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CHAPTER 5

Sukuk Market

The estimate of magnitude and size of global Islamic finance vary according to the

different sources. Abdul Rahman Al Baker, executive director of financial institutions

supervision at the Central Bank of Bahrain (CBB) believes it to be now more than 1.5 trillion

US dollars. Bloomberg1 has reported that Moodys research indicates global Islamic finance

magnitude to be about 950 billion US dollars. Islamic Financial Services based on Malaysian

and Islamic Development Bank is projecting the market to grow to 1.6 trillion US dollars by

2012. Going even further is another report quoting Moodys that Islamic finance could

eventually reach 5 trillion US dollars.2 In this fast growing and high potential financial

segment, Sukuk market is one area of Islamic finance that attracted and continues to attract

lot of interest from global business community.

Recently decade the dynamics of the Islamic finance industry has changed

dramatically, especially in the area of financial market, bonds and securities. As evidences

have shown that the use of Sukuk or Islamic securities becoming increasingly popular in the

1 Bloomberg L.P. is a privately held company that deal with financial software, media, and data. Bloomberg makes up one third of the 16 billion US dollars global financial data market. 2 Ron Robins, The Rise of Islamic Finance, http://newparadigmdigest.com/4476/the-rise-of-islamic-finance/ [8 April 8, 2011]

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last few years. As in 2000 with total only three sukuk were issued at 336 million US dollars 3

to the total number Sukuk issuance in 2010 has reached to 46 billion US dollars.

Sukuk has developed as one of the most significant instrument for raising finance in

the international capital markets through Islamically acceptable structures. Multinational

corporations, sovereign bodies, state corporations and financial institutions use

international sukuk issuance as an alternative to syndicated financing.

5.1. Sukuk Definition

Sukuk is a plural form of Arab term Sakk, which means legal instrument, deed,

cheque. It is the Arabic name for financial certificates, which commonly refers to

the Islamic equivalent of bonds.4 According to AAOIFI, Sukuk is defined as:

Investment sukuk are certificates of equal value representing undivided

shares in ownership of tangible assets, usufructs and services or (in the ownership of)

the assets of particular projects or special investment activity, however, this is true after

receipt of the value of the sukuk, the closing of subscription and the employment of funds

received for the purpose for which the sukuk were issued.5

Although, it appears that Sukuk are often named as Islamic bonds or referred as the

financial instrument that equivalent to conventional bond, but in fact these two

3 Professor Rodney Wilson, Innovation in the structuring of Islamic Sukuk securities, Lebanese American University, 2nd, Banking and Finance International Conference, Islamic Banking and Finance, Beirut, 23rd 24th February 2006 http://www.assaif.org/content/download/586/4393/file/Innovation%20in%20the%20Structuring%20of%20Islamic%20Sukuk%20securities.%E2%80%A6.pdf [accessed 17 May 2011 ] 4 http://en.wikipedia.org/wiki/Sukuk [April 10 2011] 5 Accounting and Auditing Organization for Islamic Financial Institutions AAOIFI, Sharis standard No. 17, 2008, p.307.

http://en.wikipedia.org/wiki/Arabic_languagehttp://en.wikipedia.org/wiki/Academic_certificatehttp://en.wikipedia.org/wiki/Islamic_economic_jurisprudencehttp://en.wikipedia.org/wiki/Bond_(finance)

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instruments are totally different. The main difference can be pointed out on the nature of

these two instruments. On the one hand, as definition of AAOIFI above, Sukuk is paper that

provided an investor with ownership in an underlying asset. It is asset-backed certificates

that show proportion of share of Sukuk holder on underlying asset or its usufruct.

Consequently, Sukuk holders are entitled to share in the earning generated by the Sukuk

assets. Therefore its earning return is not compensation of loan in form of interest but

share of profit on the underlying asset performance. Unlike bonds which is a type of

interest-bearing security issued by an organization that needs funds. The issuer

compensates the bondholders by paying interest for the life of the bond.6 Conventional

bonds are structured as debt instruments with fixed return. Essentially a bond consists of

loan plus interest named as coupon. Thus the bond is mere certificate of loan and debt

which has nothing to do with share ownership of anything as in case of sukuk. Unlike bonds,

the relationship between the issuer and the investor of a Sukuk can be either debt

obligations or equity characteristics depending upon the nature of Underlying Islamic

contract that the Sukuk is built. While the relationship between the issuer and investor in

any types of a bond such as asset-backed securities (ABS)7, mortgage-backed securities

(MBS)8, collateralized debt obligation (CDO)9 and Collateralized loan obligations (CLO)10

6 Burton S. Kaliski, ed, Encyclopedia of Business and Finance Volume 1 (New York :Macmillan Reference USA, 2001) P.66. 7 ABS is a financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities. For investors, asset-backed securities are an alternative to investing in corporate debt. 8 MBS is a type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by a accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution. When investor invests in a

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transactions is a loan of money.11 Since Sukuk is asset-backed security it is a necessary

condition that Sukuk issuer must have tangible asset or its usufruct to back their Sukuk. This

condition is not in case of bonds issue. Other distinction is that, bonds can be issued to

finance any purpose which is not violence legal, but in case of Sukuk the purpose must be

permitted by Shariah as well.

Despite of, at the early phase, Sukuk was introduced to be Islamic alternative to

conventional bonds, however, it has gradually developed its own characteristics that made

Sukuk difference from bonds in many of ways. Some obvious distinction can be summarized

as show in figure below:

mortgage-backed security you are essentially lending money to a home buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment markets. This type of security is also commonly used to redirect the interest and principal payments from the pool of mortgages to shareholders. These payments can be further broken down into different classes of securities, depending on the riskiness of different mortgages as they are classified under the MBS. 9 CDO is a debt instrument (a bond) that is backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds. CDOs are unique in that they represent different types of debt and credit risk. In the case of CDOs, these different types of debt are often referred to as 'tranches' or 'slices'. Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays 10 CLO is a special purpose vehicle (SPV) with securitization payments in the form of different tranches. Financial institutions back this security with receivables from loans. CLOs allow banks to reduce regulatory capital requirements by selling large portions of their commercial loan portfolios to international markets, reducing the risks associated with lending. 11 Shabnam Mokhtar, Saad Rahman, Hissam Kamal and Abdulkader Thomas, Sukuk and the Capital Markets in Sukuk, ed by Abdulkader Thomas (Selangor, Malaysia: Sweet & Maxwell Asia, 2009) pp.17-40(p.21.)

177

Figure 5.1: Comparisons between Sukuk and Conventional Bonds

Sukuk

Conventional Bonds

Nature It is a certificate of

ownership share in specified

assets, projects, services

It is a certificate of pure

debt obligation

Underlying

assets

The issuance of

certificates are backed by

tangible assets, usufruct or

services

In some cases, the

issuance of certificates are

backed by secured loans

Claims Ownership claims on the

specified assets and any income

raise from the investment on the

asset

Creditors claims on the

borrowing entity comprising

principal and interest

Security Secured by ownership

rights in the underlying assets or

projects

Generally unsecured

except for mortgage bonds

which are backed by secured

loans, and equity trust

certificates

Trading of

security

Sale of ownership rights in

a specified asset, projects or

services

Sale of debt instruments

Principal and

return

Not guaranteed by issuer Guaranteed by issuer

Prices Besides, issuer

creditworthiness, Sukuk price

depend on the appreciation and

depreciation

Price is solely depend on

Issuer creditworthiness

Purpose Issued to finance any

purpose which is not only legal in

jurisdiction but permissible

according to Shariah law

Issued to finance any

purpose which is not violative of

the legal law

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5.2. Special Purpose Vehicle (SPV)

A special purpose vehicle, sometime named as a special purpose entity (SPE) is a

legal entity that act as intermediate between the originator of the receivables and the end-

investors. As the nature of securitization involve a transfer of receivables from originator,

SPV facilitate the transfer by hold the receivable on behalf of the end-investor, this reduce

the problem that happen on direct transferring. It acts as a crucial link in the securitization

chain, intermediating between the primary market for the underlying asset and the

secondary market for the asset- backed security.12 SPV are established as isolate legal

entities for the specified purpose of managing the securities issues. Such as an SPV is capital

and tax efficient that it does not add to the costs of the transaction. Important

characteristics of a common type SPV include bankruptcy remoteness and thin

capitalization. The legal structure of an SPV depends upon the regulatory and legal

environment in which it has to work. It has to be ensured that the sale to the SPV is true

and there is a proper segregation of the asset from the original owner.13

SPVs are desired to be independent issuer that completely separates from the

obligor in terms of its ownership and management, liability and tax status. Thus, it will not

affected by the bankruptcy of the obligor. this independence ensures that the SPV /issuer is

not involved in any bankruptcy proceeding against the obligor and to ensure the sukuk

assets are not within the grasp of any bankruptcy practitioner of the obligor. To isolate the

sukuk assets and obligations from the obligor, SPV was set up to issue the sukuk and enter

12 Dr.S Gurusamy, Financial Services, 2nd edition (New Delhi: Tata McGraw-Hill, 2009) pp. 208-209.

13 Muhammad Ayub, Understanding Islamic Finance (West Sussex, England: John Wiley & Sons Ltd, 2007) pp.394-395.

179

into the transaction documents and will not be permitted to enter into any other business

or incur any liabilities outside the transaction.14

5.3. General types and structure of Sukuk

Although Sukuk is permitted to be created on loan contract, but it must be interest

free loan contract. Since benefit to the lender in a loan contract is considered as a form of

Riba which is prohibited by the Shariah, rarely Sukuk use loan contracts because there is no

value-added return to the investors. Therefore, Sukuk use a variety of other contracts to

create the asset or financial obligations to be represented by the sukuk. Generally, the asset

or financial obligations between the issuer and the investor or sukuk holder are created by

contract of sale, lease, equity partnership, and joint venture partnership. The return on

investment came from the profit elements as in the sale or lease, as well as the profit

sharing mechanism in the partnership contracts. According to Shariah Standard issued by

AAOIFI types of Sukuk can be divided into 14 different categories, some of these Sukuk are

defined as tradable and others are defined as non-tradable based on the type and

characteristics of the issued Sukuk. The general types of Sukuk are as follows:

1. Murabahah Sukuk

2. Salam Sukuk

3. Istisna Sukuk

4. Ijarah Sukuk

5. Musharakah Sukuk

6. Mudarabah Sukuk

14 Rahail Ali, Legal Certainty for Sukuk in Sukuk ed by Abdulkader Thomas (Selangor, Malaysia: Sweet & Maxwell Asia, 2009) pp.93-106 (pp.101-102)

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7. Hybrid Sukuk

5.3.1. Murabahah sukuk

Murabahah sukuk are certificate of equal value issued for the purpose of financing

the purchase of goods through Murabahah so that the certificate holders become the

owners of the Murabahah commodity15 Sukuk on the basis of Murabahah contract are

usually issued for short-term and medium-term financing. Since, the Murabahah Sukuk

represents a monetary obligation from a third party that arises out of a Murabahah

transaction, which means that it is a dayn or debt. Therefore it cannot be traded except at

face value because any deference in value would be equal to Riba. Consequently,

Murabahah-based sukuk often can be sold only in the primary market, which limits its scope

because of the lack of liquidity. To allow the trading of the Murabahah sukuk in the

secondary market, Islamic finance experts have suggested that, if the security

represents a mixed portfolio consisting of a number of transactions, then this portfolio

may be issued as negotiable certificates.16

Although Murabahah has been the main driver of Islamic finance but utilization of

this financial contract is no universal in practice. As all financial instruments that build up

on the Murabahah concept are considered as debt which is generally viewed as non-

tradable. The applications of Murabahah have been very different between Malaysia and

the GCC and the rest. In GCC and the rest, any paper representing a monetary right or

15 Accounting and Auditing Organization for Islamic Financial Institutions AAOIFI, N.5, p.308 16 M. Kabir Hassan and Mervyn K. Lewis, Handbook of Islamic banking (UK: Edward Elgar Publishing Limited, 2007) P.56

181

obligation arising out of a credit sale cannot create a negotiable instrument. Thus, Sukuk

that is created by Murabahah receivables cannot be traded in the secondary market. The

purchaser on credit in a Murabahah transaction signs a paper to evidence his indebtedness

towards the seller. Therefore, the paper represents a debt receivable by the seller. By the

rule of Hawalah17 exchange of this paper to a third party must be at par value or face value.

However, if a commodity has been purchased but not yet sold, trading in certificates issued

against it is allowed, as the certificates represent the asset that can be traded.18 In case of

Malaysia Murabahah Sukuk is tradable instrument as Malaysia authority has allowed the

practice of bai al-dayn.

Practice of bai al-dayn in Malaysia

Although, majority of Islamic jurisprudents do not accept the practice of bai al-dayn

concept and consider it as trade of debt which is prohibited in Islam, even though the debt

represented by Sukuk is supported by underlying assets. The traditional Muslim jurists are

unanimous on the point that bai al-dayn with discount or premium is not permitted by

Shariah.19 However, bai al-dayn was accepted and is being used in Malaysian financial

market. According to Malaysian Islamic jurists, Bai al-dayn refers to a transaction that

involves trade of securities or debt certificates that conforms to Shariah law. Securities or

debt certificates will be issued by a debtor to a creditor as an evidence of indebtedness. A

17 Hawalah: Literally means Change, transfer or removal. In Islamic finance it is a technical term refered to transfer of debt (liability)by way of security and corroboration, from the original debtor (transferor) to another person to whom it is transferred (transferee) 18 Muhammad Ayub, N. 13, p.405. 19 Ibid, p.172.

182

resolution of the Shariah Advisory Council of Securities Commission Malaysia (SC) was

issued on 21 August 1996, allows the usage of bai al-bayn in the Malaysian capital market.

The reason for permission for using bai al-bayn was given as Some of the Islamic jurists

allowed this concept subject to certain conditions in the context of capital market. These

conditions can be met when there is a transparent regulatory system which can safeguard

the Maslaha (public interest) of the market participants.20

Approving the application of bai al-dayn generates an Islamic promissory note as an

affirmation of the debt and a tradable instrument. As it said the note is negotiable and

when traded is understood to carry the underlying contract. When these notes are traded,

they may be sold at a discount or premium. They do not bear a coupon although there are

profits paid in instalments. This process is in contrast to the GCC and elsewhere opinion that

a negotiable instrument must attach to the ownership of real assets based upon an

underlying Shariah-permissible contract.21

The structure of Murabahah Sukuk can be as following:

Murabahah sukuk for asset acquisition

Two-Party Murabahah Sukuk

Murabahah Sukuk under Tawarruq Structure

20 Abdulkader Thomas and Bryon kraly with Sudin Haron, Mustafa Hussain and Stella Cox, The Murabaha and Simple Sale transactions in structuring Islamic Finance Transactions, ed by Abdulkader Thomas, Stella Cox and Bryan Kraty (London: Euromoney Books, 2005) pp.60-76 (p.69.) 21 Shabnam Mokhtar and Abdulkader Thomas Debt-Based Sukuk: Murabahah, Istisna and Istithmar (Tawarruq) Sukuk in Sukuk ed by Abdulkader Thomas, (Selangor, Malaysia: Sweet&Maxwell Asia, 2009) pp.125-143 (pp.126-127)

183

Murabahah sukuk for asset acquisition

This structure might be applied when a company requires good needed for

manufacturing. As the purchase the supply involves a large amount of cash, the company

might acquire the supply by raising funds by issuing Murabahah Sukuk instead of bank

financing.

When the Special Propose Vehicle (SPV) has sold the asset to the company, the

sukuk represents a receivable of the selling price. Since the Sukuk represents receivable, a

majority of Shariah jurists view that it is a claim on money and should not be traded in the

secondary market except at par value. However, the Malaysian jurists allow trading this

Sukuk freely in secondary market as Malaysia subscribes to the concept of bai al-dayn.

1. SPV issues sukuk to raise funds

2. SPV purchases the asset from supplies

3. SPV sells the assets to company by Murabahah contract

Figure 5.2: Murabahah sukuk for asset acquisition

Sukuk-holder

SPV

Supplier

Company

1

2

3

5

4

6

184

4. Company takes delivery of the asset

5. Company makes periodic payments

6. SPV distributes payments to Sukuk-holder22

Two-Party Murabahah Sukuk structure

In this structure, the SPV does not buy an asset from, the third party, supplier or

dealer, but the company itself at the time of issuance. Then the SPV sells the same assets

back to the company by Murabahah contract. This structure is known as bai al-inah which is

not accepted by AAOIFI. Thus, this structure is widely practice only in Malaysian capital

markets.

1. Company sells its own assets to the SPV for cash

2. SPV issues Sukuk to investors to raise funds for purchasing the asset from the

company

3. SPV sells the asset back to company by Murabahah contract

22 Ibid, pp.130-131

Figure 5.3: Two-Party Murabahah Sukuk

Investors

SPV Company 1

2

3

4

185

4. Company makes periodic payments of the sale price and SPV distributes

payments to Sukuk-holder23

Murabahah Sukuk under Tawarruq Structure

Outside Malaysia where the concept of bai al-inah is not accepted, Tawarruq is

applied as main building block of a Murabahah Sukuk, especially in GCC countries. The term

Tawarruq is used to describe a mode of financing, some time is considered as a reverse

form of commodity Murabahah, where the financier sells commodities to the client on

deferred payment at cost-plus profit. The client then sells the commodities to a third

party on spot basis and receives instant cash. 24 As Tawarruq is not buying and selling

between two parties, but the arranger acts as a wakeel or agent to trade commodities on

behalf of the issuer. The steps are: The issuer appoints the arranger as its wakeel to trade

commodities. Then, the issuer makes agreement to buy a commodity from its wakeel. After

that, the wakeel, buys the commodity on behalf of the issuer from a broker on a spot basis.

The issuer is now obliged to pay of it, by Murabahah transaction on a deferred basis.

Financially, to general cash flow, the wakeel, then sells the commodity to another broker.

This general cash proceeds which are paid to the issuer for the sale of the issuers

commodity. GCC have applied tawarruq concept to create Sukuk and the Sukuk is called

Murabahah Sukuk. 25 General structure of Murabahah Sukuk on Tawarruq are as follow:

23 Ibid, pp.131-132.

24 Sarah S. Al-Rifaee, Islamic Banking: Myths and Facts Arab insight, Vol. 2 No. 2 Summer 2008 pp.19-30 ( p.24) 25 Shabnam Mokhtar and Abdulkader Thomas N.21, pp.133-134.

186

1. SPV issues sukuk to obtain funds

2. SPV buys a commodity on spot basis from broker A

3. SPV sells the commodity to company by differed payment Murabahah

4. Company sells the commodity to broker B on spot basis and obtains cash, or

appoint SPV as its agent to do it.

5. Company makes periodic payments to SPV

6. SPV distributes payment to investors

5.3.2. Salam Sukuk

According to AAOIFI standard, Salam Sukuk is certificates of equal value issued for

the purpose of mobilizing Salam capital so that the goods to be delivered on the basis of

4

Figure 5.4: Murabahah Sukuk Structure as Tawarruq

Investor

SPV

Company Broker B

Broker A

1

4

2

5 3

6

187

Salam come to be owned by the certificate holders.26 Thus Salam Sukuk is certificate that

represents fractional ownership of the capital of a Salam transaction which is constructed

by an advance payment to contract party as the supplier of a commodity to be delivered at

a future date. This type of sukuk is non-tradable. The gross return to the holders consists of

the margin between the purchase price of the asset and its selling price.27 The most

prominent Salam application in financial market is the Central bank of Bahrains quarterly

Salam sukuk. The main objective of the Central Bank of Bahrain to launch the Central Bank

of Bahrain Sukuk (CBB Sukuk) was to create a short-medium term liquidity management

product for Islamic financial institutions. Salam-based Sukuk can be created and sold by an

SPV under which the funds mobilized from investors are paid as an advance to the company

SPV in return for a promise to deliver a commodity at a future date. CBB launched its Salam

sukuk short-term (90day) securities programme on June 2001, which has become a hugely

popular liquidity management tool for regional Islamic financial institution. A typical Salam

Sukuk structure is shown below, with a SPV created as a legal entity for the duration of the

sukuk with the sole purpose of administrating the payments made to the investors and

holding the title to the assets on which the sukuk is based. The first stage in the operation of

a sukuk is when the obligator transfers a title to the assets to the SPV by Salam transaction.

Then SPV issues Sukuk certificates to raise fund form Investors, who may be Islamic banks,

Takaful Islamic insurance companies or investment companies that want to hold their liquid

26 Accounting and Auditing Organization for Islamic Financial Institutions AAOIFI, Sharis standard No. 17, 2008, p.308. 27 Amr Mohamed El Tiby Ahmed, Islamic Banking: How to Manage Risk and Improve Profitability (New Jersey: John Wiley & Sons Inc., 2011) ,p.137

188

assets in a Shariah compliant form. The sukuk certificates represent an undivided right to

benefit in the assets, which means that the assets cannot be sold to another party for the

duration of the sukuk. In return for the certificates of participation, the investors make an

Advance payment with

SPV, a future return or redemption of the investment certificates plus a fixed mark-up is

agreed in advance. It is because the initial payment is in advance.28

1. Obligator sale an asset to SPV by Salam contract to transfer the asset to SPV

2. SPV issue Salam sukuk to raise fund

3. SPV sale the assets back to the obligator or appoint obligator as agent to sale

the assets to third party, in case of CBB sukuk for example29

28 Rodney Wilson, N.3, p.7. http://www.assaif.org/content/download/586/4393/file/Innovation%20in%20the%20Structuring%20of%20Islamic%20Sukuk%20securities.%E2%80%A6.pdf [accessed 17 May 2011 ] 29 Sayd Farook, Salam-Based Capital Market Instruments in Sukuk ed by Abdulkader Thomas, (Selangor, Malaysia: Sweet&Maxwell Asia, 2009) pp.1161-185 (p.168)

Figure 5.5: Basic Salam Sukuk Structure

SPV

Obligator

Investor/ Sukuk holder

2 4

1

3

Third party

189

4. Investor reimbursement cash plus a mark-up on maturity date

As the Figure shows the initial cash provided by the investors and collected by the

SPV is used to make a payment to the obligator in return for an undertaking to deliver the

asset at maturity. At that stage, typically after three months, the SPV takes delivery of the

asset, but sells it back to the obligator. The proceeds from this sale are then used to

reimburse the cash provided by the investors, and provide them with the pre-agreed mark-

up return in relation to their investment. Before obtaining the return of their cash and the

mark-up the investors have to surrender their certificates to the SPV, implying they have no

further right to an benefit in the assets.30

5.3.3. Istisna Sukuk

Istisna Sukuks are certificates of equal value issued with the aim of mobilising funds

to be employed for the production of goods so that the goods produced come to be owned

by the certificate holders.31 A Istisna Sukuk represents a fractional share in the project

financing of an undertaking to manufacture or construct an asset for a customer at a price

to be paid in future instalment, the total of which equals the total face value of the Sukuk in

addition to mark up. The sukuk can be in the form of serial notes or certificates with

different maturity dates that match the progress schedule of instalments as agreed

between the customer of the asset and the Islamic financial institution.32 Generally Istisna

30 Rodney Wilson, N.3, p.8. 31 Accounting and Auditing Organization for Islamic Financial Institutions AAOIFI, N.5, p.308. 32 Amr Mohamed El Tiby Ahmed, Islamic Banking: How to Manage Risk and Improve Profitability (New Jersey: John Wiley & Sons Inc., 2011) , pp.137-138.

190

Sukuk is used to finance large scale construction or large scale manufacturing projects. The

basic structure of Istisna Sukuk can be depicted as following:

1. SPV issues Sukuk to raise funds from investors

2. SPV uses the Sukuk proceeds to pay the contractor under the Istisna contract

to build and deliver the project.

3. SPV sells the asset to the end user under another Istisna contract.

4. End user makes periodic payment.

5. SPV distributes payments to investors.

6. Upon completion, the asset is delivered to end user.33

Istisna structure as bai al-inah sukuk

In structure of Istisna sukuk, the SPV becomes the seller and contractor-

manufacturer of an asset to an end user and uses back-to-back Istisna for creation of the

33 Shabnam Mokhtar and Abdulkader Thomas, N.21, p.137.

Figure 5.6: Basic Structure of Istisna Sukuk

Investors/ Sukuk holder

Contractor

SPV/ Issuer

End user/ Company

2

1

6

3

4

5 1

191

assets. In short, the SPV takes up itself the legal responsibility of getting the assets

constructed, and subcontracts the work to manufacturers or contractors. Under AAOIFI

standard, Istisna sukuks trade ability is limited. As Istisna Sukuk represents receivables

certificate of an asset due for delivery. Thus Istisna sukuk may only be traded at face value

and any discounting to the sukuk would be considered as trading of debt or bai al-dayn.34

Since Malaysia allows bai al-dayn the structure of Istisna sukuk would involve selling and

buying back between the Company or obligor and SPV as following figure:

1. The company enters into the first Istisna by ordering SPV or issuer to

construct an asset. The payment of the selling price is deferred.

2. SPV again enters into the second Istisna contract to ordering the company to

construct the assets. Thus SPV became buyer of the same assets from the

company. Therefore the second Istisna contract will have shorter maturity

than the first contract that able SPV to fulfil the first Istisna contract. The

purchase price is the cost to the SPV and Payment will be made in stages.

34 Hans Visser, Islamic Finance: Principles and Practice (Cheltenham, UK: Edward Elgar Publishing Limited, 2009) p.65.

Figure 5.7: Basic Structure Istisna/bai al-inah sukuk

Company SPV

Investors/ Sukuk holder

5 3

4

2

1

192

3. SPV issues Sukuk to raise funds from investors to meet progress payments.

4. Company makes periodic payment of the sale price.

5. SPV distributes payments to Sukuk holder.35

5.3.4. Ijarah sukuk

Ijarah Sukuks are certificates of equal value issued either by the owner of a leased

asset or a tangible asset to be leased by promise, or they are issued by a financial

intermediary acting on behalf of the owner with the aim of selling the asset and recovering

its value through subscription so that the holders of the certificates become owners of the

assets.36 The Ijarah sukuk is tradable financial instrument, as the subject matter is not pure-

financial asset. It represents the holders proportionate share of any profit or loss; if the

leased asset is destroyed, will bear the cost of meeting the obligation to provide an

alternative asset.37 Sukuk structured on the Ijarah is a most common form of Shariah

compliant Sukuk. It was the first Sukuk structure marketed at international level.38 Since, it

was first introduced to the global market by Malaysia in 2001: Guthrie Global Sukuk39,

35Shabnam Mokhtar and Abdulkader Thomas, N.21, p.138. 36 Accounting and Auditing Organization for Islamic Financial Institutions AAOIFI, Sharis standard No. 17, 2008, p.307. 37 Amr Mohamed El Tiby Ahmed, Amr Mohamed El Tiby Ahmed, Islamic Banking: How to Manage Risk and Improve Profitability (New Jersey: John Wiley & Sons Inc., 2011) p.138. 38 Muhammad Al-Bashir Muhammad Al-Amine, Sukuk Market: Innovations and Challenges in Islamic Capital Markets ed. by Salman Syed Ali (Jeddeh: Islamic Development Bank,Islamic Research &Training Institute, 2008) pp.33-54 ( p.36) 39 Shabnam Mokhtar, ed, Benefits of Islamic Bonds to the Issuer MIF Monthly, October 2007, p.1

193

Sukuk made up by Ijarah contract has represented 25 percent to 70 percent of issued Sukuk

every year.40

Basically, Ijarah Sukuk is a financial asset that the underlying transaction between

the issuer and the Sukuk holder involves a lease of tangible or intangible property. The

some possible structure of Ijarah Sukuk can be:

Ijarah Sukuk for asset acquisition

Ijarah Sukuk with a sale and leaseback of the underlying structure

Ijarah Sukuk asset-backed

Ijarah Sukuk structure for asset acquisition

This type of Sukuk transaction involves three parties; issuer-company, investor, and

supplier, where a company would like to acquire an asset from supplier by the means that

the company create SPV and SPV offers Sukuk certificate to the investor. Then, the Sukuk

holders become joint owner of the SPV. SPV, on behalf of the Sukuk holders, would buy the

acquired asset from the supplier, and then lease the same asset to the company. In the

structure, the ownership of the leased asset will be transferred to the company at the end

of the lease, as a gift or sale. To ensure transfer of asset ownership and the sukuk are redeemed,

the company/ obligor would usually give a purchase undertaking that it would accept the asset upon

maturity.

40 Shabnam Mokhtar, Abdulkader Thomas, Ijarah Sukuk in Sukuk ed. by Abdulkader Thomas, (Selangor, Malaysia: Sweet&Maxwell Asia, 2009) pp.145-159 (p.145)

194

1. SPV issues sukuk to raise funds from investors.

2. SPV (directly or via company as agent) purchases the asset from supplier.

3. SPV leases the asset to company

4. Company Takes delivery of the asset.

5. Purchase undertaking is given to ensure redemption of sukuk.

6. Company makes periodic payments.

7. SPV distributes payment to investors.

8. Upon maturity, purchase undertaking is exercised and asset is transferred to

company.41

41 Ibid, p.147

Figure 5.8: Structure of Ijarah Sukuk for asset acquisition

Company/

Obligor

Investors /Sukuk-holder

SPV/ Issuer

Supplier

6

3

5

1

0

2

1

0

1

1

0

7

1

0

4

1

0

8

195

Ijarah Sukuk with Sale and leaseback structure

In this structure, the issuer company uses it own existing assets to issue Sukuk by

means of sale its existing asset and leaseback the same asset. The attention of using this

structure is not requiring a new asset by to obtain liquidity.

1. The company sells its assets to the SPV.

2. SPV Issues sukuk to raise funds from investors to buy the asset.

3. SPV leases the same asset back to the company

4. The company makes a purchase undertaking to buy the asset back and

ensure redemption of sukuk.

5. The company makes periodic rental payments and SPV distributes payments

to investors.

6. Upon maturity, the purchase undertaking is exercised and the company buys

the asset back.42

42 Ibid, p.153

Figure 5.9: Ijarah Sukuk with sale and leaseback structure

Investors

SPV/Issuer Company/ Obligator

1

3

4

2 5

196

Ijarah Sukuk Structure as Asset Backed

In this mode of Ijarah sukuk, originator of asset is not leaseback the assets form SPV

but truly sale the asset to SPV. The main objective of this mode is not that originator intends

to acquire an asset or obtain liquidity but the real intention of Originator is to

securitization of asset. Therefore, from the angle of originator, this type of Ijarah sukuk is

income generating mode. The structure of Ijarah sukuk for securitization, for which the

underlying asset was leased out, thus generating income can be depicted as follows:

1. Originator has leased the asset. Thus, it is income generating.

2. Originator sells the asset to an SPV. This must satisfy the rule of true

sale and bankruptcy remoteness.

3. SPV issues sukuk to obtain funding the Acquire the assets.43

43 Ibid, p.156.

Figure: Ijarah sukuk structure as asset-backed

Originator

Obligor

Investor

SPV/Issuer

2

3 1

Figure: Ijarah sukuk structure as asset-backed

Originator

Obligor

Investor

SPV/Issuer

2

3 1

Figure 5.10: Ijarah sukuk structure as asset-backed

Originator

Obligor

Investor

SPV/Issuer

2

3 1

197

5.3.5. Musharakah Sukuk

Musharakah Sukuk are certificates of equal value issued with the aim of using the

mobilised funds for establishing a new project, developing an existing project or financing a

business activity on the basis of any of partnership contracts so that the certificate holders

become the owners of the project or the assets of the activity as per their respective shares,

with the Musharakah certificates being managed on the basis of participation, by

appointing one of the partners or another person to manage the operation, or an

investment agency,44 The objective of Musharakah structure is to replicate asset ownership

by setting up a joint-venture jointly-owned-owned by the SPV/Sukuk issuer and the

originator. The issuer and originators shareholdings in the Musharakah represent their

respective capital contributions based on a parity agreed at the outset. Generally, the issuer

contribution is capital fund and the originator contributes some specific assets and his

management skill. According to Musharakah structure, the Musharakah underlying is run

under a management of the originator. And Sukuk holders are entitled to the SPV/issuers

rights in the Musharakah joint-venture that they have rights to receiving payments from the

SPV/ issuers equity ownership in the Musharakah joint-venture.+ The Sukuk holders are

responsible for indebtedness on borrowed monies.45 Musharakah sukuk are based on an

underlying Musharakah contract that is quite similar to Mudarabah sukuk. However, the

distinction is that the intermediary will be a partner of the group of subscribers or the

Musharakah sukuk holders in much the same way as the owners of a joint stock

44 Accounting and Auditing Organization for Islamic Financial Institutions AAOIFI, Sharis standard No. 17, 2008 , p.308. 45Khalid Howladar, Shariah and Sukuk: A Moodys Primer, Moodys Investors Service 31 May 2006, p.8. http://www.assaif.org/content/download/584/4385/file/MDYs%20SukukShariah.pdf (18 May 2011)

198

company. Almost all of the criteria applied to a Mudarabah sukuk are also applicable to the

Musharakah sukuk, but in the Mudarabah sukuk the capital is from just one party. The

issuer of the certificate is the inviter to a partner-ship in a specific project or activity, the

subscribers are the partners in the Musharakah contract, and the realized funds are the

contributions of the subscribers in the Musharakah capital. The Sukuk holders own the

assets of partnership and share the profits and losses.46 The structure of Musharakah can be

depicted as below:

1. SPV issue Sukuk certificate to raise the fund for Musharakah project

distribution.

46Abbas Mirakhor and Iqbal Zaidi, Profit-and-loss sharing contracts in Islamic finance in Handbook of Islamic banking, ed by M. Kabir Hassan and Mervyn K. Lewis (Cheltenham, UK: Edward Elgar Publishing Limited, 2007) pp.49-63 (p.56.)

Figure 5.11: Musharakah Sukuk Structure

Originator

Sukuk holder/

Investor

Musharakah project

SPV/

Issuer

2b

3b

1 3c 3a

2a

a

2c

199

2. Each party provides participation capital to Musharakah project 2a) capital

contribution, 2b) capital/ asset/ land contribution, 2c) management skill and

agreement

3. Within sukuk project operation duration, profit is distributed to each party.

3a,3b,3c are profit distribution flow to each party

According to this structure, The nominal amount initially raised may be

redeemed either through a number of pre-scheduled instalments over time or at

maturity. in each case this is achieved by application of the purchase undertaking

agreement, which stipulates that the originator is required to buy out a portion or the

totality (at maturity) of the Issuers shares in the Musharakah at a price equal to the

value of the Sukuk to be redeemed. The income streams of Sukuk holders will be based on

as share of income/profit generated and it can be paid over the duration of the transaction

as a profit distribution or at maturity only, via the redemption amount47

5.3.6. Mudarabah Sukuk

Mudarabah Sukuk is certificate that projects or activities managed on the basis of

Mudarabah, by appointing one of the partners or another person as the mudarib for the

management of the operation.48 Since Mudarabah contract is an investment contract

between two parties that one party act as manager and the other is provider of capital.

Profit is distributed among the contract parties according to a per-agreed ratio. Sukuk in

Mudarabah structure, therefore, the issuer of Sukuk certificate is the mudarib, the

47 Khalid Howladar, N.45, p.9. 48 Accounting and Auditing Organization for Islamic Financial Institutions AAOIFI, Sharis standard No. 17, 2008 p.308-309.

200

subscribers or Sukuk holder are the capital providers with the sukuk proceeds are the

Mudarabah capital. The Sukuk holders own the assets of Mudarabah which will receive

profit according to a pre-agreed ratio or responsible for loss, if any, are borne by capital

providers only. Capital providers or Sukuk holders can receive their capital at the time when

Sukuks are surrendered. And profits can be as an annual proportion of the profits as agreed.

In the light of Shariah, Mudarabah sukuk can neither yield interest nor entitle owners to

make claims for any annual interest. Therefore Mudarabah sukuk is very similar to shares

with regard to varying returns, which are accrued according to the profits or loss made by

the Mudarabah project. This structure is of interest to originators who do not have assets

that they can easily make available for an Ijarah Sukuk or Musharakah Sukuk, but which

needs finance for additional business activities. The simple structure of Mudarabah Sukuk

can be depicting as below:

1. Mudarib enters into an agreement with project owner for

construction/commissioning of project.

Sukuk Holder

4

Project

SPV/

issuer/Mudarib

Project owner

1

3 2

Figure 5.12: Structure of Mudarabah Sukuk

Sukuk Holder

4

Project

SPV/ issuer/Mudarib

Project owner

3

201

2. SPV issues Sukuk to raise funds.

3. Mudarib collects regular profit payments and final capital proceeds from

project activity for onward distribution to investors.

4. Upon completion, Mudarib hands over the finished project to the owner.

5.3.7. Hybrid Sukuk

Hybrid Sukuk is other structure of Sukuk financial instrument. It is Sukuk that

combine two or more forms of Islamic financial contract in their structure. Therefore a

Hybrid Sukuk may be built of combination of Istisna with Ijarah or Murabahah with Ijarah or

another form of Islamic financial contract. In this way there is unlimited scope for

innovation in hybrid Sukuk.49 Hybrid or mixed asset Sukuk emerged in the market in

response to demand to diversify Sukuk according to investors need. In a hybrid Sukuk, the

underlying pool of assets can comprise of Istisna, Murabahah receivables as well as Ijarah.

Thus a portfolio of assets comprising of different classes allows for a greater mobilization of

funds. However, since Murabahah and Istisna contracts cannot be traded on secondary

markets therefore the proportion of untradeable contracts in a pool of assets cannot

exceed 49 percent of total asset. 50 The modus operandi of issuing mixed portfolio Sukuk is

an effective tool for converting non-marketable and illiquid assets to negotiable

49International Islamic Financial Market (IIFM), Sukuk report: A comprehensive study of the International Sukuk Market, edition 1st, 2010, p.26.

50 Haluk Gurulkan, ISLAMIC SECURITIZATION: A LEGAL APPROACH, (Istanbul: ektir&Baar Law Firm October 2010) p.68

202

instruments and able to trade in a secondary market, particularly suitable for investment

banks and development finance institutes51

Steps involved in the Hybrid Sukuk structure:

1. Islamic finance originator transfers tangible assets as well as Murabahah deals to

the SPV.

2. SPV issues certificates of participation to the Sukuk holders and receive funds.

The funds are used by the Islamic finance originator.

3. Islamic finance originator purchases these assets from the SPV over an agreed

period of time.

4. Investors/Sukuk holder receives fixed payment of return on the assets.

51 Ibid, p.69

Figure 5.13: Structure of Hybrid

Sukuk

Islamic

financial Originator

SPV

Investors

5 3

4 2

1

203

1. Transfer of tangible assets, tangible assets, Murabahah deals

2. Sukuk proceeds

3. Purchase of Assets (Ijarah contracts, Murabahah contracts, Istisna contracts)

4. Fixed payment of the return on the assets

5. Direct recourse

A prominent example of such mixed portfolio Sukuk are Islamic Development

Banks (IDB) Solidarity Trust Sukuk for 400 million US dollars issued in 2003. Its underline

assets comprise of Ijarah Sukuk 65.8 per cent, Murabahah receivables 30.73 per cent and

Istisna Sukuk 3.4 per cent.

5.4. Evolution of Sukuk Market

Although, the concept of sukuk has been introduced since 1988 by the Fiqh

Academy of the OIC, 52 but the first ever Sukuk was issued in 1990 by Malaysia. It was a

Ringgit denominated issue with a modest size of 125 million Malaysian ringgit, equivalent to

approximately 30 million US dollars, with Malaysian Ringgit denominated character this

sukuk is only for domestic market. 53 However, Sukuk did not get world attention until

2001, when Sukuk market went international with the issuance of first international

sovereign Sukuk by the Government of Bahrain. It was a 100 million US dollars Ijarah Sukuk

with a fixed rate of 5.25 per cent and 5 years maturity. Consequently quickly followed by

150 million US dollars Ijarah based Sukuk, the first quasi-sovereign global Sukuk issued by

Kunpulan Guthrie, a corporation in Malaysia. These actions were followed by several

52 International Islamic Financial Market (IIFM), N.49, p.4. 53Khalid Howladar, N.45, p.1.

204

governments of GCC counties during 2003-2004 such as the IDB Sukuk arising from Saudi

Arabia, the Qatari Governments Sovereign Sukuk and the Tabreed Sukuk arising from

the UAE,. 54. Since then a number of players have come into market including Islamic states

as well as non- Islamic states. The first non- Islamic state that enters into the market was

Germany in 2004 as the Saxony Anhalt Trust for the Federal State of Saxony, a state of

Germany, issued a Sukuk Ijarah amounting to 100 million Euros equal to 123 Million US

dollars.55 This action was followed by UK in 2005 and USA in 2006 with the issue of 168

million US dollars Sukuk base on Islamic asset backed securitization using the principles of

Musharakah by the East Cameron.56 When the global financial crisis hit global capital

market causing a decline in asset valuation, the lack of liquidity and the lack of market

confidence resulted in Sukuk issuance falling down to 18 billion US dollars in 2008.

Furthermore, the ruling from the Accounting and Auditing Organisation for Islamic

Financial Institutions (AAOFI) that questioned the Shariah compliance of some sukuk

structures also acted as a break on issuance in 2008.57 In 2009 the market seemed to be test

again when at least three Sukuk default were launched, namely, the Saad Group Golden

Belt Sukuk the only Manfaa based Sukuk in the international market, the East

Cameron Gas Company Sukuk, and the Kuwaiti Investment Dar Sukuk.58 The default

54 International Islamic Financial Market (IIFM), N.49, p.8.

55 AmInvestment Bank, Moving Towards Globalization MIF Monthly, February 2008, p.15 56 Ayman H. Abdel-Khaleq,and Christopher F. Richardson, New Horizons for Islamic Securities: Emerging Trends in Sukuk Offerings Chicago Journal of International Law, Vol. 7 No. 2, Winter 2007, p.422. 57 International Financial services London (IFSL), IFSL research: Islamic Financial 2010, January 2010, p.4. 58 Robin Wigglesworth, Defaults destabilise a reviving market Financial Times Special Report, Tuesday December 8 2009, p.2.

205

problem lead by the three Sukuk brought back attention to the question that initiative in

February 2008 about the discrepancy between Shariah contracts and the governing

law of the Sukuk in executing and interpreting the transfer of assets to the Sukuk

holders. As at the time of default, the investors of the defaulted Sukuk found themselves

without recourse to the so-called Trust assets under the governing law and therefore

were being treated just like most sub-ordinate creditors59, even though under Shariah

guidelines, they must have had full recourse to the Trust assets and should have had the

right to liquidate the same in order to recover their investments.60 Moreover, in the same

year Sukuk problem was raised by Dubai World. This problem had brought concerns about

settlement of sukuk defaults into focus with key issues that how the instruments are

settled, and how Islamic creditors are treated compared with holders of conventional

debt in a restructuring or bankruptcy. Nevertheless, some quality issuances of sukuk are

continuing to attract demand from both Islamic and non-traditional investors.

However, the good sign of the market was happened in late 2009, as two issues of

Sukuk marked a widening in the recognition and acceptance of Sukuk outside the Islamic

world. The first issue was the much-oversubscribed 5-year Aaa rated 100 million US

dollars sukuk of the International Finance Corporation (IFC), which was jointly arranged by

HSBC, Dubai Islamic Bank and Kuwait Finance House-Bahrain. It was designed to increase

59 Sub-ordinate creditor is provider of subordinated debt which is also known as subordinated

loan, subordinated bond, subordinated debenture or junior debt. The debt is referred to as subordinate,

because the debt providers (the lenders) have subordinate status in relationship to the normal debt. Such

debt is repayable only after other debts have been repaid.

60 International Islamic Financial Market (IIFM), N.49, pp.18-19.

206

funding for development activities in emerging markets, including the MENA region.

Although, the issue is relatively small but it showed that leading international institutions

such as the World Bank acknowledged the importance of sukuk as a financing tool. The

second issue was US-based GE Capitals 5-year 500 million US dollars sukuk to raise

money for general corporate and balance sheet purposes. This transaction was seen as

strategically important for GE as it raised funds from a new and important investor base.61

Although having faced difficult years, the market has been relatively quickly

recovering as at the end of 2010, according to IIFM data, the Sukuk issuance were turned up

to near its peak in 2007, in term of value, and its future seem to be bright. According to

research of International Financial services London (IFSL), public in January 2010, the

coming years of sukuk market seemed to be positive, with at least three supporting factors

fostering growth demand in the market:

There is a commitment to a substantial programme of infrastructure

investment in the GCC totalling up to 1,000 billion US dollars over the next

ten years, some of which will be financed through Sukuk.

Recent years have shown that there is an appetite and demand for

investment in Sukuk that goes well beyond Islamic investors among those

investors that wish to gain exposure to diverse but high quality assets.

Governments and regulators in a variety of countries have recognised the

important role that Sukuk can play in capital markets and have been giving

61Christophe J. Godlewski, Rima Turk-Ariss and Laurent Weill, Do markets perceive sukuk and conventional bonds as different financing instruments? BOFIT Discussion Papers 6/2011, Bank of Finland, BOFIT Institute for Economies in Transition, pp.10-11.

207

priority to developing their countries as Sukuk centres. In addition to Dubai

and the UK, these include Bahrain, Hong Kong, Malaysia, Japan, Pakistan,

Singapore and South Korea.62

5.5. Structure of Market

According to IIFM data, Malaysia is biggest player in Sukuk market as it alone

accounted for 58 per cent of total Sukuk Issuance between 2001-2010 with total value

115,393 Million US dollars. UAE is ranked second as it accounting for 16 per cent of total

market or 32,201 Million US dollars. Followed by other GCC states such as Qatar 10.2 per

cent Saudi Arabia 7.7 per cent and Bahrain 3.1 per cent of total value of sukuk issuance

between years of 2001- 2010. Sudan is the only country outside GCC and Malaysia whose

market size is 5 per cent of total Sukuk issuance in term of Value.

Malaysia is also the most active market in the world. It has completely dominated

the market in term of number of issues as evident form the number of issues which were

1592 accounting for 81 per cent of total world issues between the years of 2001 and 2010.

The reason behind Malaysia success might be from the fact that Malaysian law has played a

significant role in developing and enhancing the sukuk market. As Malaysias legal

framework facilitates the establishment of the SPVs required for all sukuk to holding title of

the underlying assets and administering payments to investors. Given this favourable legal

environment, sukuk issues easy proliferated in Malaysia and a secondary market that is

62 International Financial services London (IFSL) IFSL research: Islamic Financial 2010 January 2010, p.4

208

much more active than in the GCC region.63 The detail of global Sukuk market can be

depicted from the figures shown below:

Figure 5.14: Country-wise Breakdown of Total Global Sukuk Issuance by Value Sovereign, Quasi Sovereign & Corporate Issue (All currencies)

Period 1st Jan 2001 31st Dec 2010

Country Number of Issues

Per cent of total Number

of Issues

Value (US$ Million)

Per cent of Total Value

Malaysia 1,592 81.10% 115,393.76 58.51%

UAE 41 2.08% 32,201 16.33%

Saudi Arabia 22 1.12% 15,351.88 7.78%

Sudan 22 1.12% 13,057.713 6.6%

Bahrain 125 6.36% 6,291.69 3.19%

Indonesia 70 3.56% 4,658.5 2.36%

Pakistan 35 1.78% 3,447.207 1.75%

Qatar 6 0.3% 2,500.79 1.27%

Kuwait 9 0.45% 1,575 0.80%

Brunei 21 1.06% 1,175.091 0.60%

USA 3 0.15% 767 0.39%

UK 2 0.10% 271 0.14%

Singapore 5 0.25% 191.96 0.10%

Germany 1 0.05% 123 0.06%

Turkey 1 0.05% 100 0.05%

Japan 1 0.05% 100 0.05%

Gambia 7 0.35% 2.086 0.00%

Total 1,963 100% 197,208.496 100.00%

Source: International Islamic Financial Market64

According to data collection date between Jan 2001 31st December 2009 from

IIFM, the size of global Sukuk market started form 997 Million US dollars in 2001 and met its

peak in 2007 with total issuance of 48,808 Million US dollars. After that the market was in

decline in response to global financial crisis as in 2008 merely 18,392 Million US dollars

63 Christophe J. Godlewski, Rima Turk-Ariss and Laurent Weill, Do markets perceive sukuk and conventional bonds as different financing instruments? BOFIT Discussion Papers 6/2011, Bank of Finland, BOFIT Institute for Economies in Transition, p.10. 64 www.aaoifi.com/aaoifi/pdf%20forms/conference/p/2s.pdf [ 6 July 2011]

209

issued, its issuance decline around 62 per cent compare with previous year. However the

market quickly recovered as to nearly its peak as the total Sukuk issuance were 46,918

million US dollars in 2010.65 The growth of market is shown in following Figures:

Figure 5.15: Total Global Sukuk Issuance by Value Sovereign, Quasi Sovereign & Corporate Issue

Period 1st Jan 2001 31st Dec 2010

YEAR Value (US$ Million)

2001 997

2002 1,071

2003 6,110

2004 7,890

2005 11,775

2006 29,554

2007 48,727

2008 18,486

2009 25,680

2010 46,918

TOTAL 197,208

Source: International Islamic Financial Market (IIFM)

65 Ibid

210

Figure 5.16: Total Global Sukuk Issuance by Value

Sovereign, Quasi Sovereign & Corporate Issue Period 1st Jan 2001 31st Dec 2010

According to figure one might see that the global sukuk market experienced

problem in 2008, when global sukuk issuance declined by more than 60 per cent

compared to 2007. The significant decline in Sukuk issuance was mainly driven by credit

crisis that forced investors to step aside from the money market, hence exhausting

resources for sukuk as well. Although the damage was not as severe as for its conventional

counterpart, this incident demonstrates that the growth in sukuk market had not insulate

from the global financial crisis. Due to this credit crunch, the Gulf Cooperation Council (GCC)

and Malaysia have been the hardest hit, experiencing declines in sukuk issuance of 55 per

cent and 59 per cent respectively.66

66Nurul Aini Muhamed, Rafisah Mat Radzi Implication of Sukuk Structruing: The Comparison On The Structure of Asset Based and Asset Backed Ijarah Sukuk 2nd International Conference On Business and Economic Research(2nd ICBER 2011) Proceeding, pp.2446-2447

0

10000

20000

30000

40000

50000

60000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Value (Milliom US dollar)

Value (Milliom US dollar)

211

Figure 5.17: Total Global Sukuk Issuance Country Wise Breakdown ( Million US dollar) (Domestic & International)

Jan 2001 31st December 2009

Year 2001

2002

2003 2004 2005 2006 2007 2008 2009 Total

Asia

Malaysia 680 761 4,073

4,957

7,311 15,060

26,529

5,897 12,477

77,744

Indonesia

19 64 84 60 193 681 1,555 2,656

Pakistan 6 600 180 1,065 214 192 2,257

Brunei 580 222 31 107 940

Singapore

33 102 135

GCC

UAE 1,165

950 8,245 10,417

6,159 3,950 30,886

Saudi Arabia

500 415 500 800 5,683 1874 2,576 12,348

Bahrain 100 200 230 454 1,113 418 1,137 891 1,405 5,947

Qatar 700 270 300 137 1,407

Kuwait 200 200 400

Other

Sudan 184 5 543 700 1,283 1,872 2,427 2,509 3,221 12,744

Cayman Islands

710 635 500 1,845

USA 167 500 667

UK 261 261

Germany 123 123

Total 997 991 6,110

7,898

12,077

28,502

48,808

18,392

26,584

150,360

Source: Desktop research including daily news alert ,publications & information providers Jan 2001 31st December 2009 (IIFM)

Since, the market of Sukuk can be separated into two sub-market; domestic sukuk

market67 and international Sukuk market68. Further detail of market can be described in the

coming sections.

67 The market where Sukuk is dominated by domestic currency

212

Figure 5.18: Total Global Sukuk Issuance by Type of market Sovereign, Quasi Sovereign & Corporate

Period 1st Jan 2001 31st Dec 2010

YEAR DOMESTIC SUKUK INTERNATIONAL SUKUK TOTAL ISSUANCE

2001 747 250 997

2002 241 830 1,071

2003 4,730 1,380 6,110

2004 5,637 2,253 7,890

2005 8,767 3,008 11,775

2006 17,919 11,635 29,554

2007 34,916 13,811 48,727

2008 16,346 2,144 18,486

2009 18,230 7,450 25,680

2010 41,569 5,349 46,918

Total 149,103 48,105 197,208

Source: International Islamic Financial Market

Figure 5.19: Total Global Sukuk Issuance by Type of market

Sovereign, Quasi Sovereign & Corporate Period 1st Jan 2001 31st Dec 2010

68 The market where Sukuk is dominated by US dollar currency

0

10000

20000

30000

40000

50000

60000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Domestic Sukuk

International Sukuk

Total Issuance

213

5.5.1. Domestic Sukuk market

Within domestic Sukuk domain, Malaysia is the first leader player in domestic market

as the Malaysian domestic market was around 68 billion dollars or accounting to 67 per

cent of the total global domestic Sukuk market and it is in excess of 50 per cent entire global

market. Obviously Malaysian market is the most active domestic market with 792 issues of

Sukuk. This was followed by Sudan, the second biggest player in domestic Sukuk market;

with size of around 12 billion US dollars with 20 issues or accounting to 12 per cent of the

market.

Although, investment form GCC is an importance source of Sukuk demand, however,

as individual country domestic Sukuk market are relative very small as compared with

Malaysia and Sudan. However, as a group GCC domestic Sukuk is worth around 16 Billion US

dollars or 16 per cent of total global market. Within the group, Bahrain has been the most

active one as it possesses 77 issues in its account. The main reason for its activeness comes

from the fact that government of Bahrain is the first government in this region that

promotes Sukuk as one of its primary tools for raising fund.

However, the size of Bahrains market is relative small as compared with Saudi

Arabia and UAE as size of the market at June 2009 was 1.5 billion US dollars. 1 billion out of

the total market size had been raised in the form of nine 3 5 year Sukuk and one 10 year

Sukuk, while the rest has been raised through short-term Ijarah and Salam Sukuk with

an average size of 17 million US dollars and maturities ranging from three months to

fifteen months. All domestic Sukuk from Bahrain have been sovereign. Other major

domestic Sukuk markets in this region are Saudi Arabia and UAE even though these markets

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are less active. However, the two markets account for 85 per cent of GCC domestic market.

The issuance have had a mix of sovereign, quasi-sovereign and corporate Sukuk while

the only domestic Sukuk from Qatar has been issued by a corporate.

In Asia, although, the countries like Indonesia, Singapore and Pakistan have early

came into the market but the size of their market has been very small. They together

accounted for only around 5 per cent of total issuance during 2001-2010. Indonesia first

tapped the domestic Sukuk market in November 2002. Since then all the issues were

corporate or quasi-sovereign with a small average size. However, the government of

Indonesia launched long-term Ijarah Sukuk into the market in August 2008 worth 295.4 and

216 million US dollars. Until June 2009 the worth of Indonesian domestic sovereign Sukuk

has been 467 million US dollars. The Singapore Sukuk market, worth 134 million US dollars,

has been entirely domestic market. The first issuance is a quasi-sovereign Sukuk launched in

June 2001 and the second one did not come until recently in January 2009. Pakistan

domestic market has been mixed of about 30 sovereign and corporate Sukuk so far.

Germany enters into the market in 2004 made it is the first western country who

enters into Sukuk market. The German first and only ever since was 123 million US dollars

Ijarah based Sukuk. The Sukuk was Euro currency dominated. It is interesting to note that

some players in the domestic Sukuk market have never entered the international Sukuk

market, namely, Brunei Darussalam, Gambia, US, Germany and Singapore.69 The

detailed region-wise volume, value, status and type of domestic issues can be depicted as

following Figures:

69International Islamic Financial Market (IIFM), N.49, pp.4-6.

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Figure 5.20: Regional breakup of the Domestic Sukuk Market

Country Value ( US$ millions)

No. Of Issues Per cent of Total Value

Asia

Malaysia 67,872 792 66.8

Indonesia 1,923 48 1.9

Pakistan 1,657 31 1.6

Brunei 740 13 0.7

Singapore 99 2 0.1

GCC

Saudi Arabia 7,665 10 7.5

UAE 7,151 10 7.0

Bahrain 1,508 77 1.5

Qatar 137 1 0.1

US, Europe and Africa

Sudan 12,614 20 12.4

US 167 1 0.2

Germany 123 1 0.1

Gambia 0.388 1 0.0

T0tal 101,656 1007 100

Source: In-house IIFM Sukuk Issuance database

Figure 5.21: Breakdown of Total Domestic Sukuk Issuance by Issuer Status Sovereign, Quasi Sovereign & Corporate Issues by Value (Period 1st Jan 2001 31st Dec

2010)

Type Value (US$ Million) Percent of Total Value

Sovereign 52,645 35%

Quasi-Sovereign 3,291 2%

Corporate 93,841 63%

Total 149,777 100%

Source: International Islamic Financial Market

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Figure 5.22: Structural Breakdown of Total Domestic Sukuk Issuance by Value Sovereign, Quasi Sovereign & Corporate Issue, Period 1st Jan 2001 31st Dec 2010

Structure Value (US$ Million) Percent of Total Value

Sukuk Al Wakala70 371 0%

Sukuk Al Salam 1,291 1%

Sukuk Al Musharakah 39,318 26%

Sukuk Al Murabahah 44,628 30%

Sukuk Al Mudarabah 3,458 2%

Sukuk Al Istisna 3,469 2%

Sukuk Al Ijarah 34,073 23%

Islamic Exchangeable Bond71 408 0%

Al Istithmar Sukuk72 8,814 6%

Hybrid Sukuk (Mudarabahh+Murabahah)

164 0%

Hybrid Sukuk (Istisna+Murabahah) 40 0%

Hybrid Sukuk (Istisna+ Mudarabah) 136 0%

Hybrid Sukuk (Musharakah+ Murabahah)

1,399 1%

Sukuk Bai Ina 1,215 1%

Sukuk Bai Bithaman Ajil (BBA)73 10,993 8%

70 According to AAOIFI, sukuk wakalah is defined as certificates that represent a project or a particular activity carried out according to the wakalah principle, where a Wakil or representative is appointed to manage the project on behalf of the sukuk holder. Few domestic and international sukuk have been issued under this type of contract; these are mostly known as sukuk wakalah bi istithmar (or investment agency sukuk). The issuers are such as Bukhatir Investments Limited, Berber Investment Agency Sukuk, Islamic Development Bank and Dar Al-Arkan International Sukuk Company II from GCC portfolios. 71 The worlds first Shariah-compliant exchangeable bond was issued by Khazanah Nastional Berhad, a Malaysian Governments investment body. The certificates/bond represent interests in a trust constituted by the issuer and are exchangeable into shares of Telekom Malaysia Berhad (TM).The bond comprises 750 million US dollars 5-year Certificates due 2011 and is exchangeable into ordinary shares of RM1.00 each of Telekom Malaysia Berhad (TM). The bond was launched with an initial size of 500 million US dollars and was upsized due to strong demand.

72 The term istithmar is broadly understood to mean an investment. Under a sukuk al-istithmar structure it is possible for ijara contracts (and the relevant underlying assets), Murabahah receivables, and/or istisna receivables (each generated by the originator), as well as shares and/or sukuk certificates to be packaged together and sold as an investment. The income generated by such investment can then be used to make payments to the investors under the sukuk. Examples of sukuk al-istithmar issuances by Clifford Chance LLP and listed elsewhere include Islamic Development Banks 2009 issuance, listed on the London Stock Exchange. 73 Sukuk BBA is financial certificate based on Bai Bithaman Ajil contract that prove the ownership right of investor to the determining assets. According to Bank Negara Malaysia (2007), BBA is a deferred payment that asset requested by the client are bought by the financer, which subsequently sells the goods to the client at an agreed price, including a mark-up (profit) for the financer. BBA provides financing for the purchase of

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Total 149,777 100%

Source: International Islamic Financial Market

5.5.2. International Sukuk market

Despite the fact that, Malaysia is a dominant player in the global Sukuk market,

however, as far as international Sukuk market is concerned, GCC is biggest player on this

segment of Sukuk market. In contrast to domestic market, the region has been a dominant

player on the market since 2001 as in June 2009 it accounted for almost 80 per cent of this

segment. GCC market share is far beyond its Asian counterpart which accounts only 15 per

cent. This situation might come from the fact that Malaysia, the global biggest player, has

given most of its attention toward domestic Sukuk as the issue of Ringgit dominant Sukuk

can help Malaysia to retain and boost the position of Malaysian Ringgit.74 According to the

figure: 4.21 UAE is the biggest player in this segment with 23 issues or nearly 20 billion US

dollars in term of value. According to IIFM, eight out of ten largest international Sukuk

issues are UAE based Sukuk including Nakheel Sukuk Al Ijarah the largest Sukuk ever issue to

date with 3.52 billion US dollars.

assembly plants, factories, warehouses or machinery. The selling price is fixed and agreed by both parties and will remain unchanged until the end of the payment period. Periodic instalments are determined by the selling price and the payment period. The ownership of the property purchased will be under the claim of the financer and will be handed over to the customer upon full payment. The first Bai Bithaman Ajil sukuk issuance in 1990 by Shell MDS Sdn. Bhd. with RM150.0 million, It is also the world first Sukuk. 74Islamic finance Information Service (IFIS), IFIS Global Sukuk Market H2-2010 Report, p.9. http://www.cibafi.org/Images/Attaches/20114216477675.pdf [16 June 2011]

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Figure 5.23: Regional Break-up of the international Sukuk Market(30th June 2009)

Country No. Of International Issues

Value of Issues (US$ million)

Percentage of Total Value

GCC

UAE 23 19,785 55.1

Saudi Arabia 6 3,640 10.1

Bahrain 23 3,946 11

Qatar 3 1,270 3..5

Kuwait 2 400 1.1

Asia

Malaysia 9 3,680 10.2

Indonesia 1 650 1.8

Pakistan 1 600 1.7

Brunel 2 200 0.6

Other

UK 1 261 0.7

Cayman Island 6 1,345 307

Sudan 1 130 0.4

Total 78 35,907 100

Source: In-house IIFM Sukuk issuance database

Although, Sukuk started to be recognized as Islamic financial instrument with the

100 million US dollars Bahrain sovereign issue in 2001 and two Malaysian international

issues, the 600 million US dollars sovereign benchmark but as shown in figure 4.22 the large

part of international issuance has been corporate Sukuk as 63 per cent of the total market

value. As the growth resulted from international corporate issues which have been

growing annually at about 150 percent up to 2005, peaking at more than 400 percent as at

December 2006 but sovereign issues showed no significant growth. 75

75 Mr. Ijlal Ahmed Alvi, Islamic Capital Market and Sukuk Overview in Enhancing Capital Market

Cooreration Among IDB Member Countries, Proceedings of the 19th IDB Annual Symposium, Jeddah, Saudi Arabia 28-29 Jumad Awwal 1429H (2-3 June 2008) ed byDr. Nosratollah Nafar, Economic Policy & Statistics Department Islamic Development Bank p.128.

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Figure 5.24: Breakdown of Total international Sukuk Issuance by Issuer Status Sovereign, Quasi Sovereign & Corporate Issues by Value (Period 1st Jan 2001 31st Dec

2010)

Type Value (US$ Million) Per cent of Total Value

Sovereign 14,554 31%

Quasi-Sovereign 3,000 6%

Corporate 30,311 63%

Total 47,865 100%

Source: International Islamic Financial Market As far as structure of Sukuk is concerned, Ijarah is dominant structure in the Sukuk

market since the first few issues. It remained be popular until 2005. Although, Musharakah

and Mudarabah structure became popular structure of choice during 2006-2007, however,

Ijarah structure came back in favour again since issuance of the fatwa from the AAOIFI in

February 2008 which declared unacceptable the purchase undertaking that was being

employed in all participatory to provide guarantee to the principal value at redemption.

Structural Breakdown of total international Sukuk issuance can be depicted as following

figure:

Figure 5.25: Structural Breakdown of Total International Sukuk Issuance by Value Sovereign, Quasi Sovereign & Corporate Issue, Period 1st Jan 2001 31st Dec 2010

Structure Value (US$ Million) Percent of Total Value

Sukuk Al Wakala 2,125 4%

Sukuk Al Salam 1,958 4%

Sukuk Al Musharakah 9,286 19%

Sukuk Al Murabahah 911 2%

Sukuk Al Mudarabah 4,725 10%

Sukuk Al Ijarah 21,434 45%

Islamic Exchangeable Bond 6,190 13%

Hybrid Sukuk (Istisna+Ijarah) 487 1%

Hybrid Sukuk (Musharakah+ Murabahah)

750 2%

Total 47,865 100%

Source: International Islamic Financial Market

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5.6. Sukuk Market Present Day Challenges

Undoubtedly, Islamic finance and banking is the fastest and highest growth segment

in financial world. Within this segment, Sukuk is the most fascinating market as it grew from

997 to more than 197,208 or near 200 fold within a decade. However, the growth did not

purely come from its application or utilization ability that it can give fit to any purposes of

business requirement. But in fact, the growth of the Sukuk market has been driven mostly

by an abundance of financial resources and demand from Muslim world specially form

Middle east investors and Muslim middle class that their number are growing up around

the world. In fact the market still faces many challenges. The obvious problem can be

addressed as follow:

Lack of Shariah standard

Although Shariah interpretations and applications are similar, however this does not

mean that their translate into documentation and application are similar. Conformity

amongst the Shariah supervisory boards of Islamic financial institutions is needed for

further market growth. Currently, there are no global Shariah standards. Although some

standard have been issued by AAOIFI which have broader appeal, but differences in

interpretation remain. Recent crisis of default in Sukuk again point out the lacuna. For

example, the recent financial crisis has raised a number of problems in Sukuk such as issue

in transferring of ownership and the ability of Sukuk holder toward control over the assets

in case of default.

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Lack of uniform treatment with defaults and the maturing Sukuk market

When sukuk was first introduced to the market they were proclaimed as more

secure than conventional bonds because they were backed by real assets. However,

recent defaults have left investors nervous as to whether they have a claim over the assets

underlying. The problem of default in Sukuk market might come through the following

factor:

Lack of awareness of default case in Sukuk transition: As in conventional

financial and investment markets, the post-default path is well known. Thus,

much of the process of structuring and documenting transactions accounts

for the possibility of a worst case scenario. The simulation would give the

indication what such a scenario may entail and the guideline according to

such scenario are readily available in the context of conventional

transactions.

Lack of special legal regime toward Sukuk: Legal regime is one of other

factor that contributes to the problem as most of markets are subject to

partially or wholly non-Shariah based legal regimes such as the legal

documents governing Sukuk or the Islamic structures underlying Sukuk are

often subject to English laws. Then, Shariah based transactions structures

will be characterized and treated in various applicable jurisdictions that

make difficult to make certainty resolution toward disputes and

enforcement of rights in the relevant jurisdictions.

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As mentioned early, the recent default in Sukuk market has drawn attention to the

matter that how Sukuk structures fare in the face of defaults should clarify what they are in

a legal sense. This situation requires clear notice that it is needed for Sukuk market to have

clarified standard and universal guidelines with regard to the post-default process in Sukuk

transactions. This clarity would light the path of the maturation process of the Sukuk

market.76 The existence of a unified Shariah board that representing different Islamic

schools of thought worldwide is necessary as this would facilitate the conformity of certain

existing wider market product structures such as Sukuk. Hence, continuous improvement of

the functions of Shariah boards to achieve a global standard for Sukuk is essential because

lack of standardization in the Sukuk area is a contributory factor to low issuance levels. The

establishment of a Shariah Board at a global level will be helpful and can play a major role in

convergence as well as in facilitating the development of a robust and unified Islamic

financial services Industry. 77

Lack of liquidity

Illiquidity is other obvious weakness of Sukuk market. The Sukuk market is limited by

illiquidity in the secondary market with high originator concentration and regional

fragmentation character. The level of Sukuk Issuance by corporations and public sector

entities still remains relatively very small fraction as compared with global fixed income

market. Only a handful of large banks and managers are behind the bulk of transactions

76 Ayman Abdel Khaleq, Todd Crosby, Defaults and the maturing Sukuk market Collaborative Sukuk Report: An Agenda setting study for the growth and development of the global Sukuk industry, by Zawya pp.21-22. 77 Ijlal Alvi, Dr. Ahmad Rufai Muhammad The need for Shariah standardisation in Sukuk issuance Collaborative Sukuk Report: An Agenda setting study for the growth and development of the global Sukuk industry, by Zawya p.30

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completed by a small number of repeat issuers. Origination and servicer risk from narrow

asset supply poses challenges to investor diversification. Moreover, the lack of information

from private sources about securitized asset in many Sukuk and the prevalence of buy-and

hold investments inhibit efficient price discovery and information dissemination. 78

Presently most of the markets have lack of liquidity as there appears to be that investors

generally prefer buy and hold strategies to Sukuk until maturity. The tendency of

investors investment behaviour creates limited supply of Sukuk in secondary markets.

Given the benefit of greater market liquidity for securities in general, such as more efficient

price discovery process and effective market transactions, the Islamic finance industry will

need to step up efforts to strengthen the depth and breadth of the secondary markets for

Sukuk79

Conclusion

Although at the very first appearance, Sukuk was introduced to be an Islamic

alternative of choice for Islamic investors that has equivalence to conventional bond. But

with the different natures of Islamic and conventional financial ideology, the Sukuk has

been developed to be a distinguishing one. The most distinguishing aspect is that Sukuk

provides the ownership right for the Sukuk holder toward tangible underly asset. To

transfer ownership right from originator to Sukuk holder, Special Purpose Vehicle (SPV)

78 Andreas A. Jobst overcoming Incentive Problems in Securitization: Islamic Structured Finance In Islamic Capital Markets: Products and Strategies, editing by Kabir Hassan, Michael Mahlkneeht ( West Sussex: John & Sons, 2011) pp. 171-184 (p.181) 79 Azrul Azwar Ahmad Tajudin, Islamic Financial Needs Its Own Price Indications editing by Tomasz Janowski, in Islamic Finance: A Safe Haven In Uncertain Times ?, Thomson Reuters 2008, p.3 http://online.thomsonreuters.com/assets/downloads/islamicRep_A4_brochure.pdf [ 26 July 2011]

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become the heart of every valid Sukuk structures as it operates as agent of Sukuk and

prevent the underly assets from originators bankrupt affects.