Sukuk in the South Asian stock market

Islamic financial institutions and activities have been growing rapidly in recent years. The size of global Shariah/Islamic-compliant assets is estimated at $1.8 trillion, including banking assets, sukuk, and funds. Within this amount, approximately 15 per cent is in the form of sukuk. Sukuk is the Arabic name for financial certificates, but commonly refers to the Islamic equivalent of bonds. Since fixed-income, interest-bearing bonds are not permissible in Islam, sukuk securities are structured to comply with Islamic laws and investment principles, which prohibit the charging of and/or paying interest.
Sukuk  is generally done by involving a tangible asset in the investment. For example, giving partial ownership of a property built by the investment company to the bond owner accomplishes this purpose, since the bond owner is then able to collect his profit as a rent, which is allowed under Islamic laws. Sukuk can be structured alongside different techniques. While a conventional bond is a promise to repay a loan, sukuk constitutes partial ownership in a debt (sukuk murabaha), asset (sukuk al-ijara), project (sukuk  al-istisna), business (sukuk al-musharaka), or investment (sukukn al-istihmar).
As sukuk provides an alternative long-term financing for key sectors, such as infrastructure  assets that provide long-term stable cash flows are usually suitable to back sukuk structures. The sukuk market size itself has grown rapidly by approximately 20 per cent annual compounded growth rate in the last five years. As a financial tool, sukuk enables more diversified financing for government and private-sector entities alike.  For people who follow shariah principle strictly, sukuk as an Islamic financial instrument provides one of only a few options for financing and investment. Therefore, developing sukuk is a way to mobilise financing and savings for a segment of population in the South Asian region that would not be otherwise served by conventional finance vehicle. For many  sukuk provides an avenue to tap a new investor base, that is, individuals or institutional investors in the South Asian financial markets, both domestically and internationally.
As shariah considers money to be a measuring tool for value and not an asset in itself, it requires that one should not receive income from money (or anything that has the genus of money) alone. This generation of money from money (simplistically, interest) is "riba", and is forbidden. The implication for Islamic financial institutions is that the trading and selling of debts, receivables (for anything other than par), conventional loan lending, and credit cards are not permissible.
This principle is widely understood to mean uncertainty in the contractual terms and/or uncertainty in the existence of an underlying asset in a contract, which raises issues for Islamic scholars when considering the application of derivatives. Shariah also incorporates the concept of maslahah or "public benefit", denoting that if something is overwhelmingly in the public good, it may yet be transacted - and so hedging or mitigation of avoidable business risks, may fall into this category, but there is still much discussion to come on this issue.
The characteristics that distinguish sukuk from other Islamic instruments and which have contributed to its widespread prevalence are: (a) principle of participation in profit and loss, (b)  documents issued on behalf of the owner of categories of equal value and  (c) issued and traded in accordance with the terms and conditions of shariah.
Sukuk securities tend to be bought and held and, as a result, little of the securities enter the secondary market (allowing them to be traded). Furthermore, only public sukuk are able to enter this market, as they are listed on stock exchanges.
According to Global Islamic Finance Report 2014, $1.813 trillion of assets are being managed according to Islamic investment principles. Such principles form part of shariah, which is often understood to be 'Islamic Law', but it is actually broader than this in that it also encompasses the general body of spiritual and moral obligations and duties in Islam. In the Persian Gulf region and Asia, Standard & Poor's estimates that 20 per cent of banking customers would now spontaneously choose an Islamic financial product over a conventional one with a similar risk-return profile. Such religiously inspired non-interest loan systems can be quite mystifying for outsiders. Here the universe of investable securities is limited by certain criteria based on moral and ethical considerations. Islamic finances are also a subset of the global market, and there is little to prevent the conventional investor from participating in the Islamic market.
The emergence of Sukuk has been one of the most significant developments in Islamic capital markets in recent years. Put simply, sukuk instruments act as a bridge. They link their issuers, primarily sovereigns and corporations in the Middle East and Southeast Asia, with a wide pool of investors, many of whom are seeking to diversify their holdings beyond traditional asset classes. In this way, funds raised through sukuk can be allocated in an efficient and transparent way to infrastructure initiatives and other deserving projects in the 56 member countries of the Islamic Development Bank (IDB) as well as communities in over 100 non-member countries. Both domestic and foreign investors buy sukuk having various structures approved by shariah boards of Islamic scholars.
The secondary market, while developing, remains a niche segment with virtually all of the trading done at the institution level. The size of the secondary market remains unknown, though LMC Bahrain states they traded $55.5 million of sukuk in 2007. The European Islamic Investment Bank (EIIB) in an interview published on sukuk.net stated "Secondary market trading volume has contracted significantly in the first half of 2008 when compared to 2007 where sukuk with a nominal value of approximately $0.5bn was traded."
"Sukuk bonds" are designed to get around religious laws banning the payment of interest for money lending. But one of the most volatile debts in the Dubai World standstill is a $3.5bn Islamic bond due to be repaid in December. HSBC estimates there is $822bn Islamic finance debt outstanding in the world.
Sukuk issuance has proven its resilience during recent periods of turbulence in global capital markets. Sukuk issuance increased from US$ 14.9 billion in 2008 to US$ 23.3 billion in 2009, with Asia showing particular strength. Even so, the sukuk market is still a niche one, with huge potential for growth. The sukuk growth rate is currently 10-15 per cent in global financial markets.
Several South Asian countries are seriously engaged in efforts to develop their domestic sukuk markets, with different levels of success to date.  Bangladesh, Brunei, Hong Kong, Indonesia,  Malaysia and Pakistan are the countries which are offering sukuk as  sovereign or quasi-sovereign while in Indonesia,  Malaysia and  Singapore sukuk has been scaled up to corporations. Modern sukuk emerged to fill a gap in the global capital market. Islamic investors want to balance their equity portfolios with bond-like products. Because sukuk are asset-based securities - not debt instruments - they fit the bill. In other words, sukuk represent ownership in a tangible asset, usufruct of an asset, service, project, business, or joint venture. Each sukuk has a face value (based on the value of the underlying asset), and the investor may pay that amount or (as with a conventional bond) buy it at a premium or discount.
As with conventional bonds, sukuk are issued with specific maturity dates. When the maturity date arrives, the sukuk issuer buys them back (through a middleman called a Special Purpose Vehicle). However, with sukuk, the initial investment isn't guaranteed; the sukuk holder may or may not get back the entire principal (face value) amount. That's because, unlike conventional bond holders, sukuk holders share the risk of the underlying asset. If the project or business on which sukuk are issued doesn't perform as well as expected, the sukuk investor must bear a share of the loss.
Most shariah scholars believe that having sukuk managers, partners, or agents promise to repurchase sukuk for the face value is unlawful. Instead, sukuk are generally repurchased based on the net value of the underlying assets (each share receiving its portion of that value) or at a price agreed upon at the time of the sukuk purchase.
In practice, some sukuk are issued with repurchase guarantees just as conventional bonds are. Although not all shariah scholars agree that this arrangement complies with Islamic law, a product called sukuk ijara may come with a repurchase guarantee.
At the moment lack of standardisation, narrow liquidity and concern regarding insolvency regimes are key impediments, among others, for further growth of the sukuk asset class. In developing domestic sukuk markets, policy makers should use a framework similar to that of the development of conventional bond markets. Establishment of well-functioning money markets, efficient primary markets and security offering regimes and a robust and diversified investor base will be important. A market infrastructure that facilitates trading, price transparency, and efficient  clearing and settlement of transactions and derivatives market and hedging tools to support risk management by issuers and investors  and a credible legal and regulatory framework  will be imperative.
Dr Muhammad Abdul Mazid is Chairman, Chittagong Stock Exchange Limited and Chairman, South Asian Federation
of Exchanges.   
 [email protected]