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Hedge Fund Monthly
 

Islamic Liquidity and Secondary Markets

Eldred Buck, Managing Director
Eiger Trading Advisors
May 2011
 

Liquidity is defined as the ability of a bank to fund increases in its assets and to meet its obligations as they come due, without incurring unacceptable losses.

The raison d’ętre of a bank in an economy is in the role of maturity transformation of its short term deposits; which appear on the right hand side of its balance sheet, into long term loans; which appear on the left hand side of the balance sheet and to make a return for shareholders.

Therefore, any mismatch of this maturity transformation between assets and liabilities makes banks inherently vulnerable to liquidity risk — since banks by the very activity of ‘banking’ are able to leverage their assets in proportion to the liabilities; within regulated ratios of their capital, which completes the liability side of the balance sheet.

Furthermore, liquidity risk is driven from both an institution-specific or non systemic perspective, as well as from the market as a whole, that is, from systemic factors.

Management of this liquidity risk ensures a bank’s ability to meet its cash flow obligations, which are by their very nature, uncertain, since they are affected both by external events and other agents’ actions. Thus, liquidity risk management is of paramount importance because as was recently demonstrated in the financial crisis of 2008, a liquidity shortfall at a single institution can have huge system wide repercussions.

It is significant that the recent crisis was unique, in that severe financial problems emerged simultaneously in many different countries as a result of the increased interconnectedness of the global economy. In short, a run on a bank affects everyone.

The developments in global banking in the past two decades have increased the complexity of liquidity risk and its management enormously. The recent swathe of legislation from regulators and lawmakers around the globe have been designed primarily to reel in many of the excesses of the conventional banking system.

The global story of macro trends meet financial innovation, increased leverage, the changing forms of maturity transformation and the growth of the shadow banking system. The misplaced reliance on sophisticated mathematics and hardwired pro-cyclicality of ratings, triggers, margins and haircuts are all now being addressed.

In doing so, these new regulations have to a large extent, been an implicit endorsement of the probity of Islamic banking. This should therefore represent a green light for Islamic banking, but there remain two key issues; quality and quantity.

Liquidity is not just a function of the size of a market, but also the marketability of the instruments — in other words the quality, because it is quality that gives a secondary market its lifeblood.

As Islamic finance moves towards becoming a major part of the global interconnected financial system, and markets across jurisdictions inevitably become ever more interlinked, the issue of liquidity management becomes ever more pressing.

It has often times been repeated that the lack of a global Islamic interbank market and the concomitant liquidity management facility that this represents, has accordingly hamstrung the systemic development of Islamic finance.

Simplistically speaking, for a conventional bank, liquidity is managed through both access to interbank markets on the liability side of the balance sheet and is matched to the access of high quality, marketable securities, such as government debt and repurchase agreements on the asset side. Since the asset side of the balance sheet is the side responsible for a bank’s earnings, loan and asset quality are absolutely critical.

Quality

Date

Islamic Bonds

International Sukuk

Domestic

2003

4,282.00

1,350.00

2,932.00

2004

5,738.00

1,917.00

3,821.00

2005

7,594.00

2,521.00

5,073.00

2006

16,863.00

10,155.00

6,708.00

2007

31,002.00

15,904.00

15,098.00

2008

14,127.00

5,108.00

9,019.00

2009

20,151.00

8,390.00

11,761.00

2010

17,075.00

5,411.00

11,664.00

2011

4,553.00

500.00

4,053.00

If liquidity cannot be so readily managed in an interbank market, then what other tools and products exist? The answer offered is that it should be in Sukuk. However the reality is still some way behind where it needs to be.

The emergence of the Sukuk market from a total issuance of just US$4.28 billion in 2003 to US$17 billion in 2010, was fuelled by a desire of issuers to diversify their funding sources by the availability of Islamic and conventional money looking for investment alternatives, for their surplus liquidity. The expectation too, was that demand from Islamic investors would be driven by balance sheet requirements.

The reality is that up to 2008, it is estimated that 80% of Sukuk were held by non-Islamic investors. This has since fallen to around 60%, still a good proportion, but very concerning given the fall in gross issuance.

The market, as we all know, faltered in 2007 through to 2009 and Sukuk proved to be no less and no more liquid than some of the more exotic, though highly rated conventional bonds. What has happened since though is a cause for concern.

In the course of the restructuring and refinancing of Dubai International Group and others, Sukuk holders quickly learnt that their bonds were asset-based rather than asset-backed, with no security ring fence to protect them.

Sukuk Ratings

Ratings

US$ (million)

S&P/Moody’s

500

MARC

879

RAM

507

Unrated

20,716

The realization that this might apply to other Sukuk has been a harsh lesson for some investors and has accounted for a lack of liquidity in this product.

Looking ahead, greater reliance on the corporate credit story will need to prevail, and here we can identify a marker for part of the problem. The investors are looking for quality.

Notwithstanding the issue of the workout of the problems with the Sukuk market, going forward, what needs to be done to establish an efficient secondary market?

Of the US$22.5 billion equivalent issued in the first quarter of 2011, over 90% of Sukuk were not rated by anyone. One issue was rated by both Standard & Poor’s Ratings Services (S&P) and Moody’s Investors Service (Moody’s) and one issue was rated by Malaysian Rating Corporation (MARC) and RAM (RAM Rating Services).

Liquidity of any product relies on an active group of market makers, inevitably the lead arrangers willing to support not only the issuance of the instrument, but also a commitment to make a market in it throughout its life.

Perhaps the Sukuk market, though developing fast in certain jurisdictions, still lacks some of the track record and inherent ‘distance travelled’ that the conventional bond market has.

Furthermore of the 110 Sukuk that were issued in the first quarter of 2011, less than one third (29) show secondary market bid and ask prices which would be described as very wide for corresponding conventional maturities.

A great deal of this price inefficiency must be down to the fact that unless a security is individually researched, then without some form of rating, institutional investors and market makers simply do not have the baseline information with which to make an investment decision and to trade Sukuk in the secondary market.

Looking forward, there is no doubt that the huge infrastructure spending programs of Saudi Arabia, Qatar and Malaysia, estimated at over US$1 trillion over the next 10 years, should give an immense boost to the Sukuk market through increased issuance. Provided the misunderstandings concerning Sukuk structures have now been ironed out, the future of the Sukuk market both in terms of issuance and liquidity is sure to be both an interesting, and exciting market to be in.

 

 

Eldred is the principal manager of the Shariah compliant Eiger Coffee Green Fund. He drives the five strategic business units of Eiger trading including Islamic products; fund advisory and managed accounts; environmental, social and governance products; services, consultancy and investment advisory services and commodities trading.

 

This article first appeared in Islamic Finance News (27 April 2011, Vol 8, Issue 16, Page 20 - 21). For more information, please visit www.islamicfinancenews.com

 

 
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