gif Sukuk
Sukuk risk characteristics can vary signifi- cantly –even within a single ‘type’. Thus, until there is some broad consensual standardisation on terminology or form, in- vestors will need to look at each structure individually to understand the cash flow, risk and return profile, irrespective of the name/type of Sukuk structure used. The common theme of ‘form over substance’ throughout modern Islamic finance has, in our experience, created confusion for some market participants. ‘Asset-backed’ and ‘asset-based’ are semantically similar descriptions but mask significant differ- ences in credit risk. ‘Shariah-based’ and ‘Shariah-compliant’ are two more recent terms that seem to add some confusion.
While there was some debate regarding the method of its release, the AAOIFI’s comments constituted a positive effort to- wards improving transparency and bring- ing the ‘substance’ of Sukuk products closer to the basic tangible and risk-shar- ing principles on which there is an almost universal consensus – it is in the imple- mentation of these principles that matters become complex for investors. Whether or not the market agrees with the comments, at the very least it raises the right ques- tions for those to whom such adherence is important.
A key question for participants is whether the goal of the Islamic finance movement is to essentially replicate in its entirety the conventional financial system. How wary should practitioners be of creating instru- ments and investments that are identi- cal in substance to conventional ones by combining a redundant succession of trades and labeled with ‘new’ Arabic names? Or how much emphasis should be placed on innova- tion that encourages and favors particular types of investment (such as more tangible risk-sharing ones) and funding that is closer to Shariah principles, regardless of terminol- ogy and origin? For example, private eq- uity investments in the technology companies of Silicon Valley in the US are in substance and inherently compli- ant with the Shariah investment principles, despite the absence of any Islamic terminol- ogy. In addition, an Is- lamic financial market will always need to in- teract and engage with
Table 1: Conventional Bonds
Primary level-Loan contract to create indebtedness. Return to Investors is the extra amount charged on the loan amount-interest charges. The loan indebtedness is securitised with zero coupon. Secondary level-trading of the bonds amount to trading of debts, normally with discount. Bonds represent pure debt obligations due from issuer. The core relationship is a loan of money, which implies a contract whose subject is purely earning money on money (Riba). Bonds can be issued to finance almost any purpose which is legal in its juris- diction. Bonds holders are not concerned with assets related expenses. Bonds depends solely on the creditwor- thiness of the issuer, in case of issue failure unsecured bond holders join the pool of general creditors seeking the as- sets of a bankrupt company. Sale of bond is basically the sale of a debt, if the debt un-receivable, there will be no value to the bonds
26 Global Islamic Finance October 2010 Islamic Sukuk
the conventional one – it does not exist in some ‘isolated’ bubble thus some level of ‘contamination’ may be difficult to avoid. The credit crisis has proved the globalised nature of the world we live in: imagining that a sub-prime crisis could never happen in Islamic finance would be to encourage complacency.
The different motives of the parties in- volved in the industry also need to be con- sidered –it is not always religious or moral ethics that drive the market forward. The pursuit of profit is a powerful and perhaps legitimate driver that is in keeping with human nature, but introduces moral haz- ards and possible conflicts of interest that need to be dealt with, or at least acknowl- edged.
Key roles need to be institutionalized for the longer-term transparency health, fu- ture and sustainability of the industry. Ultimately, much is subject to interpreta- tion and opinion. Although there is no real provision for individuals (who within the faith are generally considered equal under Allah)to ‘judge’ on Islamic ‘compliance’– as opposed to offering advice, guidance, opinions and education - the market in the Gulf, tends to follow the various opinions of a relatively small and overstretched cir- cle of prominent scholars.
There has been much discussion in the media about looking at alternative finan- cial systems as various parties seek to avoid such crises in the future. While the ideals of Islamic finance offer some com- pelling ideas, the reality is that much of Is-
lamic finance today is focused on replicat- ing the conventional system. This makes it competitive with the conventional and gives customers (financial depositors and consumers) the products they want. How- ever, an inevitable consequence is that any problems/flaws are also likely to be replicated. The benefits of a truly alterna- tive investment approach are more likely felt, and the industry more sustainable, when those aspects that are different about Islamic finance are emphasised and practiced.
AAOIFI has its views, but market partici- pants can, and will, make their own deci- sions based on the precedence given to Shariah compliance in their own agendas and economic objectives – where the need for financing may be the key driver. Conventional finance has had many hun- dreds, if not thousands, of years to reach its current form and is still evolving. ‘Mod- ern’ Islamic finance is relatively young and following its own path before it reaches a point of stability/consensus. From a Sha- riah perspective, it may be the sincere niyyah or intention of the parties that is probably the most important. However any of the current Sukuk types adhere to AAO- IFI in form, but not in substance.
Primary level- very rarely use loan contract, as no value added return from debt leveraging due to prohibition of Riba in loan transaction. Primary level-use a variety of contracts to create financial obligations between issuer & investors, e.g. sale, lease, equity partnership, joint venture partnership. Return to investor comes from the in-build profit elements in the sale, lease or partnership contracts. The financial rights under the contracts are securitis- able.
Secondary level-tradability of the Sukuk depends on the nature of the financial rights underlying the Islamic se- curities. Sukuk represent ownership stake in existing and/or well defined assets. The underlying contract for a Sukuk issuance is a per- missible contract such as a lease or any of the other 14 categories defined by AAOIFI. The underlying assets monetised in a Sukuk issuance must be Islamically permissible in both of their nature and use e.g. a Truck would always be an eligible assets but not its lease to a distillery. Assets related expenses may attach to Sukuk holders. Sukuk holders are secured creditors as they are own part of the underlying assets, even if a failure occurred, Sukuk holders are paid before any secured or unsecured credi- tors, Sukuk prices depends on the market value of the underlying assets. Sale of a Sukuk represents a sale of a share of an asset
We have come to the end of part one and we have managed to derive just how impor- tant sukuk can be. We have found that su- kuk is by far one of the best ways of financ- ing a large enterprise that is beyond the ability of a single party to finance. We have also found that sukuk can provide an ideal means for investors who are seeking to de- ploy streams of capital and that require, at the same time, the ability to liquidate their positions with ease whenever the need should arise.
‘Asset-backed’ and ‘asset-based’, ‘Shariah- based’ and ‘Shariah- compliant’ are amongst some of the terms that often confuse people, these should be now be more clear at this stage of the article.
In part two, after hav- ing explained what the terms mean we will be looking at the dif- ference between ‘as- set based’ and ‘asset backed’ whilst the idea of securitisation will be introduced and dis- cussed in depth.
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