Islamic Finance and Capital Markets: Structure and Trading of Sukuk. Khalifa M Ali Hassanain

Islamic Finance and Capital Markets: Structure and Trading of Sukuk Khalifa M Ali Hassanain

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 9201-21413 Jeddah Kingdom of Saudi Arabia E-Mail: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. Page 2 of 43

Chapter 5 - Innovations in Islamic Markets... 5 Chapter Introduction... 5 Key Innovative Activities Shaping Financial Markets... 5 The Islamic Financial System and Financial Engineering... 6 Derivatives and the Islamic Financial Markets... 6 Historical Financial Innovation in Islamic Finance... 7 Scope of Islamic Financial Engineering... 8 Approaches for Financial Innovation in Islamic Finance... 9 Challenges to Innovation in Islamic Markets... 10 Chapter Summary... 12 Chapter 6 - Securitisation in Islamic Finance... 14 Chapter Introduction... 14 Sukuk as a Sharī ah-compliant Instrument... 15 Framework for an Islamic Capital Market... 16 Securitisation and Sukuk... 17 More about Sukuk... 17 Advantages and Pricing of Sukuk... 18 Parties in a Sukuk Issue... 18 Chapter Summary... 19 Chapter 7 - Structure of Sukuk... 21 Chapter Introduction... 21 Classes of Securitised Papers... 22 The SPV... 22 Risk, Contract and Cash Flow Analysis... 23 Types of Permissible Sukuk... 24 Controversial Sukuk... 25 Ijarah Contracts in Sukuk... 26 Chapter Summary... 27 Chapter 8 Categories of Sukuk... 29 Chapter Introduction... 29 Muqaradah or Mudarabah Sukuk... 30 Musharakah Sukuk... 32 Basics of Ijarah Sukuk... 33 Structuring the Ijarah Sukuk... 33 Types of Ijarah Sukuk... 34 Aspects of Ownership, Rent and Expenses... 35 Issuance and Trading of Ijarah Sukuk... 36 Basics of Salam Sukuk... 37 Page 3 of 43

Ownership and Trade in Salam Sukuk... 38 Istisna a Sukuk... 38 Trade of Istisna a Sukuk... 39 Murabaha Sukuk... 39 Use of Murabaha Sukuk... 40 Mixed Sukuk... 41 Chapter Summary... 42 Page 4 of 43

Chapter 5 - Innovations in Islamic Markets Chapter Introduction Innovations in Islamic Markets. The global financial market today is a super-efficient, sophisticated entity that is driven by financial engineering and innovation. Global financial markets have been evolving since the 1980s when the gradual breakdown of exchange rate mechanisms began, making markets volatile. Markets, both domestic and global, have seen major changes and innovations necessary to give them much-needed liquidity and a huge range of products and services. Other reasons for the spate of innovations were the financial deregulation of financial markets, breakthroughs in information processing and communication technology that made trading faster and more volatile and advancements in financial theory. 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 and Describe the innovation of a synthetic currency forward contract. Key Innovative Activities Shaping Financial Markets Financial engineering is the invention and development of new and innovative solutions to the problems and challenges of a financial market. Such solutions can result in a new product, service or process which will ultimately reduce funding costs and increase returns on investments and opportunities for risk sharing. Financial engineering can have a significant impact on the market. There are three key activities of financial engineering that shape the market. Page 5 of 43

The first is the ability to market, negotiate and transfer financial claims, which will increase liquidity in the market. The second is the development of a derivatives market to share and transfer price and credit risk. The derivatives market has many benefits such as lowering of transaction costs and dissemination of uniform prices. The third is the generation of revenues from credit and equity. A significant benefit of financial engineering is that the market is continually experimenting and making variations to instruments and processes, in a bid to reach efficiency and balance costs and returns. The Islamic Financial System and Financial Engineering Financial engineering is critical to the development of Islamic markets, and in particular to the risk management practices in Islamic markets. Today, most Islamic financial markets follow traditional practices and methods which cannot address the modern requirements for liquidity, risk and portfolio management. Asset portfolios in Islamic markets comprise only short-term options, leading to general paucity of medium- and long-term options for funds. This is because the secondary market is not well developed. This lack of medium and long-term options has affected liquidity in the market. As a result, investors are unable to expand their portfolios with different maturity options. The challenge is to overcome this difficulty by giving investors the opportunity to diversify at the lowest cost. Derivatives and the Islamic Financial Markets The modern financial markets depend on the derivatives markets for various reasons. Derivatives allow investors, corporations and countries to hedge themselves against financial risks. Derivatives provide investors information about expected market-clearing prices and future demand and supply, which will enable investors to make informed decisions through price discovery. Page 6 of 43

Derivatives provide transactional efficiency because they involve lower transactional costs. The absence of derivatives can affect Islamic financial markets in many ways. A company operating in the Islamic market can lose its competitive edge in the absence of a mechanism to handle risks occurring through variations in cost, revenue and profitability. A company that does not actively manage its risk will be considered a high-risk company. It may have to incur higher cost of raising funds, as a result of which it may face the risk of financial distress. It will be more vulnerable during a financial crisis affecting the entire market. Islamic financial institutions will find it difficult to integrate with the global financial system. Historical Financial Innovation in Islamic Finance Financial engineering is the process of restructuring existing basic variables such as returns, price risk, credit risk and country risk into more complex instruments. The modern financial market has a large number of complex instruments that are based on a basic set of instruments. However, a closer inspection reveals that the Islamic market is built upon the same basic instruments, but is not complex enough to handle the requirements of markets today. Financial engineering is required to develop these instruments into more complex instruments, while staying within the boundaries of Islam. Financial engineering of the Islamic financial market is a challenge because it requires a thorough knowledge of Islamic legal system and the principles of economics, finance and banking. Islamic nations have a long history of working within the limits of the Sharī ah. Page 7 of 43

For many years now economics and commerce in Islamic nations have grown out of a body of rulings and precedents set in accordance with the Sharī ah. However, the ancient practice of interpreting and applying the Sharī ah through the Ijtihad has been forgotten and must be revived now. Scope of Islamic Financial Engineering Islamic financial markets place a great deal of significance on the legitimacy of a new product, service or instrument with respect to the Sharī ah. When a new instrument or product is introduced, Sharī ah scholars must approve it. Approval is granted provided the product or instrument does not violate the Sharī ah s principles with respect to prohibited activities. Some of the key issues that will help us understand the extent to which financial engineering can be developed in Islamic market are freedom of contracts, building blocks of the Islamic financial system and risk/return profile of financial instruments. Freedom of Contract In Islam, there are no forbidden contracts. However, there are elements that are forbidden by the Sharī ah and they must not form part of any contract. The forbidden elements are: Riba, Gharar, Qimar and Ikrah. Traditionally, economic agents would draw up a contract and bring it to the Sharī ah scholars, who would study its legitimacy with respect to the Sharī ah. This allows market forces to innovate and evolve new contracts and approaches within the boundaries set by the Sharī ah. Financial instruments and services must be considered as groups of contracts that specify the rights and commitments of each party. Sharī ah scholars can then verify if these rights and duties are in accordance with the Sharī ah. Basic Building Blocks Page 8 of 43

Every financial system can be broken down into its basic elements or building blocks. Once the basic structures are identified, it becomes easy to build more complex market structures above them. The primary foundations of the Islamic financial system are similar to that of the conventional financial market. But Islamic financial system and modes of finance should be designed to be Sharī ahcompliant and to adhere to the Maqasid Al-Sharī ah. However, practices by some financial institutions may cause a deviation from these principles. Financial engineering in Islamic financial markets is about understanding the uniqueness in the system and then using that knowledge to build complex structures within the boundaries of Islamic financial system. Risk/Return Profile The Islamic financial system is often assumed to be a purely equity-driven market because of the stress on profit-and-loss-sharing in Islamic society. There are other types of contracts that are used in the Islamic financial market such as trade financing, leasing and sales are not equity-based. It is important to understand the risk/return profile of all these contracts before they can be developed further. Non-equity contracts such as the Murabahah, Ijarah and Salam even offer fixed income returns to investors and are allowed by the Sharī ah. Approaches for Financial Innovation in Islamic Finance Financial engineering can take any of the two approaches, once the basic building blocks of the financial market have been understood. The two primary approaches to financial engineering are reverse engineering and innovative engineering. Reverse Engineering Page 9 of 43

This approach involves the analysis of an existing set of market structures and then finding their closest substitute in the Islamic market. It means using the basic principles of the conventional structures to rebuild them into completely Sharī ah-compliant structures. The major benefit of this approach is that new Islamic structures can be introduced and merged with the existing conventional structure without difficulty because the market is familiar with the basic structure. This is particularly true when the structure has to be implemented in a different country that uses conventional structures. There is, however, a challenge. It is very easy to introduce substitutes that are closely related to the original, but not completely Sharī ah-compliant. Care must be taken to ensure that that the instrument is not contaminated. Contamination can occur when the instrument is used for a purpose for which it was not intended or for achieving a questionable end-purpose. Innovative Engineering This approach involves the identification of a menu of Islamic instruments from which new ones can be designed. The new instruments will have a unique risk/return profile and will be easily applicable in other Islamic markets. The benefit of this approach is that it will be easier to meet the requirements of the Sharī ah since it is based on a menu of Islamic instruments. The challenge to this approach is that it needs long-term commitment and will take time evolving. The other problem is that innovative engineering requires a stable Islamic financial system. Most Islamic countries do not have strong economies, supervisory or regulatory laws or Sharī ah-compliant property rights, making innovative engineering difficult to implement. There are operational difficulties involved in implementing innovative engineering. As a result, reverse engineering is likely to dominate in the short term. In the medium term, both reverse and innovative engineering will be in use. The long-term solution lies in developing instruments with a risk and return structure that will be attractive to conventional and Islamic markets. Challenges to Innovation in Islamic Markets Financial engineering is not new to conventional markets. It has been used extensively to develop the markets over the years. It was made possible by the fact that conventional markets already had a range of short- and long-term options available to them. Page 10 of 43

Additionally, there were fixed-income securities and easy entry and exit for market players. The technology available to these markets also made it easy for complex structures to be built upon existing structures. Islamic markets, on the other hand, face a number of challenges. Investment in Infrastructure Financial engineering requires the backing of established cells to conduct market research, product research and analytical modeling. While conventional institutions and banks have this in place, Islamic institutions are usually small and do not have the financial or human resources for such activity. It might be worthwhile for the institutions to come together and collectively pool resources for analytical modeling and basic market research. This will save costs and create a common body of knowledge. IRTI of the IDB Group is currently embarked on a multi-year project called Products and Financial Instruments in Islamic Fiqh. The purpose of the project is to extract new Islamic finance products from the original Fiqh sources, refine them and make applicable to modern finance and banking. Page 11 of 43

Collaboration and Cooperation IFIs can benefit from a business association with western institutions that have the benefit of resources and technology. IFIs can collaborate with western institutions for the development of new products with different risk/return profiles. IFIs can leave the designing of products to the western institutions and manage the marketing strategies of such products themselves. This way, IFIs will gain the sophistication of western institutions, but will stay with the parameters specified by the Sharī ah. Since the western institutions have already invested heavily in research, IFIs will be spared of that expense of starting from scratch. Standardisation and Exception The aim of financial engineering should be to go towards standardising contracts and processes across markets. Both the Sharī ah scholars and the regulators must work towards this by setting up standards for contracts and their practice, accounting, reporting and supervision. There is a general practice in Islamic societies of invoking Dharoora or the rule of necessity under pressure from bankers, when a product or instrument is not fully compliant with Sharī ah. This must be supervised to ensure that exceptions are invoked only when they are absolutely necessary. Chapter Summary You have completed the chapter, Innovations in Islamic Markets. The key points of this chapter are as follows: The global financial market today is driven by financial engineering and innovation. This trend began in 1980s, with the gradual breakdown of exchange rate mechanisms. Other reasons were the financial deregulation of markets, revolutionary innovations in information processing and communication technology that made trading faster and more volatile. Financial engineering means the development of innovative products, services or processes that ultimately reduce costs, increase returns or generate opportunities. It can have a significant impact on some key areas of the market. The first is negotiability and tradability. The second is the development of a derivatives market. And the third is the generation of revenues from credit and equity. Page 12 of 43

Islamic financial markets lack good medium and long-term investment options, making it difficult for investors to expand their portfolios. This problem can be solved by introducing derivatives. Without derivatives, the Islamic market will find it difficult to integrate with global markets. Financial engineering is a restructuring of existing financial instruments such as returns, price risk, credit risk and country risk, into more complex instruments while staying within the boundaries of Islam. Some of the key issues that will help us understand the extent to which financial engineering can be developed in an Islamic market are: the freedom of contract that the agents are granted, the building blocks of the market and the risk/return profile of the instruments. Traditionally, Islam has allowed agents to make their own contracts, provided it does not violate the Sharī ah. The main building blocks of the Islamic financial system are somewhat similar to the conventional financial market. But Islamic modes of finance are envisaged to be Sharī ah -compliant and to achieve the Maqasid Al-Sharī ah and are thus subject to strict scrutiny. The Islamic financial market uses both equity-based instruments and non-equity instruments such as trade financing, leasing and sale contracts. Non-equity contracts such as the Murabahah, Ijarah and Salam even offer interest-like fixed income returns to investors and are allowed by Islam. The two primary approaches to financial engineering are reverse engineering and innovative engineering. Reverse engineering involves the analysis of an existing set of market structures and then using their basic principles to rebuild it into something new. Innovative engineering involves the identification of a menu of Islamic instruments from which new ones can be designed. The challenges before Islamic markets are many. They lack a theoretical base and as a result have no basis on which to proceed. Sharī ah scholars need to be trained in banking and finance and bankers need to be trained in Sharī ah matters. IFIs might have to collaborate with Western institutions to bring in the muchneeded resources and expertise in conventional practices. This collaboration must be used to standardise practices across the 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, improve them and make them applicable to modern finance and banking. Page 13 of 43

Chapter 6 - Securitisation in Islamic Finance Chapter Introduction Securitisation in Islamic Finance. In the recent past, Sukuk and securitisation have emerged as prominent modes in Islamic banking and finance. While Shirkah-based instruments are in use since 1980s, Sukuk have been issued only since 1992. Starting with the $ 600 million Malaysian Sukuk issue in 2002, several multi-billion dollar Sukuk issues have been launched by both sovereign governments and corporate entities. Among the pioneering issues was the $400 million Islamic Development Bank and Solidarity Trust Services Sukuk issue. A recent research paper, the IRTI-IFSB Ten-Year Framework for Islamic Financial Services Development, estimates that if the market for Sukuk grows annually at 15 Page 14 of 43

percent, it will reach $1.41 trillion by 2015. At 10 percent annual growth, market size for Sukuk will be $1.25 trillion. The underlying contracts of these issues include Ijarah, Mudarabah, Musharakah, Istisna a and a mix of some of these. Due to the demand for Sharī ah-compliant instruments, Sukuk is preferred as an alternative source of funding, especially 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. It facilitates International Financial Institutions or IFIs and investors to successfully manage liquidity. 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 and Describe the key players in various issues of Sukuk. Sukuk as a Sharī ah-compliant Instrument Initially, it was believed that only an equity market finances long-term projects in an Islamic finance framework. This holds true partly because according to Sharī ah, debts can be sold only when their trading is subject to Hawalah. Therefore, debts cannot produce any return. However, the emergence of Sukuk, mainly Ijarah Sukuk and Sukuk supported by a mixed asset pool, 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, they can be traded in the secondary market at the price determined by the market forces. Sukuk, issued on the basis of Ijarah and pools of mixed assets, can provide the facilities of a normal debt market i.e., fixed return and secondary market trading, subject to certain criteria. Therefore, alternatives of conventional bonds can be developed through securitisation of assets. The instruments formed through securitisation of assets reflect the partial ownership of the holders in the assets. Page 15 of 43

The two types of return from Sukuk are variable-return Sukuk or VRS and fixed-return Sukuk or FRS. FRS differs from the conventional debt related instruments. This is because the return on Islamic instruments will be quasi-fixed, unless a third party guarantee is provided, as per the Sharī ah rules. Framework for an Islamic Capital Market The key components of an Islamic capital market are Sharī ah-compliant stocks, Islamic funds and Islamic investment certificates. A debt market, which deals in debentures and bonds, usually involves Ribâ and Gharar and, hence, it cannot be a part of Islamic financial market. Debts can be assigned to others on an equivalent value without transferring the risk of default. This process is known as Hawalah in Fiqh terminology. Sale differs from assignment in the sense that transfer in Hawalah happens with recourse, whereas transfer in sale does not provide recourse. The basic concept of a stock market is permissible under Sharī ah. However, certain conditions should be followed for investments in stocks. 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 developing Sukuk, introducing Islamic depository receipts or IDRs at a mass level, replacing debt financing with Shirkah-based direct and indirect financing, securitisation and fund management. Sukuk signifies the common undivided shares in the ownership of underlying assets. The Sukuk holders share the returns and suffer the loss, if any, in the ratio of their share in investment. Sharī ah-compliant Sukuk results in enhanced supply of risk-based capital with reduced risk due to prohibition of Ribâ, gambling and Gharar and a balanced return rate structure based on real-asset-backed economic activities. IDR involves trading of stocks in countries other than their origin. Sharī ah-compliant stocks and other instruments are traded in IDRs. IDRs can bring the convergence of Islamic capital markets by acting as an alternative to cross-listing. The listing of IDRs enables a better regulatory environment along with the generation of funds for developing Muslim countries. The issue of IDRs brings Page 16 of 43

standardisation of Sharī ah compliance across jurisdictions and helps in the growth of Islamic capital markets. The originator of the underlying asset, an investor and the custodian bank engage in IDR. Let s now learn about the advantages of IDR for the originator and investor. An IDR facilitates the originators to expand their investor base. It enables low cost of funds in extremely liquid markets and provides better securities by trading in more organized markets. For the investors, an IDR provides diversification of portfolio in other markets. It requires IFIs to have Sharī ah-compliant stocks and enables greater returns than conventional placements in Murabaha. It facilitates liquidity management for IFIs, governments, corporations and banking and nonbanking financial institutions that promote Sukuk. Securitisation and Sukuk Securitisation is a process of pooling or repackaging illiquid and non-marketable assets into tradable certificates of investment. It changes the role of the originator from an accumulator to a distributor. In securitisation, ownership of the assets underlying the certificate is transferred to a large group 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. The ownership of the securitised assets is transferred to a Special Purpose Vehicle (SPV) or Special Purpose Mudarabah (SPM). These are introduced for managing assets on behalf of Sukuk holders and issuing investment certificates. SPV serves as Mudarib and manages the liabilities and assets of the issue. More about Sukuk According to the Accounting and Auditing Organization for Islamic Financial Institutions or AAOIFI, investment Sukuk are certificates indicating undivided shares in the ownership of tangible assets, usufruct and services or in the ownership of assets of a particular project or activity. Page 17 of 43

Investment Sukuk is different from shares and bonds. A share implies the investor owns the company as a whole indefinitely. Sukuk, on the other hand, reflect certain assets and are issued for a certain period ranging from three months to ten years. Unlike bonds, Sukuk provide returns linked to the cash flow generated by the assets. Sukuk is similar to conventional securitisation. However, Sukuk does not encourage Ribâ, Gharar and the activities prohibited by Sharī ah. Advantages and Pricing of Sukuk Securitisation involves evaluating, isolating and allocating specific risks, evaluating taxation, accounting and legal implications, designing appropriate credit enhancement structures and pricing the residual risk so the units of securitised assets or pools can be priced accurately. Securitisation provides certain benefits to the investors. It 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 backed by the securitised assets, provides flexible range of maturities and offers skilled risk assessment. Securitisation is also beneficial for the originator. It offers the originators with incentives to develop a transparent fund approval process, encourages efficient collection procedures and provides a competent mechanism to control this process. Sukuk in the new form of securities assist the development of capital markets, attract conservative buyers, draw international capital and facilitate the efficient sharing of risks. Securitised papers are traded at a premium above similar vanilla corporate papers. The premium depends on the active secondary market, complexity of transaction, comfort level of investors with collateral and demand of investors at the time of issuance. Hence, securitised papers act as an efficient tool for mobilising long-term funds which are used for financing development projects in industry, agriculture and real estate development. Parties in a Sukuk Issue Page 18 of 43

Key parties involved in Sukuk transactions are the originator of Sukuk, SPV, investment banks and subscribers of Sukuk. The originator or the issuer of Sukuk sells the assets to the SPV and uses the funds. Originators are banking or nonbanking Islamic financial institutions of governments or big entities. The SPV performs the securitisation process and manages the issue. It buys assets from the originator and issues Sukuk to fund the purchase price. The SPV is often called the issuer. Investment banks are the underwriters for the issue. They manage book-making services for Sukuk for a predetermined fee. Syndicates of Islamic banks and conventional banks offering Islamic windows provide these services. Subscribers to Sukuk comprise central banks, Islamic banks, nonbanking financial institutions and individuals. Key parties involved in general securitisation process include: Obligor: A contractual debtor to the originator who pays securitized cash flows. Lead manager: Acts as a structurer for designing and executing the transaction and as arranger for the securities. Servicer: Collects and manages rentals from obligors and maintains assets. Cash administrator: Manages inflows and outflows, invests interim funds and accesses cash collateral. Credit enhancement provider: Provides credit enhancement through guarantees and Takaful/insurance. Credit rating agency: Provides rating for the deal based on structure, rating of parties, legal and tax aspects. Legal and tax counsel: Provides key opinions on the structure and underlying contracts with respect to their legal and tax implications. Auditor: Conducts due diligence. Custodian/R&T agents: Provides registration/transfer of securities and custody for underlying documents. Flowchart of a typical securitisation process is shown on screen. 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. A recent research paper, the IRTI-IFSB Ten-Year Framework for Islamic Financial Services Development, estimates that if the market for Sukuk grows annually at 15 percent, it will reach $1.41 trillion by the middle of this decade. At 10 percent annual growth, market size for Sukuk will be $1.25 trillion. Page 19 of 43

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. IDR involves trading of stocks in countries other than their origin. Sharī ahcompliant stocks and other instruments are traded in IDRs. According to AAOIFI, investment Sukuk is a certificate indicating undivided shares in the ownership of tangible assets, usufruct and services or in the ownership of assets of a particular project or activity. Securitisation is a process of pooling or repackaging illiquid and non-marketable 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 new form of securities assist the development of capital markets, attract conservative buyers, draw international capital and facilitate the efficient sharing of risks. Page 20 of 43

Chapter 7 - Structure of Sukuk Chapter Introduction Structure of Sukuk. In Islamic Finance, Sukuk refers to an instrument in which the issuer transfers ownership of the underlying assets to a large number of investors. The major classes of securitised papers include pool-based securitisation and future flow securitisation. The lead bankers undertake minute risk analysis with respect to many aspects like credit and bankruptcy, performance, asset or collateral risk, payment, return rate, exchange rate, prepayment, contract analysis and cash flow analysis. In the Islamic world, Sukuk first became popular in the 1990s. But the use of Bai al- Dayn and Bai al-inah contracts in Sukuk made the Sukuk issues controversial due to the sale-and-lease-back technique involved. Before we proceed, note that you can learn about the manifestation of securitisation in Islamic finance, the Sukuk as a Sharī ah -compliant instrument, parties to a Sukuk, benefits of Sukuk and so on covered in detail in Chapter 6, Securitisation in Islamic Finance of this course. Various types of Sukuk based on the underlying contracts are covered in Chapter 8, Categories of Sukuk. The potential and tradability of Sukuk is covered in Chapter 9, Tradability, Structures and Potential of Sukuk. 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 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. Page 21 of 43

Classes of Securitised Papers Let s look at the two types of securitised papers in a Sukuk issue. The classes include Pool-based securitisation and Future Flow securitisation. Pool-based Securitisation The three classes of pool-based securitisation are mortgage-backed securitisation, collateralised debt obligations or collateralised loan obligations that are not Sharī ahcompliant unless subjected to the rules of Hawalah and lease rentals securitisation that is established for Sharī ah compliance of Ijarah Sukuk, in which the ownership of the assets is also transferred to the holders of Sukuk. Future Flow Securitisation (FFS) Future flow securitisation is the securitisation of receivables to be generated in future. Some of the asset classes that generate future flow securitisation include: The road toll securitisation involving transfer of pro rata ownership to Sukuk holders necessary for Sharī ah compliance. The telecom receivable securitisation and The credit card receivable securitisation that is not a Sharī ah-compliant unless subjected to the rules of Hawalah. The SPV A Special Purpose Vehicle (SPV) is a distinct legal entity formed to specifically manage the securities issues. An SPV is both capital and tax efficient. But it requires legal costs to establish and manage it.. Some of the characteristics of a typical SPV include bankruptcy remoteness and thin capitalisation. It is important to note that the sale to the SPV is true and the asset is correctly segregated from the first owner. The discretion of the original owner in respect of the asset comes to an end, once the ownership is transferred to the SPV and it cannot be reversed in case of insolvency of the first owner or vice versa. The legal structure of a special purpose vehicle is mainly based on its regulatory and legal environment. Page 22 of 43

Some of the alternative payment structures adopted by SPV are Pass-through and Paythrough structures. The former is where the SPV remits any funds collected to the investors and the latter involves the servicing of the securities from the underlying cash flows. SPVs may also reinvest the funds and pay investors according to a predetermined schedule. They also serve as conduits for multiple issuances. This is applicable in case of securitisation of receivables of credit cards and commercial papers. Risk, Contract and Cash Flow Analysis The lead bankers perform various analyses on different aspects with respect to securitisation issues. These include risk, contract and cash flow analyses. Risk Analysis The lead bankers have to undertake minute risk analysis of each of the following: 1. Credit and bankruptcy risk - the ability of an entity to repay its obligations and survive as a viable entity. 2. Performance risk - the ability to meet contractual obligations. 3. Asset or collateral risk - the deviation in the value of an underlying asset. 4. Payment risk - the ability of third parties, such as credit enhancement providers, to meet their obligations. 5. Return rate risk - the variation in return rate structure. 6. Exchange rate risk the variation in exchange rates that affect the price of the securities during trading. 7. Liquidity risk - the ability to sell the underlying assets or the collateral to service the investor. 8. Risk of loss of money collected and retained by the servicer briefly before remitting to the SPV. 9. Prepayment risk - the change in maturity of the investments made due to prepayment by obligors. 10. Reinvestment risk in pay-through structures - the variation in the returns earned on investments made by the SPV for the period until the prespecified dates and 11. Legal or regulatory or tax related risk - the interpretation of various laws, regulations and complex documentation. Securitisation mitigates the risks with respect to various factors. From an originator s perspective, securitisation mitigates liquidity risk of an illiquid asset, reduces cost of funding, takes assets off balance sheet, without loss of use and reduces cost of finance if SPV is serving as multiple originators by pooling assets. Page 23 of 43

From an investor s perspective, the foreign exchange risk is reduced if underlying asset is denominated in multiple currencies, pooling of diversified assets with heterogeneous risk mitigates earnings risk and undivided ownership of the asset is an added protection. The Sukuk holders or the issuers adopt some methods to manage and mitigate risks, such as to create a Takaful fund with contributions from certificate holders, take a cover from Islamic Takaful companies and pay the contributions from the income or donations. They also keep aside a certain amount of profit to lessen the fluctuations of the distributable profit, only when there is a proper disclosure of this method in the issue documents. Contract Analysis Contract analysis focuses on rights and obligations, performance requirements, termination, events and consequences of defaults, study of transaction documentation, with the purpose of knowing the ability to fulfill the rights and obligation. Cash Flow Analysis Cash flow analysis is performed to identify key variables and expected patterns of the underlying cash flows under various scenarios and to determine the rating. Types of Permissible Sukuk The AAOIFI, in its Sharī ah Standard for Investment Sukuk has specified eight types of investment certificates or Sukuk: 1. Sukuk of ownership in leased assets such as: usufruct of existing assets, described future assets, services of a specified entity and described future services. 2. Salam Sukuk. 3. Istisna a Sukuk. 4. Murabaha Sukuk. 5. Musharakah Sukuk like participation certificates, Mudarabah Sukuk and investment agency Sukuk. 6. Muzara ah Sukuk, that is share-cropping. 7. Mus aqah Sukuk, those projects on irrigation of fruit-bearing trees. 8. Mugh arasah Sukuk that involve in projects on plantation of gardens. The most important Sukuk or investment certificates with sizeable potential are Shirkah, Ijarah, Salam and Istisna a. Page 24 of 43

According to primary rules of the Sharī ah, investment Sukuk have to be structured on the principle of Shirkah. However, depending upon the nature of the asset, usufruct of assets or services involved, certificates can be structured to be designated as Ijarah Sukuk, Salam Sukuk and Istisna a Sukuk. But business transactions may be conducted through participatory or fixed return modes or instruments. Thus, the rates of return on Sukuk will be variable if the modes on the second leg are participatory or partially fixed, as in the case of cash flow from assets securitised through fixed return modes. However, any third party guarantee can make the Sukuk fixed-return certificates of investment. Controversial Sukuk Most of the Sukuk issues are based on the concept of Ijarah, whereas few are based on Shirkah, Salam or pooled assets. Many of the Sukuk issues are not acceptable due to the involvement of controversial contracts like Bai al- Inah, Bai al-dayn and other non-sharī ah compliant traits. These made the Sukuk issue similar to the interest-based bonds. Sukuk issues are widely based on Bai al- Inah and the concept of Tabarru, while they are traded in the secondary market based on Bai al-dayn. Bai al- Inah refers to a dual sale in which the borrower and the lender sell and resell an object between them, once for cash and then for a premium, but on credit, which makes it similar to an interest based loan. Therefore, it is a legal way of evading the prohibition of Ribâ. Most jurists reject this method, although the debt represented by the Sukuk is backed by the underlying assets. But most traditional Muslim jurists and contemporary Sharī ah scholars agreed that Bai al-dayn with discount is not permitted according to the Sharī ah. However, some scholars have permitted this type of sale. They refer to the Shafi is ruling but do not consider the fact that the Shafi is permitted this type of sale only in cases where a debt is sold at its par value. Page 25 of 43

The OIC Islamic Fiqh Council, which represents all Islamic countries approved the prohibition of Bai al Dayn without a single dissenting voice. Bai al-dayn and Bai al-inah contracts are covered in detail in Chapter 8, Controversial Financing & Fee-based Products, of the course, Islamic Financial System. Ijarah Contracts in Sukuk Scholars of Sharī ah principles permit the use of a sale and lease-back technique. This technique involves the purchase of an asset from a party that can again be leased to the same party. The Ijarah contract should be executed only after the Islamic Financial Institution has obtained the asset. With respect to Ijarah Sukuk issues, the sale and lease-back technique does not lead to a Sharī ah-related problem. This is applicable provided the sale of the asset is complete in all aspects and also the Ijarah rules are made applicable. Using the sale and lease-back technique in case of consumer durables is not considered desirable by many Sharī ah scholars and practitioners. This is allowed only when the client wants to avoid interest-based financing and there is no other way out. In most sovereign Ijarah Sukuk issues, assets leased under this technique can be resold to the original owner. Sharī ah scholars suggest that sufficient time should pass before the lessee repurchases the asset. Such a period raises the possibility that the asset being sold and leased back would change in value and structure. The scholars have also recommended that the client should buy back the asset more than one year after sale. This ensures that the technique does not provide stealthy mode of interest. Concerns in Ijarah Sukuk Ijarah offers much flexibility and promise 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. According to Sharī ah rules, Sukuk holders have to jointly bear the risks of an asset s price and the ownershiprelated costs and share the rent earned by leasing it to any user. Page 26 of 43

Due to the non predictable nature of expenses and defaults, the returns could be semi-fixed, not absolutely fixed or unmodified when pegged to any benchmark. However, in reality, the returns on most of the Sukuk are absolutely fixed or unmodified. The issue of Ijarah Sukuk voids the Islamic financial system and also contradicts the investors aspiration. However, Sukuk issued 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. Therefore, they are acceptable to most Islamic scholars and banking experts, provided these issues meet the Sharī ah s essential conditions for the underlying contracts. Ijarah contracts are covered in detail in Chapter 5, A Blueprint of the Islamic Financial System-Part 3, of the course, Islamic Financial System. Chapter Summary You have completed the chapter, Structure of Sukuk. The key points of this chapter are as follows: In Islamic Finance, Sukuk refers to an instrument in which the issuer transfers the ownership of the underlying assets to a large number of investors. The major classes of securitised papers include pool-based securitisation and future flow securitisation. A Special Purpose Vehicle (SPV) is distinct legal entity formed to specifically manage the securities issues. A SPV is both capital and tax efficient and it does not add to the costs of the transaction. A SPV is both capital and tax efficient. But it requires legal costs to establish and manage it. Some of the alternative payment structures adopted by SPV are Pass-through and Pay-through structures. The former is where the SPV remits any funds collected to the investors and the latter involves the servicing of the securities from the underlying cash flows. The lead bankers perform analysis on various aspects with respect to securitisation issues. These include the Risk, Contract and Cash Flow Analysis. The most important Sukuk or investment certificates with sizeable potential are Shirkah, Ijarah, Salam and Istisna a. Thus, the rates of return on Sukuk will be either variable or quasi-fixed. Page 27 of 43

Most of the Sukuk issues are based on the concept of Ijarah, whereas few are based on Shirkah, Salam or pooled assets. Many of the Sukuk issues are not acceptable due to the involvement of controversial contracts like Bai al- Inah, Bai al-dayn and other non-sharī ah compliant traits. These issues are similar to those of interest-based bonds. The experts in Sharī ah principles permit the use of a sale and lease-back technique. This technique involves the purchase of asset from a party that can again be set to lease to the same. The Ijarah contract should be executed only after the Islamic Financial Institution has obtained the asset. Page 28 of 43

Chapter 8 Categories of Sukuk Chapter Introduction Categories of Sukuk. Sukuk can be categorised into six types: Muqaradah or Mudarabah Sukuk Musharakah Sukuk Ijarah Sukuk SalamSukuk Istisna a Sukuk Murabaha Sukuk Muqaradah or Mudarabah Sukuk Muqaradah or MudarabahSukuk are certificates denoting projects being managed on the basis of Mudarabah principle. Muqaradah or Mudarabah Sukuk are issued to encourage the public to invest in an economy. Musharakah Sukuk Musharakah Sukuk serve as the mode of security for projects involving huge amounts. As redeemable certificates, Musharakah Sukuk are issued by or to the corporate sector or to individuals to facilitate treatment or employment, to buy vehicles for business use or to construct high-quality clinics, hospitals, factories, trading centres, endowments, and so on. Ijarah Sukuk Ijarah Sukuk or certificates serve as proof of purchase of a proportion of the asset from a lessor who wishes to recover their cost of purchase of the asset to obtain cash or to make a profit even after executing the Ijarah contract. The lessor can sell the leased asset fully or fractionally, either to a single party or to multiple individuals. Salam Sukuk In a Salam Sukuk, advance payment is done 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 such as goods and delivery dates may comply with each other. However, the two contracts should be enforced independent of each other. Istisna a Sukuk Page 29 of 43

Istisna a Sukuk are contractual agreements for manufacturing products, which permits advance payment on delivery of goods in the future or both delivery of goods and payment in future. It helps finance construction of houses, plant, bridges, roads and highways. Murabaha Sukuk In a Murabaha Sukuk, the purchaser on credit signs a document to record his debt towards the seller. This paper signifies a debt receivable by the seller. The document can be transferred to a third entity only at the same price provided the transfer adheres to the rules of Hawalah. Before we proceed, note that the concept of Sukuk as the Islamic equivalent of securitisation is introduced in Chapter 6 of this course, Securitisation in Islamic Finance. The structure of Sukuk including the classes of securitised paper, risk analysis and cash flow analysis is described in Chapter 7, Structure of Sukuk. The tradability and potential of Sukuk are described in Chapter9, Tradability, Structure and Potential of Sukuk. On completing this chapter, you will be able to: Describe Muqaradah Sukuk as a mode to encourage the public to invest in an 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 and 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 can be issued by the partner or the Mudarib who manages the business. The subscribers own the capital and the funds realised from the issue are the Mudarabah capital. The assets of Mudarabah are owned by the certificate holders and Page 30 of 43