Treasury

One of the biggest challenges facing the Islamic finance industry is related to the management of liquidity and risk. Islamic banks, in terms of liquidity, are facing issues of shortages and excessiveness similar to conventional banks. However, treasury departments of Islamic financial institutions (IFIs) have been able to deal with liquidity management through developing innovative products that are shariah-compliant.

With regard to the challenges arising from market risk, fixed and floating rate risk, currency exchange risk and so on, a variety of Shariah-compliant instruments have also been created to hedge them.

Liquidity Managment

Liquidity refers to how easy, quick and costly it is to convert an asset into cash. Islamic banks do face liquidity risk as they are limited by illiquid assets to meet their liquid liabilities and other obligations. However, their exposure to liquidity risk is less when compared to their conventional counterparts. Liquidity management comprises of two components: the actual management of liquidity and the mitigation of risk where one performs Shariah-compliant hedging.

 

Types of Arrangements

Commodity Murabaha

Murabaha is an arrangement involving a mark-up sale contract in which a commodity is purchased on the spot and sold on a cost-plus-profit margin, usually on a deferred payment basis.

In the case of Commodity Murabaha, the Islamic Financial Institution (IFI) buys a commodity and sells it to the commodity desks of an Islamic bank on a deferred payment basis, after adding its profit margin. The commodity desk then uses the commodity in its trading.

Once the Murabaha contract matures, the bank would pay the IFI the Murabaha selling price (cost plus profit margin).

This is applied in cases of both, excessive and shortage of liquidity issues.

Tawarruqt

A Tawarruq arrangement consists of two contracts: sales and purchase. The first contract involves the sale of a commodity to the purchaser on a deferred basis. Subsequently, the purchaser of the first sale will sell the same commodity to a third party via an on-the-spot cash basis.

The IFI buys a commodity and then sells it directly to an Islamic bank’s treasury department on a deferred payment basis after adding its profit margin. The treasure department sells the commodity to a third party on a cash and spot basis.

Once the Murabaha contract matures, the bank would pay the IFI the Murabaha selling price (cost plus profit margin).

Wakala

Wakala is the assigning of one party (agent) on behalf of another (principal), in a known and permissible dealing.

The Islamic bank is appointed as a Wakil (agent) by the IFI for a fixed fee. The surplus funds are deposited at the Islamic bank which is then invested in Shariah-compliant channels. The funds are only invested in those channels that generate the IFI’s expected return or higher.

Once the contract matures, the Islamic bank pays back the original investment and realised profit amounts to the IFI.

 

Risk Management

From the point of view of Islamic finance, hedging is the Shariah-compliant attempt to reduce the exposure of risk arising from financial transactions. Islamic derivatives hedge financial risks related to the underlying assets involved.

 

Types of Arrangements

Islamic Profit Rate Swap

It is an arrangement to exchange profit rate swaps between fixed and floating rate parties. It uses both, the Murabaha and Waad structures.

The parties issue an independent and unilateral undertaking (Waad) to enter into a Murabaha transaction on a certain date.

The parties also enter into Murabaha contracts to trade Shariah-compliant assets with each other on a spot-payment basis and immediate delivery.

A term Murabaha generates fixed payments (cost plus profit margin) and several reverse Murabaha contracts generate floating leg payments (cost price is fixed, profit margin is floating) in the Master Murabaha contract, which is fixed only on the day the Murabaha transaction is executed.

Following the execution of underlying transactions on the trade date, both parties will have their obligations set off.

Forward FX

It is an arrangement involving the exchange of currencies (Bai’ Al-Sarf) between two parties with the promise/undertaking (Waad) by one party to purchase the required currency against another currency on a predetermined date and at a specific exchange rate.

This structure helps Islamic banks in hedging its foreign currency rate exposure.

Spot FX

In this arrangement, two different currencies are exchanged against each other. The transaction should be executed on the spot and the currencies need to be simultaneously delivered to the parties.

If one or both of the currencies are deferred, the transaction is not Shariah-compliant.

Currency Exchange Swap (Waad Based

In this arrangement, a unilateral promise (Waad) is established between the parties involved in the swap.

Only one party can make a promise to buy or sell the currency in the future, otherwise the parties may incur a loss due to the fluctuating exchange rates of foreign currency.

Islamic Options

An option gives the holder the right to buy (call option) or sell (put option) certain assets in the future at a ‘locked-in’ price that is determined today.

An Islamic contract, known as the Bai’ Al-Urboon is used to structure the options. Urboun is referred to as the earnest money that gives the right to buy or sell based on the partial payment (Urboun) on the price of goods.

The seller will retain the Urboun amount in case the buyer decides to withdraw from the contract.

Profit is realised if the market price of the asset exceeds the ‘locked-in’ price.

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