2.9
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Whereas Islamic equity funds became popular with investors who had a
“risk appetite” for equity investment, Islamic financial institutions, driven by the nature of their intermediation, kept demanding securities which could behave like conventional fixed-income debt securities, but also comply with Shari’a. In addition, Islamic financial institutions wanted to extend the maturity structure of their assets beyond the typical short-term maturities provided by trade finance instruments. The result is that within a short span since the start of the new millennium, the market for sukuk has reached an impressive size with growth doubling almost each year.
Central banks in several Islamic countries also played a key role in setting the stage for development of the capital market. They were keen to introduce instruments that provided liquidity in the market place. Such countries included Malaysia, Bahrain, Kuwait, Sudan, Iran, Jordan and Pakistan.
Some of these countries had tried to introduce a legal framework forsukuk issuance, but the first successful issuance was initiated by the Malaysian government in 1983, with the issuance of the Government Investment Issue (GII), formerly known as the Government Investment Certificate. The main objective of this instrument was to facilitate the management of assets in the Islamic banking system, which, by this time, was fairly mature.
The issuance of GII was based on the Islamic concept ofqard al-hasan (benevolent non-interest bearing loan). However, GII was not a tradable instrument since it only represented outstanding debt that cannot be traded under Shari’a principles. Recently, the underlying concept of GII was changed tobai al-inahto allow it to be traded in the secondary market.
Similarly, the Central Bank of Kuwait issued interest-free certificates to finance the purchase of properties held by nationals other than Gulf Cooperation Council (GCC) states. Iran has also introduced the concept of participation bonds on a mudaraba basis. The Central Bank of Bahrain, however, pioneered the ijara and salam sukuksas medium to short-term monetary instruments that have continued to be well received by institu- tional investors. Thus, the success of numeroussukukissuances worldwide opened up an alternative source of funding and diversification for investors, which is now tapped by many countries and corporations.
This increase in demand, together with the work that is underway to standardizesukuk issuance, is expected to provide further momentum to the growth of the market. The World Bank issued its first local-currency dominated 760 million Malaysian Ringgits ($200 million)sukukin 2005. In the same manner, hedge funds and conventional institutional investors have been keen to take up a significant portion ofsukukcertificates as they search for yield pick-up and diversification. This has resulted in a large number ofsukuksbeing issued, both public and private with the result that the issuance ofsukuksquadrupled to $27 billion in 2006, and $39 billion in October 2007, from $7.2 billion in 2004, as per McKinsey and Company’s World Islamic Banking Competitiveness report.
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Sukuk
The idea behind asukuk(popularly known as an Islamic or Shari’a-compliant
“bond”) is simple. Prohibition of interest virtually closes the door for a pure debt security, but an obligation which is linked to the performance of a real asset is acceptable. Shari’a prohibits earning returns from loan contracts upon which returns are based on interest. For instance, conventional bonds and other derivative instruments that rely on profiting holders by providing returns based on interest are unavailable to Muslims. In order words, a financial instrument that derives its returns from the performance of a tangible or even intangible asset is acceptable under Shari’a.
The word sukukis derived from the Arabic word sak, which is literally translated as “written document", or a more common meaning of “certificate", and reflects participation rights in underlying assets. In Islamic finance the concept of securitization is what is known in Arabic as “taskeek”, that is the process of dividing ownership of tangible assets, usufructs or both into units of equal value and issuing securities as per their value.
The creation of Islamic financial securities can be done in two distinct ways:
1. Direct structuring of securities; and 2. The process of asset securitization.
Direct structuring involves the initial issuance of securities, and the funds raised will be used to fund certain assets/projects with the client company.
The profits generated from these assets/ projects are then distributed amongst security holders. The opposite to direct structuring is asset securitization, where existing assets of the client company are identified, pooled, and then securities are issued against them.
There are many structures that can generate the revenue paid tosukuk holders. Mostsukukissuances to date have been wholly asset-based rather than asset-backed; this has an impact on their ratings. In an asset-based sukuk, sukuk holders rely for payment on the company seeking to raise finance (the originator), in the same way as they would under a corporate bond issue. In an asset-backedsukuk, sukukholders rely on the assets of the sukuk for security. More importantly, in an asset-based sukuk, the market value of the underlying assets has no bearing on the redemption amount as this is fixed at the outset when the relevant undertakings are agreed. More recently, the market has seen issuances with a mix of cash and assets, and in several cases, sukukshave been issued for a new business with no tangible assets. The issuances of convertible and exchangeable sukuksare more recent developments.
The modern form of sukuk is an asset-backed trust certificate. In its simplest form,sukukis a trust instrument with the sukukholder having beneficial or legal ownership of the trust asset or its usufruct. The Accounting
106 Islamic Finance in Practice
and Auditing Organization for Islamic Financial Institutions (AAOIFI) Standard 17 defines “investmentsukuk” as being:
Certificates of equal value representing after closing subscrip- tion, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity.
Sukukshould not be confused with conventional shares or bonds. Shares are issued by a stock company that has been granted independent juristic personality. In the case of bonds, the bond holder enters into a debtor-lender relationship with the bond issuer. In its simplest form, a bond is a contractual debt obligation whereby the issuer is contractually obliged to pay to bondholders, on certain specified dates, interest and principal. In compari- son, the design of thesukukis derived from the conventional securitization process in which a special purpose vehicle is set-up to acquire assets and to issue financial claims on the asset. Such financial claims represent a proportionate beneficial ownership for a defined period when the risk and the return associated with cash flows generated by an underlying asset is passed to sukuk holders (investors). Hence sukuk holders are entitled to share in the revenues generated by thesukukassets as well as being entitled to share in the proceeds of the realization of those assets.
On the other hand, there are a number of similarities between a conventional bond and asukuk. These include:
• Marketability− sukukare monetized real assets that are liquid, easily transferred and traded in the financial markets;
• Ratability−sukukcan be rated;
• Enhanceability−differentsukukstructures may allow for credit enhance- ments; and
• Versatility − the variety of sukuk structures defined in the AAOIFI standards allow for structuring across legal and fiscal domains, fixed and variable income options, etc.
Recently there has been a claim thatsukuksare asset backed rather than asset based. In an asset-basedsukuk,sukukholders rely for payment on the company seeking to raise finance (the originator), in the same way as they would under a corporate bond issue. In an asset-backedsukuk,sukukholders rely on the assets of thesukukfor security. In the case of asset-basedsukuk, the market value of the underlying assets has no bearing on the redemption amount as this is fixed at the outset when the relevant undertakings are agreed. As will be shown below, sukuk structures are essentially asset- based, but the modern structuring techniques have tended to retain the major risk of the asset with the originator of thesukuk.
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