The Islamic finance industry, much like the broader finance market, has spent much of the last two years weathering the global economic turmoil and market volatility caused by, among other things, the Russia–Ukraine conflict, high inflation and monetary tightening policies of the US Federal Reserve and other major central banks, as well as the ongoing economic fallout and steps to recovery from the COVID-19 pandemic. Higher oil prices have also negatively affected the volume of new issuances due to a decrease in financing needs from issuers based in oil-producing jurisdictions, particularly by sovereigns and sovereign-related entities in the GCC.
In this challenging macroeconomic environment, the topic of Shariah governance and standardization has continued to be central in the ongoing development of the Islamic finance industry and central banks, such as the Central Bank of the UAE, and industry bodies, such as AAOIFI, have continued to shape the regulatory and market practice framework applicable to Islamic finance transactions.
Review of 2022
Regulatory developments
In the context of the regulatory landscape of the Islamic finance industry, in particular in the Middle East and in respect of international Sukuk transactions offered to Middle Eastern investors, 2022 was a year of new and ongoing challenges.
In 2021, AAOIFI adopted AAOIFI Standard 59 and with it came a raft of Shariah-related requirements relating to the maintenance and, for the lack of a better description, ‘eligibility’ of underlying assets used in Sukuk transactions, which have necessitated certain departures from the previous status quo in terms of Sukuk documentation, particularly with regards to requirements for maintaining the tangibility of underlying assets and the consequences of the failure to meet such tangibility thresholds.
Such developments have become a focal point in Sukuk structuring in 2022, particularly given the adoption of such standards by the Higher Shari’ah Authority (HSA) of the Central Bank of the UAE, as financial institutions which are regulated by the Central Bank of the UAE are now required to only participate in Islamic finance transactions that meet the standards endorsed by the HSA.
Due to UAE financial institutions’ regular position as anchor investors in US dollar-denominated Sukuk, and in order to achieve higher demand, new and existing Sukuk issuers and arrangers have on the whole sought to adapt transactions to ensure compliance with AAOIFI standards and HSA guidelines. This has proved to have a significant impact on transaction structuring and execution time frames as stakeholders get to grips with these relatively new requirements.
Stricter tangibility requirements include an obligation to monitor and maintain the tangibility ratio above 50% throughout the tenor (rather than at the time of the issuance) of the Sukuk and, in case such a ratio falls below such a threshold, either steps must be taken to restore the ratio above 50% or, if the ratio falls below 33%, a ‘tangibility event’ occurs involving certain consequences, including: (i) cessation of tradability (other than in accordance with the Shariah principles of debt trading, ie at par or against tangible assets/eligible commodities on a spot settlement basis), (ii) delisting from any stock exchange on which the Sukuk are traded and (iii) triggering of certificate holder put rights.
Such stricter tangibility requirements have also resulted in unforeseen challenges for banks seeking to issue regulatory capital Sukuk, arising from the conflict between:
(a) Basel III rules and their implementation across relevant jurisdictions which:
i. generally restrict the exercise of certificate holder put/optional dissolution (issuer call) rights until a specific period of time (eg five years) has elapsed from the issue date and, in each case, subject to the approval of the relevant financial/banking regulator, and
ii. prohibit acceleration of Sukuk by certificate holders other than in cases of bankruptcy or liquidation of the bank), and
(b) the new AAOIFI/HSA requirements to implement certificate holder put rights and dissolution event triggers upon the occurrence of tangibility events.
As a result, banking institutions seeking to issue Basel III-compliant Tier 2 Sukuk are now having to adopt new structuring approaches in order to reconcile AAOIFI Standard 59 with Basel III rules, where the Tier 2 Sukuk are intended to be marketed to investors in line with HSA guidelines.
A further challenge for the Islamic finance industry, in particular for floating rate financings, is the transition from interbank offered rates (IBORs) to overnight risk-free rates (RFRs). Although IBOR transition has long been in the works and is a more straightforward process for conventional transactions, replacing IBORs, which are essentially ‘forward-looking’ term rates with RFRs, which are mostly calculated on a ‘backward-looking’ basis, creates complexities for Sukuk issuers, mostly because of the lack of certainty in cases of ‘backward-looking’ basis calculations.
While the majority of US dollar Sukuk issuances are with a fixed rate, Sukuk issuers (particularly programmatic issuers) have begun replacing IBORs with RFRs and inserting fallback provisions in their program documentation, and we have seen a few secured overnight financing rate (SOFR)-linked issuances in 2021 and 2022.
Arguably, term SOFR is a suitable benchmark to replace LIBOR [London Inter-Bank Offered Rate]; however, its implementation is yet to be tested in Sukuk structures containing Ijarah or Murabahah components where there is a need to specify in absolute terms in advance (as opposed to in a retrospective formulaic manner) the profit rate at the beginning of the relevant profit period.
Naturally, the aforementioned developments, and the way the market adapts to them, is a moving process and it will take some time for consensus to form on the new status quo. Global economic uncertainty and volatility have not helped in this evolutionary process, as the muted frequency and volumes of Sukuk issuances in the last 12 to 18 months have essentially acted as a practical impediment — fewer issuances have provided fewer opportunities (than perhaps usual) to stress-test and resolve such structuring challenges.
Market developments
Despite, and perhaps as a corollary of, the aforementioned regulatory developments, 2022 was a year of innovation for the Islamic finance industry, in particular in the Sukuk space.
In Saudi Arabia, SNB Capital Company established its SAR5 billion (US$1.33 billion) short-term commercial paper issuance program and completed the inaugural issuance of SAR1.25 billion (US$332.87 million) short-term certificates thereunder, introducing a novel Shariah compliant capital market instrument in the Saudi market, and the domestic Saudi riyal market remains strong, fueled by issuances by the National Debt Management Center and sovereign-related entities such as the Saudi Real Estate Refinance Company and the Public Investment Fund (PIF), including the PIF’s first-ever green transaction, as well as regulatory capital and some retail transactions by Saudi financial institutions.
In the UAE, we have seen, perhaps as an adaptive response to the structuring challenges faced by larger-scale public debt issuances, an increase in more innovative privately-placed credit transactions.
In Southeast Asia, Indonesia remains a regular issuer of jumbo green and sustainable Sukuk at the sovereign level, and Malaysia’s domestic Sukuk market (like Saudi Arabia, somewhat insulated from international market volatility), has remained resilient.
In Uzbekistan, the Ministry of Finance of the Republic of Uzbekistan, with support from the United Nations Development Programme are working toward developing a new legal and regulatory framework for plain vanilla and green Sukuk, which would, once completed, enable the issuance of Sukuk by sovereign and non-sovereign entities located in Uzbekistan, which represents an untapped market with a Muslim-majority population.
In Turkiye, the government’s target to increase the market share of participation (Islamic) banks is ongoing and the government recently announced its strategy to further support the Islamic finance industry in Turkiye by developing the legal and regulatory framework to consolidate the participation banking system, to standardize Shariah compliant products and to introduce an enabling legal framework for new products (including Takaful products).
And, as with the larger global financial market, 2022 saw rapid development and alignment of Islamic financing transactions with ESG principles, with regulatory developments across various jurisdictions, including Turkiye (Green Bonds and Sukuk Guidelines), Malaysia (updated SRI-linked Sukuk Framework), Qatar (QFC Sustainable Sukuk and Bonds Framework), the UAE (Sustainable Finance Framework) and Indonesia (Green Taxonomy 1.0), as well as ESG-linked Islamic finance transactions representing an increasingly greater proportion of the Islamic finance space.
Preview of 2023 and conclusion
Much of 2023 will depend on the state of global financial markets generally and whether the volatility we saw in 2022 subsides, which is not something anyone can easily or accurately predict. What we anticipate, however, is for 2023 to bring further innovation in the Islamic finance market as stakeholders tackle both the regulatory and structuring developments and challenges mentioned previously and global market forces to successfully bring transactions to market.
Debashis Dey is a partner at White & Case. He can be contacted at [email protected].
Xuan Jin is a counsel at White & Case. He can be contacted at [email protected].
Eren Ayanlar is an associate at White & Case. He can be contacted at [email protected].