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ccording to economic theory and in the broadest terms, liquidity refers to the ability of an economic agent to exchange their wealth of goods or services with other assets. Banks possess highly illiquid assets (loans) and generally have an obligation to repay their depositors in full at any moment.

Liquidity is a financial institution’s capacity to readily meet its cash and collateral obligations at a reasonable cost. When it comes to managing liquidity, conventional credit institutions have well-developed interbank markets at their disposal that can be tapped for short-term funding, as well as a plethora of instruments.

Liquidity problems commonly occur because of failure in funds management or unfavorable economic conditions that lead to unpredictable liquidity withdrawals by depositors.

Indeed, maintaining robust liquidity management is very challenging and difficult in today’s competitive and open economic system, which has strong external influences and sensitive market players.

Liquidity management (LM) plays a role in day-to-day monetary operations as well as in connection with liquidity regulations put in place to ensure financial stability.

Islamic banks, like their conventional counterparts, serve to bridge surplus and deficit spending of an economy.

A unique banking model, Islamic banks operate on the principles of sharia. Islamic banking aims to provide sound liquidity management and conduct activities through real business transactions. Islamic banks tie every financing contract with real assets, a unique attribute compared to conventional banks.

Therefore, Islamic banks consider the business life cycle, cooperation among business partners and good stakeholder conduct in its operations.

Thus, if liquidity risk occurs, it comes from disharmony among business partners or from unfavorable business conditions. Islamic financial institutions (IFIs) face great difficulties in managing liquidity.

Islamic banks adopt both internal and external approaches to manage liquidity. Internally, Islamic banks have an organizational structure designed to manage liquidity and balance assets and liabilities accordingly. Externally, they maintain good relations with stakeholders.

In addition, they have several usable Islamic money market instruments to fulfill regular demands for liquidity and solve liquidity pressure.

The tradability of liquidity instruments is an important criterion so that the instruments can be disposed quickly through sales at minimum loss of value and without causing significant price movements.

An active and efficient secondary market is needed for such transactions. The dearth of financial instruments at the disposal of IFIs makes for less efficient liquidity management, as more cash than necessary is held and thereby reduces their profitability.

Some of the avenues of effective liquidity management at the disposal of IFIs include Sukuk, Inter-bank Musharakah or Mudarabah-based pools, Islamic placement accounts, commodity Murabahah transactions, trading/hedging currencies, sharia-compliant equities and mutual funds.

It is very interesting to observe the development of Islamic liquidity instruments in Indonesia, where the banking system was developed alongside the lending-based model and so the tradability of Islamic liquidity instruments has always been at the forefront.

Bank Indonesia (BI) has been concerned about the lack of adequate sharia-compliant money market instruments for liquidity management and in general, the underdevelopment of Islamic money markets.