Islamic Financial Markets: Stocks and Sukuk...IDB bundled ijarah assets (65.8%), along with...

Islamic Financial Markets:Stocks and Sukuk

Professor Habib Ahmed

Durham University Business School

Outline

• Stock Markets—Islamic Perspectives

• Sukuk—Structures and Evolution

• Sukuk—Issues and Controversies

3

Introduction

• Banks and capital markets play complementary roles in allocation of funds

• Capital markets raise funds from the investors directly by issuing securities

• In conventional finance, many types of securities exist– Equity, debt, hybrid, derivatives, etc.

• Financial markets can be distinguished as – Stock market: Equity

– Bond Market: Debt

4

Companies and Shares

• Corporation is create by company law

– a legal entity

– limited liability

• Shares represent contribution to collective capital of a company in return from certain rights

– Right to profit, vote and proportionate share upon dissolution of the corporation

– The company owns the corporate property, not the shareholders—ensures continuity

5

Stock Market—Islamic

Perspectives• Islamic Fiqh Academy, Resolution No. 63/1/7, 1992

– Citing the principle of permissibility, ruled that investment in stocks is permissible, provided the prohibited are avoided

• AAOIFI—contracts of corporation to be generally valid– rules of sharikat al inan apply

• Permissibility to invest depends on the type of corporation

• Two main criteria used for screening – Sector-based

– Accounting-based

6

Stock Market:

Sector Based Screening

• Main business of the firm should be halal

– Forbidden goods and services cannot be included in the acceptable business activities.

• Unacceptable business activities include:

– Alcohol, tobacco, pork-related goods, pornography, conventional finance (banking and insurance), trading in gold and silver on a deferred basis, and entertainment (hotels, casinos/gambling, cinema, etc.).

Sector Dow Jones FTSE S&P* MSCIAlcoholic Beverages X • X •

Broadcasting & Entertainment

X • X •

ConventionalFinancial Services

X • X •

Gambling X • X •

Hotels X • X •

Insurance X • X •

Media Agencies (except newspapers)

X X

Pork-related Products

X • X •

Restaurants & Bars X • X •

Tobacco X • X •

Trading of Gold & Silver

X

Weapons & Defense X • •

Sector Screening Criteria

X—any involvement; •—core business.

8

Financial Markets:Accounting Based Screening

• Financial Ratios in identifying stocks

– No basis in Shari’ah (Quran & Sunnah)

• Two principles

– Juristic maxim: “The majority deserves to be treated as the whole of a thing”

• Simple majority —more than half (51%)

• Super majority —more than two-thirds (67%)

– Hadith of minority (1/3rd of will)

• “one-third, yet even one third is too much." (Narrated by Ibn 'Abbas)

9

Basic Balance Sheet

Assets Liabilities & Equity•Current Assets

–Cash–Accounts Receivables

•Fixed Assets–Tangible

• Real Assets• Financial Assets

– Interest bearing securities– Other Fin. Assets

–Intangible• Trademark & patents

•Debt –Short and long term

•Shareholder Equity

Market Capitalization: Value of the corporation as determined by the market price (stock price x no. of stocks)

10

Stock Market:

Accounting-Based ScreeningAcceptable Financial Ratios related to level of leverage, cash, and interest income

Criterion DJIM* S&PS**

1. Total debt/Market Capitalization Less than 33%

Less than 33%

2. Cash and interest-bearing securities/Market capitalization

Less than 33%

Less than 33%

3. Account receivables/Market capitalization

Less than 33%

Less than 49%

4. Non-permissible income (other than interest income)/Total revenue

Less than 5%

Less than 5%

* Market Cap. Moving Average 24 months; ** Market Cap. Moving Average 36 months.

11

Stock Market:

Accounting-Based Screening

• Acceptable Financial Ratios related to level of leverage, cash, and interest income

Criterion FTSE MSCI

1. Total debt/Total Assets Less than 33%

Less than 33%

2. Cash and interest-bearing securities/Total Assets

Less than 33%

Less than 33%

3. Account receivables/Total Assets Less than 50%

Less than 33%

4. Non-permissible income and other interest income/Total revenue

Less than 5%

Less than 5%

Stock Market—Issues • Distribution of zakat

o By the fund manager of investors?

• Cleansing of impure income (interest and impermissible income)

• Positive and negative screeningo Current practice—negative screening using legal perspective

• prohibition driven screening

o Need to add positive screening—social and environmental issues

Outline




15

Special features of fixed-term securities

• Capital markets raise funds directly from investors by issuing securities

• With no intermediaries, investors will not invest if their rights are not protected

• SPV is a legal entity created to protect the rights of investors

• Status and ability of obligor/ borrower to pay becomes important– Rating—determines cost of

funds and marketability– Credit enhancements

FinancialInstitution

InvestorsBorrower/

Obligor

SPV

InvestorsBorrower/

Obligor

Indirect Financing

Direct Financing

16

Securities—forms and risks

• Two forms of securities – Asset-backed—risk analysis of assets– Unsecured—risk analysis of the

sponsor/borrower

• Credit Enhancers—initiatives taken to enhance security, credit, or ratings of securities – Originator credit enhancement—Cash collateral,

over-collateralization, reserve accounts, etc. – Structural credit enhancement—security holders

senior in claims– Third party credit enhancements—guarantees

17

Special Purpose Vehicle (SPV)

• SPV (SPE, SPC)

– A legal entity created solely for the purpose of the transaction as it is impossible to transfer assets to individual investors

– A bankruptcy remote entity (shields investors from the risks of the originator)

– Usually a trust—trustees hold assets and makes payments to the sukuk holders

– Usually reputable institutions manage the SPV

18

Sukuk-definition

• Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) defines sukuk as:

“Certificates of equal value representing after closing subscription, receipt of the values of certificates and putting it to is as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of special investment activity”

19

Sukuk—Types

• AAOIFI identifies 14 types—can be broadly classified as asset-, debt-, equity, and agency- based

Asset based Ijarah (existing owned, existing leased, and future assets), manfah-usufructs (existing and future assets)

Debt Based Istisna, salam, murabahah

Equity Based Murabahah, musharakah, Muzara’a(sharecropping), Musaqa (irrigation), Mugharasa (agricultural/plantation)

Agency based Wakala

20

Sukuk—Features

1. Asset/usufruct/service/equity must underlay issuance

2. Fixed term maturity3. Types of returns—fixed/flexible 4. Tradability: Depends on the type of sukuk—

Debt based sukuk not tradable5. Redemption/Principal repayment

– Bullet payment—Asset transferred to issuer/originator at maturity

– Sinking (diminishing) Fund—Periodic amortization over time (with coupon payments)

21

Sukuk Market—Growth

• First sukuk issued in Malaysia in 1990s and in Bahrain in 2001

• During 2001-2007, average growth rate 45%

• Dubai based USD 3.5 billion PCFC sukukgenerated orders of USD 11.4 billion with 50% from non-Muslim investors (Jan 2006)

• Before crisis, 70-80% buyers of ME sukuk were Western entities

• Foreign entities issuing sukuk– German state of Saxony-Anhalt: є100 mill. Sukuk

(2004)

– East Cameron Gas Co.: $165.67 mill. sukuk (2006)

22

Evolution of Sukuk Markets

and Structures• Sukuk issuance

• 2005—USD 11.5 billion

• 2013—USD 119.7 billion

• New jurisdictions—Mauritius, Kazakhstan, UK

• Evolution of sukuk structures

• First Phase—Simple Asset-backed Structures

• Second Phase—Experimentation with New Structures (scarcity of assets lead to newer structures)

• Third Phase—More Complex Structures (added options and features)

23

Obligor(undertakes future sale

of commodity for the investors)

SPV

Investors1 2a

Salam Proceeds

Undertaking Sukuk Certificates

Commodity Commodity Sale Proceeds

Sukuk CertificatesProceeds

2b

64

3

Sukuk al-Salam

• Sale of well-defined quality and quantity of commodity

• Fixed rates of return

• Sukuk al-salam are not negotiable

5 Commodity Sale

CommodityBuyer

24

Sukuk al-Salam: ExampleSukuk name/date Sukuk al-Salam/Aug. 1, 2007 (Issue no. 75)

Sukuk base Aluminium

Obligor Government of Bahrain

Issuer Central Bank of Bahrain

Purpose of Offering Short-term liquidity

Tenor 91 days

Issue size BD 6 million

Expected rate of return

5.06%

Credit enhancers Guaranteed by Bahrain Government

Governing Law Bahraini Law

Redemption/ Principal repayment

With price at maturity

Rating None

25

Corporate/Borrower

IssuerSPV

Investors12a

Commodity

Master Agreement

Sukuk Certificates

Sale Price + profits

Sukuk Proceeds

2b

7

4

Sukuk al-Murabahah

CommodityBuyer

CommoditySupplier

Commodities3a 3bCommodity

Price

CommodityPrice6

Commodity5b 5aCommodity

Price

26

Sukuk al-Murabahah-ExampleSukuk name/date Arcapita Multicurrency sukuk/June 2005

Sukuk base Commodity (purchase/sale)

Obligor Arcapita Bank BSC

Purpose of Offering Investment in assets

Tenor 5 Years

Issue size USD 210 million


0.175% above LIBOR rates

Credit enhancers Full recourse to Arcapita


Bullet payment at maturity

Rating Arcapita rating (BBB)

27

Sponsor/Originator/

ObligorSPV

Investors

1

• Transfer of assets back to Issuer can take place is 2 ways:

a. Periodic payments include rent and amortization (capital)

b. Bullet payment at maturity (the Issuer buys back the assets)

• Sukuk al ijarah are negotiable

• Can have fixed/flexible rates

• Risks of assets transferred to certificate holders (though issuer can guarantee

the capital)

2aPurchase Price of Assets

Sale/Transfer of Assets

Lease of Assets

Sukuk Certificates

Rental Payment

Periodic RentalPayments


2b

4b

5

4a

3

Sukuk al-Ijarah

28

Sukuk al-Ijarah: ExampleSukuk name/date Qatar Global Sukuk/Oct. 8, 2003

Sukuk base Certain Land Parcel in Qatar

Obligor State of Qatar (lessee of leased assets)

Issuer Qatar Global Sukuk QSC

Purpose of Offering Construction of Hamad Medical City

Tenor 7 Years



Semi-annual lease rentals (Libor+ credit spread+ amortization payment)

Credit enhancers Guaranteed by Qatari Government

Governing Law English and Qatari Law


With rental payments (amortization with rental payments)

Rating A+ (S&P)

29

Balance Sheet Based

Sukuk—IDB • IDB is a multilateral development bank (MDB)

operating on Islamic principles • Before issuing sukuk, 100 percent equity based

institution (paid-up capital $4.3 billion)• Other MDBs raise funds from market

– World Bank raised funds worth 918% its capital (total borrowing $ 96 billion)

– ADB raised 777% of its capital (capital $3.6 billion)

• Development impact of IDB small compared to other MDBs

• Plans to raise up to USD 4 billion in the next 10 years

30

SPV

Investors

1

IDB bundled ijarah assets (65.8%), along with murabahah (30.7%) and istisna (3.5%) receivables

3a

Sells assets bundle worth $400 m.

Appoints as agent to collect income from assets

Sukuk Certificates

Sells assets $400m.

Periodic Income fromAssets


3b

2

74

IDB-Hybrid Asset Sukuk

Delegates agency role

5

Provides guarantee about assets

6

31

IDB-Hybrid Asset SukukSukuk name/date IDB Global Trust Certificates/Aug.12, 2003

Sukuk base Balance sheet assets of IDB (Ijarah, istisna,

murabahah)

Obligor Islamic Development Bank

Issuer Solidarity Trust Services Limited (through ICD)

Purpose of Offering Financing other assets

Tenor 5 Years



Semi-annual lease rentals (Fixed 3.625%)

Credit enhancers Guaranteed by IDB

Governing Law English Law


Purchase of assets at maturity at sale price

Rating AAA (S&P)

32

Corporate

SPV

Investors

1

Transfer of Assets Back to Issuer can take place is 2 ways:

1. Payments Include profit and purchase of shares (diminishing musharakah)

2. At maturity, the corporate buys back the shares.

2a

Periodic profit and Incentive fee

Physical Asset Contribution

Sukuk Certificates

Periodic profit

Sukuk Proceeds

2b

6

4

Sukuk al-Musharakah

Musharakah

Sukuk proceeds3Periodic profit 5

Corporate undertakes to buy musharakah shares

of the SPV

7

33

Sukuk al-Musharakah: Example

Sukuk name/date Wings-FZCO Sukuk/June, 2005

Sukuk base Issuer provides assets in kind ($100 million)

Obligor Emirates Airlines

Issuer Wings FZCO

Purpose of Offering Construction of Group Headquarters and

Engineering Centre

Tenor 7 Years


Expected rate of

return

1st coupon after year, thereafter semi-annually

(0.75% above USD LIBOR rates)

Credit enhancers Strength of Emirates and UAE

Governing Law English Law and Dubai Law

Redemption/

Principal repayment

Bullet payment at redemption

Rating/Listing Listed with Luxemburg SE

34

Turkey: Ijarah Certificates2010: COMMUNIQUÉ ON THE PRINCIPLES REGARDING IJARA

CERTIFICATES AND ASSET LEASE COMPANIES (Series: III, Nr.: 43)

ARTICLE 4 - (1) Asset Leasing Company (ALC) shall be incorporated by the founders with the purpose of subletting to the originators the assets assigned to it by the originators, issuing ijara certificates backed by the returns from the said lease, and to assign the asset in question back to the originator at the end of the lease term. ALC can be assigned the assets of only one originator at a time.

ARTICLE 5 - (1) The field of activity of ALC comprises the following activities to be specified in the articles of incorporation.

a) To issue ijara certificates, b) To be assigned and to lease all kinds of assets on its own behalf and

for the account of ijara certificate holders, to pay returns from such assets to ijara certificates holders in proportion to their shares,

c) To assign the leased asset back to the originator at the expiration of the lease contract, on terms established at the beginning.

2013: COMMUNIQUÉ ON LEASE CERTIFICATES (III-61.1)For new sukuk structures

(USD) Sukuk Borrowing Instruments

2011 550 15,145,416,000

2012 - 38,536,807,000

2013 1,510,645,000 83,790,780,000

2014/05 1,414,283,000 40,982,883,000

Total 3,474,928,000 178,455,888,000

Turkish Sukuk Issuances

Source: Presentation of Capital Markets Board of Turkey

Outline




37

Risks in Sukuk• Depends on how sukuk are structured• Debt

Credit-rating of the obligor High liquidity risks (illiquid)

• Asset Quality of the asset Low liquidity risks (if there is a active secondary

market)

• Equity Quality of the project or rating of the obligor Low liquidity risks (if there is a active secondary

market)

3838

Sponsor/Originator/

ObligorSPV

Investors

1

1. Guaranteeing initial capital

2. Sale of assets and transfer of ownership.

3. Sale and lease-back

4. Smoothing rental payments to the expected rate

5. Sale of asset back to originator

2a

Purchase Price of

Assets


Lease of Assets

Sukuk Certificates

Rental Payment Periodic Rental

Payments

Sukuk Certificates

Proceeds

2b

4b

5

4a

3

Shari’ah ConcernsAsset-based Structures


6

Guarantee/Undertaking

39

Shari’ah Issues and Controversies (1)

1. Guaranteeing initial capital to investors

– Guarantee in Sukuk issues—3rd party guarantees allowed without any charges• Critics: Originator/guarantor and SPV same entity–

guarantee of capital/return can open doors for riba

• Supporters: SPV independent from originator, guarantee by originator is by 3rd party

2. Sale of assets and transfer of ownership.

– Sale of assets must result in actual transfer of ownership (actual vs. beneficial ownership)

– In only 2% of sukuk (out of 560) actual sale (legal and accounting terms) takes place

40

Shari’ah Issues and Controversies (2)

3. Sale and lease-back structure—Bay' al-

istighlal (a form of bai al ‘inah)

4. Smoothing rental/profit payments to the expected rate is prohibited

– If the actual return is higher than expected, the manager of sukuk keeps it as incentive

– If the actual return is less than expected, loan is given to the investors that is recovered later.

5. Objections to redemption/purchase of asset/shares at pre-determined (selling) price

– Redemption/purchase of asset/shares at market price allowed

41

Case Study: Nakheel Sukuk• Dubai Nakheel Sukuk--$3.52 bl. 3 year ijarah sukuk issued in 2006

– Property sold—development of Dubai Waterfront skyscrapers on50 year leasehold land; Purchase undertaking at a subscribed price(par value); Dubai World (government entity) provided guarantee;Sukuk was oversubscribed;

– Last payment due on Dec. 14, 09—$4.1bl.

– Nov. 2009—Nakheel announced that it could not pay the dues

• Risks

– Legal Risks

• Applicable law—English law? Enforcement of contract?

• Leasehold right not recognized real right under Dubai law?

– Shari’ah Compliance Risk

• Sale of asset owned by government?

• Ownership of asset with undertaking?

42

Goldman Sachs Sukuk

Guarantor (GSG)

Purchaser (GSI)Issuer/Trustee

(GSCL)

Certificate Holders

Commodity Suppliers

Deferred payment price

Commodities

Certificates

Issuance proceeds

GSI acts as

buying agent for

this transactionCommodities

Guarantee of purchaser’s

obligations

GSG—Goldman Sachs Global

CSI—Goldman Sachs International

GSCL—Global Sukuk Company Limited

[email protected]

Islamic Financial Markets: Stocks and Sukuk...IDB bundled ijarah assets (65.8%), along with...

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