Revisiting the IIFM Reference Paper on Iaadat Al Shiraa (Repo - - PDF document

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Revisiting the “IIFM Reference Paper on I’aadat Al Shira’a (Repo Alternative) and Collateralization - Structuring Possibilities”

IIFM Awareness Seminar on Islamic Finance Monday, 2nd December 2019 Gulf Convention Centre, The Gulf Hotel, Manama, Kingdom of Bahrain Ijlal Ahmed Alvi Chief Executive Officer IIFM

Introduction to IIFM Reference Paper On Repo Alternative

The reference paper was published in 2010 with the aim to provide general information on the concept,

• perational mechanism and uses of conventional repurchase agreements (known as Repo or Sale and

Repurchase Agreements). The purpose of the paper was/is to also attempts to explore the possibilities for the I’aadat Al Shira’a (Repo Alternative) as an alternative to the conventional repo in order to provide the Islamic Institutions another tool to effectively manage its liquidity as well as to help it finance its inventory of Asset, mainly Sukuk and Islamic securities including equities.

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Concept of Repo in Conventional Market

Definition of Repo In a repo agreement, the borrower sells securities outright to the lender and at the same time agrees to buy equivalent securities from the lender at a specified price at some later date. Significance/Importance of Repo Conventional repo is primarily a money market instrument, which allows the seller to use financial securities as collateral for a cash loan at a fixed rate of interest. For the buyer, a repo is an opportunity to invest cash for a customized period of time. It is short-term and safer because it is a collateralized investment. Market liquidity for repos is good, and rates are competitive for investors. Moreover, repos increase the volumes in the capital market as they serve as a tool for funding the purchase of securities and repos provide an inexpensive and efficient way of improving liquidity in the secondary markets for underlying instruments.

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Concept of Repo in Conventional Market (continued)

Types of repo There are two basic types of short term money market repos available in the international market. As defined in the reference paper, there are two types repo, mentioned below, the types of repo are mentioned because of their relevance to the subject in hand. They comprise the following: Classic Repo Classic repo is an initial beneficial sale of securities with a simultaneous agreement to repurchase equivalent securities at a later date. The repurchase price is calculated by taking the price of the securities used for the initial sale and adding an amount to cover “interest" for the term of the

• transaction. In classic repo, the securities are sold outright by the seller to the buyer. They are effectively

being used as collateral for a loan of cash, which is repaid through the repurchase of equivalent

• securities. As a result, the economic risks and rewards of owning the securities remain with the seller,

and that is why, in classic repo the buyer is required to pay to the seller the value of the coupon income arising on the securities. This obligation to “pass on” the coupon is contained in the repo agreement, such as the GMRA.

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Buy/Sell Back Transaction Under a buy/sell back, as in a classic repo, the securities are sold outright at the outset and the seller simultaneously agrees to buy equivalent securities back on a later settlement date. In a buy/sell back, there is normally no pass through of any coupon interest due on the securities. Buy/sell back transactions are similar to classic repo transactions except that, if not documented, there is no margin maintenance during the life of the transaction i.e. there is an initial sale and transfer of securities and then a sale and transfer of equivalent securities at maturity. If GMRA type documentation is used, then marking to market can be applied and as a result margin maintenance can be included. Tri-Party Repo The distinguishing feature of a tri-party repo is that a custodian bank or international clearing

• rganization, the tri-party agent, acts as an agent of the two parties to the repo. The tri-party agent is

responsible for the administration of the transaction including collateral allocation, marking to market, and substitution of collateral.

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Concept of Repo in Conventional Market (continued)

Repo Period There are three types of repo maturities. They are as follows: a) Overnight Repo b) Open Repo c) Term Repo Repo Risks While repos are generally credit-risk mitigation instruments, to mitigate this risk, repos are often over- collateralized as well as being subject to daily mark-to-market margin calls. Credit risks associated with a repo are subject to many factors such as the term of the repo, the liquidity of the securities, the strength of the counterparties involved, etc.

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Concept of Repo in Conventional Market (continued)

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IIFM I’aadat Al Shira’a (IS) Findings & Structuring Possibilities

Concept 1: Bilateral Structure ‘IS’

Definition Bilateral – Sale for spot value and purchase for an agreed forward date and price (ii) Overview of Structure

Party A (Seller) Party B (Buyer) Party A Party B Party B Party A Step 1 Step 2 Step 3 Sale Agreement Undertaking To Buy Undertaking To Sell

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Key Issues on Bilateral Structure Even though the repurchased securities are equivalent securities and not the exact same securities or certificates, from a Shari’ah perspective they will be considered as the same securities with the result that it not be possible to transact such transactions between the two parties without avoiding Bai Al ‘Inah. The fact that the repurchase price is fixed at the outset, i.e. it is a fixed price irrespective of the market price at the time of repurchase raises possible Riba issues. Shari’ah Scholars’ Suggestions The Bilateral ‘IS’ is, Shari’ah wise, possible if effected using non-binding Wa’ads and the repurchase price is set at the market price at the time of the repurchase. A sale in which a purchaser buys merchandise from a seller for a stipulated price on a deferred payment basis and then sells the same merchandise back to the original seller for a price agreed than the original purchase price.

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IIFM I’aadat Al Shira’a (IS) Findings & Structuring Possibilities

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AAOIFI Shari’ah Standard No. (58) – Repurchase

Pre-requisites a) The sale must be genuine. (i.e. the ownership must be transferred, bearing of price risk and transfer

• f liability)

b) The repurchase shall be effected through a separate contract that evidences transfer of ownership c) The second contract shall not be stipulated in the first contract d) There should not be a bilaterally binding promise (Muwa’adah) to enter into the second contract

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Concept 2: Bilateral Structure with Different Undertakings

The working team also explored the possibility of using the Bilateral ‘IS’ if structured based on two different Wa’ads as follows:

Party A Has Government Sukuk to Finance It sells to Party B on 5th Feb 2010 at Market price (100.10) Party B Has Cash to invest for Short term Buys Government Sukuk from Party A on 5th Feb 2010 at a Market price (100.10) Unilateral Wa’ad From B Unilateral Wa’ad From A B undertakes to Sell on 24th March 2010 at a price of 100.25 A undertakes to purchase on 25th March 2010 at a price of 100.30

Conclusion Based on the above, it is difficult to bridge the gap between Shari’ah and market requirements for Bilateral structures (Concept 1 & 2).

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Concept 3: Three Party Structure ‘IS’ (Not Tri-Party)

(i) Overview of Structure The major difference between a conventional Tri-Party repo and the Three Party ‘IS’ under consideration is that, in the case of a conventional repo, the role of the third party is that of an Agent while for the Three Party ‘IS’ the third party will act as a principal even though It is acting in an intermediary capacity between the other two parties. Therefore, the working team has named this structure Three Party ‘IS’, as the seller, the buyer and the third party are all required to assume risk.

Party A Third Party Third Party Party B Party A Party B Step 1 Step 2 Step 3 Securities Purchase Price Securities Purchase Price Undertaking to purchase securities at Cost Price plus Profit at future date

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Concept 4: Collateralized ‘IS’

This recommendation was developed and resulted in publication of IIFM Standard 6, Master Collateralized Murabahah Agreement (MCMA) publication 2014 and is now used by a number of financial institutions in various jurisdictions as an alternative to Repo. Overview of Structure

Party A Broker 1 Party A Party B Party A Party B Step 1 Step 2 Step 3 Purchase of commodities for Cost Price Purchase Price Sells commodities for Deferred Purchase Price Deferred Purchase Price Party B grants security over securities to secure

• bligation to pay deferred purchase price

Party B Broker 2 Party A Party B Step 4 Step 5 Sells commodities for Cost Price Purchase Price Party B pays Deferred Purchase Price (being Cost plus Profit) Security released over Securities

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Shukran Wassalamu ‘Alaikum

International Islamic Financial Market (IIFM) Office 72, 7th Floor, Zamil Tower , Government Avenue, P.O. Box: 11454, Manama, Kingdom of Bahrain Tel: +973 17500161 , Fax: +973 17500171, Email: info@iifm.net, Website: www.iifm.net

Disclaimer: The information herein has been obtained from sources believed to be reliable but cannot be guaranteed. The views or opinions expressed are subjected to change at any

• time. Neither the information nor any opinion expressed can be construed as a solicitation for the purchase or sale of any securities. International Islamic Financial Market disclaims

liability in this respect.

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