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Back to basics: Sukuk structures

Back to basics: Sukuk structures

August, 2014
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The Islamic financial market has seen continuous growth in the past few years, particularly in the use of sukuk. As this debt instrument is carving itself a prominent place in the international financial market and competing with conventional debt products, we have dedicated this article to shed light on the concept of sukuk, how it works and its path to global expansion.

The different sukuk structures

The Murabaha sukuk is similar to conventional debt products as it constitutes the sale of a debt at a negotiated or discounted price where payment is deferred or made on installments.

The Ijara sukuk administers partial or pro rata ownership of assets or real estate on the owner of the certificate through periodic rental payments or usufruct for a fixed period of time. This instrument is used to raise funds to acquire assets. The assets and rental payments to be received need to be determined prior to entering into the contract of securitization.

The Salam sukuk is created in light of a promise to deliver commodities at a point in future by establishing the quantity, quality, date and place of delivery beforehand.

Istisna sukuk is issued for the production of products, where the holder of the certificate is the owner of the products and the issuer is the manufacturer or supplier of the product.

Mudaraba sukuk or muqaraba bond is issued for a specific project. The nature of capital and ratio for profit distribution, among other requirements of a sharia compliant Qirad contract, must be determined beforehand.

Musharaka sukuk is an investment sukuk used for specific projects or to finance a business activity, where the relationship between the owners is based on a partnership.

The most prominent of the above sukuk structures in the Middle East is the Ijara, whereas the Murabaha is the structure of choice in the Malaysian market. The market in most sukuk-issuing countries is mainly dominated by governmental players. Financial services, and in particular corporate issuers, account for a marginally low percentage of the global market.

The Asian market

Malaysia is the market leader in sukuk instruments as it covers 60% of total global newly issued sukuk bonds. Since it introduced the Islamic Banking Act in 1983, which allowed the issuance of the first Islamic debt, the Malaysian market has been thriving. With numbers as high as 111 Billion Dollars in 2012 (according to statistics by the Islamic Finance Information Service (IFIS)) the country has become the major contributor to Islamic finance regulatory framework throughout Asia.

Moreover, Malaysia has introduced a mandatory credit rating on all debt securities, including sukuk, which has lead other sovereign sukuk issuers, such as Dubai, Pakistan, Turkey and Bahrain, among others, to implement a rating system as well.

Hong Kong and Singapore have established a financial infrastructure to tempt foreign borrowers to issue sukuk bonds. Hong Kong is in the process of issuing its first sovereign sukuk bond in an attempt to become an Islamic financial hub in Asia.

In response to the thriving market in Malaysia, other Asian countries have expressed their interest in the Islamic Financial market, such as South Korea. The legal system in South Korea requires careful redefining in order to allow for the use of these Islamic financial certificates (Murabaha and Ijara sukuk structures are among those discussed of being introduced). The Korean Commercial Code (KCC) and the Financial Investment Services and Capital Market Act of Korea (FISCMA) have yet to come to an agreement on the definition of ‘investment securities’ in order to achieve an Islamic financial prospective for their market. The Central Bank of South Korea has, however, decided to become a member of the Islamic Financial Services Board (IFSB), which sets standards for Islamic finance, thus showing a willingness to adapt to the rapidly developing Islamic finance market.

The Middle Eastern market

In Dubai, new rules were implemented in an attempt to increase its position as an Islamic financial hub. The Dubai Financial Market (DFM) introduced Standards for Issuing, Acquiring and Trading Sukuk in April 2014. Ijara, Salam, Mudaraba, Musharaka and Muharaba sukuk are all governed by these standards. The most important elements established by the standards are the compliance with sharia law, how the sukuk holder’s rights should be protected, what liabilities the SPV has towards the certificate holders as trustee (such as not being allowed to be owned by the sukuk issuer) and if the property in question in tangible, such as real estate, then the issuer must legally have title to transfer such assets.

Moreover, the prospectus must state that a Sharia Committee is to overlook the sukuk bond and must set out the purpose for which the funds generated are to be used, which must be adhered to during the lifetime of the sukuk. As for sukuk managers, the Standards set out that they may be eligible to receive commissions and prizes based on performance and sales of the sukuk.

In response to the Standards put forward by the DFM, the Securities and Commodities Authority (SCA) has also incorporated specific regulations for sukuk in order to guarantee its sharia compliance by setting out certain rules to adhere to before a sukuk can be listed. The regulations require a sukuk to have a nominal value of at least AED 10,000,000 (ten million dirhams) and necessitate the Sharia Committee’s approval before it may be listed.

Among the Gulf Cooperation Council (GCC) countries, most have experienced a decline in the issuance of sukuk bonds, although they still rank as the second largest driver of sukuk instruments after Malaysia.

The European market

The sukuk concept is also gaining a foothold in Europe. It is noteworthy that Europe, particularly the United Kingdom and Luxembourg are taking the unprecedented step of a government issued sukuk bond. The only other European country which has issued sukuk instruments was France in 2012, although, it is important to clarify that the issuers were corporate entities and not government entities.

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Published: August 2014
Publication: Business Islamica
Title: Back to basics: Sukuk structures
Practice: Corporate and M&ABanking & Finance
Authors: Rima Mrad

 

 

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