1. Repos in the Islamic market
In our article titled "Repos in Islamic Finance"1 we concluded that Shari'ah-compliant repurchase transactions ("Repos") could play a useful role as a liquidity management instrument to assist with the short-term liquidity shortages in the Islamic finance industry. For the industry as a whole, a standard template for documenting a Shari'ah compliant Repo would be a useful starting point for all Islamic banks who wish to use the technique. For this reason, the development of the form of Master Collateralized Murabaha Agreement (the "MCMA") by the International Islamic Financial Market ("IIFM") was intended to assist in standardizing the Islamic Repo market, similar to the form of the Global Master Repurchase Agreement published by the Securities Industry and Financial Markets Association and the International Capital Market Association (the "GMRA") in the conventional market. We identify below some points which are key, in our view, to understanding Repos entered into under a MCMA.
2. The MCMA and collateralised murabaha transactions explained
Like the GMRA, the MCMA is a master agreement setting out standard provisions and the execution of a MCMA does not itself result in a transaction between the parties. Once the MCMA is signed, parties will subsequently enter into single or multiple murabaha transactions collateralised by the buyer (borrower/customer/chargor (arrahin)). Collateral will be posted by creating a security interest over the buyer's Shari'ah-compliant eligible assets.
Under a collateralized murabaha transaction, the following steps occur:
(a) purchase instruction with promise to purchase: the seller (lender/financier/secured party (al-murtinn)) will submit a "purchase instruction with promise to purchase" to the buyer, which will include details of the proposed collateralised murabaha contract, and also including the commodities subject to the collateralised murabaha transaction – commodities may consist of any Shari'ah-compliant commodities such as base metals, platinum group metals or other soft commodities (e.g., palm oil, natural gas and crude oil) but will exclude gold, silver and currencies;
(b) acknowledgement: the buyer will sign and deliver the "acknowledgement" appended to the "purchase instruction with promise to purchase", under which it will undertake to purchase the commodities subject to the collateralised murabaha transaction, and to indemnify the seller if it fails to do so;
(c) purchase of commodities: the seller will purchase the commodities from a third-party commodity broker/commodity supplier;
(d) offer notice: the seller will, following receipt of (actual or constructive) possession of the commodities, send an "offer notice" to the buyer, which will include detailed information on the commodities2 and details of the initial collateral to be posted;
(e) acceptance notice: the buyer will sign and deliver the "acceptance notice" appended to the "offer notice" and post the agreed initial collateral – execution of the acceptance notice will result in execution of the collateralised murabaha transaction;
(f) delivery of the commodities: the seller will complete (actual or constructive) delivery of the commodities to the buyer on a spot settlement basis; and
(g) payment of the deferred sale price: the buyer will pay the deferred sale price (cost price of the commodities plus agreed profit) to the seller on the deferred payment date.
3. Creating and maintaining the collateral in respect of collateralised murabaha transactions
As explained above, initial collateral under a collateralised murabaha transaction will be identified by the seller in the offer notice and will be approved by the buyer in the acceptance notice. The buyer will, as a condition precedent to the collateralised murabaha transaction, deliver the agreed collateral to the designated collateral account (specified as such in the offer notice), which will become a "posted collateral" and the seller will then complete (actual or constructive) delivery of the commodities to the buyer.
Under a MCMA, prior to the delivery of the initial collateral, the seller and the buyer may agree in writing the conditions for the holding and maintenance of the posted collateral. However, unlike a conventional Repo transaction, the posted collateral must be held in a segregated account and the seller will not be able to use the posted collateral, as the posted collateral will remain the beneficial property of the buyer. This also applies to the payments of accrued profit/dividend deriving from the posted collateral, which will belong to the buyer, and such accrued profit/dividend may be used by the buyer to partially pay the deferred payment price of the collateralised murabaha contract.
The value of the posted collateral under a MCMA must meet certain collateral coverage requirements, which are calculated daily. Accordingly, on each business day, the aggregate outstanding deferred payment prices of all outstanding collateralised murabaha transactions and the aggregate value of the all posted collateral will be calculated by a valuation agent (which can be the seller, the buyer or a third party appointed by the parties to the MCMA), and the "threshold percentages" and/or a "required minimum" agreed by the parties in relation to the coverage of the posted collateral of the outstanding deferred payment prices will need to be maintained.
In a MCMA, it is possible for the buyer to substitute the posted collateral with another eligible asset, provided that the buyer serves a substitution notice and the seller provides consent in writing to such substitution. In such case, the seller will be obliged to transfer the original posted collateral with a value, as of the date of transfer, as close as practicable to, but in any event not more than, the value of the substitute collateral as of that date.
In a MCMA, it is possible for the seller to hold the posted collateral or to appoint a third-party custodian (which can be an affiliate of the buyer) to hold the posted collateral on its behalf. If a custodian is appointed, the seller will provide a notice to the buyer, and the buyer's obligations to transfer the collateral will be fulfilled upon delivery of the collateral to such custodian. Appointment of third-party custodian isgenerally used where listed securities (e.g., trust certificates) are provided as collateral. To appoint a third-party custodian, a separate custody/service agreement will need to be executed.
4. Prepayment and late payment amounts in respect of collateralised murabaha transactions
In a MCMA, each of the seller and the buyer may, by submitting a prepayment request, request the prepayment of the whole or any part of the outstanding deferred payment price relating to the collateralised murabaha transaction. In each case, acceptance of a prepayment request is subject to the other party's consent, which can be provided in its sole discretion. In addition, the seller and the buyer may, at the time of a prepayment request, negotiate whether any rebate on the murabaha profit will be granted. Any rebate will be granted at the sole discretion of the seller. It is recommended that the number of times a rebate is made is limited, and each rebate (together with the circumstances in which a rebate is made) is approved by the relevant Shari'a adviser.
In case should any sum due and payable under a MCMA not be paid by any party on the due date, such party undertakes to pay to the other party a late payment amount, which usually is calculated based on an agreed margin (which is generally set at a maximum of 2 per cent. per annum for Shari'a-compliance reasons) which is added on top of the profit rate applicable to the MCMA. The party receiving the late payment amount may apply up to one half of any late payment amount so received by it in reimbursement of any actual direct costs (i.e., actual expenses that are directly attributable to the late payment of the relevant unpaid sum and not including any opportunity costs or funding costs or other indirect costs) incurred by it as a result of the late payment of the unpaid sum, and it will be obliged to donate an amount equal to the remainder of the late payment amount so received by it to a charitable organisation (which can be a pre-selected organisation by the parties to the MCMA or an organisation that the affected party may select under the supervision of its Shari'a board).
5. Costs, expenses, and taxes
The deferred payment price of a collateralised murabaha transaction must include all costs and expenses incurred by the seller in connection with the commodities (e.g., transportation expenses, storage expenses, fees for letters of credit, insurance), but excluding delivery costs (including any stamp, transfer or similar transaction tax or duty payable on any such delivery). Such costs must be disclosed to the buyer prior to execution of a collateralised murabaha contract. In case of physical delivery of commodities, costs associated with physical delivery will be borne by the buyer.
The buyer is also responsible for all taxes, assessment or charges of any nature that may be incurred in respect of the posted collateral. Similarly, all reasonable costs and expenses incurred by the seller in connection with the liquidation or application of any posted collateral is payable by the buyer.
In a MCMA, each party will agree with the other that it will pay any stamp tax levied or imposed upon it by a jurisdiction in which it is incorporated, organised, managed and controlled or considered to have its seat, or where an office through which it is acting for the purpose of the MCMA is located (a "stamp tax jurisdiction"), arising in connection with its execution or performance of the MCMA. In addition, each party will agree to indemnify the other party against any stamp tax imposed on such other party by any stamp tax jurisdiction which is not also a stamp tax jurisdiction with respect to the other party.
6. LIBOR transition
With discontinuation of the London Interbank Offered Rate ("LIBOR") on 30 June 2023, LIBOR will no longer be used in Repo transactions, including in Islamic Repo transactions, and a Shari'a-compliant alternative is required for new Islamic Repo transactions which contain a U.S. dollar-denominated floating profit rate. Please refer to The end is here – LIBOR cessation looms for international finance markets3 for various alternatives in Islamic finance transactions, including for floating rate murabaha transactions.