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Islamic Finance and Capital Markets:
Structure and Trading of Sukuk
Khalifa M Ali Hassanain
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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
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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.
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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
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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
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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.
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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.
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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.
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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
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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‘ah-
compliant 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
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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.
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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.
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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.
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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 much-
needed 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.
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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
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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.
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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
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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.
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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
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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.
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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‘ah-
compliant 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.
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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.
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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‘ah-
compliant 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.
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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.
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.
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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.
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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.
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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 ownership-
related costs and share the rent earned by leasing it to any user.
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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.
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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.
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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
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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
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the providers of the capital own the agreed share of the profits but also bear the loss,
if any.
Salient Features of Muqaradah or Mudarabah Sukuk
The Resolution of the Islamic Fiqh Council of the OIC,fourth session, 1988, established
the following features of Mudarabah Sukuk or certificates:
1. For a specific project, the issued Mudarabah Sukuk signify that the holders own
the project jointly.
2. Based on the issue’s prospectus, the Mudarabah Sukuk contract must provide all
information necessary for a Qirād contract, such as the capital, ratio in which
profit will be divided and conditions for a Qirād contract.
3. By selling the Sukuk in the securities market, the holder of Mudarabah Sukuk can
transfer the ownership. The market value of Muqaradah Sukuk varies with the
business profits of the related project. Rules to be followed while selling
Muqaradah Sukuk include the following:
If the Mudarabah capital is in cash before the operation of the specific
project, the trading of Muqaradah Sukuk is similar to the interchange of
money, which must comply with the rules of Bai‘ al-Sarf. If the Mudarabah capital is in the form of debt, the sale must happen
according to the principles of debt trading in Islamic jurisprudence.
If the Mudarabah capital is a combination of cash, receivables, goods, real
assets and benefits, sale must be based on the consensual market price.
4. The manager or special purpose vehicle, who receives the funds from those who
subscribe to the Muqaradah Sukuk, can obtain more profit apart from his share as
Mudarib by investing his own funds.
5. Neither the issuer nor the manager of the fund should guarantee, either in the
prospectus or the Mudarabah Sukuk the capital or a fixed profit, or a profit linked
to any fraction of the capital. Accordingly,
i. The prospectus or the Muqaradah Sukuk issued for it cannot specify that a
certain amount will be paid to the Muqaradah Sukuk holder.
ii. Profit must be split according to the rules of Sharī‘ah, which implies an amount
in excess of the capital, not the revenue or the yield and
iii. A profit and loss account for the project must be published and distributed to
Mudarabah Sukuk holders.
6. Reserves for emergencies such as destruction of capital can be built by deducting
a percentage of the profit in each accounting period.
7. The prospectus can also specify a promise by an independent legal or financial
entity to donate a certain amount to compensate for the losses in a given project,
provided such commitment is independent of the Mudarabah contract and without
expecting any return benefit. However, the issuer is not allowed to guarantee the
Mudarabah capital.
Note: The third party should be totally unrelated to the parties involved in the contract.
Islamic financial institutions can offer Mudarabah Sukuk to entities who will subscribe
and participate in the investment transactions. The funds mobilised would be similar
to the variable capital of any bank to be marketed locally by selling the issued
Mudarabah Sukuk.
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Musharakah Sukuk
Nature of Musharakah Sukuk
The Musharakah Sukuk are issued to every subscriber of the project to represent his
proportionate ownership in the assets involved and are of equal value when mobilising
funds that will be used on the basis of partnership. The Musharakah certificate holders
own the relevant project or asset in the ratio of their shares, which comprise their asset
portfolios. Musharakah redeemable Sukuk are issued by or to the corporate sector or
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.
Similarity Between Musharakah and Mudarabah Sukuk
Musharakah Sukuk are similar to Mudarabah Sukuk. The basic Sharī‘ah rules apply to
both certificates equally except that the intermediary is a partner of the group of
Musharakah certificate holders, like partners in a joint stock company.
Secondary Market for Musharakah Sukuk
Once the project commences, Musharakah certificates are considered negotiable
instruments. Musharakah or Mudarabah based certificates can be traded in the
secondary market provided the Musharakah portfolio comprises non-liquid assets
valued at more than 50 percent. A mixture of liquid and non-liquid assets can be
traded for an amount higher than the amount of liquid assets in the combination or in
the pool. The Musharakah’s profit is shared according to a pre-defined ratio, while the
loss is shared pro rata.
Uses of Musharakah Sukuk
Investment Sukuk can be issued on a Musharakah basis 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 or for the construction of projects and factories, the expansion of
projects or for working capital finance. The Musharakah structure is considered more
equitable and safer for the investors than the Mudarabah mode, as both profit and loss
are shared between the fund manager and the Sukuk holders. In addition, the
manager’s participation in the Musharakah capital provides additional security.
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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: the Ministry of Finance, Bank of
Sudan, Bank of Khartoum, Nilain Bank and other public entities.
Since 1998, central bank Musharakah certificates and government Musharakah
certificates have been issued for investors and are used instead of treasury bills and
other interest-bearing securities for open market operations and monetary
management by the central bank. The central bank sells or buys the CMCs through
auctions. They can also be traded in the secondary inter-bank market.
Basics of Ijarah Sukuk
The Concept of Ijarah
The concept of Ijarah can be used for mobilising funds to develop long-term
infrastructure projects through securitisation of tangible assets such as airports, roads,
buildings, schools and hospitals, offering Sukuk to numerous institutional and individual
investors and creating a secondary market instrument for financiers.
Representation of Ijarah Sukuk for the Investor
The certificates signify ownership of the pro rata undivided parts of the asset with all
related rights and obligations, which is thereby ownership of well-defined and known
assets linked to a lease contract, with lease rental being the return due to the Sukuk
holders.
Structuring the Ijarah Sukuk
Securitisation of Ijarah Sukuk
Securitisation of Ijarah Sukuk can solve problems of managing liquidity and raising
finance for the public sector needs in developing countries. Flexibility to pay the rentals
before, during or after the lease period can be used to develop different forms of
contracts and Sukuk suitable for various purposes. Governments with useable assets
can employ Ijarah Sukuk as a substitute for conventional, interest-based borrowing.
Ijarah Funds
Ijarah funds can be raised by purchasing and leasing the assets through issuance of
Sukuk. The fund manager or SPV continues to own the assets and the rents received
from the use of the asset are distributed by the fund managers pro rata among the
subscribers.
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Note: Mudarabah Sukuk can also be used to raise funds through services andleases
apart from selling goods.
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 unchanged, rising or falling by benchmarking or linking it to any well-
known variable such as inflation rate, any regularly declared price index, or by any
established percentage.
Note: Mufti Muhammad Taqi Usmani 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 and
Sukuk of ownership of usufruct of assets, which can be divided into four types.
Sukuk of ownership of usufructs of existing assets
Sukuk of ownership of usufructs to be obtained in the future
Sukuk of ownership of services of a particular supplier and Sukuk of ownership of services to be obtained in the future
Sukuk of Ownership in Leased Assets
These certificates are issued either by the owner of a leased asset or an asset to be
leased or by his financial agent with the aim of recovering the value of the asset
through subscription. The subscribers are buyers of the asset whereas the certificate
holders become owners of the asset jointly with its benefits and risks.
Sukuk of Ownership of Usufruct of Existing Assets
These certificates are issued either by the owner of usufruct of an existing asset or his
financial agent. The funds mobilised through subscription are the procurement price of
the usufructs, and the certificate holders then own the usufruct along with the risks
and rewards. These certificates allow trade before signing a contract of sub-leasing
the assets. When the assets are sub-leased, the certificate represents the rental dues
and thereby acts as a debt certificate that is conditional on the set of laws applying to
debts. The issuer is allowed to redeem the Sukuk of ownership of usufruct of tangible
assets, either at the market price or as determined during purchase, from the Sukuk
holder after the Sukuk have been allotted and subscription amounts paid.
Sukuk of Ownership of Usufructs to be Obtained in the Future
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These certificates are issued for the assets to be leased, whereby the rental is
obtained from the subscription income. The certificate holders own the usufruct of the
future assets. The subscribers are the buyers of usufructs and will have both the risks
and rewards. Such Sukuk can be traded only after the asset is created. It is not
permitted to sub-lease or trade in usufructs of the asset to be obtained before its
creation. Trading must comply with the laws of currency exchange. These trading
rules are also applicable for the sub-leasing of usufructs.
Sukuk of Ownership of Services of a Specified Supplier
These certificates are issued to provide or sell services through a particular supplier,
such as educational programmers in a particular university, and to obtain the value as
subscription income. The holders of the Sukuk become owners of the services.
Sukuk of Ownership of Services to be Obtained in the Future
These certificates are issued to provide or sell services through an unspecified
supplier while providing the description of the subject matter, such as educational
programmes of a specific quality, schedule, duration, etc. without specifying the
educational institution, and to obtain the value as subscription income. The Sukuk
holders own the services.
Aspects of Ownership, Rent and Expenses
Clarity on Sharing of Expenses and Rent:
At the time of Ijarah contract, both the asset to be leased and the rental amount
should be clear to the entities involved in the contract. Then, Ijarah Sukuk can be
issued on an asset or a building that is not yet erected, provided the lessor can
acquire, construct or buy the asset by the date specified for its delivery to the lessee.
Shared Ownership and Accrued Rent
The lessor can sell the leased asset provided it does not hinder the lessee in
getting benefits from the asset. The new owner or owners are owed the rentals for
the remaining duration.
Similarly, they can sell their share in the asset to the new owners.
As per Ijarah Sukuk, the holder will take on the rights and dues of the owner or
lessor in proportion to his ownership.
The holder is entitled to enjoy a percentage of the rent according to his
percentage of ownership in the asset.
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In the similar way, the holder will suffer the loss due to destruction to the assets.
It is essential that the Ijarah certificates are designed to represent ownership for
the both the profit and loss.
Sharing of Expenses and Rent
As per Sharī‘ah rules, the owner must bear the capital and basic expenses of the asset,
while maintenance expenses are to be borne by the lessee.
Ijarah Sukuk should be considered as semi-fixed return instruments as the expected
flow of returns cannot be fully fixed and predefined.
If the asset is ruined but the lessee’s fault or negligence cannot be proven, the loss has
to be borne by the lessor – the Sukuk holders.
The parties can agree that the rental should comprise two components:
1. Payment to the lessor. 2. “On account” payment to be held by the lessee for costs linked to his
ownership of the asset.
Issuance and Trading of Ijarah Sukuk
Procedure for Issuing Ijarah Sukuk
Procedure for the issuance of Ijarah Sukuk to the investors involves incorporating an
SPV to buy the assets, which will then be leased to government or any corporate
body. The SPV serves as a manager and makes payment for purchasing the asset. It
collects rental payments from the lessee and distributes it among Sukuk holders. For
the leased asset, the lessee pays recurring rent to the SPV as stipulated before hand
by the lessor with the chance of small variances on account of payment of
unpredictable expenses by the lessor linked to ownership or the chance of default by
the lessee.
Trading in Secondary Market
After the transfer of ownership to the holders, Ijarah Sukuk can be traded without
restriction in the market and are easily converted into cash. It represents real assets
and not the monetary capital. The holders have become owners of the assets after
which they can sell. Before maturity, the issuer can redeem the Sukuk of ownership of
leased assets at the market price or at a price fixed between the certificate holder and
the issuer. Similarly, Ijarah Sukuk representing ownership of the usufruct of ascertained
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assets can be traded prior to the contract of sub-leasing that represent the monetary
rent receivable.
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, advance payment is done 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. The specifications of the two contracts such as goods and
delivery dates may comply with each other. However, the contracts should be
enforced independent of each other.
The advance payment made in Salam contract help raise funds equal to the price of the
commodity by issuing Salam Sukuk certificates. The certificate is issued by the seller of
the Salam commodity, whereas the buyers are the subscribers. The subscribers would
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.
The sale based on Salam contract is attractive to both the seller and buyer. This is
because the seller can enhance his cash flow beforehand while the buyer has the edge
of lower Salam price than the prevailing spot price.
Let’s now look into an example of Salam Sukuk.
In June 2001, the Bahrain Monetary Authority or BMA offered Salam-based securities
with LIBOR-linked three-month tenure used by Islamic banks to maintain the Statutory
Liquidity Ratio or SLR. SLR is the measure of funds banks should reserve exclusively to
handle cash crisis and repay depositors in case of default by borrowers. The Bahrain
government sells a specified amount of aluminium to Bahrain Islamic Bank or BIB at a
future date based on Salam. Simultaneously, BIB appoints the government as its agent.
The agent will help promote aluminium at the time of delivery at a price that grants
returns to the security holders.
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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. This is because Sukuk
certificate represents a share in the Salam debt, denoting that it is subject to the debt
trading rules. 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
forces the bank to sell the items from their own stock without specifying units, by
maintaining an inventory.
Salam seller should deliver goods at the agreed date and time. During the delivery
period, there is a possibility of change in price of tangible goods. This affects the
expected return through the sale, giving rise to a business risk.
Salam contracts are exempted from the rule of not selling goods without owning them
by adhering to some conditions. This helps avoid excessive Gharar in transactions.
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 manufacturing products, which permits
payment delivery of goods in the future or permits both delivery of goods and payment
in future. It helps finance the building of houses, plant, bridges, roads and highways.
A Parallel Istisna‘a contract by an Islamic bank with subcontractors allows it to take on
development of any project and sell the asset for a deferred price, but outsource the
construction to the subcontractor.
Ownership of the constructed item is transferred upon delivery of goods to the buyer in
exchange for the deferred sale price. The deferred sale price includes the construction
costs and profits, which includes the cost of locking funds during the repayment period.
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Istisna‘a Sukuk are certificates of equal value issued to mobilise funds needed to
manufacture goods. They document the deferred price that needs to be paid.
The manufacturer or seller issues Istisna‘a Sukuk, whereas the buyers of the goods is
the subscriber or certificate holder.
Trade of Istisna‘a Sukuk
Istisna‘a certificates can be traded or redeemed if the money has been converted
through business or trade into assets owned by the certificate holders. This is because
Sukuk represents assets that can be disposed.
Trading in Istisna‘a certificates should adhere to the laws for repaying debts if the
money is instantaneously offered as a price in a Parallel Istisna‘a contract or if the
produced item is handed over to the buyer. This is because Sukuk represents a price
that is the debt owed by the ultimate purchaser to the manufacturer.
The ban on Ribâ disallows the sale of the debt certificates to an independent entity at
any price different from their face value. Hence, certificates cannot have a secondary
market if they can be cashed only on maturity.
Goods are sold by big entities such as, builders, industrial concerns and wholesale
suppliers, to IFIs on a deferred payment basis and Istisna‘a Sukuk are issued
periodically according to the date of payment. In exchange of the Istisna‘a Sukuk, the
certificate holder may acquire the goods for a deferred price. After acquiring the assets,
they can be disposed in any way.
The deferred price is more than the spot price of the same goods. Hence, the certificate
holder acquires the goods by paying more. The holder then relinquishes to the seller
some of the differential price above the project development cost which he obtained
from the client. This indicates that the market forces can encourage or curtail the
exchange of these certificates for goods.
Murabaha Sukuk
A monetary right or obligation occurring out of a bank’s credit sale transaction cannot
be the basis of a negotiable instrument. Hence, securitization of Murabaha receivables
to create negotiable Sukuk is not possible. It is permissible to trade relevant certificates
if the commodity has been purchased by a trader but not sold to a different party.
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In a Murabaha transaction, the purchaser on credit signs a document to record his debt
towards the seller. This paper signifies a debt receivable by the seller. The paper can
be transferred to a third entity only at the same price and the transfer should adhere
to the rules of Hawalah i.e., it can be assigned only at face value.
A mixed portfolio having many transactions may issue negotiable certificates based on
certain conditions. To achieve this, the asset pool should comprise more than 50% of
Ijarah or other fixed assets from its total worth. However, in Hanafi view, trading is
allowed even if the non-liquid assets are valued at more than 10% of the portfolio’s
total worth.
Use of Murabaha Sukuk
Purchase of goods by the public sector involves use of Murabaha Sukuk.
Government may purchase items of huge price through credit sales by paying
installments. Over the period of installments, the seller will repay his cost and the profit.
Depending on the number of installments, the government issues certificates. Each
certificate has a maturity date that will represent the seller’s property right, which can
be transferred provided the amount of claim does not change.
The collection rights can be transferred to another party by the seller or the original
certificate holder if there is a default in payment that equals the face value of the
certificate less the cost of collection for the transferee.
Murabaha funds may also issue Murabaha Sukuk. The issue proceeds can be used for
sale of pre-defined and general assets on the basis of Murabaha, which provides
Murabaha Sukuk holders with partially-fixed return.
Let’s see an example of such a Sukuk issue.
In 2005, five-year multicurrency Murabaha-backed Sukuk with a five-year bullet
maturity was issued by the Arcapita Bank B.S.C (Bahrain). The proceeds of the Sukuk
are used to trade the assets through Murabaha transactions. As Murabaha generates
fixed return, to avoid Ribâ, Sukuk holders are offered returns equivalent to three-month
LIBOR plus 175 basis points or bps.
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The SPV has full resort to Arcapita making the Sukuk freely transferable according to
the procedure approved by Arcapita’s Sharī‘ah supervisory board. Presumably, SPV will
maintain inventory or fixed assets and make its Sukuk negotiable.
Mixed Sukuk
Mixed Sukuk consists of a pool of Musharakah, Ijarah, Murabaha, Salam, Istisna‘a, and
Ju‘alah contracts. These contracts may be securitised by the banks. Depending on the
chosen mix of the contracts, the return and risk of securities varies.
A mixed portfolio Sukuk is a tool that helps convert non-marketable and illiquid assets
to negotiable instruments that can be traded in a secondary market. These are, in
particular, appropriate for investment banks and development financial institutions or
DFIs.
A mixed portfolio Sukuk is illustrated by the Solidarity Trust Sukuk for 400 million USD
issued by Islamic Development Bank or IDB in 2003.
Solidarity Trust Services or STS, as a trustee, issued fixed-rate trust certificates. These
certificates represented undivided beneficial ownership in trust assets and were issued
to buy a mix of Ijarah, Murabaha and Istisna‘a contracts initiated by the IDB.
During any time of the period, over 50% of the assets would comprise Ijarah assets.
However, if the proportion fell below 25%, the issue would be dissolved, and IDB would
be obliged to buy trustee-owned assets by adhering to the terms of the purchase
undertaking deed. Certificate holder would receive periodic returns through the profit
on Sukuk assets.
Certificates are redeemed at their principal value. If there is an occurrence of early
dissolution, the redemption of certificate is done considering the return accumulation
period. The principal of Sukuk are reinvested in Ijarah and Musharakah contracts to
form a part of Sukuk assets.
Payment is guaranteed by IDB, according to the schedule of payments, with respect to
assets owed by the trustee. This payment guarantee does not cover the trust
certificates, but guarantees the amount planned as due from the debtors of the
underlying transactions in respect of the assets. If there is any loss in returns of the
Sukuk assets, the IDB meets the shortfall. To ensure timely payment on the trust
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certificates, IDB provides an interest-free facility to the STS. Therefore, the payment of
due of certificates eventually depends on IDB.
As per the purchase undertaking deed, the IDB purchases the Sukuk assets earlier than
the maturity or dissolution date. The trust distributes the proceeds among the certificate
holders.
Chapter Summary
You have completed the chapter, Categories of Sukuk. The key points of this chapter are as follows:
The six categories of Sukuk are Muqaradah or Mudarabah Sukuk, Musharakah
Sukuk, Ijarah Sukuk, Salam Sukuk, Istisna‘a Sukuk and Murabaha Sukuk.
Muqaradah or Mudarabah Sukuk are issued to encourage the public to invest in an
economy.
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 centers, endowments,
etc.
The concept of Ijarah can be used for mobilising funds to develop long-term
infrastructure projects through securitisation of tangible assets such as airports,
roads, buildings, schools and hospitals.
Ijarah Sukuk can be used to solve problems of managing liquidity and raising
finance for the public sector in developing countries.
The procedure for the issuance of Ijarah Sukuk to the investors involves
incorporating an SPV to buy the assets, which will be leased to government or any
corporate body.
In a Salam contract, money is paid in advance for goods that would be delivered
in future.
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.
The secondary market trading of Salam Sukuk is prohibited because the Sukuk
certificate represents a share in the Salam debt. Speculators who are not interested in the final delivery may seek to profit from
Parallel Salam transactions.
Istisna‘a is a contractual agreement for future delivery of manufacturing products
that allows advance or future payment.
Istisna‘a Sukuk are certificates of equal value issued for mobilising funds needed
to manufacture goods.
Istisna‘a certificates can be traded or redeemed if the funds are transformed into
assets owned by the certificate holders through business or trade.
Purchase of goods by the public sector involves use of Murabaha Sukuk.
An organisation with access to Murabaha funds may also issue Murabaha Sukuk.
The proceeds are used for sale of pre-defined and general assets on the basis of
Murabaha, which provides Murabaha Sukuk holders with partially-fixed return.
Mixed Sukuk consists of a pool of Musharakah, Ijarah, Murabaha, Salam, Istisna‘a,
and Ju‘alah contracts. Depending on the chosen mix of the contracts, the return
and risk of securities arises.
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