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Opalesque Islamic Finance Intelligence

Featured Structure: Shari'a Polemics of Sukuk Trading By Jhordy Kashoogie

Friday, January 21, 2011

Jhordy Kashoogie, graduated from International Islamic University Malaysia (IIUM) with a B. Econs.(Hons) in Islamic Economics and Finance qualification, he recently completed his postgraduate study, MSc Islamic Finance, at Durham University, United Kingdom. He has studied various aspects of Islamic finance and co-authored the paper "Debt versus Equity Financing in the Light of Maqasid al-Shari'ah" (see reference link).

In Shari'a, sukuk have to represent the ownership of assets or services that belong to sukuk holders, and therefore sukuk have to be traded against the value of its underlying assets or services. However, that is not happening in actual practises of sukuk trading as there is a grey area for what constitutes sukuk to be tradable in the market. Therefore, in this opportunity, the sukuk trading is examined in light of Shari'a and the regulatory framework. Interviews with scholars (Prof. Tariqullah Khan and Bilal Khan), and advisers in leading Islamic banks (Abdulkhaliq Elshayyal and Nayyar Azam Saifi) are conducted in order to incorporate their insights regarding issues of sukuk trading practises, and also suggestions for the future of sukuk.

Shari'a and Regulations Framework of Sukuk Trading

From Shari'a perspective, Al-Jarhi and Abozaid (2010) impose rules and conditions (ahkam) related to the tradability of the sukuk in primary and secondary markets. To begin with, sukuk must be issued against some tangible assets and not against cash or debts. Therefore, the tradability of sukuk at the time of issuance (primary market) as well as in the secondary market must follow these rules:

1. If sukuk are issued against specific assets ('ayn) or services, then this issuance implies the sale of these assets to the sukuk holders in return for cash money based on current values of assets or services, and therefore the sukuk becomes tradable.

2. If sukuk are issued against described assets or services to be manufactured or constructed in the future (mausuf fii zimmah), then this issuance implies the sale of these assets to the sukuk holders in return for cash money, and these sukuk are not tradable until the deliverability of assets or services.

3. If sukuk are not issued against assets or services, but for the purpose of utilising the proceeds to acquire some assets, then sukuk do not become tradable until the stage at which those assets or services are purchased. This is because the sukuk up to that point represent liquid proceeds, i.e. cash money, and money cannot be sold against money unless the Shari'a rules of sarf are observed.

4. If there is any mixture between 'ayn and dayn, then 'ayn must dominate dayn in sukuk issuance.

Condition no. 1 stresses the importance of asset ownership in which asset ownership must be fully transferred to the sukuk holders, so under that condition they can trade in secondary markets with asset ownership as an object of sale (mauqud alaihi). Even if the sukuk holders wish to sell immediately after the sukuk have been traded to them in the primary market, complete transfer of asset ownership to the sukuk holders from the sukuk issuer has to be fulfilled. This condition is governed in accordance to AAOIFI Shari'a standards No. 17 on investment sukuk, clause 5/2/4 as follows:

It is permissible, immediately upon issue and up to the date of maturity, but after passing ownership of the assets to the holders of the sukuk, to trade in sukuk that represent ownership of existing leased assets or assets to be leased on promise.

Condition no. 2 is in line with AAOIFI Shari'a standards No. 17 on investment sukuk, clause 5/2/1 that govern what constitutes sukukto be tradable in the secondary market, as follows:

It is permissible, after closing subscription, allotment of sukuk and commencement of activity, to trade in and redeem investment sukuk that represent common ownership of tangible assets, usufructs or services.

As for condition no. 3, the condition is straightforward and yet there has been no specific regulation framework so far to be put by regulators. Condition no. 4, however, is still contentious because there has been a trend that sukuk issuance comprises a mixture of ayn and dayn assets, the so-called sukuk istishmar, in which the former is tradable in the market whilst the latter is not. Sukuk that include both cash and debt have to follow the laws of cash and debt in which the sukuk should be traded at par; any debt trading (bay al-dayn) either above or below the par value, it is tantamount to riba al-bay. Therefore, since the dayn is not tradable in the market, there are dissenting opinions among regulators and different practises across jurisdictions regarding the extent to which dayn can dominate the 'ayn in order for sukuk istishmar to be tradable in the market.

According to OIC Fiqh Academy resolution no. 30 (4/5), if the majority of the underlying asset is dayn then the sukuk are not tradable in the market, whilst if the majority of the underlying asset is 'ayn, then the sukuk are tradable in the market. Nevertheless, a fatwa from AAOIFI stipulates that sukuk which have 30% 'ayn asset composition is tradable in the market so long as the dayn and cash do not exceed 70%. At worst, Dubai financial markets allow sukuk that have 10% 'ayn asset composition to be traded in the market. Both AAOIFI's fatwa and the Dubai financial market practices have given rise to controversial views with regard to allowing dayn-dominant sukuk istishmar to be traded in the market. AAOIFI claims that the fatwa is derived from a Hanafi point of view, whereby as long as there is no intention for hiyal, there is nothing wrong from shari'a perspective.

However, in Malaysia, the selling of debt (bay al-dayn), which indicates no limit for level of debt, is allowed by the Shari'ah Advisory Council (SAC) of the Securities Commission (SC), which allows bay al-dayn based on the premise of Ibn Al-Qaym that bay al-dayn is permissible because there was no evidence from Qur'an and Sunnah that disallows bay al-dayn. By contrast, Gulf countries disallow bay al-dayn,as the debt money represents cash and when cash is traded with cash over premium or discount, it is tantamount to riba (Mohammad et al, 2009).

Actual Practises of Sukuk Trading

In the actual practises of sukuk trading, there are deviations from Shari'a and regulation framework found in trading sukuk in secondary market because it involves contentious issues, such as asset ownership and bay al-dayn. While for the primary market, there are no deviations since the rules are clear and straightforward, not involving contentious issues.

This deviation problem is actually rooted from the current sukuk structure, which is asset-based sukuk. Shari'a rules no. 1, 2, and 3 of sukuk trading are violated in asset-based sukukbecause asset-based sukuk are traded against pecuniary assets in the form of cash, not asset ownership, since the sukuk holders do not have recourse to the underlying assets but rather just the capital guarantee. Therefore, in those cases,sukuktrading is akin to debt trading (bay al-dayn) with the return or loss generated from the debt trading, which is tantamount to riba al-fadl and riba al-nasi'ah. Furthermore, it involves gharar, as there is an uncertainty with any debt traded in the market.

Based on the interviews, this problem happens because there is still an unwillingness of key players to adhere to the prevalent standards since they have preferred practice and practicability of sukuk issuance. The key players inherently still prefer asset-based sukuk instead of asset-backed sukuk because they are averse to market risk more than to credit risk, as Prof. Tariqullah said. So the way they structure sukuk is focusing more on credit risk of the issuer, which characterises asset-based sukuk. However, even if asset-backed sukuk are preferred for sukuk issuance, this structure still hinges problems, as it will be costly or incurring big losses in the event of significant drop of the assets' value, as noted by Abdulkhaliq in the interview.It is important also to note that the full transfer legal ownership is difficult to be realised at certain jurisdictions where the underlying assets still pose regulatory problems such as legal and taxes issues.

The Way Forward

For the way forward, all the interviewees agree that there is a need for unison standards or convergence across jurisdictions with regard to sukuk practises-including sukuk structure and sukuk trading. In order to reach the convergence of sukuk practises, closer engagement between key players, regulators, and scholars are urgently needed. Abdulkhaliq adds that regulatorsneed to tackle regulatory issues such as taxation issues, governance, product development, in order to make the current practises become more efficient. Furthermore, the transition to asset-backed structure should be facilitated as this structure represents genuine Shari'a financing, and the sukuk can be traded against values of underlying assets. Hence, the originators, rating bodies, arrangers, and regulators should sit together to discuss on how to manage the market risks, different proxies for sukuk rating, and so on for giving incentives to key players and investors to have asset-backed sukuk in the market. On another aspect, Shari'a advisors along with Shari'a compliance team, who are the gatekeepers in the industry, shall monitor and review the sukuk throughout its life tenure to ensure that the sukuk trading is Shari'a compliant at all stages. The current role of just issuing fatwa of its compliance should be abolished, as Nayyar said in the interview.

References:
- Abozaid, A & Al-Jarhi Mabid (2010). Reasons for Failure of Some Sukuk Issuances. International Fiqh Academy, IRTI & Islamic Economics Research Center Conference, Islamic Sukuk: Examination & Reevaluation, King Abdul-Aziz University & Westin Hotel, Jeddah, Saudi Arabia, May 24-25.

- Mohammad, Shamsiah, Mohd Fadhly Md Yusoff, and Abdul Aziz Al Qassar (2009). "Ground Rules for Sukuk Issuance" in Sukuk: Islamic Capital Market Series. Malaysia: Sweet & Maxwell Asia.


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