SUKUK & SECURITIZATION1. SUKUK AND SECURITIZATION VITAL ISSUES IN ISLAMIC CAPITAL MARKETS LECTURE By...

SUKUK & SECURITIZATION 1

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SUKUK AND SECURITIZATION

VITAL ISSUES IN ISLAMIC CAPITAL MARKETS

LECTURE

By

Dr. Syed Zulfiqar Ali Shah

SUKUK & SECURITIZATION

Summary of last Lecture

•Introduction•The Capital Market in an Islamic Framework•Securitization & Sukuk

SUKUK & SECURITIZATION 3

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Layout

•Securitization & Sukuk•Categories of Sukuk•Tradability of Sukuk•Issues in Terms and Structures of Sukuk•Potential of Sukuk in Fund Management and Developing the Islamic Capital Market

•Summary & Conclusion


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Securitization & Sukuk (Cont’d)5. Categories of Sukuk:Below we discuss various categories of Sukuk.

1. Muqaradah or Mudarabah Sukuk:

Mudarabah or Muqaradah Sukuk or deeds can be instrumental in enhancing public participation in investment activities in any economy.


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Securitization & Sukuk (Cont’d)These are certificates that represent projects or activities managed on the Mudarabah principle by appointing any of the partners or any other person as Mudarib for management of the business. As regards the relationship between the parties to the issue, the issuer of Mudarabah certificates is the Mudarib, subscribers are the owners of the capital and the realized funds are the Mudarabah capital. The certificate holders own the assets of the Mudarabah and the agreed upon share of the profits belongs to the owners of capital and they bear the loss, if any. In terms of the Resolution of the Islamic Fiqh Council of the OIC (fourth session, 1988), the following are the salient features of Mudarabah Sukuk/certificates:• Mudarabah Sukuk (MS) represent common ownership and entitle

their holders to a share in the specific projects against which the MS have been issued.

• The MS contract is based on the official notice of the issue or the prospectus, which must provide all information required by Shar¯ı´ah


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Securitization & Sukuk (Cont’d)for a Qir¯ad contract, such as the nature of capital, the ratio for profit distribution and other conditions related to the issue, which must be compatible with Shar¯ı´ah.• The MS holder is given the right to transfer the ownership by selling

the Sukuk in the securities market at his discretion. The market value of Muqaradah Sukuk varies with the business status and anticipated or expected profits of the concerned project. The sale of MS must follow the rules listed below:

— if the Mudarabah capital is still in the form of money before the operation of the specific project, the trading of MS will be like the exchange of money for money and it must satisfy the rules of Bai‘ al Sarf;

— if the Mudarabah capital is in the form of debt, it must be based on the principles of debt trading in Islamic jurisprudence;

— if the capital is in the form of a combination of cash, receivables, SUKUK & SECURITIZATION

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Securitization & Sukuk (Cont’d)goods, real assets and benefits, trade must be based on the market price evolved by mutual consent.

• The manager/SPV who receives the funds collected from the subscribers to MS can also invest his own funds. He will get a profit for his capital contribution in addition to his share in the profit as Mudarib.

• Neither prospectus nor MS should contain a guarantee, from the issuer or the manager of the fund, for the capital or a fixed profit, or a profit based on any percentage of the capital. Accordingly, (i) the prospectus, or the MS issued pursuant to it, may not stipulate payment of a specific amount to the MS holder, (ii) profit is to be divided, as determined by applying the rules of Shar¯ı´ah; that is, an amount in excess of the capital, and not the revenue or the yield, and (iii) the Profit and Loss Account of the project must be published and disseminated to MS holders.


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Securitization & Sukuk (Cont’d)• It is permissible to create reserves for contingencies, such as loss of

capital, by deducting from the profit a certain percentage in each accounting period.

• The prospectus can also contain a promise made by a third party, totally unrelated 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 a given project, provided such commitment is independent of the Mudarabah contract. However, it is not permissible for the issuer to guarantee the capital of the Mudarabah.

IFIs can offer Mudarabah Sukuk or certificates to the investors who would subscribe and participate in the investment transactions. The funds mobilized would be the variable capital (class B share) of any bank to be marketed regionally through the selling of the issued Mudarabah Sukuk.


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Securitization & Sukuk (Cont’d)2. Musharakah Sukuk:Musharakah is a mode which can serve as a basis for securitization easily, especially in the case of big projects where huge amounts are required. Every subscriber is given a Musharakah certificate, which represents his proportionate ownership in the assets of the project. These are certificates of equal value issued for mobilizing funds to be used on the basis of partnership, so that their holders become owners of the relevant project or the asset as per their respective shares that are part of their asset portfolios. Musharakah Sukuk can be issued as redeemable certificates by or to the corporate sector or to individuals for their rehabilitation/employment, for the purchase of automobiles for their commercial use or for the establishment of high-standard clinics, hospitals, factories, trading centres, endowments, etc.Musharakah redeemable Sukuk are almost similar to Mudarabah Sukuk. Therefore, basic Shar¯ı´ah rules relating to Mudarabah also apply to Musharakah certificates. The only major difference is that the


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Securitization & Sukuk (Cont’d)intermediary party will be a partner of the group of subscribers represented by a body of Musharakah certificate holders, in a manner similar to a joint stock company.After the project is started, these Musharakah certificates can be treated as negotiable instruments. Certificates based on Musharakah/ Mudarabah can be bought and sold in the secondary market, subject to the condition that the portfolio of Musharakah comprises nonliquid assets valuing more than 50 %. Profit earned by the Musharakah is shared according to an agreed ratio. Loss is shared on a pro rata basis. Whenever there is a combination of liquid and nonliquid assets, it can be sold and purchased for an amount greater than the amount of liquid assets in the combination or in the pool.Investment Sukuk can be issued on a Musharakah basis to mobilize short-term deposits for the development of long-term projects or for investment in general financial activities or specific projects. The proceeds of the Sukuk can be used to buy and lease certain equipment


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Securitization & Sukuk (Cont’d)or for the construction of projects and factories, the expansion of projects or for working capital finance. The Musharakah structure is considered more equitable and also safer for the investors than the Mudarabah structure, as it involves both profit- and loss-sharing between the fund manager and the Sukuk holders, not only profit-sharing. In addition, Musharakah Sukuk holders will have added comfort and security from the cushion provided by the manager’s participation in the Musharakah capital. In Sudan, a number of assets of the Ministry of Finance and the Bank of Sudan, Bank of Khartoum, Nilain Bank and other public entities have been identified for the purpose of securitization on a Musharakah basis. Instruments known as central bank Musharakah certificates (CMCs) and government Musharakah certificates (GMCs) have been issued since 1998 for investors and are used in place of treasury bills and other interest-bearing securities for open market operations and monetary management by the central bank. The CMCs are sold (or bought) by the


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Securitization & Sukuk (Cont’d)central bank through auctions and can be traded in the secondary inter-bank market.3. Ijarah Sukuk:The concept of Ijarah can be used for mobilizing funds for the development of long term infrastructure projects. This is possible through securitization of tangible assets such as airports, roads, buildings, schools and hospitals and offering Sukuk to a large number of institutional and individual investors. It is also possible to create a secondary market instrument for financiers on the basis of Ijarah. If a lessor, after executing an Ijarah contract, wishes to recover his cost of purchase of the asset to get liquidity or for the purpose of profit, he can sell the leased asset wholly or partly, either to one party or to a number of individuals. The purchase of proportion of the asset can be evidenced by issuing certificates, which may be called Ijarah certificates or Sukuk. The certificates must represent ownership of the pro rata undivided parts of the asset with all related rights and obligations. Hence, Ijarah


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Securitization & Sukuk (Cont’d)Sukuk are the securities representing ownership of well-defined and known assets tied up to a lease contract, rental of which is the return payable to the Sukuk holders.By virtue of flexibility in the rules of Ijarah, securitizing the Ijarah contracts is a key factor for solving liquidity management problems and financing the public sector needs in developing countries. Payment of Ijarah rentals can be unrelated to the period of taking usufruct by the lessee, i.e. it can be made before the 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 contracts and Sukuk that may suit different purposes of issuers and investors.If funds are raised through issuance of Sukuk for purchasing assets like buildings, motor vehicles or other equipment for the purpose of leasing them out to their ultimate users, these may be termed Ijarah funds. The ownership of the assets remains with the fund manager or SPV and the rentals received from the users are distributed by the fund managers pro


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Securitization & Sukuk (Cont’d)rata among the subscribers. As discussed in detail in Chapter 12, most of the jurists are of the view that such a fund cannot be created on the basis of Mudarabah, because Mudarabah, according to them, is restricted to the sale of goods and does not extend to the business of services and leases. However, in the Hanbali school, Mudarabah can be used in services and also leases. This view is preferred by the majority of contemporary scholars.Rental in Ijarah must be stipulated in clear terms for the first 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 like the inflation rate, any periodically announced price index, or otherwise by any settled percentage. The mainstream Shar¯ı´ah experts have permitted benchmarking with any interest rate reference, although it is not an ideal practice to them.Governments can use Ijarah Sukuk as an alternative tool to interest-based borrowing, provided they have durable assets useable in the


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Securitization & Sukuk (Cont’d)process of performing government functions. Use of assets by governments is necessary, while it does not matter whether these assets are income-generating or not.The following types of Sukuk can be issued on the concept of Ijarah:• Sukuk of ownership in leased assets. These are certificates of equal

value that are issued either by the owner of a leased asset or an asset to be leased (by promise), or by his financial agent, with the aim of recovering the value of the asset through subscription. The subscribers are buyers of the asset. The certificate holders become owners of the asset jointly, with its benefits and risks.

• Sukuk of ownership of usufruct of assets. Such certificates have various types, including the following:

— Sukuk of ownership of usufructs of existing assets. These are documents of equal value issued either by the owner of usufruct of an existing asset or a financial intermediary acting on the owner’s


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Securitization & Sukuk (Cont’d)behalf. The mobilized funds from subscription are the purchase price of the usufructs, and the certificate holders become owners of the usufruct along with the risks and rewards. It is permissible to trade in certificates of ownership of usufructs of tangible assets prior to a contract of sub-leasing the assets. When the assets are sub-leased, the certificate then represents the rent receivables, which makes it a debt certificate. Therefore, in that case, the certificate is subject to the rules and requirements of debts. It is permissible for the issuer to redeem, either at the market price or as agreed upon at the time of purchase, the Sukuk of ownership of usufruct of tangible assets from the Sukuk holder after allocation of Sukuk and payment of subscription amounts.— Certificates of ownership of usufructs to be made available in the future as per description. These are documents of equal value issued for the sake of leasing assets that the lessor is liable to provide in the future, whereby the rental is recovered from the subscription income, in which case the holders of the certificates become owners of the usufruct of the


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Securitization & Sukuk (Cont’d)future assets. The subscribers are buyers of usufructs and will have both the risks and rewards. Such Sukuk can be traded after the asset is identified. It is not valid to sub-lease or trade in usufructs of an asset to be made available prior to identification of the asset, in which case trading must be carried out in line with the rules of currency exchange. The trading rules in the case of sub-leasing of such usufructs would be the same as those discussed above.— Certificates of ownership of services of a specified supplier. These are documents of equal value issued for the sake of providing or selling services through a specified supplier (such as educational programmes in a particular university) and obtaining the value in the form of subscription income, in which case the holders of the Sukuk become owners of the services.— Certificates of ownership of services to be made available in the future as per description. These are documents of equal value issued for the sake of providing or selling services through a non existing supplier


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Securitization & Sukuk (Cont’d)with the description of the subject matter (such as educational programmes of a specific quality, schedule, duration, etc. without mentioning the educational institution) and obtaining the value in the form of subscription income, in which case the holders of the certificates become owners of the services.The following features may be kept in mind for securitization under Ijarah. It is necessary for an Ijarah contract that the asset 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. The lessor can sell the leased asset provided it does not hinder the lessee in taking benefit from the asset. The new owner(s) will be entitled to receive the rentals for the remaining period. Similarly, they can dispose of their share in the asset to the new owners individually or collectively. SUKUK & SECURITIZATION

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Securitization & Sukuk (Cont’d)As an Ijarah certificate represents the holder’s proportionate ownership in the leased asset, the holder will assume the rights and obligations of the owner/lessor to the extent of his ownership. The holder will have the right to enjoy part of the rent according to his proportion of ownership in the asset. In the case of total destruction of the assets, he will suffer the loss to the extent of his ownership. So, it is essential that the Ijarah certificates are designed to represent real ownership of the leased assets, and not only a right to receive the rent.As per Shar¯ı´ah rules, expenses related to the corpus or basic characteristics of the asset are the responsibility of the owner, while maintenance expenses related to its operation are to be borne by the lessee. Therefore, the expected return flow from such Sukuk may not be completely fixed and predetermined. From this perspective, Ijarah Sukuk should be taken as quasi-fixed return instruments in Islamic finance. There is one possibility that the owner/lessor of the asset may assure the purchaser (SPV/Sukuk holder) about – performance of the lessees, as


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Securitization & Sukuk (Cont’d)as in the case of IDB Trust. But if the asset is destroyed without any fault or negligence of the lessee, the loss has to be borne by the lessor – the Sukuk holders. It can be agreed between the parties that the rental should consist of two parts – one for payment to the lessor and the other as an “on account” payment, to be held by the lessee for any costs relating to ownership of the asset. As regards the procedure for issuance of Ijarah Sukuk, an SPV is created to purchase the asset(s), and this serves as a manager and issues Sukuk to the investors, enabling it to make payment for purchasing the asset. The asset is then leased to the government or any corporate body for its use. The lessee makes periodic rental payments to the SPV, which, in turn, distributes the same among the Sukuk holders. As the lessor can stipulate the rental in advance, the rental on Sukuk issue can be indicated in advance with the possibility of very small variation that might be possible due to payment of ownership-related unpredictable


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Securitization & Sukuk (Cont’d)expenses by the lessor or the possibility of any default by the lessee.Ijarah certificates can be negotiated and traded freely in the market and can serve as an instrument easily convertible into cash. But, this should be after transfer of ownership to the Sukuk holders, necessarily implying that the Sukuk represent real assets and not the monetary capital, and that the holders have become owners of the assets (after which they can sell). It is also permissible for the issuer to redeem, before maturity, certificates of ownership of leased assets at the market price or at the price agreed upon between the certificate holder and the issuer. Similarly, Ijarah Sukuk representing ownership of the usufruct of ascertained assets can be traded prior to the contract of sub-leasing (because in that case they would represent the monetary rent receivable).4. Salam Securities/Sukuk:Salam is a contract in which advance payment of a price is made for goods to be delivered later on. As per the AAOIFI Standard, a Salam


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Securitization & Sukuk (Cont’d)purchase can onward sell the Salam commodity by another contract which is parallel to the first. In this case, the first and the second contracts should be independent of each other. Specifications of the goods and delivery dates of the two contracts may conform to each other, but both the contracts should be independently enforceable.Salam Sukuk are certificates of equal value issued for the sake of mobilizing capital that is paid in advance in the shape of the price of the commodity to be delivered later. The seller of the Salam commodity issues the certificates, while the subscribers are the buyers of that commodity, i.e. they are the owners of the commodity when delivered. In the case of Parallel Salam, the holders of Salam Sukuk are entitled to the Salam commodity or the selling price at the time when the commodity is delivered.Salam sale is attractive to the seller, whose cash flow is enhanced in advance, and to the buyer, as the Salam price is normally lower than the prevailing spot price. The BMA, in June 2001, developed Salam-based


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Securitization & Sukuk (Cont’d)securities with LIBOR-related three-month tenures used by Islamic banks for maintaining SLR. The Bahrain government sells aluminium to Bahrain Islamic Bank (BIB), which has been nominated to represent the other banks wishing to participate in the Salam contract. The government undertakes to supply a specified amount of aluminium on the basis of Salam at a future date. At the same time, BIB appoints the government its agent to market the aluminium at the time of delivery through its channels of distribution at a price which provides a return to the security holders. Such short-term Sukuk can be developed on the basis of commodities being heavily traded, like crude oil and cotton, and the produce of big industrial projects having firm demand.So far, secondary market trading of Salam Sukuk is considered impermissible on the grounds that the certificates represent a share in the Salam debt, in which case they are subject to the rules of debt trading. The issue needs further analysis in respect of reselling the goods purchased under Salam before taking possession by the original buyer,


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Securitization & Sukuk (Cont’d)especially in the situation when he maintains inventory of that kind of goods, in which case banks would be selling those goods out of the stock maintained by them without specifying any units of the goods.The Salam seller is bound to deliver the goods at the agreed date/time. The possibility of a change in price of tangible goods during the Salam contract/the delivery period gives rise to a business risk needed for getting a return through sale. Secondly, Salam deals have been allowed as an exception from the general rule of not selling goods without having their ownership and possession by dint of some conditions that are put in place to avoid excessive Gharar in transactions. If it is allowed, the Salam Sukuk may be negotiable. The purchaser of Sukuk would be the owner of the commodity to be delivered at the specified date and the price of Sukuk would be determined by the market, depending upon the demand and supply of the underlying commodity.5. Istisna‘a Sukuk:Istisna‘a is a contractual agreement for manufacturing goods, allowing


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Securitization & Sukuk (Cont’d)cash payment in advance and future delivery or a future payment and future delivery of the goods manufactured, as per the contract. It can be used for providing the facility of financing the manufacture or construction of houses, plant, projects, bridges, roads and highways. By way of a Parallel Istisna‘a contract with subcontractors, Islamic banks can undertake the construction of any project/asset and its sale for a deferred price, and subcontract the actual construction to any specialized firms.In Istisna‘a, full ownership of the constructed item is immediately transferred upon delivery of the item to the purchaser, against the deferred sale price that normally covers not only the construction costs but also profits, which could legitimately include the cost of tying funds for the duration of the repayment period. The payable deferred price can be documented in the form of Sukuk (certificates of indebtedness), known as Istisna‘a Sukuk, which are documents that carry equal value and are issued with the aim of mobilizing the funds required for


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Securitization & Sukuk (Cont’d)producing a certain item. The issuer of the certificates is the manufacturer (seller), while the subscribers or certificate holders are the buyers of the item to be produced.It is permissible to trade in or redeem Istisna‘a certificates if the funds have been converted through business or trade into assets owned by certificate holders during the operation of Istisna‘a, as the Sukuk represent properties that can be disposed of. If the realized funds are immediately paid as a price in a Parallel Istisna‘a contract or the manufactured item is submitted to the ultimate purchaser, then trading in Istisna‘a certificates is subject to the rules of disposing of debts. This is because the Sukuk represent a price that is a monetary debt owed by the ultimate purchaser to the manufacturer.The prohibition of Riba precludes the sale of these debt certificates to a third party at any price other than their face value. Therefore, such certificates, which may be cashed only on maturity, cannot have a secondary market. However, they can be transferred at face value to a


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Securitization & Sukuk (Cont’d)third party. Builders, big industrial concerns and wholesale suppliers can sell to the IFIs certain assets on an Istisna‘a basis on deferred payment and issue Istisna‘a Sukuk redeemable periodically according to their payment dates. The holders of Istisna‘a Sukuk may acquire against them property or merchandise for a deferred price. Once acquired, such property or merchandise can be disposed of in any manner. As indicated earlier in the book, the deferred price of goods acquired against such certificates would be higher than the spot price of the same goods. The certificate holder acquiring the goods now at higher than the spot price is, in fact, relinquishing to the seller of the goods some (all, or even more) of the price differential which the former obtained from the client above the construction cost of the project he financed. This means that the market forces can play a role in encouraging or curtailing the exchange of these certificates for goods.6. Securitization on the Basis of Murabaha and Murabaha Sukuk:Any paper representing a monetary right or obligation arising out of a


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Securitization & Sukuk (Cont’d)credit sale transaction by banks cannot create a negotiable instrument. Therefore, Murabaha receivables cannot be securitized for creating negotiable Sukuk to be traded in the secondary market. The purchaser on credit in a Murabaha transaction signs a note or paper to evidence his indebtedness towards the seller. That paper represents a debt receivable by the seller. Transfer of this paper to a third party must be at par value and subject to the rules of Hawalah, meaning that its assignment also has to be at face value. However, if a commodity has been purchased but not yet sold, trading in certificates issued against it is allowed, as the certificates represent the asset that can be traded.A mixed portfolio consisting of a number of transactions, including Murabaha, may issue negotiable certificates subject to certain conditions. For this purpose, the pool of the assets should consist of Ijarah or other fixed assets valuing more than 50% of its total worth. However, if the Hanafi view is adopted, trading will be allowed even if the nonliquid assets are more than 10% of its total worth.


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Securitization & Sukuk (Cont’d)Murabaha Sukuk are more likely to be used in respect of purchases of goods by the public sector. If the government needs items of huge price, it may purchase them through credit sales by paying in instalments. The seller will amortize his cost and return (profit margin) over the period of instalments. The government will issue certificates according to the number of instalments. Each certificate having a maturity date will represent a property right of the seller, which can change hands provided the amount of the claim does not change. The seller or the original certificate holder can transfer his collection rights to another party, subject to recourse to him against payment that would be equal to the face value of the certificate minus the collection cost at the transferee’s end. Any “Murabaha funds” can also issue Murabaha Sukuk, the proceeds of which could be used for sale of pre specified and general assets on the basis of Murabaha to give a quasi-fixed return to the Murabaha Sukuk holders.Arcapita Bank B.S.C (Bahrain) issued five-year multicurrency Murabaha


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Securitization & Sukuk (Cont’d)backed Sukuk in 2005 with a five-year bullet maturity. The proceeds of the Sukuk are used for sale and purchase of assets via a series of commodity Murabaha transactions. As Murabaha may yield a fixed return, the Sukuk holders have been offered a return equivalent to three-month LIBOR + 175 bps. The SPV will have full recourse to Arcapita and, therefore, the Sukuk are a freely transferable instrument on the basis of a mechanism approved by Arcapita’s Shar¯ı´ah supervisory board. It is presumed that the SPV will be maintaining a sufficient amount of inventory or fixed assets, making its Sukuk negotiable.7. Mixed Portfolio Securities/Sukuk:Banks may securitize a pool of Musharakah, Ijarah and some Murabaha, Salam, Istisna‘a, and Ju‘alah (a contract for performing a given task against a prescribed fee in a given period) contracts. The return/risk on such securities depends on the chosen mix of the contracts. A prominent example of such mixed portfolio Sukuk are IDB’s Solidarity Trust Sukuk for US$ 400 million issued in 2003. Salient features of IDB Solidarity Trust


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Securitization & Sukuk (Cont’d)Sukuk for US$ 400 million issued in 2003. Salient features of IDB Solidarity Trust Sukuk are given below.Solidarity Trust Services (STS) served as trustee to issue the fixed-rate trust certificates that were issued to purchase a portfolio of Sukuk assets comprising Ijarah, Murabaha and Istisna‘a contracts originated by the IDB. Each certificate represented an undivided beneficial ownership in trust assets and ranked pari passu with other trust certificates. Most of the assets (over 50 %) would, at all times during the period, comprise Ijarah assets. If, at any time, the proportion of assets evidenced by Ijarah contracts fell below 25 %, a dissolution event would occur, and IDB, by virtue of its separate undertaking, would be obliged to purchase all of the assets owned by the trustee pursuant to the terms of the “purchase undertaking deed”. Profit on Sukuk assets, net of expenses of the trust, would be used to give a periodic return to the certificate holders. Certificates would be redeemed at 100% of their principal value. In the case of any early dissolution event, the redemption would be according


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Securitization & Sukuk (Cont’d)to adjustment, keeping in mind the return accumulation period. Principal amounts of Sukuk would be reinvested in Ijarah and Musharakah contracts to form a part of Sukuk assets.On the basis of a separate undertaking, IDB has guaranteed payments in respect of assets owed by the trustee by reference to the schedule of payments given by IDB at the time of sale of assets to the trustee. Certificate holders will not have any recourse for payment of any amount in respect of certificates in case the trust assets are exhausted. As such, IDB’s guarantee (for the rate on the certificates) does not comprise a guarantee of payments in respect of the trust certificates, but represents a guarantee, inter alia, of the amount scheduled as being payable by the obligors of the underlying transactions in respect of the assets. In the case of any shortfall in return on the Sukuk assets, the IDB has agreed to meet the shortfall. IDB has also agreed to provide an interest-free facility to the STS to ensure timely payment of any periodic distribution amounts on the trust certificates. Thus, the ability of the


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Securitization & Sukuk (Cont’d)trust to pay the due on certificates ultimately depends on IDB. On the basis of the “purchase undertaking deed” between IDB and the trust, the IDB will purchase the Sukuk assets on the earlier of the maturity date or the dissolution date. The proceeds will be distributed by the trust among the certificate holders, who will periodically receive a fixed rate of return net of any withholding or any other taxes. Under Islamic banking principles, IDB has to retain the risk of default on the Sukuk assets sold to the trust. As such, it is an unconditional and irrevocable guarantor to provide liquidity to the trust to cover costs and expenses, periodic distribution payments and the principal amount of investment to Sukuk holders.


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Securitization & Sukuk (Cont’d)


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Securitization & Sukuk (Cont’d)The modus operandi of issuing mixed portfolio Sukuk is an effective tool for converting nonmarketable and illiquid assets to negotiable instruments having a secondary market, particularly suitable for investment banks and DFIs.6. Tradability of Sukuk:Sukuk representing tangible assets or usufruct of such assets can be traded in the secondary market, depending upon the quality, risk and profitability of the securitized assets. Tradability is a highly important feature that has to be kept in mind while issuing Sukuk as well as for making investment. A deciding factor in this regard is whether the Sukuk create any debt obligations or they represent an ownership stake in the underlying assets or project; in the former case, the certificate will not be tradable, while in the latter case, it will be negotiable/tradable. As discussed in the case of various categories of Sukuk in the light of the AAOIFI Standard, the Shar¯ı´ah position of their trading in the in the


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Securitization & Sukuk (Cont’d)secondary market is given below:


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Securitization & Sukuk (Cont’d)7. Issues in Terms and Structures of Sukuk:Notwithstanding the exceptional growth of Sukuk in the last five years, there are some concerns that have to be taken care of for more vigorous and sustained support for the emerging financial system. The first and foremost crucial issue is that of conclusively prefixed rates of return in almost all Sukuk, in some cases even without any provision for third party guarantee. Profit rates in deferred-payment Murabaha and rentals in Ijarah are no doubt fixed, but while there could be default in receipt of Murabaha receivables, in leases there is the possibility both of ownership-related expenses and default in receipt of the due rental. The loss of the cost of funds that cannot be recovered under Islamic finance and expenses that could be incurred by the lessor as owner of the leased asset may not make it possible to give a return to Sukuk holders that is fixed and guaranteed in all respects. This concern is particularly genuine in respect of sovereign Sukuk, as a guarantee by the sovereign itself may give rise to doubts about Shar¯ı´ah compliance. Payment of rental is


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Securitization & Sukuk (Cont’d)guaranteed in the main contract itself in the form of a contractual obligation on sovereigns to pay the rent.In this regard, the general public interested in Islamic finance and practitioners need to be educated about the flexibilities and the limits of each mode/product so that the integrity of the system is not damaged. The Shar¯ı´ah scholars are unanimous that any pre-fixed return or guarantee of the investment by any of the partners in contractual Shirkah-based modes is not acceptable. According to the AAOIFI’s Standard on Sukuk, a prospectus to issue any certificates (not only those which are Shirkah-based) must not contain any clause that the issuer is liable to compensate certificate holders up to the nominal value in situations other than torts and negligence, or that he guarantees a fixed percentage of profit. (An independent third party can, however, provide such a guarantee free of charge and subject to relevant conditions). But the way in which various Sukuk are structured and marketed tends to assure the subscribers/holders that the issue carries a fixed return


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Securitization & Sukuk (Cont’d)rate, like any fixed income security in the conventional interest-based structure.One view is that the financier partner can give a part of its own profit or even out of its own wallet to the client partners, as in the case of deposits kept on the basis of Mudarabah. But even there the banks are not free; they can accommodate the clients up to the limit of a pre-agreed ratio only and any arrangement of payment of an agreed amount of profit out of the banks’ own income may dilute the sanctity of the institution of Shirkah, particularly when adopted as a system. In the case of Sukuk, even this is not possible and the SPVs have to distribute among the Sukuk holders the net proceeds of the business in which the raised funds have been used.Ijarah has flexibility in the sense that the rental rate can be fixed or floating and the lessor may know in advance his future expected receipts. But the lessor is exposed to losing rental collection when the lessee fails in timely payment.


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SUKUK & SECURITIZATION1. SUKUK AND SECURITIZATION VITAL ISSUES IN ISLAMIC CAPITAL MARKETS LECTURE By...

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