Academics and industry participants in Malaysia are advocating further developments of treasury and money market products, notably via a new exchange initiative. But commodity murabaha structures developed to facilitate liquidity management by banks based on palm oil have attracted criticism from some quarters.
The world’s Muslim population is projected by the International Journal of Environmental Science and Development to account for a quarter of the world’s estimated 7.8 billion people by 2020. As the population and wealth of Muslims increases, the size of the global murabaha business – a widely used cost-plus Islamic money markets structure – could grow dramatically, considering Islamic financial assets are today estimated at around $1 trillion.
Islamic banks in the Middle East have used contracts based on London Metals Exchange (LME) commodities to manage their liquidity positions for many years. Kuala Lumpur created its own version of commodity murabaha in 2007 by issuing central bank monetary notes backed by the country’s rich crude palm oil resources.
Because sharia-compliant financial activities must be linked to real economic sector activities and real assets, Malaysia’s sizeable inventory of the edible oil, which saw another 17 billion tonnes produced in 2010, has provided a useful alternative to base metals as a foundation on which a range of commodity murabaha financial instruments can be built.
The debut of Bank Negara Monetary Notes Murabaha (BNMN) in 2007 marked Kuala Lumpur’s intent to develop its own brand of money markets instruments. It also provided another money market option to both Islamic and conventional banks – by the nature of sharia with its four schools of thought, an instrument could be deemed acceptable by one school of Islam and rejected by another; and the school that gave its stamp of approval today could rule it non-compliant tomorrow.
“In Malaysia, due to the uncertainty factor of interbank mudaraba, we usually use it for tenor shorter than one month, and commodity murabaha for anything longer than one month,” says Norashikin.
In a typical commodity murabaha structure, such as the BNMN, an Islamic bank buys crude palm oil from a broker and sells it to Bank Negara at cost-plus. Then Bank Negara appoints the bank in turn as its agent to sell the commodity to a third party, takes the cash, and agrees to pay the bank on a deferred basis. The economic result is that the bank has placed out its excess funds with Bank Negara. The same transaction, carried out in reverse, would mean that the bank becomes the borrower and needs central bank liquidity. Moreover, a commodity murabaha structure can also be transacted between two Islamic banks and often, none of the banks involved would take physical settlement of the underlying crude palm oil.
The common pricing reference of the underlying crude palm oil in a commodity murabaha transaction is taken from the Malaysia Palm Oil Board, a research and development association that publishes daily spot crude palm oil pricing. Commodity brokerage houses act as intermediaries effecting such buying and selling/on-selling of the underlying crude palm oil through their connections with the supplier and buyers.
Norashikin says brokerage costs of around $40 per $1 million of transaction value would be too prohibitive for commodity murabaha of tenor less than one month, as the tenor will be too short to amortise such fixed brokerage cost, making the interbank cost of funding unattractive.
To promote the broader uptake of commodity murabaha as an interbank liquidity management tool, the Association of Islamic Banking Institutions Malaysia (AIBIM), a statutory industry organisation with 21 member banks based in Kuala Lumpur, introduced two standardised interbank master agreements for Islamic deposit-taking and placement transactions – the Interbank Murabaha Master Agreement and Master Agency Agreement – in April 2009.
The two bilateral agreements came one year after the Master Agreement For Treasury Placement launched by the Bahrain-based International Islamic Financial Market (IIFM), a global standardisation body set up by the central banks and monetary agencies of Bahrain, Brunei, Indonesia, Malaysia and Sudan along with Saudi Arabia’s Islamic Development Bank. The IIFM’s master agreement comprises of two structures – one with the deposit-taking entity acting as the buying agent vs the deposit-placing entity as principal; while the other structure is based on both being the principals without any agent involved.
IIFM’s chief executive Ijlal Ahmed Alvi says it is normal to have a global master agreement such as IIFM’s Master Agreements for Treasury Placement (MATP) and standardised documentation, such as those introduced by the AIBIM, at national level.
“The global master agreements are helpful to the domestic documentation given the strong documentation architecture and comprehensive process of development, which makes it a benchmark for institutions to follow as well as a reference point for jurisdictions. If we do a comparison between IIFM MATP and Malaysian Commodity murabaha documentation the overall structure of the two documents is the same, which shows that the Islamic finance industry is moving towards convergence and unification,” he says
Today Malaysia’s interbank market is the smaller part of the country’s dual banking system, where the majority of transactions are still conventional. Islamic deposits accounted for 19.3% of the country’s 1.13 trillion ringgit in total deposits as of November 2010. As Islamic law prohibits the giving or receiving of riba, or interest, interest-bearing features are often removed from Islamic money market instruments and replaced with either a profit rate, or a mark-up feature, Islamic academics say.
Bankers generally say reliance on the interbank market for funding is less preferred than maintaining a low loan-to-deposit ratio – hence, funding the bank’s assets with deposits as much as possible. However, Adinor Mohamed Yunus, head of group treasury at Islamic development bank, Bank Pembangunan Malaysia, says his bank views access to the Islamic interbank market as filling an important gap that allows his team to tap readily available funding, especially considering his main clients are corporates that demand sizeable project financing.
Islamic bank treasurers had long hoped for a money market instrument that offered better capital protection and more secured credit. Murabaha was meant to fulfil this role. However, in 2010, the majority of the Islamic interbank transactions were still done through a different product, interbank mudaraba, at 212.3 billion ringgit ($69.6 billion), compared with commodity murabaha, which totalled 58.7 billion ringgit. But the statistics may soon reverse, following Bank Negara Malaysia’s teaming up with the Securities Commission and Bursa Malaysia to build market infrastructure to facilitate commodity murabaha transactions to rival trades currently carried on the LME.
“The availability of sizeable funding on the tab is greatly preferred to raising funds through deposits in a sudden cash call. Our loan/deposit ratio is greater than one, meaning the funding on the loan is partly from borrowings. Thus, if we arrange funding through borrowing, with a medium-term note program, for example, we would need some lead time [before the proceeds could be settled], normally taking three days after the trade day at the minimum for large amounts,” he says. Bank Pembangunan is currently awaiting Bank Negara’s approval for admitting it as a participant in the Islamic interbank market.
Today Malaysia’s interbank market is the smaller part of the country’s dual banking system, where the majority of transactions are still conventional. Islamic deposits accounted for 19.3% of the country’s 1.13 trillion ringgit in total deposits as of November 2010. As Islamic law prohibits the giving or receiving of riba, or interest, interest-bearing features are often removed from Islamic money market instruments and replaced with either a profit rate, or a mark-up feature, Islamic academics say.
Interbank mudaraba is interbank lending and borrowing based on a negotiated profit-sharing ratio, which could be splits of 70:30 or 60:40 as determined by the two counterparties in a bilateral interbank trade. The rate of return is uncertain, however, as it is based on the borrower bank’s preceding month’s profit rate on a one-year investment. Islamic interbank market participants in Malaysia must declare their preceding month’s profit rate to Bank Negara Malaysia by the 15th day of every month – essentially creating an unknown in the formula when calculating the cost of funding for any bank willing to lend.
Because of this uncertainty, the lending bank will also be disincentivised to lend on any maturity that crosses the 15th day of the month since a new profit rate will be declared by the borrower bank, which becomes effective on the 16th day through to the 15th day of the following month.
“You won’t want to put more than one month [into a deficit bank using mudaraba] as this is risky, as you don’t know the bank’s following month rate of return. This means that under interbank mudaraba, a termed interbank market might not be developed quickly,” says Yazit Bin Yusuff, head of Islamic banking at OSK Investment Bank in Kuala Lumpur. On Bank Negara’s Islamic interbank money market website, a daily interbank mudaraba weighted-average rate is quoted only on the overnight tenor where the majority of the trades centre, and rarely on one-week.
Curve constraints
This shortcoming of interbank mudaraba has resulted in an inability to develop an interbank yield curve based on this structure, according to Norashikin Mohd Kassim, treasurer of Kuala-Lumpur-based Bank Islam, the country’s first Islamic bank, which was established in 1983 and is a pioneer of many Islamic money market and hedging instruments.
Amid expectation that commodity murabaha could increasingly replace mudaraba in the interbank market – and potentially expand outside of being just a money market tool to also back up other Islamic financial services such as trade finance and personal finance such as credit cards – Azzizi Ghazi, managing director of AbleaceRaakin in Kuala Lumpur, says in 2006 he and three other partners, including two palm-oil trading veterans, started providing a commodity murabaha broking service to Malaysian Islamic banks, or conventional banks that run an Islamic window.
AbleaceRaakin brokers commodity trades through its connection to the country’s crude palm oil suppliers and buyers in the real economy arena, as well as handling the encashment leg of the tawarruq transaction that dovetails every commodity murabaha interbank borrowing and lending in the financial arena.
Tawarruq, also called the reverse murabaha, is the leg in a commodity murabaha that enables that immediate cashing-out by the borrowing bank, which has promised to pay the lending bank a deferred payment (at a cost-plus) and appoints the same lending bank to on-sell the commodity on the spot market. In 2009 the Organization of Islamic Conference Fiqh Academy declared tawarruq impermissible, a ruling viewed by the industry as a potential blow to commodity murabaha.
Market participants still hold different interpretations regarding the exact reason behind OIC Fiqh Academy’s ruling. While the ruling resulted in commodity murabaha suffering significant reputational damage, brokers such as AbleaceRaakin are still actively signing up new clients to trade murabaha in the Middle East and Singapore since last year. In addition to counterparties needing approval from their own sharia advisers, Azzizi says all documentation, processes and trading systems are approved and endorsed by the broker’s Dubai-based sharia adviser, Amanie.
Azzizi says while AbleaceRaakin does not force its clients to take delivery of palm oil products that it trades on behalf of its clients, as a sharia-compliant broker his firm needs to stand ready to provide that physical delivery option if required. “Under murabaha we need to ensure that the commodity is there in existence, it can be delivered, bought and sold,” says Azzizi. “When we sell the commodity it’s up to banks to take delivery… thus far no physical delivery has happened in all the trades we have done for our clients.”
Azzizi says after the first leg of commodity trades that AbleaceRaakin has done on behalf of banks, it will help the banks to sell the palm oil products to buyers in the market. “At end of the day [banks] need assistance in squaring off the positions,” he says, but failed to provide further details. The on-selling is provided by AbleaceRaakin as part of its service to the banks.
In such a broker-arranged commodity murabaha trade, the two banking counterparties will usually have an interbank master agreement established between them – either the IIFM or the AIBIM. Azzizi says AbleaceRaakin will sign a separate master agreement unrelated to the interbank IIFM or AIBIM version. It comprises a trading agreement based on which his firm will conduct the palm oil transactions. It will sign only with the lending bank in most cases.
Raja TehMaimunah, global head of Islamic markets at Bursa Malaysia, says the reason why OIC Fiqh Academy prohibited the use of tawarruq is directly related to rogue trades whereby, in some extreme cases, there were trades carried out based on commodities that did not exist.
“The industry had suffered some reputational issues regarding rogue trades whereby commodities purchased for this purpose were either encumbered, ie, they cannot be freely dealt with, the same commodities were being sold to several parties simultaneously, or, in some cases, simply didn’t exist,” she says. That is why in August 2009 the Bursa collaborated with Bank Negara and the Securities Commission to establish an electronic, web-based, multi-currency commodity trading platform called Bursa Suq Al Sila, Arabic for ‘commodities market’.
“Instead of disallowing tawarruq we set some rules. No one has ever regulated commodity murabaha – what constitutes a proper commodity murabaha trade, what makes it invalid – this is exactly the rationale of setting up Bursa Suq Al Sila,” Raja Teh says.
Due to the tainted history of the tawarruq, Bursa Suq Al Sila conducts random sharia audits on all its supplier-members to ensure they are not short selling and they have the real physical commodity to sell to the banks. Commodity-supplying participant members are also subject to sharia audits as stipulated by exchange rules.
This distinguishes Bursa Suq Al Sila from other commodity exchanges, such as the LME, where financial institutions purchase warrants issued by brokers and Islamic compliance is subject to a financial institution’s own sharia audit. “Perhaps more importantly is the issue of risk, which is being mitigated as the exchange takes on the role of the counterparty,” adds Raja Teh. “Thus financial institutions take on the counterparty risks of the exchange as compared to taking on the credit risks of commodity brokers in a bilateral trade.”
Both physical and financial settlement is available through Bursa Suq Al Sila. While the Bursa does not operate a separate clearing house or warehouse/delivery point for the platform, in the case that the supplier fails to make a delivery and defaults on a trade, Bank Negara will provide the backstop by either procuring from other supplier-members, or making a cash settlement in lieu.
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