This article is written by Jasmine Talreja who has been working for the past 12 years as an in-house counsel with different companies. This article talks about the emergence of Sukuk as a bond in the Islamic financial system and how it is important to understand the same as it is gaining value in global finance day by day.

Introduction

The Islamic finance sector is increasing its value in the global finance industry, day by day. Today, over 300 Islamic banks and financial organizations are successfully running their business from Riyadh, Dubai, London, Los Angeles, Karachi, Jakarta, Cairo, and many other cities in the world. Islamic finance is growing at 10 to 15% per year, and there is no sign that this trend is going to slow down in the near future. It is one of the fast growing segments of global finance in the world. In spite of this many practitioners, finance faculty remain unfamiliar with the process by which Islamic financial systems work. This leads to a major shortcoming, particularly in non-Islamic financial centres. Therefore, the purpose of this article is to increase the awareness and knowledge of those who have had little or no exposure to the Islamic finance.

Concept of sukuk (Islamic bonds)

Sukuk is a plural word. Singular word is Sakk and is derived from Arabic. Sakk Literally means a certificate. Sukuk is the Arabic name for financial certificates. A Sukuk also gives a return like interest on a conventional bond however unlike a bond, Sukuk holders are granted ownership interest in the asset of the business and the return is tied to the performance of the asset in the market. It is also commonly referred to as a ‘Sharia Compliant’ bond which means that it will finance businesses that are compliant with Sharia law.

As per Sharia law, financial transactions must be free of the following:

• The acceptance of interest (Riba) is forbidden;
• Trading under uncertainty (Gharar) must be avoided;
• Gains should not be obtained by the ignorance of the other person (Jahl). 
• As per Islamic law money is merely a medium of exchange and a measuring unit. It is not an asset.
• Any transaction that involves alcoholic beverages, pork, gambling, prohibited drugs, pornography and weapons are forbidden.

On the other hand Islamic doctrine encourages investors to share the risks and rewards associated with investment activities. In line with this doctrine Sukuk contract becomes a funding arrangement between the two parties. One provides the funds (investor) and the other (Sovereign, individual or corporation) borrows the funds in return for ownership on the assets or the economic activities to be shared with the investor. 

Working of sukuk and conventional bonds

How does Sukuk work

Investors buy Sukuk. They then become Sukuk holders. They receive a certificate as evidence of ownership. They are then entitled to receive periodic profit payments on the principal amount. Upon maturity Sukuk holders get back the principal amount. The periodic payment may be in the form of rent from the asset or the profit made by the asset in the market.  There are 14 different types of Sukuk instruments however only 6 are used commonly. Let us briefly look at the different types of Sukuk:

Type of Sukuk	Short Summary
Ijarah Sukuk (Lease)	Sukuk is issued to finance the purchase of assets. The asset is leased out to lessee for payment of rent. These rent payments are used for periodic payment to Sukuk holders.
Murabaha (Mark up Sale)	Sukuk proceeds are used to purchase commodities or other assets from a supplier. They are then sold with a mark-up. The amount derived is used to pay periodic amounts to Sukuk holders.
Istisna’s (Supply Agreement)	Sukuk proceeds are used by the issuer to pay contractors for the future of a constructed or a manufactured asset. This asset will then be sold after delivery to pay back the Sukuk holders.
Salam (Futures Contract)	Sukuk proceeds are utilized as spot payment for future delivery of a commodity. The commodity is later sold out to pay back Sukuk holders.
Wakala Agency Agreement	An appointed agent (wakeel) uses the proceeds from the Sukuk to invest in permissible investments. Periodic payments are made to Sukuk holders from the proceeds.
Mudaraba Partnership Agreement	Sukuk proceeds are used by the issuer to finance business in partnership with entrepreneurs. The entrepreneur comes in with his expertise and brings in labor. Profit is shared between the issuer and the entrepreneur in a pre-agreed ratio. Profits are used by the issuer to make periodic payments to Sukuk holders.
Musharaka (Partnership Agreement)	Proceeds are utilized to finance a business on a joint venture basis. Here both the parties contribute capital to the business. Sukuk holders receive periodic payments and payments at maturity.

Conventional Bonds

Now let us see how conventional bonds work. Bonds are a type of debt security between a borrower (issuer of the bond) and a lender (investor who purchases the bond). When a government, corporation or other entity needs to raise money, they issue bonds to the investors.  Investors who purchase these bonds are lending money to the issuer for a fixed period of time. In return, investors receive an instrument which is (bond) which states that the investor will receive interest at certain intervals and also the principal amount will be returned at a future date.

Difference between Sukuk and Conventional Bonds

Although the above differences appear to be technical, they make a difference in the Islamic community. The main advantage that a Sukuk has is that the value of the Sukuk increases in relationship to the asset. If the value of the asset rises so does the value of the Sukuk. This is not the case with bonds. 

Ratings given to Sukuk

The agencies give ratings of excellent (AAA to AA) or good (A to BBB) investment grade, both of which are similar to conventional bonds, and poor (BB to B), or not investment grade. The market accepts this rating process as reasonable and it has been widely accepted by regulators and Sharia supervisors. Yet rating a Sukuk security based on the existing criteria for the bond market is questionable. Sukuk have unique features that are not amenable to bond-type rating. There is good reason to believe that widespread practices in the rating industry, though largely accepted at this stage of market development, needs to be modified.

Trends in Sukuk market

There has been a tremendous growth in the Sukuk market in the last decade. Investors are not only from the Middle East, Southeast Asia but all around the world to diversify the holdings beyond the traditional assets. Initially the issuances were in Malaysia.  Recently other countries with Muslim population like Turkey, Indonesia, and Pakistan have also become regular to issue Sukuk. Not only this, countries which didn’t have significant Muslim population like UK, South Africa, and Luxembourg also became regular issuers.

Challenges with regards to compliance with Sharia laws in an International market

For a Sukuk transaction to be successful the first and foremost essential is that it should be compliant with Sharia laws. Now this becomes a challenge in countries governed by a legal system which is independent of Sharia.  This is true not only in case of Muslim minority countries but also in the case of Muslim majority countries governed by secular laws which cannot explicitly make reference to religion. 

Let us take examples of Turkey, UK, Luxemburg and HKSAR. The legislative framework of these countries do not mention Sharia principles nor do they provide any guarantee to investors on compliance with the Islamic doctrine. The instruments are indirectly defined in the legislation without openly naming them. The role of getting opinion from Islamic scholars is left to managers of financial institutions who act as intermediaries on a per transaction basis. In the offering circular of UK’s single Sukuk the investors are reminded that any disputes are subject to the laws of England and Wales and that courts will interpret the terms of the transaction or certificates under those laws. A similar reminder is issued in the offering of Luxembourg securities SA stating that any dispute would be subject to court proceedings under laws of (i) Luxembourg (ii) England and Wales

Indonesia differs from the above as Sukuk law explicitly requires the minister to request an opinion (fatwa) on Sharia compliance from the Ulema Council of Indonesia (Majelis Ulama Indonesia) with the purpose of giving assurance to the investors that investment will not violate Sharia principles. Several “fatwa” have been issued in the context to regulate the securities and methods of issuance. 

Here it is important to note that validity of legal documents differs by jurisdiction. Extra attention must be given to the drafting of primary and secondary legislation in countries where Sharia principles are not allowed or encouraged.  Otherwise the very purpose of Sukuk is defeated. Therefore, a close coordination between relevant authorities is required in the review of the existing legislation, with a view to identify deficiencies and to devise remedies.

Conclusion

To conclude both Sukuk and conventional bonds successfully solve the same common financial problem which is raising capital for entities, being corporations or governments. However, there are various fundamental differences between the two. The conventional bonds are structured on the basis of debt while Sukuk are equity based instruments. Ultimately it is up to the bondholder to decide which method of financing he would prefer and if he would want to invest as per the religious sanctioned systems. There are a large number of affluent and religious Muslim investors all around the globe seeking an opportunity to receive a decent return on investments and at the same time be in compliance with religion. Sukuk has become an ideal choice for Islamic investors because of it. The most important point to note is that all financial institutions and individuals can invest in Sukuk irrespective of their faith and religious background. 

References

• Compare and Contrast Sukuk (Islamic Bonds) with Conventional Bonds, Are they Compatible? Dr. Tahmoures A. Afshar, School of Business, Woodbury University, USA
• Discussion Paper; MFM  Global Practice; No 18;  June 2017; Emre  Balibek; World Bank Group; Establishing a Legal Framework for Sovereign Sukuk  Issuance: A Public Debt Management Perspective
• Factbox: Key facts about Islamic finance by Reuters Staff
• The SUKUK Handbook, A Guide To Structuring Sukuk Second Edition – Latham and Watkins LLP
• Sukuk Securities by Meysam Safari, PhD, Mohamed Ariff, PhD, Shamsher Mohamad, PhD

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