Islamic Finance and Capital Markets: Sukuk Structure and Trading. Power point and Assessments

Transcription

1 Islamic Finance and Capital Markets: Sukuk Structure and Trading Power point and Assessments

2 Copy Rights Notice Islamic research and Training Institute 2016 All rights reserved. All parts of this work are subject to sole ownership of Islamic research and Training Institute (hereinafter referred to as Copyright Holder ) and remains exclusive property of the Copyright Holder. No part of this work may be copied, reproduced, adapted, distributed, modified or used in any other manner or media without prior written authorization of the Copyright Holder. Any unauthorized use of this work shall amount to copyright infringement and may give rise to civil and criminal liability. Enquiries and communications concerning authorization of usage may be made to the following: Islamic Research and Training Institute Member of the Islamic Development Bank Group P.O.Box Jeddah Kingdom of Saudi Arabia irti@isdb.org Disclaimer The content of these course have been developed solely for educational and training purposes. They are meant to reflect the state of knowledge in the area they cover. The content does reflect the opinion of the Islamic Development Bank Group (IDBG) nor the Islamic Research and Training Institute (IRTI). Acknowledgement This textbook was developed as part of the IRTI e-learning Program (2010), which was established and managed by Dr. Ahmed Iskanderani and Dr. Khalifa M. Ali.

3 Islamic Financial and Capital Markets Khalifa M Ali Hassanain Table of Contents Chapter Chapter Introduction... 7 Learning Objectives... 7 Key Innovative Activities Shaping Financial Markets... 7 Financial Engineering in the Islamic Financial System... 8 Derivatives and the Islamic Financial Markets... 8 Historical Financial Innovation in Islamic Finance... 8 Scope of Financial Engineering in Islamic Finance... 9 Approaches for Financial Innovation in Islamic Finance Challenges to Innovation in Islamic Markets Chapter Summary Key Terms Chapter Chapter Introduction Learning Objectives Sukuk as a Sharī ah-compliant Instrument Framework for an Islamic Capital Market Securitisation and Sukuk More about Sukuk Advantages and Pricing of Sukuk Parties in a Sukuk Issue Chapter Summary Key Terms Chapter Chapter Introduction Learning Objectives... 24

4 Classes of Securitised Papers The SPV Risk, Contract and Cash Flow Analysis Types of Permissible Sukuk Controversial Sukuk Ijarah Contracts in Sukuk Chapter Summary Key Terms Chapter Chapter Introduction Learning Objectives Muqaradah or Mudarabah Sukuk Musharakah Sukuk Basics of Ijarah Sukuk Structuring the Ijarah Sukuk Types of Ijarah Sukuk Aspects of Ownership, Rent and Expenses Issuance and Trading of Ijarah Sukuk Basics of Salam Sukuk Ownership and Trade in Salam Sukuk Istisna a Sukuk Trade of Istisna a Sukuk Murabaha Sukuk Use of Murabaha Sukuk Mixed Sukuk Chapter Summary Key Terms... 44

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7 Chapter Introduction Innovations in Islamic Markets. Features of the global financial market: It is efficient and sophisticated. It is driven by financial engineering and innovation. Financial markets have been evolving since the 1980s due to: Breakdown of exchange rate mechanisms Volatility of markets Requirement of liquidity Requirement for range of products Financial deregulation Breakthroughs in information processing and communication technology Advancements in financial theory Learning Objectives At the end of this chapter, you will be able to: Describe the three key financially innovative activities that shape markets. Explain the criticality of financial engineering to the Islamic financial system. Explain the consequences of the lack of derivative instruments in an Islamic financial system. Describe how historically Islam has facilitated financial innovation. Explain the three aspects to be considered for financial innovation in Islamic systems. Describe the two approaches that can be used for financial innovation in Islamic financial systems. Describe the innovation of a synthetic currency forward contract. Key Innovative Activities Shaping Financial Markets Financial engineering includes: Designing new and innovative solutions. Developing these solutions into a new product, service or process. Reducing funding costs and increasing returns on investments and opportunities for risk sharing. Activities in financial engineering that shape markets: Marketability, negotiability and transferability of financial claims Development of derivatives market Generation of revenues from credit and equity Benefits of financial engineering:

8 Market experiments continually. Market makes variations to instruments. It helps improve efficiency and balance costs and returns. Financial Engineering in the Islamic Financial System Financial engineering is critical to: Development of Islamic markets Risk management in Islamic markets Financial engineering is important because: Islamic markets follow traditional practices. Markets are unable to address modern requirements for liquidity, risk and portfolio management. Islamic markets primarily offer short-term options. There is a shortage of medium- and long-term options. The lack of secondary market has affected liquidity. Investors are unable to expand portfolios. The challenge is to give investors more options at the lowest cost. Derivatives and the Islamic Financial Markets Modern financial markets depend on derivatives markets because derivatives: Allow investors, corporations and countries to hedge themselves against financial risks. Provide information about expected market-clearing prices, future demand and supply. Provide transactional efficiency. Impact of absence of derivatives in Islamic markets: A company may lose its competitive edge. A company without active risk management will be perceived as high-risk. The company will face financial distress. The company will be more vulnerable during a financial crisis. Islamic financial institutions will find it difficult to integrate with global system. Historical Financial Innovation in Islamic Finance Financial engineering is the restructuring of: Returns Price risk Credit risk Country risk Most modern markets have complex instruments that are built on a basic set of instruments. Islamic markets are built upon the same basic structures, but without the complexity required for markets today. Financial engineering must develop modern complex instruments that are also Sharī ahcompliant.

9 The challenge: Financial engineering requires a thorough knowledge of Islamic legal system and economics, finance and banking. Islamic nations have a long history of working in accordance with the Sharī ah. Economics and commerce in Muslim countries have developed based on rulings and precedents set by Sharī ah experts in accordance with the Sharī ah. The practice of interpreting and applying Sharī ah through the Ijtihad must be revived. Scope of Financial Engineering in Islamic Finance In Islamic markets, legitimacy of a product or service, with respect to the Sharī ah, is critical. Every new product, service or instrument must be approved by Sharī ah scholars. Only products that have no element prohibited by Sharī ah will be granted approval. Key issues that help understand the extent to which financial engineering can be developed are: Freedom of contract that economic agents have Building blocks of the Islamic financial system Risk/return profile of the instruments Freedom of Contract Islam does not forbid any contracts. Sharī ah prohibits: Riba Gharar Qimar Ikrah Traditionally, economic agents drawing up contracts would show them to Sharī ah scholars to study their legitimacy. Agents have the power to enter any kind of contract, provided they stay within the Sharī ah s boundaries. Financial instruments and services must be seen as sets of contracts specifying rights and duties of each party. Sharī ah scholars verify if the rights and duties are in accordance with the Sharī ah. Basic Building Blocks It is necessary to understand the basic structures of a market. It becomes easy to build on top of these building blocks. The main building blocks of Islamic markets are similar to the conventional financial market. But Islamic financial system and modes of finance should be designed to be Sharī ah-compliant and to adhere to the Maqasid Al-Sharī ah. However, practices by some financial institutions may cause a deviation from these principles. This uniqueness must be understood while building complex structures that are also Sharī ah-compliant. Risk/Return Profile

10 There is an assumption that Islamic finance is equity-driven. Non-equity contracts used in Islamic markets are: Trade financing Leasing and sales Non-equity contracts accepted by the Sharī ah are: Murabahah Ijarah Salaam Approaches for Financial Innovation in Islamic Finance Approaches to financial engineering: Reverse engineering Innovative engineering Reverse Engineering Features of reverse engineering: Analysing existing market structures. Finding their closest substitutes in the Islamic market. Using the basic structures to rebuild them within the boundaries of the Sharī ah. Major benefit: Easy introduction and merger with conventional structures, particularly in markets outside. The challenge: The substitutes can be closely related to the original, but not completely Sharī ahcompliant. Contamination occurs due to misuse of instrument. Innovative Engineering Features of innovative engineering: Identification of a menu of Islamic instruments Designing new instruments from that menu Giving the new instrumentation a unique risk/return profile and easy applicability The benefit: Ready for Sharī ah-compliance. The challenge: Needs long-term commitment and time to evolve.

11 The problem: Innovative engineering requires an Islamic financial system. Most Islamic nations lack stable economy, supervisory or regulatory laws and Sharī ah-compliant property laws. Operational difficulties hamper innovative engineering. In the short term, reverse engineering will dominate. In the medium term, reverse and innovative engineering will co-exist. The long-term solution is to develop instruments with risk/return profiles. Challenges to Innovation in Islamic Markets Conventional markets have used financial engineering with good effect. It was easy for conventional markets because: They already had a variety of short- and long-term options. There were fixed income securities. There were easy entry and exit norms. The level of technology was fairly high. Islamic markets face a number of challenges. Theoretical Foundation Conventional markets have a strong theoretical foundation. Capital structure, portfolio diversification and options pricing are well developed. It is easy to build complex structures over and above that. Islamic markets have no theoretical foundation. Asset and risk pricing and derivatives are not well established. Islamic markets must work on building a theoretical base. For this, they must resort to cross-training. Sharī ah scholars must be trained in banking and finance. Bankers and economists must be trained in the Sharī ah. Investment in Infrastructure Financial engineering requires established cells to conduct: Market research Product research Analytical modelling Conventional institutions have a mechanism to collect market information, Islamic institutions don t. They are usually too small and lack the necessary funds and human resources. Islamic institutions must come together to collectively pool resources and conduct research. This will help reduce costs and create a research base. IRTI s Pathbreaking Initiative

12 Multi-year project titled Products and Financial Instruments in Islamic Fiqh Extensively examine original Fiqh sources and develop new products for the modern Islamic financial markets Collaboration and Cooperation IFIs and western institutions can collaborate for developing new instruments. Western institutions have the benefit of resources and technology. They can together develop products with varying risk/return profiles. Western institutions can design products and IFIs can market them. IFIs can acquire the sophistication of Western institutions while being Sharī ah-compliant. Costs of development will be low for IFIs. Standardisation and Exception Aim of financial engineering is to standardise contracts and practices. Sharī ah scholars and bankers must work towards standardising contracts, practices, accounting norms, supervisory practices. The practice of invoking Dharoora, the rule of necessity, when products do not comply with the Sharī ah, must be supervised and any misuse checked. Chapter Summary You have completed the chapter, Innovations in Islamic Markets. The key points of this chapter are as follows: Financial markets are driven by financial engineering and innovation. The trend began in the 1980s due to: A breakdown of exchange rate mechanisms Volatility of markets Requirement of liquidity Requirement for a range of products Financial deregulation Information processing Communication technology Financial engineering means designing new products, services and processes to: Reduce costs Increase returns Increase opportunities Financial engineering impacts: Tradability and negotiability Development of derivatives market Generation of revenues from credit and equity.

13 Islamic markets lack medium and long term options. The need of the market is derivatives. They are necessary for the Islamic market to integrate with global markets. Financial engineering is a restructuring of: Returns Price risk Credit risk Country risk Key issues that help understand the extent to which financial engineering can be developed are: Freedom of contracts that agents have Basic building blocks of the market Risk/return profiles of instruments Islam forbids no contract. It allows agents freedom to enter contracts that do not violate Sharī ah. The main building blocks of Islamic markets and Western markets are similar, but Islamic modes of finance are envisaged to be Sharī ah -compliant and to achieve the Maqasid Al-Sharī ah. Islamic markets allow equity and non-equity-based instruments such as Murabahah, Ijarah and Salaam. These even offer interest-like fixed returns. Approaches to financial engineering: Reverse Engineering - involves analysis of existing market structures and rebuilding them into new Innovative engineering - involves identification of Islamic instruments from which new ones can be created Challenges to financial engineering before Islamic markets: The absence of a theoretical base The need to train Sharī ah experts in banking and bankers in Sharī ah The need for collaboration of IFIs and Western institutions to develop a knowledge base and standardise practices across markets IRTI s multi-year project called Products and Financial Instruments in Islamic Fiqh aims to extract new Islamic finance products from the original Fiqh sources, refine them and make applicable to modern finance and banking. Key Terms Dharoora Gharar Ijtihad

14 Ijarah Ikrah Istisna a Maisir or Qimar Murabahah Ribâ Sharī ah

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17 Chapter Introduction Securitisation in Islamic Finance. Islamic banking and finance has gained momentum particularly in the areas of Sukuk and securitisation. Shirkah-based instruments are in use since 1980s; Sukuk have been issued only since Since 2002, Sukuk issues by both corporate entities and sovereign nations have grown in value from a few hundred million dollars to several billion dollars. The underlying contracts include Ijarah, Mudarabah, Musharakah, Istisna a and a mix of some of these. Pioneering Example: The $400mn Islamic Development Bank- Solidarity Trust Services Sukuk issue in 2003 Estimates for Sukuk market size in 2015 (IRTI-IFSB Ten-Year Framework for Islamic Financial Services Development): 15% annual growth rate= $1.41 trillion 10% annual growth rate=$1.25 trillion Sukuk is preferred as an alternative source of funding for sovereigns and corporate bodies. Sukuk provides a substitute to conventional fixed income securities issued for funding large developmental and capital expenditures of big entities. Sukuk facilitates Islamic Financial Institutions (IFIs) and investors to successfully manage liquidity. Learning Objectives On completing this chapter, you will be able to: Describe Sukuk as a Sharī ah-compliant instrument in an Islamic financial structure. Describe the features of the capital market comprising debt, equity and Sukuk markets. Explain securitisation and Sukuk in Islamic finance. Distinguish between Sukuk and conventional securitisation. Describe the advantages and pricing of Sukuk. Describe the key players in various issues of Sukuk. Sukuk as a Sharī ah-compliant Instrument It was believed that only an equity market finances long-term projects in an Islamic finance framework. According to Sharī ah, debts can be sold only when their trading is subject to Hawalah. Emergence of Ijarah Sukuk and Sukuk implies that some features and benefits of a debt market are possible in an Islamic financial structure. A Sharī ah-compliant investment certificate should not represent interest-bearing debt as a dominant part of the underlying assets. As the Sukuk issued on the basis of Shirkah and Ijarah signify the ownership of assets by Sukuk holders, it can be traded in the secondary market at the price determined by the market forces. Sukuk can provide the facilities of a normal debt market. Alternatives of conventional bonds can be developed through securitisation of assets.

18 Instruments formed through securitisation of assets represent the proportionate ownership of the holders in the assets. Two types of return from Sukuk: Variable-return Sukuk (VRS) Fixed-return Sukuk (FRS) Framework for an Islamic Capital Market Key components of an Islamic capital market are: Sharī ah-compliant stocks. Islamic funds. Islamic investment certificates. Debt market involves Ribâ and Gharar and is not an active part of the Islamic financial market. In Hawalah, debts can only be assigned to others on a par value without transferring the risk of default. Stock market investment is subject to many conditions. The conditions for trading stocks are covered in detail in Chapter 2 of this course, Advanced Islamic Instruments and Markets. An Islamic capital market can be developed by: Issuing more Sukuk Introducing Islamic Depository Receipts (IDRs). Replacing debt financing Securitisation Fund management Sukuk signify the common undivided shares in the ownership of underlying assets. Sukuk holders share the return and bear the loss in proportion to their share in investment. Sharī ah-compliant Sukuk result in: Enhanced supply of risk-based capital with reduced risk. Balanced return rate structure based on economic activities backed by real assets. An IDR involves trading of stocks of Islamic companies in countries other than their origin. Importance of IDRs: Convergence of Islamic capital markets Alternative to cross-listing Provision of better regulatory environment Generation of funds for developing Muslim countries Standardisation of Sharī ah compliance across jurisdictions Growth of Islamic capital markets The originator of the underlying asset, an investor and the custodian bank engage in IDR. Advantages of IDRs for the originators: Facilitates the expansion of the investor base Enables low cost of funds in extremely liquid markets

19 Provides better securities by trading in more organized markets Advantages of IDRs for the investors: Provides diversification of portfolio in other markets Requires IFIs to have Sharī ah-compliant stocks Enables greater returns for IFIs Facilitates liquidity management for IFIs Securitisation and Sukuk Securitisation is a process of pooling/repackaging the non-marketable and illiquid assets into tradable certificates of investment. It changes the role of the originator from an accumulator to a distributor. In securitisation, ownership of the underlying assets is transferred to a large number of investors in the form of Sukuk. Sukuk is issued on the basis of assets booked by IFIs or by purchasing the assets with proceeds of a variety of Sukuk created as per Shirkah principle. The contractual rights of Sukuk reveal the mutual ownership and benefits of the securitised assets for individual Sukuk investors. Sukuk holders receive the revenue generated and capital appreciation of the assets. A Special Purpose Vehicle (SPV) or Special Purpose Mudarabah (SPM) manage assets on behalf of Sukuk holders and issue investment certificates. More about Sukuk According to Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), investment Sukuk is a certificate representing undivided shares in the ownership of tangible assets, usufruct and services or in the ownership of assets of the any particular projects or activity. A share implies the ownership of a company as a whole for an indefinite period. Sukuk represent specified assets and are issued for a certain period ranging from three months to ten years. Unlike bonds, Sukuk hold the returns based on the cash flow originating from the assets. Sukuk do not encourage Ribâ, Gharar and the activities prohibited by Sharī ah. Advantages and Pricing of Sukuk Securitisation involves: Evaluating, isolating and allocating specific risks. Assessing taxation, accounting and legal implications. Designing appropriate credit enhancement structures. Pricing the residual risk for pricing the units of securitized assets or pools. Benefits of securitisation for the investors: Offers premium over equivalent related plain securities Provides better stability than vanilla papers Associates focused risks with securities Allows portfolio diversification Enables customised cash flow structures Provides flexible range of maturities Offers skilled risk assessment

20 Benefits of securitisation for the originator: Offers incentives to develop a transparent fund approval process Encourages efficient collection procedures Provides a competent mechanism to control approval and collection process New form of securities: Assist the development of capital markets. Attract conservative buyers. Draw international capital. Facilitate efficient sharing of risks.

21 Securitised papers are traded at a premium above similar vanilla corporate papers. The premium depends on the following: Active secondary market Complexity of transaction Comfort level of investors Demand of investors Parties in a Sukuk Issue Key parties in Sukuk transactions: Originator of Sukuk: Sells the assets to SPV and uses the funds; usually IFIs, governments or corporations SPV or issuer: Purchases assets from the originator and issues Sukuk to fund the purchase price Investment bank: Manages and directs book-making services for Sukuk for a predetermined fee; usually operate as syndicates Subscribers of Sukuk: Buy securities issued by the SPV; central banks, IFIs and individuals are subscribers Key parties in general securitisation process: Obligor Lead manager Servicer Cash administrator Credit enhancement provider Credit rating agency Legal and tax counsel Auditor Custodian/ R&T agents Chapter Summary You have completed the chapter, Securitisation in Islamic Finance. The key points of this chapter are as follows: Sukuk is preferred as an alternative source of funding, especially for sovereigns and corporate bodies. IRTI-IFSB Ten-Year Framework for Islamic Financial Services Development estimates Sukuk market to be between $ 1.25 and $ 1.4 trillion by A Sharī ah-compliant investment certificate should not represent interest-bearing debt as a dominant part of the underlying assets. Key components of an Islamic capital market are Sharī ah-compliant stocks, Islamic funds and Islamic investment certificates. Debt market, which deals in debentures and bonds, usually involves Ribâ and Gharar and, hence, it cannot be a part of Islamic financial market. Stocks of the joint stock company are traded in equity market, which is also known as stock market.

22 IDR involves trading of stocks in countries other than their origin. Sharī ah-compliant stocks and other instruments are traded in IDRs. According to AAOIFI, investment Sukuk is a certificate representing undivided shares in the ownership of tangible assets, usufruct and services or in the ownership of assets of the any particular projects or activity. Securitisation is a process of pooling/repackaging the non-marketable and illiquid assets into tradable certificates of investment. Sukuk is similar to conventional securitisation. However, Sukuk does not encourage Ribâ, Gharar and the activities prohibited by Sharī ah. Key parties involved in Sukuk transactions are the originator of Sukuk, SPV, investment banks and subscribers of Sukuk. Sukuk in the form of new securities: Assist the development of capital markets. Attract conservative buyers. Draw international capital. Facilitate the efficient sharing of risks. Key Terms Hawalah Ijarah Ijarah Sukuk Mudarabah Mudarabah Sukuk Musharakah Musharakah Sukuk Murabahah Ribâ Salam or Bai al-salam Sharī ah Sukuk

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24 Chapter Introduction Structure of a Sukuk. Sukuk refers to an instrument in which the ownership of the underlying assets is transferred to a large number of investors. Major classes of securitised papers: Pool-based securitisation Future flow securitisation The lead bankers undertake minute risk analysis, contract analysis and cash flow analysis with respect to several aspects of an issue. In the Islamic world, Sukuk first became popular in the 1990s. However, the use of Bai al-dayn and Bai al-inah contracts in these were deemed to be against the Sharī ah principles. Since then, Sukuk have been widely accepted in Islamic financial markets around the world. Before we proceed, note that you can learn about various other aspects of Sukuk in various chapters of this course: Chapter 6: Securitisation in Islamic Finance Chapter 8: Categories of Sukuk Chapter 9: Tradability, Structures and Potential of Sukuk Learning Objectives On completing this chapter, you will be able to: Describe various classes of securitised papers in a Sukuk issue. Describe the characteristics of the Special Purpose Vehicle (SPV) in terms of managing securities issues. Explain the importance of performing risk, cash flow and contract analysis. Describe the types of investment certificates permitted by the AAOIFI. Explain the controversies that arose from the application of different concepts of Sukuk issues and trading in Sukuk. Describe the features of Ijarah contracts in Sukuk. Classes of Securitised Papers Let s look at the two types of securitised papers in a Sukuk issue. Pool-based Securitisation The following are the classes of Pool-based securitisation: Mortgage-backed securitisation Collateralised debt obligations (CDO)/Collateralised loan obligations (CLO) Lease rentals securitisation Future Flow Securitisation (FFS)

25 Future flow securitisation is the securitisation of receivables to be generated in future. Some of the asset classes include: Road toll securitisation Telecom receivable securitisation Credit card receivable securitisation The SPV Purpose of an SPV A Special Purpose Vehicle (SPV) is a separate legal entity that manages the securities issues. An SPV: Is efficient with regards to both capital usage and tax. Requires legal costs to establish and manage it. Characteristics of a typical SPV: Bankruptcy remoteness Thin capitalisation It is important to ensure that: The sale to the SPV is true. The asset is correctly separated from the first owner. When the ownership is transferred to the SPV, the discretion of the original owner ends. It cannot be reversed even if the original owner is declared insolvent. The legal structure of an SPV is based on its regulatory and legal environment. Payment Structure of an SPV Alternative payment structures adopted by SPV are: Pass-through structure Pay-through structure SPVs reinvest the funds and pay investors according to a predetermined schedule. SPVs also serve as conduits for multiple issuances. Risk, Contract and Cash Flow Analysis The lead bankers perform the following analyses on various aspects with respect to securitisation issues. Risk Analysis The lead bankers undertake minute analysis of: 1. Credit and bankruptcy risk

26 2. Performance risk 3. Asset/collateral risk 4. Payment risk 5. Return rate risk 6. Exchange rate risk 7. Liquidity risk 8. Risk of loss of money 9. Prepayment risk 10. Reinvestment risk in pay-through structures 11. Legal/ Regulatory/ Tax related risk Securitisation mitigates risks with respect to various factors and it differs from an originator s and an investor s perspective. The Sukuk holders or the issuers adopt some methods to manage and mitigate risks. They are as follows: 1. Create a Takaful fund with contributions from certificate holders. 2. Take a cover from Islamic Takaful companies and pay the contributions from the income or donations. 3. Keep aside a certain amount of profit to reduce the fluctuations of the distributable profit. Contract Analysis Contract analysis mainly focuses on the following with the purpose of knowing the ability to fulfill the rights and obligations: 1. Rights and obligations 2. Performance requirements 3. Termination 4. Events of default and consequences of defaults 5. Study of transaction documentation Cash Flow Analysis Cash flow analysis is performed to: Identify key variables and expected patterns of the underlying cash flows under various scenarios. Determine the rating of the issue. Types of Permissible Sukuk The AAOIFI, in its Sharī ah standard for Investment Sukuk, has put forth eight types of investment certificates or Sukuk. Most important Sukuk are:

27 Shirkah Ijarah Salam Istisna a. As per the basic rules of Sharī ah, On one side, investment Sukuk have to be structured according to Shirkah but can be designated as Ijarah Sukuk, Salam Sukuk and Istisna a Sukuk. On the other side, they must use participatory or fixed return modes/instruments. Rates of return on Sukuk will be: Variable Quasi-fixed However, any third party guarantee can make the Sukuk fixed-return certificates of investment. Controversial Sukuk Sukuk issues are based on the concept of Ijarah, whereas few are based on Shirkah, Salam or pooled assets. Sukuk issues are criticised due to the involvement of controversial contracts like Bai al- Inah, Bai al-dayn and other non-sharī ah compliant traits. Most jurists do not accept these although the debt represented by Sukuk is supported by the underlying assets. But some of the traditional Muslim jurists and contemporary Sharī ah scholars agree on the point that Bai al-dayn with discount is not allowed according to the Sharī ah. Some scholars have allowed this kind of sale based on the ruling of the Shafi e school. They do not consider the fact that the Shafi e jurists allowed it only in a case where a debt was sold at its par value. The OIC Islamic Fiqh Council of all Islamic countries approved the prohibition of Bai al Dayn. Bai al-dayn and Bai al-inah contracts are covered in detail in Chapter 8, Controversial Financing & Feebased Products, of the course, Islamic Financial System. Ijarah Contracts in Sukuk Sale and Lease-Back Technique The sale and lease-back technique involves the purchase of an asset from a party that can again be leased to the same party. The experts in Sharī ah principles allow its use. The sale and lease-back technique does not create any Sharī ah-related problem with respect to Sukuk issue on the basis of Ijarah. The use of sale and lease-back technique in case of consumer durables is not considered

28 desirable by many Sharī ah scholars and practitioners, except when the client wants to avoid interestbased financing and there is no other way out. View of Sharī ah Scholars on the Use of Sale and Lease-back Technique 1. Sufficient time should pass before the lessee repurchases the asset. 2. This period creates the chance of a change in the value and structure of the asset being sold and leased back. 3. The client should purchase back the asset at least one year after the sale to avoid an interest-based transaction. Concerns in Ijarah Sukuk Ijarah has a great flexibility and potential for Sukuk issue. Some of the aspects of Ijarah Sukuk that need to be considered before issuing are: Ijarah Sukuk issues are pointers to different Sharī ah-related problems. Sukuk holders have to jointly bear the risks of an asset s price and the ownership-related costs and share its rent by leasing it to any user. Returns could be quasi-fixed and not absolutely fixed or unmodified when pegged to any benchmark. The issue of Ijarah Sukuk carries systemic risk of non-sharī ah-compliance. Note however that Sukuk originating from Sudan, Bahrain and other Middle Eastern countries are based on Shirkah, Ijarah, Salam, Istisna a, Istisna a-cum-ijarah or a pool of mixed assets. These Sukuk issues are acceptable to almost all of the Islamic scholars and banking experts. Chapter Summary You have completed the chapter, Structure of a Sukuk. The key points of this chapter are as follows: Sukuk refers to an instrument in which the ownership of the underlying assets is transferred to a large number of investors. The major classes of securitised papers include pool-based securitisation and future flow securitisation. An SPV is a separate legal entity that manages the securities issues. An SPV is both capital and tax efficient. However, there are legal costs in establishing and managing an SPV. Some of the alternative payment structures are Pass-through and Pay-through structures. The lead bankers perform the following analysis on various aspects with respect to securitisation issues. The most important Sukuk or investment certificates with sizeable potential are Shirkah, Ijarah, Salam and Istisna a.

29 Thus, the rates of return on Sukuk will be either variable or quasi-fixed. Sukuk issues are based on the concept of Ijarah, where as few are based on Shirkah, Salam or pooled assets. Sukuk issues are criticised due to the involvement of controversial contracts like Bai al- Inah, Bai al- Dayn and other non-sharī ah compliant traits. The sale and lease-back technique involves the purchase of an asset from a party that can again be leased to the same party. The experts in Sharī ah principles allow its use. Key Terms Bai al -Inah Bai al-dayn Ijarah Ijarah Sukuk Istisna a Mudarabah Mudarabah Sukuk Musharakah Musharakah Sukuk Murabahah Ribâ Takaful Tabarru Salam or Bai al-salam Sharī ah Shirkah

30 Sukuk Chapter 8

31 Chapter Introduction Categories of Sukuk. Sukuk can be categorised into six types: Muqaradah or Mudarabah Sukuk Musharakah Sukuk Ijarah Sukuk Salam Sukuk Istisna a Sukuk Murabaha Sukuk Muqaradah or Mudarabah Sukuk Muqaradah or Mudarabah Sukuk are certificates that represent projects or activities managed on the basis of Mudarabah principle. The purpose of Muqaradah or Mudarabah Sukuk issue is to enhance public participation in investment activities in any economy. Musharakah Sukuk Musharakah Sukuk serve as the mode of security for projects involving huge amounts. As redeemable certificates, Musharakah Sukuk are issued for: Rehabilitation or employment. Purchase of automobiles for their commercial use. Establishment of high-standard clinics, hospitals, factories, trading centres, endowments, etc. Ijarah Sukuk Ijarah Sukuk or certificates serve as an evidence for the purchase of proportion of asset that a lessor wishes to recover the cost of purchase to get liquidity or for the purpose of profit even after executing the Ijarah contract. Salam Sukuk In a Salam Sukuk, an advance payment is made for goods that would be delivered in future. A Salam buyer can onward sell the Salam commodity using a parallel contract. The specifications of the two contracts and delivery dates may conform to each other. Istisna a Sukuk

32 Istisna a Sukuk is a contractual agreement for manufacturing goods, allowing advance payment for future delivery of goods or allowing future payment and future delivery of goods, as per the contract. Istisna a Sukuk helps finance the construction of: Houses Plant Bridges Roads Highways Murabaha Sukuk In a Murabaha Sukuk, the purchaser on credit signs a paper to document his indebtedness towards the seller. This paper signifies a debt receivable by the seller. The paper can be transferred to third party only at par value and the transfer should adhere to the rules of Hawalah. Note that various structural aspects of Sukuk are described in the following chapters of this course: Chapter 6, Securitisation in Islamic Finance Chapter 7: Structure of Sukuk Chapter 9: Tradability, Structure and Potential of Sukuk Learning Objectives On completing this chapter, you will be able to: Describe Muqaradah Sukuk as a mode of enhancing public participation in investment activities in any economy. Describe Musharakah Sukuk as a mode of facilitating proportionate ownership of assets used for big projects. Describe Ijarah Sukuk as a mode of mobilising funds for long-term infrastructure projects. Explain how Ijarah Sukuk can help solve liquidity management problems. Explain the five types of Sukuk that can be issued on the concept of Ijarah. Describe the structure and issues with regard to trading and potential of Salam Sukuk. Describe the level of ownership and trading in Salam Sukuk. Describe the features of Istiana a Sukuk and their development. Describe the rules of trading and conditions for selling Istisna a certificates in the market. Explain how Murabaha Sukuk can be used for the purchase and sale of assets in the market. Describe the salient features of mixed portfolio securities and the key benefits of issuing them. Muqaradah or Mudarabah Sukuk Nature of Muqaradah or Mudarabah Sukuk: Mudarabah Sukuk is issued by Mudarib. The subscribers are the owners of the capital.

33 Realised funds are the Mudarabah capital. Assets of Mudarabah are owned by the certificate holders. Profit or loss is shared by the owners of the capital. Salient Features of Muqaradah or Mudarabah Sukuk: In terms of the Resolution of the Islamic Fiqh Council of the OIC (fourth session, 1988), the following are the salient features of Mudarabah Sukuk (MS) or certificates: 1. MS represent common ownership and entitle their holders to a share. 2. The contract must provide all compatible information required by the Sharī ah for a Qirād contract. 3. The MS holder can transfer the ownership by selling the Sukuk in the securities market by following certain rules: If capital is in the form of money, trading of MS will be done by interchanging of money that satisfy the rules of Bai al-sarf. If capital is in the form of debt, trade must be based on the principles of debt trading in Islamic jurisprudence. If capital is in the form of a combination of cash, receivables, goods, real assets and benefits, trade must be based on the market price evolved by mutual consent. 4. The manager or Special Purpose Vehicle (SPV) can obtain profit by investing his own funds in addition to his share in the profit as Mudarib. 5. MS or prospectus should not contain a guarantee from the issuer or the manager of the fund. 6. Reserves for contingencies such as loss of capital can be created by deducting a certain percentage in each accounting period from the profit. 7. The prospectus can contain a promise made by a third party in terms of legal entity or financial status. Note: The third party should be totally unrelated to the parties involved in the contract. Islamic financial institutions can offer MS to the investors who would subscribe and participate in the investment transactions. Musharakah Sukuk Nature of Musharakah Sukuk: The Musharakah Sukuk are issued to every subscriber of the project. The Sukuk have equal value for mobilising funds to be used on the basis of partnership. The Sukuk holders are the owners of the relevant project or the asset. Similarity Between Musharakah and Mudarabah Sukuk: Basic Sharī ah rules apply to both Musharakah Sukuk and Mudarabah Sukuk apart from the fact that the intermediary party involved will be a partner of the Musharakah certificate holders. Secondary Market for Musharakah Sukuk: Musharakah can be treated as negotiable instruments. Musharakah/Mudarabah can be bought and sold in the secondary market provided the portfolio comprises non-liquid assets of more than 50%.

34 The combination of liquid and non-liquid assets can be sold and purchased for an amount greater than the amount of liquid assets in the pool. The profit is shared according to an agreed ratio, while the loss is shared on a pro rata basis. Uses of Musharakah Sukuk: Musharakah Sukuk are used to mobilise short-term deposits for the development of long-term projects or for investment in general financial activities or specific projects. The proceeds of the Sukuk can be used: To buy and lease certain equipment. For the construction of projects and factories. For the expansion of projects. For working capital finance. The Musharakah structure is considered more equitable and safer for the investors than the Mudarabah structure. Musharakah Sukuk holders will have added comfort and security due to the manager s participation in the Musharakah capital. Musharakah Sukuk Issues in Islamic Countries: On Musharakah basis, a number of assets of the following institutions have been identified for the purpose of securitisation in Sudan: Ministry of finance Bank of Sudan Bank of Khartoum Nilain Bank Other public entities Since 1998, central bank Musharakah certificates (CMCs) and government Musharakah certificates (GMCs) have been issued for investors. The CMCs are sold or bought by the central bank through auctions. Basics of Ijarah Sukuk The Concept of Ijarah: Mobilise funds for the development of long-term infrastructure projects. Offer Sukuk to a large number of institutional and individual investors. Create a secondary market instrument for financiers on the basis of Ijarah. Representation of Ijarah Sukuk for the Investor: Ownership of the pro rata undivided parts of the asset. Ownership of well-defined and known assets. Structuring the Ijarah Sukuk Securitisation of Ijarah Sukuk can:

35 Solve liquidity management problems. Finance the public sector needs. Note: Assets used by governments need not generate income. Ijarah funds can be raised by purchasing and leasing assets through Sukuk issues. Note: Mudarabah Sukuk can also be used to raise funds through services and leases apart from selling goods.

36 Rental Mechanisms in Ijarah Sukuk For first term of lease, rental must be specified in clear terms. For the future renewable terms, it could be constant, increasing or decreasing. Note: Mufti Muhammad Taqi Usmani (2000a) explains that even though benchmarking with any interest rate as reference is not desirable, it is permitted as long as all the Sharî ah requirements are satisfied. Types of Ijarah Sukuk The following types of Sukuk can be issued based on the concept of Ijarah: Sukuk of ownership in leased assets Sukuk of ownership of usufruct of assets Sukuk of Ownership in Leased Assets These certificates are issued for the leased asset or for the asset to be leased (by promise) either By the owner of the asset (or) By the owner s financial agent The subscribers are buyers of the asset. The certificate holders become owners of the asset. Sukuk of Ownership of Usufruct of Existing Assets These certificates are issued for the existing asset either: By the owner of usufruct of an existing asset (or) By his financial agent. The mobilised funds from subscription are the purchase price of the usufructs. The certificate holders become owners of the usufruct along with the risks and rewards. When the assets are sub-leased, the certificate will represent the rent receivables. The issuer is allowed to redeem the tangible assets either at the market price or as agreed upon at the time of purchase. Sukuk of Ownership of Usufructs to be Made Available in the Future These certificates are issued for the assets to be leased. The rental is recovered from the subscription income. The holders of the certificates are the owners of the usufruct of the future assets. The subscribers are the buyers of usufructs and will have both the risks and rewards. It is not valid to sublease or trade or made available the asset prior to identification. Sukuk of Ownership of Services of a Specified Supplier These certificates are issued: To provide or sell services through a specified supplier.

37 To obtain the value in the form of subscription income. The holders of the Sukuk become owners of the services. Sukuk of Ownership of Services to be Made Available in the Future These certificates are issued: To provide or sell services through a non-existing supplier. To obtain the value in the form of subscription income. The holders of the Sukuk become owners of the services. Aspects of Ownership, Rent and Expenses Clarity on Sharing of Expenses and Rent: The asset to be leased and the amount of rent should be known to the parties involved in an Ijarah contract. Ijarah Sukuk can be issued on an asset or a building that is yet to be constructed. Shared Ownership and Accrued Rent: Lessor can sell the leased asset. Lessor and lessee can dispose of their share in the asset to the new owner. Holder will assume the rights and obligations of the owner. Holder will have the right to enjoy part of the rent. Holder will suffer the loss due to destruction to the assets. Ijarah Sukuk should represent ownership for the both profit and loss. Sharing of Expenses and Rent: Capital and basic expenses of asset are the responsibility of the owner. Maintenance expenses are to be borne by the lessee. If the asset is destroyed without any fault or negligence of the lessee, the loss has to be borne by the Sukuk holders (lessor). The rental should consist of: Payment to the lessor. On account payment to be held by the lessee for any costs relating to the ownership of the asset. Issuance and Trading of Ijarah Sukuk Procedure for Issuing Ijarah Sukuk: Creation of an SPV to purchase and lease assets Roles of SPV:

38 Serves as a manager. Makes payment for purchasing the asset. Collects rental payments from lessee and distributes it among Sukuk holders. Rental Payment: The lessee makes periodic rental payments to the SPV as stipulated by the lessor in advance with the possibility of small variation. Trading in Secondary Market: After the transfer of ownership to the holders, Ijarah Sukuk can: Be negotiated and traded freely in the market. Serve as an instrument easily convertible into cash. Represent only real assets and not the monetary capital. The holders become owners of the assets and the issuer can: Redeem the Sukuk of ownership of leased assets. Trade the Sukuk of ownership of usufruct of ascertained assets. Tradeability of Sukuk is covered in greater detail in Chapter 9 of this course, Tradability, Structures and Potential of Sukuk. Basics of Salam Sukuk In a Salam contract, money is paid in advance for goods that would be delivered in future. According to AAOIFI Standard, a Salam buyer can onward sell the Salam commodity using a parallel contract. Specifications of the two contracts may conform to each other. Contracts should be independently enforceable. Salam Sukuk are certificates of equal value issued to raise funds equal to the price of the commodity, but paid in advance in the Salam contract. Salam Sukuk is: Issued by the seller of the Salam commodity. Subscribed to buyers who eventually become the owners of the commodity. In Parallel Salam, the holder of Salam Sukuk is entitled to the Salam commodity or the selling price of the commodity at the time of delivery. Usually, investment banks may act as arrangers, i.e. sell the right to take delivery of the commodity at a future date. Advantages of a Salam Contract The seller of Salam contract can enhance his cash flow in advance. The buyer has the advantage of lower Salam price.

39 In June 2001, the Bahrain Monetary Authority (BMA) developed Salam-based securities with LIBORrelated three-month tenures used for maintaining Statutory Liquidity Ratio (SLR) by Islamic banks. How the Contract Works 1. Bahrain government sells a specified amount of aluminium to Bahrain Islamic Bank (BIB) at a future date. 2. BIB appoints the government as its agent. 3. Agent promotes aluminium at the time of delivery at a price which provides returns to the security holders. Such short-term Sukuk can be developed based on the commodities being traded, like crude oil and cotton. Ownership and Trade in Salam Sukuk The secondary market trading of Salam Sukuk is prohibited because the Sukuk certificate represents a share in the Salam debt and speculators who are not interested in the final delivery may seek to profit from Parallel Salam transactions. This issue should be analysed when the original buyer resells the commodity purchased under Salam before taking possession. This problem becomes acute when the buyer maintains an inventory, forcing the bank to sell the items from their own stock without specifying units. A change in price of tangible goods during the delivery period gives rise to business risk, which justifies the change in the expected return through the sale. Salam contracts are exempted from the rule of not selling goods without owning them, if the contracts are written to avoid excessive Gharar in transactions. Trading is permitted only if: The owner of the commodity to be delivered is the purchaser of Sukuk. The price of Sukuk is decided by the market depending upon the demand and supply of the underlying commodity. Istisna a Sukuk Istisna a is a contractual agreement for future delivery of manufacturing goods that allows advance or future payment. An Istisna a contract helps to finance construction of different projects. A Parallel Istisna a contract with subcontractors enables Islamic banks to undertake construction of any project and sell it for a deferred price, but outsource the actual construction to the subcontractor. Upon delivery of goods, the ownership of the constructed item is transferred to the purchaser against the deferred sale price. The price covers the construction costs and profits, which would include the cost of locking funds during the repayment period. Istisna a Sukuk: Are certificates of equal value issued for mobilizing funds required for producing goods. Document the deferred price that needs to be paid.