Islamic Financial Markets: Stocks and Sukuk. Professor Habib Ahmed Durham University Business School

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1 Islamic Financial Markets: Stocks and Sukuk Professor Habib Ahmed Durham University Business School

2 Outline Stock Markets Islamic Perspectives Sukuk Structures and Evolution Sukuk Issues and Controversies

3 Introduction Banks and capital markets play complementary roles in allocation of funds Capital markets raise funds from the investors directly by issuing securities In conventional finance, many types of securities exist Equity, debt, hybrid, derivatives, etc. Financial markets can be distinguished as Stock market: Equity Bond Market: Debt 3

4 Companies and Shares Corporation is create by company law a legal entity limited liability Shares represent contribution to collective capital of a company in return from certain rights Right to profit, vote and proportionate share upon dissolution of the corporation The company owns the corporate property, not the shareholders ensures continuity 4

5 Stock Market Islamic Perspectives Islamic Fiqh Academy, Resolution No. 63/1/7, 1992 Citing the principle of permissibility, ruled that investment in stocks is permissible, provided the prohibited are avoided AAOIFI contracts of corporation to be generally valid rules of sharikat al inan apply Permissibility to invest depends on the type of corporation Two main criteria used for screening Sector-based Accounting-based 5

6 Stock Market: Sector Based Screening Main business of the firm should be halal Forbidden goods and services cannot be included in the acceptable business activities. Unacceptable business activities include: Alcohol, tobacco, pork-related goods, pornography, conventional finance (banking and insurance), trading in gold and silver on a deferred basis, and entertainment (hotels, casinos/gambling, cinema, etc.). 6

7 Sector Screening Criteria Sector Dow Jones FTSE S&P* MSCI Alcoholic Beverages X X Broadcasting & X X Entertainment Conventional X X Financial Services Gambling X X Hotels X X Insurance X X Media Agencies (except newspapers) X X Pork-related X X Products Restaurants & Bars X X Tobacco X X Trading of Gold & X Silver Weapons & Defense X X any involvement; core business.

8 Financial Markets: Accounting Based Screening Financial Ratios in identifying stocks No basis in Shari ah (Quran & Sunnah) Two principles Juristic maxim: The majority deserves to be treated as the whole of a thing Simple majority more than half (51%) Super majority more than two-thirds (67%) Hadith of minority (1/3rd of will) one-third, yet even one third is too much." (Narrated by Ibn 'Abbas) 8

9 Basic Balance Sheet Assets Current Assets Cash Accounts Receivables Fixed Assets Tangible Real Assets Financial Assets Interest bearing securities Other Fin. Assets Intangible Trademark & patents Liabilities & Equity Debt Short and long term Shareholder Equity Market Capitalization: Value of the corporation as determined by the market price (stock price x no. of stocks) 9

10 Stock Market: Accounting-Based Screening Acceptable Financial Ratios related to level of leverage, cash, and interest income Criterion DJIM* S&PS** 1. Total debt/market Capitalization Less than 33% 2. Cash and interest-bearing securities/market capitalization 3. Account receivables/market capitalization 4. Non-permissible income (other than interest income)/total revenue Less than 33% Less than 33% Less than 5% Less than 33% Less than 33% Less than 49% Less than 5% * Market Cap. Moving Average 24 months; ** Market Cap. Moving Average 36 months. 10

11 Stock Market: Accounting-Based Screening Acceptable Financial Ratios related to level of leverage, cash, and interest income Criterion FTSE MSCI 1. Total debt/total Assets Less than 33% 2. Cash and interest-bearing securities/total Assets Less than 33% 3. Account receivables/total Assets Less than 50% 4. Non-permissible income and other interest income/total revenue Less than 5% Less than 33% Less than 33% Less than 33% Less than 5% 11

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13 Stock Market Issues Distribution of zakat o By the fund manager of investors? Cleansing of impure income (interest and impermissible income) Positive and negative screening o Current practice negative screening using legal perspective prohibition driven screening o Need to add positive screening social and environmental issues

14 Outline Stock Markets Islamic Perspectives Sukuk Structures and Evolution Sukuk Issues and Controversies

15 Special features of fixed-term securities Borrower/ Obligor Borrower/ Obligor Indirect Financing Financial Institution Direct Financing SPV Investors Investors Capital markets raise funds directly from investors by issuing securities With no intermediaries, investors will not invest if their rights are not protected SPV is a legal entity created to protect the rights of investors Status and ability of obligor/ borrower to pay becomes important Rating determines cost of funds and marketability Credit enhancements 15

16 Securities forms and risks Two forms of securities Asset-backed risk analysis of assets Unsecured risk analysis of the sponsor/borrower Credit Enhancers initiatives taken to enhance security, credit, or ratings of securities Originator credit enhancement Cash collateral, over-collateralization, reserve accounts, etc. Structural credit enhancement security holders senior in claims Third party credit enhancements guarantees 16

17 Special Purpose Vehicle (SPV) SPV (SPE, SPC) A legal entity created solely for the purpose of the transaction as it is impossible to transfer assets to individual investors A bankruptcy remote entity (shields investors from the risks of the originator) Usually a trust trustees hold assets and makes payments to the sukuk holders Usually reputable institutions manage the SPV 17

18 Sukuk-definition Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) defines sukuk as: Certificates of equal value representing after closing subscription, receipt of the values of certificates and putting it to is as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of special investment activity 18

19 Sukuk Types AAOIFI identifies 14 types can be broadly classified as asset-, debt-, equity, and agency- based Asset based Debt Based Ijarah (existing owned, existing leased, and future assets), manfah-usufructs (existing and future assets) Istisna, salam, murabahah Equity Based Agency based Murabahah, musharakah, Muzara a (sharecropping), Musaqa (irrigation), Mugharasa (agricultural/plantation) Wakala 19

20 Sukuk Features 1. Asset/usufruct/service/equity must underlay issuance 2. Fixed term maturity 3. Types of returns fixed/flexible 4. Tradability: Depends on the type of sukuk Debt based sukuk not tradable 5. Redemption/Principal repayment Bullet payment Asset transferred to issuer/originator at maturity Sinking (diminishing) Fund Periodic amortization over time (with coupon payments) 20

21 Sukuk Market Growth First sukuk issued in Malaysia in 1990s and in Bahrain in 2001 During , average growth rate 45% Dubai based USD 3.5 billion PCFC sukuk generated orders of USD 11.4 billion with 50% from non-muslim investors (Jan 2006) Before crisis, 70-80% buyers of ME sukuk were Western entities Foreign entities issuing sukuk German state of Saxony-Anhalt: є100 mill. Sukuk (2004) East Cameron Gas Co.: $ mill. sukuk (2006) 21

22 Evolution of Sukuk Markets and Structures Sukuk issuance 2005 USD 11.5 billion 2013 USD billion New jurisdictions Mauritius, Kazakhstan, UK Evolution of sukuk structures First Phase Simple Asset-backed Structures Second Phase Experimentation with New Structures (scarcity of assets lead to newer structures) Third Phase More Complex Structures (added options and features) 22

23 Sukuk al-salam Obligor (undertakes future sale of commodity for the investors) Undertaking 1 2a Salam Proceeds 3 Commodity 4 SPV 5 Commodity Sale Sukuk Certificates Sukuk Certificates Proceeds 2b Commodity Sale Proceeds 6 Investors Commodity Buyer Sale of well-defined quality and quantity of commodity Fixed rates of return Sukuk al-salam are not negotiable 23

24 Sukuk al-salam: Example Sukuk name/date Sukuk al-salam/aug. 1, 2007 (Issue no. 75) Sukuk base Obligor Issuer Aluminium Government of Bahrain Central Bank of Bahrain Purpose of Offering Short-term liquidity Tenor Issue size Expected rate of return Credit enhancers Governing Law Redemption/ Principal repayment Rating 91 days BD 6 million 5.06% Guaranteed by Bahrain Government Bahraini Law With price at maturity None 24

25 Sukuk al-murabahah Corporate/ Borrower Commodity Price Master Agreement 1 Commodity 4 Commodity Price 6 5b 5a Commodity Commodity Buyer Issuer SPV Commodity Price Sukuk Certificates 2a Sukuk Proceeds 2b Sale Price + profits 7 Commodities 3a 3b Commodity Supplier Investors 25

26 Sukuk al-murabahah-example Sukuk name/date Arcapita Multicurrency sukuk/june 2005 Sukuk base Obligor Purpose of Offering Tenor Issue size Expected rate of return Credit enhancers Redemption/ Principal repayment Rating Commodity (purchase/sale) Arcapita Bank BSC Investment in assets 5 Years USD 210 million 0.175% above LIBOR rates Full recourse to Arcapita Bullet payment at maturity Arcapita rating (BBB) 26

27 Sukuk al-ijarah Sponsor/ Originator/ Obligor Sale/Transfer of Assets 1 Purchase Price of Assets 3 Lease of Assets 4a Rental Payment 4b SPV Sukuk Certificates 2a Sukuk Certificates Proceeds 2b Periodic Rental Payments 5 Investors Transfer of assets back to Issuer can take place is 2 ways: a. Periodic payments include rent and amortization (capital) b. Bullet payment at maturity (the Issuer buys back the assets) Sukuk al ijarah are negotiable Can have fixed/flexible rates Risks of assets transferred to certificate holders (though issuer 27 can guarantee the capital)

28 Sukuk al-ijarah: Example Sukuk name/date Qatar Global Sukuk/Oct. 8, 2003 Sukuk base Obligor Issuer Certain Land Parcel in Qatar State of Qatar (lessee of leased assets) Qatar Global Sukuk QSC Purpose of Offering Construction of Hamad Medical City Tenor Issue size Expected rate of return Credit enhancers Governing Law Redemption/ Principal repayment Rating 7 Years USD 700 million Semi-annual lease rentals (Libor+ credit spread+ amortization payment) Guaranteed by Qatari Government English and Qatari Law With rental payments (amortization with rental payments) A+ (S&P) 28

29 Balance Sheet Based Sukuk IDB IDB is a multilateral development bank (MDB) operating on Islamic principles Before issuing sukuk, 100 percent equity based institution (paid-up capital $4.3 billion) Other MDBs raise funds from market World Bank raised funds worth 918% its capital (total borrowing $ 96 billion) ADB raised 777% of its capital (capital $3.6 billion) Development impact of IDB small compared to other MDBs Plans to raise up to USD 4 billion in the next 10 years 29

30 IDB-Hybrid Asset Sukuk Provides guarantee about assets 6 Sukuk Certificates 3a Sells assets bundle worth $400 m. 1 5 Delegates agency role Appoints as agent to collect income from assets Sells assets $400m. 2 4 SPV Sukuk Certificates Proceeds 3b Periodic Income from Assets 7 Investors IDB bundled ijarah assets (65.8%), along with murabahah (30.7%) and istisna (3.5%) receivables 30

31 IDB-Hybrid Asset Sukuk Sukuk name/date IDB Global Trust Certificates/Aug.12, 2003 Sukuk base Obligor Issuer Purpose of Offering Tenor Issue size Expected rate of return Credit enhancers Governing Law Redemption/ Principal repayment Rating Balance sheet assets of IDB (Ijarah, istisna, murabahah) Islamic Development Bank Solidarity Trust Services Limited (through ICD) Financing other assets 5 Years USD 400 million Semi-annual lease rentals (Fixed 3.625%) Guaranteed by IDB English Law Purchase of assets at maturity at sale price AAA (S&P) 31

32 Sukuk al-musharakah Corporate Physical Asset Contribution 1 Periodic profit and Incentive fee 4 Periodic profit 5 Corporate undertakes to buy musharakah shares of the SPV 7 Musharakah 3 SPV Sukuk proceeds Sukuk Certificates 2a Sukuk Proceeds 2b Periodic profit 6 Investors Transfer of Assets Back to Issuer can take place is 2 ways: 1. Payments Include profit and purchase of shares (diminishing musharakah) 2. At maturity, the corporate buys back the shares. 32

33 Sukuk al-musharakah: Example Sukuk name/date Wings-FZCO Sukuk/June, 2005 Sukuk base Obligor Issuer Purpose of Offering Tenor Issue size Expected rate of return Credit enhancers Governing Law Redemption/ Principal repayment Rating/Listing Issuer provides assets in kind ($100 million) Emirates Airlines Wings FZCO Construction of Group Headquarters and Engineering Centre 7 Years USD 550 million 1 st coupon after year, thereafter semi-annually (0.75% above USD LIBOR rates) Strength of Emirates and UAE English Law and Dubai Law Bullet payment at redemption Listed with Luxemburg SE 33

34 Turkey: Ijarah Certificates 2010: COMMUNIQUÉ ON THE PRINCIPLES REGARDING IJARA CERTIFICATES AND ASSET LEASE COMPANIES (Series: III, Nr.: 43) ARTICLE 4 - (1) Asset Leasing Company (ALC) shall be incorporated by the founders with the purpose of subletting to the originators the assets assigned to it by the originators, issuing ijara certificates backed by the returns from the said lease, and to assign the asset in question back to the originator at the end of the lease term. ALC can be assigned the assets of only one originator at a time. ARTICLE 5 - (1) The field of activity of ALC comprises the following activities to be specified in the articles of incorporation. a) To issue ijara certificates, b) To be assigned and to lease all kinds of assets on its own behalf and for the account of ijara certificate holders, to pay returns from such assets to ijara certificates holders in proportion to their shares, c) To assign the leased asset back to the originator at the expiration of the lease contract, on terms established at the beginning. 2013: COMMUNIQUÉ ON LEASE CERTIFICATES (III-61.1) For new sukuk structures 34

35 Turkish Sukuk Issuances (USD) Sukuk Borrowing Instruments ,145,416, ,536,807, ,510,645,000 83,790,780, /05 1,414,283,000 40,982,883,000 Total 3,474,928, ,455,888,000 Source: Presentation of Capital Markets Board of Turkey

36 Outline Stock Markets Islamic Perspectives Sukuk Structures and Evolution Sukuk Issues and Controversies

37 Risks in Sukuk Depends on how sukuk are structured Debt Asset Equity Credit-rating of the obligor High liquidity risks (illiquid) Quality of the asset Low liquidity risks (if there is a active secondary market) Quality of the project or rating of the obligor Low liquidity risks (if there is a active secondary market) 37

38 Shari ah Concerns Asset-based Structures Sponsor/ Originator/ Obligor Guarantee/Undertaking Sale/Transfer of Assets 1 Purchase Price of Assets 3 Lease of Assets 4a Rental Payment 4b Sale/Transfer of Assets 6 SPV Sukuk Certificates 2a Sukuk Certificates Proceeds 2b Periodic Rental Payments 5 Investors 1. Guaranteeing initial capital 2. Sale of assets and transfer of ownership. 3. Sale and lease-back 4. Smoothing rental payments to the expected rate 5. Sale of asset back to originator 38 38

39 Shari ah Issues and Controversies (1) 1. Guaranteeing initial capital to investors Guarantee in Sukuk issues 3 rd party guarantees allowed without any charges Critics: Originator/guarantor and SPV same entity guarantee of capital/return can open doors for riba Supporters: SPV independent from originator, guarantee by originator is by 3 rd party 2. Sale of assets and transfer of ownership. Sale of assets must result in actual transfer of ownership (actual vs. beneficial ownership) In only 2% of sukuk (out of 560) actual sale (legal and accounting terms) takes place 39

40 Shari ah Issues and Controversies (2) 3. Sale and lease-back structure Bay' alistighlal (a form of bai al inah) 4. Smoothing rental/profit payments to the expected rate is prohibited If the actual return is higher than expected, the manager of sukuk keeps it as incentive If the actual return is less than expected, loan is given to the investors that is recovered later. 5. Objections to redemption/purchase of asset/shares at pre-determined (selling) price Redemption/purchase of asset/shares at market price allowed 40

41 Case Study: Nakheel Sukuk Dubai Nakheel Sukuk--$3.52 bl. 3 year ijarah sukuk issued in 2006 Property sold development of Dubai Waterfront skyscrapers on 50 year leasehold land; Purchase undertaking at a subscribed price (par value); Dubai World (government entity) provided guarantee; Sukuk was oversubscribed; Last payment due on Dec. 14, 09 $4.1bl. Nov Nakheel announced that it could not pay the dues Risks Legal Risks Applicable law English law? Enforcement of contract? Leasehold right not recognized real right under Dubai law? Shari ah Compliance Risk Sale of asset owned by government? Ownership of asset with undertaking? 41

42 Goldman Sachs Sukuk Guarantor (GSG) Guarantee of purchaser s obligations Certificate Holders Certificates Issuance proceeds GSI acts as buying agent for this transaction Issuer/Trustee (GSCL) Deferred payment price Commodities Commodities Purchaser (GSI) Commodity Suppliers GSG Goldman Sachs Global CSI Goldman Sachs International GSCL Global Sukuk Company Limited 42

43 QUESTIONS?