INCEIF
The Global University in Islamic Finance
IB 1006
Islamic Capital Market
(26 NOV 2009)
By Prof. Iraj Toutounchian
Capital Mobilization
Demand and Supply of capital
 Common stock is an equity product that runs on the „No pain no
gain” principles of al-ghorm bil ghonm (with risk comes profit)
and al-kharaj bil daman (profit is accompanied with
responsibility).
 The capital supplier‟s main concern is how much he can make
from his investment. God has entrusted him with wealth and thus,
he must look after this God given bounties the best way possible.
 If he plans to make an investment, then he must be concern about
how many cents he can earn out of every dollar invested. He
cannot be negligent and careless to cause erosion of his wealth as
this is tantamount to israf (ie.wastage and extravagant spending).
 This is the philosophy of investment in Islam.
Capital Mobilization
Supply of Capital
 Capital supplier is interested to know the expected rate of return of
capital.
 One way to compute this expected rate of return is by using the
Capital Asset Pricing Model (CAPM). But not everyone use CAPM.
 For example, retail investors are more driven by tips and rumors.
Some look at the price-earnings ratio of the stock. Fund managers
use all sorts of models such as technical analysis, charts and also
CAPM.
 Some of them are entrusted with Islamic funds and using CAPM is
not an exception. There are other models besides CAPM but CAPM
is the simplest. On this note, we will use CAPM to illustrate the
factor determining the supply of capital.
Capital Mobilization
Supply of Capital
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CAPM says that the supply of capital is determined amongst other by its
expected rate of return (Re).
Supply of Capital = f (Re)
Re can be obtained from the CAPM equation. The CAPM equation is given
below:
Re = Rf + B (Rm – Rf)
Where,
Re = expected rate of return
Rf = risk-free rate. This rate is considered free from default risk since the borrowing
party is the government.
B = Beta. This variable explains the volatility of the common stock. If beta = 2, it
means that 1% increase in the market will increase the common stock by 2%. It
means that the stock is quite volatile.
Rm = Market rate; the market rate is represented by a stock index, say in the United
States, Standard & Poor 100.
Capital Mobilization
Supply of Capital
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The CAPM equation says that the expected rate of return of a common
stock is made up of:
the risk-free rate
risk-premium or Beta(Rm-Rf).
That is, the risk premium consists of the Beta multiply by the difference
between the market rate and risk-free rate (Rm-Rf).
For example, if Rf = 5% and Beta = 1.5 and Rf = 15%. Then
Re = 3 + 1.5(15 – 5) = 3 + 1.5 (10) = 3 + 15 = 18%.
What the above means is that the expected rate of the common stock has a
risk premium of 15%. When adding the Rf to this risk premium, the total
expected rate of return is 18%.
Capital Mobilization
Supply of Capital
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The question is “can fund managers who are entrusted with Islamic
funds use CAPM?” Since CAPM has an interest rate component (Rf),
it is easy to say NO. However, there is no consensus regarding the
Islamic opportunity cost of capital (ICOC). Some say that it should
be based on the real sector performance rather than the financial
service sector performance.
If Rf = 0, then:
Re = 0 + 1.5 (15 – 0) = 23.5 which means that the Re without Rf is
higher than Re with Rf. Since there is no guaranteed component (Rf),
the investment is seen as more risky and thus investors expects to
earn more from the investment. To those who are seeking capital, this
is no good as the cost of equity capital is now higher than one with
Rf.
The cost of equity capital is therefore its expected rate of return (Re).
Capital Mobilization
Gordon Growth Model
Price of Stock X = Dividend per share / (expected rate of return - rate of growth
of dividend)
Po = D1 /[r-g]
Po: value or market price of common stock
D1: dividend to be received in 1 year
r = investor‟s required rate of return
g: rate of growth
Assume market price of Stock X (Pm) is $40. The dividend to be paid at the end
of the month is $4 per share and is expected to grow at a constant annual rate
of 6%. Then the targeted price of the common stock is:
Pt = $4 / (r – 6%).
Capital Mobilization
Gordon Growth Model
We can obtain r from CAPM.
r = Re
Re = Rf + Beta (Rm – Rf)
Assume that Re = 18%, thus r = $18
Pt = $4/(18% -6%) = $4/0.12 = $33.30
Pm = $40
Pt = $33
Pm > Pt, ie. $40 < $33.30, thus the stock is undervalued.
Decision: Buy Stock X.
Islamic Equities .
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Construction of Shariah Indexes
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The construction of Shariah Indexes is a straightforward exercise once the Shariah screening is
successfully conducted to differentiate the
permissible stocks from the non-permissible ones.
The Dow Jones Islamic index is a price-weighted
index while some other Shariah Indexes valueweighted. The following Table shows how a valueweighted Islamic index is constructed.
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Islamic Equities .
Construction of Shariah Indexes
Islamic Stock Index
CONSTRUCTING A VALUE-WEIGHTED ISLAMIC STOCK INDEX
Shariah
Compliant
Company
Total Shares
Outstanding on
both dates
Based period
market price
April 19, 2007
Recent period
market price
April 24, 2007
Percentage price
charge
JEBAK (oil palm
plantation)
60,000
$30
$45
50%
ANGKAT
(construction)
20,000
$25
$80
220%
MINANG (iron &
steel)
90,000
$65
$85
31%
TOTALS
170,000
$120
$210
Islamic Equities .
VALUE-WEIGHTED ISLAMIC STOCK INDEX
(Islamic content defined on the basis of Activity / Production Approach
0nly)
(April 19, 2007 market value/ April 24, 2007 market value ) x 100)
([60,000 x 30] + [90,000 x 65] + [20,000 x $25] / [60,000 x 45] + 20,000 x
80] + [90,000 x 85]) =
($11,950,000 / $8,150,000) x 100 = 146.63
*Interpretation: The three stocks increased by 46.63% from their base date
April 19 on average.
Islamic Venture Capital .
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Venture capital firms are typically structured as partnerships, the
general partners of which serve as the managers of the firm and will
serve as investment advisors to the venture capital funds raised.
This is where the principles of musharakah can be readily applied.
Investors in venture capital funds are known as limited partners,
meaning that losses in the ventures will only affect their capital
investments and not their private properties.
Investors comprises mainly of high net worth individuals and
institutions with large amounts of available capital, such as state and
private pension funds, university financial endowments,
foundations, insurance companies, and pooled investment vehicles,
called fund of funds or mutual funds.
Islamic Venture Capital .
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There are basically 4 stages of financing offered in Venture
Capital, namely:
Stage 1: Early start-up stage where firms need funding for
expenses associated with marketing and product development.
This is the most risky level of investment.
Stage 2: Working capital for early stage companies that are
selling product, but not yet turning a profit
Stage 3: Mezzanine financing, this is expansion money for a
newly profitable company
Stage 4:bridge financing where it is intended to finance the
"going public" process
Islamic Venture Capital .
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One main objective of a venture capitalist is to make capital
gains from the sale of company stocks they hold. As such the
determination of stock ownership is crucial. So, the deal is the
percentage equity he should seek in the company.
Suppose, the venture company (VC) injected $50 million with
50 million shares and holds 60 percent or 30 million shares.
Price per share is $1.
After 5 years, the value of business has increased to $100
million with price at $2 per shares. Upon exiting, the VC sells
the shares at $1 profit per unit, hence total profit is $30 million
Islamic Perspective on Derivatives
Let us look at one example of derivative, that is commodity future trading.
1.
Jim a Kansas wheat farmer expects to harvest 40,000 bushels of wheat in
early August.
2.
On June 15, the price of wheat is $3.50 per bushel.
3.
Jim is concerned that the price of wheat per bushel will fall below $3.50
before his August delivery date.
4.
Jerry told Jim that he should hedge his position by selling August wheat
futures.
5.
By selling wheat futures, Jim can lock in the August price of $3.45 per
bushel.
6.
Jim took Jerry‟s advice and SOLD EIGHT 5,000 BUSHELS OF
AUGUST WHEAT FUTURES.
7.
When August came, the price of wheat had fallen to $3.00 per bushel.
Islamic Perspective on Derivatives
8.
9.
However, Jim‟s hedge covered his losses because WHAT HE LOST ON
THE CASH CROP WAS OFFSET BY HIS GAINS ON THE FUTURES
CONTRACT minus a small transaction charge.
The value of the hedge position was calculated as follows:
a)
b)
c)
d)
e)
Revenues from sales of physical wheat = $3.00 x 40,000 = $120,000 revenue.
Sale of 8 wheat futures = 8 x $3.45 x 5,000 = $138,000 revenue
Purchase of 8 wheat futures contract = 8 x $3.00 x 5,000 = $120,000.
Gain of futures contract = $138,000 - $120,000 = $18,000.
Jim‟s net cash flow for August was $138,000 = ($120,000 + $18,000).
View from Islamic perspective:
 b and c is a short sale. Jim sold what he does not own in b and give it back
through c.
 a is permissible i.e physical sale at spot price and delivery.
Islamic Perspective on Derivatives
Islamic perspective
 It is a challenging task to arrive at an Islamic verdict on
financial derivatives today.
 The muftis (Muslim jurists) are the ones responsible for
making the fatwas (legal rulings) on whether investment in
derivatives is wajib (obligatory), sunnat (optional) makruh
(discouraged), mubah(permissible) or haram (prohibited).
 Guidelines on financial derivatives generally relates to
interest rates and forex swaps.
 Stock derivatives such as financial futures and options have
been in the market for quite sometimes. Be that as it may, the
whole story is about risk management - how to protect oneself
from market related potential losses.
Overview of Islamic Sukuk Market.
Sukuk al-Manfaah
Sukuk al-Intifa‟
Sukuk Milkiyyat al-Khadamat
Sukuk al-Khadamat al-Mawsufah fi al-Zimmah
Sukuk Al- Salam
Sukuk al-Istisna‟
Sukuk Al-Murabahah
Sukuk musharaka
Overview of Islamic Sukuk Market.
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Sukuk musharaka mobilizes funds based on a
partnership principle of shirkat-ul amwal i.e
partnership in capital
In Islamic jurisprudence, the term shirkah is
commonly used to denote musyarakah. Shirkah means
“sharing”. It can be classified into two, namely
shirkat-ul-milk and shirkah-ul-aqd. Shirkat-ul-milk is
a joint ownership of two or more persons in a
particular property. This contract is not relevant to our
present problems.
Overview of Islamic Sukuk Market.
Overview of Islamic Sukuk Market.
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Shirkat-ul-aqd means a partnership affected by a mutual contract,
which can be translated as a „joint commercial enterprise‟. Further
classification of shirkah-ul-aqd into three categories will show its
relevance to the requirement of setting up a new business.
The first category is shirkat-ul-amwal. In this financial contract all
partners invest some capital as well as expertise into the new business.
Second, shirkat-ul-‘amal involves only services rendered by partners.
Finally, there is shirkat-ul-wujuh where no capital input is required.
The business purchases goods on credit and sell them cash.
The profit generated from the business of shirkat will be distributed
among the partners at an agreed ratio or percentage. Of the three
types of shirkat-ul-‘aqd, the first kind, namely shirkat-ul-amwal, is
associated with musyarakah financing. In fact, the term musyarakah is
not readily found in books of Fiqh. It was casually used in Islamic
banking literatures to imply shirkat-ul-amwal as it deals with capital
investment
Overview of Islamic Sukuk Market.
Sukuk Musharakah
Returns according to Musharaka agreement
Musharik
(Obligor)
Contribution
Cash/Kind
Musharaka
Agreement
Sukuk
proceeds
Investors
(Sukuk Holders)
Cash
SPV
Issuing
Sukuk
Returns
Project
Overview of Islamic Sukuk Market.
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The obligor i.e the party who is interested to raise capital for
project finance investment will structure a financial arrangement
to mobilize the capital. The parties involved are:
1. Special Purpose Vehicle: this party serves to issue the
sukuk. It will act on behalf of the sukuk holders to invest the
capital into the Project.
2. The Obligor: It contributes part of the total capital such as
land or cash. It is common that the obligor will undertake
responsibility to manage the Project:
a.
b.
3.
4.
in capacity as a partner to the project
as an authorized party where it collects fees or profit for the work done.
The Trustee
The Investor
Overview of Islamic Sukuk Market.
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a)
Musharakah Certificate
These are certificate of equal value issued with the aim of using the
mobilised funds for establishing a new project.
Developing an existing project or financing a business activity on the basis of
any of partnership contracts so that the certificate holders become the owners
of the project or the assets of the activity as per their respective shares, with
the Musharakah certificates being managed on the basis of Musharakah or
Mudarabah or through an investment agency.
There are three modes of issuing securities based on musharakah
concept:
Sukuk al-Musharakah - Participation certificate (Issuer is a
musharik or partner)
These are certificates representing projects or activities managed on
the basis of Musharakah by appointing either one of the partners or
another person to manage the operation.
Overview of Islamic Sukuk Market.
b.
c.
Sukuk al-Mudarabah - Mudarabah Sukuk (Issuer is the
mudarib or manager)
 These are certificates that represent projects or activities that
are managed on the basis of Mudarabah by appointing the
mudarib for the management of the operation.
Sukuk al-Wakalah - (Investment Agency Sukuk)
 These are certificates that represent projects or activities that
are managed on the basis of investment agency by appointing
an agent to manage the operation on behalf of the certificate
holders.
 These are also forms of musharakah participation in the field
of plantation and agricultural procedure. These are as
follows:
Overview of Islamic Sukuk Market.
I.
II.
III.
Sukuk al-Muzara’ah - Muzara‟a (sharecropping certificates)
These are certificates that carry equal value issued for the purpose of using
the mobilized funds through the subscription for financing a project on the
basis of muzara‟a so that the certificate holders become entitled to a share
in the crop according to the terms of the agreement
Sukuk al-Musaqah - Musaqah (irrigation) certificates
These are certificates that carry equal value issued for the purpose of
employing the funds mobilised through subscription for the irrigation of
fruit bearing trees, spending on them and caring for them on the basis of a
musaqa contract so that so that the certificate holders become entitled to a
share in the crop as per agreement.
Sukuk al-Mugharasah - Mugharasah (agricultural) certificates
These are certificates that carry equal value issued on the basis of a
mugharasah contract for the purpose of employing funds for planting trees
and undertaking the work and expenses required by such plantation so that
the certificate holders entitled to a share in the land and the plantation.
Overview of Islamic Sukuk Market.
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All of these securities which are based on equity-based contracts such as
musharakah, mudarabah, muqaraah, muqasah and mugharasah are essentially
asset-based securities.
The issuance and the tradability of these securities will not pose any Shariah
issue across jurisdictions because the trading of these securities is always
based on a kind of asset which removes the element of monetary asset in
these securities.
Sukuk al-Istithmaar
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These are the Sukuk which are hybrid in nature. They combine both financial
assets such as Murabahah receivables and tangible assets such as Ijarah
leased asset according to a proportion of 70:30 respectively.
The issuance of these securities which was initiated by the Islamic
Development Bank was a breakthrough in addressing the issue of receivables
securitization.
These securities have been deemed as asset-based securitization and therefore
are tradable in the secondary market without any Shariah constraint in trading
these securities.
Overview of Islamic Sukuk Market.
Overview of Islamic Sukuk Market.
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Tradability of Islamic Securities
According to AAOIFI Shariah Standard on Investment Sukuk,
not all sukuk are tradable because of certain features and
characteristics of the particular type of Sukuk.
Below is the summary of explanations on the tradability of
sukuk instruments. The meaning of tradability in this context is
the ability from the Shariah perspective to sell these securities
on the secondary market at market value that is determined by
market forces.
There are two issues with regards to Islamic Securitization,
namely the origination of these securities and the tradability of
these securities in the secondary market. As for the origination,
almost all (lawful) assets, financial or otherwise, can be
securitized.
Overview of Islamic Sukuk Market.
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The tradability status of various Islamic securities
Types of Securities
Murabahah
Salam
Istisna’
Ijarah (existing asset)
Status
Tradable after the purchasing of the commodity
from the supplier and before selling it to the buyer
on murabahah credit term. Not tradable after
delivery of the commodity to the buyer on
murabahah credit term.
Not tradable all the way
Not tradable until the money has been converted
into asset to be owned by the investors. If the asset
is sold to the istisna’ buyer and the payment is due
to the investors, then the trading of sukuk must
follow the respective rules on disposal of debt. If the
asset is to be leased (Istisna’ cum ijarah), then the
sukuk is tradable
Tradable upon the passing of ownership of leased
asset to the sukuk holder
Overview of Islamic Sukuk Market.
Manfaah (ownership of
usufruct)
Sukuk Milkiyyat
al-khadamat (ownership of
existing services)
Sukuk Milkiyyat al-Khadamat
al-Qadimah (ownership of
future services )
Musharakah, agency and
mudharabah
Tradable to the last lessee in the chain, once the asset from
which usufruct is to be derived from is ascertained. For the
second lessor (lessee cum lessor), rental receivables, if
were to be traded must be subjected to the rules for
disposal of debt
Permissible prior to sub-leasing such services. When the
services are subleased, the certificate represents rental
receivables to be collected from the second lessee. Rules
on the disposal of debt are applicable
Not tradable before the source from which the services
would be provided is identified, except by observing the
rules for dealing in debts. When the source of services is
identified, trading of such sukuk may take place
Tradable after the closing of subscription, allotment of the
certificates and commencement of activity with respect to
the assets and usufructs.
Overview of Islamic Sukuk Market.
Muzara’ah &
musaqah
Mugharasah
Ijarah (assets to be
leased on promise)
Tradable after the closing of subscription,
allotment of the certificates and commencement
of activity with respect to the assets and
usufructs. This rule applies when the sukuk
holders own the land. If the sukuk holders act as
workers (who undertake to provide agricultural
or irrigation works) in which case trading in
these sukuk is not allowed before the maturity of
the fruits and plants
Tradable after the closing of subscription,
allotment of the certificates and commencement
of activity irrespective of the certificate holders
being owners of the land or workers.
Tradable upon the passing of ownership of
leased asset to the sukuk holder.
Overview of Islamic Sukuk Market.
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The main issue in determining the tradability of a particular
sukuk is both the underlying contract as well as the manner of
the utilization of the proceeds, of the issuance.
The explanation for the above reasoning is that the sukuk may
use musharakah or mudharabah structure, but when the activity
is to purchase receivables, hence the rules pertaining to the
disposal of debts must be followed in the trading of the debt.
This has rendered these sukuk, though initially based on
mudarabah or musharakah, as sukuk of receivables.
The receivables from the AAOIFI Shariah Standard perspective
are classified as monetary assets, thus subject to spot and equal
exchange of the true counter values to avoid riba prohibition.
Overview of Islamic Sukuk Market.
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The Malaysian perspective on debt securitisation is somewhat
different from international Shariah standard.
It has been argued that receivables which originate from lawful
Shariah contracts such as murabahah, istisna‟ and ijarah (with regard
to rental payment only excluding the leased asset) are deemed to be in
the position of „asset‟ as the receivables are the outcome from selling
or renting some asset to another party.
This is to be distinguished from receivables which originate from a
loan contract which is void of any asset in creating these receivables.
In short, though murabahah or istisna‟ or ijarah receivables, are
classified as financial assets, they do have some features of „asset‟ that
would allow the trading of these securities or bonds at market value.
A typical Islamic Securities or bond based on receivables-based
securitisation is illustrated in the following figure.
Overview of Islamic Sukuk Market.
Islamic Bond Based on Islamic Receivables Securitisation
Overview of Islamic Sukuk Market.
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Consists of both profit margin and principal amount. The
only distinction between conventional bond and Islamic
bond is that the underlying from each other.
For Islamic bond, the contract that creates this obligation
must be Shariah compliant and this includes murabahah,
istisna‟ and ijarah contracts respectively whereby the
contract of loan for an interest is not permissible under the
Shariah principles.
Clearly, Islamic bond in this context refers to the right of
the holders to receivables arising from a murabahah
contract. Therefore, it is termed as receivables-based
securitisation.
Overview of Islamic Sukuk Market.
Islamic Securities and Conventional Securities
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Conventional securities, like conventional banking products, are
essentially based on lending and borrowing concept, which are
driven by the interest mechanism.
However, conventional securities are different from conventional
banking products in terms of some features which are peculiar to
securities market only.
Generally speaking, the term „securities‟ in conventional finance
refer to both bonds and stocks. This section is primarily concerned
with bond instruments which are fixed income instruments.
In conventional finance, there are two basic structures of securities,
namely asset-backed securities and plain securities. Plain securities
are represented by bonds and notes. Basically, both bonds and notes
are “IOU” certificates meaning the issuer owes the holders a debt.
Overview of Islamic Sukuk Market.
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The issuer is obliged to pay the principal and interest (in the form
of coupon) at a later date, termed maturity. The word bond and
notes are used in many various jurisdictions to indicate different or
same meaning as the case may be.
In some markets, bonds are used for an issue with a longer maturity
period. A shorter period of issue is termed as notes. Elsewhere, in
some other markets this distinction has disappeared, and both bonds
and notes are used interchangeably irrespective of the maturity.
Bonds or notes represent right to claim a payment. Technically
speaking, it is originated from receivables securitisation.
In Arabic terms, this is called tawriq i.e. receivables securitization
that is to transform a deferred debt and the maturity period into
papers which can be traded in the secondary market.
The following is a figure that illustrates how a conventional
bond/note is issued.
Overview of Islamic Sukuk Market.
Conventional bond based on a receivables securitisation
Issuer issues bonds as evidence of indebtedness
Overview of Islamic Sukuk Market.
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The above figure shows that the issuer, upon borrowing the money
from the investors, will issue a bond that is an IOU. The bond
entitles the investors to claim fixed payments from the issuer at
agreed intervals.
As it is based on a loan transaction, the obligation of the issuer to
pay the investor consists of both the principal amount, which will
be paid at the maturity, and interest payments, which will be paid at
agreed dates, for example, semi-annually. The basic characteristics
of a bond comprise three features:
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It has a maturity date at which time the bondholder receives the par value of
the bond.
 The interest payment, which refers to the interest rate that the issuer of the
bond promises to pay the bondholder in return for the use of the money
loaned.
 Repayment of principal, which the issuer promises to pay back at the maturity
date. This refers to receivables‟ securitisation.
Overview of Islamic Sukuk Market.
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Therefore, Islamic bonds and notes which are used in some
jurisdictions like Malaysia represent receivables securitisation.
The holders of the Islamic bonds and notes are the rightful owner to
claim a payment from the issuer. This payment, for Islamic bonds
and notes, must originate from Islamic approved contracts such as
murabahah, istisna‟ and ijarah in some respects.
This form of securities has been termed by some scholars as
sanadat, which are certificates of debt.
In conventional securities market, there are also asset-backed
securities. Asset-backed securities refer to private debt securities
that are issued pursuant to a securitisation.
Asset backed-securitisation transactions, on the other hand, refer to
an arrangement that involves the transfer of assets (and risk) to a
third party where such a transfer is funded by the issuance of
securities to investors.
Overview of Islamic Sukuk Market.
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What is peculiar in ABS, unlike non-ABS structures, is that
payments to investors are principally derived, directly or
indirectly, from the cash flows of the assets transferred from
the originator to the issuer.
The asset pools can comprise of any type of receivables from
either a common cash flow, such as credit card payments, auto
loans and mortgages, or an esoteric cash flow, such as aircraft
leases and royalty payments.
They may also include tangible or physical assets in the sense
that the originator sells its tangible assets, such as a hospital or
airport, to the issuer/SPV.
Overview of Islamic Sukuk Market.
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Typically, prior to securitisation, the securitised assets may be
highly illiquid and, to some extent, private in nature. Take, for
example, the account receivables of a mortgage corporation or
building complex. These assets are not liquid.
Under asset-backed securitisation these assets, be they
financial or tangible, could be sold to a SPV to be turned into
securities that are can be traded.
Investors who subscribe to these securities would become the
new legal owners of these assets. The cash flow generated will
be passed on to the investors.
The following figure illustrates a typical structure for
conventional asset-backed securities, based on an asset of
mortgage loans.
Overview of Islamic Sukuk Market.
The originator transfers his or her poll of asset to the issuer
Overview of Islamic Sukuk Market.
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Figure shows that the issuing of bonds to investors is backed by a
cash flow that has been transferred to the SPC/issuer. In this case,
the cash flow comes from the mortgage loans payable by the
mortgage holders.
In other words, investors are fully aware that the payment of interest
and principal amount of the bonds will be sourced from this income
stream, which is now transferred into an SPC.
Theoretically, this is a more „secured‟ bond because the obligation
to pay the bond is backed by this asset in the form of receivables
generated from mortgage loans. Asset-based transactions are
peculiar to Islamic finance.
It is known in Arabic as taskik which is a process of the division of
the ownership of tangible assets, or the rights to use those assets, or
both, or the rights to an interest in a project, into units which have
equal value which are later made tradable.
Overview of Islamic Sukuk Market.
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The securities structured under this methodology are known as
sukuk.
Sukuk as defined by the AAOIFI Shariah Standards are “certificates
of equal value representing undivided shares in ownership of
tangible asset, a usufruct and services or (in the ownership) the
assets of particular projects or special investment activity”.
Interestingly, sukuk are deemed as neither shares nor bonds. The
examples of each of these types of securities have been provided in
the previous section.
There are clear differences between Sukuk and Islamic bonds. The
differences in the features of both instruments are illustrated in the
table below.
SPC/SPV is an entity created to issue bonds to the investors and to
hold the assets in their favour . These assets cannot be seized in a
bankruptcy proceeding.
Overview of Islamic Sukuk Market.
Sukuk Ijarah
Bond
Use of Funds
Normally used for a single purpose to
acquire or lease a specific underlying
asset.
General use.
Listing
Can be listed in any eligible secondary
market both Over-The-Counter and
Exchange Traded.
Can be listed in any
eligible secondary market
both Over-The-Counter
and Exchange Traded.
Denomination
Can be pre-specified.
Can be pre-specified.
Tenure
Fixed maturity ranging from 3 to 10
years.
Fixed.
Issuer
Typically a bankruptcy remote special
purpose vehicle.
Borrower or SPV.
Use of Funds
Normally used for a single purpose to
General use.
acquire or lease a specific underlying
asset.
The difference between Sukuk Ijarah and Islamic bond
Overview of Islamic Sukuk Market.
Listing
Can be listed in any eligible secondary
market both Over-The-Counter and
Exchange Traded.
Can be listed in any eligible
secondary market both
Over-The-Counter and
Exchange Traded
Trading
Can be tradable in the secondary market
on a willing-buyer willing-seller basis.
Contentious.
Return
Returns will be based on profit rates
generated by the underlying leased asset.
Fixed income
Capital Gains
Capital gains can be made from increased
market value of the Instrument.
Capital gains can be made
from increased market
value of the Instrument
Redemption
Will be redeemed at par value at a fixed
maturity date through a par value
principal redemption process.
Subject to redemption
formula.
Rating
Instrument can be rated by international
rating agencies.
Subject to rating.
Inherent Risk
Issuer Default risk. Market Price risk.
Issuer default risk.
The difference between Sukuk Ijarah and Islamic bond
Overview of Islamic Sukuk Market.
Market Participants for Respective Type of Islamic Securities
Overview of Islamic Sukuk Market.
Market Participants for Respective Type of Islamic Securities
Figure summarizes the whole securities issuance process and establishes the flow of
various transactions amongst the various market participants. In order to appreciate the
nature of each market participant, there is a need to understand the particular process that
each market participant is expected to undertake.
Overview of Islamic Sukuk Market.
Product Development & Due Diligence
i. Issuer
 The product development stage will naturally begin with the issuer for
Islamic debt securities or the originator in the case of an Islamic asset
backed/based securities. An issuer or and originator may come in the
form of a sovereign country, government agencies or corporate entities.
In short, the issuer is a party who needs to raise fund using Islamic
securities.
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The issuer‟s purpose of raising the fund will be to finance its operations.
For example, a sovereign country‟s purpose of issuing securities would
be to finance development projects that are crucial for the development
of the economy. The same scenario would apply to corporate issuers, the
issuance of securities by them would be to finance their expansion in
order to generate more profitability.
Issuers by law are responsible for the obligations of the issue. They will
have to undertake to declare all material information (legal and financial)
that are related to the issuance.
Overview of Islamic Sukuk Market.
ii. Corporate Advisors
There are a few types of corporate advisors that may participate in
advising the issuer on the issuance of securities
Investment bank
 The function of an investment bank is usually as an end to end
advisor. This means that investment bank will play a role in every
process that the issuer will have to undertake before any securities can
be issued. Most importantly, investment banks will liaise with the
regulators and will coordinate with the other advisers who are
involved in arranging the issue of securities.
Corporate Advisory Firms
 While most issuers might go with investment banks, some issuers
would prefer to go with boutique corporate advisory firms to advise
them on the issuance of securities. There are a few reasons for
choosing these firms over the investment banks;
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Overview of Islamic Sukuk Market.
a. Cost
 Cost is a very important consideration for issuers. This is
especially true with small to medium sized enterprises and
organizations. To engage an investment bank for advisory work
can be very costly. Therefore, some issuers look for a more
affordable alternative in the form of boutique corporate advisory
firms.
b. Unique Expertise
 Another reason for using these firms would be to tap in their
unique expertise. Most of these firms have extensive experience
in small to medium sized advisory deals as compared to
investment banks. Therefore it would make more sense for
issuers to work with them in such deals.
Overview of Islamic Sukuk Market.
Legal Firms
 Any issuance of securities shall involve the process of drafting
legal documentation to be adopted by all parties to the issue. To
assist in this process, a legal firm needs to be retained.
 The lawyers from legal firm shall assist in drafting the specific
terms, contracts and the prospectus/information memorandum
that will be used in the offering. They will also advise the issuer
on regulatory matters and will liaise with regulatory bodies to
ensure compliance.
 Another aspect of advisory that is provided by the legal firm is
the due diligence process. Lawyers will have to verify any
statement that is made in the financial statement and also the
prospectus to be certain that they represent the material facts.
Overview of Islamic Sukuk Market.
Accounting Firms
 The responsibility of the accounting firm is to prepare, review
and audit the financial statement of the issuer so that such
information is available for potential investors to use when
evaluating the viability of investing in the securities.
 In addition to that, the financial statements are also used as a
measuring tool by the regulators in order to determine the
eligibility of the issuer to offer securities.
 The numbers that are generated will also be used by rating
agencies as a basis to form their opinion on the credit worthiness
of the issuer.
Overview of Islamic Sukuk Market.
iii.Shariah Advisor
 In an Islamic issuance, the Shariah advisor will work hand in
hand with the corporate advisor from the start to ensure that the
issuance shall comply with the rules and principles of the
Shariah.
 However, this will normally apply in the issuance of fixed
income instruments and not equity (unless the companies
intending to float their shares are seeking the Shariah
compliance status prior to their IPO).
 There are a few different ways in which the Shariah advisor may
participate in the process of issuance.
Overview of Islamic Sukuk Market.
By virtue of being a member of the investment bank’s Shariah board
 If the issuer is being advised by an investment bank, they will have
access to the investment bank‟s Shariah board. The Shariah board will
provide guidance in the process of developing the securities until the
issuance stage.
Shariah advisory companies
 For issuers who choose to use the services of corporate advisory
firms, they might engage independent Shariah advisory companies to
assist them in the product development stage.
Independent Shariah Scholars
 There have been cases where the issuer has directly engaged reputable
independent Shariah scholars to advise them. This is not uncommon
occurrence as independent Shariah scholars particularly those of high
repute are able to structure complicated innovative structures in a
more timely and effective manner.
Overview of Islamic Sukuk Market.
Regulatory
i. Regulators
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After the product development stage is completed there is a need to seek the
approval of the relevant regulatory bodies before the securities could be issued. In
most cases, there will be two major types of regulatory bodies that oversee the
financial industry.
Central Bank/ Monetary agency
It is common for central banks to regulate the activities and products of banks and
insurance companies. In most cases, the central bank will be responsible in making
sure that banking and insurance companies adhere strictly to the local banking and
insurance act.
This means that any institution that wishes to participate in the banking and
insurance industry must be licensed by the central bank. In addition to the above,
any products that the companies wish to sell must obtain prior approval from the
central bank.
Any sales of unapproved products will be considered as a breach of the regulations
and the companies involved will be prosecuted under the relevant act.
Overview of Islamic Sukuk Market.
Regulatory
Securities agency
 The securities agency on the other hand will be responsible in
regulating the capital market activities in a particular country.
Among the main activities of a securities agency would be to
license various parties who wishes to be involved in the capital
market and to approve public fund raising activities whether
through debt or equity.
 While the practice of having different organizations to oversee
the different parts of the industry may be the norm, there are
exceptions where in some countries one single organization may
be responsible in regulating the whole financial industry.
Overview of Islamic Sukuk Market.
Rating
i. Rating Agencies
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Rating agencies provide a third party opinion on the merits of a
particular security and the creditworthiness of the issuer. A credit
rating serves as an unbiased, independent evaluation of the
creditworthiness of a borrower.
It is essentially a grading system which provides an objective
measure of credit quality, especially on the ability to pay the
financial obligations upon maturity.
A credit rating considers the following risks:
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Business risk
Financial risks
Overview of Islamic Sukuk Market.
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The credit rating process also takes into consideration the
existence of credit enhancement tools such as guarantees, sinking
fund, letters of credit that are created to supplement the main
instrument in order to reduce the default risk on specific issues.
The credit rating process also takes into consideration the
existence of credit enhancement tools such as guarantees, sinking
fund, letters of credit that are created to supplement the main
instrument in order to reduce the default risk on specific issues.
Since a credit rating is considered as an unbiased third party
opinion on creditworthiness, it promotes more transparency and a
greater amount of disclosure in the capital market.
Overview of Islamic Sukuk Market.
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It seeks to supplement internal evaluations, particularly those
done by the regulators and investors. A credit rating also serves
as a focused tool to differentiate between different credits
qualities.
Aside from the internal rating, it also allows for the process of
continuous monitoring which serves updates on company
performance and will give a snapshot on its credit standing at any
point in time.
Having a credit rating is equivalent to the issuer announcing that
both the issue and the issuers have been subjected to, and can
withstand, objective scrutiny.
In most cases, having a credit rating will assist the issuer to get a
lower cost of fund.
For different type of issuers, there is an issue of which rating
agency would be most suitable to rate their proposed issuance.
Overview of Islamic Sukuk Market.
Domestic Rating Agencies
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For a domestic issuance, most issuers would prefer to use a
domestic rating agency for the reasons stated below.
Cost:
As compared to international rating agencies, the
domestic rating agencies would charge a lower fee in the
respective country‟s currency therefore making its services more
affordable to local issuers.
Coverage: The domestic rating agency will have more coverage
on the local market. The knowledge of local regulations and
ways of doing business puts the domestic rating agency in a
better position to rate local issuance.
Overview of Islamic Sukuk Market.
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The domestic rating agencies play a crucial role in the
development of the capital market in their countries.
In Malaysia for example, both of its domestic rating agencies
(Rating Agency Malaysia and the Malaysian Rating Corporation)
play a crucial role in the Malaysian government‟s push for a more
sophisticated and transparent capital market practices.
As the Malaysian capital market is still considered as an
emerging capital market, the government has imposed a
mandatory credit rating regulation for all issuers.
Until the removal of this regulation, it is the responsibility of both
Malaysia‟s domestic rating agencies to assist the government in
upholding this mandatory credit rating rule.
Overview of Islamic Sukuk Market.
International Rating Agencies
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On the other hand, some issuers might be more inclined to use the
services of an international rating agency for the following reasons.
1. International Acceptance
For an issuer who wishes to tap the global capital markets investors,
being rated by an international rating agency would facilitate a wider
acceptability of the issuance.
2. Enhanced Reputation
For cross border deals, even good performing companies might not be
widely known internationally.
A global public relations exercise designed to attract investors would
cost a lot and even then success will not be necessarily guaranteed.
Instead, most companies take the option of being rated by an
international rating agency that has a good reputation globally.
Overview of Islamic Sukuk Market.
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Cross border issuers may “borrow” the international rating
agency‟s reputation by being associated with them through the
ratings exercise.
In addition to the above, international rating agencies play a
crucial role in deepening the pool of investors that is available for
a particular issuance.
Well known international rating agencies such as Standard and
Poors (S&P), Moodys and Fitch have a wide global presence.
Investors are now able to access key relevant information on a
foreign issuance easily through this network.
As a result of this, an issuance that is rated by these international
agencies would potentially attract a sizable amount of interest
from foreign investors.