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Sukuk Market at a Crossroad

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Points of Essence:

  • Sukuk is said to have soured amid the global credit crisis and Shariah challenges.
  • From Nov 2007-Feb 2008 no international, dollar-denominated, rated Sukuk came to the market.
  • Two of the most common Sukuk types – Mudarabah (a form of trust financing) and Musharakah (joint partnership) allegedly do not conform to the Shariah. The argument being while the Mudarabah and Musharakah Sukuk are essentially equity-type instruments, the market uses certain techniques such as repurchase agreements (at maturity or specified default events) to guarantee the return of the Sukuk. This is at odds with the spirit of Islamic finance, where profits should be shared and interest is prohibited.

By Ali Ravalia

With global Sukuk issuance reaching US$100 billion in 2007 it was widely felt that the Sukuk market was coming of age. The volume and variety of deals together with the growing appetite for GCC (Gulf Cooperation Council) issuers to tap debt markets were all seen as factors underpinning the development of the Sukuk market. More recently, the sub-prime crisis and the so called ‘Shariah challenge’ (see below) have dampened the level of issuances coming to the market. Is this just a blip or is it reflective of something more fundamental occurring in this market?

The second annual London Sukuk Summit, held on the 25th and 26th June, attracted practitioners, issuers, regulators and others. Much of the discussions had focused on examining the implications of the credit crisis and the Shariah challenge. In November last year a prominent religious scholar active in the Islamic finance market issued a statement suggesting that two of the most common Sukuk types – Mudarabah (a form of trust financing) and Musharakah (joint partnership) – do not conform to the Shariah. Although Sukuk are widely seen as the Shariah compliant equivalent of conventional debt securities, Sukuk comes in a number of different guises with an array of different economic and risk characteristics.

The underlying reason for the scholar’s concern was that while the Mudarabah and Musharakah Sukuk are essentially equity-type instruments, the market uses certain techniques such as repurchase agreements (at maturity or specified default events) to guarantee the return of the Sukuk. This is at odds with the spirit of Islamic finance, where profits should be shared and interest is prohibited. This controversy is referred to as the ‘Shariah challenge’. It is estimated that over 80% of Sukuk are affected, but some Sukuk structures such as the Ijarah Sukuk (leasing) are not. In fact it is the Ijarah Sukuk which is the preferred structure for the UK government’s sterling sovereign Sukuk issuance.

The divergence in opinion between Islamic law scholars has caused concern in the market. In general though, the market has reacted positively to the Shariah challenge, considering the clarification as being helpful. Confusion, a lack of clearly defined parameters and divergences of opinion between scholars may yet damage the credibility of the market.

An example is the move by the Japan Bank for International Co-operation (JBIC) to issue a Sukuk. JBIC was preparing to issue its first Sukuk in May 2008 to fund its activities in promoting trade and international development projects. JBIC had selected Citibank of Dubai and CIMB of Malaysia to arrange the deal but the Shariah boards of the two banks disagreed on the whether it was Shariah compliant. The transaction will need to be restructured – from the original Murabahah structure to the Musharakah version – adding to cost, time and frustration for the issuer. Such an outcome cannot be beneficial to the market.

Although Sukuk are referred to as Islamic bonds, they often fall into one of two broad types; asset-based (where the credit risk of the bond is linked to the issuer) or asset-backed (the credit risk is linked to the underlying asset). The latter is similar to conventional asset- backed securities (ABS) which have risen in prominence in recent years. It was envisaged that the Shariah challenge may lead to a shift away from asset-based to asset-backed structures.

However, Geert Bossuyt, managing director and regional head of Middle East structuring at Deutsche Bank, indicates that this shift will probably not materialize for a number of reasons. Firstly there is a dearth of suitable underlying assets for issuers to use in asset-backed transactions (although in a few instances third parties are leasing assets to issuers for this purpose).

Secondly, many markets especially those in the GCC do not currently have a legal structure that can support the securitization market. Property rights; trust law; insolvency law etc. are often rudimentary or non-existent. Related to this, the enforceability of contracts in these and other emerging markets maybe uncertain and untested. He also indicated that even if these issues are resolved there are more fundamental issues to consider. Essentially, issuers demand products that mirror conventional debt in terms of risk and economic substance. ABS Sukuk simply does not fulfill these requirements.

Mutlaq Al-Morished, vice president of corporate finance at Saudi Basic Industries Corporation, one of the largest Sukuk issuers in the world, echoed these sentiments, adding that issuers will use Sukuk only if it makes economic sense.

The market is at an important juncture: it is clear that there is a desire among scholars and certain practitioners to focus on more ‘authentic’ asset-backed structures. Yet it was clear at the Summit that issuers are fundamentally driven by cost and there is preference for instruments which closely resemble conventional debt. At first glance this may seem an insurmountable gap. However, the market seems to have an infinite capacity to innovate within the guidelines laid by the scholars.

Recent evidence suggests that a new round of innovation could yet boost the fledgling market. For example, Shaikha Al-Sudairy, manager at HSBC Amanah in Riyadh, talked about two recent deals pioneered by her bank – the SABIC-Iand SABIC-II Sukuk and the Saudi Electricity Company (SEC) Sukuk -which use innovative new asset classes such as pools of petrochemical marketing contracts and electricity meters and the tariffs due on them, which were then securitized.

These examples demonstrate that there is a wider range of assets that are acceptable from the perspective of Islamic law. This will be beneficial to the market as previously only tangible fixed assets such as aircraft, shipping or real estate were considered as being acceptable.

From November 2007 till February 2008 the Sukuk market suffered; in this period no international, dollar-denominated, rated Sukuk came to the market. The impact of the recent credit crisis and the Shariah challenge inflicted a deep wound. Innovative deals like SABIC and SEC Sukuk indicate that human ingenuity and imagination may yet help this market flourish.

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Written by Suapi Shaffaii

July 11, 2008 at 9:06 am

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