Much will depend on the wording of the investment contracts. With asset-based Sukuk defaults are less likely as the originator and the investor share in the market risk. In contrast with asset-backed Sukuk, the originator takes on the entire market risk, the risk to the investors being that the originator defaults.
The practice may however deviate from the theory, as is all too often the case in Islamic finance. The legal wording of the contracts may seek to protect the investors from market risk, even when the Sukuk are asset-based. This however is undesirable from a Shariah perspective, and from a finance perspective only serves to increase the possibility of defaults. Defaults are seldom well managed, and moving to asset-based Sukuk will not make much difference.
Emeritus professor, Durham University UK
The Islamic banking industry has shown a high level of flexibility over the last few decades and is responding to the needs of its user by continuous innovation and is coming up with novel ideas in terms of new product structures.
Similarly, the recent focus of moving toward asset-based Sukuk structure is a very positive and healthy transition for the industry as it will enhance the credibility of Islamic banking and would provide a mechanism where the Islamic banks and businesses (as partners) would be focusing on the profits generated through the productive process involving actual trade and business transactions.
This shift of focus on the underlying business and viewing assets as investment to generate return and not only as a collateral will definitely result in better credit decision making and Islamic bank’s active involvement and monitoring of the business enterprise and would increase the transaction based on Musharakah. If the process of issuance of Sukuk on the above lines is followed in its true spirit and Islamic banks moves to the next level by having industry experts/specialists on board as part of their investment banking and corporate teams, it would reduce the chances of default for the industry and in the long run provide a better handle to Islamic banks for handling default scenarios.
We have recently seen significant activity in the Pakistani Sukuk market where Islamic banks like Meezan Bank are now focusing on business enterprise-based Sukuk structures based on Musharakah where the bank and customers are sharing on the gross profits/loss of the underlying business and this trend is expected to grow as more and more customers are now finding it easy to do Musharakah transactions with Islamic banks.
AHMED ALI SIDDIQUI
Executive vice-president & head, product development & Shariah compliance, Meezan Bank
Sukuk have never really been asset ‘backed’ structures — 95% have always been asset-based with the same credit risk as unsecured debt.
Senior credit officer, asset-backed and Sukuk finance, Moody’s Middle East
The asset-backed security makes sure that the revenue earned from the asset subject to finance, are distributed among security holders, as against asset-based security, which does not make sure such revenue distribution, rather the issuer can pay profits to the security holders from the revenues of any other asset.
Accordingly, asset-based security holders receive profits from the issuer, irrespective of whether the profits are paid out of the revenue streams generated by the asset subject to finance or not. Consequently, the issuer feels comfort while issuing asset-based security, because he is not worried about the generation of revenues from the asset, subject finance, rather he can pay profits to the security holders from any other source of revenues. This became the main factor behind the popularity for the issuance of asset-based securities and this is why ‘sale and lease back Ijarah’ and ‘sale and purchase back diminishing Musharakah’ structures were practiced, especially for the government guaranteed/ sovereign Sukuk, to either provide liquidity to the government or to finance budget deficit.
On the other hand, the corporate Sukuk issuers felt comfort, providing assets to make ‘sale and lease back Ijarah’ and ‘sale and purchase back diminishing Musharakah’ structures Shariah compliant when either they needed liquidity for their businesses or to convert their conventional loans into Shariah compliant financing.
Issuance of asset-based securities provided room for the growth of Islamic finance in the infancy stage, where the motive was to introduce Islamic finance as parallel to conventional loans. However, since this infancy stage has passed, asset-backed securities should replace the issuance of asset-based securities.
The issuance of asset-backed securities can provide the following distinguished advantages:
a) The central governments will have to make strategic planning before receiving finance to make sure that assets subject to finance must produce revenues, by themselves;
b) The Shariah principle of ‘economic purpose/materiality’ will be served which is unfortunately lacking in most of the issues of asset based securities;
c) There will be control over deficit financing and obviously will help control inflation;
d) Funds will be utilized to finance new capital development expenditure of the Central government which will yield the prosperity of the general public.
Based on the above advantages, it is hoped that Islamic finance can rapidly achieve its true objective, in near future, as soon as the asset-backed securities are issued instead of issuance of asset based securities.
Senior vice president & head of product development & research, MCB Islamic Banking Group
While supporters of Islamic finance have reasons to be joyous over the impressive growth of Sukuk, especially in Malaysia, caution must be exercised when advising investors and issuers on matters related to Sukuk. The current trend in Sukuk structuring is towards debt-based structures, which render most of the Sukuk issued similar to conventional bonds in their risk-return profile. This is a significant concern given the increasing share of Sukuk in the total assets under management of institutions offering Islamic financial services (at present assets under Sukuk are estimated to be about one fifth of the total global Islamic financial assets of US$1.35 trillion, according to the Global Islamic Finance Report 2012).
An over-emphasis on asset-based Sukuk structures means corporates and sovereigns borrowing from the Islamic capital markets will increase their indebtedness, thus magnifying the use of leverage in their capital structures. This will not only endanger operational sustainability of the borrowing corporates but will also contribute to the instability of the Islamic financial system as a whole. Governments borrowing through debt-based Sukuk structures like commodity Murabahah are draining the Islamic capital markets of the liquidity required for real private sector investments. This will result in governments using Islamic structures to finance their budget deficits.
As Malaysia is at the forefront of Sukuk issuance, it is absolutely imperative for the government (Securities Commission Malaysia) to actively discourage commodity Murabahah in Sukuk structures, and ensure that there is no secondary market for such Sukuk that have already been issued. Failure to do so may result in a debt crisis that has the potential to bring down every stakeholder in the industry. There is a lot at stake for Malaysia. Currently, Kuala Lumpur is attracting a lot of interest in its Islamic finance industry. In the event of a crisis, popularity will diminish. If one takes for example Bahrain: once a central player in Islamic finance; today it is a struggling financial center.
Asset-based Sukuk are all but conventional bonds in their economic effects. In the event of default, investors may end up losing significantly and will not have any recourse to an underlying asset. Sukuk defaults have just started. For instance, there are problems on the horizon for those who invested in Dana Sukuk, which was a nearly US$1 billion Sukuk maturing on the 31st October 2012, but with the obligor out of cash hindering paybacks to the investors. It will take one large default to happen in Kuala Lumpur before investors will start going elsewhere. We definitely will not like to see all the effort, time and money invested in Islamic banking and finance in Malaysia to be at stake. Hence, this is a precautionary note on the use of asset-based Sukuk at the expense of asset-backed Sukuk.
PROFESSOR HUMAYON DAR
Chairman, president & CEO, Edbiz Consulting
Clarity about the terminology is essential.
I understand ‘asset-backed’ to mean that the underlying asset has fully transferred to the ownership of the Sukuk structure. Consequently insolvency of the original owner which has sponsored the Sukuk’s creation does not imperil the asset. Furthermore failure by the sponsor to perform its contractual obligations will mean that the special purpose vehicle (SPV) used to issue the Sukuk can sell the asset and distribute the funds to the Sukuk investors.
I understand ‘asset-based’ to mean that the underlying asset is not fully transferred to the Sukuk issuing SPV. Instead the SPV merely has some legal rights sufficient to enable the Shariah Supervisory Board to sign off the Sukuk as Shariah compliant. If the original owner becomes insolvent, its creditors can seize the asset. Conversely the SPV does not have sufficient ownership of the asset to sell it in the case of failure by the original owner to honor its contractual commitments under the Sukuk arrangements, such as paying rent for use of the asset.
For many years the ratings agencies warned that most Sukuk being issued by GCC companies should be regarded as only being asset-based (using the above definitions) for several reasons, including insufficiently developed insolvency laws and local restrictions on ownership of land by foreign persons. Investors largely ignored these warnings until the recent Gulf financial crisis.
Investors in asset-based Sukuk (using the above definitions) have much less security than investors in asset-backed Sukuk. They need to satisfy themselves that they are being paid a return commensurate with the additional risks that they are taking on.
Islamic finance consultant and former UK head of Islamic finance at PwC
The pure structuring of the Sukuk (asset-based/asset-backed) should have no impact at all on how the Islamic creditors behave (lenient and magnanimous through restructuring and grace – firstly amicable by all means), since Shariah makes no distinction in this case.
Should the conventional creditors decide not to abide by the Islamic prescriptions — as can be expected since they will look greedy to the available assets and only have eyes for the pure monetary aspect of the situation — then probably conventional debtor protection schemes will come in play and failure thereof real default will be declared. Fast unwinding/enforcement will be the case. It is obvious that this will be at the cost of all parties directly involved and indirectly of the community at large.
It becomes more and more clear that same as structuring issues, dispute settlement for Islamic financial instruments should be dealt with in an Islamic environment. Or at least that legal engineering by convinced and dedicated practitioners for these cases should be stepped up one notch.
Senior foreign counsel, Azmi & Associates law office (Kuala Lumpur-Malaysia and Singapore); Lawyer, Antwerp Bar Association (Belgium); CEO, Senturiyon Global
The distinction between asset-backed and asset-based Sukuk has emerged following the first defaults under Sukuk that arose in 2009 and the earlier position taken by the AAOIFI as regards the criteria that should be strictly complied with in order to ensure that a Sukuk issuance is a genuine Shariah compliant issuance. In a nutshell, the AAOIFI made it clear that Sukukholders must be the true legal owners of the underlying assets. This will ensure that, in case of default of the Sukuk issuer, the Sukukholders can directly manage the underlying assets themselves.
However, it is debatable whether the new Sukuk issuances strictly comply with the above rule. In practice, this rule has led to the ownership in the underlying assets being passed by way of a true sale from the originator of the Sukuk to an ad hoc SPV that will issue the Sukuk and act as trustee for the Sukuk holders for the management of the underlying assets. However, this new type of structuring does not, in itself, ensure Shariah compliance for those new issuances. Indeed, one should still check whether the Sukukholders are actually granted ownership rights in the underlying assets and therefore will recover effective management rights over the underlying assets in case of default of the SPV. If this latter criterion is not complied with, the new issuances will have the same drawbacks as the former Sukuk issuances in case of default by the SPV. This means that the classification of Sukuk as ‘asset-backed’ or ‘asset-based’ is, in itself, irrelevant.
Managing director, Dananeer