Given the historical weighting of Islamic finance to Islamic banks and their requirements, efficient liquidity management has been a necessary focus. The primary objective of the Islamic interbank market (IIM) is to meet the short-term (typically from overnight to 12 months) liquidity requirements of banks and financial institutions by enabling banks with a cash deficit to take funds from banks with surplus liquidity. These are essential activities that enable banks to comply with the liquidity stipulations set by their regulator.
An increasing number of central banks now provide Shariah compliant ‘lender of last resort’ facilities to eligible banks and financial institutions under their supervision in their respective jurisdictions. A variety of Shariah compliant instruments are employed to facilitate these liquidity management transactions, with the most frequently utilized contracts being commodity Murabahah, Tawarruq and Wakalah.
Although the IIM has been expanding across borders for more than 40 years, the global financial crisis undoubtedly reinforced the importance of its position within the enabling infrastructure of the wider Islamic financial marketplace. During the unprecedented challenge of that crisis, it represented principal recourse to liquidity for most Islamic banks and the operational inefficiencies that became apparent during that period that caused regulators, industry infrastructure organizations and market participants to reflect upon them and prioritize delivery of solutions.
Since then, those collaborative efforts have enabled the IIM to experience exponential growth as confidence returned to the global financial services sector and our industry footprint has grown. Such rapid growth also led to an increased focus on the requirements of participants within the IIM’s environment, culminating in the need for an increasing number of central banks to recognize the requirement to offer banks and financial institutions in their respective jurisdictions a Shariah compliant alternative to the conventional, short-term liquidity management facilities they typically extend to conventional sector banks. The Bank of England joined that group at the end of 2021, after a protracted development period, with the launch of its Alternative Liquidity Facility.
Review of 2022
Ensuring a diverse range of short-term liquidity products has, at times, been problematic for Islamic banks and, despite the development of various solutions, the sector lacked for some time the level of market organization and support that benefits the conventional global money market. The introduction of industry-targeted solutions by Islamic market industry infrastructure organizations has improved Islamic liquidity management and helped to boost capacity and scale.
Among them are the concerted efforts of the International Islamic Liquidity Management Corporation (IILM), an international organization that develops and issues short-term Shariah compliant financial instruments. The IILM is a regular issuer of short-term Ṣukuk across varying tenors and amounts to cater to the liquidity needs of institutions offering Islamic financial services.
Rated ‘A-1’ by S&P, the IILM has issued a total of US$84.19 billion across 181 short-term Sukuk issuances over the last eight years, reflecting the organization’s ability to provide high-quality Shariah compliant instruments and reliable offerings to primary dealers and investors, as well as offering stability to the global Islamic liquidity market. In the nine months to the end of September 2022, the IILM achieved cumulative issuances totaling US$430 million through 28 Sukuk series, with the current outstanding issuance size amounting to US$3.51 billion.
One constant in driving forward the enablement of the IIM has been the pioneering work undertaken by the International Islamic Financial Market (IIFM). The IIFM has innovated a series of documented standards to assist Islamic financial institutions accommodate a broad range of treasury and banking products and has also supported the development Shariah compliant solutions to keep our industry abreast of global market developments resulting from the cessation of the London Inter-Bank Offered Rate (LIBOR) and the market transition to risk-free reference rates (RFRs).
These standards have established a pathway for Islamic financial institutions to navigate the transition from historical, forward-looking LIBOR benchmarks to the new, retrospective RFRs required within the core IIM, treasury, capital markets and banking products. The transition to RFRs has continued during 2022 across the world’s major currencies, though further work remains to be done. For example, Sterling LIBOR is still in use for certain maturities that are due to roll off during the course of 2023.
Preview of 2023
Another positive and more recent development for the IIM, and one which has gathered great pace in the past 12 months and will continue to do so in response to globally adopted initiatives, is the ever-increasing focus on sustainable finance. ESG factors are of elevating importance within all areas of banking and finance, including the Islamic finance industry.
Banks and other financial institutions are looking at ways to embed these considerations across their culture, their operations and in their transactions and portfolios while regulators and central banks are beginning to codify ESG requirements to promote transparency and standardization.
While ESG factors are known to play a key role in generating long-term sustainable returns across all asset classes, the importance of ESG considerations in banking, including strategies for liquidity management and other treasury products, should not be precluded. The adoption of ESG considerations in IIM activity provides further opportunity to mitigate risk while effecting positive change.
For example, a significant percentage of contracts and instruments that support Islamic interbank and liquidity management requirements rely upon the purchase and sale of physical assets, particularly commodities. It is therefore of critical importance that the consideration of ESG-type factors is embodied within long-established approaches to Shariah review and validation of the contracts and the processes and procedures between parties that support their execution.
Review of such factors now will support the integration of sustainability-based values with our industry’s more traditional Shariah stipulations, social impact priorities and financial governance protocols. Credit rating agencies are increasingly incorporating ESG considerations into their analysis and, during the summer of 2022, both Climate Bonds and the International Capital Markets Association, both of whose guidelines and standards for green and sustainable bonds are referenced as benchmarks by issuers of Sukuk, introduced revisions.
These amended guidelines are designed to ensure that any assets that underlie the issuance of capital market instruments, including bonds and Sukuk, are subjected to the independent, sustainability-focused scrutiny already given to the deployment of proceeds. This has potentially very significant implications for our industry given that most of our relevant financial contracts depend upon the purchase and sale of assets.
Conclusion
Undoubtedly, recent years have witnessed significant positive development in the IIM notwithstanding the challenges presented by the COVID-19 global pandemic and the crisis in Ukraine that have impacted liquidity flows across the financial markets during the past two years. These have served again to reinforce the importance of the IIM to our industry sector and participants, where cross-border expansion, the ongoing evolution of innovative liquidity management products, cutting-edge technology applications to support them and associated engagement by financial regulators and relevant standard-setters have ensured that its future is extremely positive.
Stella Cox is the managing director of DDCAP Group. She can be contacted at [email protected]