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Islamic Finance and Banking

Prepared By:
Dr. H. M. Mosarof Hossain
Professor
Department of Finance
University of Dhaka
mosarof@du.ac.bd

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Sukuk Market
Shariah framework for Islamic securities:

Definition of sukuk- the most comon Arabic term used for


islamic securities in the market today is sukuk that means
certificates. It is defined as certificates that represent the
holders proportionate ownership in an undivided part of an
underlying asset where the holder assumes all rights and
obligations to such asset. It can be broadly categorised into:
i. asset-based sukuk, where the underlying assets offer fairly
predictable returns to the sukuk holders, such as the case of
salam, istisna and ijarah
ii. Equity-based sukuk, where the returns are determined on a
profit-and-loss-sharing in the underlying investment which does not
offer fairly predictable returns.
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Sukuk Market
Shariah framework for Islamic securities:

Origin of sukuk- Yahya related to me from Malik that he had


heard that receiptsb were given to people in the time of Marwan
ibn al-Hakam for the produce of the market at al-jar. People
bought and sold receipts among themselves before they took
delivery of the goods. Zayd Thabit and one of the companions
of the messanger od Allah (swt), may Allah bless him and grant
him peace, went to Marwan ibn al-Hakam and said, Marwan!
Do you make usury halal? He said, I seek refuge with Allah!
What is that? He said, These receipts which people buy and
sell before they take delivery of goods. Marwan therefore sent
a guard to follow them and to take them from peoples hands
and return them to their owners.
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Sukuk Market
A number of authors have highlighted this as sukuk that refers
to grain/commodity coupons that was used to pay soldiers
during the Umayyad period. The soldier could present these
coupons to colect grain upon maturity. Some soldiers sold
these sukuk prior to maturity to obtain cash. Since the sukuk
represent food, the trading of such sukuk prior to maturity was
seen to contradict the prohibition of selling food items before
taking possession. Nonetheless, the concept of sukuk itself,
where a certificate is used to represent the value of an
underlying asset. Was not prohibited.

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Sukuk Issuing process

Step-by-step process of issuing a sukuk based on an asset:


a) A business firm requiring capital (the originator) creates a
special purpose vehicle (SPV), an independent entity.
b) he SPV purchases assets (such as land, building,
machinery) from the originator.
c) The SPV converts the value of the assets into securities
(sukuk) which it issues and sells to investors.
d) The sale proceeds are paid to the originator/debtor as the
price of the assets.
e) The SPV, acting as a trustee on behalf of the sukuk-holders,
arranges to lease the assets back to the originator who pays
the sukuk-holders the lease income.
f) The originator buys back the asset from the SPV at a nominal
price on termination of the lease.
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Role of shariah framework in sukuk structuring
A number of authors have highlighted this as sukuk
that refers to grain/commodity coupons that was used
to pay soldiers during the Umayyad period. The
soldier could present these coupons to colect grain
upon maturity. Some soldiers sold these sukuk prior to
maturity to obtain cash. Since the sukuk represent
food, the trading of such sukuk prior to maturity was
seen to contradict the prohibition of selling food items
before taking possession. Nonetheless, the concept of
sukuk itself, where a certificate is used to represent
the value of an underlying asset was not prohibited.

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Role of shariah framework in sukuk structuring
When structuring sukuk one has to first pay attention
to the relationship in the primary market. If investors
want to enjoy return, the primary relationship cannot
be loan transaction. Furthermore, the underlying asset
according to the global shariah standard, sholud not
include receivables that are traded at discount. Next,
to ensure that sukuk can be traded in the secondary
market, it is important to look at the underlying asset
they represent. If they represent a debt, the global
shariah standard does not allow the secondary
trading of such sukuk.

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Sukuk structures
The type of shariah contract chosen by an issuer
depends on shariah requirements, economic
objectives, the availability of assets and the level of
debt the company has, the credit rating of the issuer,
the legal framework in the jurisdiction and the tax
implication of a structure. Followings are the sukuk
structures based on shariah:
(i) Sales-based: bay bithaman ajil, murabahah,
salam, istisna
(ii) Lease-based: ijarah, ijarah muntahiyah bittamilk, ijarah
mawsufah fi dhimmah
(iii) Partnership-based: mudarabah, musharakah
(iv) agency-based: wakalah bi istithmar
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Sukuk structures
Sukuk classification based on commercial function:
(i) corporate
(ii) Sovereign
(iii) Exchangeable and convertible
(iii) Subordinated
(iv) Stapled
(v) Asset-based
(vi) Project financing

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Sukuk structures
Sales-based sukuk: the primary subscriber and the issuer shall
execute a purchase agreement under which the primary subscriber
shall purchase the identified assets at the purchase price from the
issuer. Immediately thereafter, the primary subscriber shall sell the
identified asset to the issuer of an agreed selling price through the
execution of a sale agreement. The selling price shall consists of
the purchase price plus the profit margin payable on a deferred
basis over a period of time.

Shariah issues in issuance of Sales-based sukuk : the sale and


buyback transaction known as bay al-inah, literally means sale of
cash. In the islamic capital market, bay al-inah structure requires the
client to have an asset that can be sold and bought back. The
shariah advisory council, after deliberating the various opinions in
the schools of islamic law adopted the shariah view to allow the
application of this in this market and tradable in secondary market.
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Sukuk structures
Lease-based sukuk: The most commonly used sukuk structure
(based on volume of issuances during 2008) is that of sukuk al-
ijara. The popularity of this structure can be attributed to a
number of different factors; some commentators have described
it as the classical sukuk structure from which all other sukuk
structures have developed, whilst others highlight its simplicity
and its favour with Sharia scholars as the key contributing
factors. In the Islamic finance industry, the term ijara is broadly
understood to mean the transfer of the usufruct of an asset to
another person in exchange for a rent claimed from him or, more
literally, a lease.

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Sukuk structures
In order to generate returns for investors, all sukuk
structures rely upon either the performance of an
underlying asset or a contractual arrangement with
respect to that asset. The ijara is particularly useful in
this respect as it can be used in a manner that provides
for regular payments throughout the life of a financing
arrangement, together with the flexibility to tailor the
payment profile - and method of calculation - in order to
generate a profit. In addition, the use of a purchase
undertaking is widely accepted in the context of sukuk
al-ijara without Sharia objections. These characteristics
make ijara relatively straightforward to adapt for use in
the underlying structure for a sukuk issuance.
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Sukuk structures
The rationale of Sukuk Al-ijara is that when a company
needs an asset but cannot afford to purchase it directly3, a
Special Purpose Vehicle ("SPV") comes to the scene. The
SPV purchases the asset and then leases it to the company
for a fixed period of time. Obviously, SPV is established with
the finds of the purchasing company. Another reason to opt
for Sukuk Al-ijara is that although the company can afford to
purchase the asset, it may need to maintain its cash, and
thus, the company may first purchase the asset and then
sell it to the SPV and the SPV leases it back to the
company (sale and lease back). Either way SPV, which may
be some form of a partnership or a trust company, acts as
the sukuk issuer.
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Sukuk structures
Equity based Sukuk: The types of sukuk this would include are
mudaraba and musharaka, where the sukuk investors are taking
a quasi-equity investment in the financial institution, albeit at a
higher level of priority than common equity. However, the types
of sukuk that would qualify under these rules would probably
share features with the hybrid Tier 1 sukuk being sold now by
ADIB: a perpetual, callable (after >5 years) sukuk where the
distributions are dependent upon the underlying performance of
the bank, and with the ability to see distribution fall if profits come
in below the amount required to fund the anticipated coupon.

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Sukuk structures
In general, however, I would expect this type of instrument
to function similarly to how some of the mudaraba sukuk
have been designed post-AAOIFI clarification, with features
included that will lead to a greater probability that the
anticipated dividends will be paid on schedule. This is
typically set up so that the profits generated are allocated
between the bank (mudarib) and sukuk holders (rabb ul-
mal) in a preagreed split. The dividend amount is based on
a benchmark interest rate plus a spread, and is paid out of
the investors' share of profits. Any excess is placed in a
reserve account to 'top up' future distributions if there is a
shortfall in profits below the benchmark plus spread.

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Sukuk structures
It is not clear exactly how the loss-sharing aspect will
work within a mudaraba sukuk, except that in general
the rabb ul-mal is supposed to bear all losses, and will,
with the exception of funds remaining in the reserve
account. The key point is that most mudaraba sukuk
allow the bank to use the funds alongside its own
funds, so there will have to be some breakdown of any
losses between the bank's invested capital and the
mudaraba between the bank and sukuk holders.

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Issues, Opportunities and Challenges in the Sukuk
Market
1. Sukuk- Debt or Equity: mostly debt, but at present
some scholars consider as equity.
2. Sukuk trading Mostly hold to maturity, but tradable in
secondary market.
3. Sukuk pricing - Depends on demand condition and
liquidity premium.
4. Sukuk default Not free from defaultness.

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