CAIRO — Indonesia is passing a legislation that will allow the issuance of sukuk, Islamic bonds, for the first time in the world's most populous country to ease economic woes, diversify debt instruments and lure Islamic investments.
"We'll consider both the domestic and international environments when deciding whether the sukuk will be institutional and mainly international, or domestic retail," Finance Minister Mulyani Indrawati told the Financial Times on Wednesday, April 9.
The parliament is set to pass on Thursday, April 10, a legislation, which the government has been working on for two years, allowing it to sell Islamic bonds at home and abroad.
Mulyani said the government intends to issue up to $1.6bn in sukuk in the second half of this year, once the law is put into force.
Officials hope the sukuk will open up a new funding source for both the government and companies by luring Middle Eastern investors, many of whom only use Islamic products.
They believe that the Islamic bonds will also help to cover a ballooning state budget deficit.
Indonesia's need for the funding alternative has increased recently, with the government set to run a wider-than-expected 27 percent budget deficit this year.
Like other forms of Islamic financing tools, sukuk do not receive or pay interest.
It typically operates through actual transactions such as profit-sharing or leasing.
Companies that have issued Islamic bonds make payments to investors using profits from the underlying business, instead of paying interest.
Promising
The government hopes that by allowing sukuk, the country will tap into a booming global market.
"I'm optimistic that Indonesia will be able to compete," said Minister Mulyani.
Bankers are also optimistic that sukuk would bring good news for Indonesia amid the budget deficit and the soaring inflation.
Rakesh Bhatia, the head of HSBC in Indonesia, sees the sukuk legislation as "extremely positive".
"The law will give the government and the country access to additional capital," he told the FT.
"We're already in advanced talks with companies that are just waiting for the government to take the lead."
Abiprayadi Riyanto, head of Mandiri Investasi, a subsidiary firm of Indonesia's largest lender PT Bank Mandiri, doubts the country could compete with Asia's Islamic finance hub Malaysia "in the near future".
"The Malaysian government's commitment to develop sukuk is so high, while in Indonesia there are so many bureaucratic hurdles."
Southeast Asian giant Malaysia has the world's largest Islamic bond market.
It issued about 47 billion dollars or two-thirds of the total Islamic bonds outstanding worldwide last year.
Sukuk are increasingly popular and saw a growing market around the world in recent years.
They are already available in the US, Britain and Japan through corporate issuers, but never by a Western state.
Some countries, like Thailand, are contemplating the issuance of Islamic bonds of their own.
The British government has launched a comprehensive study to analyze the feasibility for the government to issue Islamic bonds to enhance London's standing as an Islamic finance hub.
Tuesday, October 21, 2008
Sukuk: Emergence as a Multi-Purpose Shariah Compliant Financing Product
With the Islamic banking and finance market estimated to be worth $500 billion, and having a growth rate of 15-20 per cent annually, affluent Muslim investors are looking for some serious investment options that comply with Islamic Shariah.
Standard and Poor’s estimates that 20 per cent of those investors, with billions to invest, would now spontaneously choose an Islamic financial product over a conventional one with a similar risk-return profile.
That has led to the increased use of the Sukuk, especially in the Gulf countries and Malaysia. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), defines Sukuks as “certificates of equal value representing after closing subscription, 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.”
Introduced in varied structures and sizes, Sukuks worth $20 billion hit the market in 2006 and are expected to surpass $50 billion in 2007 as the companies seek to diversify their sources of financing. Although companies in Kuwait, Bahrain, Saudi Arabia and Qatar have all been actively using Sukuk financings over the years, Malaysia led the Sukuk issue market in 2006 with a share of about 60 per cent. That year also witnessed the first Sukuk that originated in the United States. The trends in 2007 clearly suggest that the United Arab Emirates, especially Dubai, have most likely taken over the lead.
Sukuk structures are being used for a variety of purposes and have evolved rapidly in response to the demands of issuers and investors. Sukuk issues have ranged from the simple sale and leaseback (Ijara) structures, such as the $1 billion Dubai Department of Civil Aviation Sukuk issued in November 2004, to the $2.53 billion trust finance Sukuk structure issued by Aldar Properties in March 2007, demonstrating the flexibility of Islamic finance principles.
Below are examples of some recent Sukuk issues that show and emphasise that Sukuk has matured into a diversified, internationally-acceptable instrument to raise corporate finance for acquisitions or working capital purposes, or to re-finance existing debt, or use in the transportation sector (especially in the shipping and aircraft sectors), real estate, construction and petrochemical projects in several countries.
German Sukuk (Saxony-Anhalt Sukuk)
In 2004, a €100 million Sukuk, structured as a Sukuk Al Ijara, was issued in the federal state of Saxony-Anhalt in Germany. The Federal Republic of Germany guarantees the debts of Saxony-Anhalt. The underlying transactions are a certain number of specified buildings owned by the Ministry of Finance. The master lease was sold for 100 years to a special purpose vehicle, incorporated in the Netherlands for tax reasons, which in turn rented it back for five years to the Ministry of Finance. The certificate holders receive a variable rent benchmarked to the EURIBOR over the rented period. The Sukuk is listed on the Luxembourg Stock Exchange. Incidentally, as of July 2007, the Saxony-Anhalt Sukuk remains the only sovereign Sukuk from a non-Islamic country to have tapped the market.
Sukuks by the Governments of Bahrain, Qatar and Malaysia
The Central Bank of Bahrain, on behalf of the Government of Bahrain, regularly issues Sukuk-Al-Ijara and Sukuk Al-Salam to finance various infrastructure projects in Bahrain. Malaysia’s Global Sukuk, launched in June 2002, was similarly backed by an Ijara lease on a single piece of government property. The money raised by the Government of Qatar through the $700 million Qatar Global Sukuk is being used partly to finance the construction of the Hamad Medical City.
First Airlines Sukuk - Emirates Airlines Sukuk
The first Sukuk issued by Dubai’s national airlines, Emirates, closed in July 2005. At $550 million, this was the single largest corporate Sukuk issuance at that time. The Sukuk has a seven-year tenor and is structured as a Musharaka. The proceeds of the issue, which is listed on the Luxembourg Stock Exchange, will be used to finance the new Emirates Engineering Centre and their headquarters building in Dubai.
First Ship Finance Sukuk – MT Venus Glory Sukuk/Al Safeena Sukuk
In 2005, ABC International Bank jointly with Abu Dhabi Commercial Bank arranged, structured and jointly underwrote a pioneering Islamic ship finance transaction through the issuance of a $26 million Al-Safeena Ijara Sukuk. At that time, Al-Safeena Sukuk was the first issue that combined Islamic equity with conventional debt for the same asset, which in this case was VLCC (called “Venus Glory”), owned by Pacific Star (Pac Star) International Holding Corporation, which in turn is owned by Saudi Aramco, the world’s largest oil exporting company.
Dubai Civil Aviation Authority Sukuk
The Dubai Civil Aviation Authority, a quasi-sovereign entity, broke the mould in 2004 by going down the Sukuk route instead of plain vanilla finance, by issuing a $1 billion Sukuk, the world’s largest single Sukuk issuance in terms of size at that time by any issuer. The proceeds were used to finance the building of a new international terminal and for the expansion of existing engineering and other infrastructure. The Musharaka was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai’s airport that will ultimately be leased to Emirates. Profit, in the form of lease returns, generated from the Musharaka will be used to pay the periodic distribution on the trust certificates.
Bahrain Financial Harbour - Al Marfa'a Al Mali Sukuk
The Istisna'a-Ijara Sukuk, known as the Al Marfa'a Al Mali Sukuk, has been structured by the Liquidity Management Centre in accordance and in compliance with the principles of Islamic Shari'a. The Sukuk has a five-year term maturing in 2010 offering a quarterly profit distribution with the proceeds used to finance the development and construction of the Financial Centre which represents the first phase of the Bahrain Financial Harbour project comprising the Dual Towers, the Financial Mall and the Harbour House.
Dubai World Sukuk
In 2006, Dubai property developer Nakheel Group, developer of three palm-frond shaped islands off Dubai's coast, sold the world's largest Islamic bond after increasing its size by more than 40 per cent to $3.52 billion to meet demand. Nakheel will use cash from its Sukuk to fund projects in Dubai, which is leading a surge in Gulf Arab investment in construction and real-estate developments. The Sukuk has been listed on the Dubai International Financial Exchange.
DP World Sukuk
In 2007, global marine terminal operator DP World priced a $1.75 billion conventional bond and a $1.5 billion Sukuk. It is the first issuer to list both conventional and Islamic debt securities on the Dubai International Financial Exchange.
The $1.5 billion, 10-year Sukuk attracted demand globally, including from the United States. This was the first time U.S. investors had the opportunity to subscribe to a UAE corporate rated Sukuk. DP World's Sukuk is ground breaking and innovative because it is partly convertible to shares in the event the ports group lists through an initial public offering, thus becoming the first convertible instrument in the Islamic finance market. The issue is part of a large financing package being arranged for general corporate activities, ongoing business development needs, and expansion plans, including the financing of the purchase of the British rival P&O.
East Cameron Gas Sukuk
The first and only Sukuk to have originated from the United States tapped the market in 2006. The unique feature of the East Cameron Gas Sukuk was that it was the first ever Shariah compliant gas backed securitisation and was the first-ever Islamic securitisation rated by Standard and Poor’s. The $165.7 million Sukuk originated from Houston based East Cameron Partners, whose reserves are located in the shallow waters off the shores of the State of Louisana. The Sukuk was structured as a Musharaka structure in terms of the management of the assets and then a funding agreement between the issuer and the purchaser.
The initiatives taken by the governments of the UAE, Bahrain, Malaysia and the United Kingdom, to name a few, have acted as a catalyst for the evolution and growth of the Sukuk market and the development of Islamic Finance as a whole. The regulatory bodies within such countries have been actively introducing rules and regulations pertaining to the issuing and offering of Sukuks, which we hope in time will help provide standardisation, resulting in the maturation of the field.
From the financing structures focused mainly on plain vanilla type commodity-trading murabaha transactions to the complex structures involved in the Sukuks, Islamic finance has come a long way and Sukuks have emerged as high profile financial instruments. With top international banks, financial institutions, law firms and other financial services providers scampering for a piece of the cake in the Middle East, Islamic banking and finance has grown into a full-fledged practice area of its own. With a catalogue of successful issues worth billions of dollars reflecting the huge appetite for Sukuks, there are all signs pointing towards the long term success and growth of Sukuks.
For more information please contact Rory Todd at rtodd@applebyglobal.com
Standard and Poor’s estimates that 20 per cent of those investors, with billions to invest, would now spontaneously choose an Islamic financial product over a conventional one with a similar risk-return profile.
That has led to the increased use of the Sukuk, especially in the Gulf countries and Malaysia. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), defines Sukuks as “certificates of equal value representing after closing subscription, 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.”
Introduced in varied structures and sizes, Sukuks worth $20 billion hit the market in 2006 and are expected to surpass $50 billion in 2007 as the companies seek to diversify their sources of financing. Although companies in Kuwait, Bahrain, Saudi Arabia and Qatar have all been actively using Sukuk financings over the years, Malaysia led the Sukuk issue market in 2006 with a share of about 60 per cent. That year also witnessed the first Sukuk that originated in the United States. The trends in 2007 clearly suggest that the United Arab Emirates, especially Dubai, have most likely taken over the lead.
Sukuk structures are being used for a variety of purposes and have evolved rapidly in response to the demands of issuers and investors. Sukuk issues have ranged from the simple sale and leaseback (Ijara) structures, such as the $1 billion Dubai Department of Civil Aviation Sukuk issued in November 2004, to the $2.53 billion trust finance Sukuk structure issued by Aldar Properties in March 2007, demonstrating the flexibility of Islamic finance principles.
Below are examples of some recent Sukuk issues that show and emphasise that Sukuk has matured into a diversified, internationally-acceptable instrument to raise corporate finance for acquisitions or working capital purposes, or to re-finance existing debt, or use in the transportation sector (especially in the shipping and aircraft sectors), real estate, construction and petrochemical projects in several countries.
German Sukuk (Saxony-Anhalt Sukuk)
In 2004, a €100 million Sukuk, structured as a Sukuk Al Ijara, was issued in the federal state of Saxony-Anhalt in Germany. The Federal Republic of Germany guarantees the debts of Saxony-Anhalt. The underlying transactions are a certain number of specified buildings owned by the Ministry of Finance. The master lease was sold for 100 years to a special purpose vehicle, incorporated in the Netherlands for tax reasons, which in turn rented it back for five years to the Ministry of Finance. The certificate holders receive a variable rent benchmarked to the EURIBOR over the rented period. The Sukuk is listed on the Luxembourg Stock Exchange. Incidentally, as of July 2007, the Saxony-Anhalt Sukuk remains the only sovereign Sukuk from a non-Islamic country to have tapped the market.
Sukuks by the Governments of Bahrain, Qatar and Malaysia
The Central Bank of Bahrain, on behalf of the Government of Bahrain, regularly issues Sukuk-Al-Ijara and Sukuk Al-Salam to finance various infrastructure projects in Bahrain. Malaysia’s Global Sukuk, launched in June 2002, was similarly backed by an Ijara lease on a single piece of government property. The money raised by the Government of Qatar through the $700 million Qatar Global Sukuk is being used partly to finance the construction of the Hamad Medical City.
First Airlines Sukuk - Emirates Airlines Sukuk
The first Sukuk issued by Dubai’s national airlines, Emirates, closed in July 2005. At $550 million, this was the single largest corporate Sukuk issuance at that time. The Sukuk has a seven-year tenor and is structured as a Musharaka. The proceeds of the issue, which is listed on the Luxembourg Stock Exchange, will be used to finance the new Emirates Engineering Centre and their headquarters building in Dubai.
First Ship Finance Sukuk – MT Venus Glory Sukuk/Al Safeena Sukuk
In 2005, ABC International Bank jointly with Abu Dhabi Commercial Bank arranged, structured and jointly underwrote a pioneering Islamic ship finance transaction through the issuance of a $26 million Al-Safeena Ijara Sukuk. At that time, Al-Safeena Sukuk was the first issue that combined Islamic equity with conventional debt for the same asset, which in this case was VLCC (called “Venus Glory”), owned by Pacific Star (Pac Star) International Holding Corporation, which in turn is owned by Saudi Aramco, the world’s largest oil exporting company.
Dubai Civil Aviation Authority Sukuk
The Dubai Civil Aviation Authority, a quasi-sovereign entity, broke the mould in 2004 by going down the Sukuk route instead of plain vanilla finance, by issuing a $1 billion Sukuk, the world’s largest single Sukuk issuance in terms of size at that time by any issuer. The proceeds were used to finance the building of a new international terminal and for the expansion of existing engineering and other infrastructure. The Musharaka was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai’s airport that will ultimately be leased to Emirates. Profit, in the form of lease returns, generated from the Musharaka will be used to pay the periodic distribution on the trust certificates.
Bahrain Financial Harbour - Al Marfa'a Al Mali Sukuk
The Istisna'a-Ijara Sukuk, known as the Al Marfa'a Al Mali Sukuk, has been structured by the Liquidity Management Centre in accordance and in compliance with the principles of Islamic Shari'a. The Sukuk has a five-year term maturing in 2010 offering a quarterly profit distribution with the proceeds used to finance the development and construction of the Financial Centre which represents the first phase of the Bahrain Financial Harbour project comprising the Dual Towers, the Financial Mall and the Harbour House.
Dubai World Sukuk
In 2006, Dubai property developer Nakheel Group, developer of three palm-frond shaped islands off Dubai's coast, sold the world's largest Islamic bond after increasing its size by more than 40 per cent to $3.52 billion to meet demand. Nakheel will use cash from its Sukuk to fund projects in Dubai, which is leading a surge in Gulf Arab investment in construction and real-estate developments. The Sukuk has been listed on the Dubai International Financial Exchange.
DP World Sukuk
In 2007, global marine terminal operator DP World priced a $1.75 billion conventional bond and a $1.5 billion Sukuk. It is the first issuer to list both conventional and Islamic debt securities on the Dubai International Financial Exchange.
The $1.5 billion, 10-year Sukuk attracted demand globally, including from the United States. This was the first time U.S. investors had the opportunity to subscribe to a UAE corporate rated Sukuk. DP World's Sukuk is ground breaking and innovative because it is partly convertible to shares in the event the ports group lists through an initial public offering, thus becoming the first convertible instrument in the Islamic finance market. The issue is part of a large financing package being arranged for general corporate activities, ongoing business development needs, and expansion plans, including the financing of the purchase of the British rival P&O.
East Cameron Gas Sukuk
The first and only Sukuk to have originated from the United States tapped the market in 2006. The unique feature of the East Cameron Gas Sukuk was that it was the first ever Shariah compliant gas backed securitisation and was the first-ever Islamic securitisation rated by Standard and Poor’s. The $165.7 million Sukuk originated from Houston based East Cameron Partners, whose reserves are located in the shallow waters off the shores of the State of Louisana. The Sukuk was structured as a Musharaka structure in terms of the management of the assets and then a funding agreement between the issuer and the purchaser.
The initiatives taken by the governments of the UAE, Bahrain, Malaysia and the United Kingdom, to name a few, have acted as a catalyst for the evolution and growth of the Sukuk market and the development of Islamic Finance as a whole. The regulatory bodies within such countries have been actively introducing rules and regulations pertaining to the issuing and offering of Sukuks, which we hope in time will help provide standardisation, resulting in the maturation of the field.
From the financing structures focused mainly on plain vanilla type commodity-trading murabaha transactions to the complex structures involved in the Sukuks, Islamic finance has come a long way and Sukuks have emerged as high profile financial instruments. With top international banks, financial institutions, law firms and other financial services providers scampering for a piece of the cake in the Middle East, Islamic banking and finance has grown into a full-fledged practice area of its own. With a catalogue of successful issues worth billions of dollars reflecting the huge appetite for Sukuks, there are all signs pointing towards the long term success and growth of Sukuks.
For more information please contact Rory Todd at rtodd@applebyglobal.com
Seeking sukuk
While Malaysia continues to dominate sukuk issuance, some mega-deals announced in the past two years point to bright prospects elsewhere in the Islamic world
Billions of dollars worth of sukuk bonds have been issued this year, indicating a continuing boom in the use of fundraising instruments that comply with sharia (Islamic law). High oil prices and greater customer awareness are driving demand from Islamic institutional and private investors for investments that avoid the prohibited areas of riba (interest), gharar (uncertainty) and maysir (gambling). Issuance has already reached $41 billion worldwide, and is growing fast. Abdullah al Muajel, head of the sharia control department at Al Rajhi Bank in Riyadh, expects this to rise to $150 billion by the end of 2010.
To meet this demand, the sukuk market (see box) will have to expand into new areas - and a few large and innovative sukuk deals this year may point the way. January 2006 saw the launch of the largest sukuk to date, an issue by the Dubai Ports, Customs and Free Zone Corporation (PCFC), arranged by Dubai Islamic Bank, and listed on the Dubai International Financial Exchange. Intended to raise funds for PCFC's takeover of UK port operator P&O, through its Dubai Ports World subsidiary, the sukuk was oversubscribed more than four times, receiving a total of $11.4 billion in bids. This demand led PCFC to increase issuance from $2.8 billion to $3.5 billion.
But it is not just the size of the PCFC sukuk that has attracted attention of Islamic financiers. PCFC, in anticipation of an initial public offering (IPO) at some point in the future, structured it as a convertible sukuk. Up to 30% of the sukuk can be redeemed into PCFC shares if an IPO goes ahead in the next two years - otherwise, the sukuk produces a higher yield at redemption, 10.125% a year rather than 7.125%.
The deal was based on a musharaka (venture capital) arrangement. The two partners in the musharaka structure were PCFC, which contributed $1.5 billion in kind, and a special-purpose vehicle (SPV), PCFC Development FZCO, which contributed the $3.5 billion raised by the sukuk. The key to the deal was the SPV's establishment of an English law trust over its right to share the joint venture's profits - selling the trust certificates gave investors a share of profits.
With the trust certificates came the option to convert into PCFC stock. Normally, such a transaction would raise issues of gharar, but according to PCFC's sharia board, as the strike price and the stock were set in advance, there was no uncertainty in the structure.
The PCFC sukuk was listed on the Dubai International Financial Exchange (DIFX), which opened for business in September 2005 - PCFC was the first sukuk to list there.
Aabar Petroleum, an Abu Dhabi oil exploration and production company, listed the second sukuk - a fully convertible bond - on the DIFX in June. Harris Irfan, Deutsche Bank's Dubai-based director of emerging markets structuring, whose bank acted as bookrunner and lead manager, explains: "Aabar is the first truly convertible sukuk that converts wholly into the shares of the underlying company. There are scenarios in which cash would be offered instead, but essentially it operates as a conventional convertible - if it is in-the-money, you get the equity, and if it is out-of-the money, you get par."
The Aabar sukuk raised $460 million, with a fixed profit rate of 6.894%, based on the four-year dollar swap rate at the time of pricing. It will mature on June 28, 2010. The conversion price is $1.0895; Aabar's stock is currently at 3.43 dirhams ($0.934).
Convertible bonds are not unique to Dubai - the Malaysian market saw its first issue in 2005 - but they have not, so far, been widely issued in any market. Market participants say this is not because of difficulties with sharia (even though equity options are widely regarded as being unreal instruments, or 'promises', rather than actual assets). Instead, it may be due to a simple lack of experience among the structuring banks.
"It is actually an extremely difficult instrument to structure. It requires a lot of different skill sets and resources and technology to make it work. So far, very few institutions have demonstrated that they are capable of structuring and executing these complex instruments from start to finish," says Deutsche Bank's Irfan. "I think it is probably the Western investment banks, ironically, that are best placed to do the complex transactions, rather than the local and regional institutions, even though traditionally Islamic instruments have been the preserve of the local Islamic banks."
In spite of the difficulties in structuring some Islamic financial instruments, the industry is growing fast. The obvious explanation for the growth is the five-year oil bull-run. The rise in oil prices, from $28 in January 2001 to a record high of $78.65 in August this year, means there's plenty of liquidity in the region, with investors keen to place their spare cash in Islamic investments. "Just by internal growth in the region, the assets under management should grow drastically. I don't think it will be growth from foreign investors - it is not about bringing back money invested elsewhere, it is about internal growth of the wealth they already have," says David Ishoo-Mirzayoo, London-based co-head of Societe Generale's (SG) derivatives and solutions group for Europe, the Middle East and Africa.
While much of the growth may be endogenous, investors outside of the Middle East have also been showing interest. Some high-profile sukuk issues have attracted significant proportions of non-Islamic cash - investors in the US and Europe bought 20% of the inaugural $600 million sukuk issued by the Malaysian government in 2002, and 70% of the $400 million 2003 Islamic Development Bank (IDB) sukuk, for example.
However, the Islamic finance business in general - sukuk included - has a disadvantage compared with conventional financing, say analysts. "In most cases, Islamic banks will be competing with conventional institutions, but Islamic products are less commoditised and require more tailoring and oversight, and this leads to substantial overheads," notes Adel Satel, an analyst at Moody's Investors Service in London. "As a result, it is difficult for Islamic (pricing) to compete with conventional market interest rates. In addition, in most markets where Islamic banks have been established, they are small institutions, even by local standards, and this puts further pressure on their cost base."
The additional cost associated with structuring customised Islamic bonds means only a handful of issuers outside the Middle East and Asia have issued sukuk. The finance ministry of the German federal state of Saxony-Anhalt issued the first European sukuk in July 2004. Although the issue raised its target of $100 million, the German authority has no plans for another sukuk issue - and few other European issuers have followed its lead.
By the end of 2005, only a handful of sukuk had been issued in Europe, and all were on behalf of Middle Eastern borrowers - a 2003 sukuk issued by the IDB used a Channel Islands-based SPV; the 2005 $26 million Al Safeena tanker financing was structured in London by ABC International Bank of Bahrain; Taib Bank of Bahrain issued a £143 million sukuk in London in 2005 to finance the purchase of a London office building; and a Jersey SPV, Caravan I, was used for the 2004 securitisation of a Saudi rental car fleet.
Edgar Kresin, head of the Saxony-Anhalt treasury office, says its sukuk issue was a success - but only because the government had more than financial objectives in mind. "We use it as a kind of marketing instrument for our region in the Middle East," he says, adding that a sukuk would only make sense for a European sovereign or sub-sovereign issuer if it hoped to reap indirect benefits. The region's economic ministry, responsible for promoting inward investment in Saxony-Anhalt, launched a push for Middle Eastern investment alongside the sukuk.
Without this push, there is no reason to use a sukuk rather than a familiar conventional instrument, Kresin says: "You need another target beside just funding. It doesn't make so much sense just from a funding perspective, but from a strategic way of thinking it may make sense for a state."
One of the hurdles to growth is the lack of standardisation in the Islamic market. Sunni Islam, the larger of the two major Islamic sects, contains four major schools of legal thought. Hanbali, the most conservative, is commonest in Saudi Arabia and the Gulf states; hanafi, the largest, is most common in south and central Asia and Europe; Africa is dominated by the maliki school; while Malaysia and Indonesia tend to follow the liberal shafi school.
This matters because each regulator, bank and institution has its own sharia board. And opinions on legally permissible structures vary not only from country to country, but also from bank to bank. However, not all banks are equal: a sukuk by the IDB, based in Jeddah in Saudi Arabia, may have opened the way for a new wave of non-ijara (sale/leaseback) sukuk, says Mohammed al-Sheikh, co-head of the Islamic finance unit at the law firm White & Case in Riyadh.
The sukuk, issued in July 2003, was the bank's first, and raised $400 million (up from $300 million after oversubscription). Previous sukuk, issued by the Malaysian and Qatari governments, had relied entirely on real estate sale/leaseback as underlyings. Other IDB sharia-compliant assets, such as murabaha (cost-plus sale agreements) and istisna'a (cost-plus production agreements) would not normally have been permissible, as they are undertakings to pay as opposed to actual assets - the murabaha and istisna'a deals themselves are sharia-compliant, but their securitisation would not have been.
But, al-Sheikh explains, IDB managed to push the envelope: "The novelty of the IDB was that their sharia committee, a very respected committee, said that as long as the ijara component was more than 50% of the portfolio, you could put whatever else you wanted in. That has really created a push toward more sukuk issuance. It is not a binding precedent, but it is a precedent that gives comfort."
In fact, the IDB deal left room for further flexibility, setting an absolute limit of 25% ijara "under specific circumstances and for very limited durations", below which the sukuk would be dissolved. In the event, the portfolio was 66% ijara.
However, the existence of a central decision-making body would add even more clarity to the process. Deutsche's Irfan comments: "I believe it is healthy to have sharia boards that act across schools of thought. We have a board of five scholars who may have divergent opinions, and that actually helps us sell the product, because investors say the most conservative views must have been applied to the underlying transactions here."
Standardised documents could also help develop the market for simpler transactions - Irfan suggests a profit rate swap as one example. In an Islamic profit rate swap, first developed by the Commerce International Merchant Bank (CIMB) of Malaysia in June 2005, the two legs are fixed- and floating-rate sale agreements, with the floating rate based on the Kuala Lumpur interbank offered rate (Klibor). A notional asset is sold for a notional sum, and then repurchased for the notional sum plus a fixed profit rate - effectively an agreement to pay the fixed profit rate. A similar sale/repurchase arrangement underpins the floating leg of the swap, and the result is a fixed/floating rate swap that is sharia-compliant.
Launching the product in June 2005, CIMB's head of Islamic banking in Kuala Lumpur, Badlisyah Abd Ghani, told Risk's sister magazine, Asia Risk, that the connection to an interest rate did not make the deal un-Islamic. "But in terms of a benchmark, this can be whatever is agreeable between the two parties. Klibor is just a mathematical formula. It is just a number. The act of charging money on money (is unlawful) but the number itself is just a number. Klibor is just a way to agree terms, and there is nothing wrong in using it."
But the complexity of the profit rate swap documentation - "like Tolstoy's War and Peace" compared with the brief International Swaps and Derivatives Association documentation for a conventional rate swap, according to Julian Candiah, Singapore-based director of structured products and debt-capital markets at BNP Paribas - means that more standardisation is needed.
Looking further ahead, SG's Ishoo-Mirzayoo suggests, the next step will be a move from cash to synthetic deals. "The cash market on the conventional world has been replaced by the synthetic market ... cash collateralised debt obligations (CDOs) moving to synthetic CDOs. Well, the Islamic market is moving in the same direction - we are able more and more to repackage synthetically Islamic exposure for investors."
Structuring such products while staying within the boundaries of sharia is not easy. Ishoo-Mirzayoo declined to give details of how the products would be structured, but notes they have been traded on a non-public basis since 2005. "We are trading these, and we are not the only ones," he adds.
In fact, some dealers argue that any product can be made sharia-compliant, so long as an appropriate wrapper is used. "A sukuk is nothing more than an Islamic wrapper on an underlying, and you will see more and more development of Islamic wrappers on different underlyings," says Ishoo-Mirzayoo. "It all depends how conservative the underlying investor is. Some people are just happy with the (Islamic) wrapper, as long as the flows are Islamic, regardless of the underlying product; some others need to be much more conservative."
Even interest-bearing loans could be acceptable as underlyings for some clients, so long as the structure itself follows sharia rules. "Some investors look just at the top layer, some look all the way down to the underlying," says Ishoo-Mirzayoo. "It all comes down to one thing - there is appetite for yield, and it is very difficult to find yield in traditional Islamic markets."
And Deutsche's Irfan predicts sharia instruments will move away from the lease-based type, or sukuk al-ijara, and more to traditional profit and loss sharing systems like musharaka (venture capital) and mudaraba (trustee investment).
"You will probably see two strands of sukuk ... simple corporate and sovereign bonds, and bonds that have a story behind them - structured project bonds for example," adds Ishoo-Mirzayoo. "The latter type of instrument may be required for project finance, and naturally those instruments will be more prevalent in areas that have huge infrastructure requirements and a decent credit story - an ability to repay."
Meanwhile, the next big market could be Indonesia. Infrastructure companies, such as the Indonesian Satellite Corporation, have already issued several sukuk, and the government plans to follow, with a launch planned for early 2007. Its proximity and commercial links to the heart of the sukuk business in Malaysia should prove an advantage. The state energy company, Perusahaan Listrik Negara, is planning a $1.6 billion sukuk to fund power station construction and has named UBS as the arranger. The archipelago's need for infrastructure investment is acute and, with better corporate governance rules making investment in the country less risky, using sukuk to funnel Gulf cash to Indonesian projects could be a profitable business.
WHAT IS A SUKUK?
A sukuk is often described as an Islamic bond or Islamic security. A sukuk is a tradable certificate, which represents an investment in an underlying asset of the issuer and carries a fixed or floating profit rate (the equivalent of a coupon on a conventional bond). The commonest form of sukuk remains the sukuk al-ijara, based on the sale and leaseback of the underlying asset, but sukuk can also use financial contracts as long as the majority of the underlying is ijara.
Three possible financial underlying contracts are:
- istina'a, an agreement in advance for production of goods at a certain time and price.
- murabaha, cost-plus sales in which payment is deferred (thus the equivalent of buying on credit).
- musharaka, a venture capital agreement in which profits from the joint enterprise are shared according to a prearranged rate rather than in proportion to the investment.
Islamic investors may also use a mudaraba arrangement. This is the equivalent of a trust, in which funds are deposited with an agent who manages their investment in return for a fee.
Alexander Campbell
If you want to comment on this article, please email the Editorial Director, Nick Sawyer on nick.sawyer@incisivemedia.com
Billions of dollars worth of sukuk bonds have been issued this year, indicating a continuing boom in the use of fundraising instruments that comply with sharia (Islamic law). High oil prices and greater customer awareness are driving demand from Islamic institutional and private investors for investments that avoid the prohibited areas of riba (interest), gharar (uncertainty) and maysir (gambling). Issuance has already reached $41 billion worldwide, and is growing fast. Abdullah al Muajel, head of the sharia control department at Al Rajhi Bank in Riyadh, expects this to rise to $150 billion by the end of 2010.
To meet this demand, the sukuk market (see box) will have to expand into new areas - and a few large and innovative sukuk deals this year may point the way. January 2006 saw the launch of the largest sukuk to date, an issue by the Dubai Ports, Customs and Free Zone Corporation (PCFC), arranged by Dubai Islamic Bank, and listed on the Dubai International Financial Exchange. Intended to raise funds for PCFC's takeover of UK port operator P&O, through its Dubai Ports World subsidiary, the sukuk was oversubscribed more than four times, receiving a total of $11.4 billion in bids. This demand led PCFC to increase issuance from $2.8 billion to $3.5 billion.
But it is not just the size of the PCFC sukuk that has attracted attention of Islamic financiers. PCFC, in anticipation of an initial public offering (IPO) at some point in the future, structured it as a convertible sukuk. Up to 30% of the sukuk can be redeemed into PCFC shares if an IPO goes ahead in the next two years - otherwise, the sukuk produces a higher yield at redemption, 10.125% a year rather than 7.125%.
The deal was based on a musharaka (venture capital) arrangement. The two partners in the musharaka structure were PCFC, which contributed $1.5 billion in kind, and a special-purpose vehicle (SPV), PCFC Development FZCO, which contributed the $3.5 billion raised by the sukuk. The key to the deal was the SPV's establishment of an English law trust over its right to share the joint venture's profits - selling the trust certificates gave investors a share of profits.
With the trust certificates came the option to convert into PCFC stock. Normally, such a transaction would raise issues of gharar, but according to PCFC's sharia board, as the strike price and the stock were set in advance, there was no uncertainty in the structure.
The PCFC sukuk was listed on the Dubai International Financial Exchange (DIFX), which opened for business in September 2005 - PCFC was the first sukuk to list there.
Aabar Petroleum, an Abu Dhabi oil exploration and production company, listed the second sukuk - a fully convertible bond - on the DIFX in June. Harris Irfan, Deutsche Bank's Dubai-based director of emerging markets structuring, whose bank acted as bookrunner and lead manager, explains: "Aabar is the first truly convertible sukuk that converts wholly into the shares of the underlying company. There are scenarios in which cash would be offered instead, but essentially it operates as a conventional convertible - if it is in-the-money, you get the equity, and if it is out-of-the money, you get par."
The Aabar sukuk raised $460 million, with a fixed profit rate of 6.894%, based on the four-year dollar swap rate at the time of pricing. It will mature on June 28, 2010. The conversion price is $1.0895; Aabar's stock is currently at 3.43 dirhams ($0.934).
Convertible bonds are not unique to Dubai - the Malaysian market saw its first issue in 2005 - but they have not, so far, been widely issued in any market. Market participants say this is not because of difficulties with sharia (even though equity options are widely regarded as being unreal instruments, or 'promises', rather than actual assets). Instead, it may be due to a simple lack of experience among the structuring banks.
"It is actually an extremely difficult instrument to structure. It requires a lot of different skill sets and resources and technology to make it work. So far, very few institutions have demonstrated that they are capable of structuring and executing these complex instruments from start to finish," says Deutsche Bank's Irfan. "I think it is probably the Western investment banks, ironically, that are best placed to do the complex transactions, rather than the local and regional institutions, even though traditionally Islamic instruments have been the preserve of the local Islamic banks."
In spite of the difficulties in structuring some Islamic financial instruments, the industry is growing fast. The obvious explanation for the growth is the five-year oil bull-run. The rise in oil prices, from $28 in January 2001 to a record high of $78.65 in August this year, means there's plenty of liquidity in the region, with investors keen to place their spare cash in Islamic investments. "Just by internal growth in the region, the assets under management should grow drastically. I don't think it will be growth from foreign investors - it is not about bringing back money invested elsewhere, it is about internal growth of the wealth they already have," says David Ishoo-Mirzayoo, London-based co-head of Societe Generale's (SG) derivatives and solutions group for Europe, the Middle East and Africa.
While much of the growth may be endogenous, investors outside of the Middle East have also been showing interest. Some high-profile sukuk issues have attracted significant proportions of non-Islamic cash - investors in the US and Europe bought 20% of the inaugural $600 million sukuk issued by the Malaysian government in 2002, and 70% of the $400 million 2003 Islamic Development Bank (IDB) sukuk, for example.
However, the Islamic finance business in general - sukuk included - has a disadvantage compared with conventional financing, say analysts. "In most cases, Islamic banks will be competing with conventional institutions, but Islamic products are less commoditised and require more tailoring and oversight, and this leads to substantial overheads," notes Adel Satel, an analyst at Moody's Investors Service in London. "As a result, it is difficult for Islamic (pricing) to compete with conventional market interest rates. In addition, in most markets where Islamic banks have been established, they are small institutions, even by local standards, and this puts further pressure on their cost base."
The additional cost associated with structuring customised Islamic bonds means only a handful of issuers outside the Middle East and Asia have issued sukuk. The finance ministry of the German federal state of Saxony-Anhalt issued the first European sukuk in July 2004. Although the issue raised its target of $100 million, the German authority has no plans for another sukuk issue - and few other European issuers have followed its lead.
By the end of 2005, only a handful of sukuk had been issued in Europe, and all were on behalf of Middle Eastern borrowers - a 2003 sukuk issued by the IDB used a Channel Islands-based SPV; the 2005 $26 million Al Safeena tanker financing was structured in London by ABC International Bank of Bahrain; Taib Bank of Bahrain issued a £143 million sukuk in London in 2005 to finance the purchase of a London office building; and a Jersey SPV, Caravan I, was used for the 2004 securitisation of a Saudi rental car fleet.
Edgar Kresin, head of the Saxony-Anhalt treasury office, says its sukuk issue was a success - but only because the government had more than financial objectives in mind. "We use it as a kind of marketing instrument for our region in the Middle East," he says, adding that a sukuk would only make sense for a European sovereign or sub-sovereign issuer if it hoped to reap indirect benefits. The region's economic ministry, responsible for promoting inward investment in Saxony-Anhalt, launched a push for Middle Eastern investment alongside the sukuk.
Without this push, there is no reason to use a sukuk rather than a familiar conventional instrument, Kresin says: "You need another target beside just funding. It doesn't make so much sense just from a funding perspective, but from a strategic way of thinking it may make sense for a state."
One of the hurdles to growth is the lack of standardisation in the Islamic market. Sunni Islam, the larger of the two major Islamic sects, contains four major schools of legal thought. Hanbali, the most conservative, is commonest in Saudi Arabia and the Gulf states; hanafi, the largest, is most common in south and central Asia and Europe; Africa is dominated by the maliki school; while Malaysia and Indonesia tend to follow the liberal shafi school.
This matters because each regulator, bank and institution has its own sharia board. And opinions on legally permissible structures vary not only from country to country, but also from bank to bank. However, not all banks are equal: a sukuk by the IDB, based in Jeddah in Saudi Arabia, may have opened the way for a new wave of non-ijara (sale/leaseback) sukuk, says Mohammed al-Sheikh, co-head of the Islamic finance unit at the law firm White & Case in Riyadh.
The sukuk, issued in July 2003, was the bank's first, and raised $400 million (up from $300 million after oversubscription). Previous sukuk, issued by the Malaysian and Qatari governments, had relied entirely on real estate sale/leaseback as underlyings. Other IDB sharia-compliant assets, such as murabaha (cost-plus sale agreements) and istisna'a (cost-plus production agreements) would not normally have been permissible, as they are undertakings to pay as opposed to actual assets - the murabaha and istisna'a deals themselves are sharia-compliant, but their securitisation would not have been.
But, al-Sheikh explains, IDB managed to push the envelope: "The novelty of the IDB was that their sharia committee, a very respected committee, said that as long as the ijara component was more than 50% of the portfolio, you could put whatever else you wanted in. That has really created a push toward more sukuk issuance. It is not a binding precedent, but it is a precedent that gives comfort."
In fact, the IDB deal left room for further flexibility, setting an absolute limit of 25% ijara "under specific circumstances and for very limited durations", below which the sukuk would be dissolved. In the event, the portfolio was 66% ijara.
However, the existence of a central decision-making body would add even more clarity to the process. Deutsche's Irfan comments: "I believe it is healthy to have sharia boards that act across schools of thought. We have a board of five scholars who may have divergent opinions, and that actually helps us sell the product, because investors say the most conservative views must have been applied to the underlying transactions here."
Standardised documents could also help develop the market for simpler transactions - Irfan suggests a profit rate swap as one example. In an Islamic profit rate swap, first developed by the Commerce International Merchant Bank (CIMB) of Malaysia in June 2005, the two legs are fixed- and floating-rate sale agreements, with the floating rate based on the Kuala Lumpur interbank offered rate (Klibor). A notional asset is sold for a notional sum, and then repurchased for the notional sum plus a fixed profit rate - effectively an agreement to pay the fixed profit rate. A similar sale/repurchase arrangement underpins the floating leg of the swap, and the result is a fixed/floating rate swap that is sharia-compliant.
Launching the product in June 2005, CIMB's head of Islamic banking in Kuala Lumpur, Badlisyah Abd Ghani, told Risk's sister magazine, Asia Risk, that the connection to an interest rate did not make the deal un-Islamic. "But in terms of a benchmark, this can be whatever is agreeable between the two parties. Klibor is just a mathematical formula. It is just a number. The act of charging money on money (is unlawful) but the number itself is just a number. Klibor is just a way to agree terms, and there is nothing wrong in using it."
But the complexity of the profit rate swap documentation - "like Tolstoy's War and Peace" compared with the brief International Swaps and Derivatives Association documentation for a conventional rate swap, according to Julian Candiah, Singapore-based director of structured products and debt-capital markets at BNP Paribas - means that more standardisation is needed.
Looking further ahead, SG's Ishoo-Mirzayoo suggests, the next step will be a move from cash to synthetic deals. "The cash market on the conventional world has been replaced by the synthetic market ... cash collateralised debt obligations (CDOs) moving to synthetic CDOs. Well, the Islamic market is moving in the same direction - we are able more and more to repackage synthetically Islamic exposure for investors."
Structuring such products while staying within the boundaries of sharia is not easy. Ishoo-Mirzayoo declined to give details of how the products would be structured, but notes they have been traded on a non-public basis since 2005. "We are trading these, and we are not the only ones," he adds.
In fact, some dealers argue that any product can be made sharia-compliant, so long as an appropriate wrapper is used. "A sukuk is nothing more than an Islamic wrapper on an underlying, and you will see more and more development of Islamic wrappers on different underlyings," says Ishoo-Mirzayoo. "It all depends how conservative the underlying investor is. Some people are just happy with the (Islamic) wrapper, as long as the flows are Islamic, regardless of the underlying product; some others need to be much more conservative."
Even interest-bearing loans could be acceptable as underlyings for some clients, so long as the structure itself follows sharia rules. "Some investors look just at the top layer, some look all the way down to the underlying," says Ishoo-Mirzayoo. "It all comes down to one thing - there is appetite for yield, and it is very difficult to find yield in traditional Islamic markets."
And Deutsche's Irfan predicts sharia instruments will move away from the lease-based type, or sukuk al-ijara, and more to traditional profit and loss sharing systems like musharaka (venture capital) and mudaraba (trustee investment).
"You will probably see two strands of sukuk ... simple corporate and sovereign bonds, and bonds that have a story behind them - structured project bonds for example," adds Ishoo-Mirzayoo. "The latter type of instrument may be required for project finance, and naturally those instruments will be more prevalent in areas that have huge infrastructure requirements and a decent credit story - an ability to repay."
Meanwhile, the next big market could be Indonesia. Infrastructure companies, such as the Indonesian Satellite Corporation, have already issued several sukuk, and the government plans to follow, with a launch planned for early 2007. Its proximity and commercial links to the heart of the sukuk business in Malaysia should prove an advantage. The state energy company, Perusahaan Listrik Negara, is planning a $1.6 billion sukuk to fund power station construction and has named UBS as the arranger. The archipelago's need for infrastructure investment is acute and, with better corporate governance rules making investment in the country less risky, using sukuk to funnel Gulf cash to Indonesian projects could be a profitable business.
WHAT IS A SUKUK?
A sukuk is often described as an Islamic bond or Islamic security. A sukuk is a tradable certificate, which represents an investment in an underlying asset of the issuer and carries a fixed or floating profit rate (the equivalent of a coupon on a conventional bond). The commonest form of sukuk remains the sukuk al-ijara, based on the sale and leaseback of the underlying asset, but sukuk can also use financial contracts as long as the majority of the underlying is ijara.
Three possible financial underlying contracts are:
- istina'a, an agreement in advance for production of goods at a certain time and price.
- murabaha, cost-plus sales in which payment is deferred (thus the equivalent of buying on credit).
- musharaka, a venture capital agreement in which profits from the joint enterprise are shared according to a prearranged rate rather than in proportion to the investment.
Islamic investors may also use a mudaraba arrangement. This is the equivalent of a trust, in which funds are deposited with an agent who manages their investment in return for a fee.
Alexander Campbell
If you want to comment on this article, please email the Editorial Director, Nick Sawyer on nick.sawyer@incisivemedia.com
Differentiating Between Sukuk and Debt Bonds
In my last article I discussed the necessity of taking into consideration the controversial jurisprudential dispute entailed in Islamic bonds (sukuk) during the rating process conducted by credit rating agencies.
In response to the aforementioned article, I received a comment from the General Manager of Moody’s Investor Service in the Middle East, Mr. Jihad al Nakhla, in which he expressed his rejection of the idea that credit rating agencies should take the jurisprudential dispute into account during the rating process. He cited a number of considerations; including his statement that credit rating is an independent opinion that determines the issuers’ ability to fulfill the terms and pay back the debt in accordance with the their credit worthiness.
Credit rating also highlights the legal risks involved in sukuk and the nature of the contractual relationship between its members. As for the assessment of Islamic bonds, this process is conducted in collaboration with Islamic fatwa committees and the concerned consultants who are together in charge of determining whether the sukuk in question are Shariaa-compliant or not.
Let us assume that we must consider the contentious jurisprudential dispute entailed within the structure of Islamic bonds and ratings; it must be clarified that in order to deem sukuk as Shariaa-compliant it is necessary to resort to an external competent jurisprudential committee to offer its legitimate opinion. This means that our remarks upon the legitimate authority result in involving us so that we become party to the dispute, and thus lose the independence required for any credit rating agency.
Mr. Jihad concluded his comments by saying that many Muslims have sufficient confidence in the scholars of fatwa committees and therefore it was not necessary to take the controversial jurisprudential dispute sukuk into consideration during the credit rating process. Mr. Jihad believes that there is no difference between Islamic bonds and debt bonds since they all are liability related.
These are the major points in Mr. Jihad’s comment. Clearly, his comment was of great benefit to me and included valuable information.
Mr. Jihad’s argument has made it clear to me that the points of difference between us do not lie in the details but rather in the basic view of Islamic bonds. Mr. Jihad believes that sukuk are just like debt bonds. His viewpoint supports the idea upon which I elaborated in my previous article regarding the credit rating agencies’ perception of sukuk.
I believe that Islamic bonds or sukuk should be regarded from an independent perspective that considers their particularity since the concept is based upon the fact that sukuk holders own part of an asset, utility or service, and thus the ensuing profit is an outcome of this asset, utility or service. Moreover, the other perception is that the structure of sukuk should conform to Shariaa; this is a fundamental difference between sukuk and debt bonds.
For the jurisprudential controversy to affect credit rating, we must decide whether it is deemed risky or not in terms of its impact upon the liquidity of sukuk and its impact upon contractual commitments resultant of sukuk.
With respect to its impact upon liquidity, undoubtedly sukuk that comply with Shariah are considered a decisive factor for the majority of investors regarding whether they should or should not invest in these bonds. Other criteria follow and this is exactly what I had asserted in my previous article.
As for its impact upon the commitments of sukuk holders, Standard & Poor’s Agency stated in a report that focused on the issue of Islamic bonds (12 January 2006) that it will take the jurisprudential dispute into account when rating sukuk if the aforementioned bonds were subject to legitimate courts since the dispute over them may compel the court to invalidate these sukuk in the end.
I would like to clarify a certain point that was mentioned in my previous article, which is that I did not request that rating agencies offer their opinion regarding whether the Islamic bonds in question are Shariaa-compliant or not. Rather, I simply demanded that the jurisprudential dispute entailed in sukuk be considered in the process of rating and acknowledged in their reports.
For instance, if the opinion upon which sukuk had been based was found to be contradictory to the legitimate criteria set by the Auditing and Accounting Organization for Islamic Financial Institutions or if it flouts resolutions issued by Islamic jurisprudential academies, then the agency should make mention of it. This is not considered a judgment upon sukuk or an amendment to the approved authority; rather it is a practice to ensure transparency and clarity in the credit rating report. This would be easy to implement and does not require a legitimate Shariaa authority but rather a researcher schooled in Shariaa, as this information is available and attainable for whoever has Shariaa knowledge background.
In conclusion, I believe that the existence of rating agencies that specialize in Islamic banking similar to the International Islamic Agency for Rating will solve this dilemma that results from a lack of consideration for the particularity of Islamic banking.
www.aawsat.com
In response to the aforementioned article, I received a comment from the General Manager of Moody’s Investor Service in the Middle East, Mr. Jihad al Nakhla, in which he expressed his rejection of the idea that credit rating agencies should take the jurisprudential dispute into account during the rating process. He cited a number of considerations; including his statement that credit rating is an independent opinion that determines the issuers’ ability to fulfill the terms and pay back the debt in accordance with the their credit worthiness.
Credit rating also highlights the legal risks involved in sukuk and the nature of the contractual relationship between its members. As for the assessment of Islamic bonds, this process is conducted in collaboration with Islamic fatwa committees and the concerned consultants who are together in charge of determining whether the sukuk in question are Shariaa-compliant or not.
Let us assume that we must consider the contentious jurisprudential dispute entailed within the structure of Islamic bonds and ratings; it must be clarified that in order to deem sukuk as Shariaa-compliant it is necessary to resort to an external competent jurisprudential committee to offer its legitimate opinion. This means that our remarks upon the legitimate authority result in involving us so that we become party to the dispute, and thus lose the independence required for any credit rating agency.
Mr. Jihad concluded his comments by saying that many Muslims have sufficient confidence in the scholars of fatwa committees and therefore it was not necessary to take the controversial jurisprudential dispute sukuk into consideration during the credit rating process. Mr. Jihad believes that there is no difference between Islamic bonds and debt bonds since they all are liability related.
These are the major points in Mr. Jihad’s comment. Clearly, his comment was of great benefit to me and included valuable information.
Mr. Jihad’s argument has made it clear to me that the points of difference between us do not lie in the details but rather in the basic view of Islamic bonds. Mr. Jihad believes that sukuk are just like debt bonds. His viewpoint supports the idea upon which I elaborated in my previous article regarding the credit rating agencies’ perception of sukuk.
I believe that Islamic bonds or sukuk should be regarded from an independent perspective that considers their particularity since the concept is based upon the fact that sukuk holders own part of an asset, utility or service, and thus the ensuing profit is an outcome of this asset, utility or service. Moreover, the other perception is that the structure of sukuk should conform to Shariaa; this is a fundamental difference between sukuk and debt bonds.
For the jurisprudential controversy to affect credit rating, we must decide whether it is deemed risky or not in terms of its impact upon the liquidity of sukuk and its impact upon contractual commitments resultant of sukuk.
With respect to its impact upon liquidity, undoubtedly sukuk that comply with Shariah are considered a decisive factor for the majority of investors regarding whether they should or should not invest in these bonds. Other criteria follow and this is exactly what I had asserted in my previous article.
As for its impact upon the commitments of sukuk holders, Standard & Poor’s Agency stated in a report that focused on the issue of Islamic bonds (12 January 2006) that it will take the jurisprudential dispute into account when rating sukuk if the aforementioned bonds were subject to legitimate courts since the dispute over them may compel the court to invalidate these sukuk in the end.
I would like to clarify a certain point that was mentioned in my previous article, which is that I did not request that rating agencies offer their opinion regarding whether the Islamic bonds in question are Shariaa-compliant or not. Rather, I simply demanded that the jurisprudential dispute entailed in sukuk be considered in the process of rating and acknowledged in their reports.
For instance, if the opinion upon which sukuk had been based was found to be contradictory to the legitimate criteria set by the Auditing and Accounting Organization for Islamic Financial Institutions or if it flouts resolutions issued by Islamic jurisprudential academies, then the agency should make mention of it. This is not considered a judgment upon sukuk or an amendment to the approved authority; rather it is a practice to ensure transparency and clarity in the credit rating report. This would be easy to implement and does not require a legitimate Shariaa authority but rather a researcher schooled in Shariaa, as this information is available and attainable for whoever has Shariaa knowledge background.
In conclusion, I believe that the existence of rating agencies that specialize in Islamic banking similar to the International Islamic Agency for Rating will solve this dilemma that results from a lack of consideration for the particularity of Islamic banking.
www.aawsat.com
An Overview of Sukuk: Size, Basics and the Role of Sharia Advisors
http://www.assaif.org/content/download/351/2246/file/An%20Overview%20of%20Sukuk.pps
Islamic Sukuk Market soars to record $37.3 billion
The report by Islamic Finance Information Service (IFIS) showed that Malaysia Ringgit denominated sukuk made up for 54% or $20.1billion of the global sukuk market during third quarter, IINA reported.
Sukuk listed on the Dubai International Financial Exchange (DIFX) and London Stock Exchange (LSE) amounted to $16.14 billion and $7.2 billion respectively.
HSBC Amanah topped the overall (international and domestic) IFIS Bookrunners Sukuk League Table with total sukuk issuance of $3 billion as well as the International Sukuk Bookrunners table valued at $ 2.78 billion.
Sukuk listed on the Dubai International Financial Exchange (DIFX) and London Stock Exchange (LSE) amounted to $16.14 billion and $7.2 billion respectively.
HSBC Amanah topped the overall (international and domestic) IFIS Bookrunners Sukuk League Table with total sukuk issuance of $3 billion as well as the International Sukuk Bookrunners table valued at $ 2.78 billion.
SUKUK value tops $10 billion on DIFX with DIFC investments listing
DIFC Investments LLC has listed a $1.25 billion Sukuk on the Dubai International Financial Exchange (DIFX), taking the total value of Sukuk listed on the exchange to $10.43 billion, the highest of any exchange worldwide.
DIFC Governor His Excellency Dr Omar Bin Sulaiman said, “The success of our first Sukuk is an endorsement of investors’ trust and confidence in the Dubai International Financial Centre (DIFC) as a world class financial centre and a leader of the Islamic Finance Industry.”
Bisher Barazi, Managing Director of DIFC Investments, said: “We are extremely pleased with the response we received from a diverse investor base. We expect the enthusiasm for the Sukuk to generate a buoyant secondary market.”
The high level of international interest in the Sukuk resulted in 67% of its subscription originating outside the region, with 47% sold to European investors, 33% to Middle East investors and 20% to investors in Asia.
Per E. Larsson, Chief Executive of the DIFX, said: “As the international exchange serving its region, the DIFX is positioned to play a leading role in Islamic finance. The DIFX attracted 70 per cent by value of all Sukuk that listed on exchanges worldwide in 2006. We look forward to expanding our involvement with this dynamic asset class as issuance increase around the world.”
The DIFX now has a total of eight Sukuk, with issuers based in Kuwait, Saudi Arabia and the United Arab Emirates. The listing from DIFC Investments further strengthens DIFX’s position as the global leader in Sukuk; the exchange has been the largest in the world for Sukuk by listed value since October 2006.
Hamed Ali, Executive Officer of the DIFX, said: “We are talking to a growing geographical range of issuers, some of whom are developing innovative Sukuk structures to enhance their appeal to investors.”
DIFC Investments’ 5-year al-Mudarabah Sukuk received ratings of “A1” from Moody’s and “A+” from Standard & Poor’s. It is the largest Sukuk to have received a rating.
DIFC Investments is the investment arm of the Dubai International Financial Centre (DIFC). It is also the sole shareholder of the DIFX.
DIFC Governor His Excellency Dr Omar Bin Sulaiman said, “The success of our first Sukuk is an endorsement of investors’ trust and confidence in the Dubai International Financial Centre (DIFC) as a world class financial centre and a leader of the Islamic Finance Industry.”
Bisher Barazi, Managing Director of DIFC Investments, said: “We are extremely pleased with the response we received from a diverse investor base. We expect the enthusiasm for the Sukuk to generate a buoyant secondary market.”
The high level of international interest in the Sukuk resulted in 67% of its subscription originating outside the region, with 47% sold to European investors, 33% to Middle East investors and 20% to investors in Asia.
Per E. Larsson, Chief Executive of the DIFX, said: “As the international exchange serving its region, the DIFX is positioned to play a leading role in Islamic finance. The DIFX attracted 70 per cent by value of all Sukuk that listed on exchanges worldwide in 2006. We look forward to expanding our involvement with this dynamic asset class as issuance increase around the world.”
The DIFX now has a total of eight Sukuk, with issuers based in Kuwait, Saudi Arabia and the United Arab Emirates. The listing from DIFC Investments further strengthens DIFX’s position as the global leader in Sukuk; the exchange has been the largest in the world for Sukuk by listed value since October 2006.
Hamed Ali, Executive Officer of the DIFX, said: “We are talking to a growing geographical range of issuers, some of whom are developing innovative Sukuk structures to enhance their appeal to investors.”
DIFC Investments’ 5-year al-Mudarabah Sukuk received ratings of “A1” from Moody’s and “A+” from Standard & Poor’s. It is the largest Sukuk to have received a rating.
DIFC Investments is the investment arm of the Dubai International Financial Centre (DIFC). It is also the sole shareholder of the DIFX.
Search: SUKUK ISSUANCE GLOBALLY TO EXCEED US$200 BLN IN 2010
KUALA LUMPUR, Oct 7 (Bernama) -- Islamic finance is now one of the fastest growing segments of the global financial system with the sukuk market in particular exceeding US$14 billion as of August this year.
It is expected to exceed US$200 billion in 2010.
The sukuk market has also expanded at an annual growth rate of 40 percent, Bank Negara Governor, Tan Sri Dr Zeti Akhtar Aziz said yesterday.
She said 2007 witnessed an exceptional growth of the global sukuk market which expanded by more than 70 percent with new issues during the year reaching a record high of about US$47 billion.
"The outstanding global sukuk market has now surpassed the US$100 billion mark. This growth is spurred in part by the growing funding requirements in emerging market economies, in particular, in Asia and the Middle East.
"This is reinforced by the continued confidence of investors in Islamic financial instruments," she disclosed in her keynote address, titled "Islamic Finance:A Global Growth Opportunity amidst a Challenging Environment" at the State Street Islamic Finance Congress 2008 in Boston, United States.
The text of her speech was released here today.
Zeti said Islamic finance, with total assets under management by Islamic banks and conventional banks offering Islamic banking services, has reportedly exceeded US$500 billion.
"This growth has also been in the other major components of the Islamic financial system. Islamic mutual funds are estimated to be about US$300 billion, while global takaful or Shariah-compliant insurance contributions are estimated to be about US$5 billion.
"Thus far, the global financial crisis has had a limited direct impact on Islamic finance," added the governor.
According to Zeti, as Islamic finance continues to internationalise on an expanding scale,there will be greater intermediation linkages among the East Asian, West Asian, and the Middle East regions - creating the "New Silk Road".
She also pointed out that there was a growing number of established international financial centres such as London, Tokyo, Hong Kong and Singapore have initiated plans for the integration of Islamic finance.
She highlighted that the scope of the Islamic financial business had expanded to more sophisticated financial products in response to the changing global customer base.
"Such Shariah-compliant products include private equity, project finance, the origination and issuance of sukuk, as well as fund, asset and wealth management products.
"Greater financial integration has essentially been facilitated by the more rapid pace of liberalisation supported by the progress achieved in the development of the international Islamic financial infrastructure," she said.
Zeti stated this trend had been prompted by the need for greater diversification of risks in the management of funds. --BERNAMA
It is expected to exceed US$200 billion in 2010.
The sukuk market has also expanded at an annual growth rate of 40 percent, Bank Negara Governor, Tan Sri Dr Zeti Akhtar Aziz said yesterday.
She said 2007 witnessed an exceptional growth of the global sukuk market which expanded by more than 70 percent with new issues during the year reaching a record high of about US$47 billion.
"The outstanding global sukuk market has now surpassed the US$100 billion mark. This growth is spurred in part by the growing funding requirements in emerging market economies, in particular, in Asia and the Middle East.
"This is reinforced by the continued confidence of investors in Islamic financial instruments," she disclosed in her keynote address, titled "Islamic Finance:A Global Growth Opportunity amidst a Challenging Environment" at the State Street Islamic Finance Congress 2008 in Boston, United States.
The text of her speech was released here today.
Zeti said Islamic finance, with total assets under management by Islamic banks and conventional banks offering Islamic banking services, has reportedly exceeded US$500 billion.
"This growth has also been in the other major components of the Islamic financial system. Islamic mutual funds are estimated to be about US$300 billion, while global takaful or Shariah-compliant insurance contributions are estimated to be about US$5 billion.
"Thus far, the global financial crisis has had a limited direct impact on Islamic finance," added the governor.
According to Zeti, as Islamic finance continues to internationalise on an expanding scale,there will be greater intermediation linkages among the East Asian, West Asian, and the Middle East regions - creating the "New Silk Road".
She also pointed out that there was a growing number of established international financial centres such as London, Tokyo, Hong Kong and Singapore have initiated plans for the integration of Islamic finance.
She highlighted that the scope of the Islamic financial business had expanded to more sophisticated financial products in response to the changing global customer base.
"Such Shariah-compliant products include private equity, project finance, the origination and issuance of sukuk, as well as fund, asset and wealth management products.
"Greater financial integration has essentially been facilitated by the more rapid pace of liberalisation supported by the progress achieved in the development of the international Islamic financial infrastructure," she said.
Zeti stated this trend had been prompted by the need for greater diversification of risks in the management of funds. --BERNAMA
Sukuk shipping bonds surging
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SUKUK, the version of Islamic bonds favoured by LNG operator MISC and other leading Malaysian shipping companies, will exceed $200Bn in total value worldwide by 2010, a banking authority has predicted. The governor of Malaysia’s central bank Tan Sri, Zeti Akhtar Aziz, told a Boston seminar that the global sukuk market's global total value has already surpassed $100Bn, the Bernama News Agency reported. “The growth is spurred in part by the growing funding requirements in emerging market economies, in particular in Asia and the Middle East,” she told delegates to the seminar ‘Islamic Finance: A Global Growth Opportunity Amidst a Challenging Environment’. Aziz encouraged the shipping sector to explore alternative ways of financing during today’s financial turmoil. “The global financial crisis has had limited direct impact on Islamic finance,” declared Aziz, who added that total assets being managed by Islamic banks and conventional banks offering Islamic banking services now purportedly exceed $500Bn. Sukuk-administered repayments do not include interest and are instead benchmarked on an asset-based premise, so lenders pay a fixed repayment amount.
SUKUK, the version of Islamic bonds favoured by LNG operator MISC and other leading Malaysian shipping companies, will exceed $200Bn in total value worldwide by 2010, a banking authority has predicted. The governor of Malaysia’s central bank Tan Sri, Zeti Akhtar Aziz, told a Boston seminar that the global sukuk market's global total value has already surpassed $100Bn, the Bernama News Agency reported. “The growth is spurred in part by the growing funding requirements in emerging market economies, in particular in Asia and the Middle East,” she told delegates to the seminar ‘Islamic Finance: A Global Growth Opportunity Amidst a Challenging Environment’. Aziz encouraged the shipping sector to explore alternative ways of financing during today’s financial turmoil. “The global financial crisis has had limited direct impact on Islamic finance,” declared Aziz, who added that total assets being managed by Islamic banks and conventional banks offering Islamic banking services now purportedly exceed $500Bn. Sukuk-administered repayments do not include interest and are instead benchmarked on an asset-based premise, so lenders pay a fixed repayment amount.
SUCCESSFUL INTERNATIONAL “SUKUK” ISSUE FOR PAKISTAN ARRANGED
http://a248.e.akamai.net/7/248/3622/e29553621e43c3/www.middleeast.img.hsbc.com/public/meregional/common/assets/en/hsbc_announcement_17MAR05.pdf
Microsoft PowerPoint - Sukuk Conference - Jamal Zaidi
www.iirating.com/presentation/first_intl_conference_for_islamic_sukuk.pdf
Overview of the sukuk market
http://www.euromoneyplc.com/images/covers/Islamic%20Bonds%20Your%20Guide%20to%20Issuing%20Structuring%20and%20Investing%20in%20Sukuk/sample%20chSukuk.pdf
www.euromoneyplc.com
www.euromoneyplc.com
FAQ - Sakuk issuance
1. How are sukuk (Islamic bonds) different from conventional bonds?
Sukuk is a trust certificate whereas a bond is a contractual debt obligation. Generally, sukuk represents a beneficial ownership interest in the underlying asset. Returns on sukuk are tied to the returns earned through the underlying assets. For bond, the issuer is contractually obliged to pay bond holders, on certain specified dates, interest and principal.
2. How do we ensure the sukuk structure conform to Shariah principles?
The structure of sukuk must be approved by a Shariah adviser appointed by the issuer. In the case of ringgit sukuk issuance, the sukuk can be structured by applying various Shariah principles and concepts that are listed in Appendix 1 of the Guidelines on the Offering of Islamic Securities (Guidelines) which have been endorsed by the Securities Commission Shariah Advisory Council (SAC). For new Shariah principle structure which has yet to be introduced in the market, the SAC’s approval is required.
For non-ringgit issuance, Malaysia will accept the Shariah opinion of other jurisdictions and the issuer need not obtain a Shariah endorsement from the SAC.
Who can become an independent Shariah adviser for sukuk and what are the requirements?
Approval by the Securities Commission (SC) for an independent Shariah adviser for sukuk is based on satisfying the criteria stipulated in paragraph 6.01 of the Guidelines. For companies, the criteria stipulated in paragraph 6.02 must also be satisfied. For approval, please write to:
Head, Islamic Capital Market Department
Securities Commission
3 Persiaran Bukit Kiara
Bukit Kiara
50490 Kuala Lumpur
4. What is the advantage of sukuk compared to conventional bond?
Sukuk is based on an underlying transaction which creates a close link between financial and productive flows. The financing must be channeled for productive purposes such as project financing, rather than for speculative activities. Thus, the risk exposure is to the project and not to the uncertainties or activities that have no real economic benefits. This contributes to greater stability of the financial system. Moreover, under the risk sharing principle required, there is an explicit sharing of risk by the financier and the borrower. This arrangement will entail the appropriate due diligence and the integrating of the risks associated with the real investment activity into the financial transaction. The real activity is expected to generate sufficient wealth to compensate for the risks.
In contrast, conventional bonds generally separate such risks from the underlying assets. As a result, risk management and wealth creation may, at times, move in different or even opposite directions. Conventional bonds also allow for the commoditisation of risks. This has led to its proliferation through multiple layers of leveraging and disproportionate distribution, in turn, which could result in higher systemic risks, thus, increasing the potential for instability in the financial system.
In addition, transparency represents a basic tenet underlying all Islamic financial transactions. The profit-sharing feature of Islamic financial transactions imposes a high level of disclosure in the financial contract. The accountabilities of the respective parties involved in the transaction are clearly defined in the contract.
Issuing sukuk also give access to a wider investor base as the instruments attract not only the Islamic investors but also conventional investors. It was reported that more than 80% of sukuk investors are conventional institutional investors. Sukuk is also considered as a new asset class with a relatively attractive pricing. The growing demand for sukuk is attributed by growing awareness, increased in petrodollars, wealth and reserves as well as the massive development of infrastructure projects.
5. Why should I choose Malaysia to issue sukuk?
Malaysia has a well-developed sukuk market where more than 60% of sukuk outstanding globally are from Malaysia. Malaysia offers the following benefits:
* Breadth and depth of the Islamic capital market with wide range of Islamic financial instruments and diversified players
* Wide investor base from Islamic and conventional financial institutions, pension funds and fund management companies
* Pool of talent in structuring new innovative Islamic financial instrument
* Comprehensive legal, regulatory and Shariah framework to ensure the integrity and confidence level remain high
* Competitive pricing, which may be better as compared to conventional bond pricing due to the high demand of sukuk in the market
* Flexibility to issue sukuk in Ringgit and foreign currencies
* Full tax deductions on issuance cost for all Islamic securities until 2010
* Stamp duty exemption on documentation
* Tax neutrality on all Islamic instruments and transactions
* Liberal foreign administration policy – free to use proceeds in and out of the country
* Mutual recognition of Shariah opinions issued in other jurisdictions by a recognized Shariah committee
* International credit rating is allowed
6. Are there exchange control restrictions for foreigners intending to issue sukuk in Malaysia?
Malaysia maintains a liberal foreign exchange regime. Foreign issuers are free to issue sukuk in any currency. They are also free to repatriate the proceeds from raising Ringgit or foreign currency sukuk to any country outside Malaysia and free to swap to other currencies and hedge their positions.
7. Can a non-Islamic company issue a sukuk?
Any institution or company can issuer a sukuk so long as its activities are considered as permissible activities under Shariah. Some prominent non-Islamic companies that have issued sukuk in Malaysia are Shell MDS, Nestle, the World Bank, Tesco and AEON Credit, a Japanese-based company.
8. How long does it take to get approval for a sukuk application?
Application for issuance with AAA local rating or BBB international rating will be deemed approved upon submission to the SC. Otherwise, the normal approval process by the SC will take not more than 14 working days from the date of the full submission. For application to issue foreign currency sukuk or issuance by a foreign institution, an approval from the Controller of Foreign Exchange, Bank Negara Malaysia must also be obtained.
mifc.com
Sukuk is a trust certificate whereas a bond is a contractual debt obligation. Generally, sukuk represents a beneficial ownership interest in the underlying asset. Returns on sukuk are tied to the returns earned through the underlying assets. For bond, the issuer is contractually obliged to pay bond holders, on certain specified dates, interest and principal.
2. How do we ensure the sukuk structure conform to Shariah principles?
The structure of sukuk must be approved by a Shariah adviser appointed by the issuer. In the case of ringgit sukuk issuance, the sukuk can be structured by applying various Shariah principles and concepts that are listed in Appendix 1 of the Guidelines on the Offering of Islamic Securities (Guidelines) which have been endorsed by the Securities Commission Shariah Advisory Council (SAC). For new Shariah principle structure which has yet to be introduced in the market, the SAC’s approval is required.
For non-ringgit issuance, Malaysia will accept the Shariah opinion of other jurisdictions and the issuer need not obtain a Shariah endorsement from the SAC.
Who can become an independent Shariah adviser for sukuk and what are the requirements?
Approval by the Securities Commission (SC) for an independent Shariah adviser for sukuk is based on satisfying the criteria stipulated in paragraph 6.01 of the Guidelines. For companies, the criteria stipulated in paragraph 6.02 must also be satisfied. For approval, please write to:
Head, Islamic Capital Market Department
Securities Commission
3 Persiaran Bukit Kiara
Bukit Kiara
50490 Kuala Lumpur
4. What is the advantage of sukuk compared to conventional bond?
Sukuk is based on an underlying transaction which creates a close link between financial and productive flows. The financing must be channeled for productive purposes such as project financing, rather than for speculative activities. Thus, the risk exposure is to the project and not to the uncertainties or activities that have no real economic benefits. This contributes to greater stability of the financial system. Moreover, under the risk sharing principle required, there is an explicit sharing of risk by the financier and the borrower. This arrangement will entail the appropriate due diligence and the integrating of the risks associated with the real investment activity into the financial transaction. The real activity is expected to generate sufficient wealth to compensate for the risks.
In contrast, conventional bonds generally separate such risks from the underlying assets. As a result, risk management and wealth creation may, at times, move in different or even opposite directions. Conventional bonds also allow for the commoditisation of risks. This has led to its proliferation through multiple layers of leveraging and disproportionate distribution, in turn, which could result in higher systemic risks, thus, increasing the potential for instability in the financial system.
In addition, transparency represents a basic tenet underlying all Islamic financial transactions. The profit-sharing feature of Islamic financial transactions imposes a high level of disclosure in the financial contract. The accountabilities of the respective parties involved in the transaction are clearly defined in the contract.
Issuing sukuk also give access to a wider investor base as the instruments attract not only the Islamic investors but also conventional investors. It was reported that more than 80% of sukuk investors are conventional institutional investors. Sukuk is also considered as a new asset class with a relatively attractive pricing. The growing demand for sukuk is attributed by growing awareness, increased in petrodollars, wealth and reserves as well as the massive development of infrastructure projects.
5. Why should I choose Malaysia to issue sukuk?
Malaysia has a well-developed sukuk market where more than 60% of sukuk outstanding globally are from Malaysia. Malaysia offers the following benefits:
* Breadth and depth of the Islamic capital market with wide range of Islamic financial instruments and diversified players
* Wide investor base from Islamic and conventional financial institutions, pension funds and fund management companies
* Pool of talent in structuring new innovative Islamic financial instrument
* Comprehensive legal, regulatory and Shariah framework to ensure the integrity and confidence level remain high
* Competitive pricing, which may be better as compared to conventional bond pricing due to the high demand of sukuk in the market
* Flexibility to issue sukuk in Ringgit and foreign currencies
* Full tax deductions on issuance cost for all Islamic securities until 2010
* Stamp duty exemption on documentation
* Tax neutrality on all Islamic instruments and transactions
* Liberal foreign administration policy – free to use proceeds in and out of the country
* Mutual recognition of Shariah opinions issued in other jurisdictions by a recognized Shariah committee
* International credit rating is allowed
6. Are there exchange control restrictions for foreigners intending to issue sukuk in Malaysia?
Malaysia maintains a liberal foreign exchange regime. Foreign issuers are free to issue sukuk in any currency. They are also free to repatriate the proceeds from raising Ringgit or foreign currency sukuk to any country outside Malaysia and free to swap to other currencies and hedge their positions.
7. Can a non-Islamic company issue a sukuk?
Any institution or company can issuer a sukuk so long as its activities are considered as permissible activities under Shariah. Some prominent non-Islamic companies that have issued sukuk in Malaysia are Shell MDS, Nestle, the World Bank, Tesco and AEON Credit, a Japanese-based company.
8. How long does it take to get approval for a sukuk application?
Application for issuance with AAA local rating or BBB international rating will be deemed approved upon submission to the SC. Otherwise, the normal approval process by the SC will take not more than 14 working days from the date of the full submission. For application to issue foreign currency sukuk or issuance by a foreign institution, an approval from the Controller of Foreign Exchange, Bank Negara Malaysia must also be obtained.
mifc.com
World's largest sukuk to list on new bourse
Dubai: World's biggest-ever Islamic bond, the Dh10.27 billion ($2.8 billion) sukuk for Ports, Customs and Free Zone Corporation (PCFC), is likely to be listed on the Dubai International Financial Exchange (DIFX) in two months, a senior official said.
"We plan to list a Dh10 billion sukuk on DIFX within the next two months," Fadi Ghosaini, head of business development at DIFX, told a meeting hosted by Dubai Property Group on Sunday.
He, however, did not reveal the identity of the issuer.
Currently PCFC's Dh10.27 billion sukuk is the only Islamic instrument of that size that is being offered for subscription.
The listing of the sukuk would boost the profile of Dubai's newest exchange which witnessed less than expected trading during the initial weeks of its launch.
"This will be followed by the listing of a major real estate investment trust fund on the exchange," he said. "We expect between three to five initial public offerings (IPOs) within the next few months with a combined capital offering of more than Dh3.67 billion."
As many as 15 further IPOs are planned by the end of 2006, he said.
PCFC's sukuk has been launched to finance a £3.3 billion acquisition by its international port management arm, Dubai Ports World, of British ports, ferries and property group, Peninsular & Oriental Steam Navigation Company (P&O).
Ghosaini said, DIFX has identified the property sector as one of the major growth areas for the exchange.
"Dubai's real estate boom has attracted local, regional and international investors into the burgeoning property market," said Ghosaini.
"The DIFX will provide a perfect platform for developers and real estate investors to raise capital by utilising a multitude of fund raising tools currently available. Such tools, which include debt and equity products, can help real estate companies expand their operations or finance projects in a more effective manner," he added.
The size of the region's Islamic bond market is valued less than Dh10 billion.
"If we can tap at least 25 per cent of the $300 billion Swiss funds that are looking for Islamic instruments, it will fetch us $75 billion worth of Islamic funds," he said, explaining the opportunities available in the market.
The DIFX opened on September 26 this year with five listed securities. These are structured products issued by Deutsche Bank, which cover the US S&P 500, the German
DAX 30, the Japanese Nikkei 225, the EuroStoxx 50 and the Stoxx 50.
Expectation
Issue likely to be oversubscribed
The Dh10.27billion sukuk for Ports, Customs and Free Zone Corporation (PCFC), lead-managed by Dubai Islamic Bank (DIB) and Barclays Capital (BC), has received an excellent response, and is likely to be oversubscribed by at least 50 to 75 per cent, with an expected book size of between $4 billion to $5 billion, officials said.
Dr. Mohammad Khalfan Bin Kharbash, UAE Minister of State for Finance and Industry and Chairman of Dubai Islamic Bank (DIB), said, "DIB will break its own previously-held record of lead managing the world's largest sukuk.
"The PCFC sukuk is the largest and also the first-ever convertible sukuk issue. It is convertible to 30 per cent equity shares of the PCFC entities when they go for the IPO within the next three years."
"The unique structure of the sukuk, with its convertible element, along with the attractive potential yield ranging from 7.25 per cent to 8.25 per cent per annum have made this a highly sought after instrument. If the IPO does not happen, then the yield of the Sukuk will become over 10 per cent per annum," he added.
"We plan to list a Dh10 billion sukuk on DIFX within the next two months," Fadi Ghosaini, head of business development at DIFX, told a meeting hosted by Dubai Property Group on Sunday.
He, however, did not reveal the identity of the issuer.
Currently PCFC's Dh10.27 billion sukuk is the only Islamic instrument of that size that is being offered for subscription.
The listing of the sukuk would boost the profile of Dubai's newest exchange which witnessed less than expected trading during the initial weeks of its launch.
"This will be followed by the listing of a major real estate investment trust fund on the exchange," he said. "We expect between three to five initial public offerings (IPOs) within the next few months with a combined capital offering of more than Dh3.67 billion."
As many as 15 further IPOs are planned by the end of 2006, he said.
PCFC's sukuk has been launched to finance a £3.3 billion acquisition by its international port management arm, Dubai Ports World, of British ports, ferries and property group, Peninsular & Oriental Steam Navigation Company (P&O).
Ghosaini said, DIFX has identified the property sector as one of the major growth areas for the exchange.
"Dubai's real estate boom has attracted local, regional and international investors into the burgeoning property market," said Ghosaini.
"The DIFX will provide a perfect platform for developers and real estate investors to raise capital by utilising a multitude of fund raising tools currently available. Such tools, which include debt and equity products, can help real estate companies expand their operations or finance projects in a more effective manner," he added.
The size of the region's Islamic bond market is valued less than Dh10 billion.
"If we can tap at least 25 per cent of the $300 billion Swiss funds that are looking for Islamic instruments, it will fetch us $75 billion worth of Islamic funds," he said, explaining the opportunities available in the market.
The DIFX opened on September 26 this year with five listed securities. These are structured products issued by Deutsche Bank, which cover the US S&P 500, the German
DAX 30, the Japanese Nikkei 225, the EuroStoxx 50 and the Stoxx 50.
Expectation
Issue likely to be oversubscribed
The Dh10.27billion sukuk for Ports, Customs and Free Zone Corporation (PCFC), lead-managed by Dubai Islamic Bank (DIB) and Barclays Capital (BC), has received an excellent response, and is likely to be oversubscribed by at least 50 to 75 per cent, with an expected book size of between $4 billion to $5 billion, officials said.
Dr. Mohammad Khalfan Bin Kharbash, UAE Minister of State for Finance and Industry and Chairman of Dubai Islamic Bank (DIB), said, "DIB will break its own previously-held record of lead managing the world's largest sukuk.
"The PCFC sukuk is the largest and also the first-ever convertible sukuk issue. It is convertible to 30 per cent equity shares of the PCFC entities when they go for the IPO within the next three years."
"The unique structure of the sukuk, with its convertible element, along with the attractive potential yield ranging from 7.25 per cent to 8.25 per cent per annum have made this a highly sought after instrument. If the IPO does not happen, then the yield of the Sukuk will become over 10 per cent per annum," he added.
Saudi Hollandi seeks $400m sukuk
Saudi Hollandi bank plans to seek shareholder approval to sell 1.5 billion riyals ($400m) of Islamic bonds, reported Reuters. The bank will hold a shareholder meeting to discuss the bond sale proposal on Nov. 11. Hollandi is the second Saudi firm this week to announce plans for a sukuk issue after property developer Dar Al-Arkan, Saudi Arabia's largest property developer by market value.
The "Sukuk" Risks
Sukuk [Islamic bonds] are distinct from traditional bonds by some risks that each issuer and investor must take into account. These sukuk should not be treated simply as debt instruments that do not differ from bonds and whose underlying assets as well as their contractual structures are kind like bridge for transferring funds from investors to the sukuk issuers. This perception leads to the inability to [properly] assess the sukuk and, as a result, these risks will not be covered by the appropriate means.
The risks that the sukuk encounter vary according to the structure of the sak (singular for sukuk); so the risks of “Sukuk al-Murabaha” (Fixed Return Notes) differ from those of “Sukuk al-Musharaka” (Partnership Sukuk); the risks of “Sukuk al-Istisna’” (project finance using a contract where a commodity is transacted before it is manufactured) differs from those of “Sukuk al-Ijara” (Variable Return Notes based on Leasing); the same is true for the risks of “Sukuk al-Murakaba” (Fixed Return Notes) combined of many contracts which they differ from those of “Sukuk al-Basita” (Regular Sukuk) formed from one contract. These risks also vary depending on the underlying assets of these sukuk, were they fixed or movable assets, utilities or services. They can be outlined as follows:
First: Violation of the Islamic Shari’a Provisions
Since the sukuk are financial tools based on the Islamic Shari’a provisions, the violations of these provisions would lead to damages that vary according to the type of violation and the degree of its seriousness. It ranges from voiding the sak in its entirety to the cancellation of certain conditions. For example, when the underlying components of the sak are “Deyoun Murabahat” (debts to be paid back through fixed return notes) and “Usul Mouajara” (leased-assets based on variable return notes) the percentage of the debt should not exceed 33% of (the assets) underlying the sak throughout the lifetime of the sak so that its circulation would be permitted. If the debts were higher than this percentage, then the sak may not be circulated and thus becomes a weak liquidity (tool), or the ownership of the assets of “Sukuk Al-Ijara” becomes artificial.
For example, many of the Islamic institutions transfer the ownership of some of their customers’ assets to a mortgage status and not for an actual sale. If these institutions bond these assets to a form of “Sukuk al-Ijara” or “Musharaka” or other kinds of available sukuk, these sukuk will become null and void because the institution had sold to the sukuk holders something that they do not own, which is among the prohibited sales in the Islamic shari’a. There are many ways of violating Islamic law, and each of the sukuk structures has its Islamic religious controls whose violations are considered among the risks for which the possibility of their occurrence, the ways to reduce them and the methods to address them must be studied.
Second: Operational Risks
Since the structures of the tradable Islamic sukuk must be based on assets and the return on these sukuk originates from these assets, then the operational risks of these assets must be carefully studied. For example, it is known that the return in the “Sukuk al-Ijara” is the revenue of the sak; so if the benefits to the leasing tenants as underlined in the “Sak al-Ijara” were late to materialize, the lessee must not pay for the lease and therefore the sak would have no revenue. Hence, the property-based “Sukuk al-Ijara” are less prone to the risks of revenue loss, due to the delay in getting their benefits compared to those sukuk that are based on vehicles, factories, aircrafts or ships. Furthermore, the potential risks arising from ownership of these assets will be carried out by the sukuk holders such as the environmental damages caused by factories or ships and other risks that are separately related to each asset.
Third: Legal Risks
Since many of the regulations and legislations in many countries are emplacement regulations [man-made], that cause many of their clauses to violate the provisions of Islamic shari’a, a conflict between these regulations and the provisions of Islamic shari’a might occur, and the application of the Islamic shari'a provisions will be ignored in litigations.
Conclusion
The importance of taking into account the difference between sukuk and traditional debt bonds is clear. This difference would result in risks that must be studied and measured in an accurate scientific method to be followed by efforts to cover these risks by appropriate means that are compatible with Islamic shari’a.
memrieconomicblog.org
The risks that the sukuk encounter vary according to the structure of the sak (singular for sukuk); so the risks of “Sukuk al-Murabaha” (Fixed Return Notes) differ from those of “Sukuk al-Musharaka” (Partnership Sukuk); the risks of “Sukuk al-Istisna’” (project finance using a contract where a commodity is transacted before it is manufactured) differs from those of “Sukuk al-Ijara” (Variable Return Notes based on Leasing); the same is true for the risks of “Sukuk al-Murakaba” (Fixed Return Notes) combined of many contracts which they differ from those of “Sukuk al-Basita” (Regular Sukuk) formed from one contract. These risks also vary depending on the underlying assets of these sukuk, were they fixed or movable assets, utilities or services. They can be outlined as follows:
First: Violation of the Islamic Shari’a Provisions
Since the sukuk are financial tools based on the Islamic Shari’a provisions, the violations of these provisions would lead to damages that vary according to the type of violation and the degree of its seriousness. It ranges from voiding the sak in its entirety to the cancellation of certain conditions. For example, when the underlying components of the sak are “Deyoun Murabahat” (debts to be paid back through fixed return notes) and “Usul Mouajara” (leased-assets based on variable return notes) the percentage of the debt should not exceed 33% of (the assets) underlying the sak throughout the lifetime of the sak so that its circulation would be permitted. If the debts were higher than this percentage, then the sak may not be circulated and thus becomes a weak liquidity (tool), or the ownership of the assets of “Sukuk Al-Ijara” becomes artificial.
For example, many of the Islamic institutions transfer the ownership of some of their customers’ assets to a mortgage status and not for an actual sale. If these institutions bond these assets to a form of “Sukuk al-Ijara” or “Musharaka” or other kinds of available sukuk, these sukuk will become null and void because the institution had sold to the sukuk holders something that they do not own, which is among the prohibited sales in the Islamic shari’a. There are many ways of violating Islamic law, and each of the sukuk structures has its Islamic religious controls whose violations are considered among the risks for which the possibility of their occurrence, the ways to reduce them and the methods to address them must be studied.
Second: Operational Risks
Since the structures of the tradable Islamic sukuk must be based on assets and the return on these sukuk originates from these assets, then the operational risks of these assets must be carefully studied. For example, it is known that the return in the “Sukuk al-Ijara” is the revenue of the sak; so if the benefits to the leasing tenants as underlined in the “Sak al-Ijara” were late to materialize, the lessee must not pay for the lease and therefore the sak would have no revenue. Hence, the property-based “Sukuk al-Ijara” are less prone to the risks of revenue loss, due to the delay in getting their benefits compared to those sukuk that are based on vehicles, factories, aircrafts or ships. Furthermore, the potential risks arising from ownership of these assets will be carried out by the sukuk holders such as the environmental damages caused by factories or ships and other risks that are separately related to each asset.
Third: Legal Risks
Since many of the regulations and legislations in many countries are emplacement regulations [man-made], that cause many of their clauses to violate the provisions of Islamic shari’a, a conflict between these regulations and the provisions of Islamic shari’a might occur, and the application of the Islamic shari'a provisions will be ignored in litigations.
Conclusion
The importance of taking into account the difference between sukuk and traditional debt bonds is clear. This difference would result in risks that must be studied and measured in an accurate scientific method to be followed by efforts to cover these risks by appropriate means that are compatible with Islamic shari’a.
memrieconomicblog.org
Islamic finance poised for massive growth as London becomes key hub outside the Middle East
London is emerging as the key centre for Islamic finance outside of the Middle East as financial institutions clamber to become part of a growing market. Currently it is estimated that Islamic banking manages funds of $200 billion. It is predicted to increase by up to 15% a year and be worth a trillion dollars by 2010.
Although Sharia-compliant finance has existed in some form for hundreds of years the world's first Islamic bank was founded in 1975 and it is only in the last five years that this area of finance has surged.
Regarded for many years as outside the mainstream, Islamic finance has been boosted by a number of factors. Firstly, at a very basic level, there are more Muslims in the world seeking mortgages, investments, bonds and specialist finance products.
What used to be a sector for high net worth individuals is now open to the fast growing Muslim middle classes.
Secondly, economic growth in the Middle East, fuelled by high oil prices, has created an increased demand which local financial markets have been unable to keep up with. As a result Middle Eastern investors are looking for suitable alternatives.
Global banking giants such as HSBC, Barclays Capital, Royal Bank of Scotland, BNP Parabas and Deutsche Bank, are putting their weight behind Islamic finance as they realise many products have a wider appeal than the immediate Muslim community.
But it is London that has taken a lead for various reasons. It has been a major financial centre for centuries and is regarded as open to innovation and ideas. The UK was the first member of the EU to authorise Islamic banks.
English law is highly regarded throughout the world. It is the preferred jurisdiction for many Islamic transactions.
Also the UK government is actively encouraging the growth of Islamic finance. It has introduced a number of changes to support the growth of Islamic finance. Most notably it acted quickly to introduce changes so that Islamic mortgages would not be subject to double taxation.
The latest figures from the International Financial Services London show there are 23 banks, nine fund managers and a number of law firms in the city now offering Islamic compliant services.
'When you look at London what you have is a global financial centre that makes it easier to trade with other markets. Taxation issues have been dealt with, the regulatory authorities are sending out encouraging messages and there is good co-operation with other banks, particularly in the Middle and Far East,' said Mohammad Shafique of the Institute of Islamic Banking and Insurance in London.
The UK government has also created an Islamic Finance Expert Group with representatives from the industry, the City and Muslim organisations to advise on future opportunities.
Further evidence of London's growing role in Islamic finance is shown by the UK being the only western country to feature, at number 10, in the IFSL global ranking of Sharia-compliant assets by country.
The UK's first stand along Islamic Bank, Islamic Bank of Britain, opened in 2004 and there are now five totally Sharia-compliant banks registered by the Financial Services Authority, the UK's banking regulator.
Indeed the FSA is taking a leading role and actively encouraging expansion. 'Islamic finance is a fast growing force in the world economy. The FSA has an open and principle-based approach to regulation that offers the right environment for it to flourish in the UK. There is huge potential for expansion,' said FSA chairman Sir Callum McCarthy.
In April this year the London Stock Exchange listed its maiden Sukuk, a Sharia-compliant bond. There are now at least eight and the government is expected to sell its own Sukuks soon. 'The UK has taken some commendable steps to allow Sukuk financing,' said Arul Kansasamy, head of Islamic Banking at Barclays Capital.
The FSA describes London as 'a centre of choice for listing Sukuk by establishing the world's first secondary market for Sukuk.' Sukuk trade volumes in London now exceed $2 billion.
Islamic finance is based on the principles of Sharia law and operates without the use of interest. So the products offered are structured in a different way to those provided by conventional banks and financial institutions.
There are also laws regarding the type of business financial institutions can deal with. Investment in business involved with arms, pork, tobacco, drugs, alcohol and pornography are not permitted.
Although they cannot charge interest, they can profit from customers buying a property using different schemes whereby the customer is charged rent, for example. They are structured so that they retain a clearly differentiated status between shareholders' capital and clients' deposits to make sure profits are shared.
A key issue, according to James McDonald of international legal firm Lovells, is the interpretation of Sharia law. Each bank has a Sharia Supervisory Committee or Board who advise on Sharia law.
But according to McDonald, and this is backed up by the FSA, there is a shortage of scholars. Also the interpretation of Sharia law varies with some scholars more strict than others. 'We need Sharia scholars that are flexible and open to the needs of investors,' he said.
Lovells, a major player in the sector that advises on the structuring, regulation and tax implications of Islamic finance, has seen a huge surge in demand for its services and has an office in Dubai. McDonald, a partner in the funds team based in London, believes Sharia-compliant investment funds are a major growth area and large funds cannot ignore this. 'If your investment fund is not Sharia-compliant then you have no chance of tapping in to the huge amount of wealth in the Middle East,' he said.
A sign that Islamic finance is edging towards becoming more mainstream is the range of products now on offer. IBB launched the UK's first completely 100% Sharia compliant home purchase plan earlier this year. It is not just aimed at Muslim customers.
'As lenders withdraw many of their products, customers uncertain of what their options are as a result of the credit crunch will find this offers a new way of financing a home purchase. A growing number of non Muslims are turning to more ethical products,' said Sultan Choudhury, commercial director of IBB.
Indeed IBB has always marketed its services and products beyond the Muslim community.
Although banks like HSBC are involved in Islamic retail banking, they have not yet moved into investment banking or commercial financing. But it is only a matter of time. 'The opportunities are growing. The UK government is really committed to making this market flourish in order to make London a hub for Sharia banking in Europe,' said Nade Kamel, of HSBC.
Islamic insurance, or Takaful, is another growth area. London now has its first Islamic insurance provider. The Salaam Halal company is backed by finance from the United Arab Emirates, Saudi Arabia, Bahrain, Kuwait and Malaysia.
Not only is London becoming the key centre outside the Middle East, it is also acting as a global gateway for Middle East banks into Europe. By having offices in London they can, under EU agreements, offer products in other EU countries without the need for separate authorisation, or even a presence, in each country.
This also offers opportunities for investment companies. Global Securities House, a Sharia-compliant international property firm based in Kuwait, has opened an office in London to establish a UK investment arm.
'We were attracted by the UK government's policy to attract more Islamic financing to London. The city is increasingly popular with Muslim investors because of the favourable regulatory regime. The UK is well known for its innovative financial products and also for the deep pool of professional talent,' said managing director Richard Thomas.
Gatehouse Bank, a subsidiary of the Securities House of Kuwait, was approved by the FSA in April this year. Samer Merhi, executive director, believes the potential for growth is massive. 'The UK has the potential to become the international heart of the Islamic finance business because of the high demand,' he said.
Other European nations are envious and indeed anxious to catch up. France, in particular, is trying to attract more Islamic finance. Recently Rudolf Bohmlet, executive board member at Deutsche Bundesbank, praised London.
Next year sees the world's first conference fully focused on exploring the financial relationship between Europe and the Middle East. Islamic Investment World 2009 next May in Geneva is taking place as a result of demand.
'Investors globally are seeking a safe haven from sub-prime debt, excessive volatility, out of control inflation and central bank meddling. Private equity, structured products, hedge funds and other alternative opportunities are rapidly emerging and catching the eye of the biggest investors in the Middle East,' said a spokesman for the event.
www.propertywire.com
Although Sharia-compliant finance has existed in some form for hundreds of years the world's first Islamic bank was founded in 1975 and it is only in the last five years that this area of finance has surged.
Regarded for many years as outside the mainstream, Islamic finance has been boosted by a number of factors. Firstly, at a very basic level, there are more Muslims in the world seeking mortgages, investments, bonds and specialist finance products.
What used to be a sector for high net worth individuals is now open to the fast growing Muslim middle classes.
Secondly, economic growth in the Middle East, fuelled by high oil prices, has created an increased demand which local financial markets have been unable to keep up with. As a result Middle Eastern investors are looking for suitable alternatives.
Global banking giants such as HSBC, Barclays Capital, Royal Bank of Scotland, BNP Parabas and Deutsche Bank, are putting their weight behind Islamic finance as they realise many products have a wider appeal than the immediate Muslim community.
But it is London that has taken a lead for various reasons. It has been a major financial centre for centuries and is regarded as open to innovation and ideas. The UK was the first member of the EU to authorise Islamic banks.
English law is highly regarded throughout the world. It is the preferred jurisdiction for many Islamic transactions.
Also the UK government is actively encouraging the growth of Islamic finance. It has introduced a number of changes to support the growth of Islamic finance. Most notably it acted quickly to introduce changes so that Islamic mortgages would not be subject to double taxation.
The latest figures from the International Financial Services London show there are 23 banks, nine fund managers and a number of law firms in the city now offering Islamic compliant services.
'When you look at London what you have is a global financial centre that makes it easier to trade with other markets. Taxation issues have been dealt with, the regulatory authorities are sending out encouraging messages and there is good co-operation with other banks, particularly in the Middle and Far East,' said Mohammad Shafique of the Institute of Islamic Banking and Insurance in London.
The UK government has also created an Islamic Finance Expert Group with representatives from the industry, the City and Muslim organisations to advise on future opportunities.
Further evidence of London's growing role in Islamic finance is shown by the UK being the only western country to feature, at number 10, in the IFSL global ranking of Sharia-compliant assets by country.
The UK's first stand along Islamic Bank, Islamic Bank of Britain, opened in 2004 and there are now five totally Sharia-compliant banks registered by the Financial Services Authority, the UK's banking regulator.
Indeed the FSA is taking a leading role and actively encouraging expansion. 'Islamic finance is a fast growing force in the world economy. The FSA has an open and principle-based approach to regulation that offers the right environment for it to flourish in the UK. There is huge potential for expansion,' said FSA chairman Sir Callum McCarthy.
In April this year the London Stock Exchange listed its maiden Sukuk, a Sharia-compliant bond. There are now at least eight and the government is expected to sell its own Sukuks soon. 'The UK has taken some commendable steps to allow Sukuk financing,' said Arul Kansasamy, head of Islamic Banking at Barclays Capital.
The FSA describes London as 'a centre of choice for listing Sukuk by establishing the world's first secondary market for Sukuk.' Sukuk trade volumes in London now exceed $2 billion.
Islamic finance is based on the principles of Sharia law and operates without the use of interest. So the products offered are structured in a different way to those provided by conventional banks and financial institutions.
There are also laws regarding the type of business financial institutions can deal with. Investment in business involved with arms, pork, tobacco, drugs, alcohol and pornography are not permitted.
Although they cannot charge interest, they can profit from customers buying a property using different schemes whereby the customer is charged rent, for example. They are structured so that they retain a clearly differentiated status between shareholders' capital and clients' deposits to make sure profits are shared.
A key issue, according to James McDonald of international legal firm Lovells, is the interpretation of Sharia law. Each bank has a Sharia Supervisory Committee or Board who advise on Sharia law.
But according to McDonald, and this is backed up by the FSA, there is a shortage of scholars. Also the interpretation of Sharia law varies with some scholars more strict than others. 'We need Sharia scholars that are flexible and open to the needs of investors,' he said.
Lovells, a major player in the sector that advises on the structuring, regulation and tax implications of Islamic finance, has seen a huge surge in demand for its services and has an office in Dubai. McDonald, a partner in the funds team based in London, believes Sharia-compliant investment funds are a major growth area and large funds cannot ignore this. 'If your investment fund is not Sharia-compliant then you have no chance of tapping in to the huge amount of wealth in the Middle East,' he said.
A sign that Islamic finance is edging towards becoming more mainstream is the range of products now on offer. IBB launched the UK's first completely 100% Sharia compliant home purchase plan earlier this year. It is not just aimed at Muslim customers.
'As lenders withdraw many of their products, customers uncertain of what their options are as a result of the credit crunch will find this offers a new way of financing a home purchase. A growing number of non Muslims are turning to more ethical products,' said Sultan Choudhury, commercial director of IBB.
Indeed IBB has always marketed its services and products beyond the Muslim community.
Although banks like HSBC are involved in Islamic retail banking, they have not yet moved into investment banking or commercial financing. But it is only a matter of time. 'The opportunities are growing. The UK government is really committed to making this market flourish in order to make London a hub for Sharia banking in Europe,' said Nade Kamel, of HSBC.
Islamic insurance, or Takaful, is another growth area. London now has its first Islamic insurance provider. The Salaam Halal company is backed by finance from the United Arab Emirates, Saudi Arabia, Bahrain, Kuwait and Malaysia.
Not only is London becoming the key centre outside the Middle East, it is also acting as a global gateway for Middle East banks into Europe. By having offices in London they can, under EU agreements, offer products in other EU countries without the need for separate authorisation, or even a presence, in each country.
This also offers opportunities for investment companies. Global Securities House, a Sharia-compliant international property firm based in Kuwait, has opened an office in London to establish a UK investment arm.
'We were attracted by the UK government's policy to attract more Islamic financing to London. The city is increasingly popular with Muslim investors because of the favourable regulatory regime. The UK is well known for its innovative financial products and also for the deep pool of professional talent,' said managing director Richard Thomas.
Gatehouse Bank, a subsidiary of the Securities House of Kuwait, was approved by the FSA in April this year. Samer Merhi, executive director, believes the potential for growth is massive. 'The UK has the potential to become the international heart of the Islamic finance business because of the high demand,' he said.
Other European nations are envious and indeed anxious to catch up. France, in particular, is trying to attract more Islamic finance. Recently Rudolf Bohmlet, executive board member at Deutsche Bundesbank, praised London.
Next year sees the world's first conference fully focused on exploring the financial relationship between Europe and the Middle East. Islamic Investment World 2009 next May in Geneva is taking place as a result of demand.
'Investors globally are seeking a safe haven from sub-prime debt, excessive volatility, out of control inflation and central bank meddling. Private equity, structured products, hedge funds and other alternative opportunities are rapidly emerging and catching the eye of the biggest investors in the Middle East,' said a spokesman for the event.
www.propertywire.com
WHAT IS ISLAMIC FINANCE?
The Islamic Bank of Britain gives one of the best definitions of the principles behind Islamic finance: "Central to Islamic finance is the fact that money itself has no intrinsic value. As a matter of faith, a Muslim cannot lend money to, or receive money from someone and expect to benefit - interest is not allowed. To make money from money is forbidden - wealth can only be generated through legitimate trade and investment in assets. Money must be used in a productive way."
When applied to an Islamic fund these principles imply a joint pooling of funds where the investor contributes their money for the purpose of its investment to earn halal profits.
A number of ideas are crucial. Instead of a fixed return tied up with their face value, Islamic investments must carry a 'proportionate profit' actually earned by the fund, and that means that neither the principal nor a rate of profit can be guaranteed.
But how do index and fund providers translate these ethical ideas into practical investments? The MSCI Islamic Series, for example, is based on a normal MSCI index of shares but with equity screens applied to weed out all the non-compliant shares. They exclude securities using two types of criteria: business activity and financial ratios. The screens involve excluding any company that derives more than 5 per cent of its revenue (cumulatively) from, the activities like gambling, alcohol and pork processing. For more details, see www.mscibarra.com
When applied to an Islamic fund these principles imply a joint pooling of funds where the investor contributes their money for the purpose of its investment to earn halal profits.
A number of ideas are crucial. Instead of a fixed return tied up with their face value, Islamic investments must carry a 'proportionate profit' actually earned by the fund, and that means that neither the principal nor a rate of profit can be guaranteed.
But how do index and fund providers translate these ethical ideas into practical investments? The MSCI Islamic Series, for example, is based on a normal MSCI index of shares but with equity screens applied to weed out all the non-compliant shares. They exclude securities using two types of criteria: business activity and financial ratios. The screens involve excluding any company that derives more than 5 per cent of its revenue (cumulatively) from, the activities like gambling, alcohol and pork processing. For more details, see www.mscibarra.com
Islamic funds
Islamic finance is finally breaking into the mainstream. The driver for much of the growth in demand comes from Muslims who are looking for financial services that observe core Shariah ethical principles. However, another key factor has been growing oil wealth, with demand for ethical investments soaring in the Gulf region. Local stock markets have struggled to cope with this wall of money, forcing many Gulf-based investors to look overseas - and to London in particular with its many Islamic-compliant services. The UK also boasts a number of Islamic-compliant banks (five in total), including London-listed The Islamic Bank of Britain, which opened for business in 2004. This wave of new products and Islamic institutions has touched the debt markets, too – in April this year, the London Stock Exchange listed Sukuk, a Sharia-compliant bond.
The fastest growth, though, has been in the funds space: Islamic assets already total around $1 trillion (£560bn) globally, estimates the Asian Development Bank, with annual growth of 10 to 15 percent a year.
This huge wall of money has sparked a frenzy of new financial structures and ever more complex interpretations of religious guidelines and rules. Crucially, this innovation has been centred on working out ways that allow believers to invest in the developed world's stock markets, alongside markets in Islamic countries, knowing that they're not buying an asset of which their scriptures would disapprove.
Equitable distribution
The fact that Islamic laws prohibit paying and receiving interest doesn't mean that that they frown on making money or encourage reverting to an all-cash or barter economy. At its core, Islamic finance is about linking the return to productivity and the quality of the project, thereby ensuring a more equitable distribution of wealth, based around a contract that manages risk.
In practice this means that in the funds space pretty much any structure can work if its ethically designed with expert opinion and approval – funds targeted at private Islamic private investors range from a Shariah-compliant baby bond from the Children's Mutual through to Islamic hedge funds. Commodity funds specialist ETF Securities has even launched a Shariah-compliant commodity funds platform, based on spot prices via physical ownership of key precious metals.
Last month saw London's first specialist Islamic closed-end fund list on stock market. Called the Family Shari'ah Fund, this Cayman Islands-registered but Bahrain-based fund is the UK's first actively-managed listed investment vehicle dedicated to Islamic finance. Its stated objective is to generate "stable long-term capital appreciation across a market cycle through a diversified pool of investments" including money-market instruments, leasing and fixed-income sukuks – real estate, private equity and structures replicating hedge funds returns – plus equities.
Exchange-traded funds
The biggest growth has been seen in the index tracking or exchange-traded funds (ETFs), in part because the idea of an Islamic stock market index is far from new. The first Shariah-compliant indices from a major provider were launched by Dow Jones Indexes in 1999, and FTSE followed suit with its own family in 2000. Later entrants include S&P (tracked by a new family of Deutsche DBX funds) and indices from MSCI. It's important that investors understand that not all Islamic indices are created in the same way – the S&P index, for example, screens out those companies that engage in the trading of gold and silver as cash on a deferred basis, while the MSCI indexes screens out companies involved in the music industry (including radio broadcasting), hotels and the film and television industry (including television broadcasters, cable providers and theatres).
Over in the ETF fund provider space, the key innovator has been Barclays' iShares unit. Traditionally, it is very good at spotting new and alternative investment ideas – iShares' range of alternative asset and property funds is still the most comprehensive by a considerable margin and it's constantly churning out new ideas like its emerging markets infrastructure ETF. Not surprisingly, then, it was also the first to launch Islamic index funds using the MSCI index – there are three funds on the market allowing Islamic investors to invest in the US, Emerging Markets and a wide World Developed Markets index. But iShares is not alone – it's now facing stiff competition from its arch rival Deutsche DBX, which has just launched its own range of three ETFs that are (bar one fund) considerably cheaper than the iShares' funds.
Looking at the funds in detail, you need to be aware that the key decision to exclude financials (traditional banks) does have two major effects. First, these indices have avoided some of the credit-crunch panic, but at the risk of increased exposure to energy and resource stocks. Holdings of these kind of resource stocks in the iShares ETFs range from 34 per cent (US fund) through to 48 per cent for the emerging markets fund. Second, healthcare becomes an important sector – although, in bear markets, that may be something of a plus as most healthcare stocks are fairly defensive by nature.
Still, with all sorts of ethically 'challenged' companies deliberately screened out, it comes as no surprise to learn that some non-Muslim socially-responsible (SRI) investors have started taking these funds seriously. Many Christian investors, for example, would probably share many, if not most, of the same ethical views as Islamic investors – the only key difference seems to be that some Islamic funds do not exclude weapons manufacturers but they do exclude banks, which tend to past most SRI tests. Apart from these inconsistencies, investors might also want to question whether they're entirely comfortable with the idea of the advisory committees setting the ethical screens – these tend to be comprised of a small number of supposedly religious/business experts who set the standards based on their interpretation or reading of the key religious texts. Investors also need to be aware that these ETF funds are all still very small – they might be closed if not successful – and still very much focused on mainstream equities with no exposure yet to bonds or alternative asset classes.
The fastest growth, though, has been in the funds space: Islamic assets already total around $1 trillion (£560bn) globally, estimates the Asian Development Bank, with annual growth of 10 to 15 percent a year.
This huge wall of money has sparked a frenzy of new financial structures and ever more complex interpretations of religious guidelines and rules. Crucially, this innovation has been centred on working out ways that allow believers to invest in the developed world's stock markets, alongside markets in Islamic countries, knowing that they're not buying an asset of which their scriptures would disapprove.
Equitable distribution
The fact that Islamic laws prohibit paying and receiving interest doesn't mean that that they frown on making money or encourage reverting to an all-cash or barter economy. At its core, Islamic finance is about linking the return to productivity and the quality of the project, thereby ensuring a more equitable distribution of wealth, based around a contract that manages risk.
In practice this means that in the funds space pretty much any structure can work if its ethically designed with expert opinion and approval – funds targeted at private Islamic private investors range from a Shariah-compliant baby bond from the Children's Mutual through to Islamic hedge funds. Commodity funds specialist ETF Securities has even launched a Shariah-compliant commodity funds platform, based on spot prices via physical ownership of key precious metals.
Last month saw London's first specialist Islamic closed-end fund list on stock market. Called the Family Shari'ah Fund, this Cayman Islands-registered but Bahrain-based fund is the UK's first actively-managed listed investment vehicle dedicated to Islamic finance. Its stated objective is to generate "stable long-term capital appreciation across a market cycle through a diversified pool of investments" including money-market instruments, leasing and fixed-income sukuks – real estate, private equity and structures replicating hedge funds returns – plus equities.
Exchange-traded funds
The biggest growth has been seen in the index tracking or exchange-traded funds (ETFs), in part because the idea of an Islamic stock market index is far from new. The first Shariah-compliant indices from a major provider were launched by Dow Jones Indexes in 1999, and FTSE followed suit with its own family in 2000. Later entrants include S&P (tracked by a new family of Deutsche DBX funds) and indices from MSCI. It's important that investors understand that not all Islamic indices are created in the same way – the S&P index, for example, screens out those companies that engage in the trading of gold and silver as cash on a deferred basis, while the MSCI indexes screens out companies involved in the music industry (including radio broadcasting), hotels and the film and television industry (including television broadcasters, cable providers and theatres).
Over in the ETF fund provider space, the key innovator has been Barclays' iShares unit. Traditionally, it is very good at spotting new and alternative investment ideas – iShares' range of alternative asset and property funds is still the most comprehensive by a considerable margin and it's constantly churning out new ideas like its emerging markets infrastructure ETF. Not surprisingly, then, it was also the first to launch Islamic index funds using the MSCI index – there are three funds on the market allowing Islamic investors to invest in the US, Emerging Markets and a wide World Developed Markets index. But iShares is not alone – it's now facing stiff competition from its arch rival Deutsche DBX, which has just launched its own range of three ETFs that are (bar one fund) considerably cheaper than the iShares' funds.
Looking at the funds in detail, you need to be aware that the key decision to exclude financials (traditional banks) does have two major effects. First, these indices have avoided some of the credit-crunch panic, but at the risk of increased exposure to energy and resource stocks. Holdings of these kind of resource stocks in the iShares ETFs range from 34 per cent (US fund) through to 48 per cent for the emerging markets fund. Second, healthcare becomes an important sector – although, in bear markets, that may be something of a plus as most healthcare stocks are fairly defensive by nature.
Still, with all sorts of ethically 'challenged' companies deliberately screened out, it comes as no surprise to learn that some non-Muslim socially-responsible (SRI) investors have started taking these funds seriously. Many Christian investors, for example, would probably share many, if not most, of the same ethical views as Islamic investors – the only key difference seems to be that some Islamic funds do not exclude weapons manufacturers but they do exclude banks, which tend to past most SRI tests. Apart from these inconsistencies, investors might also want to question whether they're entirely comfortable with the idea of the advisory committees setting the ethical screens – these tend to be comprised of a small number of supposedly religious/business experts who set the standards based on their interpretation or reading of the key religious texts. Investors also need to be aware that these ETF funds are all still very small – they might be closed if not successful – and still very much focused on mainstream equities with no exposure yet to bonds or alternative asset classes.
The new UK tax law on sukuk
Mohammed Amin MA FCA AMCT CTA (Fellow), tax partner at PricewaterhouseCoopers LLP and head of the firm’s Islamic finance practice in the UK, explores the new UK tax law on sukuk. This article is based on the presentation given by the author at IIBI’s monthly lecture in London, July 2007 and published 01 January, 2008 in IIBI's NewHorizon Magazine.
Diagram 1 illustrates an ijara sukuk. The owner has a building and decides to raise money using that building. It sets up a special purpose vehicle (SPV) and sells the building to that SPV, and then rents it back. The SPV pays for that building by issuing sukuk. Those sukuk are not a debt owed by the SPV; instead they are a direct legal claim on a proportionate share of the building and of the rent it generates.
Diagram 2 illustrates a mudarabah sukuk, based upon an actual example. XYZ trading company has a collection of business assets and wants to raise $500 million to use in its business. It sets up an SPV, here XYZ Sukuk Ltd, which raises $500 million to buy the assets. That $500 million comes from the investors as payment for sukuk certificates. Next the assets, which are now owned by XYZ Sukuk Ltd on trust for the investors, are contributed to a mudarabah whereby 99 per cent of the profits of the mudarabah will go to the trust for payments to investors subject to a maximum limit, in this case of six per cent, i.e. six per cent of $500 million = $30 million p.a. Again, the investors are not receiving interest but a share of the business profits.
Before this year’s tax law, what happened if a sukuk was issued? The basic problem was that tax costs arose in the issuing SPV company. The SPV is receiving something that is clearly taxable income. However the payments that the SPV makes to the investors do not give rise to any tax relief. Those payments to the investors are not interest; they are simply paying on to the investor the fractional entitlement to the rent or the fractional entitlement to the income of the mudarabah. There is no reason why the SPV should get tax relief for those payments under basic UK tax law. So tax arises in the SPV.
Even if the sukuk-issuing SPV tried to argue that this payment to the investors should really be treated like interest, it still wouldn’t get tax relief. There is a very specific provision in our tax code, in the Income and Corporation Taxes Act (ICTA) 1988 section 209(2) (e) (iii). If you issue securities, in other words debt instruments, under which the interest payable on those securities is dependent upon the results of the company’s business, then that interest doesn’t get tax relief. Instead it is treated as a distribution, like a dividend. It is not a tax-deductible expense.
We now have some new legislation in the Finance Act (FA) 2007. However, if you search FA 2007 for the word ‘sukuk’, you will not find it. The rules for sukuk introduced in 2007 follow the same overall approach as the 2005 rules for murabaha transactions or mudarabah transactions. HM Treasury simply created a definition, a new concept in UK tax law; something called an ‘alternative finance investment bond’ (AFIB). If the definition is met, certain tax consequences follow.
* The definition of an AFIB
The legislation requires one or more persons to pay money to a bond issuer. The bond issuer is going to acquire some assets which will generate income or gains.
There has to be a fixed period of time when the arrangements will end. A sukuk that is perpetual won’t qualify. As part of the legal agreements, the issuer has to undertake that at the end of the sukuk it will dispose of any bond assets that are left.
The issuer will also make other payments to the investors, which are called additional payments. In diagram 1, the additional payments come from the rent and in diagram 2 from the business profits.
The additional payment must not exceed a reasonable commercial return on a loan equal to the amount of the capital. One of the things that the UK Government was most concerned about was ensuring that it did not give a tax deduction for payments on sukuk instruments which had equity characteristics, i.e. which were equivalent to ordinary shares. The law does not stipulate what is a reasonable commercial return; that would depend upon the facts and circumstances.
The bond issuer is going to manage the bond assets. In other words, the bond assets are not managed by the investors. Of course, the bond issuer can delegate management. In diagram 2, once the bond assets have been contributed to the mudarabah, XYZ Trading Company as the mudarib is going to manage that mudarabah.
The sukuk, the bond, has to be transferable. This doesn’t mean it has to be physically transferred. The sukuk could be issued and the same people may hold it for its entire five- or ten-year life, which is actually very common with sukuk. There is relatively little secondary trading in practice, but the critical thing is that they have to be transferable.
The AFIB has to be listed on a recognised stock exchange. There is a provision in the Income Tax Act 2007 section 1005 which details what a recognised stock exchange is and there is a provision in the legislation to recognise a stock exchange purely for the purpose of the AFIB rules. As well as a long list of fully recognised stock exchanges, HM Revenue & Customs (HMRC) lists seven exchanges which are recognised only for the purposes of the AFIB rules. (See www.hmrc.gov.uk/fid/rse.htm)
Diagram 1 Ijara sukuk
If issuing a sukuk from the UK, it is important to make sure that it is listed on a fully recognised stock exchange within the Income Tax Act 2007 definition to avoid paying withholding tax. If a sukuk is listed on a fully recognised stock exchange, then the consequence of the 2007 rules is that it is treated for tax purposes as if it were a debt instrument and the exemption for listed eurobonds should apply. Interest on listed eurobonds can be paid without withholding tax.
If a UK-based sukuk is created and listed on a stock exchange which is only recognised for the purpose of the AFIB rules and not recognised for any other purposes, then the eurobond exemption would not apply. The eurobond exemption looks specifically at stock exchange designations under Income Tax 2007, not at the extension for sukuk. Finally, there is an accounting test. If the issuer were to prepare accounts under International Financial Reporting Standards (IFRS), the sukuk would be treated as a financial liability.
After all the strict definitions there are a few relaxations:
* The issuing entity can acquire the bond assets either before or after the sukuk itself is issued.
* Bond assets can be any kind of property and can be secondary rights in property. For example, it could be that instead of owning a building the asset could be a lease over a building.
* A declaration of trust is permitted but not mandatory.
* Bond holders may be given the right to terminate early.
* The additional payment, the economic return to the bond holder, can be either fixed or variable. However, if the payments are not fixed then the test of whether they represent only an amount equivalent to a normal commercial return on the capital is made by looking at the maximum amount of the additional payments. To ensure that the additional payments cannot exceed a reasonable commercial return, it may be worth including a numerical cap in the documentation, as in diagram 2.
* Finally, the redemption payment can be satisfied by the issue or transfer of shares. This caters for convertible or exchangeable sukuk, corresponding to convertible or exchangeable bonds.
* Tax consequences of qualifying as an AFIB
From the issuing company’s perspective, the AFIB is treated as a loan relationship. In other words, it is treated as if it were debt and all the tax rules for corporate debt apply to the AFIB. The Government is not saying that this is a debt instrument or that the issuer is paying interest, it is merely saying that it is going to apply the same tax law that would have applied if there had been a debt instrument.
Diagram 1 Mudarabah sukuk
The additional payments are treated as if they were interest for tax purposes. This potentially makes them tax-deductible, and there is an express override of section 209 (2) (e) (iii). The issuer is taxed as if it beneficially owned the assets, which means that it is entitled to any capital allowances (tax depreciation) the assets qualify for.
To a limited extent the issuer is treated as a financial institution. The existing tax law for Islamic finance in FA 2005 and FA 2006 applies only if one party to the transaction is a financial institution, broadly speaking a bank, a building society, a wholly owned subsidiary of a bank or building society, or an overseas recognised deposit taker. The issuer of an alternative finance investment bond is treated as a financial institution but only for two specific categories of asset. These are purchase and resale assets, in other words assets which are used in a murabaha transaction, and diminishing shared ownership assets.
The reason for these two choices is that when drafting this legislation HM Treasury primarily saw sukuk as an equivalent to conventional securitisation. Conventional banks lend conventional mortgages and often securitise them. Islamic banks typically provide mortgages by purchase and resale of property or proportional ownership of property. Accordingly, the AFIB rules enable Islamic banks to securitise their Islamic mortgages.
* Taxation of buyers and sellers of AFIBs
Buyers and sellers of sukuk are legally buying and selling a fractional ownership interest in assets. Before FA 2007, this gave rise to many technical questions. Was the purchase and sale of the assets subject to stamp duty; was it subject to capital gains tax or income tax; and was it subject to VAT or stamp duty land tax? If a sukuk paid rental income, was that rental income taxed in the UK if you were non-resident? Most of these questions are actually unresolved because sukuk were quite unfamiliar in a UK tax context.
The situation now is that for both corporate and individual investors, sukuk are treated exactly as equivalent conventional debt would be treated for tax purposes, both for the taxation of income payments and for the taxation of gains or losses from buying and selling sukuk.
* Areas where further change is needed
In diagram 1, the first thing the owner does is to sell the buildings to the SPV. That sale is a taxable sale. If the building has gone up in value, the company will pay tax on the gain. If the company had issued a conventional eurobond it would not have sold the building or transferred the building anywhere and therefore it would not have paid tax.
There needs to be some mechanism designed to stop tax arising on the gain when the building is sold, perhaps by deferring it as long as the building eventually reverts to the entity which sold it to the SPV.
Similarly, that sale of the building will give rise to stamp duty land tax. Again, that is an extra cost which does not arise if a conventional debt instrument is issued. The sale may also give rise to value added tax consequences. These are areas where the law needs to go further to put sukuk issuers into an equivalent position to conventional bond issuers.
Source: NewHorizon
Diagram 1 illustrates an ijara sukuk. The owner has a building and decides to raise money using that building. It sets up a special purpose vehicle (SPV) and sells the building to that SPV, and then rents it back. The SPV pays for that building by issuing sukuk. Those sukuk are not a debt owed by the SPV; instead they are a direct legal claim on a proportionate share of the building and of the rent it generates.
Diagram 2 illustrates a mudarabah sukuk, based upon an actual example. XYZ trading company has a collection of business assets and wants to raise $500 million to use in its business. It sets up an SPV, here XYZ Sukuk Ltd, which raises $500 million to buy the assets. That $500 million comes from the investors as payment for sukuk certificates. Next the assets, which are now owned by XYZ Sukuk Ltd on trust for the investors, are contributed to a mudarabah whereby 99 per cent of the profits of the mudarabah will go to the trust for payments to investors subject to a maximum limit, in this case of six per cent, i.e. six per cent of $500 million = $30 million p.a. Again, the investors are not receiving interest but a share of the business profits.
Before this year’s tax law, what happened if a sukuk was issued? The basic problem was that tax costs arose in the issuing SPV company. The SPV is receiving something that is clearly taxable income. However the payments that the SPV makes to the investors do not give rise to any tax relief. Those payments to the investors are not interest; they are simply paying on to the investor the fractional entitlement to the rent or the fractional entitlement to the income of the mudarabah. There is no reason why the SPV should get tax relief for those payments under basic UK tax law. So tax arises in the SPV.
Even if the sukuk-issuing SPV tried to argue that this payment to the investors should really be treated like interest, it still wouldn’t get tax relief. There is a very specific provision in our tax code, in the Income and Corporation Taxes Act (ICTA) 1988 section 209(2) (e) (iii). If you issue securities, in other words debt instruments, under which the interest payable on those securities is dependent upon the results of the company’s business, then that interest doesn’t get tax relief. Instead it is treated as a distribution, like a dividend. It is not a tax-deductible expense.
We now have some new legislation in the Finance Act (FA) 2007. However, if you search FA 2007 for the word ‘sukuk’, you will not find it. The rules for sukuk introduced in 2007 follow the same overall approach as the 2005 rules for murabaha transactions or mudarabah transactions. HM Treasury simply created a definition, a new concept in UK tax law; something called an ‘alternative finance investment bond’ (AFIB). If the definition is met, certain tax consequences follow.
* The definition of an AFIB
The legislation requires one or more persons to pay money to a bond issuer. The bond issuer is going to acquire some assets which will generate income or gains.
There has to be a fixed period of time when the arrangements will end. A sukuk that is perpetual won’t qualify. As part of the legal agreements, the issuer has to undertake that at the end of the sukuk it will dispose of any bond assets that are left.
The issuer will also make other payments to the investors, which are called additional payments. In diagram 1, the additional payments come from the rent and in diagram 2 from the business profits.
The additional payment must not exceed a reasonable commercial return on a loan equal to the amount of the capital. One of the things that the UK Government was most concerned about was ensuring that it did not give a tax deduction for payments on sukuk instruments which had equity characteristics, i.e. which were equivalent to ordinary shares. The law does not stipulate what is a reasonable commercial return; that would depend upon the facts and circumstances.
The bond issuer is going to manage the bond assets. In other words, the bond assets are not managed by the investors. Of course, the bond issuer can delegate management. In diagram 2, once the bond assets have been contributed to the mudarabah, XYZ Trading Company as the mudarib is going to manage that mudarabah.
The sukuk, the bond, has to be transferable. This doesn’t mean it has to be physically transferred. The sukuk could be issued and the same people may hold it for its entire five- or ten-year life, which is actually very common with sukuk. There is relatively little secondary trading in practice, but the critical thing is that they have to be transferable.
The AFIB has to be listed on a recognised stock exchange. There is a provision in the Income Tax Act 2007 section 1005 which details what a recognised stock exchange is and there is a provision in the legislation to recognise a stock exchange purely for the purpose of the AFIB rules. As well as a long list of fully recognised stock exchanges, HM Revenue & Customs (HMRC) lists seven exchanges which are recognised only for the purposes of the AFIB rules. (See www.hmrc.gov.uk/fid/rse.htm)
Diagram 1 Ijara sukuk
If issuing a sukuk from the UK, it is important to make sure that it is listed on a fully recognised stock exchange within the Income Tax Act 2007 definition to avoid paying withholding tax. If a sukuk is listed on a fully recognised stock exchange, then the consequence of the 2007 rules is that it is treated for tax purposes as if it were a debt instrument and the exemption for listed eurobonds should apply. Interest on listed eurobonds can be paid without withholding tax.
If a UK-based sukuk is created and listed on a stock exchange which is only recognised for the purpose of the AFIB rules and not recognised for any other purposes, then the eurobond exemption would not apply. The eurobond exemption looks specifically at stock exchange designations under Income Tax 2007, not at the extension for sukuk. Finally, there is an accounting test. If the issuer were to prepare accounts under International Financial Reporting Standards (IFRS), the sukuk would be treated as a financial liability.
After all the strict definitions there are a few relaxations:
* The issuing entity can acquire the bond assets either before or after the sukuk itself is issued.
* Bond assets can be any kind of property and can be secondary rights in property. For example, it could be that instead of owning a building the asset could be a lease over a building.
* A declaration of trust is permitted but not mandatory.
* Bond holders may be given the right to terminate early.
* The additional payment, the economic return to the bond holder, can be either fixed or variable. However, if the payments are not fixed then the test of whether they represent only an amount equivalent to a normal commercial return on the capital is made by looking at the maximum amount of the additional payments. To ensure that the additional payments cannot exceed a reasonable commercial return, it may be worth including a numerical cap in the documentation, as in diagram 2.
* Finally, the redemption payment can be satisfied by the issue or transfer of shares. This caters for convertible or exchangeable sukuk, corresponding to convertible or exchangeable bonds.
* Tax consequences of qualifying as an AFIB
From the issuing company’s perspective, the AFIB is treated as a loan relationship. In other words, it is treated as if it were debt and all the tax rules for corporate debt apply to the AFIB. The Government is not saying that this is a debt instrument or that the issuer is paying interest, it is merely saying that it is going to apply the same tax law that would have applied if there had been a debt instrument.
Diagram 1 Mudarabah sukuk
The additional payments are treated as if they were interest for tax purposes. This potentially makes them tax-deductible, and there is an express override of section 209 (2) (e) (iii). The issuer is taxed as if it beneficially owned the assets, which means that it is entitled to any capital allowances (tax depreciation) the assets qualify for.
To a limited extent the issuer is treated as a financial institution. The existing tax law for Islamic finance in FA 2005 and FA 2006 applies only if one party to the transaction is a financial institution, broadly speaking a bank, a building society, a wholly owned subsidiary of a bank or building society, or an overseas recognised deposit taker. The issuer of an alternative finance investment bond is treated as a financial institution but only for two specific categories of asset. These are purchase and resale assets, in other words assets which are used in a murabaha transaction, and diminishing shared ownership assets.
The reason for these two choices is that when drafting this legislation HM Treasury primarily saw sukuk as an equivalent to conventional securitisation. Conventional banks lend conventional mortgages and often securitise them. Islamic banks typically provide mortgages by purchase and resale of property or proportional ownership of property. Accordingly, the AFIB rules enable Islamic banks to securitise their Islamic mortgages.
* Taxation of buyers and sellers of AFIBs
Buyers and sellers of sukuk are legally buying and selling a fractional ownership interest in assets. Before FA 2007, this gave rise to many technical questions. Was the purchase and sale of the assets subject to stamp duty; was it subject to capital gains tax or income tax; and was it subject to VAT or stamp duty land tax? If a sukuk paid rental income, was that rental income taxed in the UK if you were non-resident? Most of these questions are actually unresolved because sukuk were quite unfamiliar in a UK tax context.
The situation now is that for both corporate and individual investors, sukuk are treated exactly as equivalent conventional debt would be treated for tax purposes, both for the taxation of income payments and for the taxation of gains or losses from buying and selling sukuk.
* Areas where further change is needed
In diagram 1, the first thing the owner does is to sell the buildings to the SPV. That sale is a taxable sale. If the building has gone up in value, the company will pay tax on the gain. If the company had issued a conventional eurobond it would not have sold the building or transferred the building anywhere and therefore it would not have paid tax.
There needs to be some mechanism designed to stop tax arising on the gain when the building is sold, perhaps by deferring it as long as the building eventually reverts to the entity which sold it to the SPV.
Similarly, that sale of the building will give rise to stamp duty land tax. Again, that is an extra cost which does not arise if a conventional debt instrument is issued. The sale may also give rise to value added tax consequences. These are areas where the law needs to go further to put sukuk issuers into an equivalent position to conventional bond issuers.
Source: NewHorizon
Demystifying Sukuk
DOWNLOAD: An overview of Sukuk and its applications.
http://www.sukuk.net/files/news_images/headlines/DIFC%20Week%20IMB%20Sukuk%20Presentation.pdf
Source: AJP
http://www.sukuk.net/files/news_images/headlines/DIFC%20Week%20IMB%20Sukuk%20Presentation.pdf
Source: AJP
Examples of Sukuk issuances and their structures
Standard and Poor’s estimates that 20 per cent of those investors, with billions to invest, would now spontaneously choose an Islamic financial product over a conventional one with a similar risk-return profile.
That has led to the increased use of the Sukuk, especially in the Gulf countries and Malaysia. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), defines Sukuks as “certificates of equal value representing after closing subscription, 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.”
Introduced in varied structures and sizes, Sukuks worth $20 billion hit the market in 2006 and are expected to surpass $50 billion in 2007 as the companies seek to diversify their sources of financing. Although companies in Kuwait, Bahrain, Saudi Arabia and Qatar have all been actively using Sukuk financings over the years, Malaysia led the Sukuk issue market in 2006 with a share of about 60 per cent. That year also witnessed the first Sukuk that originated in the United States. The trends in 2007 clearly suggest that the United Arab Emirates, especially Dubai, have most likely taken over the lead.
Sukuk structures are being used for a variety of purposes and have evolved rapidly in response to the demands of issuers and investors. Sukuk issues have ranged from the simple sale and leaseback (Ijara) structures, such as the $1 billion Dubai Department of Civil Aviation Sukuk issued in November 2004, to the $2.53 billion trust finance Sukuk structure issued by Aldar Properties in March 2007, demonstrating the flexibility of Islamic finance principles.
Below are examples of some recent Sukuk issues that show and emphasise that Sukuk has matured into a diversified, internationally-acceptable instrument to raise corporate finance for acquisitions or working capital purposes, or to re-finance existing debt, or use in the transportation sector (especially in the shipping and aircraft sectors), real estate, construction and petrochemical projects in several countries.
German Sukuk (Saxony-Anhalt Sukuk)
In 2004, a €100 million Sukuk, structured as a Sukuk Al Ijara, was issued in the federal state of Saxony-Anhalt in Germany. The Federal Republic of Germany guarantees the debts of Saxony-Anhalt. The underlying transactions are a certain number of specified buildings owned by the Ministry of Finance. The master lease was sold for 100 years to a special purpose vehicle, incorporated in the Netherlands for tax reasons, which in turn rented it back for five years to the Ministry of Finance. The certificate holders receive a variable rent benchmarked to the EURIBOR over the rented period. The Sukuk is listed on the Luxembourg Stock Exchange. Incidentally, as of July 2007, the Saxony-Anhalt Sukuk remains the only sovereign Sukuk from a non-Islamic country to have tapped the market.
Sukuks by the Governments of Bahrain, Qatar and Malaysia
The Central Bank of Bahrain, on behalf of the Government of Bahrain, regularly issues Sukuk-Al-Ijara and Sukuk Al-Salam to finance various infrastructure projects in Bahrain. Malaysia’s Global Sukuk, launched in June 2002, was similarly backed by an Ijara lease on a single piece of government property. The money raised by the Government of Qatar through the $700 million Qatar Global Sukuk is being used partly to finance the construction of the Hamad Medical City.
First Airlines Sukuk - Emirates Airlines Sukuk
The first Sukuk issued by Dubai’s national airlines, Emirates, closed in July 2005. At $550 million, this was the single largest corporate Sukuk issuance at that time. The Sukuk has a seven-year tenor and is structured as a Musharaka. The proceeds of the issue, which is listed on the Luxembourg Stock Exchange, will be used to finance the new Emirates Engineering Centre and their headquarters building in Dubai.
First Ship Finance Sukuk – MT Venus Glory Sukuk/Al Safeena Sukuk
In 2005, ABC International Bank jointly with Abu Dhabi Commercial Bank arranged, structured and jointly underwrote a pioneering Islamic ship finance transaction through the issuance of a $26 million Al-Safeena Ijara Sukuk. At that time, Al-Safeena Sukuk was the first issue that combined Islamic equity with conventional debt for the same asset, which in this case was VLCC (called “Venus Glory”), owned by Pacific Star (Pac Star) International Holding Corporation, which in turn is owned by Saudi Aramco, the world’s largest oil exporting company.
Dubai Civil Aviation Authority Sukuk
The Dubai Civil Aviation Authority, a quasi-sovereign entity, broke the mould in 2004 by going down the Sukuk route instead of plain vanilla finance, by issuing a $1 billion Sukuk, the world’s largest single Sukuk issuance in terms of size at that time by any issuer. The proceeds were used to finance the building of a new international terminal and for the expansion of existing engineering and other infrastructure. The Musharaka was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai’s airport that will ultimately be leased to Emirates. Profit, in the form of lease returns, generated from the Musharaka will be used to pay the periodic distribution on the trust certificates.
Bahrain Financial Harbour - Al Marfa'a Al Mali Sukuk
The Istisna'a-Ijara Sukuk, known as the Al Marfa'a Al Mali Sukuk, has been structured by the Liquidity Management Centre in accordance and in compliance with the principles of Islamic Shari'a. The Sukuk has a five-year term maturing in 2010 offering a quarterly profit distribution with the proceeds used to finance the development and construction of the Financial Centre which represents the first phase of the Bahrain Financial Harbour project comprising the Dual Towers, the Financial Mall and the Harbour House.
Dubai World Sukuk
In 2006, Dubai property developer Nakheel Group, developer of three palm-frond shaped islands off Dubai's coast, sold the world's largest Islamic bond after increasing its size by more than 40 per cent to $3.52 billion to meet demand. Nakheel will use cash from its Sukuk to fund projects in Dubai, which is leading a surge in Gulf Arab investment in construction and real-estate developments. The Sukuk has been listed on the Dubai International Financial Exchange.
DP World Sukuk
In 2007, global marine terminal operator DP World priced a $1.75 billion conventional bond and a $1.5 billion Sukuk. It is the first issuer to list both conventional and Islamic debt securities on the Dubai International Financial Exchange.
The $1.5 billion, 10-year Sukuk attracted demand globally, including from the United States. This was the first time U.S. investors had the opportunity to subscribe to a UAE corporate rated Sukuk. DP World's Sukuk is ground breaking and innovative because it is partly convertible to shares in the event the ports group lists through an initial public offering, thus becoming the first convertible instrument in the Islamic finance market. The issue is part of a large financing package being arranged for general corporate activities, ongoing business development needs, and expansion plans, including the financing of the purchase of the British rival P&O.
East Cameron Gas Sukuk
The first and only Sukuk to have originated from the United States tapped the market in 2006. The unique feature of the East Cameron Gas Sukuk was that it was the first ever Shariah compliant gas backed securitisation and was the first-ever Islamic securitisation rated by Standard and Poor’s. The $165.7 million Sukuk originated from Houston based East Cameron Partners, whose reserves are located in the shallow waters off the shores of the State of Louisana. The Sukuk was structured as a Musharaka structure in terms of the management of the assets and then a funding agreement between the issuer and the purchaser.
The initiatives taken by the governments of the UAE, Bahrain, Malaysia and the United Kingdom, to name a few, have acted as a catalyst for the evolution and growth of the Sukuk market and the development of Islamic Finance as a whole. The regulatory bodies within such countries have been actively introducing rules and regulations pertaining to the issuing and offering of Sukuks, which we hope in time will help provide standardisation, resulting in the maturation of the field.
From the financing structures focused mainly on plain vanilla type commodity-trading murabaha transactions to the complex structures involved in the Sukuks, Islamic finance has come a long way and Sukuks have emerged as high profile financial instruments. With top international banks, financial institutions, law firms and other financial services providers scampering for a piece of the cake in the Middle East, Islamic banking and finance has grown into a full-fledged practice area of its own. With a catalogue of successful issues worth billions of dollars reflecting the huge appetite for Sukuks, there are all signs pointing towards the long term success and growth of Sukuks.
sukuk.net
That has led to the increased use of the Sukuk, especially in the Gulf countries and Malaysia. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), defines Sukuks as “certificates of equal value representing after closing subscription, 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.”
Introduced in varied structures and sizes, Sukuks worth $20 billion hit the market in 2006 and are expected to surpass $50 billion in 2007 as the companies seek to diversify their sources of financing. Although companies in Kuwait, Bahrain, Saudi Arabia and Qatar have all been actively using Sukuk financings over the years, Malaysia led the Sukuk issue market in 2006 with a share of about 60 per cent. That year also witnessed the first Sukuk that originated in the United States. The trends in 2007 clearly suggest that the United Arab Emirates, especially Dubai, have most likely taken over the lead.
Sukuk structures are being used for a variety of purposes and have evolved rapidly in response to the demands of issuers and investors. Sukuk issues have ranged from the simple sale and leaseback (Ijara) structures, such as the $1 billion Dubai Department of Civil Aviation Sukuk issued in November 2004, to the $2.53 billion trust finance Sukuk structure issued by Aldar Properties in March 2007, demonstrating the flexibility of Islamic finance principles.
Below are examples of some recent Sukuk issues that show and emphasise that Sukuk has matured into a diversified, internationally-acceptable instrument to raise corporate finance for acquisitions or working capital purposes, or to re-finance existing debt, or use in the transportation sector (especially in the shipping and aircraft sectors), real estate, construction and petrochemical projects in several countries.
German Sukuk (Saxony-Anhalt Sukuk)
In 2004, a €100 million Sukuk, structured as a Sukuk Al Ijara, was issued in the federal state of Saxony-Anhalt in Germany. The Federal Republic of Germany guarantees the debts of Saxony-Anhalt. The underlying transactions are a certain number of specified buildings owned by the Ministry of Finance. The master lease was sold for 100 years to a special purpose vehicle, incorporated in the Netherlands for tax reasons, which in turn rented it back for five years to the Ministry of Finance. The certificate holders receive a variable rent benchmarked to the EURIBOR over the rented period. The Sukuk is listed on the Luxembourg Stock Exchange. Incidentally, as of July 2007, the Saxony-Anhalt Sukuk remains the only sovereign Sukuk from a non-Islamic country to have tapped the market.
Sukuks by the Governments of Bahrain, Qatar and Malaysia
The Central Bank of Bahrain, on behalf of the Government of Bahrain, regularly issues Sukuk-Al-Ijara and Sukuk Al-Salam to finance various infrastructure projects in Bahrain. Malaysia’s Global Sukuk, launched in June 2002, was similarly backed by an Ijara lease on a single piece of government property. The money raised by the Government of Qatar through the $700 million Qatar Global Sukuk is being used partly to finance the construction of the Hamad Medical City.
First Airlines Sukuk - Emirates Airlines Sukuk
The first Sukuk issued by Dubai’s national airlines, Emirates, closed in July 2005. At $550 million, this was the single largest corporate Sukuk issuance at that time. The Sukuk has a seven-year tenor and is structured as a Musharaka. The proceeds of the issue, which is listed on the Luxembourg Stock Exchange, will be used to finance the new Emirates Engineering Centre and their headquarters building in Dubai.
First Ship Finance Sukuk – MT Venus Glory Sukuk/Al Safeena Sukuk
In 2005, ABC International Bank jointly with Abu Dhabi Commercial Bank arranged, structured and jointly underwrote a pioneering Islamic ship finance transaction through the issuance of a $26 million Al-Safeena Ijara Sukuk. At that time, Al-Safeena Sukuk was the first issue that combined Islamic equity with conventional debt for the same asset, which in this case was VLCC (called “Venus Glory”), owned by Pacific Star (Pac Star) International Holding Corporation, which in turn is owned by Saudi Aramco, the world’s largest oil exporting company.
Dubai Civil Aviation Authority Sukuk
The Dubai Civil Aviation Authority, a quasi-sovereign entity, broke the mould in 2004 by going down the Sukuk route instead of plain vanilla finance, by issuing a $1 billion Sukuk, the world’s largest single Sukuk issuance in terms of size at that time by any issuer. The proceeds were used to finance the building of a new international terminal and for the expansion of existing engineering and other infrastructure. The Musharaka was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai’s airport that will ultimately be leased to Emirates. Profit, in the form of lease returns, generated from the Musharaka will be used to pay the periodic distribution on the trust certificates.
Bahrain Financial Harbour - Al Marfa'a Al Mali Sukuk
The Istisna'a-Ijara Sukuk, known as the Al Marfa'a Al Mali Sukuk, has been structured by the Liquidity Management Centre in accordance and in compliance with the principles of Islamic Shari'a. The Sukuk has a five-year term maturing in 2010 offering a quarterly profit distribution with the proceeds used to finance the development and construction of the Financial Centre which represents the first phase of the Bahrain Financial Harbour project comprising the Dual Towers, the Financial Mall and the Harbour House.
Dubai World Sukuk
In 2006, Dubai property developer Nakheel Group, developer of three palm-frond shaped islands off Dubai's coast, sold the world's largest Islamic bond after increasing its size by more than 40 per cent to $3.52 billion to meet demand. Nakheel will use cash from its Sukuk to fund projects in Dubai, which is leading a surge in Gulf Arab investment in construction and real-estate developments. The Sukuk has been listed on the Dubai International Financial Exchange.
DP World Sukuk
In 2007, global marine terminal operator DP World priced a $1.75 billion conventional bond and a $1.5 billion Sukuk. It is the first issuer to list both conventional and Islamic debt securities on the Dubai International Financial Exchange.
The $1.5 billion, 10-year Sukuk attracted demand globally, including from the United States. This was the first time U.S. investors had the opportunity to subscribe to a UAE corporate rated Sukuk. DP World's Sukuk is ground breaking and innovative because it is partly convertible to shares in the event the ports group lists through an initial public offering, thus becoming the first convertible instrument in the Islamic finance market. The issue is part of a large financing package being arranged for general corporate activities, ongoing business development needs, and expansion plans, including the financing of the purchase of the British rival P&O.
East Cameron Gas Sukuk
The first and only Sukuk to have originated from the United States tapped the market in 2006. The unique feature of the East Cameron Gas Sukuk was that it was the first ever Shariah compliant gas backed securitisation and was the first-ever Islamic securitisation rated by Standard and Poor’s. The $165.7 million Sukuk originated from Houston based East Cameron Partners, whose reserves are located in the shallow waters off the shores of the State of Louisana. The Sukuk was structured as a Musharaka structure in terms of the management of the assets and then a funding agreement between the issuer and the purchaser.
The initiatives taken by the governments of the UAE, Bahrain, Malaysia and the United Kingdom, to name a few, have acted as a catalyst for the evolution and growth of the Sukuk market and the development of Islamic Finance as a whole. The regulatory bodies within such countries have been actively introducing rules and regulations pertaining to the issuing and offering of Sukuks, which we hope in time will help provide standardisation, resulting in the maturation of the field.
From the financing structures focused mainly on plain vanilla type commodity-trading murabaha transactions to the complex structures involved in the Sukuks, Islamic finance has come a long way and Sukuks have emerged as high profile financial instruments. With top international banks, financial institutions, law firms and other financial services providers scampering for a piece of the cake in the Middle East, Islamic banking and finance has grown into a full-fledged practice area of its own. With a catalogue of successful issues worth billions of dollars reflecting the huge appetite for Sukuks, there are all signs pointing towards the long term success and growth of Sukuks.
sukuk.net
Model of a classic Sukuk structure
Over the last few years there has been a dramatic growth in the use of Islamic finance techniques in raising capital that complies with the requirements of Shari'a law.
According to recent reports assets invested in an Islamic, Shari'a compliant, manner are now estimated to exceed US$250 billion with the pool of money held by Muslim investors estimated at US$1.5 trillion (and growing rapidly with high oil prices).
The growth of the Sukuk market, which only opened in 2002 with the Malaysian government US$600 million Sukuk issue, is a prime indicator of this trend. By 2004, US$6.7 billion of capital was raised through the issue of Sukuks and in the first six months of 2005 the total raised reached US$6.2 billion.
Under the Koran, interest (riba) earned on money (for example, a loan) is forbidden, but many other types of finance are allowed. The basic principle behind the Sukuk is that the holder has an undivided ownership interest in a particular asset and is therefore entitled to the return generated by that asset. The classic Sukuk structure involves an acquisition of a property asset by a special purpose company (SPC) established in a tax neutral jurisdiction. The company funds itself by the issue of Sukuk, declaring a trust in favour of the Sukuk holders. The Sukuk holders receive a return based on the rental income of the asset, taking the credit risk of the underlying lessee (see box "Classic structure").
There are a number of accounting and tax consequences which can arise when a UK property is transferred to a UK based SPC but these are beyond the scope of this article.
Increasing interest
The growth in the Sukuk market is due to the confluence of a number of factors ranging from the geopolitical impact of the 9/11 atrocities to a more general interest in developing Shari'a compliant products and structures. The fundamental drivers behind the Sukuk market are the same as those for the conventional securities market as it aims to:
-Broaden the pool of investors.
- Spread risk away from financial institutions.
- Dis-intermediate the link between investors and borrowers.
Although the market is relatively small, the excess liquidity currently being pumped into Gulf economies means that another pool of investment funds is becoming available to corporate treasurers. As the market is developing rapidly and the jurisprudence from the Islamic scholars is becoming more settled, the issue costs for a Sukuk structure continue to fall. The TCIP (Trust Certificate Issuance Programme) established by the Islamic Development Bank (IDB) in May 2005 marks a further step in the development of the Sukuk market with the IDB able to use some of the financial assets on its balance sheet to underpin Sukuk issues under a medium term note (MTN) like programme structure. The TCIP structure is similar to that outlined above with the underlying assets being a mixture of ijara (lease), murabaha (instalment sale) and istisna'a (conditional sale) contracts.
Eligible assets
The main stumbling block for accessing the Sukuk market is the availability of underlying assets that generate a Shari'a compliant income stream. An interest-derived income stream will not be eligible for inclusion in a Sukuk, but a rental-based income stream (whether from real estate or movable property) is ideal. The most popular asset class to date is real estate where rental income can be generated to provide cash flow returns to holders and repurchase obligations can be entered into to ensure principal repayments on the scheduled maturity dates. Other eligible assets have included aircraft, car fleets, pipelines and large air conditioning units.
Enforceability
Before being brought to market any Sukuk will need a declaration or opinion from Shari'a scholars that the relevant transaction complies with Shari'a law. There has been a degree of confusion as to the interplay between compliance with Shari'a law and with the enforceability of the relevant contracts. Recently, in Shamil Bank of Bahrain EC v Beximco Pharmaceuticals Ltd & Ors, the Court of Appeal held that an Islamic financing agreement which was expressed to be governed by both English and Shari'a law was governed by English law (www.practicallaw.com/5-102-6474). The court held that the question of whether or not a contract was Shari'a compliant does not have a bearing on its enforceability. This confusion can of course be minimised by clear drafting.
The future
It is expected that there will be continued strong growth in the Sukuk market. There is increasing standardisation of Sukuk documents in the marketplace which will drive costs down and improve the competitiveness of these instruments.
Andrew Roberts is a partner and Katsumasa Suzuki is an associate at Linklaters.
According to recent reports assets invested in an Islamic, Shari'a compliant, manner are now estimated to exceed US$250 billion with the pool of money held by Muslim investors estimated at US$1.5 trillion (and growing rapidly with high oil prices).
The growth of the Sukuk market, which only opened in 2002 with the Malaysian government US$600 million Sukuk issue, is a prime indicator of this trend. By 2004, US$6.7 billion of capital was raised through the issue of Sukuks and in the first six months of 2005 the total raised reached US$6.2 billion.
Under the Koran, interest (riba) earned on money (for example, a loan) is forbidden, but many other types of finance are allowed. The basic principle behind the Sukuk is that the holder has an undivided ownership interest in a particular asset and is therefore entitled to the return generated by that asset. The classic Sukuk structure involves an acquisition of a property asset by a special purpose company (SPC) established in a tax neutral jurisdiction. The company funds itself by the issue of Sukuk, declaring a trust in favour of the Sukuk holders. The Sukuk holders receive a return based on the rental income of the asset, taking the credit risk of the underlying lessee (see box "Classic structure").
There are a number of accounting and tax consequences which can arise when a UK property is transferred to a UK based SPC but these are beyond the scope of this article.
Increasing interest
The growth in the Sukuk market is due to the confluence of a number of factors ranging from the geopolitical impact of the 9/11 atrocities to a more general interest in developing Shari'a compliant products and structures. The fundamental drivers behind the Sukuk market are the same as those for the conventional securities market as it aims to:
-Broaden the pool of investors.
- Spread risk away from financial institutions.
- Dis-intermediate the link between investors and borrowers.
Although the market is relatively small, the excess liquidity currently being pumped into Gulf economies means that another pool of investment funds is becoming available to corporate treasurers. As the market is developing rapidly and the jurisprudence from the Islamic scholars is becoming more settled, the issue costs for a Sukuk structure continue to fall. The TCIP (Trust Certificate Issuance Programme) established by the Islamic Development Bank (IDB) in May 2005 marks a further step in the development of the Sukuk market with the IDB able to use some of the financial assets on its balance sheet to underpin Sukuk issues under a medium term note (MTN) like programme structure. The TCIP structure is similar to that outlined above with the underlying assets being a mixture of ijara (lease), murabaha (instalment sale) and istisna'a (conditional sale) contracts.
Eligible assets
The main stumbling block for accessing the Sukuk market is the availability of underlying assets that generate a Shari'a compliant income stream. An interest-derived income stream will not be eligible for inclusion in a Sukuk, but a rental-based income stream (whether from real estate or movable property) is ideal. The most popular asset class to date is real estate where rental income can be generated to provide cash flow returns to holders and repurchase obligations can be entered into to ensure principal repayments on the scheduled maturity dates. Other eligible assets have included aircraft, car fleets, pipelines and large air conditioning units.
Enforceability
Before being brought to market any Sukuk will need a declaration or opinion from Shari'a scholars that the relevant transaction complies with Shari'a law. There has been a degree of confusion as to the interplay between compliance with Shari'a law and with the enforceability of the relevant contracts. Recently, in Shamil Bank of Bahrain EC v Beximco Pharmaceuticals Ltd & Ors, the Court of Appeal held that an Islamic financing agreement which was expressed to be governed by both English and Shari'a law was governed by English law (www.practicallaw.com/5-102-6474). The court held that the question of whether or not a contract was Shari'a compliant does not have a bearing on its enforceability. This confusion can of course be minimised by clear drafting.
The future
It is expected that there will be continued strong growth in the Sukuk market. There is increasing standardisation of Sukuk documents in the marketplace which will drive costs down and improve the competitiveness of these instruments.
Andrew Roberts is a partner and Katsumasa Suzuki is an associate at Linklaters.
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