shariah compliant liquidity management tool ... · pdf file1 shariah compliant liquidity...

1

Shariah Compliant Liquidity Management Tool Collateralisation & Tri Party

Ismail Dadabhoy

Advisor - IIFM

IIFM Industry Seminar on ICMM

Hosted by Monetary Authority of Singapore,

June 2nd, 2014, Singapore

1

Some Tools For Liquidity Management

Murabaha

Salam

Wakalah

Mudarabah

Sukuk

Credit Risk>>>>>>>>>>>>>>>>>>> Generally Short Term

Credit Risk>>>>>>>>>>>>>>>>>>>> Generally Short Term

Investment Risk / Credit Risk >>>>> Generally Short Term

Investment Risk / Credit Risk >>>>> Generally Short Term

Credit Risk / Market Risk>>>>>>>> Generally Long Term

2 IIFM Industry Seminar on Islamic Capital and Money Market, 2nd June 2014, Singapore

2

Enhancing Liquidity Management

• Financing Transaction with the benefit of Collateral


Conventional Collateral Market Eurex Repo on the up and up Frankfurt | 04 April 2014

Eurex Repo, which operates Swiss Franc, Euro Repo and GC Pooling markets, recorded in all

markets in March 2014 an average outstanding volume of €217.3 billion, increasing from the €215.3 billion seen last year.

The secured money market GC Pooling recorded an average outstanding volume of €150.1

billion, decreasing from the €151.8 billion seen year-on-year.

The Euro Repo market grew by 32 percent and reached an average outstanding volume of 40.1 billion euros (March 2013: 30.4 billion euros). The Swiss Franc Repo market

achieved 27.1 billion euros.

22 April 2014 - ISDA

“Collateralisation has a fundamentally important role to play in risk

mitigation,” said Robert Pickel, CEO of ISDA.

“Over the past 14 years, ISDA’s Margin Survey has provided a consistent set of benchmarks

for collateral use and is part of a broader set of the association’s initiatives in the area of

collateral, including documentation, best practices and practitioner

guidelines.”


3

Murabaha Collateralised by Sukuk

Requires

Liquidity

Cash Rich

Party

Murabaha

Sukuk


Collateralisation

How does it Work?


4

Collateralized Product Benefits

Alternative to Clean Lending

Collateralized financing offers a structure that requires some extra operational task but does provide credit enhancement as well as providing an effective liquidity management tool for use with the

Collateral Management Agent.

Central Bank Market Intervention

Liquidity Management

Credit Risk Management

Having the comfort of collateral allows the institutions to finance for a longer duration and or larger quantum as the credit risk is reduced.

as long as the extra collateral is followed, Counterparty exposure is reduced to the margin threshold plus Sukuk execution risk, rather than a

full clean exposure. It can allow for positive capital treatment.

Development for Sukuk

CB can include Islamic Banks as part of its market liquidity actions ( Add or Remove Cash from the system. Also, Islamic Financial Institutions can

use this liquidity instrument to raise funds from the CB

Allowing Financial institutions to maintain less cash and allocate more in income generating Sukuk. Giving rise to greater take up of Sukuk by

Islamic investors


Purpose of Collateralisation

A Tool

that

Flows

Liquidity

Into the

Cash &

Sukuk Market


5

Collateralization Overall Transaction Flow

Commodity

Seller

Commodity

Buyer

Single

or

Pool of Sukuk

From Party A

PARTY A -requires

Funding

Acting

as

Agent

Acting

as

Principal

6

2

3

4

3

1- Party B appoints Party A as

Agent to purchase Commodity and

transfers Cash to Party A’s

account to purchase the

commodity

2- Party A buys commodity for Spot

Payment and Spot Deliver from the market

as Agent for Party B

3- Party A NOW acting as

Principal Purchases the

same commodity from

Party B for Spot Deliver But

with deferred Payment

4- Party A sells commodity to the market

for spot deliver & spot payment and raises

Cash for its funding needs

6 3

Bi- Lateral Transaction

Party B Provides Funding

1 6


Collateralisation

With proper Collateralisation and monitoring in place

One can afford a bit of peace


6

Collateralisation – The Key is to Ensure Margin Maintenance

Bank to provide more (same or other) acceptable Sukuk

Provide other acceptable Collateral as previously agreed

Or Provide acceptable Letter of Credit

To bring the collateral level back up to 110%

If none of the above agreed instrument is delivered then the Party A will be in Default

Party B will Return part of the Sukuk in order to bring it back down to 110% of the Finance Amount

Or Party A may consider not to request this extra amount from Party B and may wish to leave extra buffer and save on operational cost

A (1) Assuming the Collateral Value Decreases Below the Threshold Variance

A (2) Assuming the Collateral Value Increases Above the Threshold Variance


What Does Tri–Party Offer ?

Tri- Party plays and important role by providing independent operational facility while holding underlying collateral

Allows entities to participate in Collateralised Financing even when their operation and IT capabilities cannot support due to limitation

Its function is to ensure the Collateral Value are maintained by daily mark to market the Collateral, Call for additional Margin if required, ensure the Collateral is of the type and quality as per the agreement and to process Corporate actions

Central Banks, Pension Funds, Asset Managers, Leasing Co and Corporate entities can provide extra cash liquidity to the market. Knowing the exposures are monitored by an independent entity

Credit Enhancement

Operation Out Sourcing

Credit Management

Expands

Client Base


7

Murabaha Collateralised by Sukuk

Requires

Liquidity

Cash Rich

Party

TRI PARTY

Sukuk

Custodian

Margin Calls

Margin Calls



Commodity

Seller

Tri-Party

Agent

Commodity

Buyer

Single

or

Pool of Sukuk

From Party A

Collateral

PARTY A -requires

Funding

Acting

as

Agent

Acting

as

Principal

1

2

3

4

5

1- Party B appoints Party A as Agent to

purchase Commodity and transfers Cash to

Collateral Management Agent acting as

Tri Party Agent to forward the funds to

Party A to purchase the commodity >

Collateral Management Agent to Receive

Collateral from Party A






same commodity from






5- Party A delivers acceptable pool of

Sukuk having market value in excess of the

Deferred Cash as collateral

6

6 – Party A transfers the

Deferred payment at maturity

and receives its Sukuk back

Workings of TRI - PARTY


1

6

5

5

2


8

Tri Party – Collateral Optimisation

Now

Enjoy

The

Fruits

Knowing your Exposure is Monitored independently by a an engine that optimizes

The Collateral pool while ensuring Credit exposure is monitored, reported and actioned


OIC Jurisdiction Regulator Contribution & Industry Support

Create an environment to support the Islamic Inter-bank market by making the transacting banks more comfortable to deal with each other

Collateralized regime will be established which will improve the capital ratios of the Islamic banks - IFSB to provide guidance

Working towards establishing a clear legal frame works that allows for Netting , Set Offs, enforceability, this will un-doubtly enhance the market by providing greater legal comfort .


9

Regulatory ,Legal & other Challenges

In the case of conventional market repo documentation, the collateral is effected through netting i.e. the ability to close out and set-off in an insolvency where the value of the collateral securities can be determined and applied in set off against the repurchase price. However, the legal framework in most of the OIC countries does not recognize this technique.

The Islamic Industry need to assess and tackle this requirement or find a workable solution

Certain Institutions either do not carry Sukuk in their portfolio or do not invest in Sukuk. What is the solution for them on Collateralisation?

Answer, consider Equities.

However, here there may be issues in terms of Foreign ownership, taxation etc. OIC members , where these prohibition exists can consider allowing Collateralisation for funding purposes and incase of default, the Equity acquired as a consequence of Default MUST then be sold immediately to a local buyer


• Tenth Harvard University Forum on Islamic Finance Harvard Law School - March 24-25, 2012

Mahmoud Mohieldin, Managing Director, World Bank Group, highlighted Six Challenges facing Islamic finance as the industry evolves into its next phase:

Improving regulatory oversight

Strengthening insolvency frameworks

Rebalancing tax treatment

And

Promoting standardization

Establishing sound risk-management practices

Ensuring adequate liquidity


10

Appendix

Step By Step & Flow Charts Collateralised Mubaraha


IIFM Consultative Process

Collateralization Consultative Meeting

Collateralization Working Group

A core working group comprising representatives from IIFM member

banks reviewed to produce Standard Collateralization product

structure, documentation. Third draft of the agreement was

presented to the IIFM Sharia Executive Committee .Next step is

to present to Sharia Borad incorporating Sharia Executive

comments

IIFM , organized an industry consultative meeting in Dubai . It was well attended by all the stake holders , including Islamic Banks, Islamic windows, Sharia Scholars, Lawyers, Accountants, and Global Custodians. The participant supported this initiative which lead to IIFM producing a white paper. Market response, Collateralised Murabaha


11

Murabaha Collateralisation Product Macro Steps -- an Example

Both parties agrees on Term of the murabaha transaction, the mark up, type of Sukuk, and Margin call parameters (Top-up or extra collateral, Threshold & Base Currency)

Party B invest $100 million Cash for say1 Month via a Murabaha transaction with a local bank

Party B receives acceptable Sukuk as agreed by both parties to a value of $ 110 million to collateralize the exposure and allow 10% variance on both side. Reason to provide 10 million extra coverage is to allow for price fluctuation and to reduce the movement of Collateral back and forth

Assuming Collateral fluctuation remains within the band then on the deferred maturity date the Party B receives its $ 100 million Cash + the profit and the Party B returns all of the Sukuk Collateral to the Islamic bank

Step 1

Step 3

Step 2

Step 4


Collateralization Transaction Macro Flow

To show how the structure will work, the following commodity Murabaha based structure is presented for illustrative purposes only. Moreover, International & Domestic Sukuk is considered as collateral:

(i) Overview of Structure

Step 1 Party B transfers cash to Collateral Management Agent (CMA) as Tri-Party Agent for

onward transfer to Party A and receives Collateral. CMA receives a fee for its services

Purchase of commodities for Cost Price

Step 2 Pays Purchase price

Sells commodities for Deferred Purchase price

Step 3 Party A to pay deferred Price at maturity date

Party A grants transfers Sukuk to Domestic

Step 4 Agent to secure obligation to pay deferred

purchase price

Step 5 Sells Commodities for Cost price

Pays Purchase Price

Step 6 Party A pays Deferred Purchase Price (being Cost plus Profit)

Security released against payment

Party A (as agent to B)

Party B

Party B

Party A

Party B

Broker 1

Party A

Party A

Broker 2

Party A


12

Collateralized Product Margin Maintenance – An Example

Bank to provide more (same or other) acceptable Sukuk

Provide other acceptable Collateral as previously agreed

Or Provide acceptable Letter of Credit

Initial Collateral of 110% with 5% variance margin either way.

If Value of Collateral breaches105%, Then bring the collateral level back up to 110%

If none of the above agreed instrument is delivered then the Party A will be in Default

If Value of Collateral breaches 115%,then Party B will Return part of the Sukuk in order to bring it back down to 110% of the Finance Amount

Or Party A may consider not to request this extra amount from Party B and may wish to leave extra buffer and save on operational cost

A (1) Assuming the Collateral Value Decreases Below the Threshold Variance

A (2) Assuming the Collateral Value Increases Above the Threshold Variance


Collateralized Product Margin Maintenance & Foot Note

At all times during the 1 Month Transaction a 100% to 110 % collateral cover will be maintained against its Deferred payment exposure

Any Increase above the 115%, Party A has the right to call collateral back

Any Decrease below 105%, Party B has the right to ask for Top up

The counter parties would be Banks or any Financial Institution

International Sukuk & Domestic Sukuk considered by relevant clearing service provider

Rating Parameters of Sukuk can be considered subject to agreement by both parties

Other securities which could be used as collateral are not considered at this time

Use of underlying collateral by receiving bank – requires further Shariah guidance as reuse is an issue for consideration

Governing Law – seems English law needs to be used ** * The ratio of excess margin and the variance band is subject to negotiation between the 2 parties and will vary depending on

the credit quality of the parties and the collateral offered . The percentages shown are for illustration purposes.

** Other governing law can be considered subject to agreement by both parties and also presence of relevant insolvency and collateral taking law

b) Commitment of Both Parties *

Notes


13


Commodity

Seller

Commodity

Buyer

Single

or

Pool of Sukuk

From Party A

Collateral

PARTY A -requires

Funding

Acting

as

Agent

Acting

as

Principal

6

2

3

4

3

1- Party B appoints Party A as

Agent to purchase Commodity and

transfers Cash to Party A’s

account to purchase the

commodity






same commodity from






3- Party A delivers acceptable pool of

Sukuk having market value in excess of the

Deferred Cash as collateral

6 3

Bi- Lateral Transaction


1 6


Documentation & Product Requirements

1. Product Structuring & related material

2. Product Guidelines

3. Collateralized Murabaha Agreement

4. Pledge Agreement

5. Global Master Agreement

6. Collateral Management Document & Client Service Documents (review only from Shari’ah perspective)

The standard product & documentation likely to include


14

Shukaran Wassalamu ‘Alaikum

27

International Islamic Financial Market (IIFM) Office No. 72, 7th Floor, Zamil Tower (Main Tower), P.O. Box: 11454, Manama, Kingdom of Bahrain Tel: +973 17500161 , Fax: +973 17500171, Email: [email protected], Website: www.iifm.net

Disclaimer: The information herein has been obtained from sources believed to be reliable but cannot be guaranteed. The views or opinions expressed are subjected to change at any time. Neither the information nor any opinion expressed can be construed as a solicitation for the purchase or sale of any securities. International Islamic Financial Market disclaims liability in this respect.