London: The New Souk For Sukuk

Islamic finance is now the Buzz Topic in the City of London. While the Middle East's economies thrive and prosper, the enormous funds generated are seeking the best opportunities for investment the markets can offer. The Chancellor, Gordon Brown - perhaps the next Prime Minister- has been key to the debate; last month, he announced in his budget that Sukuk were to be given equivalent tax treatment to traditional interest-bearing bonds. The intention is that the City should eventually compete with Dubai and Kuala Lumpur in the development of new financial instruments which comply with Shariah law.

Although Shariah law prohibits certain activities, including the earning of interest, speculation, contracts which have an element of uncertainty and transactions which are overly advantageous to one party at the expense of another, the Islamic finance industry has developed various structures in order to meet the financing needs of businesses and investors who wish to comply with Shariah. Incidentally, these arrangements may have a broader appeal to those interested in investing 'ethically'. These structures can deliver the same results that conventional financing transactions are able to achieve. Among these financing instruments is the Sukuk.

What is a Sukuk?

The Accounting and Auditing Organisation for Islamic Financial Institutions ("AAOIFI") - the regulatory and accounting standards body for Islamic finance - defines Sukuk as being:

"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".

Popularly referred to as an 'Islamic Bond', the Sukuk is, in fact, an asset-backed, trust certificate showing evidence of ownership of an asset or its usufruct (earnings or fruits). The claim embodied in Sukuk is not simply a claim to cash flow but an ownership claim. The closest instrument comparable to them in the conventional financial system would be a bond such as those issued in relation to a securitisation. A Sukuk confers a beneficial interest to the holder in terms of holding a proportional ownership of the underlying asset as well as the income that it generates. The Sukuk holder also assumes all rights and obligations for the maintenance of the asset.

Their use in the world of Islamic finance has become increasingly popular in the last few years, both because they provide the means to raise government finance through sovereign issues, and as a way of companies obtaining funding through the offer of corporate Sukuk.

Differences between Sukuk and Conventional Bond Securities:

Sukuk holders claim an undivided beneficial ownership in the underlying assets, whereas since the bond is a contractual debt obligation, the issuer is contractually obliged to pay bond holders, on certain specified dates, interest and principal. Consequently, Sukuk holders are entitled both to share in the revenues generated by the Sukuk assets and to share in the proceeds of the realization of the Sukuk assets.

Sukuk holders have the right to profits but are also under an obligation to bear losses, whereas the holders of securities are not similarly bound.

A unique feature of a Sukuk is that in instances where the certificate represents a debt to the holder, the certificate will not be tradable on the secondary market and instead is held until maturity or sold at par.

Characteristics of Sukuk:

Sukuk are based on an investment process which involves investors mixing their profits with other investors in order to make profits.

They are a tradable Shariah-compliant capital market product providing medium to long-term fixed or variable rates of return.

They are assessed and rated by international rating agencies.

They provide regular periodic income streams during the investment period with easy and efficient settlement and a possibility of capital appreciation.

The primary condition for issuance of Sukuk is the existence of assets on the balance sheet of the issuing entity. The identification of sufficient assets is the most important step before the issue of the Sukuk certificate. The model of Sukuk security is derived from the conventional securitization process in which a special purpose vehicle ("SPV") is set up to acquire assets and to issue financial claims on the assets. These financial assets claims represent a proportionate beneficial ownership to the Sukuk holders.

Types of Sukuk:

Islamic markets offer different instruments to satisfy both providers and users of funds in a...