Sukuk and the Problem of Short-term Liquidity

Although the rapid expansion of Islamic banking in recent years has been quite impressive, it is important to note that the variety of available investments that are compliant with Shariah is still quite limited when compared to conventional Western finance. Non-Muslim banks can invest in a wide variety of government issued financial instruments, both for short term and long term gain. However, Islamic finance still falls short when it comes to an alternative to Treasury Bills that offers similar convenience and returns.

Fortunately, sources in Islamic finance have stated that there has been progress in creating sukuk that can help solve this gap in short term liquidity. These sukuk are based on Salam. This type of Islamic finance allows quick access to cash for the investor. In Salam, a sale contract involves an advance payment for the delivery of products with prior agreement of quantity, quality, and dates. This unavailability of short-term financial instruments had been a challenge to the Islamic finance industry in recent years. The situation is quickly changing thanks to the emergence of Salam based sukuk.

It is important to understand that sukuk is backed by tangible assets with value rather than by debt. Because of this, short-term liquidity had been a challenge. The emerging sukuk with high short term liquidity are backed by oil imports. In short, the government seeks investment from Islamic banks for purchase of oil and oil-based products for import. The agreements stipulate that that the transaction is then settled from the sales of these oil-based products in a period of up to six months, essentially a Salam agreement between the two parties. This financial instrument greatly improves the ability of Islamic banks to manage their liquidity in the short term and also helps boost a secondary market for shorter term investment.

Of course, there is still room for improvement. One difficulty of Islamic finance is that there is still a shortage of structured Islamic financial instruments, leading to problems of redundancy and lack of diversity in investment. Currently, recent short-term sukuk offer about eight percent return, which still puts them at a disadvantage compared to six month treasury bills and comparable bonds.