Looking Beyond the High Issuance of Sukuk

Dhafer Salih Alqahtani

Executive principal Rusmal Consult Manama, Kingdom of Bahrain. dhaferq@gmail.com

As 2013 unfold, and as we begin to look towards a better new year, hopefully, global investors are waiting anxiously for nerve-racking volatility and uncertainty in the world economy to settle down at an acceptable and tolerable level, with anticipation of restoring confidence in the financial sector. In Europe, investors are hoping for a resolution to the European sovereign debt crisis that will avoid escalating and propagating the woes of the western European economy. In addition, the U.S. economys path to recovery has been dominated by the contrary aims of bickering politicians. Unfortunately, it all adds up to a bigger fearthat the goal of reaching workable long term solutions to those crises on both sides of the Atlantic is not getting serious and timely attention thus reducing the options for solutions and escalating further the global economic deterioration. Austerity measures are spreading like fire all over the globe, and their implications are profoundly negative. And if that was not enough, ratings agencies are rushing into downgrading sovereign debts and financial institutions, adding insult to injury. The irony of this bleak picture is the fact that sovereign debt was created specifically to solve economic problems and stimulate the market economy. Instead, and in due course, the solution itself became the problem. Accordingly, we now have two major problems troubled economies and bad debtswhich raises the question of whether so-called capitalism (particularly the Western version) is in denial about what it promised to deliver through its interest-based system. We are left with over-leveraged economies and overborrowed countries, not to mention the over distressed individuals who are struggling to make ends meet, and the situation will not get any better even after countries enforce their super-national lenders austerity plans and belttightening measures. At the same time, funding resources are drying out and funding has become more expensive, thus forcing governments, banks, and corporations alike to seek alternatives outside the interest-based (i.e., assetbased) system. One alternative that has received wide attention is Islamic finance and its crown jewelSukuk. In fact, the demand for Sukuk is outstripping the supply and its not yet offered at the retail level. And why not, in light of the unprecedented growth in the Islamic banking sector, averaging 15%20% annually for the past decade, even during the financial crisis. Most of that growth took place in the Gulf Cooperation Council (GCC) region and some parts of Asia that happen to be the least affected by the financial crisis. The Islamic finance area also enjoys surplus liquidity, particularly in oil-rich countries (i.e., GCC countries). Accordingly, in their quest for surplus liquidity, the rest of the worlds countries and financial institutions facing liquidity

squeezes, debt crises, holding extremely risky assets, rating downgrades, increasing unemployment and streets unrestare looking toward Islamic instruments to do business. Meanwhile, with the financial crisis tremors being felt in the background, the Arab Spring revolutions swept across the Middle East and North Africa (MENA) region. Some countries are yet to recover from the aftermath of the Arab Spring revolutions, which is continues to harvest tyrants and install Islamists who promise to embrace democracy ??- after decades of dictatorship. After decades of suppression and rejection, Islamic banking is starting to flourish in some of these countries, starting with Tunisia, Egypt, Libya, Morocco, Yemen, and very soon Syria, thus adding new markets and a new players as well new challenges and issues. The majority of these countries and their newly elected governments, however, inherited huge deficits and infrastructures in shambles with great need for liquidity as well as huge unemployment rates. Resolving these issues in the current troubled macroeconomics times will require serious navigation. Logically, because Islamists hold the majorities in most of these newly elected governments, Sukuk will be a favorite tool to tackle these issues and government official nightmares. Also unfolding in the gulf region, other countries acted ahead of the unrest in the streets and forged ahead with their infrastructure development and social programs by expanding their budget spending and thus, with minimal confrontation, met most of the demands of the protesters and the social media campaigns. Those measures did stimulate the economy in the gulf region in a major with more weight on the infrastructure development. Islamic finance and its institutions are an intricate part of this unsympathetic economic cycle and unstable political atmosphere. Hence, they are not isolated from its impacts and progression or digression on certain occasions. Accordingly, Islamic finance and investment should take advantage of this turmoil and come forward as the solution provider for the crisis, not just as a safe harbor for excess liquidity that seeks a better yield. In order to do so, it will need to rapidly adapt to a myriad of ongoing changes in the markets. Islamic finance has already demonstrated its resiliency and sustainability, so it should be able to see and capture opportunities in the crisis while preserving and defending the authenticity and genuineness of Shariah-based products. No dialogue or scholarly discussion about Islamic finance and banking as a whole would be complete without addressing one of the cornerstones of Shariah-compliant investments instruments Sukuk. Sukuk as an instrument are less than two decades old, and recently, since 2007, they have been under intensive scrutiny about whether they are workable, real Islamic financial instruments. The conflict between the Sukuk documents and the governing law of Shariah, especially cross-border Sukuk, arises from the differences between asset-backed and asset-based Sukuk. In a true Sukuk, an asset-backed one, the Sukuk holders have recourse in case of default through the transfer of the underlying assets through a trustthis is known as an equity Sukuk. In so-called complaint or asset-based Sukuk, also known as debt Sukuk where no true sale or real ownership take place between the originator and the issuer i.e., (trust SPV), hence Sukuk units holders have

recourse to originator, contrary to true sale in asset-backed Sukuk, where recourse is to the Sukuks SPV that represents the Sukuk units holders ownership of the underlying assets and no recourse to originator in case of default. Such concerns as this or others that have been raised by Shariah standards setting bodies (e.g., Accounting and Auditing Organizations for Islamic Finance, or AAOIFI) are needed to further refine and tune Sukuk structures without violating the principals of risk and profit sharing on which Sukuk should be based. The rapid growth and mounting global interest in Sukuk will bring with it new and innovative structures designed to serve specific needs and demands, consequently giving rise to new challenges and concerns. Unfortunately, the core issue remains unsolved and unanswered, at least by the scholars who are suppose to be the gatekeepersthat is, the shift toward asset-backed Sukuk instead of debt Sukuk, (Asset-based Sukuk), its a case of substance over form. Indicators are pointing in the right direction for a change, signaling a possible recovery on the horizon, thus the time is ripe for the Sukuk to move to the next level of its development and advancement, as well as carving a place for true Sukuk in the global financial market while correcting the way Sukuk are being issued, structured, and administered. With that said, and out of fear and concern for where the Sukuk industry might be headed where we are blinded by the huge demand, I would like to contribute and share my views and suggestions as a practitioner and a veteran of the industry. Thus, I have few pointers on how we can possibly make Sukuk more genuine and appealing (i.e., investment Sukuk) while holding their creditability and conformity with shariah, also preventing reputational risk in the new world order of the global financial market as well as our direct markets. 1. We start with the most important component of any Sukuk development the Shariah Supervisory Board (SSB) and Shariah scholars The Gatekeepers. Their duties and mandates should go beyond issuing a signed and sealed fatwa for Sukuk or any product for that matter, the SSB must be fully responsible and accountable in addition to being proactive, from the concept level of structuring and the Fatwa process to implementation and execution and, eventually, the attainment of maturity for the instrument or security, as well as a possible default. These Gatekeepers should serve in this role for all related Shariah-complaint structures, securities, and products as well as Halal businesses. The Shariah compliance and/or audit officer should spearhead such crucial functions under a direct mandate from the SSB. 2. All SSBs, separately or collectively, should encourage if not require assetbacked Sukuk (equity Sukuk or investment Sukuk) with clear and well-defined recourse for investors while discouraging asset-based Sukuk (debt Sukuk) with the objective of eventually minimizing if not eradicating debt Sukuk. Such a task is only possible and feasible through the institutionalization of an SSB process.

3. Introduce Sukuk at the retail level (distribution of wealth) by allocating sizeable tranches to the retail segment, thus expanding the trading platform of Sukuk to augment accessibility, consequently expanding the secondary markets. At the same time, this adds another attractive and viable asset class for investors (i.e., Sukuk) in addition to traditional equity and real estate. (Moreover, real estate as an asset class is illiquid in nature, and it is becoming too expensive to acquire by the regular investor, which gives all the more reason to push for Sukuk as an alternative asset class that is liquid for Muslim and non-Muslim investors alike who may have limited choices.) 4. Contribute to the expansion of the secondary market by issuing larger Sukuk to address the volume concerns, which will enhance their liquidity and marketability. 5. Increase the number of long-term Sukuk ( +10 years), which will increase both the diversity and the attractiveness of Sukuk, particularly for long-term investors (e.g., asset managers, sovereign wealth funds, pension funds, Waqf organizations and takaful companies). 6. Advance and encourage issuance of Sukuk for short and medium terms to expand the breadth and depth of secondary markets as well as the numbers and diversity of Sukuk. 7. Governments issuances should promote Sukuk as a saving instrument option for individuals, allowing them to participate in major issuances at the retail level by creating retail portions for private individuals. 8. Sukuk issuance cost should be driven down, thus allowing cash-starved medium-capitalization businesses to become issuers to finance expansion and growth and fulfill one of their vital roles in the economy, that isjobs creation. This could come mainly through more standardization in terms of Sukuk generic structures and types by AAOIFI and other standards-setting bodies for Islamic finance (e.g., Islamic Financial Services Board or IFSB; International Islamic Financial Market or IIFM). 9. Infrastructure development and mega-project originators and issuers, both governments and quasi-governments, should utilize Sukuk for financing their needs instead of using their surpluses. This would expand the volume of the Sukuk market while directing those surpluses to more pressing issues at the social level, such as education and health care. 10. Explore and encourage innovative features and structures that are hybrid in nature, beyond the 14 Sukuk types of AAOIF (especially, the well-known Sukuk alijarah or leasing structure),to enhance versatility and adaptability in meeting the increasingly complex needs and situations faced by issuers.

11. Encourage new asset classes as the underlying asset other than the traditional assets (i.e., real estate and Islamic financial institutions), such as infrastructure, railroads, airports, manufacturing, power generation, education, and health care sectors, thus widening diversity as well as the risk profile for Sukuk. Similarly, encourage more issuances in local currencies other than the dollar. 12. One of the major misconceptions in the Islamic finance industry is calling a Sukuk an Islamic bond. Islamic finance does not have any structure that can be called a bond. Similarly, a bond as we know it is contrary to Islamic finance principals. Thus, a bond cannot be called Islamic, and its not a Sukuk, as Sukuk are an investment instrument. Accordingly, there is no such thing as Islamic bond, and a Sukuk is not any kind of bond. Those issuances that are being called Islamic bonds are only debt instruments that are being forced to be Shariah-complaint while mimicking many features of the conventional bondso, calling those issuances Islamic bonds is not far from the truth, even though there is no such thing as an Islamic bond. But calling them Sukuk is major distortion to the substance and a misrepresentation of the form of Sukuk as a major Islamic investment product that derives its uniqueness and functionality from the equity side. Sukuk is an investment instrument, in which the Sukuk units represent a partial ownership of the underlying assets, with direct claim to those assets and profits or losses in distribution or liquidation. 13. Significantly improve the disclosure and transparency of Sukuk structures and unit holder rights and obligations to the underlying assets, including the case of default, market risk, pricing, fees, charges, and uses of the funds. Similarly, risk and return prevailing conditions with their essential dynamics should be embedded in the transparency and disclosure process, both quantitative and qualitative. 14. Educational institutions that cover Islamic finance and economics in their degree programs, but who have been invisible until now while claiming they have Islamic finance research centers, should go beyond their curriculum guidelines and textbooks for Islamic finance and constructively challenge, analyze, and criticize the industry practices and products through research and development. Their findings, criticisms, recommendations, and analyses should be made public, sharing it with the concerned regulators, standardssetting bodies, and Islamic financial institutions. 15. Islamic finance standard-setting bodies (e.g., AAOIFI, IFSB) should move beyond their present mandate by being vocal in enforcing their regulations and raising the red flags publicly whenever needed and by introducing newer regulations and guidelines. At the same time, they must be proactive in terms of being ahead of the industrys needs and requirements. Considering these pointers and recommendations, which largely address the creation of a vibrant secondary investment Sukuk market as well as accessibility, will enhance growth and reinforce confidence in Sukuk and

attract a sizeable share of the liquidity surplus by opening a new window for private individuals savings, an area that yet to be developed. By the same token, following these recommendations will give more choices and flexibility to asset managers for better asset allocations by developing more innovative products in the fixed-income industry, with different tenors, returns, and risk profiles involving investment Sukuk. This will bring more investors to structured Sukuk funds, in particular, which have been battling to gain market share in the mutual and fixed-income funds sector. They have encountered difficulties in attracting investors due to the lack of breadth and depth caused by the shortage in diversity and volume in the Sukuk issuance as well as the low variety of sectors in relation to the underlying assets in Sukuk issuance, and a lack of variety in the currencies mix. Fortunately, Sukuk funds can be now re-energized on the basis of the Sukuk issuances record for 2011, 2012 and its high prospects for 2013 and beyond. On the issuance side, governments through central banks will have a stable instrument to manage the money supply as well as the fiscal and monetary budget. In the larger picture, governments of Islamic countries should also foster the growth of Shariah-compliant products by utilizing Islamic finance instruments (i.e., investment Sukuk) to finance major infrastructure developments, power grids, bridges, transportation projects, housing, agriculture development and mining projects. At the same time, the government issuances will enable citizens at the individual level (retail segment) to become Sukuk unit holders (wealth distribution) with clear recourse to the underlying assets, thus investing in financing those projects through those Sukuk while getting reasonable returns on their participation alongside having the comfort from knowing that they are investing in genuine Sukuk. In addition, those citizens will feel pride in knowing that they are owners of a mega project in their country for their benefit. Allowing individual participation in Sukuk will eventually create products for preserving wealth and encouraging savings for citizens, while gradually developing a vibrant secondary market and slowly moving away from concentration of wealth. The unprecedented growth of the Sukuk has raised many red f lags and requires all of the parties involved to step back and take the time to evaluate, analyze, and examine its merits and virtues, its impact on the industry as a wholein particular, its integrity, reputation, creditability, and its authenticity. Its the responsibility of all of us practitioners, lawyers, and regulators, with a particular focus on scholars; this responsibility and accountability should go beyond the race to introduce another debt Sukuk while blinded by the fees to be earned from those issuances to the market, as that debt Sukuk undoubtedly will backfire on the industry. In short, debt Sukuk is an accident is waiting to happen, thus let us prevent it from happening and be vigilant of such a trend. The rush of many sovereign and conventional financial institutions, investment and commercial banks, as well as international regulators, to Sukuk issuance is mainly driven by the drying fountain and high cost of conventional debt. They are also lured by the surplus liquidity in the Arabian

Gulf region and some parts of Asia; this was demonstrated most recently by the announcement that South Africa, Japan, Hong Kong, Ireland, Kazakhstan, Bermuda, France, China, India, and Australia, among others, are joining the issuers league, or contemplating the idea. This coincides with the fact that a large sum of the gulf regions liquidity is starved and in most cases constrained to Shariah-compliant instruments and securities. Such a new paradigm of debt demand and supplyjointly with the wrong intentions and purposes (camouflaged greed or needs)can be a recipe for disaster. Thus, although the sprouting interest motives and aims in Sukuk should be welcomed, it must also be challenged and scrutinized, especially by the Gatekeepers (i.e., Shariah scholars) as well the standards setting bodies (e.g., AAOIFI, IFSB), until the establishment of a universal regulatory body to supervise and scrutinize Sukuk to guarantee the conformity and adherence to Shariah guidelines at all times. This scrutiny and supervision will prevent any threats to the authenticity and integrity of Sukuk and the Islamic finance alike, while serving the essence of Islamic economy in term of fairness, distribution of wealth, and equality as opposed to concentration of wealth. At the same time, the balanced growth of the industry will progress without any major setbacks while carrying out best practice in terms of transparency and governance.

PPENDIX GLOSSARY Accounting and Auditing Organization for Islamic Financial Institutions . AAOIFI is an Islamic international, autonomous, non-profit corporate body that prepares accounting, auditing, governance, ethics, and Shariah standards for Islamic financial institutions and the industry. Professional qualification programs (notably CIPA, the Shariah Adviser and Auditor or CSAA, and the corporate compliance program) are presented by AAOIFI in its efforts to enhance the industrys human resources base and governance structures. AAOIFI was established as an independent international organization in accordance with the Agreement of Association, this was signed by Islamic financial institutions on February 26, 1990, in Algiers. It was registered on March 27, 1991, in the Kingdom of Bahrain. AAOIFI is supported by institutional members (200 members from 45 countries, so far) including central banks, Islamic financial institutions, and other participants from the international Islamic banking and finance industry, worldwide. (www.aaoifi.com)
Fatwa. Under Islamic teachings, in Arabic fatwa is a religious opinion concerning Islamic law issued by an Islamic scholar in Arabic, an alim or ulama for plural. Ulama is a body of recognized Muslim clergy who have completed several years of training, research, and study of Islamic sciences. GCC. The Arabian Gulf Cooperation Council was established on May 25, 1981. The GCC is a political and economic union of the Arab states bordering the Arabian Gulf and constituting the Arabian Peninsula, namely Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates. The unified economic agreement between the countries of the Gulf Cooperation Council was signed on November 11, 1981, in Abu Dhabi. These countries are often referred to as the GCC States. (www.gcc-sg.org)

International Islamic Financial Market. IIFM is the global standardization body for the Islamic capital and money market segment of the Islamic financial services industry (IFSI). Its primary focus lies in the standardization of Islamic financial products, documentation, and related processes. IIFM was founded with the collective efforts of the Central Bank of Bahrain, Bank Indonesia, Central Bank of Sudan, Labuan Financial Services Authority (Malaysia), Autoriti Monetari Brunei Darussalam, and the Islamic Development Bank-IDB (Saudi Arabia). IIFM is supported by its permanent member State Bank of Pakistan. Dubai International Financial Centre Authority (DIFCA), ABC Islamic Bank, Bank Islam Malaysia Berhad, Crdit Agricole CIB, European Islamic Investment Bank, Kuwait Finance House, National Bank of Kuwait, Standard Chartered Saadiq. (www.iifm.net) Islamic Economic System. An economic system that identifies and promotes an economic order that conforms to Islamic scripture and traditions that evolved around creating a real economy that is ethical and socially responsible, where money is always in circulation and equitable while sharing risk and reward, with an interestfree financial system as guided by Shariah law through Islamic economic jurisprudence. Islamic financial institution. An IFI is a bank or investment house or financing entity or takaful (co-operative insurance) or re-takaful that fully adheres and conforms to Shariah rules and guidelines as stipulated and enforced by the firms Shariah supervisory board (SSB) as well as its articles of incorporation. Islamic Financial Services Board . The IFSB is based in Kuala Lumpur, Malaysia, and was officially inaugurated on November 3, 2002, and started operations on March 10, 2003. It serves as an international standards-setting body of regulatory and supervisory agencies that have vested interest in ensuring the soundness and stability of the Islamic financial services industry, which is defined broadly to include banking, capital market, and insurance. In advancing this mission, the IFSB promotes the development of a prudent and transparent Islamic financial services industry through introducing new or adapting existing international standards consistent with Shariah principles and recommending them for adoption. The IFSB also conducts research and coordinates initiatives on industry-related issues, as well as organizing roundtables, seminars, and conferences for regulators and industry stakeholders. IFSB works complement the Basel Committee on Banking Supervision, International Organization of Securities Commissions, and the International Association of Insurance Supervisors. IFSB has 191 member; 54 are regulatory and supervisory authorities, 7 international inter-governmental organizations, and 130 market players, professional firms, and industry associations operating in 43jurisdictions. (www.ifsb.org) MENA. Middle East and North Africa Shariah (Islamic Law). A set of rules and guidelines derived from two primary sources of Shariah. First, the divine revelations set forth in the Quran (the holy book of Muslims and the main religious text); second, the Hadith, the sayings and example set by the Islamic Prophet Muhammad in the Sunnah (Arabic word that means habit or usual practice; the Muslim usage of this term refers to the sayings and living habits of the prophet Muhammad). Fiqh (jurisprudence) interprets and extends the application of Shariah to questions not directly addressed in the primary sources by including secondary sources. These secondary sources usually include Ijma (the consensus of the religious scholars) and analogy from the Quran and Sunnah through Qiyas (the analogical reasoning). In relation to this article, the Islamic law for

investment and finance calls for all financial transactions to be free of interest/usury (riba), speculation (maisir), uncertainty (gharar), while sharing risk beside profit and loss sharing, and to not invest in businesses that provide goods or services considered forbidden and prohibited (haram). Prohibited business activities can relate to food (production and sales of alcoholic beverages, including pubs and restaurants; pork products; tobacco), gambling (casinos; online gambling; betting; lottery schemes), adult oriented (video; magazines; on-line material; strip clubs), dubious or immoral, and illicit trades (online dating; prostitution; drugs), weapons production and manufacturing, insurance, and reinsurance. In general, Shariah is not dissimilar to socially responsible investing (SRI); also, because speculation and gambling is forbidden in any form, derivatives, forwards, options, and futures can be considered prohibited. Other forbidden practices include short selling, margin, day, and scalping trading. Shariah Supervisory Board. An SSB is an executive body of few Islamic scholars (ulama) retained under a mandate by Islamic financial institutions to ensure compliance and adherence to Shariah as well issue fatwa for the products and transactions within Islamic financial institutions. Sukuk. Arabic, plural of sakk, means legal instrument, deed, check, and is the Arabic name for Shariah-compliant financial certificates. It is often mistakenly referred to as the Islamic equivalent of bonds, which it is not. Sukuk is similar to an obligation backed by asset securities but is not in any way a bond, because it is not based on debt with interest. It can be regarded as a commercial paper/certificate that gives the investor a share of ownership in the underlying asset or a pool of assets. The issuer must identify the asset(s) to be sold to investors by transferring it to undivided beneficial ownership in the underlying asset(s). Investors enjoy the usufruct of the assets in proportion to their investment and bear the credit risk of the issuer. Sukuk are traded and rated financial instruments. The AAOIFI defines Sukuk as, Certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity.