Quarterly Bulletin 2017 Q3

© Bank of England 2017ISSN 2399-4568

Topical articleIslamic banks and central banking

156 Quarterly Bulletin 2017 Q3

Islamic banks and central banking

By Arshadur Rahman of the Bank’s Sterling Markets Division.(1)

• Islamicbankingisarelativelyyoungbutgrowingsectorofthebroaderfinancialservicesindustry.NumerousbanksaroundtheworldofferIslamic,orShari’ahcompliant,financialproducts.

• SomecentralbanksofferShari’ahcompliantliquidityfacilitiestoIslamicbanks,affordingthemsimilarflexibilitytootherfirmsinmanagingtheirliquidity.Suchfacilitiesavoidthepaymentorreceiptofinterest,whichisotherwisethemostcommonbasisforoperatingaliquidityfacility.

• TheBankisestablishingaShari’ahcompliantfacility,specificallyadepositfacilitytoallowUKIslamicbankstoholdcentralbankassetsaspartoftheirliquidassetsbuffer.Thisarticleexploresthevariouswaysinwhichthiscanbedone,alongwiththemodeltheBankhaschosentoadopt.

(1) TheauthorwouldliketothankJamesSouthgateforhisfeedback,andalsoUKIslamicfinancemarketparticipantsandcolleaguesfromcentralbanksaroundtheworld,whoseinputhelpedtoinformthisarticle.

Overview

IslamicfinanceisactivityconductedinaccordancewithIslamiccommercialjurisprudence,whichisinturninformedbythehigh‑levelprinciplesofIslamiclaw,orShari’ah.Amongotherthings,thisemphasisesreal‑economyactivityandaprohibitiononpaying/receivinginterest.TheglobalIslamicfinancemarkethasgrownoverrecentdecades,andbysomeestimatescurrentlystandsatapproximatelyUS$1.9trillion,thoughthisisstilllessthan1%oftheglobalfinancialservicessectoroverall.

WithinthebroaderIslamicfinanceindustry,theIslamicbankingsectorhasalsogrown,andintheUnitedKingdom

therearecurrentlyfivestandaloneIslamicbanks.ThesearefirmswhichonlyconductactivityonaShari’ahcompliantbasis(unlikesomeconventionalbanks,whichofferIslamicfinanceproductsaspartofabroaderserviceoffering).Liketheirconventionalcounterparts,Islamicbanksmusteffectivelymanagetheirliquidity(thatis,theabilitytomeettheirfinancialobligationsastheyfalldue),whichincludesadheringtotheBaselIIIliquidityrules.Amongotherthings,therulesrequirefirmstoholdabufferofhigh‑qualityliquidassets(HQLA)whichtheycanrundowniftheyexperienceasuddenfinancialstress.Thisbufferwilltypicallybeintheformofassetsknownassukuk,instrumentsprovidingabeneficialinterestinanunderlyingShari’ahcompliantassetoractivity.However,thesupplyofHQLA‑eligiblesukukislimited(seesummary chart).Islamicbanksthereforedonothavethesameflexibilityasconventionalbanksinmanagingtheirliquidity.AsidefromholdingHQLAintheformofsukuk,anotherwaytomeettherequirementistoholddepositsatthecentralbank;thesecanbequicklywithdrawntomeetasuddenliquiditystress.However,theBankofEngland’scurrentfacilitiesareallinterestbearing,andsoinaccessibletoIslamicbanks.

ToaffordUKIslamicbankssimilarflexibilityinmanagingtheirliquidity,theBankthereforebeganworkin2015tofirstassessthefeasibilityof,andthenestablish,aShari’ahcompliantdepositfacility.ThisarticlesetsouttheresultsoftheBank’sanalysis.

2001 03 05 07 09 11 13 15 17

Estimated non-HQLAEstimated HQLA

Sukuk outstanding

Islamic fund assets

Takaful contributions

Islamic banking

US$ billions

US$ billions

1,493.4

318.556.125.1

0

50

100

150

200

250

300

350

400

450

Summary chart Size of global Islamic finance industry, and growth of sukuk market over time

Sources:Islamic Financial Services Industry Stability Report 2017andBloomberg:USforeignexchangeconversiondateforlatter7June2017.

Topical articles Islamic banks and central banking 157

Centralbanksaroundtheworldusearangeoftoolstoensuremonetaryandfinancialstability.Theseincludeprovidingaccesstothecentralbankbalancesheetbyacceptingdepositsfromcommercialbanks,whichareremuneratedattheprevailingcentralbankinterestrate.Suchdepositscanbeusedasaliquiditybufferassetandbepromptlyliquidatedbyafirmexperiencingasuddenfinancialstress.However,becausesucharrangementstypicallyinvolvethepaymentandreceiptofinterest,theycannotbeusedbyIslamicbanks,whichareprohibitedfromengagingininterest‑basedactivityunderShari’ahprinciples.

ThisarticleexplainshowcentralbanksaroundtheworldstructureliquidityfacilitiesinaShari’ahcompliantmanner(thatis,avoidingthepaymentorreceiptofinterest),toprovideIslamicbankswithsimilarflexibilitytoconventionalbanksinmanagingtheirliquidity.ThisisrelevantbecausetheIslamicbankingsectorgloballyisgrowing.Withthatgrowththefinancialstabilityrisksassociatedwiththesectorareincreasing,andsoisdemandforcompatiblecentralbankliquidityfacilitiestohelpmanagethoserisks.Yetthemeansbywhichsuchfacilitiesareorcanbestructuredisnotcommonlyunderstood.

TheBankofEngland(‘theBank’)isitselfintheprocessofestablishingaShari’ahcompliantliquidityfacility(SCF),aspartofitsstrategytobroadenaccesstoliquidityprovision.ThefirststageofthisworkinvolvedasurveyofShari’ahcompliantcentralbankliquidityfacilitiesalreadyavailablearoundtheworld.ThesecondstageentailedselectingthemostappropriatemodelfortheUnitedKingdom,bearinginmindtheBank’sspecificobjectivesandthenatureofthelocalmarket.

TheSCFwillenablethefiveUKIslamicbanks,whichconductbusinessonapurelyShari’ahcompliantbasis,toplacedepositsatthecentralbank,asconventionalbanksarealreadyabletodo.ThestructuretheBankhasselected,basedoninternalanalysisandmarketfeedback,iscalledawakalah(agency‑based)fundmodel,whichwillbeadjustedtomeetthespecificregulatoryandlegalrequirementsoftheUnitedKingdom.

What is Islamic finance?

IslamicfinancereferstocommercialactivityconductedinaccordancewithIslamicjurisprudence,or‘fiqh’.Thisinturnisinformedbythehigh‑levelprinciplesofIslamiclaw,or‘Shari’ah’.ProductsandservicesinIslamicfinancearethereforesometimesreferredtoas‘Shari’ahcompliant’.Shari’ahprinciplesincludetheviewsthat:

(i) Moneyhasnointrinsicvalue.Itcanserveonlyasamediumofexchange.

(ii) Thepaymentorreceiptofinterestisprohibited.Tradingorinvestmentincomeishoweverpermissible.Debtisalsoallowed,thoughitcanonlybetransferredatparvalue.

(iii) Thereshouldbeafocusonreal‑economyactivity,andanemphasisonfairapportionmentofriskandreward.Bothspeculationontheonehand,andrent‑seekingontheother,shouldbeavoided.

(iv) Investmentinactivitiesconsideredtobesociallydetrimentalshouldbeprohibited.Thisincludesinvestmentinsectorssuchastobacco,alcoholandpornography.

Islamicfinancethereforesharesanumberofcommoncharacteristicswiththebroaderethical/sustainablefinancesector.

Duetotheprohibitiononinterest,firmswhichofferShari’ahcompliantproducts,eitherexclusively(thatis,as‘standalone’Islamicfinancefirms),oraspartofabroaderproductrange(normallyofferedthroughseparatebusinessunitsknownas‘windows’)muststructuretheirproductsdifferentlytogenerateareturn.Thistypicallyinvolvestheuseofanunderlyingassetinsomeway.Forexample,aprofitcanbemadefromtradinginassets(suchascommodities),orleasingorsellinganassetininstalments(suchasproperty,plantorequipment).(1)Table AprovidesasimplifiedbreakdownofIslamicfinanceproductsacrossdifferentfinancialsectors.

The Islamic finance market and the UK regulatory approach

The global Islamic finance industryTheglobalIslamicfinanceindustryhasgrownrapidlyoverthepastfifteenyears.Whilereliablefiguresaredifficulttoobtain,someestimatesputthesizeofthemarketatapproximately£1.9trillionasofend‑2016.Approximatelythreequartersofthisisconstitutedofbankingassets,withmostoftheremaindercapitalmarketsandasmallproportionofShari’ahcompliantinsurance.MuchoftheactivityisconcentratedincountrieswithsignificantMuslimpopulations,especiallyintheMiddleEastandAsia.(2)

The Islamic finance industry in the United KingdomIntheUnitedKingdom,therearecurrentlyfivestandaloneIslamicbanks(Table B).Thesefirmshaveanaggregatebalancesheetofapproximately£3.5billion.Therearealsoover20conventionalbanksintheUnitedKingdomoperatingShari’ahcompliantwindows,andnumerousinvestmentmanagement,advisoryandinsurancesectorfirms.

(1) Formoredetailontransactiontypes,seeGlossary,page7;www.imf.org/~/media/files/publications/cr/2017/cr17145.ashx.

(2) Seewww.ifsb.org/docs/IFSB%20IFSI%20Stability%20Report%202017.pdf.

158 Quarterly Bulletin 2017 Q3

The UK regulatory approach to Islamic financeIntheUnitedKingdom,allfinancialfirmsaresupervisedunderthesameunitaryandprinciples‑basedregulatoryframework;firmsengaginginIslamicfinancearenotsubjecttoseparaterules,asthismightgiverisetoregulatoryarbitrage,thatis,theriskofparallelregulatoryregimesinwhichonesetofrequirementsisconsideredtobemorefavourableorlessonerousthantheother.TheUKauthoritiesemphasiseanon‑discriminatoryapproach,endeavouringtoensurealevelplayingfieldforallfinancialfirms,tothegreatestextentpossible.

SupervisionoffinancialfirmsisdividedbetweenthePrudentialRegulationAuthority(PRA),whichispartoftheBankofEngland,andtheFinancialConductAuthority(FCA).ThePRAisresponsiblefortheprudentialregulationofapproximately1,500banks,buildingsocieties,creditunions,insurersandthelargestinvestmentfirms.TheFCAisresponsibleforregulatingtheconductofallfinancialfirmsintheUnitedKingdom—this

coversprotectionofconsumersandfinancialmarkets,andpromotionofeffectivecompetition.Itisalsoresponsiblefortheprudentialregulationofapproximately18,000generallysmallerfirms.

Compliance with Shari’ah principlesIslamicfinancefirmswillnormallyappointaShari’ahSupervisoryBoard(SSB)ofIslamicscholars,tocertifyandevidencethefactthattheiractivitiesandproductsarecompliantwithShari’ahprinciples.Thesescholarsaretrainedinthespecialisedreligiousjurisprudencerelatingtocommercialactivity(‘fiqhalmu’amalat’),inadditiontohavingageneralgroundinginbothjurisprudenceandconventionalfinance;notallreligiousscholarswillbequalifiedtositonSSBs.Insomejurisdictions,SSBscholarsareapprovedcentrallybytheregulator,whileinothers—suchastheUnitedKingdom—theyarenot,havinginsteadsimilarstatustoafirm’sexternallegalcounselorauditors.

BankingActivitywillbeconductedviaexistingconventionalbankingentitiesas‘windows’,throughaseparateIslamicbankingbranchnetwork,orthroughaseparatestandalonelegalentity.

InvestmentsActivitywillbeconductedthroughaseparatelegalentity,orthroughaconventionalfirmmanagingafundunderaShari’ahcompliantmandate.

Insurance (takaful)ActivitywillbeconductedunderaShari’ahcompliantmutualstructure,orthroughalimitedcompanywithownsharecapitalandreserves.Ifthelatter,takafuloperatorcanprovideaninterest‑freeloan(‘qard’)totopuptheunderwritingfundincaseofdeficit,repaidfromanysubsequentunderwritingsurpluses.

Currentaccounts,depositandinvestmentaccounts.

Mortgages/homepurchaseplansandotherfinancing.

Fundsandsukuk. Generalinsurance,family/lifeinsurance,pensions.

Howisincomegenerated? Howisthecostoffinancingcovered?

Howisreturngenerated? Howcantheinsurancebeused?

Wakalah(agencybased)—inwhichdepositsareusedbythebankunderadelegatedauthoritytoinvestinShari’ahcompliantactivity.

Ijarah(leasing)—inwhichthecustomerleasesthepropertyforthecontractterm,withmonthlypaymentscomprisedofachargefortheleaseandalsoarentalcomponent,astheyarelivinginthepropertyatthesametime.

By investing in: equitiesoffirmswhichare(a)engagedinShari’ahcompliantactivityand(b)notexcessivelyleveraged(indebted);cashatzeroreturnasa‘safe’diversificationasset;sukuk,whichareinstrumentsrepresentingabeneficialinterestinaShari’ahcompliantassetoractivity,butexcludingshares(sowithoutvotingrights);tangibleassetssuchaspropertyandmachinery.

By underwriting:onlyShari’ahcompliantrisks;premiumscanbeinvested,butonlyinShari’ahcompliantassetsasperinvestmentprinciples.

Murabaha(costplusmark‑up)—inwhichthebanktradesincommoditiestogenerateareturn,whichispassedbacktothecustomerinlieuofinterest.

Diminishing musharaka(partnership)—inwhichthecustomerandbankbecome‘co‑owners’ofthepropertyinproportiontotheirinitialdepositvsfinancingamount.Monthlypaymentsareusedtograduallyincreasethecustomer’sownershipstakeintheproperty,andtitletransfersuponconclusionofthecontract.

Cannot invest in: bondsbearinginterest(includingzero‑couponbondsinwhichtheinterestisembedded),orinderivativesusedforspeculativepurposes.

Cannot underwrite:non‑Shari’ahcompliantriskssuchaspubsordistilleries.Also,someinsuranceproductscannotbeofferedviatakafulduetoentailingexcessiveuncertainty(‘gharar’),suchaswholeoflifepoliciesordefinedbenefitpensions.Mudarabah(silentpartnership)

—onepartnerprovidescapital(depositor),theotherprovidesexpertise(firm),withprofitsharedproportionately.

Table A Common forms of Islamic finance activity

Topical articles Islamic banks and central banking 159

IntheUnitedKingdom,theauthoritiescannotopineonwhetheraparticularIslamicfinanceactivityorproductisShari’ahcompliantornot.Thisisbecauseassecularinstitutions,theycannottakeaviewonreligiousstandards.Anditwouldbedifficulttodosoeveniftheycould,becauseopinionsonwhatispermissibleunderShari’ahdiffer,bothbetweenandwithinjurisdictionswherethisaspectisregulated:thehigh‑levelprinciplescanbeinterpretedindifferentways.However,intheUnitedKingdom,thebasisuponwhichagivenproductispromotedasbeingShari’ahcompliantmustalwaysbecommunicatedtothecustomerinamannerwhichisclear,fair,andnotmisleading,inaccordancewiththeapproachoftreatingcustomersfairly.Financialdisclosurerulesapplytoallfirms,andcustomersmustbeinpossessionofallthefactsrequiredtomakeaninformedpurchasingdecision.

AlthoughtheUKauthoritiesdonotregulateShari’ahcompliance,theBanknonethelessrecognisestheimportanceofdialoguewithotherauthoritiesontheeffectivesupervisionofwhatisayoungbutgrowingindustry.Tothisend,theBankbecameanassociatememberoftheIslamicFinancialServicesBoard(IFSB)inNovember2015.TheIFSBisaninternationalbodywhichaims,amongotherthings,topromotethedevelopmentofaprudentandtransparentIslamicfinancialservicesindustry,andtoprovideguidanceontheeffectivesupervisionandregulationofIslamicfinancefirms.

The liquidity rules

The liquid asset buffer (LAB) requirementBaselIIIliquidityrules(whichareimplementedintheEuropenUnion(EU)throughtheCapitalRequirementsDirectiveandCapitalRequirementsRegulation(together,CRDIV)andrelatedsubordinatemeasures)requirebankstoholdaliquidassetbuffer(LAB)ofunencumberedandhigh‑qualityliquidassets(HQLA)atalltimes.Theassetsinthisbuffershouldbereadilyaccessibleandeasytoconvertintocashinprivatemarkets,tomeetanysuddendemandsforliquiditythefirmmayface.Thisshouldholdtrueespeciallyduringperiodsoffirm‑specificstress,ormoregeneralmarketdisruption.(1)

Allbanks,includingstandaloneIslamicbanks,mustcomplywiththerequirementtoholdanLAB.However,Islamicbanksareunabletoholdassetsthatearninterest,orarebasedonactivitywhichisotherwiseprohibitedunderShari’ahprinciples.IntheUnitedKingdom,thepoolofassetsthatarebothsuitableforusebyIslamicbanksandofsufficientlyhighqualityislimited:onesuchasset,theUKGovernment’s2014£200millionsovereignsukuk,washeavilyoversubscribedonissue.(2)

1970s Shari’ahcompliantaviationleasingcontractsofferedinLondon.

Londonmarketbrokersofferwholesaleliquiditymanagementusingcommodities.

1980s EarliestIslamicmortgagesofferedintheUnitedKingdombyAlbarakaBank.

1997 IslamicmortgagesofferedintheUnitedKingdombyUnitedBankofKuwait(nowAhliUnitedBank).

2003 HSBCAmanahlaunchesIslamicmortgagesandbankaccountsintheUnitedKingdom.

2004 AlRayanBankplcauthorised(formerlyIslamicBankofBritain).

CourtcaseofBeximcovsShamilBankofBahrainestablishesprinciplethatsecularauthoritiescannotopineonShari’ahcompliance.

ABCInternationalBankoffersIslamicmortgagesunderAlBuraqbrand.

2005 Children’sMutuallaunchesShari’ahcompliantChildTrustFund.

LloydsTSBoffersShari’ahcompliantcurrentaccount.

2006 EuropeanIslamicInvestmentBankplcauthorised(convertedtoinvestmentfirmin2014—Rasmalaplc,nolongerauthorised).

2007 BankofLondonandtheMiddleEastplcauthorised.

InvestmentfirmAmiriCapitalauthorised.

FSAoutlinesregulatoryapproachtoIslamicfinancein:‘IslamicfinanceintheUnitedKingdom:regulationandchallenges’.

2008 QIB(UK)Ltdauthorised(formerlyEuropeanFinanceHouse).

GatehouseBankplcauthorised.

BritishIslamicInsuranceHoldings/PrincipleInsuranceauthorised(dissolvedin2015).

ConsultationpaperCP08/22outlinestheliquidassetbufferrequirementforallbanks.

2012 ADIB(UK)Ltdauthorised.

HSBCAmanahexitsUKmarket.

2013 CobaltUnderwritingauthorised.

2014 UKGovernmentissuesitsfirstsovereignsukuk.

InvestmentfirmArabesqueAssetManagementauthorised.

2015 IslamicInsuranceAssociationofLondonestablished.

BankofEnglandcommencesShari’ahcompliantfacilities(SCF)project.

2017 Shari’ahcompliantcrowdfundingfirmYieldersauthorised.

Table B Islamic finance in the United Kingdom — timeline of selected events

(1) Seepage7;www.bis.org/publ/bcbs238.pdf.(2) Seewww.gov.uk/government/news/government‑issues‑first‑islamic‑bond.

160 Quarterly Bulletin 2017 Q3

Anumberofjurisdictions(Bahrain,Qatar,TurkeyandMalaysiaforexample)havealsoissuedsovereignsukuk,whichcanbeusedbytheirrespectiveIslamicbanksforlocallyimplementedbufferrequirements.(1)However,asillustratedinthesummary chart,thegeneralandglobalscarcityofhighquality,liquidandShari’ahcompliantassetscontinuestoposeachallengefortheindustry.

BaselIIIrecognisesthechallengeforIslamicbanksinmeetingtheirLABrequirements.Therulesallowthemtouseawiderrangeofassetsfortheirbuffer,whicharesubjecttohaircuttingtoavoidfavourabletreatmentoverconventionalfirms.(2)ThisrecognitionisalsoreflectedinrelevantEU‑levellegislation.(3)Theunderlyingscarcityofthesupplyofsuitableassetsmeansthatbanksfrequentlyholdthemtomaturity,resultinginlimitedsecondarymarketliquidity.Nevertheless,theassetsrepresentastoreofvalueastheycanbereadilysold,althoughtheydonotprovideameansofmanagingliquidityonaday‑to‑daybasisastheymaybedifficulttoreplace.

The role of central bank facilities in meeting liquidity requirementsTherearetwomainwaysinwhichcentralbankscanprovideliquidityfacilitiesforusebycommercialbankstomanagetheirliquidityandmeettheBaselIIIrequirements.Thefirstisbyacceptingdeposits,whichcanbewithdrawnatanytimetomeetaliquiditystress.IntheUnitedKingdom,theBankoffers

reservesaccountswhichcanbeusedinthisway.Thesecondisbyprovidingaliquidityupgrade,bygivingHQLAtocommercialbanksintheformofcentralbankfundsorgovernmentsecurities,inexchangeforarangeoflessliquidassetssuchascorporatebondsandloanportfolios.Afewjurisdictions,suchasTurkey,IndonesiaandPakistan,allowtheuseofsukukintheiropenmarketoperations(OMOs)underaformofShari’ahcompliantrepo,toprovideIslamicbankswithfurtherflexibilityintheirliquiditymanagement.Theboxaboveshowshowthisworksinpractice.TheBankprovidesthisupgradethroughtheIndexedLong‑TermRepo(ILTR)operationsandDiscountWindowFacility(DWF).AllthesearrangementsareofferedviatheBank’sSterlingMonetaryFramework(SMF),andcanhelptocontributetowardscommercialbanks’LABrequirements.

TheBankremuneratesreservesaccountbalances,typicallyattheratesetbytheMonetaryPolicyCommittee—BankRate.Insodoing,theBankestablishesashort‑termrisk‑freerate.Thisrateinfluencestheratesconventionalbanksarewillingtochargeorpayonshort‑termloansorborrowingsinthe

(1) Malaysiastoppedissuingshort‑datedsovereignsukukin2015;www.sukuk.com/sukuk‑profile/.

(2) Seeparagraph68:www.bis.org/publ/bcbs238.pdf.(3) SeeinparticularArticle12oftheCommissionDelegatedRegulation(EU)2015/61,

availableathttp://eur‑lex.europa.eu/legal‑content/EN/TXT/PDF/?uri=CELEX:32015R0061&from=EN.

Shari’ah compliant open market operations (OMOs)

Openmarketoperations(OMOs)areatoolwhichcentralbanksusetoeitherinjectordrainliquidityfromthemarket.TheBankofEnglandprovidesOMOs,currentlythroughtheIndexedLong‑TermRepo(ILTR).(1)Shari’ahcompliantOMOsnormallyentailusingawa’ad(promise)basedmodel.Underthisarrangement,theIslamicbankfacingaliquiditystresswouldsella(Shari’ahcompliant)asset,suchasasukuk,tothecentralbank,whowouldsubsequentlyselltheassetbackatamark‑up(Figure A).Thistransactionissimilartoaconventionalcollateralisedloanarrangementcalledarepurchaseagreement(‘repo’),andthemark‑uponthesalechargedbythecentralbankonthesecondtransactionmaybebasedontheconventionalreporatetomakeiteconomicallyequivalent.

Wherethewa’admodeldiffersfromaconventionalrepoisinthesecondlegofthetransaction,whichistreatedinShari’ahcompliancetermsasadiscretionarypromiseratherthanacontractualobligation:thecentralbankwilleitherpromisetosellthesecuritybacktotheIslamicbank,ortheIslamicbankwillpromisetobuythesecurityfromthecentralbank.Havingthisseparationtechnicallyavoidswhatiscalled‘baialinah’(salewithimmediaterepurchase),whichisnotallowedunderShari’ahprinciplesbecauseitisconsideredtobeoverlysyntheticbysomeShari’ahscholars.However,opinionsstilldovarybetweenjurisdictionsontheoverallpermissibilityunderShari’ahofthistransactionalmodel,whichiswhyitisnotusedinsomecountries.RegardlessofwhetheritisthecentralbankortheIslamicbankwhichisactingasthepromisor,theunderlyingcommercialdocumentationisnormallystructuredasadeedtobecontractuallybinding—imposinginlegaltermsanobligationintheabsenceof‘consideration’,orpayment.Thisprovidescomforttobothcounterpartiesthatthesecondtransactionlegwillbecompleted.

(1) FormoreinformationontheILTR,seetheBankofEngland’s‘RedBook’,availableatwww.bankofengland.co.uk/markets/Pages/sterlingoperations/redbook.aspx.

Islamic bank Central bank1

2

Figure A The wa’ad based liquidity support model

1 TheIslamicbanksellssecuritytocentralbank.2 Onmaturity,thecentralbanksellssecuritybacktotheIslamicbank,atamark‑upthatmaybebasedontheequivalentconventionalreporate.

Topical articles Islamic banks and central banking 161

market.(1)RemunerationofreservesisthereforefundamentaltotheBank’sframeworkforimplementingmonetarypolicy.(2)TherateschargedontheILTRandDWFareatamark‑uptoBankRate,andarethereforealsointerest‑based.AsIslamicbanksareprohibitedfromreceivinginterestunderShari’ahprinciples,theBank’sexistingfacilitiesundertheSMFareinaccessibletothem.

TheBankthereforecommencedworkinthesecondhalfof2015,toassessthefeasibilityofestablishingaShari’ahcompliantliquidityfacilityforUKIslamicbanks.ThiswouldprovidethemwithgreaterflexibilityinmanagingtheirliquidityandmeetingtheBaselIIIliquidityrules(asimplementedintheEU).

Overview of Shari’ah compliant deposit facility models

The Bank’s preliminary surveyTheBankcommencedworkin2015onassessingthefeasibilityofestablishingaShari’ahcompliantfacility.ThefirststageofthisconsistedofasurveyofSCFmodelsusedaroundtheworldbyothercentralbanks,(3)toprovidebothdepositandliquiditysupportfacilities.(4)Thesurveyfoundthatcentralbanksusedadiverserangeofmodelstounderpintheirfacilities,andtherewasnouniversallypreferredstructure.

Thepurposeofthesurveywasnottoprovideanexhaustivelistofallthefacilitiesusedinalljurisdictions,buttogainasenseoftheoptionstheBankmightbeabletodrawuponindevelopingitsownfacility.Inconsideringthevariousmodelsinuse,theBankhasnottakenaviewonwhethersomemodelsareinherentlybetterorworsethanothers,sincesuitabilitywilldependonthespecificobjectivesandrequirementsofeachindividualcentralbank,aswellasthenatureoftheirlocalmarketandregulatoryframework.

Oftheninecentralbankswhichconfirmedtheyprovidedsomeformoffacility,atleastoneofferedtoacceptdepositsatzeroreturn,andsomeoffered(orwereplanningtooffer)emergencyliquiditysupportwithoutcharginginterest(knownasa‘qardhasan’).(5)

However,themostcommonmethodusedtounderpinfacilitieswasthecommoditymurabahamodel(CM),usedforbothdepositsandliquiditysupportinKuwait,Malaysia,SaudiArabiaandtheUnitedArabEmirates.(6)Murabahasimplymeanstopurchaseanasset,andthensellitonatadisclosedmark‑up.Inaddition,severalothermodelswerefoundtobeinusespecificallyfordepositfacilities:

• Wakalah(agency‑based)fundmodel—usedinBahrain.

• Wadiah(safecustody)model—currentlyusedinMalaysia;previouslyalsousedinIndonesia.

• Ju’alah(remunerationforaspecifiedtask)model—usedinIndonesia.

Thesemodelsarediscussedinmoredetailinthenextsection.

The commodity murabaha modelIntheCMmodel(Figure 1),thecentralbankusesdepositsfromIslamicbankstoundertakeaseriesoftradesinanunderlyingcommodity.(7)Thereturnfromthistrading,minuscostsandfees,isreturnedtotheIslamicbanksinlieuofinterest.

(1) Formoreinformation,seetheBank’s‘RedBook’,availableatwww.bankofengland.co.uk/markets/Pages/sterlingoperations/redbook.aspx.

(2) ForfurtherinformationontheBank’sSterlingMonetaryFramework,seewww.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q210.pdf.

(3) TheBank’ssurveyfocusedoncentralbanksinjurisdictionsinwhichbothIslamicandconventionalbanksoperate,similartotheUKmarket.

(4)Basedonmarketfeedback,theareaofmostpressingneedforUKIslamicbanksisintheprovisionofdepositfacilities,sothishasbeenprioritised.TheBankintendstoconsiderthefeasibilityofestablishingliquiditysupportfacilitiesatalaterdate.

(5) Somecentralbanksusedmorethanonetransactionalmodel.(6) TheCentralBankoftheUnitedArabEmiratesusesthemurabahastructureto

underpincertificatesofdeposit.(7) Thesewouldtypicallyincludenon‑preciousmetalssuchassteel,tinorzinc,butcan

alsopotentiallycoverothersufficientlystandardised‘soft’commoditiessuchaspalmoil,sugarorrice—thescopeofacceptablecommoditieswouldbesubjecttoagreementbythecounterpartiestothetradeandtheirrespectiveShari’ahscholars.Shari’ahprinciplesexcludetheuseofgoldorsilverforthistransactionalmodelasthesecommoditiesareconsideredtobetoo‘money‑like’—thatis,theyfallintothecategoryofassetswhichshouldbetreatedonlyasamediumofexchange.

Broker A

Broker B

Islamic bank Central bank

23

56

1

4

Figure 1 The commodity murabaha deposit model

1 TheIslamicbankpurchases£1millionofcommoditiesfromBrokerA.

2 TheIslamicbanksellsthecommoditiestocentralbankattheoriginal£1millionprice,plusamark‑up(eg£2,000),onadeferredpaymentbasis(egoneweek).

3 ThecentralbankappointstheIslamicbankasagenttosellthecommoditiesbackintomarket.

4 TheIslamicbanksellsthecommoditiestoBrokerBattheoriginalpriceof£1milliononbehalfofcentralbank,forimmediatepayment.

5 TheIslamicbankcreditsthe£1millionproceedsfromthesaletoBrokerBtothecentralbank.

6 Onmaturity(afteroneweek),thecentralbankmakesthedeferredpaymentof£1,002,000totheIslamicbank.

162 Quarterly Bulletin 2017 Q3

ThecentralbankbasedCMarrangementdetailedinFigure 1hasbeensimplified—variationswillexistbetweendifferentjurisdictions.TwobrokersarerequiredforthismodeltobeShari’ahcompliant:usingonlyonebrokertobothsourceanddisposeoftheassetwouldmakethetransactionresembletoocloselya‘baialinah’(salewithimmediatepurchase).Itishoweverpossibleforthetwobrokerstonetoffexposurestoeachotherbilaterally,sothatthefirstbrokerobtainstheunderlyingcommodityagainattheendofthetransaction,allowingittousethisforthenextCMtransaction.

TheCMtransactionisnormallyveryshortinduration—allthestepsinthemodeltypicallycompletewithinanhour,apartfromthedeferredpaymentleginstepsix.Asaconsequence,thecommodityisnotleftonthebalancesheetofeitherthecentralbankortheIslamicbankforanysignificantperiodoftime.

Asthepurposeofthetransactionistofacilitateliquiditymanagementratherthantobecomeactivelyinvolvedinaparticularcommoditymarket,thepriceandmark‑upwillbefixedattheoutset.Thismitigatestheriskofadversemovementsinthemarketpriceoftheunderlyingcommodityaffectingthereturn.

The wakalah modelWakalah(agency‑based)modelsarefrequentlyusedintheinterbankmarketforbothdeposit‑takingandinvestmentactivity,aswellasintheprovisionofcentralbankdeposits.Underthismodel,oneinstitutionactsasagent(‘wakil’)inmanagingthedepositorinvestmentofaprincipal(‘muwakkil’)inafundofShari’ahcompliantassets(Figure 2).

Inonevariantofthecentralbankwakalahmodel,thecentralbankplacesthedepositsofIslamicbanksintoafundofsukuk(Figure 2).Banknotescanalsobeincludedinthefundasnon‑interest/returngeneratingassets,therebybalancingtheoverallportfolioreturntotargetanexpectedprofitrate(EPR).TheEPRmightmatch,sitwithinacorridorof,orindeedbecompletelyunrelatedto,theequivalentcentralbankinterestrateofferedtoconventionalbanks,dependingontheobjectivesofthecentralbank.

Iftherateofreturnonawakalahdepositfacilityisarrangedtobesimilartothecentralbankpolicyrate,thismaybelowerthanthereturnanIslamicbankwouldotherwiseearnfromholdingthesukukdirectly.However,Islamicbanksmayswapthehigherreturnonthesukukforgreaterliquidityfromacallablecentralbankdeposit,andalsotoreducetheirconcentrationriskbydiversifyingtheircounterpartyexposurestoincludeexposuretoacentralbank.

The wadiah and ju’alah based modelsInthewadiahmodel,thecentralbankholdstheIslamicbank’sdepositincustody.Althoughtheprincipalmustremaincertain,theIslamicbankmaypermitthecentralbanktousethefundstoengageinShari’ahcompliantactivitytogenerateareturn.Thisreturnisusedtocoverthecostofoperatingthefacility,andpartofitmaybereturnedtothedepositingIslamicbankintheformofa‘hiba’(discretionarygift).Ifthecentralbankisnotpermittedtousethedepositstogenerateareturn,itwouldneedtochargetheIslamicbankafeeforholdingthedeposittomakethearrangementeconomicallyviable.

Theju’alahbasedmodelisastructureinwhichthecentralbankacceptsdepositsfromtheIslamicbanks,andprovidesaunilateralpromisetopayacertainreturnuponcompletionofaspecified(Shari’ahcompliant)taskorachievingaspecificoutcome.Thestructureofthisarrangementisonlyspecifiedathighlevel,leavingconsiderableflexibilityintheimplementation.

The Bank’s preferred deposit model

Further internal analysis and public consultationUponcompletingthepreliminarysurvey,theBankdeterminedthatthetwodepositmodelsmostlikelytobeviableintheUnitedKingdomweretheCMmodelandthewakalahfundbasedmodel.ThesewereoriginallyincludedinapublicconsultationinFebruary2016,whileatthesametimebeingsubjecttofurtherinternalanalysisonthefinancial,operationalandlegalrisks.(1)Bothmodelswerebrokendownintotheirconstituentsteps,andexaminedinfurtherdetail,tounderstandpreciselyhowtheywouldworkinthecontextof

Islamic bank

Wakalah fund

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1

1

52

43

Sukuk

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Figure 2 The wakalah deposit model

1 Thecentralbankestablishesafundconstitutedofsuitablesukuk,andbanknotesifrequired.

2and3TheIslamicbankplacesadepositwiththecentralbank,whichiseitherinvesteddirectlyinthewakalahfund,orheldseparatelyandbackedbythewakalahfund(Bankproposedmodel).

4and5Thecentralbankreturnstheprincipal,plusanyprofitonthefund,totheIslamicbankuponmaturity.

(1) Seewww.bankofengland.co.uk/markets/documents/scfgreenpaper.pdf.

Topical articles Islamic banks and central banking 163

theUKlegalandregulatoryenvironment,andparticularlywithintheframeworkoftheBank’sexistingprocessesandinfrastructure.Eachmodelwasassessedagainstacommonsetofevaluativecriteria(seetheboxabove).

Responsestothefirstconsultationexercise,fromthecorestakeholderpopulationofUKIslamicbanksandtheirrespectiveSSBscholars,suggestedthatthewakalahmodelwouldbeconsideredmoreShari’ahcompliantoverall(thoughrespondentsalsoindicatedthatbothmodelswouldhavebeenacceptablestructurestounderpinacentralbankdepositfacility).FromtheBank’sperspective,thewakalahmodelwasconsideredtobemoreoperationallystraightforward,requiringfewerchangestointernalsystems,andwithfewerdependenciesonexternalthirdparties.TheBankissuedafollow‑upconsultationpaperinApril2017,announcingitsintentiontoestablishanSCFusingthewakalahfundbasedmodel.TheBank’sdecisionwasinformedbyacombinationofinternalanalysisandmarketfeedbackfromtheconsultationexercise.

Thepreferredwakalahfundbasedmodelisdetailedinthissection(Figure 3),andthealternativeCMmodelisdetailedintheannex.ThediagramsprovidedareintendedtoillustratehowthesedepositmodelscouldworkwithinaUKcentralbankingcontext;therewillbevariationsinthedetailfromhowthemodelsarecurrentlyimplementedbycentralbanksinotherjurisdictions,andalsoinhowtheyareimplementedinapurelycommercialsetting.

IntheUnitedKingdom,awakalahbasedcentralbankdepositfacilitywouldentaildepositsplacedbyIslamicbankswiththe

centralbankbeingbackedbyafundcontainingShari’ahcompliantassetssuchassukuk.TheIslamicbankdepositwouldbeheldbythecentralbankseparatelyfromotherassetsonitsbalancesheet(topreventitbecomingmixedwithnon‑Shari’ahcompliantassetsoractivity),andtheIslamicbankwouldreceiveareturnfromthewakalahfundinlieuofinterestearnedonaconventionaldeposit.

The rate of return on the facilityRatherthanincludingcashinthefundatzeroreturntoadjusttheoverallreturnonthefacility,intheBank’sproposedarrangementthefundwouldlikelybemadeupentirelyofsukuk.If,asislikelyinmostscenarios,theoverallfundreturnexceedsthestatedEPR,anysurplusafteradministrativecostswouldbeusedtograduallybuildupareserve.Thiswouldthenactasacushionduringperiodsinwhichthefundisnotabletogenerateasufficientreturn.Bearinginmindtheoriginalassessmentprinciples,insettingtheEPRtheBankwouldneedtoensurethefacilitypaysareturnwhichissufficientlyconsistentwiththatpaidtoconventionalSMFparticipants,whileatthesametimenotsimplyreplicatingBankRate.

Pre‑establishing the fund and hedging riskEstablishingthefundinadvanceofacceptingdepositsisnecessary,becauseintheUnitedKingdomthereisascarcityofreadilyavailableandsuitablehigh‑qualityliquidassetstoputintoit.Inotherjurisdictionsoperatingcentralbankdepositfacilitiesonthismodel,pre‑establishmentmightnotbenecessaryifthecentralbankalsoregularlyissuesitsownsukukforuseinthefund.

Evaluation criteria used by the Bank to assess deposit models

• Themodelistransparentandsimpletoexplainandunderstand,maximisingthepossibilityofitbeingrecognisedasmeetingtheneedsofcurrentandpotentialusers.WhiletheBankwouldaimtoensurethatanyselectedSCFmodelissufficientlytransparent,theonuswouldfallontheIslamicbankstosatisfythemselvesonShari’ahcompliance.ThisisbecausetheBankasasecularbodywouldbeunabletoprovidethisassurance.

• ThemodelhelpsIslamicbankstobettermeettheirLABrequirementsundertheliquidityrules,orprovideseffectiveliquiditysupporttoIslamicbanksintheeventofafirm‑specificormarket‑widestress.

• TherisksarisingfromthemodelfitwithintheBank’stolerancethresholds,includingwithrespecttocredit,market,liquidity,operational,counterpartyandlegalrisk.

• ThemodeliscompatiblewiththeSterlingMonetaryFramework(SMF)—anySCFshouldnotconflictwithmonetarypolicy,norunderminetheBank’sexistingliquidityfacilities.

• Themodelisaccessiblespecificallytoinstitutionswhich,intheirarticlesofincorporation/association,areprohibitedfromengagingininterest‑basedactivity.ThisisnecessarytoensurethattheexistingSMFfacilitiesremaintheprimarytoolintheUnitedKingdomformonetarypolicyimplementationandliquidityprovision.

• ThepricingofthemodelissufficientlyconsistentwithequivalentconventionalfacilitiesforittoberegardedasattractiveandfairforIslamicbanks.

• BankresourcesrequiredtooperateanySCFinsteady‑stateareproportionatetothesizeofthefacility.

• Themodelcanbeappliedwithoutbeingcontingentonfuturemarketdevelopments.

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Thesukukfundforthisdepositfacilitywillincurtwomainformsoffinancialrisk.Thefirst,andmostsubstantive,isforeignexchange(FX)risk,giventhatalargeproportionofHQLA‑eligiblesukukarelikelytobeUSdollar‑denominated,whiletheobligationsundertheSCFwillbeinsterling.ItwouldbepossibletohedgeFXriskintheportfoliousingShari’ahcomplianthedginginstruments,thecontractualtermsofwhichhavebecomeincreasinglymorestandardisedover

recentyears.Thesecondfinancialriskisprofitraterisk,theriskthattherateofreturnontheconstituentsukukintheportfoliofallsshortofthestatedEPR.Thisisanalogoustointerestrateriskforequivalentconventionalfixed‑incomeinstruments.However,thisriskcanbemitigatedbyreducingtheactualprofitratepaidouttoavoidashortfall;theEPRisonlyanindicativerate,notafixedobligation.Inaddition,thefacilitycanbecarefullymanagedbyensuringthatonly

Islamic Bank A

Islamic Bank B

Islamic Bank C

Central bank

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Special Purchase Vehicle

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5Initial cash flow

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Figure 3 Detailed analysis of the wakalah fund based deposit facility at the Bank

1 TheBankestablishesthefacilityinthefirstinstance,byplacingadepositwiththeSPVwhichisequaltotheaggregatevalue(atcost)ofsukuktobepurchasedforthebackingfund.

2and3TheSPVpurchasessukukforthefund.Atthesametime,wheresukukaredenominatedinanon‑sterlingcurrency(mostlikelyUSdollars),anaccompanyingFXhedgeispurchasedfromoneoftheBank’sexistingcounterparties.AsShari’ahcomplianthedginginstrumentsareavailableinthemarket,theuseofconventionalhedgescanbeavoided.

4 Islamicbanksareinvitedtoparticipateinthefacility,payinganannualaccessfeecommensuratewiththatforanequivalentconventionalfirmaccessingtheSMF.IslamicbanksplacedepositswiththeSPV,onatermbasisandforanexpectedprofitrate(EPR)whichwouldbesetatthestartofthetransaction.Thetermwillbesetatoneweek,butwillbebreakablebyIslamicbanksatanytime.TheBankreducesitsowndepositinthefacilitybyanamountcorrespondingtotheaggregatedepositsplacedbytheIslamicbanks,toensurethefacilityremainsfullyutilised—itwillremainaco‑depositorforanyresidualamount.TheBankwillreceivethesameEPRonitsdepositsastheIslamicbanks,meaningtheSPVwillnotengageinanyinterest‑basedactivity.

5 TheBankguaranteestoeachIslamicbanktheprincipalamountofthedepositsplacedbyitintotheSPV.Thiswouldbeanoverarchingor‘master’guaranteetocovertheaggregateprincipaldeposit,soastoavoidtheneedforanewguaranteetobeenteredintoeachtimeafirmincreasesorreducesitsdeposit.TheBankwouldnotberemuneratedfortheguarantee,norwouldtheguaranteeimposeanyfinancialorcommercialobligationuponthedepositorIslamicbanks.

6 Onmaturityofthedeposit,areturnispaidtoalldepositorsinthefacilityinproportiontotheirholdings.Thiswilldependontheperformanceofthesukukportfolio,andmayormaynotbeequaltotheEPR.Thisprofitratereferencesthereturnonthefund,netofanyhedgingorotheroperationalcosts,andcontributionstoareservefund.

Topical articles Islamic banks and central banking 165

high‑qualityinstrumentsusingstructureswhichenablepredictablecashflowsareincludedinthefund.Thesewouldincludeinstrumentsissuedbyhighlyratedsovereignsandmultilateraldevelopmentbanks.

Guaranteeing the principal of depositsAkeycriterionfortheSCFisthatthefundsheldintheSPVcanbetreatedas‘Level1’HQLAfortheLiquidityCoverageRatio(LCR)underCRDIV.Toachievethis,theBankwillundertaketotheparticipatingIslamicbankstoguaranteetheprincipal—butnotthereturn—offundstheyplaceinthefacility.Thiswillbedoneinordertoestablishaclaimguaranteedbythecentralbank.Inotherjurisdictionsofferingwakalahdeposits,thisguaranteemaybeimplicit.IntheUnitedKingdom,theguaranteewillbeprovidedinlinewiththemarketstandardforIslamicbanks,thatis,itwillgranttheIslamicbanks,asdepositors,adiscretionaryrighttoaclaimagainstthecentralbankforanylossofprincipalvalue.

Underapurerisk‑sharingarrangement,wheretheIslamicbanksdidnothavearighttocallupontheguarantee,theconsequentlosswouldautomaticallypassthroughtoIslamicbanksintheformofareductionintheprincipalamountreturned.However,thiswouldnotbesufficienttoconstituteaclaimuponthecentralbank.WhiletheBankrecognisesthetensionwhichexistsbetweenregulatoryandShari’ahcompliancerequirementsontheissueoftheprincipalguarantee,italsonotesthattheonlyscenarioenvisagedinwhichthisundertakingcouldbecalleduponbytheIslamic

bankswouldbethedefaultofasukukinthebackingfund.Giventhatonlyhigh‑qualityinstrumentswouldbeeligibleforthefund,theprobabilityofsuchadefaultwouldbeverylow.

Conclusion

FollowingtheclosureofthesecondconsultationexerciseinMay2017,theBankhasbeguntoimplementthewakalahfundbasedmodel.AmongotherthingsthisinvolvesworktointegratethefacilityintotheBank’sexistinginternalsystemsandprocesses,andcreateasetofstandardisedtermsandcontractualdocumentation,similartothoseusedbyparticipantsoftheBank’sexistingSMF.Thedocumentationwillincludedetailsonthetermofdepositsandfrequencyofaccess.

WhilethefacilitywillbestructuredtobeacceptableforusebyUKIslamicbanks,consistentwithBaselIIIandEUliquidityrules,itwillalsobeavailabletoanyotherbankswhicharepreventedfromengagingininterest‑bearingactivityintheirarticlesofassociationorincorporation.ThiswillmeanthatcommercialbanksintheUnitedKingdomwillbeabletoaccesseithertheBank’sconventionalSMFfacilities,ortheSCF—butnotboth.TheSCFprojectrequiresasubstantialexpenditureofresource,andthefacilityisthereforeunlikelytobereadybeforeSpring2018.Furtherdetailsonimplementation,includingtimeline,willbepostedontheBank’swebsiteinduecourse.

166 Quarterly Bulletin 2017 Q3

Annex Detailed analysis of the alternative commodity murabaha based deposit facility

Aspartofitsanalysis,theBankalsoconsideredtheimplementationofadepositfacilityusingthecommoditymurabahamodel.Thisannexoutlineshowsuchadepositfacilitywouldhaveworkedinpractice,iftheBankhadchosentoimplementit.

Central bankcommodity account

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Figure A1 Detailed analysis of the alternative commodity murabaha based deposit facility

1 IslamicbankmakesrequesttocentralbanktomakeShari’ahcompliantdeposit,instructscentralbankasagenttopurchasethecommodities.2 CentralbanknotifiesBrokerAofIslamicbank’srequesttomakedeposit.3 BrokerAissuescombinedSeller’sOfferandPurchaser’sAcceptancetocentralbank.4 CentralbanksignsandreturnsPurchaser’sAcceptancetoBrokerA.5 BrokerA,actingascustodian,transfersspecifiedcommodityfromowninventorytocommodityaccountofcentralbank.6 CentralbankissuesPurchaseConfirmationtoIslamicbankwithdetailsofcommoditypurchasedbycentralbankasagentforIslamicbank.7 Islamicbankpaysagreedspotpurchasepriceforcommodity.8 CentralbankcreditsBrokerA’ssettlementaccountwithspotpurchaseprice.9 BrokerAissuescommoditycertificateandwarrantlistingtocentralbank.10 CentralbankissuesSaleConfirmationtosignandreturnbyIslamicbank.11 CentralbankdebitsBrokerA’ssettlementaccount,creditsBrokerB’ssettlementaccountwithpurchaseprice.12 CentralbanksendsrequesttoBrokerBtoissuecombinedPurchaser’sOfferandSeller’sAcceptance.13 BrokerBissuescombinedPurchaser’sOfferandSeller’sAcceptancetocentralbank.14 CentralbanksignsandreturnsSeller’sAcceptancetoBrokerB.15 CentralbankdebitsBrokerB’ssettlementaccountwithsaleprice(sameasoriginalspotpurchaseprice)andcreditsitsownaccount.16 CentralbankissuesDeliveryNoticetoBrokerAconfirmingcommoditysoldtoBrokerB.17 BrokerAactingascustodiantransferscommodityfromcentralbankcommodityaccounttoBrokerB’scommodityaccount.18 BrokerBsellsbackcommoditytoBrokerA.19 BrokerAactingascustodiantransferscommodityfromBrokerB’scommodityaccounttoitsowngeneralinventory.20Uponmaturity,centralbankmakesdeferredpayment(includingmark‑up)toIslamicbank.

Topical articles Islamic banks and central banking 167

Although there are a number of notification steps in the process, these are typically automated, through the use of Broker A’s web‑based CM system. This is important, because if any of the steps are missed or fall out of sequence, the overall transaction may be deemed non‑Shari’ah compliant. This also highlights the importance of Broker A to the CM arrangement more generally. If their system suffers an outage, or if the broker is otherwise unavailable, the transaction cannot proceed and the policy objective of the SCF cannot be fulfilled. Selection of the CM model would therefore entail careful due diligence of Broker A’s trading systems as well as their general capability as a trading intermediary.

Similarly, this model would require the Bank to open settlement accounts in respect of Brokers A and B, to net off exposures with the commodity brokers. This way, the only actual cash flows are between the Bank and the participating Islamic banks. For the Bank, a minimum of four accounts would likely be required, if two brokers are used on a regular basis, with two additional brokers as a contingency. Selection of a range of brokers to diversify counterparty risk could however be challenging, since only a small number of firms are active in this highly specialised market. It might be possible to mitigate this risk by transacting via commodity exchanges rather than directly with brokers, but ultimately oversight of this form of central banking activity could not be outsourced — responsibility would have to remain with the Bank.

Under the murabaha model, if an Islamic bank wished to break their deposit it would require them to initiate a countervailing trade with the Bank, running through all the process steps in Figure A1, but with the flows reversed. As noted previously, there would be a number of steps involved, but system automation would reduce the operational burden.

Use of commodities and commodity accountsSelection of the specific commodity to be traded is an important consideration. The Bank would have to give due regard to market preference on the list of permitted commodities for CM transactions, since this is primarily a question of Shari’ah compliance, and the commodities in question will be held by the broker rather than the Bank itself. The Bank might though find certain commodities to be less suitable for operational reasons: soft commodities such as cocoa and coffee would need to be transacted in greater quantities to reach the same transactional values, and some which are liquid, such as palm oil, might be problematic due to Shari’ah concerns over commingling in storage. A balance would need to be struck between having a suitable range of commodities to transact with, and ensuring each eligible commodity has a sufficiently high unit value and liquid market.

Broker A needs to open commodity accounts in respect of the central bank, and Broker B. This means that commodities are actually held by the broker; they are not held directly by either the central bank or the Islamic bank. This is sufficient to constitute constructive possession under Shari’ah standards, and reduces the need for the Bank to change/adjust its systems to be able to hold commodities, which central banks do not normally do. In commercial terms, it also makes it easier for Broker A to net off their commodity holdings with those of Broker B, especially if/when Broker B sells the commodity back to them. However, it is commonly understood that even if constructive possession is sufficient, physical delivery must be at least possible, even if seldom effected in practice. In terms of current market practice, where physical delivery is required by broker clients (which is rare), this must be requested prior to the initiation of a CM transaction.

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Glossary of selected Islamic finance terms

‘Aqd—Acontract.

Bai—Asale.

Bai al inah—Asalewithimmediaterepurchase—normallydeemedimpermissibleasitcanbeusedtoreplicateaconventionalinterest‑bearingtransaction.

Fiqh—Islamicjurisprudence,theinterpretationofthehigh‑levelprinciplesofIslamiclaw.Commonlydividedinto‘fiqhalmu’amalat’(jurisprudencepertainingtoactivitiesbetweenpeople)and‘fiqhalibadah’(jurisprudencepertainingtoactsofworship).

Gharar—Excessiveuncertaintyinacontract,whichmaygiverisetodispute.

Halal—PermissibleunderShari’ah.

Haraam—ImpermissibleunderShari’ah.

Ijarah—Alease‑basedcontract.

Islamic—Adheringto,orconsistentwith,thevaluessystemofIslam.

Ju’alah—Acontractinwhichonepartyoffersspecifiedremunerationtoanotherinreturnforthecompletionofaspecificpieceofwork.

Mudarabah—Asilentpartnershiparrangementinwhichoneparty(the‘rabbalmaal’)providescapitalandtheother(‘mudarib’orentrepreneur)providestime/expertisetoanenterprise.

Murabaha—Asaleofaparticularassetatadisclosedmark‑up.OftenusedinconjunctionwithcommoditiestogenerateareturnforShari’ahcompliantdeposits.

Musharakah—Apartnershiparrangementbetweentwoormoreparties,inwhichrisksandrewardaresharedproportionately.

Qard hasan—Aninterest‑freeloan,oftenusedforcharitablepurposes.

Riba—Technically,‘excess’orexcessivecompensation;theArabictermforinterestorusury.

Shari’ah—Thehigh‑levelprinciplesofIslamiclaw,commonlyderivedfrom(inorderofhierarchy):theQur’an,Sunnah(therecordedacts,sayingsandtacitapprovalsoftheProphetMuhammad),ijma’(consensusoftheearlyMuslimcommunity)and‘qiyaas’(reasoningbyanalogy).

Sukuk—Technically,pluralof‘sakk’.AcertificateentitlingtheholdertoabeneficialinterestinaShari’ahcompliantactivityorunderlyingasset,butexcludingshares.IntheUnitedKingdom,sukukareoftendesignatedundertheapplicablelegislationasAlternativeFinanceInvestmentBonds(AFIBs).Theeconomicandriskprofileofsukukwillvarydependingontheunderlyingstructure—somebehavelikeconventionalfixed‑incomeinstruments,whileotherswillresembleequitiesbutwithoutthevotingrights.

Takaful—Technicallymeaning‘tomutuallyguarantee’,aformofShari’ahcompliantinsurance.

Wa’ad—Apromise,normallyprovidedintheformofanundertakingtocarryoutaspecifiedactionatsomepointinthefuture.Commonlyenactedaseitherunilateral(inwhichapromisorprovidesanundertakingtoapromisee,wherethelatterisundernoobligation),orbilateral(knownas‘muwa’ada’inwhichtwopartiesproviderespectivelybindingundertakingstoeachother).Canbeusedtounderpinopenmarketoperationsorfinancialriskhedgingactivity.

Wadiah—Asafecustodyarrangement.Insomeinstances,abankholdingdepositsunderwadiahmaybepermittedtousethefundstogenerateaprofit,inwhichcasetheycanofferadiscretionaryreturn(‘hiba’,orgift)tothecustomer.

Wakalah—Anagency‑basedarrangement,inwhichaparty(‘wakeel’)actsasagentforaprincipal(‘muwakkil’).Commonlyusedasthebasisforbanking,investmentandinsuranceactivity.

Topical articles Islamic banks and central banking 169

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Accounting and Auditing Organization for Islamic Financial Institutions (2015),Shari’ahStandards.

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Kahf, M and Hamadi, C (2014),‘AnattempttodevelopShari’ahcompliantliquiditymanagementinstrumentsforthefinancieroflastresort:thecaseofQatar’,Islamic Economic Studies,Vol.22,No.1,pages109–38.

Shafiq, M (2015),‘Goodbyeambiguity,helloclarity:theBankofEngland’srelationshipwithfinancialmarkets’,availableatwww.bankofengland.co.uk/publications/Documents/speeches/2015/speech801.pdf.

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