Islamic Capital Market - Lecture 5

Definition of Islamic Capital Market (ICM)

  • Bursa Malaysia: ICM operates in accordance with Islamic principles, avoiding prohibited activities like riba (usury), maisir (gambling), and gharar (ambiguity).

  • Security Commission Malaysia: ICM transactions align with Muslim conscience and Islamic law, prohibiting usury, gambling, and ambiguity.

Role of ICM

  • Raise Long-Term Funds (Primary Market)

    • Mobilizes savings from individuals and channels them into long-term investments (e.g., EPF, PNB, Trust & Mutual Funds).

    • Facilitates Initial Public Offerings (IPOs).

  • Trading Platform (Secondary Market)

    • Enables stock market transactions.

  • Pooling Domestic Savings

  • Mobilizing Capital for Productive Purposes

    • Provides equity capital and infrastructure development capital for long-term sustainable growth and business expansion.

  • Promotes Public-Private Sector Partnership

    • Reduces government fiscal expenditure and debt burden.

  • Attracts Foreign Portfolio Investors

  • Financing Real Economic Activities

ICM Structure

  • Surplus Units (Investors)

    • Investors, VC, Pension Funds, Trust Funds, Mutual Funds, Takaful intermediaries, Merchant banks, Commercial banks, Investment banks

  • Deficit Units

    • Government, Corporations

  • Real Sector

    • Production of goods and services.

  • Financial Sector

    • Meeting the financial needs of the real sector.

    • Mobilizing savings from surplus units to fund productive units.

    • Risk transfer via direct access in ICM.

Financial Sector Components

  • Banks

  • Capital Market

    • Equity/Stock Market

    • Bond/Sukuk Market

    • Derivatives Market

    • Foreign Exchange Market (Forex)

  • Money Market

  • Insurance & Takaful

  • Pension Funds

  • Other Financial Intermediaries

Main Elements of Islamic Capital Market

  • Sukuk (Debt Market)

  • Equity Market

    • Islamic Stocks

    • Islamic REITs

    • Islamic Funds

What is Sukuk?

  • Literal Meaning

    • Sukuk is the plural of sak, meaning certificates.

    • Taskik: process of dividing assets into papers (sukuk).

    • Tawriq: rendering something into cash.

  • Technical Meaning

    • AAOIFI: Investment sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufructs, and services within particular projects or special investment activity.

    • Malaysian Securities Commission: A document or certificate representing the value of an asset, which may include financial assets (receivables, debts) and non-financial assets (tangible assets, usufructs, services).

Basic Structure of Sukuk

  • Obligor/Project Developer contracts with the Issuer/Trustee.

  • Proceeds from Sukuk sales go to the obligor for the income-generating project.

  • Income from the project is distributed to Sukuk investors.

Sukuk vs. Bond

  • Sukuk

    1. Holder owns assets.

    2. Uses various contracts (sale, lease, equity partnership, joint-venture) to create financial obligations.

    3. Return linked to profit elements in sale, lease, or partners

  • Bonds

    1. Holder owns cash flow only.

    2. Uses a loan contract to create indebtedness.

    3. Return linked to interest charged out of the loan contract.USD1

Bases for Sukuk Classification

  • The Underlying Contracts

    • Sales-based

    • Lease-based

    • Partnership-based

  • Nature and Type of Asset

    • Asset-based (normal)

    • Asset-Backed (ABS)

    • Debt-based

    • Tangible assets

  • Technical and Commercial Features

    • Hybrid Structure (convertible & exchangeable)

Types of Sukuk

  • Asset-Based

    • Sales-Based (Murabahah, Salam, Istisna)

    • Lease-Based (Ijarah, Ijarah Muntahiyah, Ijarah Mawsufah fi Zimmah)

    • Partnership-Based (Mudarabah, Musharakah bi Tamlik)

    • Agency-Based (Wakalah bi Istithmar)

  • Asset-Backed

    • Hybrid

    • Convertible

    • Exchangeable

Sukuk Classification Based on Commercial Function

  • Corporate Sukuk: Issued by non-government companies.

  • Sovereign Sukuk: Issued by government or sovereign entities.

  • Exchangeable and Convertible Sukuk: Convertible into shares (equity) at maturity.

  • Subordinated Sukuk: Repayment is subordinated to other creditors.

  • Stapled Sukuk: Two instruments attached together and cannot be traded separately.

  • Asset-Backed Sukuk: Backed by an income-generating asset; involves true sale securitization.

  • Asset-Based Sukuk: Originator repurchases assets at maturity for an amount equal to the principal repayment. Relies on the originator's creditworthiness.

  • Project Financing Sukuk: Finances a project; repayment comes from the project's cash flow.

Factors to Consider in Structuring Sukuk

  • Shariah Requirement

  • Availability of Asset

  • Level of Debt

  • Tax Implication

  • Legal Framework

  • Credit Rating of Issuer

Tradability of Sukuk

  • Depends on the type of underlying asset (Debt (Dayn) or Tangible Asset (Ayn)).

  • Sale of Debt (Financial promise/IOU) in general is permissible if the sale is done at par value not at Discounted value!

How about if it is a Mixture (khultah) Between Dayn and Ayn?

Case Studies

  • USD400mln Sukuk by the IDB

    • Ijarah, Istisna, Murabahah Structure

    • Only 51% Assets?

    • IDB bundles Ijarah, Istisna, and Murabaha receivables.

    • SPC creates a trust and issues Sukuk.

    • SPC appoints ICD as agent to collect receivables.

    • IDB provides guarantees.

  • Sukuk Issuance Programme by the IDB

    • Ijarah, Murabahah, Istisna Structure

    • Only 30% Assets?

    • IDB Trusts creates a trust and issues Sukuk Al-Istismar.

    • IDB bundles Ijarah, Istisna, and Murabaha receivables.

    • IDB Trusts appoints IDB as Agent to collect receivables.

  • Sukuk Mudarabah for Project Financing

    • Investors (Rabb al-mal) provide capital.

    • Issuer (Mudarib) invests in a project.

    • Profit shared according to pre-agreed proportions.

    • Loss borne totally by rabb al-mal (unless negligence or misconduct occurred).

  • In Essence Mudarib Cannot Guarantee Capital Nor Return Unless Negligence or Misconduct!

  • How to Protect the Interest of Investors (Rabbul Maal)?

    • Feasibility Study or Business Plan (دراسة الجدوى)

    • Accountability!

  • What is Feasibility Study or Business Plan (دراسة الجدوى)?

    • Objectively uncovers strengths, weaknesses, opportunities, and threats.

    • Assesses resources required and prospects for success.

    • Includes historical background, product/service description, accounting statements, operations details, marketing research, financial data, legal requirements, and tax obligations.

  • Business Plan Makes Mudarib Accountable

    • If Mudarib projects a 12% return and there is a 2% shortfall, they compensate for it.

    • Based on the legal maxim: "that deception by words entails compensation/indemnification in the same way as deceiving by acts requires"

  • Burden of Proof is on Manager of Funds

    • Producing evidence is the duty of the party which lodges a claim while the party denying the claim is required to take oath that his stand is correct

    • Jurists unanimously hold that Al-Muddai (the Claimant) refers to a person who claims occurrence of an event which is not common or the norm.

  • DP World Sukuk Mudarabah Structure

    • DP World Limited (Mudarab) enters into a Mudharaba Agreement.

    • DP World Sukuk Limited (Issuer & Trustee) issues certificates.

    • Investors provide proceeds.

    • Periodic distributions are made.

  • Sukuk Musharakah for Project Financing

    • Investors (sharik/partner) invest capital.

    • Issuer (sharik/partner) invests in the project.

    • Profit shared according to pre-agreed proportions.

    • Loss borne by partners based on ratio of capital contribution.

From Equity to Debt

  • Equity-Based Sukuk

    • Purchase Undertaking at Par

  • Debt-Based Structure

    • Liquidity Facility ("top-up facility")

    • Redemption of capital at par (Capital Protected)

    • Periodic coupon payment remain intact(Return Protected)

Summary of AAOIFI Challenge

  • Tradable Sukuk

    • Must represent ownership not debt.

  • Equity based Sukuk

    • No liquidity facility, but reserve is allowed.

    • Purchase undertaking not at par. Actual or market price is allowed.

  • Sukuk Al-Ijarah

    • Allow purchase undertaking at par.

  • Shariah Board

    • Ongoing supervision (issuance, implementation, operation).

    • Encourage partnership.

Sukuk Ijarah for Project Financing

  • Land Owner/Waqf leases land to Developer (Munshaat).

  • Developer leases rights for future use of units to Sukuk Investors.

  • Sukuk Investors receive payments for lease rental.

  • Funds are used for Zam Zam Tower development.

Sukuk Murabahah (Case Study on Tesco)

  • The Issuer (Tesco) sells relevant Shariah-compliant assets to the Trustee.

  • Trustees pay the Purchase Price from the proceeds collected

  • The trustees immediately sell the asset to the issuer.

  • Issue Sukuk to evidence indebtedness

Sukuk Murabahah (Tawarruq)

  • SPV issues investment certificates to primary subscribers.

  • SPV buys LME metal warrants.

  • SPV sells commodity to the corporate at a profit margin.

  • Commodity is sold on the spot in the secondary market.

Case Study

  • BTA $250 Million Syndicated Sukuk

    • July 06, the largest Islamic syndicated financing facility in Kazakhstan

    • Syndicated Wakalah restricted with commodity murabahah

    • ADIB = Shariah adviser, documentation agent, wakeel/facility agent

    • BTA Bank = leading banks in Kazakhstan that pioneered Islamic finance

    • BTA uses proceed to finance its client's Islamic trade finance activities

Asset-Backed Sukuk (ABS)

What is Asset-Backed Sukuk?

  • ABS involve pooling various categories of assets and creating securities to represent the pooled asset (securitization).

  • ABS derive their value from the asset pool and income streams.

  • Investors rely solely on those assets for payment.

ABS vs Corporate Bond

  • Asset Backed Securities

    • A financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities (MBS).

  • Corporate Bond

    • A debt security issued by a corporation and sold to investors.

ABS

  • Is converted loan/obligation

  • Backed by income generating asset

Bond

  • Is a loan

  • Backed by general obligation/strength of company

Definition of ABS

  • Guidelines on the Offering of Asset-Backed Securities, 2004

  • Private Debt Securities or Islamic Securities that are issued pursuant to a securitization transaction

  • Assets must generate cash flow

  • 'True-Sale' to SPV and assets are Transferred at a fair value

  • There are no impediments that prevent
    Effective transfer of the assets or the
    Rights in relation to such assets from
    An originator to SPV

Moody's Comment on ABS

  • The presence of asset does nothing to enhance the credit risk profile of the Sukuk

Categories of Sukuk….

  • Unsecured asset-based Sukuk

    • The issuance principal is effectively "guaranteed", in most cases by the originator, via a purchase undertaking agreement.

  • Secured asset-backed Sukuk

    • Neither the principal nor the coupons are subject to formal guarantees. Sukuk performance is asset driven and the effective legal transfer of assets to investors is critical.

Translated factors into rating….

  • Asset based

    • Creditworthiness of the originator providing the guarantee

  • Asset backed

    • Economic and financial attributes of the pool.

    • Enable an ABS to enjoy higher rating than the Obligor's rating

Asset backed vs Asset based

  • Asset backed

    • Risk & return depend on asset

    • Asset plays a genuine role

  • Asset based

    • Risk and return depend on obligor

    • Asset does not play any genuine role

Most Sukuk are asset based…

  • Various rating bodies has indicated that most Sukuk issued today are only asset based, not asset backed….

The challenge of true sale

  • In a securitization (ABS), true sale must be achieved

  • In issuance of securities (bond), true sale is not a must

  • True sale

    • Accounting de-recognition of the asset

    • Bankruptcy remote

True Sale IFSB….

  • IFSB Exposure Draft: Capital Adequacy Requirement for Sukuk Securitization

  • What:

    • Transfer of economic value of assets from one party (seller) to another (buyer) and the transfer is bankruptcy remote

  • Once the asset has been truly transferred, the creditor or liquidator (of the seller) could not claim the asset from the buyer

True Islamic ABS

  • There must be an ASSET ASSET must generate CASH FLOW. Additional Shariah Requirement should be based on solely monetary debts/receivables TRUE SALE criteria