SUKUK FROM A MEDITERRANEAN

PERSPECTIVE

By: Camille PaldiCEO of FAAIFPresentation for Malta Institute of ManagementRecent Trends and Development in Islamic Finance October 24, 2014

INTRODUCTION: THE ORIGIN OF SUKUKSukuk is derived from the word sakk, which can mean

legal instrument, deed, and cheque. Sakk can also mean to strike a seal on a paper document.

The first sukuk transaction took place in Damascus, Syria in the Great Mosque of Damascus (Umayyad Mosque) in the 7th Century AD. Syria is a treasure house of culture and history.

SHEIKH ZAYED MOSQUE, ABU DHABI

SUKUK LINGUISTIC ORIGIN AND DEFINITIONTawriq (from wariq) means to render something into cash. Taskik (from Sakk) is also used as securitization though literally refers to the process of dividing the assets into papers (Sukuk).

Tawriq is defined as: “transforming a deferred debt for the period between the establishment of the debt and the maturity period into papers, which can be traded in the secondary market.” (in Majallah Majma ‘Al Fiqh’)

AAOIFI AND IFSB DEFINITIONS OF SUKUKAAOIFI in its Shari’ah Standard 17(2), defined investment sukuk (Sukuk Istithmar) as “certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services, assets of particular projects or special investment activity.”

The IFSB, in its Capital Adequacy Standard (IFSB 2), defined sukuk as “Certificates that represent the holder’s proportionate ownership in an undivided part of an underlying asset where the holder assumes all rights and obligations to such asset.”

MAIN FUNCTION OF SUKUK

The main function of sukuk is to provide an alternative to conventional bonds, in other words, to provide the benefits associated with conventional bonds, but in a Shari’ah compliant manner.

SUKUK V BONDS

A conventional bond is a contractual debt obligation whereby the issuer is contractually obliged to pay to bond holders, on a certain specified date, interest and principal.

Under a Sukuk structure, the Sukuk holders each hold an undivided beneficial ownership interest in the underlying assets.

Sukuk holders are entitled to a share in the revenues generated by the Sukuk assets.

In sum, Sukuk are monetary denominated participation certificates of equal unit value to be issued to investors to represent their proportionate share in the ownership of the underlying assets and a pro- rata share in the income generated by those assets.

SUKUK V BONDS

While bonds represent pure debt obligations from the issuer to the investors or bondholders, the sukuk represent ownership of a well-defined asset.

The sale of sukuk, both in primary and secondary markets, is a sale of a share of an asset, while selling a bond is basically the sale of debt.

SUKUK V BONDS

In terms of pricing, sukuk prices are market driven and depend on the fluctuation of the market value of the underlying assets. In the case of the issuer’s default, sukuk holders will possess the asset and they can sell it to other buyers or keep it as an asset.

On the other hand, bondholders depend solely on the creditworthiness of the issuer without any specific assets to be relied on. Therefore, in the case of the issuer’s failure, unsecured bondholders will be jointly seeking the assets of a bankrupt company.

SUKUK V BONDS

The aim of bond traders usually is to make capital gains as fixed-interest bond prices rise when variable market interest rates fall.

Bond trading is therefore largely about exploiting interest rate developments and trading in paper that is usually unrelated to the value of any underlying asset.

SUKUK V BONDS

The major risk for holders of conventional bonds is of payments default, but this risk is usually assessed solely on the basis of credit ratings, with the ratings agency rather than the bond purchaser estimating the risk.

Hence, the bonds are regarded as mere pieces of paper with third parties estimating the risk and the purchaser, at best, only making a risk/return calculation without any reference to the business being financed.

SUKUK V BONDSSUKUK BONDS

Ownership in Assets No ownership in assets

Pricing by profit share Pricing by interest rate

Profit after risk-sharing Interest: fixed or variable

Pay-Off After Income Earned No risk-sharing

No asset-backing or asset-based = no funding

Interest payable even if no profit earned

SUKUK V SHARES

Sukuk is an undivided ownership share in specific assets while holding shares means holding an ownership share in a corporation or a company.

In sukuk, the assets should be Shariáh compliant and a minimum of 51% are tangible assets.

Ordinary shares do not require the company to be Shariáh compliant and the percentage of tangible assets is not determined.

SUKUK V BONDS V SHARESComparison Sukuk Bond Stock

Type of Security Share of revenue stream Debt Ownership in a corporation

Type of Return Profit sharing specified Coupon specified Dividends Unspecified

Priority in Paying Principle First Priority First in Priority Less in Priority

Risk Lower Lower Higher

Voting Rights Not Entitled Not Entitled Higher Entitled

TYPES OF SUKUK

Leased-based sukuk, i.e., sukuk al ijarah.

Partnership-based sukuk, i.e., sukuk mudharabah and sukukmusharakah.

Sale-based sukuk, i.e., sukuk murabahah, sukuk istisnaá, and sukuksalam.

SUKUK HISTORY

In 1990, in Malaysia Shell (MDS Sdn Bhd) issued a sukuk ijarah worth RM 125 million.

Issuances grew 145% in 2006 compared to 2005 to reach US$27 Billion.

In 2010, the sukuk market reached US$121.5 billion and In 2013, the market topped US$269.4 billion.

Ernst and Young predicts the sukuk market will reach US$900 billion in 2017.

SUKUK FACTS

Some estimates suggest that conventional investors may account for between 40% - 60% of any individual sukuk offering.

New sukuk issuances are often oversubscribed.

I.e. The US$500 Million Goldman Sachs Sukuk of September 2014 (New York, USA) had an order book of US$1.5 Billion and the September 2014 Luxembourg Sukuk had an order book, which was oversubscribed by two times. The June 2014 UK 200 Mn Euro Sukukhad an order book of 2 Bn Euros.

SUKUK AND MALTA

Malta can tap into the billion dollar sukuk market to raise funds for its businesses and government and attract Foreign Direct Investment.

All Malta’s government debt is funded domestically. Indeed, Malta has never yet tapped the international market.

Sukuk and Bonds are considered an important channel for governments, companies, and institutions to provide the necessary liquidity to finance its projects at relatively low cost.

In addition, the Sukuk and Bonds market will enable investors to diversify their investments and provide financial protection for their portfolios with lower risk tools, which ensure a safe and periodic return for the investor.

BENEFITS OF SUKUK - TAQIUSMANISukuk are among the best ways of financing large enterprises that are beyond the ability of a single party to finance.

Sukuk represent an excellent way of managing liquidity for banks and IFI’s.

Sukuk may enable equitable wealth distribution across society.

BENEFITS OF SUKUK – TAQIUSMANIWhen banks and IFI’s are in need of disposing of excess liquidity they may purchase sukuk; and when they are in need of liquidity, they may sell their sukuk into the secondary market.

Sukuk are a means for the equitable distribution of wealth as they allow all investors to benefit from the true profits resulting from the enterprise in equal shares.

In this way, wealth may circulate on a broad scale without remaining the exclusive domain of a handful of wealthy persons.

MALTA AS THE DISPUTE RESOLUTION CENTER FOR GLOBAL SUKUK DEFAULTSMalta can also attract millions in funds through creating an Islamic Finance Bankruptcy Court to handle all Sukuk defaults worldwide.

It is possible to attach a Standardized Dispute Resolution Contract to all Sukuk Transactions naming the Islamic Finance Bankruptcy Court in Malta as the Governing Law of the contract.

This will generate revenue for Malta as well as solve the problem of how to deal with investor and creditor rights in terms of sukukdefaults and near –defaults and create investor confidence in the global sukuk market.

HOW TO GET INVOLVED IN THE SUKUK MARKETMalta can introduce a legislative and regulatory framework enabling sukuk transactions if necessary. Some are in the view that Malta has a sound framework already.

I.E. Recently, the state of New York and Illinois in the USA and Cyprus have initiated such legislation.

Malta can host training workshops on Sukuk for banking, legal, and government professionals through MIM and Finance Malta.

ENGAGE WITH OTHER NATIONSThe Malta Financial Services Authority can engage in mutual recognition agreements with the regulatory bodies of other countries.

I.E. The DFSA has signed a Mutual Recognition Agreement with Malaysia’s SEC model, which helps to facilitate the cross-border flow of Islamic funds.

This opens the investment space between the Gulf and Malaysia as well as increases the accessibility of issues and enables mutual recognition of products and services.

MFSA CONSULTATION DOCUMENT ON ISLAMIC FINANCEMalta Financial Services Authority issued the MFSA Guidance Note for Shariáh Compliant Funds in 2009.

To provide guidance to fund promoters considering setting up a Shariáh fund under the Investment Services Act.

And To set out the issues, which Shariáh funds in Malta must address as part of their licensing conditions.

MFSA CONSULTATION DOCUMENT ON ISLAMIC FINANCESharia’h funds in Malta must comply with the Standard License Conditions set out in the MFSA’s Investment Services Rules for Retail Collective Investments Schemes or for Professional Investor Funds.

In addition, the fund must comply with the Shariáh Funds Guidance Note and will need to seek MFSA prior approval for any deviations therefrom.

GENERAL INTRODUCTION

The principal categories of collective investment schemes that can be set up under this common framework are the following:

Retails Investment Schemes: UCITS and non-UCITS

Professional Investor Funds: Experiences Investor Funds; Qualifying Investor Funds; Extraordinary Investor Funds.

LICENSING FRAMEWORK

Shariáh compliant funds will be expected to follow the risk-spreading principle except when this can be waived in terms of the proviso to the definition of collective investment scheme in the Act.

The managing body of a Shariáh fund (Board of Directors in the case of a corporate fund) will be responsible for ensuring that the fund satisfies the relevant Shariáh principles and requirements as disclosed in the fund’s prospectus and other investor information documentation.

Except for the applicability of this Guidance Note, Sharia’h funds set up as retail funds (UCITS or non-UCITS) or Professional Investor Funds, will be regulated in the same manner as non-Shariáh compliant funds falling under the same category.

LICENSING FRAMEWORK

The selected extra-financial criteria (Shariáh Guidelines, which the fund will adopt) must comply with all prevailing regulatory and statutory requirements.

No specific difficulties arise provided that the extra-financial criteria do not infringe regulatory principles.

APPOINTMENT OF A SHARIÁHADVISORY BOARDThe Manager of the fund shall appoint a Shariáh Advisory Board composed of at least two internationally recognized Shariáh Scholars to ensure that the fund meets Sharia’h compliance standards in the management of its assets.

Members of the Shari’ah Advisory Board are to be independent of the Manager.

The Role of the Shariáh Board is spelled out in Section A, Page 3 of the MFSA Document.

Section B spells out the Disclosures in the Prospectus and Section C details the Disclosure in the Audited Financial Statements of the Shariáh Fund.

PRIME MINISTER OF MALTA OPEN TO SUKUKDr. Joseph Muscat, Prime Minister of Malta said, “As a country we are actually considering whether we should issue a Sukuk ourselves, a small one, to see what the reaction of the markets would be and to give a political message that this is the sort of instrument we are in favour of…”

THE TIME IS NOW FOR MALTA AND SUKUKAll the while Malta has been contemplating the introduction of Islamic finance, France, Germany, Spain, and Luxembourg have been working in earnest to seize the opportunities.

Luxembourg has been very successful in attracting Islamic funds and issuing sukuk.

In the meantime, Malta’s competing jurisdictions, Guernsey, Jersey, the Cayman Islands, and Cyprus, are making significant progress.

Guernsey is becoming a reputable Islamic finance centre, the Cayman Islands have managed to attract a number of special purpose vehicles, and Cyprus has registered two Islamic banks.

MALTA FUNDS

Fund managers in Cyprus as in Malta are urging the state to consider issuing Islamic bonds (Sukuk) similar to a 5-year issue by the UK government and Luxembourg that each raised 200 mn Euros.

The Islamic funds market is estimated at about $2 trln, with an annual growth rate of 5%.

Currently, there are 102 funds in Cyprus that manage about 3 blneuros, 12,889 funds in Ireland with 2.5 trln under management, and Malta catching up with 600 funds and 9.4 bln euros.

THE MALTA STOCK EXCHANGEEnhance the stock exchange to facilitate sukuk transactions and trading.

Launch a sukuk and bonds trading platform.

EXAMPLE OF SAUDI ARABIA

In an effort to attract international investors and improve liquidity in the secondary trading in the Kingdom’s debt capital market, the Tadawul, the Saudi Stock Exchange, launched the Gulf’s third sukukand bonds trading platform after Bahrain and NASDAQ Dubai.

There is a withholding tax levied on overseas investors and there is also a requirement for international investors to have their own, rather than a nominee, bank account in the Kingdom to undertake the purchase of securities.

Therefore, the reality today is that international investors have a preference for offshore issuances in major bond centres such as London and Luxembourg.

THE MALTA STOCK EXCHANGE INTERNATIONAL STRATEGYOne focus of the Exchange's international strategy has been to achieve connectivity with other markets.

In this context, the first interoperable link was set up between Clearstream Banking and the Exchange's own depository, which has also led to the launch of the Exchange's custody business.

Also, the Exchange has launched a number of major technological upgrades designed to bolster and support its international strategy, chief amongst which are the adoption of the use of the XETRA trading platform, supplied by Deutsche Bourse, AG in July, 2012.

Other recent key milestones were the launch of the Market Making rules and the designation of the Exchange as a Designated Offshore Securities Centre by the US Securities and Exchange Commission.

DESIGNATED OFFSHORE SECURITIES MARKETThis makes it easier for US persons to trade and transact in Malta.

MALTA IS AN ATTRACTIVE FINANCIAL DESTINATIONMalta was cited as a tax haven in a US Congressional report as recently as January 2013, has a score of 48 points out of 100 on the Financial Secrecy Index, and a google search for “offshore company incorporation Malta” leads to multiple suppliers.

There are 27 stock exchanges which are designated offshore securities markets including Malta, Frankfurt, London, Luxembourg, Bermuda, and Zurich.

THE EXAMPLE OF CYPRUS

A new bill on Alternative Investment Funds has been approved by the Council of Ministers and is now in parliament for review and final approval, which in conjunction with the enactment of the Open-Ended Undertakings for Collective Investment Law in June 2012, and the Alternative Investment Fund Managers Law of 2013, will set up a comprehensive framework for the management of the International Collective Investment Schemes (ICIS).

Cyprus has been one of the first countries to adopt into law the European Union’s Alternative Investment Fund Managers Directive (AIFMD).

With this modern and new framework and the effective supervision of the sector by CySEC, new opportunities will be created in Cyprus.

FEEL FREE TO CONTACT ME AT CAMILLE@FAAIF.COM

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