I am about to wrap up the current topic of explaining how investment-based Sukuk are different from Sukuk Ijarah and in the last article I had briefly touched upon the Shariah way for Sukuk Musharakah investors to mitigate the equity, return and performance risks.

I hope by now readers must have grasped that for Sukuk to be tradeable, it can be based either on an Ijarah, Mudarabah, Musharakah or Wakalah contract. Sukuk can be issued based on Murabahah, Salam or Istisnah; nevertheless, it is not permissible in Shariah that it is listed and traded on a bourse. Why? You will need to scan the previous articles to find out the Shariah doctrine for not allowing the trading of debts, either at a discount or premium.

When I worked in conventional banking in the UAE — which seems a lifetime ago — my best-selling products were discounting, factoring and forfaiting since they earned me upfront interest and commission. Collecting the discounting interest upfront from a client allowed me to enhance my overall yield from the account. The icing on the cake was the recovery of discounting commission and I got an excellent earning uplift to my portfolio. On the other hand, my clients were also happy to pay a price for having received the funds now, rather than waiting for the maturity of debts.

Upon entering Islamic banking, I tried to introduce my best discounting clients to my new employer but to my astonishment I found that no discounting facility was offered by the Islamic bank. I approached the head of corporate banking — a seasoned Islamic banker of his time — with the confidence to introduce him to the ‘virtues’ of discounting. When I completed my lecture, he looked back with a smile and said: “Welcome to Islamic banking.”

In view of the Shariah impermissibility to buy or sell debts, Sukuk Murabahah, Salam and Istisnah can be issued; however, these cannot be listed on a bourse for trading purposes. In other words, the Sukukholders shall be required to hold onto the Sukuk until maturity to be able to get redeemed.

An excellent case in point is the Sukuk Salam issued by the Central Bank of Bahrain (CBB) from time to time in order to manage its liquidity position. Here, the CBB is the seller of a commodity and receives an upfront sale price from investors. The CBB Sukuk Salam replace the conventional local currency treasury bonds and are issued for a short tenor of 91 days. The Sukuk are not listed for trading.

In order to manage the Shariah constraint of not being able to issue listed and traded Sukuk Murabahah, Salam or Istisnah, an innovative approach was adopted in recent years under the supervision of the reputed Shariah scholars to combine the debt with a tangible asset to create a portfolio which was then allowed to be the basis of issuing the tradable Sukuk. The combination was allowed on a condition that the debt in the portfolio should not exceed a certain threshold (70%) and the tangible asset must not be less than a certain level (30). Such a hybrid structure is now commonly used for the issuance of Sukuk globally.

I am not against using the hybrid structure; however, unfortunately it has been seen that some entities have exploited the Shariah permissibility by entering into a superficial commodity Murabahah-based debt rather than utilizing the existing original debt they may be holding in the books. The so-called commodity Murabahah debt is then combined with Mudarabah to comply with the tangibility ratio in the portfolio which is then utilized for the issuance of Sukuk.

I have written enough in this series about the ills of extensively and excessively using the commodity Murabahah and how the practice is camouflaging the other beautiful offerings by the Islamic financial system. Hence, I will be happy if the originators of the hybrid Sukuk avoid making a few brokerage firms super rich through the use of the commodity Murabahah approach and instead include the receivables portfolio developed by them through entering into genuine trade transactions.

I am aware of the argument put forward by the market players that the genuine receivables will be phased out as and when they fall due whereas the commodity Murabahah debt is tailor-made to last until the Sukuk maturity, or is coincided with each periodic distribution date when a new (superficial) commodity Murabahah transaction is entered into.

However, as defined earlier, an Islamic finance transaction ought to have both components, ie form and substance. By adopting the commodity Murabahah approach, the originators of such Sukuk are merely following the form at the cost of substance. So what if the genuine debts will phase out on the respective maturity? This can be addressed by devising the mechanism to allow the Sukuk originating entity either to partially redeem the Sukuk at each periodic distribution date, or reinvest the realized debt amount in the entity’s running business for and on behalf of the Sukukholders.

Another concerning factor in such Sukuk is that while the hybrid structure usually uses Mudarabah, the entire profit paid to the Sukukholders exclusively comes from the commodity Murabahah arm and the Mudarabah is made redundant vis-a-vis the earning perspective.

In the next article, I will explain the appropriate usage of the hybrid structure where investors can mitigate (and not eliminate) the equity, return and performance risks. So stay tuned.

The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.

Sohail Zubairi is an Islamic finance specialist and AAOIFI-certified Shariah advisor and auditor. He can be contacted at [email protected].

Next week: Discussion on Sukuk transactions shall continue.