06 June 2011
In simple terms, sukuks can be considered the Islamic equivalent of conventional bonds, although the concept and structuring for both are very different. For Oman's economy, sukuks represent a new source of funds for sovereign entities, corporates and small and medium size enterprises. They are currently in high demand given the growing Islamic wealth pool with banks, high net worth individuals, takaful companies, fund managers and general public.
Sukuks are asset-backed, income generating, tradable, Sharia compliant investment product.
From an issuer's perspective, sukuks would offer large scale financing for commercial and industrial ventures that are typically beyond the ability of a single party to finance.
From an investor's point of view, sukuks are investment products linked to the real economy, providing attractive returns and with the convenience of liquidity whenever the need should arise. In its true form, sukuk investment allows investors to benefit from the true profits resulting from the underlying assets. For conventional investors also, sukuk offers diversification away from traditional lending.
Finally, sukuks represent an excellent mechanism to manage liquidity for banks and Islamic financial institutions.
The strong demand for sukuk products has not gone unnoticed.
Several sovereign issuers including Malaysia, Bahrain, Qatar and the UAE have launched international sukuk programmes raising several billion dollars. These include a mix of short tenor and long term sukuks, in local and other currencies. Sukuk instruments also offer central banks the necessary tool to truly manage domestic money supply and credit extension of Islamic banks.
Similarly, corporates and financial institutions from Middle East, Asia, Europe and United States have successfully approached Sharia sensitive investors with sukuk investment products to raise financing for their businesses. This includes large corporates like SABIC and General Electric. Key economic sectors that have benefited from using sukuk products are financial services, real estate, government institutions, power and utilities, transport and oil and gas.
Difference from conventional bonds
The most prominent characteristics of conventional bonds may be summarised as follows:
Bonds do not represent ownership on the part of the bond holders in the underlying assets. Rather, they document the interest bearing debt owed to the holders of the bond by the issuer.
Regular interest payments are made to the bond holders. The interest payment is determined as a percentage of the capital, and not linked to real returns.
Finally, bond instruments guarantee the return of principal when redeemed at maturity, regardless of the performance of the underlying venture.
Sukuk structures in practice
The quality of sukuk products from Sharia perspective depends upon the sharing of risk and the equitable distribution of profits between investors. There are several sukuk structures in the market today, based on Ijarah, Musharaka, Salam and Istisna'a contracts.
Ijarah sukuks are issued on stand-alone assets which can be a parcel of land, equipment or the likes of aircraft or ships, for lease.
Musharaka sukuks are used to finance commercial ventures and involves co-ownership of assets. Payments under Musharaka sukuks are supported by income generated by the project or assets.
Salam sukuks involve advance payment for future delivery of assets. These are typically for short term maturities. The Central Bank of Bahrain has successful used this sukuk structure to serve as Sharia treasury bills, using aluminium as the underlying asset.
Istisna'a sukuk could also be a hybrid structure, involving Ijarah contracts, for project, construction or manufacturing financing.
One can clearly see that innovative sukuk structures have proliferated over the past decade and have strongly contributed to the growth of the Islamic finance industry. Some of this innovation, however, has also been challenged by Sharia scholars, been duly noted by the industry, and some corrections made. For example, the inclusion of Murabaha contracts into some sukuk structures has brought into question the issue of the sale of debt that is prohibited under Islamic financial principles.
Similarly, Sharia authorities have challenged product structures where the sukuk holders were not conferred true ownership of the underlying assets, or where the returns are simply benchmarked to conventional interest rates regardless of the performance of the underlying asset. All of this requires careful review.
Sukuk capacity building
The supply and demand dynamics for sukuk market has led to the standardisation of the investment instruments, a welcome development for the industry.
The key challenges facing the industry is to keep pace with the growing demand for sukuk products from investors, development of a secondary market, innovation and development within permissible parameters, rating system, and regulatory and accounting standards.
The industry has responded through multiple initiatives.
Accounting, Sharia and governance standards have been issued by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), a global industry setting body headquartered in Bahrain. AAOIFI members comprise a large number of central banks, regulatory authorities and private sector financial institutions.
Industry participants have also contributed to set up a capital market institution to help guide the nascent industry. International Islamic Financial Market (IIFM) is also headquartered in Bahrain.
The regulatory practices and governance issues are addressed holistically by Islamic Financial Services Board (IFSB), another institution created by industry stakeholders, and headquartered in Malaysia. In addition, the Islamic Development Bank is also promoting several key initiatives including creation of liquidity management institution, sukuk origination and trading platforms and rating agency amongst others.
It appears that with the establishment of these institutions, the industry is well positioned for sustainable growth.
Learning from experience
Everyone agrees that Islamic finance is not here to replicate the same products and engage in the same operations as conventional banks. The objective for which riba was prohibited is the Sharia's demand for an equitable distribution of investment returns among the participants.
Undoubtedly, in the early days of Islamic banking, Sharia boards, bankers and academic councils had to agree to carry out certain operations that were not necessarily reflective of the true spirit of Islamic economic system. These permissions were granted under difficult circumstances, and when Islamic banks were few in numbers and were faced with shortage of human resources. It is expected that with time, the Islamic banks will progress to genuine operation and would distance themselves, even step by step, from what resembles interest-based enterprises.
This is where Oman, bringing an independent, fresh mindset to Islamic finance, could play a useful leadership role.
Unique opportunity for Oman
By virtue of being a new market for Islamic finance, Oman has a real opportunity to build a distinctive, credible position for itself in the evolving international sukuk market.
The starting point has to be a facilitative regulatory framework that sets the parameters for issuers, investors and infrastructure institutions in the sukuk market.
Here it could certainly be useful to incorporate leading practices from standard setting institutions like AAOIFI and IFSB.
The most productive application of sukuk finance would be for new commercial and industrial ventures, promoted by the private businesses or public sector. When the sukuks are issued to mobilise finances for existing businesses, the structure should provide for sukuk holders to have ownership in real assets.
Additionally, the framework should require issuers to pay to the sukuk holders the actual return earned on the underlying asset. The basis of investment return to sukuk holders should not be the conventional interest rates. If there is to be an incentive for the sukuk manager, it could also be based on the expected returns from the enterprise.
Similarly, Sharia scholars maintain that it is unlawful for the sukuk manager to lend money when actual profits are less than expected. They also maintain that unlawful for the mudarib, partner or a sukuk agent, to commit to repurchase the assets at face value. Instead, the Sharia authorities ask that the resale must be undertaken on the basis of the net value of the assets, or at a price that is agreed upon at the time of purchase.
In the final analysis, the ultimate responsibility for ensuring sanctity of the sukuk structures lies on the Sharia supervisory boards who must abide by the international Sharia standards issued by industry bodies like IIFM, IFSB and AAOIFI.
If sukuks are issued on this basis, they will play a major role in the development of the Islamic banking industry and the larger Omani economy.
Ashar Nazim and Abid Shakeel - two experts on Islamic finance - are working with the Islamic Finance Centre of Excellence at Ernst and Young in Bahrain. Nazim is a director and leads the Islamic Finance Center of Excellence at Ernst & Young, while Shakeel leads the banking, capital markets and takaful team within the Islamic Financial Centre of Excellence with Ernst & Young.
The views expressed by our contributing writers in the article are their own and may not necessarily reflect those of Times of Oman.
Part: VI (Special to Times of Oman)
In simple terms, sukuks can be considered the Islamic equivalent of conventional bonds, although the concept and structuring for both are very different. For Oman's economy, sukuks represent a new source of funds for sovereign entities, corporates and small and medium size enterprises. They are currently in high demand given the growing Islamic wealth pool with banks, high net worth individuals, takaful companies, fund managers and general public.
Sukuks are asset-backed, income generating, tradable, Sharia compliant investment product.
From an issuer's perspective, sukuks would offer large scale financing for commercial and industrial ventures that are typically beyond the ability of a single party to finance.
From an investor's point of view, sukuks are investment products linked to the real economy, providing attractive returns and with the convenience of liquidity whenever the need should arise. In its true form, sukuk investment allows investors to benefit from the true profits resulting from the underlying assets. For conventional investors also, sukuk offers diversification away from traditional lending.
Finally, sukuks represent an excellent mechanism to manage liquidity for banks and Islamic financial institutions.
The strong demand for sukuk products has not gone unnoticed.
Several sovereign issuers including Malaysia, Bahrain, Qatar and the UAE have launched international sukuk programmes raising several billion dollars. These include a mix of short tenor and long term sukuks, in local and other currencies. Sukuk instruments also offer central banks the necessary tool to truly manage domestic money supply and credit extension of Islamic banks.
Similarly, corporates and financial institutions from Middle East, Asia, Europe and United States have successfully approached Sharia sensitive investors with sukuk investment products to raise financing for their businesses. This includes large corporates like SABIC and General Electric. Key economic sectors that have benefited from using sukuk products are financial services, real estate, government institutions, power and utilities, transport and oil and gas.
Difference from conventional bonds
The most prominent characteristics of conventional bonds may be summarised as follows:
Bonds do not represent ownership on the part of the bond holders in the underlying assets. Rather, they document the interest bearing debt owed to the holders of the bond by the issuer.
Regular interest payments are made to the bond holders. The interest payment is determined as a percentage of the capital, and not linked to real returns.
Finally, bond instruments guarantee the return of principal when redeemed at maturity, regardless of the performance of the underlying venture.
Sukuk structures in practice
The quality of sukuk products from Sharia perspective depends upon the sharing of risk and the equitable distribution of profits between investors. There are several sukuk structures in the market today, based on Ijarah, Musharaka, Salam and Istisna'a contracts.
Ijarah sukuks are issued on stand-alone assets which can be a parcel of land, equipment or the likes of aircraft or ships, for lease.
Musharaka sukuks are used to finance commercial ventures and involves co-ownership of assets. Payments under Musharaka sukuks are supported by income generated by the project or assets.
Salam sukuks involve advance payment for future delivery of assets. These are typically for short term maturities. The Central Bank of Bahrain has successful used this sukuk structure to serve as Sharia treasury bills, using aluminium as the underlying asset.
Istisna'a sukuk could also be a hybrid structure, involving Ijarah contracts, for project, construction or manufacturing financing.
One can clearly see that innovative sukuk structures have proliferated over the past decade and have strongly contributed to the growth of the Islamic finance industry. Some of this innovation, however, has also been challenged by Sharia scholars, been duly noted by the industry, and some corrections made. For example, the inclusion of Murabaha contracts into some sukuk structures has brought into question the issue of the sale of debt that is prohibited under Islamic financial principles.
Similarly, Sharia authorities have challenged product structures where the sukuk holders were not conferred true ownership of the underlying assets, or where the returns are simply benchmarked to conventional interest rates regardless of the performance of the underlying asset. All of this requires careful review.
Sukuk capacity building
The supply and demand dynamics for sukuk market has led to the standardisation of the investment instruments, a welcome development for the industry.
The key challenges facing the industry is to keep pace with the growing demand for sukuk products from investors, development of a secondary market, innovation and development within permissible parameters, rating system, and regulatory and accounting standards.
The industry has responded through multiple initiatives.
Accounting, Sharia and governance standards have been issued by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), a global industry setting body headquartered in Bahrain. AAOIFI members comprise a large number of central banks, regulatory authorities and private sector financial institutions.
Industry participants have also contributed to set up a capital market institution to help guide the nascent industry. International Islamic Financial Market (IIFM) is also headquartered in Bahrain.
The regulatory practices and governance issues are addressed holistically by Islamic Financial Services Board (IFSB), another institution created by industry stakeholders, and headquartered in Malaysia. In addition, the Islamic Development Bank is also promoting several key initiatives including creation of liquidity management institution, sukuk origination and trading platforms and rating agency amongst others.
It appears that with the establishment of these institutions, the industry is well positioned for sustainable growth.
Learning from experience
Everyone agrees that Islamic finance is not here to replicate the same products and engage in the same operations as conventional banks. The objective for which riba was prohibited is the Sharia's demand for an equitable distribution of investment returns among the participants.
Undoubtedly, in the early days of Islamic banking, Sharia boards, bankers and academic councils had to agree to carry out certain operations that were not necessarily reflective of the true spirit of Islamic economic system. These permissions were granted under difficult circumstances, and when Islamic banks were few in numbers and were faced with shortage of human resources. It is expected that with time, the Islamic banks will progress to genuine operation and would distance themselves, even step by step, from what resembles interest-based enterprises.
This is where Oman, bringing an independent, fresh mindset to Islamic finance, could play a useful leadership role.
Unique opportunity for Oman
By virtue of being a new market for Islamic finance, Oman has a real opportunity to build a distinctive, credible position for itself in the evolving international sukuk market.
The starting point has to be a facilitative regulatory framework that sets the parameters for issuers, investors and infrastructure institutions in the sukuk market.
Here it could certainly be useful to incorporate leading practices from standard setting institutions like AAOIFI and IFSB.
The most productive application of sukuk finance would be for new commercial and industrial ventures, promoted by the private businesses or public sector. When the sukuks are issued to mobilise finances for existing businesses, the structure should provide for sukuk holders to have ownership in real assets.
Additionally, the framework should require issuers to pay to the sukuk holders the actual return earned on the underlying asset. The basis of investment return to sukuk holders should not be the conventional interest rates. If there is to be an incentive for the sukuk manager, it could also be based on the expected returns from the enterprise.
Similarly, Sharia scholars maintain that it is unlawful for the sukuk manager to lend money when actual profits are less than expected. They also maintain that unlawful for the mudarib, partner or a sukuk agent, to commit to repurchase the assets at face value. Instead, the Sharia authorities ask that the resale must be undertaken on the basis of the net value of the assets, or at a price that is agreed upon at the time of purchase.
In the final analysis, the ultimate responsibility for ensuring sanctity of the sukuk structures lies on the Sharia supervisory boards who must abide by the international Sharia standards issued by industry bodies like IIFM, IFSB and AAOIFI.
If sukuks are issued on this basis, they will play a major role in the development of the Islamic banking industry and the larger Omani economy.
Ashar Nazim and Abid Shakeel - two experts on Islamic finance - are working with the Islamic Finance Centre of Excellence at Ernst and Young in Bahrain. Nazim is a director and leads the Islamic Finance Center of Excellence at Ernst & Young, while Shakeel leads the banking, capital markets and takaful team within the Islamic Financial Centre of Excellence with Ernst & Young.
The views expressed by our contributing writers in the article are their own and may not necessarily reflect those of Times of Oman.
Part: VI (Special to Times of Oman)
© Times of Oman 2011
