Archive for October, 2008

October 27, 2008

Islamic finance the core concepts

Islamic finance the core concepts

What is Islamic Finance?
At its broadest, Islamic finance covers all financial activity that enables Muslims to invest in conformity with Islamic law, or Sharia. In practice, Islamic finance involves using traditional investment techniques and structures that comply with Sharia to create arrangements that work in ways that are analogous to modern conventional finance.

Islamic banks and conventional banks that invest some of their capital in Islamic finance through an Islamic finance “window” have a religious board or committee composed of Sharia scholars (the Sharia committee). The Sharia committee examines proposed transactions and, in the case of Islamic banks, reviews the overall activities of the bank, for compliance with Sharia.

Key Principles
Key principles of Sharia relevant to finance transactions include:
Interest (Riba). Sharia regards money as simply a means of exchange, without intrinsic value and holds that money cannot be used to make money. Interest is the classic example of Riba. Payment or receipt of interest is strictly prohibited, and any obligation to pay interest is considered void under Sharia.

Speculation (Maisir). Sharia prohibits and treats as void transactions that rely on chance or speculation, rather than effort, to produce a return. This can create problems in relation to contracts that are seen as tantamount to gambling, which includes some conventional derivative transactions such as swaps, futures and options.

Uncertainty (Gharar). Sharia prohibits and treats as void contracts that are uncertain. All the fundamental terms of a contract (such as subject matter, price and time of delivery) must be absolutely certain at the outset.

Unjust enrichment/unfair exploitation. Sharia prohibits and treats as void contracts under which one party unfairly exploits the other or gains unjustly at their expense.

Unethical purpose. Sharia-compliant finance can be raised only for purposes that are permitted by Sharia and for the benefit of society.

Basic Transaction Structures
The main transaction structures used in Islamic finance are considered below.
In practice, commercial transactions will often combine a number of different techniques to produce the desired economic result and it is not uncommon for large fund-raisings (such as significant infrastructure projects) to incorporate both Sharia-compliant and conventional tranches.

Murabaha techniques are often used for trade finance and are analogous to conventional loans. Like conventional loans, they can be syndicated.

In a basic Murabaha, the financier buys an asset from a supplier and sells it to the customer at a premium. The purchase price is typically payable in installments. The premium is generally based on a benchmark figure, such as LIBOR, plus a margin. The economic effect is similar to a conventional asset finance facility.
Reverse Murabaha can be used where the customer requires a cash lump sum.
The customer buys an asset from the financier as in Murabaha but rather than retaining the asset for use in its business, the customer then sells it, either back to the original supplier or on to a third party.

It is possible to create a “revolving” reverse Murabaha, analogous to a conventional revolving loan facility (that is, a facility which allows a borrower to draw down, repay and re-borrow amounts throughout the life of the facility).
However, the methods for achieving this vary and the techniques are not universally accepted.

It is fundamental to Murabaha and reverse Murabaha arrangements that the financier actually acquires title to the asset in question, taking some commercial risk in relation to it. However, in practice this may be only for a very brief period.

Bai al Salam
Bai al Salam can be used to provide working capital. The key difference to Murabaha is that, while the financier still buys an asset, delivery is deferred.
Usually, the financier will receive a discount for advance payment, typically calculated by reference to a benchmark, such as LIBOR, plus a margin. Financier may at the same time enter into a parallel but separate Bai al Salam with a third party to resell the asset for an increased price (also calculated by reference to a conventional benchmark such as LIBOR), as illustrated in the diagram, or it may simply sell the asset on delivery.

Istisna’a is a technique similar to Bai al Salam and is used to provide advance funding for construction and development projects.

The key practical difference to Bai al Salam is that, instead of buying a finished asset with delivery deferred, the financier pays an amount to fund the manufacture, development, assembly, packaging or construction of an asset to an agreed specification. On completion, it will typically sell the asset to the customer or lease it back to the developer under an Ijara (see below).
The financier’s return usually takes the form of a premium on resale, typically calculated by reference to a benchmark, such as LIBOR, plus a margin.

An Ijara is a lease, often used to provide asset finance. In a financing context an Ijara is invariably preceded by an asset sale or Istisna’a.

In a simple financing Ijara, the financier buys an asset from a supplier and leases it to the customer. The customer pays rent representing an agreed profit, typically calculated using a benchmark, such as LIBOR, plus a margin.
One feature that distinguishes an Ijara from a conventional finance lease is the increased and ongoing risk the financier takes in relation to the asset. In an Ijara, the financier must take responsibility for insurance and major (as opposed to day to day) maintenance of the asset.

Mudaraba is an investment arrangement under which an investor or group of investors (Rab al Maal) place funds in the hands of a fund manager, usually a bank or financial institution (Mudareb), which provides expertise and manages the fund by investing in Sharia-compliant investments in return for a fee, typically based on a share of the profits.

In a commercial context, Mudaraba can be used as a tool to syndicate other Sharia-compliant financing arrangements (although conventional investment agency agreements are usually also Sharia-compliant). More commonly, Mudaraba is used to establish investment funds and Sharia-compliant retail bank accounts.

Musharaka is similar to a conventional partnership or joint venture and is often used in long-term investment projects.

The financier will usually contribute cash and the customer will contribute assets into a joint venture or enterprise. They share in the profits of the enterprise in agreed proportions but must share the losses in proportion to their initial investment. In a financing context, the profit-sharing arrangement is usually structured so that the financier receives his initial investment plus a return based on a benchmark, such as LIBOR, plus a margin.
A variation is the diminishing Musharaka, so called because the financier’s participation diminishes over time as the customer essentially buys out the financier’s share of the joint enterprise. Residential mortgages sometimes use structures that include a diminishing Musharaka.

Sukuk (singular Sakk) are financial instruments, such as certificates, that can be bought and sold on the capital markets.

Sukuk represent an undivided ownership share in an underlying asset or interest held by the issuer. This distinguishes them from both conventional bonds (which represent debt obligations of the issuer) and conventional equities (which represent ownership interests in the issuer itself).
The basic principle is that an ownership share in the underlying asset entitles the Sakuk holder to a proportionate share of the returns generated by the asset. The overall economic effect is similar to a conventional bond.
Sukuk are used in combination with other Sharia-compliant financing echniques to give rise to a Sharia-compliant return on an underlying asset.
Many different structures can be used for Sukuk, but Sukuk al Ijara and Sukuk al Musharaka are the most common.

Key features
In a typical structure, the entity looking to raise funds (the originator) will establish a special purpose vehicle (the issuer) in a suitable tax neutral jurisdiction. The originator will sell the underlying assets to the issuer, which will hold them under an English law trust in favor of the Sakk holders, to whom it issues certificates. The issuer funds the purchase of the assets with the issue proceeds.

While Sukuk are based on assets, the Sakk holder does not necessarily have any claim over the underlying assets in the event that the issuer fails to distribute the holder’s profit share: that will depend on whether the issuer’s obligations are secured on those assets in such a way that they can be made available to satisfy the holder’s claim in the event of the issuer’s default.

This is not typically the case, and the Sakk holder normally relies instead on an undertaking given by the originator to re-purchase the underlying assets at an agreed price on maturity or earlier in the event of default (the purchase undertaking).

This feature distinguishes the asset-based Sukuk that have been issued to date from the asset-backed securities issued by a conventional securitization vehicle. In practice, this means that, unless some additional credit enhancement element is included to improve the rating, Sukuk tend to have the same credit rating as the originator because repayment relies on the robustness of the purchase undertaking.
As might be expected, credit rating agencies do not verify Sharia compliance of rated Sukuk and do not take Sharia compliance into account as a relevant factor in rating Sukuk, unless non-compliance constitutes an event of default.

The terms and conditions of Sukuk are typically governed by English or New York law and are subject to the jurisdiction of the English or New York courts to help create legal certainty within the international financial community as to the nature and effect of the certificates.
However, in practice, some legal uncertainty can remain where judgment has to be enforced elsewhere (for example, in the jurisdiction in which the originator is domiciled). In addition, some of the underlying documents, such as sale and purchase agreements, may be governed by local law.

The Future
Sukuk issuance is the fastest-growing segment of the Islamic finance market and the volume out of the Middle East this year is expected to be phenomenal. However, the Islamic finance industry faces a number of challenges, including: Skills shortage. There are very few appropriately qualified Sharia scholars: it can take up to 30 years before a person is considered qualified, and there is no universal agreement on what makes a person “qualified” in this context.
No global consensus on Sharia. There is no international consensus on Sharia interpretations, especially in relation to innovative products. There are, however, some signs that the market may be settling.

Lack of standardization. Lack of consensus on Sharia, a high level of innovation and low transaction volumes mean that documents for the Islamic finance market (and the Sukuk market in particular) tend to be tailor-made for individual transactions, leading to much higher transaction costs than conventional finance alternatives. These costs should diminish as transaction volumes increase, and various industry bodies are taking steps to speed up the standardization process. Limited secondary market. Until very recently, there has been only a shallow and limited secondary market for Islamic finance products (again, Sukuk in particular) as most traditional investors have tended to hold their investments until maturity.

Need for assets. Much Sharia-compliant finance is assets-based, relying in some way on an income stream generated from assets. In practice, this can limit fund-raising to the assets available.

Restrictions on hedging. Traditional hedging techniques using derivatives are not always Sharia-compliant (for example, some derivatives fall foul of the prohibition of gambling). This means that hedging risks relating to currency, fair value or profit volatility is not easily achieved in Sharia-compliant finance. This can take up to 30 years before a person is considered qualified, and there is no universal agreement on what makes a person “qualified” in this context.

No global consensus on Sharia. There is no international consensus on Sharia interpretations, especially in relation to innovative products. There are, however, some signs that the market may be settling.

Tax disadvantages. The tax treatment of Sharia-compliant structures may not follow the treatment of their conventional finance alternatives. For example, where the financier’s return is structured as a profit share rather than interest, a tax deduction may not be available for the Islamic funding cost. In practice, this can necessitate careful structuring to ensure that Sharia-compliant finance does not become a more expensive fund-raising method than conventional finance.

Sara Catley is an analyst with PLC (Practical Law Company), the UK’s preeminent provider of legal know-how, transactional analysis and market intelligence for business lawyers. Catley would like to thank Andrew Calderwood and Natalya Pilbeam of Herbert Smith LLP, Luma Saqqaf of Linklaters LLP, Simon Sinclair of Clifford Chance LLP and Farmida Bi of Denton Wilde Sapte for their assistance with this article.


October 27, 2008

Islamic Funding Structures And Financing Vehicles

[This article was published in the 10th issue of Nida’ul Islam magazine, November-December 1995]

Islamic banks around the world have devised many creative financial products based on the risk-sharing, profit-sharing principles of Islamic banking. For day to day banking activities, a number of financial instruments have been developed that satisfy the Islamic doctrine and provide acceptable financial returns for investors. Broadly speaking, the areas in which Islamic banks are most active are in trade and commodity finance property and leasing. Some of the basic financial techniques of Islamic banking are the following:

Murabaha: This is the sale of a commodity at a price which includes a stated profit known to both the vendor and the purchaser. This can be called a cost plus profit contract. The price is usually paid back by the buyer in deferred payments. Under Murabaha, the Islamic bank purchases, in its own name, goods that an importer or a buyer wants, and then sells them to him at an agreed mark-up. This technique is usually used for financing trade, but because the bank takes title to the goods, and is therefore engaged in buying and selling, its profit derives from a real service that entails a certain risk, and is thus seen as legitimate. Simply advancing the money to the client at a fixed interest rate would not be legitimate. It is important to note that only a legitimate profit in addition to the actual price is considered lawful under Islamic law. Any excessive addition on account of deferred payments will be disallowed as it would amount to a payment based on the value of money over time i.e. interest.

Mudaraba: This implies a contract between two parties whereby one party, the rabb al-mal (beneficial owner or the sleeping partner), entrusts money to the other party called the mudarib (managing trustee or the labour partner). The mudarib is to utilise it in an agreed manner and then returns to the rabb al-mal the principal and the pre-agreed share of the profit. He keeps for himself what remains of such profits. The following characteristics of mudaraba are of significance:

* The division of profits between the two parties must necessarily be on a proportional basis and cannot be a lump-sum or guaranteed return.
* The investor is not liable for losses beyond the capital he has contributed.
* The mudarib does not share in the losses except for the loss of his time and efforts.

Briefly, an Islamic bank lends money to a client – to finance a factory, for example – in return for which the bank will get a specified percentage of the factory’s net profits every year for a designated period. This share of the profits provides for repayment of the principal and a profit for the bank to pass on to its depositors. Should the factory lose money, the bank, its depositors and the borrower all jointly absorb the losses, thereby putting into practice the pivotal Islamic principle that the providers and users of capital should share risks and rewards.

Musharaka: This is a partnership, normally of limited duration, formed to carry out a specific project. It is therefore similar to a western-style joint venture, and is also regarded by some as the purest form of Islamic financial instrument, since it conforms to the underlying partnership principles of sharing in, and benefiting from, risk. Participation in a musharaka can either be in a new project, or by providing additional funds for an existing one. Profits are divided on a pre-determined basis, and any losses shared in proportion to the capital contribution.

In this case, the bank enters into a partnership with a client in which both share the equity capital- and perhaps even the management – of a project or deal, and both share in the profits or losses according to their equity shareholding.

Ijara Wa Iktina: Equivalent to the leasing and installment-loan, hire-purchase, practices that put millions of drivers on the road each year. These techniques as applied by Islamic banks include the requirement that the leased items be used productively and in ways permitted by Islamic law.

Muqarada: This technique allows a bank to float what are effectively Islamic bonds to finance a specific project. Investors who buy muqaradah bonds take a share of the profits of the project being financed, but also share the risk of unexpectedly low profits, or even losses. They have no say in the management of the project, but act as non-voting shareholders.

Salam: A buyer pays in advance for a specified quantity and quality of a commodity, deliverable on a specific date, at an agreed price. This financing technique, similar to a futures or forward-purchase contract, is particularly applicable to seasonal agricultural purchases, but it can also be used to buy other goods in cases where the seller needs working capital before he can deliver.

Besides their range of equity, trade financing and lending operations, Islamic banks world-wide also offer a full spectrum of fee-paid retail services that do not involve interest payments, including checking accounts, spot foreign exchange transactions, fund transfers, letters of credit, travellers’ cheques, safe-deposit boxes, securities safekeeping investment management and advice, and other normal services of modern banking.

Almost every Islamic bank has a committee of religious advisers whose opinion is sought on the acceptability of new instruments and who have to provide a religious audit of the bank’s end of year accounts.

The concepts of equity and morality are at the root of Islamic banking. In Islam moral and equitable values form an integral part of the rules of law governing contractual and financial relations to such an extent that the relationship which exists between equity, law and religion is an organic rather than supplementary relationship. The importance of Islamic banking has increased dramatically over the past 10 years. The main difference between Western and Islamic-style banking is the concentration on people and their businesses rather than on accounts- it is a much more ‘grass roots’ banking according to one expert.

October 27, 2008

Model of a classic Sukuk structure

Model of a classic Sukuk structure

Over the last few years there has been a dramatic growth in the use of Islamic finance techniques in raising capital that complies with the requirements of Shari’a law.

According to recent reports assets invested in an Islamic, Shari’a compliant, manner are now estimated to exceed US$250 billion with the pool of money held by Muslim investors estimated at US$1.5 trillion (and growing rapidly with high oil prices).

The growth of the Sukuk market, which only opened in 2002 with the Malaysian government US$600 million Sukuk issue, is a prime indicator of this trend. By 2004, US$6.7 billion of capital was raised through the issue of Sukuks and in the first six months of 2005 the total raised reached US$6.2 billion.

Under the Koran, interest (riba) earned on money (for example, a loan) is forbidden, but many other types of finance are allowed. The basic principle behind the Sukuk is that the holder has an undivided ownership interest in a particular asset and is therefore entitled to the return generated by that asset. The classic Sukuk structure involves an acquisition of a property asset by a special purpose company (SPC) established in a tax neutral jurisdiction. The company funds itself by the issue of Sukuk, declaring a trust in favour of the Sukuk holders. The Sukuk holders receive a return based on the rental income of the asset, taking the credit risk of the underlying lessee (see box “Classic structure”).
There are a number of accounting and tax consequences which can arise when a UK property is transferred to a UK based SPC but these are beyond the scope of this article.

Increasing interest

The growth in the Sukuk market is due to the confluence of a number of factors ranging from the geopolitical impact of the 9/11 atrocities to a more general interest in developing Shari’a compliant products and structures. The fundamental drivers behind the Sukuk market are the same as those for the conventional securities market as it aims to:
-Broaden the pool of investors.

– Spread risk away from financial institutions.

– Dis-intermediate the link between investors and borrowers.

Although the market is relatively small, the excess liquidity currently being pumped into Gulf economies means that another pool of investment funds is becoming available to corporate treasurers. As the market is developing rapidly and the jurisprudence from the Islamic scholars is becoming more settled, the issue costs for a Sukuk structure continue to fall. The TCIP (Trust Certificate Issuance Programme) established by the Islamic Development Bank (IDB) in May 2005 marks a further step in the development of the Sukuk market with the IDB able to use some of the financial assets on its balance sheet to underpin Sukuk issues under a medium term note (MTN) like programme structure. The TCIP structure is similar to that outlined above with the underlying assets being a mixture of ijara (lease), murabaha (instalment sale) and istisna’a (conditional sale) contracts.

Eligible assets

The main stumbling block for accessing the Sukuk market is the availability of underlying assets that generate a Shari’a compliant income stream. An interest-derived income stream will not be eligible for inclusion in a Sukuk, but a rental-based income stream (whether from real estate or movable property) is ideal. The most popular asset class to date is real estate where rental income can be generated to provide cash flow returns to holders and repurchase obligations can be entered into to ensure principal repayments on the scheduled maturity dates. Other eligible assets have included aircraft, car fleets, pipelines and large air conditioning units.


Before being brought to market any Sukuk will need a declaration or opinion from Shari’a scholars that the relevant transaction complies with Shari’a law. There has been a degree of confusion as to the interplay between compliance with Shari’a law and with the enforceability of the relevant contracts. Recently, in Shamil Bank of Bahrain EC v Beximco Pharmaceuticals Ltd & Ors, the Court of Appeal held that an Islamic financing agreement which was expressed to be governed by both English and Shari’a law was governed by English law ( The court held that the question of whether or not a contract was Shari’a compliant does not have a bearing on its enforceability. This confusion can of course be minimised by clear drafting.

The future

It is expected that there will be continued strong growth in the Sukuk market. There is increasing standardisation of Sukuk documents in the marketplace which will drive costs down and improve the competitiveness of these instruments.
Andrew Roberts is a partner and Katsumasa Suzuki is an associate at Linklaters.

Classic structure
Source: Practical Law Company

October 27, 2008

Islamic Banking Opertunities knoking Indian Subcontinet

Islamic finance in India is slowly beginning to take off, but it will be some time before Islamic banks are really able to make their mark in the booming economy as Mike Gallagher reports
The Middle East has long had trade links with India. Indian Muslims make up 13.4 per cent of the country’s 1.3 billion population and many of these have been going on pilgrimages to Mecca for centuries, so it is no surprise that Islamic banks have been eyeing India for quite some time, although none has a presence there.
This is easy to understand at a practical level. The central bank of India has had a tough time trying to keep up with the pace of the economic boom. It is fully aware of the economic benefits of Islamic finance from an institutional and retail point of view and knows that a number of regulatory changes need to be made, but is often hamstrung by corrupt or recalcitrant regional governments and political infighting amongst the various parties in the coalition government. The banking system is in dire need of reform, but this is unlikely to take place until at least after the general election which is due to take place. However, Islamic finance does exist in various states across India, but it tends to be through cooperative banks or Islamic finance companies such as The Amanath Cooperative Bank, Pune-based Muslim Cooperative Bank, Baitun Nasr Urban Cooperative Society in Mumbai, Al Ameen Islamic Financial & Investment and Al-Falah Investment. Many of these cooperative banks and Islamic finance institutions tend to operate in rural areas such as Kerala.
Islamic finance at a retail level has not been successful in India. Its development has largely been hampered by a lack of adequate central bank rules which would allow it to function alongside conventional banks, such as in the UK or the Middle East.
Islamic banks cannot fully participate in the banking system in India because in order to receive banking licences, they need to comply with central bank rules on capital adequacy ratios and statutory liquidity ratios. These rules mean that all banks have to maintain and deposit 8.5 per cent of their total cash reserves at the central bank.
They then receive interest on 5.5 per cent while 3 per cent does not receive any interest. This immediately puts them at odds with Shari’ah. The fact that they do not and cannot operate under central bank regulations means that the central bank cannot act as a lender of last resort, should the worst come to the worst. Hence the reason for their small scale and the difficulty they have to establish a presence in India. This has meant that conventional banks have also had difficulty opening Islamic windows.
The majority of Islamic finance institutions in India are registered under the Non Banking Finance Companies Reserve Bank Directives 1997 RBI (Amendment) Act 1997 which means they are unable to offer the kinds of services that conventional banks can offer such as credit cards or cheque books and subsequently cannot make use of the settlement and clearing system.
Opportunities exist for Islamic finance in India, but they have not yet reached a retail level. Chetan Mehra, regional head of private banking and NRI services (GCC and Africa) of ICICI Bank in Dubai said, “It would be high net worth or institutional investors that will initially be investing in Islamic finance in India and this will be through the fund route. There is also a lot of activity taking place on the Islamic real estate side in India, especially in development.”
A number of Islamic banks from the Middle East have also been looking to expand internationally and India is highly likely to be somewhere they will be looking seriously at. Taib Bank has Islamic mutual funds such as the Taib GCC Islamic Fund and Taib Everest Fund II and others have been offering Islamic mutual funds through deals with Indian banks. At least one company is looking at the Islamic capital markets as India struggles to build its infrastructure. Velcan Energy, a renewable energy company from France is planning to raise $200 million in a Sukuk offering in the first quarter of 2008 to finance the construction of a hydroelectric dam in India, a first for India. The Sukuk will list on the DIFX.
Baader Wertpapierhandelsbank, a trade finance bank from Germany is planning to launch an Islamic fund in India, while 2iCapital from Bangalore started a $250 million Shari’ah compliant infrastructure fund in 2007. Islamic brokerage, Parsoli Corporation is also planning to join forces with Baader to launch an asset management company within the next 18 months.
At the close of 2007 Kuwait-based Khaleej Finance and Investment, in conjunction with ICICI Bank of India, launched a $200 million private equity fund. The fund has minimum subscription of $250,000 for individuals and $1 million for institutions with a targeted internal rate of return of around 25 per cent. The objective of the fund is to invest in unlisted Indian companies that are involved in areas like real estate, telecommunications, IT and infrastructure.
There has been a tremendous amount of activity by private equity companies in India, with an estimated 400 private equity companies thought to be active and there is believed to be room for Islamic private equity to increase its share of the alternative investments arena.
Some banks expect that at least $1 billion will be ploughed into Indian-orientated Islamic funds over the next 12 months. Kotak Mahindra Mutual Fund, which is part of the giant India Kotak Mahindra conglomerate, has recently launched a $300 million Shari’ah compliant fund.
Meanwhile, Kuwait Finance House and HSBC recently joined forces to arrange what they say is the first Ijarah facility ever to originate from India, a $50 million transaction for an Indian company called SREI Infrastructure Finance.
Investors have plenty of choice if they are looking for Shari’ah compliant investments on Indian stock exchanges, according to Dr Shariq Nisar, a Mumbai-based investment consultant. He estimated that between one third and a half of all stocks on Indian stock exchanges could be Shari’ah compliant. He carried out a survey which showed that nearly 240 listed companies on the Bombay Stock Exchange (BSE) met Shari’ah standards, while 335 out of 1000 on the National Stock Exchange (NSE) also met the criteria for Shari’ah compliance. He added that at least 60 per cent of all Indian companies meet Shari’ah compliance standards, compared to 57 per cent in Malaysia, 51 per cent in Pakistan and just 6 per cent in Bahrain. India even has its own Islamic equity exchange. The Parsoli Islamic Equity Index is an Islamic equity benchmark index, which includes 41 stocks from top 100 companies on exchanges from the BSE Sensex and the NSE Nifty Indices.
Majeed Zubair, the dean of the Institute of Islamic Banking and Finance in Hyderabad, believes that India could cater both to Malaysian and Middle Eastern investors and the differing Shari’ah standards. He also said that demand for courses in Islamic finance was far outstripping supply as banks anticipate increasing business from institutional investors looking for access to alternative forms of capital, particularly as the country’s infrastructure is being built up.
The biggest development of late featuring a Middle Eastern Islamic investment bank has been the $10 billion deal that Gulf Finance House (GFH) from Bahrain signed with the state of Maharashtra to develop an economic development zone near Mumbai. This deal was singed at the end of December 2007. The 1600-acre development comes a year after GFH had signed a similar agreement with the state for the development of India’s first energy business district, Energy City India.
Al Baraka from Bahrain, which owns 91 per cent of Al Baraka Islamic Bank, plans to expand into Asia with an initial investment of at least $300 million in the next couple of years and has identified India as one place it hopes to establish a presence, alongside Indonesia and Malaysia. ADCB, which has a Takaful and savings programme called ADCB Meethaq has been active in India since the early 1980s and will in all likelihood, be biding its time as the Indian government prepares to push through legislation to allow Islamic banks to operate under the same rules as conventional banks

October 17, 2008

Islamic bonds (Sukuk): Its introduction and application

Islamic bonds (Sukuk): Its introduction and application

The use of Sukuk or Islamic securities have become increasingly popular in the last few years, both as a means of raising government finance through sovereign issues, and as a way of companies obtaining funding through the offer of corporate sukuk.

Beginning modestly in 2000 with total three sukuk worth $336 millions the total number sukuk by the end of 2006 has reached to 77 with over US$ 27 billion funds under management. By the end of 2007 the total figure is expected to exceed US$35 billion.

Sukuk has developed as one of the most significant mechanisms for raising finance in the international capital markets through Islamically acceptable structures. Multinational corporations, sovereign bodies, state corporations and financial institutions use international sukuk issuance as an alternative to syndicated financing.

What are sukuk? how are they structured? and how they are different from the conventional bond and the conventional securitization processes is discussed in this paper in some detail.

What is Sukuk
Sukuk in general may be understood as a shariah compliant ‘Bond’. In its simplest form sukuk represents ownership of an asset or its usufruct. The claim embodied in sukuk is not simply a claim to cash flow but an ownership claim. This also differentiates sukuk from conventional bonds as the latter proceed over interest bearing securities, whereas sukuk are basically investment certificates consisting of ownership claims in a pool of assets.

Sukuk (plural of word sak) were extensively used by Muslims in the Middle Ages as papers representing financial obligations originating from trade and other commercial activities. However, the present structure of sukuk are different from the sukuk originally used and are akin to the conventional concept of securitization, a process in which ownership of the underlying assets is transferred to a large number of investors through certificates representing proportionate value of the relevant assets.

Sukuk and Bond
– A bond is a contractual debt obligation whereby the issuer is contractually obliged to pay to bondholders, on certain specified dates, interest and principal, whereas, the sukuk holders claims an undivided beneficial ownership in the underlying assets. Consequently, sukuk holders are entitled to share in the revenues generated by the sukuk assets as well as being entitled to share in the proceeds of the realization of the sukuk assets.

– A distinguishing feature of a sukuk is that in instances where the certificate represents a debt to the holder, the certificate will not be tradable on the secondary market and instead is held until maturity or sold at par.

Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) defines sukuk as being:

“Certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity”.

In 2000 total size of the sukuk was only US$ 336 million with no sovereign sukuk in the market. We can see from the above table that the size of total sukuk issued in 2001 was only US$ 336 million and in a short span of just six year the total size of sukuk has crossed US$ 27 billion. The growth achieved in 2003 has been most impressive at 483%. In 2006 also total growth achieved by sukuk is 122%.

Benefits and Features
– Tradable shariah-compliant capital market product providing medium to long-term fixed or variable rates of return. Assessed and rated by international rating agencies, which investors use as a guideline to assess risk/return parameters of a sukuk issue.

– Regular periodic income streams during the investment period with easy and efficient settlement and a possibility of capital appreciation of the sukuk.
– Liquid instruments, tradable in secondary market.

Uses of Sukuk Funds
The most common uses of sukuk can be named as project specific, asset-specific, and balance sheet specific.

a. Project-specific Sukuk

Under this category money is raised through sukuk for specific project. For example, Qatar Global sukuk issued by the Government of Qatar in 2003 to mobilize resources for the construction of Hamad Medical City (HMC) in Doha. In this case a joint venture special purpose vehicle (SPV), the Qatar Global sukuk QSC, was incorporated in Qatar with limited liability. This SPV acquired the ownership of land parcel, that was registered in the name of HMC. The land parcel was placed in trust and Ijara-based Trust Certificates (TCs) were issued worth US$700 million due by October 2010. The annual floating rate of return was agreed at LIBOR plus 0.45 per cent.

b. Assets-specific Sukuk

Under this arrangement, the resources are mobilise by selling the beneficiary right of the assets to the investors. For example, the Government of Malaysia raised US$ 600 million through Ijara sukuk Trust Certificates (TCs) in 2002. Under this arrangement, the beneficiary right of the land parcels has been sold by the government of Malaysia to an SPV, which was then re-sold to investors for five years. The SPV kept the beneficiary rights of the properties in trust and issued floating rate sukuk to investors.

Another example of Asset-specific sukuk is US$250 million five-year Ijara sukuk issued to fund the extension of the airport in Bahrain. In this case the underlying asset was the airport land sold to an SPV.

c. Balance Sheet-specific Sukuk

An example of the balance sheet specific use of sukuk funds is the Islamic Development Bank (IDB) sukuk issued in August 2003. The IDB mobilised these funds to finance various projects of the member countries. The IDB made its debut resource mobilization from the international capital market by issuing US$ 400 million five-year sukuk due for maturity in 2008.

Types of Sukuk
Sukuk can be of many types depending upon the type of Islamic modes of financing and trades used in its structuring. However, the most important and common among those are ijarah, shirkah, salam and istisna. Among the fourteen eligible sukuks identified by the AAOIFI, following are more common:

1. Mudaraba Sukuk

These are investment sukuk that represent ownership of units of equal value in the Mudaraba equity and are registered in the names of holders on the basis of undivided ownership of shares in the Mudaraba equity and its returns according to the percentage of ownership of share. The owners of such sukuk are the rabbul-mal. (AAOIFI). Mudarba sukuk are used for enhancing public participation in big investment projects.

Salient Features:

Following are the salient features of mudarba sukuk:

I. Mudarba sukuk (MS) represent common ownership and entitle their holders share in the specific projects against which the MS has been issued.

II. The MS contract is based on the official notice of the issue of the prospectus which must provide all information required by shariah for the Qirad contract such as the nature of capital, the ratio for profit distribution and other conditions related to the issue, which must be compatible with shariah.

III. The MS holder is given the right to transfer the ownership by selling the deeds in the securities market at his discretion. The sale of MS must follow the rules listed below:
a. If the mudarba capital, before the operations of the project, is still in the form of money, the trading of MS would be like exchange of money for money. In that case the rules of bay al-sarf would be applied.
b. If muqarda capital is in the form of debt then it must satisfy the principles of debt trading in Islam.
c. If capital is in the form of combination of cash, receivables, goods, real assets and benefits, trade must be based on market price evolved by mutual consent.

IV. The Manager/SPV who receives the fund collected from the subscribers to MS can also invest his own fund. He will get profit for his capital contribution in addition to his share in the profit as mudarib.

V. Neither prospectus nor MS should contain a guarantee, from the issuer or the manager for the fund, for the capital or a fixed profit, or a profit based on any percentage of the capital. Accordingly;

a. The prospectus or the MS issued pursuant to it, may not stipulate payment of a specific amount to the MS holder,
b. The profit is to be divided, as determined by applying rules of shariah; that is, an amount access of the capital, and not the revenue or the yield; and
c. Profit and Loss account of the project must be published and disseminated to MS holders.

VI. It is permissible to create reserves for contingencies, such as loss of capital, by deducting from the profit.

VII. The prospectus can also contain a promise made by a third party, totally un-related to the parties to the contract, in terms of legal entity or financial status, to donate a specific sum, without any counter benefit, to meet losses in the give project, provided such commitment is independent of the mudarba contract.
On the expiry of the specified time period of the subscription, the Sukuk holders is given the right to transfer the ownership by sale or trade in the securities market at his discretion.

Steps involved in the structure:

-Mudarib enters into an agreement with project owner for construction/commissioning of project.
-SPV issues sukuk to raise funds.
-Mudarib collects regular profit payments and final capital proceeds from project activity for onward distribution to investors.
-Upon completion, Mudarib hands over the finished project to the owner.

Mudaraba Sukuk in practice
Shamil Bank of Bahrain raised 360 million Saudi Riyal investment capital through the Al Ehsa Special Realty Mudaraba, representing an investment participation in a land development transaction with a real estate development company in the Kingdom of Saudi Arabia. The investment objective of the Mudaraba is to provide investors with annual returns arising from participation in the funding of a land financing transaction Profits due to investors will be accrued on the basis of returns attained from investing the subscriptions.

2. Musharaka Sukuk

These are investment sukuk that represent ownership of Musharaka equity. It does not differ from the Mudaraba sukuk except in the organization of the relationship between the party issuing such sukuk and holders of these sukuk, whereby the party issuing sukuk forms a committee from the holders of the sukuk who can be referred to in investment decisions (AAOIFI).
Musharaka Sukuk are used for mobilizing the funds for establishing a new project or developing an existing one or financing a business activity on the basis of partnership contracts. The certificate holders become the owners of the project or the assets of the activity as per their respective shares. These Musharaka certificates can be treated as negotiable instruments and can be bought and sold in the secondary market.

“These are certificates of equal value issued with the aim of using the mobilized funds for establishing a new project, developing an existing project or financing a business activity on the basis of any partnership contracts so that the certificate holders become the owners of the project or assets of the activity as per their respective shares, with the Musharaka certificates being managed on the basis of participation or Mudaraba or an investment agency.” (AAOIFI Standard 17, 3/6)

Steps involved in the structure:

Corporate and the Special Purpose Vehicle (SPV) enter into a Musharaka Arrangement for a fixed period and an agreed profit-sharing ratio. Also the corporate undertakes to buy Musharaka shares of the SPV on a periodic basis.

-Corporate (as Musharik) contributes land or other physical assets to the Musharaka
-a & b. SPV (as Musharik) contributes cash i.e. the issue Proceeds received from the investors to the Musharaka
-The Musharaka appoints the Corporate as an agent to develop the land (or other physical assets) with the cash injected into the Musharaka and sell/lease the developed assets on behalf of the Musharaka.
-In return, the agent (i.e. the Corporate) will get a fixed agency fee plus a variable incentive fee payable.
-The profits are distributed to the sukuk holders.
-The Corporate irrevocably undertakes to buy at a pre-agreed price the Musharaka shares of the SPV on say semi-annual basis and at the end of the fixed period the SPV would no longer have any shares in the Musharaka.

Musharaka Sukuk in Practice
US$550 million sukuk transaction for Emirates airline, the seven-year deal was a structured on a Musharaka contract. The Musharaka or joint venture was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai’s airport which will ultimately be leased to Emirates. Profit, in the form of lease rentals, generated from the Musharaka venture will be used to pay the periodic distribution on the trust certificates.

Sitara Chemical Industries Ltd, a public limited company, made a public issue of profit-and-loss sharing based term finance certificates (TFC’s) worth Rs 360 million which were subscribed in June 2002. The TFC’s had a fixed life tenor of five years and profit and loss sharing was linked to the operating profit or loss of the Chemical Division of the company.

Kuwait Finance House (KFH), Liquidity Management Center (LMC) and Al Muthanna Investment Company (MIC), the mandated lead arrangers launched US$ 125 million Lagoon City Musharaka sukuk to support the Lagoon City residential and commercial real estate development as part of Kheiran Pearl City project.

3. Ijara Sukuk

These are sukuk that represent ownership of equal shares in a rented real estate or the usufruct of the real estate. These sukuk give their owners the right to own the real estate, receive the rent and dispose of their sukuk in a manner that does not affect the right of the lessee, i.e. they are tradable. The holders of such sukuk bear all cost of maintenance of and damage to the real estate. (AAOIFI)

Ijarah sukuk are the securities representing ownership of well defined existing and known assets tied up to a lease contract, rental of which is the return payable to sukuk holders. Payment of ijarah rentals can be unrelated to the period of taking usufruct by the lessee. It can be made before beginning of the lease period, during the period or after the period as the parties may mutually decide. This flexibility can be used to evolve different forms of contract and sukuk that may serve different purposes of issuers and the holders.

Features of Ijarah sukuk

1. It is necessary for an ijarah contract that the assets being leased and the amount of rent both are clearly known to the parties at the time of the contract and if both of these are known, ijarah can be contracted on an asset or a building that is yet to be constructed, as long as it is fully described in the contract provided that the lessor should normally be able to acquire, construct or buy the asset being leased by the time set for its delivery to the lessee (AAOIFI, 2003: 140-157). The lessor can sell the leased asset provided it does not hinder the lessee to take benefit from the asset. The new owner would be entitled to receive the rentals.

2. Rental in ijarah must be stipulated in clear terms for the firs term of lease, and for future renewable terms, it could be constant, increasing or decreasing by benchmarking or relating it to any well-known variable.

3. As per shariah rules, expenses related to the corpus or basic characteristics of the assets are the responsibility of the owner, while maintenance expenses related to its operation are to be borne by the lessee.

4. As regards procedure for issuance of ijarah sukuk, an SPV is created to purchase the asset(s) that issues sukuk to the investor, enabling it to make payment for purchasing the asset. The asset is then leased to third party for its use. The lessee makes periodic rental payments t the SPV that in turn distributes the same to the sukuk holders.

5. Ijara sukuk are completely negotiable and can be traded in the secondary markets.

6. Ijara sukuk offer a high degree of flexibility from the point of view of their issuance management and marketability. The central government, municipalities, awqaf or any other asset users, private or public can issue these Sukuk. Additionally, they can be issued by financial intermediaries or directly by users of the leased assets.

Steps involved in the structure
-The obligator sells certain assets to the SPV at an agreed pre-determined purchase price.
-The SPV raises financing by issuing sukuk certificates in an amount equal to the purchase price.
-This is passed on to the obligator (as seller).
-A lease agreement is signed between SPV and the obligator for a fixed period of time, where the obligator leases back the assets as lessee.
-SPV receives periodic rentals from the obligator;
-These are distributed among the investors i.e. the sukuk holders.
-At maturity, or on a dissolution event, the SPV sells the assets back to the seller at a predetermined value. That value should be equal to any amounts still owed under the terms of the Ijara sukuk.

Ijara Sukuk in Practice
In December 2000, Kumpulan Guthrie Berhad (Guthrie) was granted a RM1.5 billion (US$400 million) Al-Ijara Al-Muntahiyah Bit-Tamik by a consortium of banks. The original facility was raised to re-finance Guthrie’s acquisition of a palm oil plantation in the Republic of Indonesia. The consortium was then invited to participate as the underwriter/primary subscriber of the Sukuk Transaction.

US$350 million sukuk Trust Certificates by Sarawak Corporate Sukuk Inc. (SCSI) Sarawak Economic Development Corporation (SEDC) raised financing amounting to US$350 million by way of issuance of series of trust certificates issued on the principle of Ijara sukuk. The certificates were issued with a maturity of 5 years and under the proposed structure, the proceeds will be used by the issuer to purchase certain assets from 1st Silicon (Malaysia) Sdn Bhd. Thereafter, the issuer will lease assets procured from 1st Silicon to SEDC for an agreed rental price for an agreed lease period of 5 years.

4. Murabaha Sukuk

In this case the issuer of the certificate is the seller of the Murabaha commodity, the subscribers are the buyers of that commodity, and the realised funds are the purchasing cost of the commodity. The certificate holders own the Murabaha commodity and are entitled to its final sale price upon the re-sale of the Commodity. The possibility of having legally acceptable Murabaha-based sukuk is only feasible in the primary market. The negotiability of these Sukuk or their trading at the secondary market is not permitted by shariah, as the certificates represent a debt owing from the subsequent buyer of the Commodity to the certificate-holders and such trading amounts to trading in debt on a deferred basis, which will result in riba.

Despite being debt instruments, the Murabaha Sukuk could be negotiable if they are the smaller part of a package or a portfolio, the larger part of which is constituted of negotiable instruments such as Mudaraba, Musharaka, or Ijara Sukuk. Murabaha sukuk are popular in Malaysian market due to a more liberal interpretation of fiqh by Malaysian jurists permitting sale of debt (bai-al-dayn) at a negotiated price.

Steps involved in the structure:

-A master agreement is signed between the SPV and the borrower
-SPV issues sukuk to the investors and receive sukuk proceeds.
-SPV buys commodity on spot basis from the commodity supplier.
-SPV sells the commodity to the borrower at the spot price plus a profit margin, payable on installments over an agreed period of time
-The borrower sells the commodity to the Commodity buyer on spot basis.
-The investors receive the final sale price and profits.

Murabaha Sukuk in Practice
Arcapita Bank, a Bahrain-based investment firm has mandated Bayerische Hypo-und Vereinsbank AG (“HVB”), Standard Bank Plc (“SB”) and WestLB AG, London Branch (“WestLB”) (together the “Mandated Lead Arrangers”), to arrange a Five Year Multicurrency (US$, € and £) Murabaha-backed Sukuk. Sukuk will have a five-year bullet maturity and proposed pricing three month LIBOR +175bps.

5. Salam Sukuk

Salam sukuk are certificates of equal value issued for the purpose of mobilising Salam capital so that the goods to be delivered on the basis of Salam come to the ownership of the certificate holders. The issuer of the certificates is a seller of the goods of Salam, the subscribers are the buyers of the goods, while the funds realized from subscription are the purchase price (Salam capital) of the goods. The holders of Salam certificates are the owners of the Salam goods and are entitled to the sale price of the certificates or the sale price of the Salam goods sold through a parallel Salam, if any.

Salam-based securities may be created and sold by an SPV under which the funds mobilized from investors are paid as an advance to the company SPV in return for a promise to deliver a commodity at a future date. SPV can also appoint an agent to market the promised quantity at the time of delivery perhaps at a higher price. The difference between the purchase price and the sale price is the profit to the SPV and hence to the holders of the Sukuk.

All standard shariah requirements that apply to Salam also apply to Salam sukuk, such as, full payment by the buyer at the time of effecting the sale, standardized nature of underlying asset, clear enumeration of quantity, quality, date and place of delivery of the asset and the like.

One of the Shariah conditions relating to Salam, as well as for creation of Salam sukuk, is the requirement that the purchased goods are not re-sold before actual possession at maturity. Such transactions amount to selling of debt. This constraint renders the Salam instrument illiquid and hence somewhat less attractive to investors. Thus, an investor will buy a Salam certificate if he expects prices of the underlying commodity to be higher on the maturity date.

Steps involved in the transaction:

-SPV signs an undertaking with an obligator to source both commodities and buyers. The obligator contracts to buy, on behalf of the end-Sukuk holders, the commodity and then to sell it for the profit of the Sukuk holders.
-Salam certificates are issued to investors and SPV receives Sukuk proceeds.
-The Salam proceeds are passed onto the obligator who sells commodity on forward basis
-SPV receives the commodities from the obligator
-Obligator, on behalf of Sukuk holders, sells the commodities for a profit.
-Sukuk holders receive the commodity sale proceeds.

Salam Sukuk in Practice
Aluminum has been designated as the underlying asset of the Bahrain Government al Salam contract, where by it promises to sell aluminum to the buyer at a specified future date in return of a full price payment in advance. The Bahrain Islamic Bank (BIB) has been nominated to represent the other banks wishing to participate in the Al Salam contract. BIB has been delegated to sign the contracts and all other necessary documents on behalf of the other banks in the syndicate. At the same time, the buyer appoints the Government of Bahrain as an agent to market the appropriate quantity at the time of delivery through its channels of distribution. The Government of Bahrain provides an additional undertaking to the representative (BIB) to market the aluminum at a price, which will provide a return to al Salam security holders equivalent to those available through other conventional short-term money market instruments.

6. Istisna Sukuk

Istisna sukuk are certificates that carry equal value and are issued with the aim of mobilising the funds required for producing products that are owned by the certificate holders. The issuer of these certificates is the manufacturer (supplier/seller), the subscribers are the buyers of the intended product, while the funds realised from subscription are the cost of the product. The certificate holders own the product and are entitled to the sale price of the certificates or the sale price of the product sold on the basis of a parallel Istisna, if any. Istisna Sukuk are quite useful for financing large infrastructure projects. The suitability of Istisna for financial intermediation is based on the permissibility for the contractor in Istisna to enter into a parallel Istisna contract with a subcontractor. Thus, a financial institution may undertake the construction of a facility for a deferred price, and sub contract the actual construction to a specialised firm.

Shariah prohibits the sale of these debt certificates to a third party at any price other than their face value. Clearly such certificates cannot be traded in the secondary market.

Steps involved in the structure:

-SPV issues Sukuk certificates to raise funds for the project.
-Sukuk issue proceeds are used to pay the contractor/builder to build and deliver the future project.
-Title to assets is transferred to the SPV
-Property/project is leased or sold to the end buyer. The end buyer pays monthly installments to the SPV.
-The returns are distributed among the Sukuk holders.

Istisna Sukuk in Practice
Tabreed’s five-year global corporate Sukuk (on behalf of the National Central Cooling Company, UAE) provided a fixed coupon of 5.50%. It is a combination of Ijara Istisna and Ijara Mawsufah fi al dhimmah (or forward leasing contracts). The issue was launched to raise funds to retire some existing debt, which totals around US$136 million, as well as to finance expansion.

The Durrat Sukuk will finance the reclamation and infrastructure for the initial stage of a broader US$ 1 billion world class residential and leisure destination known as ‘Durrat Al Bahrain’, currently the Kingdom of Bahrain’s largest residential development project. The return on the Sukuk is 125 basis points over 3 months LIBOR payable quarterly, with the Sukuk having an overall tenor of 5 years and an option for early redemption. The proceeds of the issue (cash) will be used by the Issuer to finance the reclamation of the land and the development of Base Infrastructure through multiple project finance (Istisna) agreements. As the works carried out under each Istisna are completed by the Contractor and delivered to the Issuer, the Issuer will give notice to the Project Company under the Master Ijara Agreement and will lease such Base Infrastructure on the basis of a lease to own transaction.

7. Hybrid Sukuk

Considering the fact that Sukuk issuance and trading are important means of investment and taking into account the various demands of investors, a more diversified Sukuk – hybrid or mixed asset Sukuk – emerged in the market. In a hybrid Sukuk, the underlying pool of assets can comprise of Istisna, Murabaha receivables as well as Ijara. Having a portfolio of assets comprising of different classes allows for a greater mobilization of funds. However, as Murabaha and Istisna contracts cannot be traded on secondary markets as securitised instruments at least 51 percent of the pool in a hybrid Sukuk must comprise of Sukuk tradable in the market such as an Ijara Sukuk. Due to the fact the Murabaha and Istisna receivables are part of the pool, the return on these certificates can only be a pre-determined fixed rate of return.

Steps involved in the structure:

-Islamic finance originator transfers tangible assets as well as Murabaha deals to the SPV.
-SPV issues certificates of participation to the Sukuk holders and receive funds. The funds are used by the Islamic finance originator.
-Islamic finance originator purchase these assets from the SPV over an agreed period of time.
-Investors receive fixed payment of return on the assets.

Hybrid Sukuk in practice

Islamic Development Bank issued the first hybrid Sukuk of assets comprising 65.8% Sukuk al-Ijara, 30.73% of Murabaha receivables and 3.4% Sukuk al-Istisna. This issuance required the IDB’s guarantee in order to secure a rating and international marketability. The $ 400 million Islamic Sukuk was issued by Solidarity Trust Services Limited (STSL), a special purpose company incorporated in Jersey Channel Islands. The Islamic Corporation for the Development of Private Sector (ICD) played an intermediary role by purchasing the asset from IDB and selling it to The Solidarity Trust Services Limited (STSL) at the consolidated net asset value.

The market for sukuk is now maturing and there is an increasing momentum in the wake of interest from issuers and investors. sukuk have confirmed their viability as an alternative means to mobilise medium to long-term savings and investments from a huge investor base.

Different sukuk structures have been emerging over the years but most of the sukuk issuance to date have been ijara sukuk, since they are based on the undivided pro-rata ownership of the underlying leased asset, it is freely tradable at par, premium or discount. Tradability of the sukuk in the secondary market makes them more attractive. Although less common than Ijara sukuk, other types of sukuk are also playing significant role in emerging markets to help issuers and investors alike to participate in major projects, including airports, bridges, power plants etc. The sovereign sukuk issues, following Malaysia’s lead, are enjoying widespread and positive acclaim among Islamic investors and global institutional investors alike.
Source: Finance in Islam