Wednesday, 19 September 2018

Sukuk – Back to the future

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The rate of growth of the sukuk market has slowed: which is hardly surprising in these credit crunch times. By Rahail Ali, Global Head of Islamic Finance, and Imran Mufti, Counsel, Lovells, Dubai.

So there shouldn't be a polemic as to the causes of why the sukuk market has slowed down? Wrong. What is curious about the stagnated state of the sukuk market is the propensity by some to attribute it to the debate among the Sharia scholars, culminating in the ruling by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in February 2008.

However, economics is ultimately the prime substantive reason for the relative lack of activity in the sukuk market, caused by the credit crunch and exacerbated by the fact that the Gulf Co-operation Council (GCC) state economies are in a different cycle to that of the US economy, against whose currency the GCC local currencies are predominantly pegged. Those who point to the Sharia debate are really missing the point and, more significantly, failing to understand the foundation principles for the intellectual application of Islamic finance. Causality confusion was bound to follow.

Consider first the macroeconomic dynamic for the sukuk market. With oil revenues in the GCC set to exceed US$600bn for 2008 and 2009, sentiment towards the region's capital markets should now be viewed far more positively than was previously the case. This is because the days of the wholesale exodus of oil revenues from GCC states to Western stock markets are over – GCC states, buoyed by a construction boom and real estate sector liberalisation, and the ever increasing numbers of people who want to bank and place deposits in an ethical manner, consistent with their religious beliefs, want to retain that liquidity for the direct expansion of their economies by development of the region's capital markets.

The sukuk market has been a strong catalyst in that development. Against this backdrop, the market would be expected to expand both in terms of volume of issues and types of sukuk. These conditions ordinarily would be ripe for growth and innovation of the sukuk market, particularly through harnessing the returns and appetite for equity-linked sukuk. The reality, of late, has been different.


The debate as to the potential revaluation of GCC, US dollar-pegged currencies, as well as GCC monetary union, is not a new one, but has recently stepped up in pace. No GCC government has yet confirmed that it will revalue its currency but statements from the UAE, Bahrain and Qatar have indicated that they may consider doing so. Kuwait de-pegged its currency from the US dollar in May 2007.

There is no agreement on what steps will be taken by the GCC, although monetary union is (for many, optimistically) pencilled in for 2010. The UAE has put forward the possibility of targeting the currency through a currency basket, but Saudi Arabia appears to have resisted such a move. What is generally agreed across the GCC is that the time has come for the region to actively pursue its own policy, separate from the US economy, to which it is currently inextricably linked by the currency peg, and this is particularly evident in the current economic climate.

Despite an upturn in recent weeks, the US dollar's loss in value has led to imported inflation across the GCC, and the peg forces interest rates in the region to stay low, in line with the Fed's cuts in US interest rates, limiting the GCC governments' ability to drain liquidity out of their systems. Within the GCC, rampant speculation as to the potential de-pegging of the local currencies, in tandem with concerns over the decline in value of the US dollar, has led to a high volume of purchases of GCC currency, putting further pressure on interest rates to stay low.

At the same time, liquidity in the market has remained high, with investors holding an abundance of local currency keen to invest it. As a result of all this, sukuk issuance by the GCC private sector has been slow since the credit crunch hit the US and Europe. However, sukuk have been predominantly local currency issues. In an illustration of this point, in 2007 the Government of Dubai Electricity and Water Authority (DEWA) pulled its proposed dollar sukuk offering and replaced it with a dirham-denominated offering.

As long as speculation remains, demand for local currency bonds and sukuk will remain comparatively high. Of late, the exodus of capital from the GCC region on account of hedge investors giving up on currency de-pegging or revaluation, a general pull-back from the equity stock markets and the volume of local currency financings has led to liquidity supply constraints – accentuating the stunted growth and innovation in the sukuk market.

Sukuk structures – Return of the ijara

Sukuk are instruments structured to provide a Sharia-compliant return. A conventional bond, put simply, is an IOU. Renting money and trading in debt is forbidden according to the Sharia. To make a Sharia-compliant return, assets need to be sold, leased or invested in. This is the essence of a sukuk. A sukuk is a certificate entitling the holder to the return generated by an income-generating underlying asset. But – and this is critical – a sukuk can be structured so that it can provide an economic return equivalent to the yield on a conventional bond. The difference is that one is Sharia-compliant, and therefore permitted, and the other is a return from "renting money", ie interest, and forbidden.

Going forward, the sukuk al-ijara structure promises to be the structure of choice. In the past, the predominant use of the sukuk al-ijara was explained, and justified, by the need to present investors with familiar structures: a sale and lease-back structure is easily understood even by those unfamiliar with Islamic financing – even the most attractive of credit stories can be distracted from overly complex structuring. The return in earnest of the sukuk al-ijara structure as the structure that needs to be explored first is really a case of "back to the future" for the sukuk market.

Other sukuk structures, primarily musharaka and mudaraba, have been developed to overcome the disadvantages of the sukuk al-ijara structure, namely that the sukuk issue amount cannot be justified because the value of the assets earmarked to be the subject of the sale and leaseback structure are insufficient to approximate to the issue amount, or the leased position of those assets does not permit sukuk structural flexibility, for example, periodic redemptions.

Redemption flexibility is, of course, vital for equity-linked sukuk such as convertible and exchangeable sukuk offerings. The sukuk structure needs to accommodate the commercial deal where the sukuk may be redeemed in the same scenarios as a conventional convertible bond, for example, voluntary redemption, change of control, elective tax redemption etc.

It was in fact the convertible sukuk offerings that needed to overcome the commercial issues involved in using sukuk al-ijara. One of the structures developed to include the flexibility required for a convertible offering was the sukuk al-mudaraba. The first international mudaraba sukuk was the US$460m sukuk for Aabar Petroleum, which closed in June 2006. That was succeeded by a number of further offerings, including in October 2007 the US$1bn sukuk by Dana Gas.


A mudaraba is a "'partnership' in profit" (akin to a non-discretionary investment management arrangement) between a capital provider and a person who applies skill and expertise in investing that capital – put differently, one partner, the rab ul–maal (or the investor), contributes money and the other, the mudarib (or investment trustee), invests its time and skill with a view to generating profit on that capital.

Dana Gas sukuk



The Dana Gas sukuk was issued through an offshore SPV with the proceeds of those sukuk being applied as capital of the mudaraba. The mudaraba agreement provides that those proceeds will be invested by Dana Gas PJSC (as mudarib) in its business activities in accordance with a predetermined investment plan prepared by Dana Gas. Returns to the sukuk holders are generated through profit payments to the Issuer and distributed by Dana Gas on quarterly periodic distribution dates.

The flexibility that the mudaraba structure offers makes it a natural choice for issuers looking to the convertible bond investor. It has formed the basis for a number of convertible sukuk, including Aldar Properties. The mudaraba structure has, however, not been without its critics among the Sharia scholar fraternity. At first glance, the cashflow characteristics of the mudaraba structure seem to mimic very closely the calculations, periodic payments and redemption mechanics of a conventional bond, with the obligor ultimately underwriting the return due to sukuk holders through the purchase undertaking. That concern gained an international spotlight towards the middle of 2007.

Sukuk and the scholars – Disruption or devoutness

Acceptability of sukuk structures has become the prime subject of discourse within the Islamic finance industry, and in particular the scholars, following the emergence of profit participation structures, such as the sukuk al-mudaraba and the sukuk al-musharaka, primarily introduced to circumvent the asset restrictions inherent with an ijara structure.

Statements ascribed to Sheikh Mohammed Taqi Usmani questioning, among other things, the orthodoxy of unilateral purchase undertakings in the context of musharaka and mudaraba sukuk structures received widespread media attention, causing practitioners to examine the implications of such a view and the lack of consensus among Sharia scholars on fundamental aspects of Sharia structuring. Those comments, coupled with the recent economic downturn, have not gone unnoticed in a market in its relative infancy.

One can, however, understand the rationale for such an analysis. Mudaraba and musharaka are quintessentially equity (and risk) participation arrangements, so the very notion that a partner (in the context of a musharaka) or the mudarib (in the context of a mudaraba) should effectively underwrite the capital return of another partner or the rab ul-maal by granting a "put" option against it seems, at face value, to run contrary to that view.

There will no doubt be continuing dialogue among the Sharia scholars on these, and other, issues affecting sukuk as the Islamic finance industry continues to evolve; perhaps with the net result that some form of common consensus is reached. What has been confirmed as a result of these discussions surrounding sukuk is the universal acceptability of the ijara as the preferred structure.

The sukuk market is still very much in its formative years. The divergent requirements of issuers, financial institutions and financial markets and, ultimately, the fact that an intellectual difference of opinion among Sharia scholars is a normal feature of Islamic jurisprudence will inevitably necessitate further innovation among Islamic finance practitioners.

Independent of the Sharia debate surrounding sukuk, regulatory constraints, particularly in the context of convertible sukuk, have played their part in forcing issuers to think twice before entering the market. In the GCC, the absence of a developed legal and regulatory regime for equity capital market offerings has challenged equity-linked sukuk offerings.

Some of the issues that have cropped up include that the target issue size of a convertible sukuk may have to be restricted to the paid up capital of the issuer, severely impacting on the amounts that issuers can expect to raise; and that conversion mechanics require that, rather than the sukuk obligor issuing shares in satisfaction of its obligation for redemption of the sukuk that are to be converted, the sukuk "debt" is "paid" by the sukuk obligor to sukuk holders and that amount is then used to purchase new shares to be issued to exercising sukuk holders. These examples illustrate the way in which the regulatory environment is still behind the curve in terms of the advances that have taken place in the sukuk market.

It is clear that the sukuk market is entering a seminal stage in its development. Adverse market conditions coupled with intellectual differences of opinion on sukuk structures could be viewed as a lethal cocktail spelling the end of what had been viewed as the sector with the greatest potential in the international capital markets space.

Along with pricing and geographical considerations, traditional distribution networks for sukuk increasingly have to consider the extent to which a potential investor will agree (or refuse) to purchase sukuk on the basis of the structure adopted. All involved in the industry should take a stride back, recognise the demands of financial institutions and issuers alike and step up to the challenges that those demands present.

At a time when the markets are volatile, it is important to provide non-contentious sukuk structures so that striking the equilibrium between investor appetite and issuer demand is not unnecessarily overshadowed by complex debates on Sharia compliance. Those familiar with Islamic jurisprudence will recognise that intellectual differences of opinion are a virtue. To the uninitiated in the sukuk market, certainty is key. Otherwise, like Marty McFly in the film of the same name, it may be a case of "back to the future" again and again.

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