Analysis of Islamic Liquidity Management instruments

Introduction
The development of Islamic finance suffers from the absence of an Islamic interbank market, which suffers
also from the lack of liquidity management tools. This does not necessarily imply that there are not
sufficiently developed. On the contrary, many initiatives have been done and the panel of liquidity
management instruments found in the bibliography is quite broad.
In fact, the Islamic finance structurers have developed many instruments based on almost all Islamic contracts,
such as Murabahah, Mudarabah, Musharakah, Wakalah, Wadiah, Qard Hassan, Rahn, Ijarah and Salam.
Taking into account the young age of Islamic finance, what it is done up today is significant.
The weaknesses of the majority developed and designed instruments themselves are the reason of the lack of
reliable and efficient liquidity management tools. These limitations are due mainly to the fact that the
development of these instruments has been primarily driven by one of the following reasons:
Sharia Compliance: some instruments, willing comply with the Sharia, find themselves disconnected from
economic reality and are hardly viable in practice.
Replication of conventional instruments: some instruments, willing to replicate conventional instruments,
are disconnected from the principles of Sharia and therefore condemned by the majority of Sharia Scholars.\

Methodology of analyzing liquidity Management Instruments

It is therefore important to establish first the criteria required for the development of an instrument of liquidity
management that is feasible, effective and Sharia compliant.
To do this, the following criteria are identified as being necessary for the development of Liquidity
Management Instruments (LMI noted below) reliable:
-

Structure: LMI should be a flexible and easy to structure.

Liquid & Secondary Market: an LMI should be exchangeable on the secondary market and
sufficiently liquid.

Risk: an LMI should not be very risky or safe, including credit (operational and legal).

Cost: an LMI should not generate high transaction costs.

Sharia compliance: an LMI should be Sharia compliant and, preferably, approved by the Scholars of
the four schools of Islamic jurisprudence.

Pricing: the price and the rate of return on an LMI should be easily measurable on the market.

Benchmark: the rate of return on an LMI should be compared to a reference rate or benchmark. The
existence of a benchmark for a given instrument facilitates the commercialization of the instrument.

Maturity: LMI must be able to be performed on all maturities ranging from the Overnight (O/N) to 1
year.

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Standardization: The existence of standards and framework contracts for LMI facilitates its
development and marketing. (as well as international development)

Vehicle of Monetary Policy: an LMI should be sufficiently widespread in the market to be an effective
vehicle of the monetary transmission issued by the Central Bank.

Review of the analyzed liquidity management instruments

In this section, the structure of a variety of available liquidity management instruments are detailed. These

instruments are based on almost all types of Islamic contracts, namely: Murabahah, Mudarabah, Musharakah,
Wakalah, Wadiah, Qard Hassan, Rahn, Ijarah and Salam. It is therefore possible to classify them under three
categories:

Trade-based contract instruments. (Ouqoud al-Mouawadat)

Partnership-based contract Instruments. (Ouqoud sharikat)

Charity-based contract Instruments. (Ouqoud at-Tabaru-at)
The definition that we will give to different instruments is taken from the interbank market. The main
actors are the Financial Institutions (noted FI) and the Central Bank (noted CB).
Moreover, these instruments could be seen from several angles, i.e.:

The placement of excess liquidity in a financial institution (FI) to the Central Bank (CB).

Alternatively, the refinancing of a financial institution (FI) in lack of liquidity by the Central Bank
(CB).

So, some are schematized as a placement (an investment) (FI -> CB), others are schematized as a perspective
refinancing (CB ->FI). Finally, these structures are considered in both directions or between two (FI)
financial institutions.

2.1 Trade-based contract instruments

2.1.1 Commodity Murabahah (CM)
The Commodity Murabahah is one of the most popular short-term funding instruments that are practiced in
the interbank markets. It represents an alternative to government bonds or Treasury Bills, and is widely
adopted and accepted. However, certain Sharia Scholars have some reservations about the compliance of this
instrument to the Sharia. The Commodity Murabahah is a contract in which there is a purchase of goods for
cash followed by a sale at a future price to a third party, in order to invest the liquidity excess.
On an interbank market, the Commodity Murabahah could be used by a financial institution (FI) to invest
their excess liquidity with the Central Bank. In this form of deposit, the Commodity Murabahah is
summarized in these three transactions:
1. The FI purchases from the market (for instance LME: London Metal Exchange), through a broker, a
commodity with cash price P.
2. The FI sells then the commodity to CB at a price P + margin with a deferred payment (Murabahah).
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3. The CB sells also the commodity on the market through a broker with a cash price P.

Commodity Broker

1
2

Central Bank (CB)

Financial Institution (FI)

Commodity Flow

Cash Flow

Figure 1 : Commodity Murabahah (CM) structure

2.1.2 Tawarruq (TWQ)

The Tawarruq is also one of the most popular short-term financing instruments that are practiced on the
interbank markets. This instrument is widely adopted in the countries of Southeast Asia but is not accepted by
the majority of Sharia Scholars.
The Tawarruq is a contract whereby it is buying a commodity at a future price with a Murabahah contract
followed by a sale of this merchandise for cash to a third party in order to obtain liquidity.
Tawarruq could be seen as a hedging instrument of Commodity Murabahah. Indeed, in the Commodity
Murabahah, sale of the commodity is a real and an actual sale that cannot be undone or halted as it can be
done in a simple conventional interbank deposit. So to resolve this position, the bank may appeal to Tawarruq
(Reverse Commodity Murabahah) which consists of three transactions:
1.

At the request of the FI, the CB purchases from the market (for instance LME), through a broker, a
commodity at a cash price P.

2.

The CB then sells the commodity to the FI at the price P + margin with a deferred payment
(Murabahah).

3. FI sells then this commodity on the market through a broker at a cash price P.
Commodity Broker

1
2

Central Bank (CB)

Commodity Flow

Financial Institution (FI)

Cash Flow

Figure 2: Tawarruq (TWQ) structure

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2.1.3 Sell and Buy Back Agreement (SBBA)

The Sell and Buy Back Agreement or Bai al-Inah is a variant of Sharia-compliant repo*. This instrument is
mainly used in interbank Malaysia but is not accepted by the Sharia Scholars from other countries including
the Gulf.
The SBBA is a contract whereby there is an outright purchase and sale of an asset between the same two
actors with a deferred payment to allow one of them to obtain liquidity. In the same way, the so-called reverse
SBBA involves deferred purchasing and cash sale of an asset between the same two actors. The difference
between this structure and the structure of Tawarruq is the existence of a third party for the purchase or sale in
the Tawarruq.
In the interbank market, the SBBA could be summed up as follows:
1. FI sells assets to CB at the cash price P.
2. Later, the FI buys (or promises to buy back) the same assets from the CB (who promised to sell) at
price P + Margin with deferred payment (Murabahah).1

Central Bank (CB)

Financial Institution (FI)

Commodity Flow

Cash Flow

Figure 3: Sell and Buy Back Agreement (SBBA) structure

2.1.4 I'aadat Al Shira (IAAS)

I'aadat Al Shira (IAAS) is an instrument that was developed by the International Islamic Financial Market
(IIFM) as an alternative to Repo. The Islamic Repo*1 (SBBA) (previously explained) developed and practiced
in Asia is not Sharia Compliant according to many Sharia Scholars in the Middle East. It is therefore useful
and recommended to find another alternative Sharia Compliant. The IAAS, which means buying back
(repurchase), is a kind of tripartite repo structured as follows:

1
*Refinancing operations are different techniques, the most important in the interbank market is conventional take or
reverse debt know as Repo (Repurchase Agreement). For such operations, the Central Bank refinances the banking
system (repo), or possibly reduced this funding (sale of receivables) and thus influence on short-term rates.

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1. FI sells securities S at a cash price P to a Broker.

2. The broker sells the securities S at a cash price P to CB.
3. FI promises to repurchase (Wa'ad) from CB, at a future date, securities S or equivalent securities at a
price plus P + Margin. CB is free to sell the securities S to another Financial Institution or to another
broker.

Commodity Broker
1

2
3

Central Bank (CB)

Financial Institution (FI)

Commodity Flow

Cash Flow

Figure 4: I'aadat Al Shira (IAAS) structure

2.1.5 Bai Al Wafa (BAW)

Bai Al Wafa is an instrument similar to the two previous instruments (SBBA & IAAS) and which represents
an Islamic alternative to Repo. However, it is highly contested by most Sharia Scholars for the second sale of
this operation which is not at the market price. This contract is a combination of a sale of an asset at a price P,
and a promise of repurchase and the repurchase of that asset after a period defined in the same sale price P.
This instrument is very close to the conventional Repo.
The only exception is that in the BAW, resale price must be equal to the purchase price and implies a real
transfer of ownership of the sold assets.
In the interbank market, the instrument could be structured as follows:
1- FI sells securities S at a cash price P to CB.
2- FI promises to repurchase S from the BC at the end at the same selling price P.
3- At maturity, CB resells the securities at a price P.

Central Bank (CB)

Financial Institution (FI)

3
Securities Flow

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Cash Flow

Figure 5: Bai Al Wafa (BAW) structure

Therefore, in this instrument, there is no margin between the price of the first and second sale.
However, given that the repurchase does not happen at the market prices, this operation is either in favor of
the Central Bank (if the market price of Securities S traded is less than the selling price P) or in favor of the
Financial Institution (if the market price of Securities S traded is higher than the selling price P). All depends
on the direction of the promise.

2.1.6 Sukuk Al-Salam (SA)

Sukuk Al-Salam was introduced on the market in 2001 by the Central Bank of Bahrain (CBB) as an instrument
for liquidity management. It was a great success thanks to the issuance program established by the
Government of Bahrain. Indeed, the CBB issues on a regular basis, a well-defined volume of Sukuk Al-Salam
with a maturity equal to 91 days. Sukuk Al-Salam is based on a contract whereby there is a purchase of a
commodity at a price made in cash against delivery of the goods in the future.
Sukuk Al-Salam could be summarized as follows:
0. The CB sets the commodity that will be the subject of the contract Salam.
1.

FI buys Sukuk Al-Salam from the SPV for a nominal amount equal to P. Hence, FI becomes the
owner of a right in the assets of the SPV.

2.

The SPV pays cash (price P) commodity, which will be delivered in the future by CB.

3.

At maturity, the CB delivers commodity to the SPV.

4. In another contract (parallel Salam contract), the CB buys commodity at price P + Margin.
5.

The SPV shall refund the FI the nominal increased by the margin.

Central Bank (CB)

1
Financial Institution (FI)
SPV

Sukuk Salam

Cash Flow

Commodity Flow

Figure 6: Sukuk Al-Salam (SA)structure

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2.1.7 Sukuk Al-Ijarah (SI)

As Sukuk Al-Salam, Sukuk Al-Ijarah has been introduced by the Central Bank of Bahrain (CBB) in the
market as an instrument for liquidity management in 2005. This experience of Sukuk of short maturity (six
months) issued regularly by the CBB has been followed by Central Bank of Malaysia (BNM). It has started
issuing Sukuk Al-Ijarah regularly in the interbank market since 2006. In both cases, asset-pool that represents
the underlying Sukuk is the property of states.
Sukuk Al-Ijarah is Ijarah-based, which is a contract (between two parties, the lessor and the lessee), where the
lessee benefits from a specific service against a specified consideration or rent from the asset owned by the
lessor. Eventually, the lessee has the option to acquire the asset.
Sukuk Al-Ijarah could be summarized as follows:
1. CB sells a pool of assets at a price P to the SPV.
2. FI buys Sukuk Al-Ijarah from the SPV for a nominal price P.
3. The SPV leases the pool of assets acquired to the CB against a regular rent paid to the FI.
4. At maturity, CB buys the asset pool from the SPV at a price P.
5. The SPV reimburses FI the amount of the principal P.

Central Bank (CB)

Sukuk Ijarah

SPV

Financial Institution (FI)

Cash Flow

Asset Flow

Figure 7: Sukuk Al-Ijarah (SI) structure

NB: There is an instrument called Mutajarah mainly practiced in Saudi Arabia, where the financial institution,
deposits to SAMA (Central bank of Saudi Arabia) its liquidity excess. This deposits acts as a portfolio of State
Sukuk and thus produces the same return as the Sukuk. Partnership-based contract instruments

2.1.8 Mudarabah-based Interbank Investment (MDB)

The Mudarabah based interbank Investment also noted Il-Mudarabah is an instrument of liquidity
management that is highly developed in Sudan. This instrument has the approval of all Sharia Scholars.
The Il-Mudarabah is a contract between a financial institution (FI) in need of liquidity (Mudarib) and the
Central Bank (CB) or another financial institution (FI) in excess liquidity (Rab-ul-Mal). Both parties agrees
within a contract of Mudarabah on a pool of investments and a well defined ratio of profit sharing for a period
from the overnight (O/N) to 12 months. The ratio of profit sharing is negotiable between both parties. There is
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a range of techniques to evaluate the rate of return used in this type of instrument. The most common method
is to calculate the rate based on the rate of gross profit of an investment in one year by the Financial
Institution Mudarib. Furthermore, as in any Mudarabah contract, the Financial Institution Rab al-Mal bears
alone the loss risk of the principal, except in case of negligence or fault on the of management of Mudarib.

2.1.9 Musharakah-based Interbank Investment (MSK)

The Musharakah based interbank investment also noted Il-Musharakah is also a liquidity management
instrument. It is very similar to the II-Mudarabah. It is also very developed in Sudan through a program of
regular issuance supported by the State and accepted by the majority of Sharia Scholars.
Specifically, the Financial Institution isolates an asset pool or an investment pool, under the Musharakah
contract, which will also serve to calculate the rate of return. The Central Bank, by providing capital becomes
partner of the Financial Institution on this investment pool. Profits will be shared between two parties on a
predetermined ratio. Losses will be beared proportionally of capital invested of each party in the joint venture.
The II-Mudarabah and Il-Musharakah could be diagrammed as follows:
0. FI isolates an asset pool covered by the contract Mudarabah or Musharakah.
1. The CB provides an amount P to the FI, which will invest it according to a predefined profit sharing
ratio.
2. At maturity, the FI reimburses the CB the principal P + its share of the generated profit
2

Central Bank (CB)

Financial Institution (FI)

Investment pool

Cash Flow

Figure 8: Musharakah-based Interbank Investment (MSK) structure

2.2 Charity-based contract instruments

2.2.1 Wadiah Acceptance (WA)
The Wadiah Acceptance is a tool that facilitates the liquidity management in the Islamic interbank
market. This instrument is widely endorsed by the Sharia Scholars and is mainly practiced /in the Malaysian
Islamic interbank market with BNM (Bank Negara Malaysia).
In general, the Wadiah is a custody (escrow) agreement by which an applicant deposits its money, valuables
or assets in an escrow agent who shall retain and shall return later. With the permission of the depositor, the
escrow agent may invest the money deposited, but it has no obligation to share any profits with the applicant.

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However, the escrow agent may choose to pay dividends to the applicant as a gift (Hibah).
On the interbank market, the Wadiah Acceptance is characterized by two operations between the Financial
Institution (FI) and the Central Bank (CB):
1. FI deposits its excess cash (P) in an account Wadiah at the Central Bank (CB).
2. At maturity, BC gives back the principal P to the FI.
3. BC is free to pay dividends or not (as Hibah) to the FI.
2

Financial Institution (FI)

Central Bank (CB)

1
Cash Flow

Hiba

Figure 9: Wadiah Acceptance (WA) structure

NB: In the same way, there is an instrument known as: The Wakalah Deposit. It is an instrument based on
Wakalah contract, which is used for depositing a fixed or a variable return but within a threshold. On the
interbank market, the Wakalah Deposit is characterized by two transactions between two financial institutions:
1- FI1 deposits its excess liquidity P in a Wakalah Deposit account in the FI2. As a Wakeel the latter is
committed to the former to generate a target return TR (often in line with the interbank market rate).
2- At maturity, the FI2 pays the FI1 the first amount P plus the main target return (Target Return: TR).
Any surplus or deficit of the performance in relation with TR goes back to FI2.

2.2.2 Qard Hassan (QH)

The Qard Hassan is very similar to Wadiah Acceptance. It has been practiced in the interbank market
until 1993 as a Malaysian alternative instrument of Treasury bills. It is widely accepted and widely
recommended by the Sharia Scholars around the world.
The Qard Hassan is a loan whereby the borrower pays exactly the same amount of money borrowed.
However, the borrower could choose to repay the principal plus a margin (as Hibah) from the moment it is not
stipulated in the contract. Unlike Wadiah Acceptance which represents a deposit of money, Qard Hassan is
an interest free loan. On the interbank market, the Qard Hassan is characterized by two transactions between
the Financial Institution and the Central Bank:
1. The FI lend the amount P to the Central Bank (CB).
2. At maturity, BC repay the principal amount P to the FI.
3. The CB is free to pay or not a margin to the FI as Hibah.
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3
2

Financial Institution (FI)

Central Bank (CB)

1
Cash Flow

Hiba

Figure 10: Qard Hassan (QH) structure

NB: It is useful to note the existence of an instrument called Exchange of Deposit, which is often used, by the
Islamic banks to manage their currency risk or the management of their need for liquidity in foreign
currencies. This instrument is based on a double Qard Hassan in two different currencies.

2.2.3 Rahn Agreement (RA) (collateral loan or Covered deposit)

The Rahn, often known as a hedge against the risk of counterparty default, could be used as an instrument for
liquidity management (like a conventional interest free loan with collateral). In fact, we find this instrument
(Rahn Agreement), among others, in the interbank market Malaysian and it is widely supported by a variety of
Sharia Scholars.
The Rahn is an arrangement that involves the development of a collateral pool of valuable assets value in
return for a loan. Thus, the amount borrowed must be equal to the value of collateral. The latter could be
transferred to the lender in case of default.
In that case (case of default), the creditor is allowed to sell the collateral in order to be reimbursed for the
principal.

The

potential

surplus

generated

by

this

sale

must

be

repaid

to

the

borrower.

As an interbank market liquidity management tool, the Rahn Agreement is simply a Qard Hassan
collateralized and it may be summarized as follows:
1- The CB lends an amount P to the FI.
2- The FI provides a set of securities with a value equal to P as collateral loan granted by the BC.
3- At maturity, the FI reimburses BC the principal amount P and recovers its securities.
4- In case of default of the FI, CB has the right to acquire ownership of the securities comprising the
collateral. It also has the right to sell these assets to reimburse its principal P.

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3
Financial institution (FI)

Central Bank (CB)

2
Securities

4
Cash Flow

Securities

Figure 10: Rahn Agreement (RA) structure

3 Liquidity management instruments Analysis

The description of different structures and instruments of liquidity management that we found in the
bibliography, leads to a qualitative analysis of these instruments based on different criteria identified in the
first paragraph of this article.

3.1 Commodity Murabahah (CM) & Tawarruq (TWQ)

-

Structure: Apart from the multitude of actors needed to perform these operations (different brokers);
these instruments are relatively easy to structure but heavy in practice.

Liquidity & Secondary market: These instruments cannot be tradable on the secondary market. They
are not liquid.

Risk: These instruments are primarily exposed to the market risk (volatility of the commodity) and to
a lesser extent the counterparty risk.

Cost: These instruments can generate high transaction costs, which are reflected in their prices.

Sharia-compliance: These instruments are disputed by most Sharia Scholars (with a lesser degree, the
Commodity Murabahah). Indeed, these instruments do not contribute to any development or any
economic growth (One of main Islamic Finance targets).

Pricing: The price of the traded commodity and the margin is set by the market.

Benchmark: the margin is often calculated based on LIBOR. This facilitates the evaluation of prices
of these instruments.

Maturity: these instruments cannot be exchanged for maturities lesser than 7 days due to heavy
operational treatments. They are not valuable for short-term interbank investments (e.g. Y / N).

Standardization: these instruments are standardized. In addition, the IIFM (International Islamic
Finance Market) is working on the development of contracts under Commodity Murabahah for
(Murabahah Master Agreement).

Monetary Policy Vehicles: These instruments are relatively well spread on the interbank markets. The
Central Bank may impose monetary policy so that influences the margin rate charged

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The Commodity Murabahah and Tawarruq are effective tools because they are easy to
structure and they respond more or less to the investment needs of excess liquidity and the refinancing
of Financial Institutions. The simplicity of structuring these instruments comes basically from the
dynamic commodity market and the use of LIBOR as a benchmark. Therefore, evaluating prices and
profit margins of these instruments are easy to do. This makes them even more efficient in the
transmission of central Bank monetary policy. In addition, standardization is another advantage for
these instruments.
However, the multitude of actors (different brokers) necessary for these operations, the
various intermediate operations and the related costs (such as brokerage fees, transportation costs and
storage of commodities) constitute a real handicap to these instruments. The major obstacle remains
in the opinion of Scholars related to the Sharia compliance of these instruments. The majority of the
Sharia Scholars agree that these instruments are unavoidable" for Islamic finance but they must be
regarded as instruments of last resort.

3.2 Sell and Buy Back Agreement (SBBA), Iaadat al Shiraa (IAAS) & Bai Al Wafa
(BAW)
-

Structure: These instruments are very similar to conventional Repo, and are very easy to structure
compared to previous instruments.

Liquidity & Secondary market: These instruments are debt securities; they cannot be tradable on the
secondary market. They are therefore illiquid.

Risk: these instruments are exposed to a counterparty risk.

Cost: From their simplicity these instruments require very low transaction costs.

Sharia-compliance: These instruments are rejected by the majority of Sharia Scholars (with a lesser
extent for the IAAS). Indeed, in the three instruments, the sale of securities is not the ultimate intention
of the contract but rather a ruse to circumvent the Riba.

Pricing: For SBBA and IAAS, the profit margin could be calculated on LIBOR basis. Thus, the three
instruments pricing is simple.

Benchmark: The margin is often calculated on LIBOR basis. This facilitates the evaluation of prices
of these instruments (SBBA and IAAS).

Maturity: These instruments span the range of all possible maturities in the interbank market (from the
O/N to 1 year).

Standardization: Since there are similarities with respect to the conventional Repo, the standardization
of these instruments is very doable. The IIFM is also currently working on developing a contract
framework for the IAAS.

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Monetary Policy Vehicles: These instruments could be very good transmission mechanisms of the
Central Bank monetary policy.

These instruments of what is called Islamic Repo" are very attractive on several levels: structuring easy, low
transaction costs, Monetary efficiency, possible standardization of contracts, existence of benchmark, and the
price & the profit margin are easily calculated. They also promote a dynamic interbank market because these
instruments do not require the intervention of the Central Bank.
In addition, since there are many similarities with the conventional Repo, these operations may be performed
between an Islamic financial institution and a conventional financial institution. Thus, they disadvantage any
segmentation of mixed interbank markets.
To conclude, these instruments have all the good qualities required for an instrument of liquidity management.
However, and unfortunately for Islamic finance, these instruments are not accepted by the majority of Sharia
Scholars since according to them, these instruments represents a ruse to circumvent the Riba and they do not
generate any economic activity.

3.3 Sukuk Al-Salam (SS) & Sukuk Al-Ijarah (SI)

-

Structure: like all Sukuk, these instruments are not easily structured.

Liquidity & Secondary Market: Sukuk Al-Salam is not tradable on the secondary market because it is
a debt instrument. Therefore, it is not liquid. On the other hand, Sukuk Al-Ijarah is a perfect
instrument exchangeable on the secondary market, which gives it a liquid quality.

Risk: Sukuk Al-Salam is exposed to market and counterparty risks. Sukuk Al-Ijarah is, meanwhile,
exposed only to counterparty risk but with a lesser extent because of the existence of the underlying
asset representing a collateral. The possession of the underlying asset, gives Sukuk Al-Ijarah an
additional risk which is the risk of ownership (Liability Risk). Therefore, the risk is the potential loss
of the asset.

Cost: Sukuk Al-Salam is less costly than Commodity Murabahah transaction through the securitization
and the long maturity (amortized cost).
Sukuk Al-Ijarah does not generate high transaction costs, but could lead to maintenance costs of the
underlying assets.

Sharia-Compliance: Sukuk Al-Salam is a debt instrument that is not accepted by all the Scholars. It is,
however, less challenged compared to the Commodity Murabahah because of its relatively long
maturity. Nevertheless, Sukuk Al-Ijarah is much more accepted as the remuneration of the investor
and is a direct result of the performance of the underlying asset.

Pricing: For Sukuk Al-Salam, the return and the price are easy to identify. However, they are a little
more difficult to calculate for Sukuk Al-Ijarah.

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Benchmark: LIBOR could serve as benchmark for calculating the profit of Sukuk Al-Salam and the
profitability of the pool of underlying assets of the Sukuk Al-Ijarah.

Maturity: These instruments have long enough maturities for the interbank market (from 3 months for
Sukuk Al-Salam and 6/12 months for Sukuk Al-Ijarah). They are not efficient for very short-term
interbank investments.

Standardization: These instruments are not standardized.

Monetary Policy Vehicles: These instruments can be mechanisms of monetary transmission because
of their relatively long maturities.
Comparing to Commodity Murabahah or Tawarruq, Sukuk Al-Salam could be considered as an
alternative more Sharia Compliant. They are usually used, for long maturities (Sharia requirement),
thus they are less attractive than those on the interbank market. However, financially the Commodity
Murabahah

and

Tawarruq

are

much

more

attractive

than

Sukuk

Al-Salam.

Sukuk Al-Ijarah is a useful instrument since it is readily tradable on the secondary market and it is
Sharia Compliant. On one hand, the strengths that make this instrument attractive to investors are:
First the affiliation to a pool of underlying assets represents good collateral. Second, the remuneration
arises directly from this asset pool.
On the other hand, the major weaknesses of this instrument are the difficulty of identifying a pool of
underlying assets generating a good return (performance) equivalent to market rates and the long
maturity for an interbank market.

3.4 II-Mudarabah (MDB) & II-Musharakah (MSK)

-

Structure: The structure of these instruments is not simple due to the difficulty of building an asset or
investment pool (subject Musharakah or Mudarabah).

Liquidity & Secondary market: These instruments are fully tradable on the secondary market. They
are thus liquid. Besides, the Central Bank is eligible to repurchase these instruments, which makes
them more liquid.

Risk: These instruments are risky since they are participatory tools, which by definition require no
collateral, and the investor should assume the risk of losing all or a part of the principal. This risk
depends obviously on the issuer of such instruments. Moreover, depending on the underlying-asset
pool, the holder of these instruments could be exposed also to market risk.

Cost: These instruments generate low transaction costs. However, Il-Mudarabah requires
management costs of Mudarib.

Sharia-compliance: These instruments, as any participatory contract based instrument, are strongly
encouraged and recommended by most Sharia Scholars.

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Pricing: Generally, calculating the return of the underlying assets is ex post, which makes the
determination of the performance of these instruments difficult to upstream.

Benchmark: Since the rate of return depends on the performance of underlying assets, it is difficult to
find a benchmark for these instruments.

Maturity: These instruments exist for very short maturities.

Standardization: these instruments are not standardized.

Monetary Policy Vehicles: Although these instruments have a high potential for commercialization in
the market, they are poor signals of monetary transmission mechanisms. This is because the rate of
return is calculated ex-post.

The II-Mudarabah and II-Musharakah instruments are very attractive in terms of compliance with Sharia.
They perfectly convey Islamic finance principles in terms of participation and PLS (Profit & Loss
Sharing).
Their structure is also interesting since the securities traded against cash are shares of asset pool
(consisted of projects, investments or shares in companies). In addition, the opportunity of exchange or
trade on secondary market for very short maturities (even the O/N) makes them more liquid. Besides,
compared to Tawarruq, Commodity Murabahah and Sukuk, they require the minimal costs and fees.
However, there are many reasons that make these instruments not yet fully spread on the interbank
markets. First, they are exposed to default risk. Second, there is a challenge to build an asset pool (of
investments or projects). Third, it is difficult to evaluate the rate of return on these assets ex-ante. Finally,
if the issuer of these certificates is the Central Bank or the State (as is the case in Sudan with CMC and
GICs), it is difficult for an investor to assume that these issuers can generate profits because they first are
not intended to do it, moreover because they obviously may go into debt to help monetary policy and save
the financial and economic system (for example in case of crisis).
For instance, in Sudan, the solution to such a problem is the establishment of a special fund made up
from share of the State and the Central Bank shares in banks. Such a fund will have an identifiable value
and return. This solution may not be exportable to countries where banks are 100% privatized.

3.5 Wadiah Acceptance (WA), Qard Hassan (QH) & Rahn Agreement (RA)
-

Structure: all these three instruments are easy to structure.

Liquidity & Secondary market: These instruments are debt securities, they cannot be tradable on the
secondary market, and they are therefore illiquid.

Risk: These instruments are only exposed to a counterparty risk with a greater exposure to Wadiah
Acceptance and Qard Hassan.

Cost: These instruments require very little and even no transaction fees.

Sharia-Compliance: These instruments are very encouraged by Sharia Scholars.

Pricing: These instruments do not require calculation of rates of return or profit, except Wadiah
Acceptance that could pay dividends.

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Benchmark: LIBOR could serve as a benchmark for the calculation of Wadiah Acceptance dividends.
For other instruments, there is no need to a benchmark.

Maturity: these instruments span the wide range of possible maturities in the interbank market (from
the O/N to 1 year).

Standardization: These instruments are interest-free loans. They thus are obviously standardized.

Monetary Policy Vehicles: By their nature, these instruments cannot be used by the Central Bank to
influence the rate of return.
These instruments, while highly recommended by the Sharia Scholars, are limited and practiced
exceptionally. Indeed, the conventional and Islamic financial institutions are hard-pressed to make
maximum profits due to the economic situation, financial issues and the reality of the highly
competitive global financial market.
Such instruments, that normally do not generate any profit and their counterparty risks are not covered
(except Rahn Agreement), are not possible in an interbank market. However, they remain possible
between Islamic Financial Institutions and Central Bank as a LOLR (lender of last resort) in a 100%
Islamic financial system. (Otherwise, it would create inequalities between Islamic banks and
conventional banks).

3.6 Summary Table

CM

TWQ

SBBA

IAAS

BAW

SS

SI

MDB

MSK

WA

QH

RA

Structuring

Liquidity & Secondary market

Risk

Cost

Sharia-Compliance

Pricing

Benchmark

Maturity

Standardization

Monetary Policy Vehicles

J Good

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K Neutral

L Bad

4 Reflections
The study and the analysis of various instruments of liquidity management lead us to suggest some thoughts
and ideas to organize the Islamic interbank market and to structure new instruments.

4.1 Interbank Takaful

We can be inspired by Takaful model to establish an Islamic interbank market model. Indeed, in the Takaful
based on Wakalah model, all policyholders are also members of the Takaful Fund, composed by their
contributions. The Takaful operator provides a guarantee to the Takaful Fund in case of financial problems
and as a Wakeel, he manages the fund (investing in Sharia-compliant investments, provides compensation to
policyholders in disasters...).
Applied to an interbank market, this model will be as explained below:
The Islamic banks, (via contributions\participations), will form an interbank Fund. On one hand, this
fund is a source of refinancing for banks in lack of liquidity and on the other hand, is an investment
vehicle for banks in excess liquidity.
The Interbank Fund will be managed by the Central Bank through a Wakalah contract. The CB (Central
Bank) will have a dual role in this scheme:

It is the guarantor of the Fund by providing the required resources in case of liquidity problem, as
Qard Hassan;

As a Wakeel, it invests a part of the fund in Sharia-compliant investments for a relatively short
time (e.g. 3 months); we will call it period.

Each time the bank requests the Interbank Fund for a refinancing, it will have a penalty. Conversely, a
bank that does not solicit funds during the period will have a bonus.
At the end of each period, the Central Bank distributes the profits generated by its investments to the
shareholder banks in a ratio proportionate to their holdings in the Fund. These dividends will be
reduced or increased by respectively any penalty or bonus.
This model is inspired by Takaful model based on Wakalah and not the one based on Mudarabah, because
according to the Sharia scholars the Wakeel could guarantee the Takaful Fund, (while the Mudarib couldnt
guarantee it).
Moreover, this model could be considered as a combination of these instruments: Wadiah Acceptance, Qard
Hassan and II-Mudarabah that we have seen earlier.

4.2 Securities Swap and Buy Back (SSBB)

This instrument is intended to be an alternative as a Sharia-compliant Securities Lending & Borrowing
(SLAB),

and

could

therefore

serve

as

an

instrument

for

liquidity

management.

One could imagine the operation where two financial institutions realize barter or swap titles followed by two
unilateral sale promises of their titles.
This instrument could be schematized as follows:
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1- IF1 (in lack of liquidity) and IF2 (excess liquidity) exchange (with transfer of ownership) securities
S1 and S2. Since IF2 does a service to IF1, it may require the application of a Haircut, i.e. that the S2
value is equal to 90% of the S1 one. Thus, at the end of this operation, the IF1 is in possession of
securities S2 (with a value of 0.9P) and IF2 is in possession of securities S1 (with a value of P).
2- This exchange is followed by a double sale promises (Wa'ad):
The IF1 promises to sell the securities S2 to IF2 at price P to a date d1.
b. The IF2 promises to sell the securities S1 to IF1 at a price P to a date d2.
Sales Agreement of S2
Financial Institution 1

Financial Institution 2

FI1

FI2
Sales Agreement of S1

3 - At the date d1, the IF1 sells securities S2 to IF2 at price P. It has then the liquidity needed. In return, the
IF2 has S1 shares as collateral.
Financial Institution 1
FI1

Securities S2

Financial Institution 2
FI2

Cash=P

4 At the date d2, the IF2 sells securities S1 to IF1 at price P.

Financial Institution 1
FI1

Cash=P

Financial Institution 2

Securities S1

FI2

The idea of this instrument comes from the fact that financial securities are not usurious products (see Hadith2
about 6 usurious products). They can then be exchanged freely, i.e. without requiring the trade of equal
quantities or simultaneous exchange. In addition, this instrument should be based on the Wa'ad. In this case, a
binding force is required for financial institutions to be sure of the fulfillment of their promises even if heldsecurity prices vary against them.
That said, the use of Wa'ad in Islamic finance is still limited because there still no consensus (Ijmah) yet on its
licitness (Sharia compliance).

2
The six commodities Hadith was narrated by Abu Said al-Khudri on the authority of the prophet:
Gold is to be paid for by gold, silver by silver, wheat by wheat, barley by barley, dates by dates, salt by salt, like by like, payment being made hand to
hand. He who made an addition to it, or asked of an addition, in fact dealt in usury. The receiver and the giver are equally guilty. (Muslim, no date, V.
III: 834).

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4.3 Interbank Accounts PSIA

As we have seen earlier, one difficulty of the instrument Il-Mudarabah is to determine the asset or investment
pool that will serve as the underlying Mudarabah contract.
To facilitate this task and to make such transactions easier to structure, one could imagine that each financial
institution has a PSIA account in other financial institutions with which it deals. These PSIA accounts will be
restricted to a number of loan portfolios that generate regular and stable cash flows. This could be an
alternative for Murabahah portfolio that can be used as underlying assets of Sukuk (Bai Al Dan).

5 Conclusion
By the development and the internationalization of Islamic finance, liquidity management has become a true
challenge for these three main reasons:
a. Lack of liquidity management instruments.
b. The near absence of Islamic interbank market dynamics.
c. The lack of Lender of Last Resort (LOLR).
The reasons b) and c) are closely related to lack of Sharia Compliant, simple and effective liquidity
management

instruments.

This article showed that the panel of Islamic liquidity management instruments is quite broad.
However, these instruments are, in most cases, ineffective. Indeed, qualitative analysis performed in the first
section of the article shows that we could not have an instrument that meets all the criteria we defined first.
Some are easy to structure and were accepted by the majority of Sharia Scholars, but they generate little or no
return. Other systems provide good returns, are low risk but are difficult to structure and are disputed by many
of the Scholars. Other tools provide good returns, are less risky but are difficult to structure and are not
accepted by many of Sharia scholars. Others are fully Sharia-compliant, generate high return but are risky and
difficult to structure.
Finally, no instrument has been efficiently replicating the characteristics of the conventional repo, as an
excellent liquidity management for conventional banks. Thus, is the replication of conventional Repo is the
only solution that exists for Islamic banks?
We think that Islamic banks should assume their own identity and turn more towards these aspects:
On one hand, instruments based on participative contracts for the interbank market with the development of
interbank accounts PSIA (Profit-Sharing Investment Account). On the other hand, instruments based on
charitable contracts for different operations with central bank by using deposit accounts based on Wakalah
or/and Wadiah.
In addition, the model of interbank Takaful presented in the last section seems to be an alternative that
deserves

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further

study.

To conclude, this work leads us to raise several issues:

-

Should liquid reserves, which Islamic banks maintain for prudential reasons, absolutely generate a
return?

Is the race for the maximization of profitability, which Islamic banks have engaged for competitive
reasons (with conventional banks), deviating them from their main objective that is financing the real
economy?

Can an interbank market, whose objective is to generate a return on a very short-term deposits (O/N),
has its place in the Islamic economic system?

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