INSTRUMENTS AND

MARKETS
Edi Susilo
 Introduction
Modern Islamic financial products and services
are developed using two different approaches.
The first approach is by identifying existing
conventional products and services that are
generally acceptable to Islam, and modifying
them as well as removing any prohibited
elements so that they are able to comply with
sharia principles. The second approach involves
the application of various sharia principles to
facilitate the origination and innovation of new
products and services (Warde, 2000).
 Traditional money markets
instruments
Treasury bills
Call money market
Certificates of deposit
Islamic money market instruments
Tradeable Islamic financial assets
Mudaraba certificates These represent certificates of
permanent ownership in a project or company where
the holder is not entitled to exercise management
control or voting rights.
Musharaka certificates These are defined as with the
mudaraba certificates, with the notable exception
that the bearer holds management and voting rights.
Musharaka term finance certificates These represent
certificates that entitle the holder to a temporary
ownership of a project or company. The certificates
may include or exclude management control and/or
voting rights.
Islamic money market instruments
Murabaha and istisnaa certificates are debt securities
arising from standard istisnaa or murabaha contracts.
The periodic repayment of the debt under these
certificates is not broken up between principal or
coupons and the total debt or any portion therefrom
cannot be traded in compliance with the ban sharia
imposes on debt trading. The certificates are similar to
a zero coupon security.
Salam certificates These securities arise from salam
contracts which require prepayment for the future
delivery of a commodity. The pre-paid funds can
represent debt certificates for a commodity. However,
the certificates are non-tradeable for the same reason
as the murabaha and istisnaa certificates.
Islamic money market instruments
Sukuk structures
Sukuks represent sharia-compliant securities that
are backed by tangible assets. Conceptually,
sukuks are similar to traditional asset-backed
securities with the notable exception that the
backing cannot be solely comprised of debt. The
stipulation applies irrespective of the contractual
form of debt, and regardless of whether such
debt was based on murabaha or istisnaa. Instead,
the issuing entity should possess a tangible asset
(or group of assets).
Islamic money market instruments
Ijara sukuk These are certificates backed by lease
agreements of land, buildings or equipment. The
underlying lease payments, which determine the
return on the sukuk certificates, can be fixed or
variable. The terms of the certificates cannot exceed
the term of the underlying leases but there is no
compelling reason why the sukuk cannot have a
shorter term.
Hybrid sukuk If the underlying revenues are not solely
dependent on revenues from leases, but include
istisnaa or murabaha receivables, the sukuk certificates
are designated as hybrids provided that the proportion
of lease-based assets exceeds 50 per cent.
Islamic money market instruments
Variable rate sukuk In some cases, the issuer may
be willing to step in by pledging some assets that
are beyond the underlying leases in order to
collaterize the sukuk certificates. Such action has
the advantage of enhancing the credit quality of
the certificates and realizing a more stable cash
flow to the certificate holders who are no longer
solely dependent on the dividend payout from
the leases but also on the direct profitability of
the issuer. Consequently, these sukuk are referred
to as Musharaka term finance certificates
(MTFCs).
 Zero-coupon non-tradeable sukuk When the backing
assets do not yet exist or are not completed at the time
the sukuks are issued, the sukuks are then similar to
murabaha and istisnaa certificates. In this case, these
sukuks are subject to the same restriction on secondary
market tradeability imposed by the sharia as the
certificates.
Malaysian Islamic Inter-bank Money Market (IIMM)
A centrepiece for the healthy operation of an Islamic
banking system is the existence of a liquid money market
that affords financial institutions the ability to adjust their
portfolios in the short term through a funding facility. This
was the prime objective of the Islamic Inter-bank Money
Market (IIMM) which was introduced in January 1994 in
Malaysia.
 Mudaraba inter-bank investment (MII) MII refers to a
mechanism whereby a deficit Islamic banking institution
(investee bank) can obtain investment from a surplus Islamic
banking institution based on mudaraba. The period of
investment is from overnight to 12 months, while the rate of
return is based on the rate of gross profit before distribution
for investment of one year of the investee bank. The profit-
sharing ratio is negotiable between both parties.
Wadia inter-bank acceptance This is an inter-bank transaction
between the Malaysian Central Bank and the Islamic banking
institutions. The instrument represents a mechanism
whereby the Islamic banking institutions place their surplus
fund in the custody of the Central Bank. Under this concept,
the acceptor of funds is viewed as the custodian of the funds
without any obligation to pay a specific return. Any dividend
paid by the custodian is perceived as a gift (hiba). The Wadia
inter-bank acceptance facilitates liquidity management by
giving the central bank the flexibility to declare a dividend
without the obligation to invest the funds received.
 Government investment issues (GII) When the first
Islamic bank in Malaysia began operations in 1983, the
bank could not, among other things, purchase or trade
in Malaysian government securities, Malaysian
Treasury bills or other interest-bearing instruments.
However, Islamic banks had a serious need to hold
liquid securities to meet their statutory liquidity
requirements and to park their idle funds. To meet
their needs, the Malaysian Parliament passed the
Government Investment Act in 1983 which permitted
the issuance of non-interest bearing certificates known
as Government Investment Certificates (GIC). These
certificates have since been replaced by Government
Investment Issues (GII) under the concept of qard
hasan (Haron, 1997).
 Bank Negara negotiable notes These notes represent
short-term instruments issued by the Central Bank
predicated on the concept of baial-inah. These notes
were introduced in November 2000 and are tradeable
in the secondary market. The price of the notes is
determined on a discount basis and issued by the
Central Bank for a maximum term of one year. The
notes are an effective tool used by the Central Bank to
manage liquidity (Bank Negara Malaysia, 1999, 2001,
2004).
Sale and buy-back agreement These represent an
Islamic money market transaction entered between
two parties in which one counterparty sells an asset at
an agreed price with the obligation to buy it back in the
future at a predetermined and higher price.
 Cagamas mudaraba bonds These were
introduced in March 1994 to finance the
purchase of Islamic housing debts from
financial institutions that provide Islamic
house financing to the public (Bank Islam
Malaysia, 1994). The mudaraba bonds are
structured under the concept of mudaraba
where the bondholders and Cagamas share
the profits according to predetermined profit-
sharing ratios.
 When issue (WI) When Issue is a transaction for the
sale and purchase of debt securities before they are
issued. The Malaysian National Sharia Advisory Council
ruled that the WI transactions are allowed, according
to the permissibility of sale and buy-back agreements.
Islamic Accepted Bills An Islamic Accepted Bill (also
known as Interest-Free Accepted Bill) was introduced in
1991 with the objective to promote domestic and
foreign trades by providing merchants with an
attractive Islamic trade finance product. The
instrument is formulated on the Islamic notion of
murabaha (deferred lump-sum sale or cost-plus) and
baial-dayn (debt trading). The Islamic Accepted Bills
are equivalent to the traditional bankers acceptance, a
money market instrument used primarily to finance
foreign trade. There are two types of financing under
the Islamic Accepted Bills facility: imports and local
purchases, and exports and local sales.
 Islamic negotiable instruments These instruments take
two separate forms. The first is Islamic Negotiable
Instruments of Deposit (INID). For these, the applicable
concept is mudaraba. It refers to a sum of money
deposited with an Islamic banking institution and
repayable to the bearer on a specified future date at the
nominal value of INID plus declared dividend. The second
instrument is the Negotiable Islamic Debt Certificate
(NIDC). This transaction involves the sale of a pro rata
share in the banks assets to the customer at an agreed
price on a cash basis. Subsequently the pro rata share is
purchased back from the customer at a principal value
plus profit and settled at an agreed future date.
Islamic private debt securities These securities were
introduced in Malaysia in 1990. Current securities in the
market are issued based on the sharia-compliant
concepts of bai bi-thaman ajil, murabaha and mudaraba.
 Rahn agreement Under this structure, the lender
provides a loan to the borrower, based on the concept
of qard hasan. The borrower pledges its securities as
collateral against the loan. Should the borrower fail to
repay the loan on the maturity date, the lender has the
right to sell the pledged securities and use the
proceeds to settle the loan. If there is surplus money,
the lender will return the balance to the borrower. The
Rahn agreement is predicated on the concept of a
repurchase agreement (or Repo), a very popular
instrument in traditional money markets, though its
use by Islamic banks is more limited. The Central Bank
uses these instruments as a tool for liquidity
management for money market operations. Any
returns realized from these securities are considered a
gift (hiba) and determined according to the average
inter-bank money market rates.