Misused murabaha hurts industry

Metals are often used as the basis for a commodity murabaha, but in reality there may be no physical items involved. (Jung Yeon-Je/AFP/Getty Images)

A commonly used Islamic finance product could cause the downfall of the industry because it is being used inappropriately, a senior banking figure has claimed.

Islamic banks often use commodity murabaha agreements to invest their surplus cash in a Shariah compliant way. This involves buying into a basket of commodities, such as metals, held by another bank for a pre-determined amount of time and a pre-determined return.

However, in practice, many of the transactions never see any commodities change hands and sometimes there are no commodities involved, merely cash flows between banks and brokers.

"The situation is a little bit embarrassing for the industry," said Ruggiero Lomonaco, head of Middle East and Islamic private investor products, ABN Amro Markets, speaking at the Islamic Finance Forum in Dubai last month.

He pointed out that sometimes there is not even enough of a particular kind of commodity in existence to account for all of the transactions that are taking place.

Lomonaco said: "I believe these very transactions can cause the fall of the industry in a very short period of time."

He proposed the use of the wa'ad swap, a controversial finance agreement that has been criticised by others in the Islamic finance community recently.

"Through this arrangement it's possible to invest in a pool of assets and link the performance of these assets to external benchmarks," he said.

Islamic investors would receive returns which could be linked to LIBOR, equities indices, or even the performance of hedge funds.

The commodity murabaha transaction was also criticised by Dr Aznan Bin Hasan, assistant professor at International Islamic University Malaysia, who said Islamic banks should only use it as a last resort if they could find no other use for their surplus liquidity.

"Otherwise if you have any other way to do it, you should do that first before a commodity murabaha," he said.

ABN Amro's Ruggiero said that economic forces could encourage Islamic banks to stop using the financial tool. "There is an incentive," he said. "You will see very shortly when interest rates go down, back to 2003 [levels], people will find alternatives."

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Full List of Alternatives Suggested
Posted by Ruggiero Lomonaco, London, United Kingdom on Friday 8 February 2008 at 14:51 UAE time

Just for the records, beside the use of Wa'ad based instruments, I suggested the following alternatives to Commodity Murabaha:
1. Islamic interbank investment accounts
2. Sukuks with short term rental reset rates
3. Use of conventional money market instruments, as a temporary exception until a real alternative is found.

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