tools such as Sukuk to enable them to comply.