iibi pgd module 4 lesson 4

7/28/2019 IIBI PGD Module 4 Lesson 4

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Institute ofIslamic Banking andInsurance London, United Kingdom

Module IV Lesson 4 Page 1 of 45

Treasury and Capital Market Operations

Module IV


Lesson 4

Securitisation and Sukuk

Introduction

Sukuk are like trust certificates whereas bonds are contractual debt obligations.

Generally, sukukrepresents a beneficial ownership interest in the underlying asset.

Returns on sukukare 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. While Sukuk may have similar characteristics to

conventional asset-backed bonds but are structured in accordance with Shariah and

may be traded in the market.

Securitisation is the practice of using predictable income flows from a specified asset

as backing for an issue of bonds. In other words, it is a financing technique where

the income stream of an asset is used to service the interest and principal

repayments on the relevant debt instruments. For this reason securitisation is often

preferable to other forms of financing, originated by banks and other credit providers.

It enables the bond issuer to raise cash from investors by borrowing against assets.

This lesson will discuss the essence ofsukukin the modern Islamic perspective that

lies in the concept of asset monetisation - the so-called securitisation - that is

achieved through the process of issuance of sukuk. Its great potential is in

transforming an assets future cash flow into present cash flow.


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Nature of Securitisation

Securitisation is the process of issuing new negotiable securities backed by existing

assets such as loans, mortgages, credit card debt, or other assets (including

accounts receivable). OECD 2001 Source of Publication SNA 11.75

A more specific definition characterises securitisation as the process of packaging

designated pools of assets with or without credit enhancement into securities, and

the sale of these securities to the appropriate investors. The process involves the

creation of homogenous assets - both in kind and in underwriting criteria - and then

pooling them into a significant saleable size. Generally, a pool, on the whole, has a

better credit characteristic (through diversification of credit risk, transaction size,

geography, etc.) than an individual asset. The process may also involve the

provision of additional protection for the investors against late payments, pre-

payments, potential write-offs, as well as cash-flow timing mismatches. Such

protection is often provided in the form of credit and/or liquidity enhancement

schemes,

The concept of securitisation originated from the USA, but almost all the major

financial systems now have certain securitisation schemes. The sale of whole loanscould be dated as far back as the 1880's in the USA. The origins of securitisation of

assets, however, are traced to the 1970's when the Government National Mortgage

Association ("GNMA") developed the GNMA pass-through, a mortgage -backed

security collateralized by single-family Federal Housing Administration ("FHA") and

Veterans Administration ("VA") mortgage loans. Securitisation grew into a significant

business in the 1990's. Today, securitised assets under the conventional financial

system not only include mortgages on properties, but also credit card receivables,

computer leases, equipment notes financing, auto loans, and even future sales of

music records.

Securitisation, in the correct circumstances, is one of the very most efficient forms of

financing. This is because of two additional trends. The first is the increasing

importance of the use of information to create wealth. The second is the increasing


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sophistication of technology which has made possible to store and retrieve extensive

data about the historical behavior of pools of assets. This historical data in turn

enables one to predict, under the right circumstances, the behavior of pools of such

assets subsequently originated by the applicable bond issuer. Because the

knowledge about such behavior may be so precise and reliable, when structured

correctly, a securitisation may entail less risk than a financing of the entity that

originated the securitised assets.

The expected behavior of a pool of assets and the ability of the investor to rely on

those assets for payment must not be materially impaired by the financial behavior of

the related bond issuer or any of its affiliates. In most legal systems, this is not

practicable without the isolation of those assets legally from the financial fortunes of

the bond issuer. Isolation, in turn, is almost always accomplished by the legal

transfer of the assets to another entity, often a special purpose vehicle ("SPV") that

has no businesses other than holding, servicing, financing and liquidating the assets

in order to insure that the only relevant event to the financial success of the

investors' investment in the assets is the behavior of such assets.

Almost all of the structural complexities that securitisation entails are required, either

to create such isolation, or to deal with the indirect effects of the creation of such

isolation. For example, the

(i) attempt to cause such transfers to be "true sales" in order to eliminate the

ability of the bond issuer to call on such assets in its own bankruptcy,

(ii) "perfection" of the purchaser's interest in the transferred assets,

(iii) protections built into the form of the SPV, its administration and its capital

structure all in order to render it "bankruptcy remote", and

(iv) limitation on the liabilities that an SPV may otherwise incur are each

attributes of the structure of a securitisation designed to insure that the

isolation of the transferred assets is not only theoretical but also real.


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Securitisation is commonly used as a risk management tool. It helps decrease

funding risk by diversifying funding sources. Financial institutions also employ

securitisation to purge interest rate mismatches. As an example, banks can offer

long-term fixed rate financing without significant risk, by passing the interest rate and

other market risk to investors seeking long term fixed rate assets.

Securitisation can also benefit investors. It allows them to make their investment

decisions independently of the credit-standing of the originator, and instead to

concentrate on the degree of protection provided by the structure of the SPV and the

capacity of securitised assets to meet the promised principal and interest payments.

Furthermore, securitisation creates more complete markets by introducing formerly

remote asset classes that better suit investor risk preferences and by increasing the

potential for investors to achieve the benefits of diversification. Therefore, by meeting

the needs of different market segments, securitisation transactions can generate

gains for both originators and investors.

Securitisation focuses on processes - the process of pooling assets, the process of

packaging them into securities, and the process of distributing securities to investors.

As Islamic institutions are more concerned with the Islamic acceptability of the

securitisation business, their focus is more on the content of the "package" rather

than the process of packaging. Therefore, they tend to ensure that the assets in the

package - and not the package alone - are Islamically acceptable.

Securitisation for Islamic Banks

The securitisation process has also some specific benefits for Islamic financial

institutions. As Islamic finance tends to relate finance to assets, asset backed

securitisation is the right product for Islamic financial institutions, as long as theseassets are structured in accordance with Shariah principles. The concept of asset

backing is prevalent in all other Islamically- structured transactions. For example, in

trade finance the use of "murabaha" contract enables Islamic banks to purchase

certain goods and sell the same to a client at a pre-agreed profit margin, rather than

giving an interest-bearing loan to the client, who then purchases the goods from the


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Islamic bank. In project finance, the preference is to buy equipment and lease it to a

project-promoter, instead of providing the party with liquid capital against payment of

interest.

Definition ofSukuk

Generally, Sukuk are a form of commercial paper that provides an investor with

ownership in an underlying asset. It is an asset-backed security that has a stable

income.

The primary condition for issuance ofsukukis the existence of assets on the balance

sheet of the issuing entity that wants to mobilise its financial resources. Theidentification of suitable asset is the first and most important step in the process of

issuing sukuk.

In current business practice, the term sukuk means a claim similar to a note or

certificate, like a trust certificate. This claim however is not simply a financial claim to

a cash flow, but an ownership claim. A sukukrepresents either a proportional or an

undivided interest in an asset or pool of assets. Whether or not the ownership

interest drives to tangential ownership rights, it is those rights that carry with them

the right to a proportionate share of cash flow or other benefits and risks of

ownership. Sukuk, therefore, are, as one international law firm characterises them,

an entitlement to rights in certain assets inclusive of some degree of asset

ownership.

The model ofsukuksecurity is derived from the conventional securitisation process

in which a special purpose vehicle (SPV) is setup to acquire assets and to issue

financial claims on the assets. These financial assets claims represent a

proportionate beneficial ownership to the sukukcertificate holders.

The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)

defines investment sukuk as certificates of equal value representing, after closing

subscription, receipt of the value of the certificates and putting it to use as planned,


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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.

The AAOIFI standard goes on to distinguish investment sukuk from shares, notes

and bonds, within the confines of the standard, as instruments with an intrinsic value.

The standard also emphasises that investment sukukdo not represent debts owed

by the issuer or certificate holder and that such sukukmay not be issued for a pool of

receivables. Finally, the standard indicates that the underlying business contract or

arrangement for such sukukmust be consistent with Shariah.

Historical Basis ofSukuk

In classical period Islam Sakk(plural: sukuk) which is cognate with the European

root "cheque", meant any document representing a contract or conveyance of rights,

obligations or monies done in conformity with the Shariah. Empirical evidence

shows that sukuk were a product extensively used during medieval Islam for the

transferring of financial obligations originating from trade and other commercial

activities.

The Hadith (record of the sayings and practices of Prophet Muhammad (pbuh))

provide a context in which it is possible to determine that certain forms of transfer are

permissible and certain are forbidden. The rulings of Islamic scholars through the

years, as well as historical references in documents, such as the discovery in 1896

of the genizah documents, also assist in examining applications of the concept as a

broad and flexible tool for the further development of modern Islamic finance, notably

in the field of securitisation.

The modern concept of sukuk is a financial security that carries with it specific

property rights and obligations including some form of asset ownership. On the basis

of the ancient meaning denoting striking ones seal on a document or tablet, sukuk

represents a contract or conveyance of rights, obligations and or monies. A critical

understanding of the eligibility of specific sukuk relates first to the underlying

transaction and second to the ongoing rights and obligations that move from person

to person with the sukuk.


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The Genizah documents

The 1896 discovery in Cairo Genizah, located in the Ezra Synagogue in Fostat (Old

Cairo, Egypt), was one of the greatest treasures of documents found that provided a

detailed picture of the economic and cultural life of the Middle Eastern and

Mediterranean region over many centuries.

A genizah (Hebrew) is a hiding place (or storeroom) for unused documents usually

inside of a synagogue. The documents, dating from the 11 th through to the 13th

Century (CE) were an assemblage of correspondences and documents such as

dowries, contracts, laws, and histories as well as religious material including parts of

Jewish religious writings and fragments from the Holy Bible and The Holy Qur'an and

even fragments from books of Islamic literature.

Modern Sukuk

Modern sukuk, sometimes referred to as Islamic bonds, are better described as

Islamic investment certificates. This distinction is as crucial as it is important, and it is

stressed throughout this pioneering work that sukukshould not simply be regarded

as a substitute for conventional interest-based securities. The aim is not simply to

engineer financial products that mimic fixed-interest-rate bills and bonds and floating-

rate notes as understood in the West, but rather to develop innovative types of

assets that comply with the Shariah.

It is important to note that the essential concepts are:

transparency and clarity of rights and obligations;

that income from securities must be related to the purpose for which

the funding is used, and not simply comprise income that may be

attributed to any form of interest; and

that securities should be backed by real underlying assets, rather than

being simply paper derivatives.


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Islamic fixed-income securities are already emerging as a significant class of asset,

and are as potentially important for the Muslim investor as conventional bonds are

for investors generally. In addition, for non-Muslims who already own conventional

bonds, the acquisition of sukuk introduces a new asset class into their portfolios,

bringing further welcome diversity and possibly reducing risk.

The legitimacy ofsukuk

Although there is no compulsion to comply with the rulings of the Fiqh Academy of

the Organisation of the Islamic Conference (the Islamic Fiqh Academy), their rulings

carry considerable weight with most Islamic financial institutions and their Shariah

committees and advisers. At the request of delegates from Jordan, Pakistan and

Malaysia, the Islamic Fiqh Academy considered the question of Islamic investment

certificates at their fourth annual plenary session held in Jeddah in February 1988.

They noted that the Shariah encourages the documentation of contracts as

stipulated in The Holy Quran [2:282]: When ye deal with each other, in transactions

involving future obligations in a fixed period of time, reduce them to writing It is more just

in the sight of God, more suitable as evidence and more convenient to prevent doubts among

yourselves...

Subject to proper legal documentation, the Islamic Fiqh Academy ruling in 1988

stipulated:

that any collection of assets can be represented in a written note or bond: and

that this bond or note can be sold at a market price provided that the

composition of the group of assets, represented by the security, consists of a

majority of physical assets and financial rights, with only a minority being cashand interpersonal debts.

The Council of the Islamic Fiqh Academy (in its sixth session held in Jeddah,

Kingdom of Saudi Arabia, from 17 to 23 Shabaan 1410 H - corresponding

to March 14-20, 1990), resolved the following concerning bonds:


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(i) the bonds, which represent an undertaking to pay their amount along

with an interest related to its face value or to a pre-determined profit,

are prohibited in Shariah. Their issuance, their purchase and their

negotiation are all prohibited because they are interest-bearing loans,

no matter whether their issuing authority belongs to the private sector

or is a public entity related to the State. The change in the

nomenclature, such as calling bonds certificates, investment

securities or saving certificates, or calling the interest profit,

income, service charge or commission has no effect on the

aforesaid ruling;

(ii) the zero coupon bonds are also prohibited because they are loans

sold at a price inferior to their face value, and the owners of such

bonds benefit from the difference in their prices which is considered a

discount on the bonds; and similarly, the prize bonds are also

prohibited because they are loans in which a liability to pay a pre-

determined profit or an additional amount is undertaken in favour of

their bearers as a whole, or in favour of an undetermined number ofpersons out of them. Moreover, these bonds bear a resemblance to

gambling (Qimar). Resolution of AAOIFI Shariah Board The

issuance of all kinds of bonds is prohibited when these bonds include

stipulations forthe return of the amount of the loan and excess in any

form, whether such excess is paid at the time of satisfaction of the

principal amount of loan, is paid in monthly or yearly instalments, or

in another manner. It is also prohibited whether this excess

represents a percentage of the value of the bond, as is the case with

most types of bonds, or a part of it, as is the case with zero coupon

bonds. Likewise, prize bonds are also prohibited. This applies

irrespective of the bonds being private, public or governmental.

Trading in bonds, both sale and purchase, is prohibited and so is

their pledging and endorsement, and so on. The Shariah substitute


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for bonds is investment Sukuk.

The need for Islamic bonds

Conventional bonds that yield interest (generation of money from money), or riba,

are prohibited under Shariah. Furthermore, those who buy and sell conventional

bonds are rarely interested in what is actually being financed through the bond issue,

which could include activities and industries that are deemed haram (unlawful or

non-permissible) under Shariah such as the production or sale of alcohol.

Companies that are highly leveraged with bank debt may seek refinancing through

issuing bonds, but such companies are not regarded as suitable for Muslim

investors.

The aim of bond traders usually is to make capital gains as fixed-interest bond prices

rise when variable market interest rates fall. Bond trading is therefore largely about

exploiting interest rate developments and trading in paper that is usually unrelated to

the value of any underlying asset. The major risk for holders of conventional bonds is

of payments default, but this risk is usually assessed solely on the basis of credit

ratings, with the ratings agency rather than the bond purchaser estimating the risk.

Hence the bonds are regarded as mere pieces of paper with third parties estimatingthe risk and the purchaser, at best, only making a risk/return calculation without

necessarily any reference to the business being financed.

The issuance ofsukukon the basis of the rules ofShariah is among the objectives

of Islamic banking, and is also one of the greatest means of establishing Islamic

economies in society. This, however, is on condition that the tools used to develop

and structure sukuk are in consonance with the fundamental principles which

distinguish the Islamic economic system from others. The interest-based system

prevalent in the world today regularly issues bonds that yield interest from capital-

intensive enterprises that bring great profits and regular revenues. Yet, the holders of

such certificates are no more than lenders to the sponsors of such enterprises; and

their earnings come from the interest on their loans in a percentage that accords with

the price of interest in the marketplace. The profits of these enterprises after costs,


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including interest payments1, return exclusively to the sponsors. The basic concept

behind issuing sukuk, however, is for the holders of the sukukto share in the profits

of large enterprises or in their revenues. If sukukare issued on this basis they will

play a major role in the development of the Islamic banking business and thereby

contribute significantly to the achievement of the objectives sought by the Shariah.

Among the benefits ofsukukare the following:

1. Sukukare among the best ways of financing large enterprises that are beyond

the ability of a single party to finance.

2. Sukukprovide an ideal means for investors seeking to deploy streams of capital

and who require, at the same time, the ability to liquidate their positions with ease

whenever the need should arise. This is because it is envisioned that a secondary

market for the trading ofsukukwill develop. Thus, whenever investors require cash

from their investments, or from a part of the same, it will be possible for them to sell

their sukuk holdings, or a part thereof, and receive their value from their original

investment plus earnings, if the enterprise is profitable, in cash.

3. Sukuk represent an excellent way of managing liquidity for banks and Islamic

financial institutions. When these are in need of disposing of excess liquidity they

may purchase sukukand hold them; and when they are in need of liquidity, they may

sell theirsukukinto the secondary market.

4. Sukuk are a means for the equitable distribution of wealth as they allow all

investors to benefit from the true profits resulting from the enterprise in equal shares.

In this way, wealth may be distributed on a wider scale without remaining the

exclusive domain of a handful of wealthy persons. This is clearly among the most

important of all the higher purposes sought by an Islamic economic system.

Sukukalso allow Islamic banks institution to manage balance sheet mismatches to

securitise longer term assets. Investors are also given the option to invest in asset

grades that are suitable for their investment needs. Also, financial markets provide

opportunities for public sector resource mobilisation through issuances ofsukuk.


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Some Shariah scholars, most notably senior Shariah scholar Sheikh Muhammad

Taqi Usmani, have stressed that one of the distinguishing features legitimising

Islamic finance is that it must involve the funding of trade in, or the production of, real

assets. Merely funding the purchase of financial securities would involve second

order financing akin to lending for derivatives that derives value from another asset

employing options, convertible bonds and futures contracts, the subsequent gearing

being speculative and increasing uncertainty, or gharar. Hence, with murabaha,

commodities are purchased on behalf of a client and resold to the client, the

temporary ownership of the commodity justifying the financiers mark-up. Istisnaa

involves the financing of manufacturing capacity through pre-production payments,

but these relate to construction or equipment purchases where real capacity can be

identified. Similarly, Ijarah involves the leasing of real assets, with the use of the

assets justifying the payment of rental to the owner.

As Islamic finance is by nature participatory, purchasers ofsukuksecurities arguably

have the right to information on the purposes for which their monies are to be

allocated. In other words, the funding raised through Islamic bond issues should be

hypothecated or earmarked rather than used for general unspecified purposes,

whether by a sovereign or corporate issuer. This implies that identifiable assets

should always back Islamic bonds (sukuk).

Sukukand Conventional Bonds

The most prominent characteristics of conventional bonds may be summarised as

follows, these characteristics are not to be found in sukuk, at least not directly.

1. Bonds do not represent ownership on the part of the bond holders in the

commercial or industrial enterprises for which the bonds were issued. Rather, theyrepresent a contractual debt obligation and document the interest-bearing debt owed

to the holders of the bonds by the issuer, the owner of the enterprise.

2. Regular interest payments are made to the bond holders. The amount of interest

is determined as a percentage of the capital and not as a percentage of actual


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profits. Sometimes the interest is fixed, while oftentimes in bonds with longer tenors

the rate of interest is allowed to float.

3. Bonds guarantee the return of principal when redeemed at maturity, regardless

of whether the enterprise was profitable or otherwise. The issuer of such bonds is

not required to return more than the principal and the agreed amount of interest.

Whatever profits may have been earned by the enterprise accrue entirely and

exclusively to the issuer. So the bond holders have no right to seek a share in the

profits beyond the interest.

Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)

Srandard 17 defines sukukas being: 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.

Sukukcompared to Bonds and Shares

Sukuk Bonds Shares

Nature Not a debt. Representsundivided ownership in

specific

assets/projects/services

Debt of Issuer Ownership of ashare in a company

Asset Backed A minimum of 51% tangible

assets

Generally not

required

Not required

Claims Ownership claims on the

specific underlying

assets/projects/services

Creditors claims on

the borrowing entity,

and in some case

lien on assets

pledged

Ownership claims

on the company

Security Secured by ownership

rights in the underlying

assets or projects in

addition to any collateral;

Generally unsecured

debentures

Unsecured


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enhancements structured

Principal and

Return

Not guaranteed by Issuer Guaranteed by

Issuer

Not Guaranteed by

company

Purpose Must be issued only for

Shariah-compliant

transactions/activities

Can be issued for

any purpose

Can be offered for

any purpose

Responsibility

of holders

Responsibility for defined

duties relating to the

underlying assets/projects

limited to the participation

in the issue

Bondholders have

no responsibility for

the circumstances of

the issuer

Responsibility for

the affairs of the

company limited to

the extent of

shareholding in the

company

The Principle

The structure of sukukmust be approved by a Shariah adviser appointed by the

issuer.

Sukukcan be structured alongside different techniques. While a conventional bond

is a promise to repay a loan, sukuk present partial ownership in a debt (Sukuk

murabaha sukuk), asset (Ijarah sukuk), project (istisnaa sukuk) or business

(musharakah sukuk).

Most commonly sukukstructures replicate the cash flows of conventional bonds, and

are listed on exchanges and made tradable through the conventional organisations.

A key technique to achieve the capital protection without amounting to a loan is a

binding promise to repurchase certain assets, e.g. in the case of sukuk ijara by the

issuer. In the meantime a rent is being paid, which is often benchmarked to an

interest rate benchmark like LIBOR (which is disliked by Shariah scholars).

From a Shariah perspective, certificates of debt are not tradable (although a

different view is held by many in Malaysia), and certain structuring elements for

mudarabah sukukand musharakah sukuk faced severe critics late 2007 by senior


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Shariah scholar, Sheikh Taqi Usmani, followed by a meeting of the Accounting and

Auditing Organisation for Islamic financial institutions (AAOIFI).

The most accepted structure, which is tradable, is considered to be the Ijarah sukuk.

Debt certificates can be only bought before the finance occurs and then hold to

maturity from an Islamic perspective, which is critical on debt trading at market value

regarding any difference to be like the prohibited Riba (interest on money).

As Shariah considers money to be a measuring tool for value and not an asset in

itself, it requires that one should not be able to receive income from money (or

anything that has the genus of money) alone. This generation of money from money

(simplistically interest) is "Riba", and is forbidden. The implications for Islamic banks

are that the trading and selling of debts, receivables (for anything other than par),

conventional loan lending and credit cards are not permissible.

This principle is widely understood to mean uncertainty in the contractual terms

and/or the uncertainty in the existence of an underlying asset in a contract and this

causes issues forShariah scholars when considering the application of derivatives.

Shariah also incorporates the concept of maslahah or "public benefit", denoting that

if something is overwhelmingly in the public good, it may yet be transacted and sohedging or mitigation of avoidable business risks may fall into this category but there

is still much discussion yet to come.

The structuring ofSukuk(Islamic bonds)

A conventional, plain vanilla bond or note is a simple debt, and the note holders

return for providing capital to the note issuer takes the form of interest. An Islamic

bond, or Sakk (plural: sukuk), obviously cannot involve any financing interest. In

order for sukuk to be Shariah compliant, the sukuk holder must also have a

proprietary interest in the assets which are being financed. The sukukholders return

on the subscription proceeds is income generated by the assets which the holder,

through holding the sukuk, has proportional ownership of.


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There are a number of ways of structuring sukuk, the most common of which may be

described as trust or partnership structures. Typically, a bankruptcy remote issuer

would acquire property, which will be held on trust for the sukuk holders. The

property will generally be leased, in order to generate income. The sukuk, or trust

certificates, are issued by the issuer to the sukuk holders, who thereby acquire a

proprietary interest in the assets of the issuer. The nature of this proprietary interest

will depend on the view taken by the Shariah scholars, but it is understood that the

minimum ownership requirement for the sukuk holder is an entitlement to income

generated by the assets. The issuer, acting as trustee, collects such income and

distributes it to the sukukholders in accordance with their proportional interest in the

assets.

Return or Possible Loss

Partners

A Basic Sukuk Structure

Shariah-compliantagreement

Shariah-compliant

project

Return ( or Possible Loss)

Investors

(Sukukholders)

Issuing Sukuk

SPV

Sukuk proceeds


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Types ofSukuk

Islamic markets offer different instruments to satisfy both providers and users of

funds in a variety of ways. While the main types of Islamic financial instruments are

conceptually simple, they may become complicated in practice as some financial

institution combine aspects of two or more types of instruments.

The proper classification of assets classes will determine the type of certificates to

be issued. It is important to note that these assets can be prepared and issued for

the issuance in a number of ways conditional to the need of the issuing entity.

The Accounting and Auditing Organisation of Islamic Financial Institution (AAOIFI)issued standard for different types of sukuk, where some of these sukuk are

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

and characteristics of the issued sukuk. In recent issuances, the common types of

sukukwere as follow:

Murabaha Sukuk(purchase order)

The Murabaha technique (cost-plus financing) is one of the most widely used

instruments for Islamic short-term financing. It is based on the traditional notion of

purchase finance.

The structure of murabaha is relatively straightforward and is based on declared

mark-up integrated into the selling price with a deferred payment. The Islamic bank

purchase and takes title of the necessary equipment or goods from a third party, the

Islamic bank then sells the equipment or goods to its customer at cost plus a

reasonable profit.

In this case the issuer of the certificate is the seller of the murabaha commodity, the

subscribers are the buyers of that commodity, and the realised funds are the

purchasing cost of the commodity. The certificate holders own the murabaha

commodity and are entitled to its final sale price upon the re-sale of the commodity.


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The possibility of having legally acceptable murabaha-based sukukis only feasible in

the primary market.

The negotiability of these sukuk or their trading at the secondary market is not

permitted by Shariah, as the certificates represent a debt owing from the

subsequent buyer of the commodity to the certificate-holders and such trading

amounts to trading in debt on a deferred basis, which will result in riba. According to

Shariah principles, money can only be traded at par value and not for profit.

Despite being debt instruments, the murabahasukukcould be negotiable if they are

the smaller part of a package or a portfolio, the larger part of which is constituted of

negotiable instruments such as mudarabah, musharakah, or Ijarah sukuk (see

section below on Hybrid mixed asset sukuk). Murabaha sukuk are popular in

Malaysian market due to a more liberal interpretation of the Islamic Fiqh by

Malaysian jurists permitting sale of debt (bai-al-dayn) at a negotiated price.

Steps involved in the structure:

A SPV (Mudarabah) is set up as the first step in the proposed issue of

securities

A master agreement is signed between the SPV and the borrower

SPV issues sukukto the investors and receive sukukproceeds

SPV buys commodity on spot basis from the commodity supplier

SPV sells the commodity to the borrower at the spot price plus a profit margin,payable on installments over an agreed period of time

The borrower sells the commodity to the Commodity buyer on spot basis

The investors receive the final sale price and profits


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MudarabahSukuk(partnership/finance trusteeship)Mudarabah is an agreement made between a party, who provides the capital and

another party (an entrepreneur), to enable the entrepreneur to carry out business

projects, which will be on a profit sharing basis, according to predetermined ratios

agreed on earlier (participation or trust financing). In the case of losses, the losses

are born by the provider of the funds only.

Mudarabahsukukare investment sukuk that represent ownership of units of equal

value in the mudarabah equity and are registered in the names of holders on the

basis of undivided ownership of shares in the mudarabah equity and its returns

according to the percentage of ownership of share. The owners of such sukukare

Investor 1(Rub al Mal)





IslamicBorrower

Principal

Profit(& Principal @ maturity)

1) Funds

2) Sukuk

4) Profit

(& Principal @ maturity)

No-withdrawal agreement(Special exit conditions)

( Manager / Mudarib)

3) Revolving International CommodityMurabaha Facility

Mudaraba(Issuer)

Direct Obligation

Murabaha SukukStructure


20/45




the rabbul-mal. (AAOIFI). Mudarabah sukuk are used for enhancing public

participation in big investment projects.

Following are the salient features ofmudarabah sukuk:

Mudarabah sukuk represent common ownership and entitle their holders

share in the specific projects against which the mudarabah sukukhave been

issued

The mudarabah sukukcontract is based on the official notice of the issue of

the prospectus which must provide all information required by Shariah for the

partnership contract such as the nature of capital, the ratio for profit

distribution and other conditions related to the issue, which must be

compatible with Shariah

The mudarabah sukukholders are given the right to transfer the ownership by selling

the deeds in the securities market at his discretion. The sale of mudarabah sukuk

must follow the rules listed below:

a. If the capital, before the operations of the project, is still in the form of money, the

trading of mudarabah sukuk would be like exchanging money for money. In that

case the rules of bai al-sarf would be applied (bai al-sarf is a contract of exchange of

money for money. This contract is tightly regulated under Shariah because it can be

easily manipulated for the purpose of producing an interest-bearing loan, which is

prohibited by the Shariah).

b. If the capital is in the form of debt then it must satisfy the principles of debt trading

in Islam.

c. If the capital is in the form of combination of cash, receivables, goods, real assets

and benefits, trade must be based on market price evolved by mutual consent.

The Manager/SPV who receives the fund collected from the subscribers to


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mudarabah sukukcan also invest their own funds and receive profit for their

contribution in addition to their share in the profit as mudarib

Neither prospectus nor mudarabah sukukshould contain a guarantee, from

the issuer or the manager for the fund, for the capital or a fixed profit, or a

profit based on any percentage of the capital. Accordingly;

a. The prospectus or the mudarabah sukuk issued pursuant to it, may not stipulate

payment of a specific amount to the mudarabah sukukholders,

b. The profit is to be divided, as determined by applying rules of Shariah; that is, anamount access of the capital, and not the revenue or the yield; and

c. Profit and Loss account of the project must be published and disseminated to

mudarabah sukukholders.

It is permissible to create reserves for contingencies, such as loss of capital,

by deducting from the profit

The prospectus can also contain a promise made by a third party, totally un-

related to the parties to the contract, in terms of legal entity or financial status,

to donate a specific sum, without any counter benefit, to meet losses in the

give project, provided such commitment is independent of the mudarabah

contract

On the expiry of the specified time period of the subscription, the sukukholders is

given the right to transfer the ownership by sale or trade in the securities market at

his discretion.


Mudarib (manager) enters into an agreement with project owner for

construction/commissioning of project


22/45




SPV issues sukukto raise funds

Mudarib collects regular profit payments and final capital proceeds from

project activity for onward distribution to investors

Upon completion, mudarib hands over the finished project to the owner

Musharakah Sukuk

This is very similar to the mudarabah contract and its widely used in equity

financing. Musharakah is an Islamic mode of financing in the form of a partnership

between the bank and its client whereby each party contributes to the capital of the

partnership in equal or varying degrees either to establish a new project or share in

an existing project. The accruing profit is divided between the partners pre-agreed

formula, while losses are shared on pro rata basis.

A musharakah sukuk is ideal for borrowing to finance large commercial ventures,

such as a factory expansion or construction projects. Using sukuk/ certificates, a

special purpose vehicle company (SPV) can purchase, commission or construct

musharakah assets owned, or to be bought or constructed by the issuing entity or

obligor.

The SPV pays cash towards the capital of the musharakah, using sukuk/certificates.

The SPV then leases the underlying musharakah assets to the issuing entity, or

obligor, for a period equal to the maturity of the sukuk, at agreed periodic rentals.

The periodic rentals will be fixed in case of a fixed coupon sukuk or linked to any

index (i.e. LIBOR + mark-up) in case of a floating coupon sukuk. Upon default or

maturity, the issuing entity issues a waad (promise) to musharakah units from the

SPV at an agreed price. Likewise, the sukukholders can sell the units back to the

obligor and receive the sale price (sukukprincipal).


23/45




The structure of musharakah involves establishing a partnership or company to

provide financing with the participants sharing in the profits in relationship to the size

of their investment share. Notes can be issued on the basis of such financing and

both Sudan and Iran have launched such securities. In practice these have been

very similar to mudarabah certificates rather than being a distinct asset class, with

the rights and privileges ofmusharakah certificate holders better defined in relation

to those of equity investors and mudarabah certificate holders.


A corporate body and the Special Purpose Vehicle (SPV) enter into a

Musharakah (partnership) Arrangement for a fixed period and an agreed

profit-sharing ratio. Also the corporate undertakes to buy musharakah shares

of the SPV on a periodic basis

The corporate (as musharik, a partner) contributes land or other physical

assets to the musharakah

SPV (also as musharik) contributes cash i.e. the issue proceeds received

from the investors to the musharakah

The musharakah appoints the corporate as an agent to develop the land (or

other physical assets) with the cash injected into the musharakah and

sell/lease the developed assets on behalf of the musharakah

In return, the agent (i.e. the corporate) will receive a fixed agency fee plus a

variable incentive fee payable

The profits are distributed to the sukukholders

The corporate irrevocably undertakes to buy at a pre-agreed price the

musharakah shares of the SPV on say semi-annual basis and at the end of


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the fixed period the SPV would no longer have any shares in the musharakah

Musharakah SukukStructure

Ijarah Sukuk(leasing)

This is one of the most common sukukissuance types, especially for project finance.

Ijarah sukuk is a leasing structure coupled with a right available to the lessee to

purchase the asset at the end of the lease period (finance lease). The certificates are

issued on stand-alone assets identified on the balance sheet.

Ijarah is an operating lease whereby the bank will buy and lease out equipment or

other assets required by a business client for an agreed rental fee. The agreement

does not include a promise that the leased asset at the end of the lease term will be

transferred to the lessee

Ijarah sukuk represent ownership of equal shares in a rented real estate or theusufruct of the real estate. These sukukgive their owners the right to own the real

estate, receive the rent and dispose of theirsukuk in a manner that does not affect

the right of the lessee, i.e. they are tradable. The holders of such sukukbear all cost

of maintenance of and damage to the real estate. According to AAOIFI

Ijarah sukuk are the securities representing ownership of well defined existing and

Corporate

SPV

Investors

Musharakah

1. Physical AssetContribution

3.Periodic Profit

4. Periodic Profit +Incentive fee

2b.Issue proceeds

6. Undertakes to buyMusharakah shares ofthe SPV on a periodic

2a.Sukuk Proceeds

5. Issues Sukuk Musharakah + Periodic profit


25/45




known assets tied up to a lease contract, rental of which is the return payable to

sukuk holders. Payment of Ijarah rentals can be unrelated to the period of taking

usufruct by the lessee. It can be made before beginning of the lease period, during

the period or after the period as the parties may mutually decide. This flexibility can

be used to evolve different forms of contract and sukuk that may serve different

purposes of issuers and the holders

Thus, the ijara asset-backed sukuk is built on a sale-and-leaseback structure. A

special purpose vehicle company (SPV) buys assets (such as real estate,

machinery, equipment etc) from an issuing entity or other sellers.

The SPV leases these to the issuing entity, or obligor, for a period equal to the

maturity of the sukuk, at periodic rentals. The rentals are fixed in case of a fixed

coupon sukuk or linked to any index (i.e. LIBOR + margin) in case of a floating

coupon sukuk.

Upon default or maturity, the issuing entity issues a waad to purchase the assets

from the SPV at an agreed price. Likewise, the sukuk/certificate holders can sell the

asset back for the sale price (sukukprincipal).

The rental rates of return on those sukukcan be fixed or floating depending on the

agreement. The cash flow from the lease including rental payments and principal

repayments are passed through to investors in the form of coupon and principal

payments. The Ijarah sukuk provides an efficient medium-to-long term mode of

financing.

These instruments have been used in a variety of cross-border applications for an

increasing range of asset classes including ships, aircraft, telecommunications

equipment and power station turbines.

Ijarah has a great potential in making Islamic banking a sizeable industry. Similarly,

securitising the Ijarah contracts is a key factor in solving liquidity management

problems and for financing the public sector needs in developing countries. A lessor,

after entering into Ijarah, can sell the leased assets wholly or partly either to one


26/45




party or to a number of individuals. In the latter case, each individual would be given

Ijarah sukuk or certificates representing his proportionate ownership in the leased

assets and will assume the rights and obligations of the owner/lessor to that extent.

All certificate holders will have the right to enjoy a part of the rent according to their

proportion of ownership in the asset. These certificates, being an evidence of

proportionate ownership in a tangible asset, can be negotiated and traded freely in

the market and can serve as instruments convertible into cash.

Governments Ijarah sukuk is suitable for sovereign or local governments in need of

resources. The government may sell unencumbered specific fixed assets to the SPV

(managed by an independent board of trustees) for forming a pool of assets for

leasing to the Government. The assets may be leased to the Government against

which the SPV will issue Ijarah sukuk in local or international markets to those

interested in investment. On purchase of the Ijarah securities the holders will

become owners of the undivided leased asset. However, as the securities represent

a proportionate ownership in the asset, holders are not entitled to claim any specific

part of the asset. The rentals stipulated between the SPV and the government and

calculated per security would represent the possible earnings to the holders. The

SPV will distribute the net rental income among the security holders on quarterly or

annual basis. Such Ijarah sukukhave been issued in Malaysia, Bahrain, Qatar, etc

and some of the securities issued so far are Malaysian Global First, Malaysian

Global Ijarah Sukuk, Bahrain Ijarah Sukuk, Qatar Global Ijarah Sukuk, Saxony-

Anhalt Sukuk (in which a German State transferred the rights on some state

properties to a Dutch foundation), etc.

If such SPV finances only the Government and its agencies, there would be hardly

any risk of default and the certificate holders would be getting almost fixed return on

their investment. Separate pool of assets would have to be sold to the SPV for every

issue. Once the government has sold any asset, the same asset cannot become

basis for further securitisation unless the government repurchases them in the

normal way or through hire-purchase with separate agreements. The Ijarah based

securities will be issued at par value while subsequent trading in secondary market

can be conducted at any price above or below the face value. A suggestion has also


27/45




been given that the Central Bank may purchase the entire issue from the SPV at

face value and then call an auction and announce the targeted amount and the

rentals that the SPV has agreed to pay. Islamic banks could quote any price above

or below par. The Central Bank would determine its cut-off rate and sell the

securities accordingly. Once auctioned, the secondary market trading can take

place at any price.

The Shariah conditions to be fulfilled in this regard are that Ijarah securities will

represent the pro rata ownership in the real leased assets and the certificate holders

should get return according to performance of the asset, i.e. rental received.

Following are the salient features ofIjarah sukuk:

It is necessary for an Ijarah contract that the assets being leased and the

amount of rent both are clearly known to the parties at the time of the contract

and if both of these are known, Ijarah can be contracted on an asset or a

building that is yet to be constructed, as long as it is fully described in the

contract provided that the lessor should normally be able to acquire, construct

or buy the asset being leased by the time set for its delivery to the lessee

(AAOIFI, 2003: 140-157). The lessor can sell the leased asset provided itdoes not hinder the lessee to take benefit from the asset. The new owner

would be entitled to receive the rentals

Rental in Ijarah must be stipulated in clear terms for the firs term of lease, and

for future renewable terms, it could be constant, increasing or decreasing by

benchmarking or relating it to any well-known variable

As per Shariah rules, expenses related to the corpus or basic characteristics

of the assets are the responsibility of the owner, while maintenance expenses

related to its operation are to be borne by the lessee

For issuance of Ijarahsukuk, an SPV is created to purchase the asset(s) that

issues sukukto the investor, enabling it to make payment for purchasing the


28/45




asset. The asset is then leased to third party for its use. The lessee makes

periodic rental payments t the SPV that in turn distributes the same to the

sukukholders

Ijara sukukare negotiable and can be traded in the secondary markets

Ijara sukuk offer a high degree of flexibility from the point of view of their

issuance management and marketability. The central government,

municipalities, waqaf (trust) or any other asset users, private or public can

issue these sukuk. Additionally, they can be issued by financial intermediaries

or directly by users of the leased assets.

Steps involved in the structure

The obligator sells certain assets to the SPV at an agreed pre-determined

purchase price

The SPV raises financing by issuing sukukcertificates in an amount equal to

the purchase price

This is passed on to the obligator (as seller)

A lease agreement is signed between SPV and the obligator for a fixed period

of time, where the obligator leases back the assets as lessee

SPV receives periodic rentals from the obligator

These are distributed among the investors i.e. the sukukholders

At maturity, or on a dissolution event, the SPV sells the assets back to the

seller at a predetermined value. That value should be equal to any amounts

still owed under the terms of the ijarasukuk


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Ijarah SukukStructure

Ijarah/Murahaba Sukuk (Hybrid mixed asset sukuk)

As Murabaha contracts cannot be traded on secondary markets as securitised

instruments at least 51 percent of the pool in a hybrid Sukukmust comprise ofsukuk

tradable in the market such as an ijara sukuk. Due to the fact the murabaha

receivables are part of the pool, the return on these certificates can only be a pre-

determined fixed rate of return.

An ijara/murabaha sukukis suitable for acquiring finance, equipment, working capital

financing, etc. Using sukuk/certificates, a special purpose vehicle company (SPV)

acquires Ijara assets from an issuing entity, or obligor, for approximately 60% of the

sukukprincipal.

Using the remaining funds, approximately 40%, the SPV enters into a murabaha

agreement with the obligor and buys assets, such as real estate, equipment,

2) CashIslamicIssuer

IslamicInvestors

S.P.V

6) Buys Back theAssets at Maturity

5) Rental Payments /Coupons

2 Bis) Certificates ofParticipation (IjarahSukuk)

7) Reimbursement of100% of the IssuePrice at Maturity

Direct Recourse

3) Lease Agreement

4) Rental Payments

1) Sells the Assets


30/45




machinery and/or Shariah-compliant equities. The SPV then sells the murabaha

assets to the obligor at a profit.

The SPV leases the ijara assets to the obligor for a period equal to the maturity of

the sukukat agreed periodic rentals.

The obligor will issue a waad to buy the ijara assets from the SPV at an agreed

price, upon default and/or maturity. Likewise, the sukuk/certificate holders can sell

the assets back and receive 60% of the principal.

Upon an accelerated murabaha principal+ profit payment from the obligor, the

sukuk/certificate holders receive the remaining sukuk principal and any accrued

coupon.

Salam Sukuk(deferred commodity delivery)

Salam is a short-term agreement in which a financial institution makes full

prepayments for future delivery of a specified quantity of goods on a specified date.

A salam is primarily a deferred delivery sale contract usually used for commodity

finance. It is similar to a forward contract where delivery is in the future in exchange

for spot payment. To mitigate the asset risk, a financier can enter into a parallel

salam with another party.

The main concept ofsalam sukukrefers to a sale, whereby the seller undertakes to

supply a specific commodity to the buyer at a future date in return for an advanced

price paid in full on the spot (the salam price normally being lower than the prevailing

spot price). The price is in cash but the supply of the purchased good is deferred. As

a form of financing, the purchaser is able to acquire the assets by advance payment

at a discounted price and subsequently sells the assets upon delivery. Salam sukuk

represents a type of a forward contract which is forbidden underShariah law unless

there are strict conditions attached that aims at the eliminate uncertainty. The Salam

sukuk is differ from istisnaa sukuk in that, the purchase price for the assets under

salam sukukmust paid in full and the date of delivery must be fixed.


31/45




The issuer of salam sukuk certificates is a seller of the goods of Salam, the

subscribers are the buyers of the goods, while the funds realized from subscription

are the purchase price (Salam capital) of the goods. The holders of salam

certificates are the owners of the salam goods and are entitled to the sale price of

the certificates or the sale price of the salam goods sold through aparallelsalam, if

any.

Salam-based securities may be created and sold by an SPV through which the funds

mobilised from investors are paid as an advance to the company SPV in return for a

promise to deliver a commodity at a future date. SPV can also appoint an agent to

market the promised quantity at the time of delivery perhaps at a higher price. The

difference between the purchase price and the sale price is the profit to the SPV and

hence to the holders of the sukuk.

All standard Shariah requirements that apply to salam also apply to salam sukuk,

such as, full payment by the buyer at the time of effecting the sale, standardized

nature of underlying asset, clear enumeration of quantity, quality, date and place of

delivery of the asset and the like.

One of the Shariah conditions relating to salam, as well as for creation of salamsukuk, is the requirement that the purchased goods are not re-sold before actual

possession at maturity. Such transactions amount to selling of debt. This constraint

renders the salam instrument illiquid and hence somewhat less attractive to

investors. Thus, an investor will buy a salam certificate if the investor expects prices

of the underlying commodity to be higher on the maturity date.

There has been some debate amongst Shariah scholars about whether it is

legitimate to exchange the rights to commodities sold on a salam basis prior to

delivery or, in other words, to trade salam certificates. lbn Taimiyah (12631328).

the distinguished Muslim scholar ruled that such exchanges are permissible as long

as when the certificates were sold to the seller it was not for a price higher than that

agreed originally, as this might be seen as exploitation.Sales to third parties could

be at any price that such buyers are willing to pay. The Maliki School of Islamic


32/45




jurisprudence stipulated that salam contracts relating to foodstuffs should not be

traded, as this could be interpreted as speculating on necessities. Sami Homoud,

(one of the pioneers of Islamic banking in the Arab world, and a Jordanian national)

states that it is not permissible to resell the commodity covered by a salam contract

before receiving it. But this does not preclude the recipient from reselling the

commodity by another contract parallel to the first one.The aim of such a parallel or

back-to-back salam contract is to ensure that the financier, usually a bank, is not left

with a commodity that it has no expertise in trading. However, creating salam

certificates could also be viewed as a way out of this dilemma for a bank.

The Bahrain Monetary Agency (BMA) has developed salam based securities to be

used by Islamic banks for liquidity management. Aluminum has been designated as

the underlying asset for the salam contracts. The Bahrain government sells

aluminum to the buyer. The Bahrain Islamic Bank purchases the aluminum. It has

also been nominated to represent the other banks wishing to participate in the salam

contract. As consideration for advance payment, the Bahrain government

undertakes to supply a specified amount of aluminum at a future date. At the same

time, the buyer appoints the Government as an agent to market the appropriate

quantity at the time of delivery through its channels of distribution at a price which

provides a return to security holders.

Steps involved in the transaction:

SPV signs an undertaking with an obligator to source both commodities and

buyers. The obligator contracts to buy, on behalf of the end-sukukholders, the

commodity and then to sell it for the profit of the sukukholders

Salam certificates are issued to investors and SPV receives sukukproceeds

The salam proceeds are passed onto the obligator who sells commodity on

forward basis

SPV receives the commodities from the obligator


33/45




Obligator, on behalf ofsukukholders, sells the commodities for a profit

Sukukholders receive the commodity sale proceeds

Salam Sukuk Structure

IstisnaaSukuk(manufacturing or project finance)

Istisnaa is a contract for acquisition of goods or assets by specification or order

where the price is paid progressively in accordance with the progress of a work to be

undertaken. An example would be for the purchase of a house to be constructed,

payments are made to the developer or builder according to the stage of work

completed. Istisnaa type of sukuk is used for the advance funding of real estatedevelopment, major industrial or infra-structure projects or large items of equipment

such as: turbines, power plants, ships or aircraft (construction/manufacturing

financing). Originally, istisnaa was seen as an appropriate way of financing

S.P.V

(Issuer)

4) Undertaking agreement(instantly executed)

3) at maturity, Delivery ofthe goods (Sukuk alsalam)

IslamicUltimate

Borrower

Islamic

Investors

Off-Takers

(recipient of the end-product of a project)

1) Cash

1 Bis) Certificates of Participation(Sukuk al salam)

5) Payment of price +Margin

2) Payment against futuredelivery of the Assets


34/45




manufacturing as goods have to be produced and costs incurred before they are

sold.

Istisnaa sukuk certificates carry equal value and are issued with the aim of

mobilising the funds required for producing products that are owned by the certificate

holders. The issuer of these certificates is the manufacturer (supplier/seller), the

subscribers are the buyers of the intended product, while the funds realised from

subscription are the cost of the product. The certificate holders own the product and

are entitled to the sale price of the certificates or the sale price of the product sold on

the basis of a parallel istisnaa, if any. The suitability of istisnaa for financial

intermediation is based on the permissibility for the contractor in istisnaa to enter

into a parallel istisnaa contract with a subcontractor. Thus, a financial institution may

undertake the construction of a facility for a deferred price, and sub-contract the

actual construction to a specialised firm. Shariah prohibits the sale of these debt

certificates to a third party at any price other than their face value for which reason

such certificates cannot be traded in the secondary market. This also applies in the

case ofmurabaha certificates.

To use istisnaa, the public authority or private company commissioning the project

provides details of the specifications and timing for the delivery of the completed

parts. The deferred price certificates representing debt obligations may be used to

purchase goods or services whose price is equal to the face value of the certificate.

The purchase price of the goods may be less than the deferred price as this rep-

resents a trading transaction. Permission to transfer the debt contract from the

financier to a supplier of goods and services must be sought from the original debtor,

the public authority or private company commissioning the project.

The Islamic bank funding the manufacturer or the contractor during the construction

of the asset, acquires title to that asset and up on completion either immediately

passes title to the developer on agreed deferred payment terms or, possibly, leases

the asset to the developer under an Ijarah sukuk. However, it should be noted that, if

the sukukare listed during the istisnaa period, the sukukshould be traded only at


35/45




par as the underlying assets does not exists yet. (Debt cannot be traded according to

Shariah).

Steps involved in the structure

SPV issues sukukcertificates to raise funds for the project

Sukuk issue proceeds are used to pay the contractor/builder to build and

deliver the future project

Title to assets is transferred to the SPV

Completed property/project is leased or sold to the end buyer.

The end buyer pays monthly instalments to the SPV

The returns are distributed among the sukukholders.

Istisnaa SukukStructure

SPV

Sukukholders

Contractor

(1) Sukuk proceed

(2) Sell Asset to SPV

(3) Payments madeby SPV

(4a) Transfer title toassets

(4b) Pay Monthlyinstalments to SPV

End buyer

(5) SPV pays coupon to investors


36/45




Ownership of usufructs or financial benefits

Both current and future purchases of financial benefits are permitted under AAOIFI

rules. However, there must be a clear acquisition of financial benefits and risks, and

not merely the benefits in order to comply with Islamic rules. Favourable Shari ah

rulings in this area have permitted the acquisition of benefits and risks related to an

asset that will become available in the future: purchase and sale of services and

reselling of the same are permitted by the AAOIFI rules and this has the ultimate

logical extension to the acquisition of certificates in investment agents.

The identification and assembly of existing, definable, measurable and valuable

assets is an initial necessity for the issuance of the Ijarah. Such assets may be

tangible fixed assets. These assets may be securitised individually - as in the case of

the Qatar and some of the Bahrain sovereign sukuk issuances in which a single

parcel of land or a unitary operating property such as a hospital represents the

underlying security - or as a pool of assets such as equipment subject to lease in the

Guthrie corporate issuance (Malaysia). Multiple parcels of land in the case of the

Malaysian sovereign issuance, or multiple asset and contract classes as in the case

of the Islamic Development Bank (IDB) multi-state agency issuance.

Islamic Development Bank - The IDB issue

The IDB issuance was the first sukuk issuance to represent a diverse universe of

securities in the form of different Islamically structured finance. The issue brought to

the market a blended pool assets comprising Ijarah sukuk, murabaha receivables

and istisnaa sukuk. These sukuk represented assets domiciled in multiple

jurisdictions throughout the IDBs member countries. On the one hand, the IDB

issuance was a model relating to the possibility of securitising a dynamic balancesheet comprising different asset classes. The Shariah consent underlying the issue

was in line with the principle of negotiability of instruments relating to mixed funds

provided that such funds comprise a majority of tangible assets (more than 51% - a

ratio that must be maintained) and/or financial rights based on tangible assets such

as Ijarahsukukas opposed to debt claims such as murabaha receivables. Given the


37/45




general Shariah rejection of trading receivables, this rule thus validated the inclusion

of the murabaha receivables in the asset pool.

Risks Underlying SukukStructure and Issuance

Sukuk are exposed to different types of risks. The most important are the market

risk, operations risk and Shariah compliance risk.

Market Risk

Market risk is defined as the risk on instruments traded in well-defined markets

(Heffernan, 2003). Two categories of market risks are identified: general (systematic)

and firm specific (idiosyncratic). Systematic risks can arise due to governmental and

economic policy shifts whereas idiosyncratic risk arises because different firm

specific instruments are priced out of correlation with other firms instruments. Market

risk is composed of interest rate risks, foreign exchange risks, equity price risks and

commodity risks.

Interest Rate Risk (rate of return risk)

Sukuk certificates are exposed indirectly to interest rate fluctuations through the

widespread benchmarking with LIBOR in their financing operations. Consequently,

the nature of these assets is that they are exposed to fluctuations in the LIBOR rate

or even the market rates. For example, the mark-up is a defining characteristic of the

murabahah contract that is currently the most popular Islamic financial instrument on

the asset side of the balance sheet. Every contract benchmarked with LIBOR inherits

the possibility that in the future the LIBOR rates will rise and that the issuer, on the

asset side, will not have made as much profit as future market conditions might

dictate. Interlinked is the liabilities side of the issuers balance sheet that has

provisions for adjusting to market conditions. The sukukissuers will have to respond

to fluctuations in LIBOR because any increase in earnings will have to be mutual

with the investors. However, on the asset side, the re-pricing ofmurabaha contracts

is not possible as debts are non-tradable. Therefore, murabaha contracts expose the

issuer as well as the buyer of the issue to a considerable interest rate risk, albeit


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indirectly. Some of the sukuk issuances, such as the 1DB trust certificates, have an

underlying portfolio of assets that include murabaha receivables, rendering the whole

issuance indirectly exposed to an interest rate risk.

Foreign Exchange Rate Risks

Currency risk arises from unfavourable foreign exchange rate fluctuations which will

have an effect on foreign exchange positions. In the event of a divergence between

the unit of currency in which the assets in the sukukpool are denominated, and the

currency of denomination in which the sukuk funds are accumulated, the sukuk

investors are rendered to an exchange risk.

Operational Risks

There are numerous other risks specific to the operation of the sukuk. These risks

mirror those existent in conventional bond markets and are operational in the sense

that they are inherent to the structure of the issuances rather than the underlying

Islamic principles.

Default Risk: Default risk refers to credit risk that involves the probability that an

asset or loan becomes irrecoverable due to a default or delay in settlements. If the

relationship involves a contractual arrangement than the counterparty risk is the

probability that the counterparty retracts on the conditions of the contract. The

consequences can be severe with a decline in the value of a banks assets. The

credit and counterparty risks inherent in Islamic finance are unique owing to the

nature of Islamic financial instruments that become the foundation of the sukukasset

pools. Unlike conventional financial institutions, Islamic banks do not have access to

derivative instruments and other credit risk management mechanisms due to

Shariah considerations.

Each prospectus has provisions for the termination of the certificate in the event of a

default by the obligor. In case the obligor fails to pay the rentals on the Ijarah

agreements that form the coupon payments, the certificate holder can exercise the

right to nullify the contract and force the obligor to buy back the assets. In the event


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that the obligor fails to reimburse the principal amount the certificate holder can

exercise the right to take legal action and force the obligor to enter into debt

rescheduling proceedings. Salam contracts are exposed to the risk that commodities

will not be supplied on time or to the agreed quantity. Istisna contracts involve

performance risk. The client of the bank may default on the conditions of the contract

and the sub-contractor may fail to render the necessary services.

Coupon Payment Risk: The obligor may fail to pay the required coupons on time.

Any delayed coupons will be subject to a specified payment amount that will be

accumulated with the SPV. However, these accumulated funds are recommended by

Shari ah councils to be donated for charitable purposes.

Asset Redemption Risk: The originator has to buy back the underlying assets from

the certificate holder. The principal amount paid may not be equal to the sukukissue

amount and, as a result, there is the risk that the assets may not be fully redeemed.

SPV Specific Risks: The Special Purpose vehicle is generally designated to be a

standalone institute that is bankruptcy remote from the originator. However, there

may be a notion of settlement risk involved with the SPV in that the originator will

have to channel the payments through a clearinghouse. The certificate holders willthen be reimbursed through the clearing house.

Investor Specific Risks: The certificate holder is rendered to several risks pertinent

to sukuk structures. These are primarily regarding liquidity issues. The sukuk

structures, as welcome as they are in dealing with liquidity management issues in

Islamic finance, are exposed to a liquidity risk because there currently does not exist

a well structured and sufficiently liquid secondary market. The certificates are listed

on several local markets but this alone does not signify their liquidity. The sukuk

certificates are medium to long term in maturity and their continued success will

largely depend on their ability to evolve into highly liquid means of fund investment

with adequate risk management mechanisms. As is the currently the case, most of

the certificates tend to be held until maturity.


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Risks Related to the Asset: The underlying assets of the sukuk certificates are

subject to numerous risks as well. Primarily, there is the risk of loss of the assets.

These are minimal with regards to Ijarah assets of land parcels. However, in the

case of equipment and large scale construction typifying some of the underlying 1DB

assets the risk of loss may not be so negligible. Nevertheless, Islamic finance has

Shariah compliant provisions for insurance claims in the form of Takafuland these

arrangements will have to be utilised to mitigate the risks of asset losses. Related to

the asset risk as well is the need to maintain the structures of the assets. Proper

maintenance will ensure adequate returns to the certificate holder. According to

Shariah principles, the SPV will usually be required to bear the responsibilities on

ensuring asset structure maintenance.

Shariah Compliance Risks

Shari ah compliance risk refers to the loss of asset value as a result of the issuers

breach of its fiduciary responsibilities with respect to compliance with the Shari ah.

There could be several such instances of willful or innocent breaches. The

dissolution clauses of the sukukprospectus define events that will make the sukuk

deed null and void due to Shari ah non-compliance.

Islamic finance is an economic paradigm reflecting the essence of a faith that is a

way of life for Muslims. The pressure to maintain the nature of Islamic financing in a

Shariah compliant manner, therefore, remains powerful. The sukukstructures must

not only reflect this but also preserve competitiveness. Often it is the case that a fine

balance is struck between Shariah conformity and project feasibility considerations

to the extent that jurists and Shari ah consultants play a continuously integral role in

the formulation of the sukukprospectuses.

SukukRating

Similar to the conventional securities, sukuk can be rated on a sovereign and

corporate basis. The rating analyst or the rating agency will mainly focus on the

credit rating of the instrument and any expected default or losses, the agency will

give high priority to the legal, the structure and the underlying assets of the sukuk.


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The rating agency will take the sukukassets in account only if the assets in place,

otherwise, the rating will be based on the borrower portfolio.

SukukSecondary Market

Sukuksecurities tend to be bought and held and, as a result, little of the securities

enter the secondary market (allowing them to be traded). Furthermore, only public

sukukare able to enter this market, as they are listed on stock exchanges.

The sustenance of any primary market depends heavily on the development of a

sustainable and robust secondary market. Islamic savers and investors, like

conventional ones, portray varying risk preferences and a secondary market shouldbe developed to reflect this. Sukuk certificates are unique in that the investor

becomes asset holder and is directly tied in to the nature and functioning of the

underlying asset pools. Sukukcertificate holders carry the burden of these unique

risks.

An important consideration to make with regards to Islamic secondary markets is the

Shari ah applicability of the trading involved in the exchanges. It is considered that

the central bank or the security commissioner will have a pivotal role in mediating the

interactions between the brokers and traders to lend adequate support and

supervision to facilitate the functioning of markets. The optimal structure of an

Islamic secondary market would be a dealer market where several groups of

individuals will liquidate substantial proportions of assets into tradable securities. The

Central Banks role in such an arrangement would be to allocate adequate funds and

supervision so as t

iibi pgd module 4 lesson 4

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