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Sukuk as headline product and barometer of Islamic finance

• A global product - accessible to issuers and investors in all locations around the world
• Involvement of Islamic, conventional, regional and global deal arrangers and distributors

• Visible league tables, ensuring healthy competition and demonstrable success rate
• Accessible to different types of issuers (sovereigns, corporates, financial institutions) and investors (financial institutions, funds, asset managers, family offices, sovereign wealth funds)

• Supports assertion that IB is for everyone and not just restricted as an option for Muslims

• Access for issuers to a new Islamic investor base

• Access for Islamic investors to a new asset class, previously unavailable

There are many more causative factors that have resulted in the sukuk market becoming the global flagship product for the IB industry. One consequence is that trends of volumes of issuance of global sukuk are closely followed by analysts (and the wider IB market itself) and are seen as an overall indicator of how "healthy" the IB industry is.

And the general trend in the sukuk market is a positive one - Zawya's own figures show 2011 issuance at USD 84 billion, a 62% increase on the previous year's figure of USD 52 billion. Yemen, Iran and Jordan entered the sukuk markets in 2011, with others lining up from within the Muslim world and elsewhere.

So everyone should be happy, shouldn't they?

Well, if we dig a little below the surface, we notice a few things.

Sukuk Structures

The comprehensive search engine on the Zawya site lists almost 30 different types of structure. That is an impressive array available to issuers and investors. There was, however, some "noise" in the markets from Taqi Usmani's paper since it was first presented towards the end of 2007. There appears to have been some consequence in the markets, with some rebalancing towards certain structures that are seen to be less prone to criticism. But has it resulted in a real change in the essence of Sukuk?

In my experience, the issue lies not so much with one structure compared to another, but in the analysis of the underlying essence of the product. To put it simply...

If a reasonably complex and layered structure is used to enable assets to be bought, sold, leased, managed etc, and if the end result is that the investors receive an income that is priced as a spread over LIBOR (or similar interest benchmark) then the only conclusion that I can reasonably draw (after many years of structuring such products in the markets) is that this is, at its heart, a debt product, priced at LIBOR, but with assets inserted here and there in the structure.

It appears that I am not alone in this opinion, and readers can verify that for themselves if they have the inclination. It is reasonable to state that there is a (not insignificant) swell of opinion in the market that echoes these sentiments.

This article is not to pitch one opinion against another, as that is quite a well trodden path. Rather to look at the consequences of such a state of affairs.

Defaults

With some sukuk having defaulted in the last few years, we have been seeing, for the first time, structures and obligations being tested in a legal environment. It appears that the analysis of such proceedings only serves to prove that sukuk products sit in that grey area somewhere in between conventional bonds and equity investments.

Sukukholders quite often have found themselves with little recourse to the underlying assets that they thought they had recourse to. In other cases, such assets were determined to have little economic value in the first place, such as the sea-bed in one instance.

Again, we are not going to solve this issue here. But it can come as no surprise to any observer that given we have introduced a sukuk structure that at its heart is a contradiction (assets used to deliver debt) then it is only natural that such contradiction only serves to maintain a state of confusion on all fronts.

There are many red flags apparent to those who wish to understand the deeper nature of the instrument:

• Many sukuk are rated (this is debt terminology)
• Many are priced transparently at a spread to LIBOR (or equivalent benchmark). I have yet to see a product that replicates bond income streams (issuance, coupon and redemption) and prices in a similar way, yet in fact be an equity-type or asset-risk instrument
• Conventional banks readily put these sukuk in their conventional bond book as trading assets. They certainly would not do this unless they were convinced they were in essence bond instruments
• Legal documents are heavy, and reasonably complex. This is only to be expected because we are starting with the premise that the issuer wants to deliver bond cash flows, and investors wish to receive bond cash flows. Yet we have to have assets in there somewhere, so we have to create the relevant special purpose vehicles and structures to enable that, and figure out who owns what, and when they own it, how they own it, and what rights and obligations it gives them, and what recourse they have in certain scenarios. Then we have to thoroughly and methodically develop more legal constructs to remove all the associated risks, obligations and unwanted exposure to assets and asset risk and asset based cash flows, so that we are once more left with a bond structure.

The general message from the ratings agencies has been that sukuk investors do not have recourse to assets and generally rank as creditors of the issuer. This appears to be a very sensible conclusion.

Enough analysis - back to the core of the issue.

Where Does All This Leave Us?

At the very least, there are many stakeholders in the IB industry that are uncomfortable with the fact that we do have a lot of instruments (not just sukuk, of course) and products priced to interest. And given that sukuk is the flagship product, it is natural to assume that any analysis of the industry will look at sukuk as a product.

With more and more new countries and governments looking at entering the IB industry in some way, it is almost accepted now that one needs to issue a sukuk to show they really want to join the IB club. So it is clear our approach to sukuk needs to be tailored to take its obvious importance into account. It is not just another product.

I think we can agree that on any objective analysis, sukuk at best shows itself to be a product that loosely adheres to the mantra of being asset-backed, whilst in reality delivering cash flows and risks that are not really linked to the assets.

At worst, sukuk shows itself to be a product that works very hard to deliver exactly the one thing whose prohibition is most widely known as the key differentiator between Islamic and conventional banking, and that is debt/ interest.

Either way, it doesn't reflect well on the IB industry - that the industry is aligning itself very closely to the very things it claims are forbidden.

Whilst the IB industry continues to permit and promote sukuk as its flagship product, it is my view that IB faces an existential threat - that fundamentally we are creating shackles for ourselves and robbing ourselves of any real credibility. And what is faith-based banking without credibility? I don't know that answer.

What we have is a flagship product that is perhaps not even Islamic, but it gets us noticed.

Where Do We Go From Here?

I see three possible routes for the future of sukuk.

The first is that nothing really changes; we continue to churn out debt sukuk, and continue to bask in positive trends, new entrants, an asset class that is slowly increasing in liquidity, providing investors access to a more diversified portfolio of fixed-income assets. New currencies, new countries, new corporates - full steam ahead, and let's pat ourselves on the back.

I have seen a sukuk issued by a "non-Islamic" corporate, arranged by "non-Islamic" arrangers, sold 100% to "non-Islamic" investors, and it was a huge success by all accounts. Does it get any better than this? It just proves IB is the best solution, even non-Muslims are falling over themselves to get a piece of it. Doesn't it?

Or does it show that in our pursuit to make sukuk (and the wider IB market) more palatable to the global markets, issuers and investors, (and also Islamic investors and banks that wish to buy sukuk to prop up balance sheets already dominated by interest and debt on both sides), we have lost sight of our higher values?

Where a potential barrier exists, (i.e. we can't really deal with interest) we find clever ways to bypass that and still end up with something that looks like debt, prices like debt, and delivers returns and risk like debt, and that non Islamic buyers happily lump it into their bond portfolios. It appears there is nothing we cannot do.

We have ended up with debt in everything but name. But that is a crucial aspect - you will not see debt or interest mentioned in the prospectus or the structure, so what really is the problem here?

The second alternative is that there is some gradual shift in emphasis from debt sukuk to equity/investment sukuk. More sukuk shall be issued that really transfer asset risk, and asset cash flows to investors. This investment sukuk market shall operate in parallel to the debt sukuk market, which shall be carrying on in its merry way.

In a sense, we will have a debt sukuk market, in addition to a "real" sukuk market. One is Islamic, and the other is ... Islamic too? Or is one more Islamic than the other?

This reminds me of something a friend of mine said to me some years ago, on viewing an advert for a diet version of a popular soft drink. It went along the lines of: "It tastes exactly the same, brings you the same great feeling, but it has less caffeine/sugar and so it is better for you." My friend asked: "Who are they trying to fool? If that was completely true, then why were they still making the drink that tasted absolutely the same, had the same great feeling, but had MORE caffeine/sugar? Do they take us for fools?"

The third alternative is that perhaps we shall see a complete shift so that debt sukuk are phased out and equity/investment sukuk replace them and the development of a whole new asset class to replace the debt asset class, and show a genuine alternative to debt. There shall be no more debt instruments; no loans, no debt sukuk, and we shall be embarking on a journey towards a true interest/debt-free IB industry.

My personal view is that the outcome shall be somewhere between the first two options. In reality, we are more likely to see the wider conventional market begin to shun over-use of debt and interest (as they have seen the damage it can do when over-utilised) and limits being placed on the usage of debt in the wider economy. Once that happens, we can happily claim that it proves we were right in the first place to forbid debt, and then hope nobody notices that we had been embracing it all the time.

And who shall decide? Issuers? Investors? Regulators? Academics? Bankers? Scholars? Or Muslims demonstrating in the streets?

Who knows? Personally I think the scholars and the public are best equipped to provide the guidance needed. No one else has shown the inclination or capacity.

It is easy to criticise and not offer options, advice and possible alternatives to improve the situation. Make no mistake, the eradication of debt in the IB industry is an undertaking that is so vast, complex and difficult that it is easy to think there is no solution. However, even the longest and most arduous of journeys begins with a single step. And then another step. And then another.

In turn, I do have thoughts on ideas, solutions and ways forward. And I am trying my best to take the first small, tentative steps to making them a reality. Perhaps they may fail. Perhaps they may inspire others more intelligent, better qualified and with more influence than myself to visualise a better solution, and be in a stronger position to try to begin its implementation.

In the end, it's not really whether we get there, but clarity within ourselves as to where we draw the line and wish to take a stance, and what we try to do about it.

"Two roads diverged in a wood, and I -
I took the one less traveled by,
And that has made all the difference."
- Robert Frost

Safdar Alam is the chief executive officer at Solum Asset Management (www.solum.am). He was previously head of Islamic structuring at JP Morgan.

© Zawya 2012