The Islamic Debt Market for Sukuk Securities - Term Paper Example

Introduction Islam has an exceptional dispensation on financing instruments, wealth ownership and distribution. The Sharia law has a great impact on Islamic finance. Kettell (13) states that all agreements involving finance and investment decisions must be in line with the guidelines outlined in the Islamic faith and the provisions of Sharia law. Islamic finance is structured in a manner that ensures mutual benefits between debtors and creditors. Investment in the Islamic finance is based on the stock market and the real estate. Sukuk have emerged as the most commonly used financing means in the Islamic economy in the recent past. Sukuk have gained popularity in Islamic finance as one of the best strategies to raise funds over the last few decades. Sukuk can be termed as legally acceptable certificates or securities issued in the Islamic economy with the intention to raise capital. These certificates serve the same purpose as bonds in the western economies. Bonds are not accepted in the Islamic finance structure since they carry an interest rate. Charging interest on securities is not acceptable under the Islamic sharia laws since it violates the principle of contractual certainty and mutual benefit between the financier and the debtor. According to the Islamic faith, wealth is God given, and mankind was created to guard and make good use of wealth and resources. In this regard, charging interest on bonds is against God’s will on equality and brotherhood. The Islamic sharia law is the foundation on which the Islamic finance is built. For any financial decision to be acceptable in the Islamic economies, it must fulfill all the requirements enshrined in the sharia law. The concept of Sukuk Sukuk is an Arabic word used to refer to securities that are structured in accordance with the provisions of the Islamic law and intended to raise capital (Ariff, Iqbar, and Mohamed 13)Sukuk are used to stand in place of undivided shares in the ownership of real/visible assets concerning a specific investment undertaking. For Sukuk to be issued, there must be a clear record of the existing tangible assets on the balance sheet of the entity intending to raise capital. The process of issuing Sukuk starts by identifying the assets of the entity to assess their validity. The next step involves arrangement of an effective organizational structure that respects the Sharia law. Once an effective organizational structure has been established, the adjacent step involves the application of a suitable Sariah structure. Once that has been accomplished, a lead manager is selected, and legal documentation, based on Islamic law, is agreed by both parties. Legal documentation gives authority for the securities to start circulating in the market. It is apparent that the investment in Sukuk is aimed at financing trade. In essence, through Sukuk investment, security of real assets is enhanced thereby promoting promising returns on investment in the future. The difference between Sukuk and bonds There are several differences between Sukuk and Bonds. For instance, Sukuk do not carry any interest rates as is the case with bonds (Safari, Mohamad and Ariff 42). The Islamic law forbids tagging of interest on securities since it is against God’s teachings. In Islam, people are not supposed to take advantage of others to acquire wealth. The returns from Sukuk are expected to flow from transactions such as leases and sharing of profits. Unlike in Sukuk, the only way to fetch returns from investment in bonds is through additional amount charged on a loan, the interest rate. In bonds, the principle employed is the time value for money. In this regard, the payment duration is determined by considering the performance of the economy at the time of issuance and the projected future performance. The basic requirement for issuance of Sukuk is existence of tangible assets. Absence of tangible assets does not guarantee returns from investing in Sukuk. On the contrary, issuance of bonds does not require the presence of tangible assets. Instead, simple receivables can qualify a firm to invest in bonds. In Sukuk, the contract is based on tenancy or a distinct business transaction between the Sukuk holders and the issuers. Issuance of Sukuk develops a mutual relationship between the Sukuk holder and the issuer such that no party is discriminated in terms of earning. On the other hand, contract in bonds is based on earning money. In fact, the relation that emerges in bonds is a lender-borrower relationship. How has the Sukuk become an alternate source of capital to fund mega infrastructure and other development projects? Construction of mega-infrastructure and development of large scale business projects require stable and reliable source of fund. An investor must establish the sources of finance first before commencing a development project. Apparently, there are abundant sources of funds in the world economy today but only a few of them are reliable for long term projects. The exchange rates in the international market keep fluctuating from time to time and so does the cost of operating businesses and development projects. The world economy has experienced a lot of dynamism in the past few decades. As a result, numerous financing instruments have been developed for both short and long term financial needs. Sukuk is among the financing instruments that have developed as major financing tools in the Islamic finance for funding mega infrastructural development and business projects. The use of Sukuk as instruments for raising capital has been a gradual process. In essence, the full use of Sukuk in financing activities has been a challenging transition. Governments of various Arabic countries have put endless effort in ensuring that Sukuk receive international recognition as a financing tool. For instance, in the late 1990s, Pakistan enacted a law that legalized the use of Mudarabah Sukuk to raise capital. Since then, many developments have occurred in the Islamic financial market to promote full inception of Sukuk as financing tools in Islamic countries. Introduction of Sukuk in the Islamic financial market increased the mechanisms used for sourcing funds and planning development strategies. A recent survey showed that the market for Sukuk has grown to over $100 billion, and it is anticipated that the market will do even better in the future. Indicators such as oversubscription in the global market and adoption of the Sukuk by conventional financial institutions are clear affirmations that the market will be larger in a few years to come. The rapid growth and adoption of Sukuk as a financing strategy by businesses and organizations across the world has been contributed by a number of factors. For instance, Sukuk financing is fresh in the market and the rates of return are attractive. Investment in Sukuk has proved to be among the best rewarding investment decisions. The chances of losing investment capital on Sukuk are less compared to other methods used to raise capital such as bonds. Sukuk have aided in overcoming the challenges of borrowing from Islamic banking by offering an alternative means of raising funds. Both private investors and the government can borrow money for mega projects more conveniently than borrowing from banks. A comprehensive analysis of the Islamic institution depicts that there is surplus capital that lay idle. In this regard, introduction of Sukuk in the market has provided an alternative for investing the surplus capital. The Sukuk market is not limited to the Islamic banks only and, therefore, other banks are free to join the market. With Sukuk, it is possible to raise huge amounts of capital so long as permissible assets are present. In addition, no interest rates are charged on issuance of Sukuk. The investor is assured to recover the invested capital since there are tangible assets attached to Sukuk. In this regard, many investors, both the Muslims and non-Muslims, have turned to Sukuk financing since it is cheap and convenient. In additional, Sukuk have gained international recognition and therefore it is possible to conduct multinational projects by means of Sukuk financing. In essence, investment in the Sukuk market is open for any government or business entity therefore investors from different countries can join. The only requirements are; availability of tangible assets and conducting transactions in accordance with the Islamic law. In this regard, Sukuk financing has emerged as a convenient strategy for funding mega projects in the Islamic world and across the globe. Types of Sukuk securities Pure Ijarah Sukuk These securities are issued based on individual assets recognized on the financial statements of an organization. The profits on these securities can either be fixed or floating depending with the source. The assets in consideration can either be part of a leased building, land or equipment. The issuer must be certain about the existence of the tangible assets in question. Apparently, these securities give the holders the right to ownership of real estates and; therefore, they can enjoy proceeds such as rent and leasing fee. The holders of these securities assume all the damages and maintenance expenses for the real estates. Hybrid pooled Sukuk These type of securities are based on a collection of assets and can consist of Istisna, Murabahah, and Ijarah. Having a collection of assets comprising of varied classes, facilitates effective deployment of finances. It is important to understand that least 51% of the group of assets to be considered must be from Ijarah for these securities to be valid Variable rate redeemable Sukuk These type of securities consider comprehensive representation of tangible assets on the balance sheet. These securities are commonly referred to as Musharakah term finance certificate since it does not only cover part of the balance sheet but also provides a detailed analysis of the balance sheet to identify the strength of each asset. Zero-coupon non-tradable Sukuk These type of securities are based on the tangible assets envisioned for materialization but are not available. The reason behind issuing zero-coupon non-tradable Sukuk is to create more assets for a company. Securities of this type cannot be traded because they do not fulfill all the requirements for financing instruments as directed by the Islamic law. Process and Issuance of Sukuk (Twareeq) Tawreeq is the Arabic term used to refer to the process of issuing certificates such as the Sukuk. The process involves an outline of all legal requirements for successful issuance of securities. The key objectives of Twareeq include; improving the efficiency of financing transactions, ensuring perfect compliance with the Islamic law, minimizing risks involved in financing activities, and providing foreign exchange guidelines to financial institutions. For the process and issuance of Sukuk to be effective there must exist a mutual agreement between the issuer and the obligator. The general process for issuing Sukuk starts by identification of tangible assets possessed by the enterprise wishing to raise capital. The identified tangible assets are then relocated to a special purpose Mudarabah (SPM) for an already decided buying price. Once the assets have been transferred to SPM, they are detached from the issuer’s balance sheet, thereby eliminating future financial risks that might face the issuer. It is important to note that SPM serves as an affirmation to the investor about financial security and credit quality of the Sukuk. After reaching the agreed maturity period, the assets are sold back to the owner at an agreed price, and the payment is made to the investor. The price is predetermined before accepting an offer in order to ensure financial security of the investor. The core principle guiding the Sukuk market is financial security of the investor. Conclusion The Islamic finance has diversified in the recent times. The dynamics in the world economy and complexities in Islamic banking have led to the establishment of Sukuk as a financing tool. Sukuk have proved to be reliable means of raising funds for Mega infrastructure development. Sukuk is different from bonds since no interest is charged on them. For Sukuk to be issued, an organization must show prove of tangible assets. The Islamic law is the basis on which all guiding principles regulating process and issuance of Sukuk are founded. The use of Sukuk as a financing tool is projected to gaining more popularity across the world in the future. Works cited: Ariff, Mohamed; Iqbar, Munawar and Mohamed, Shamsher. The Islamic Debt Market for Sukuk Securities: The Theory and Practice of Profit Sharing Investment. Cheltenham: Edward Elgar Pub, 2012. Print. Kettell, Brian. Islamic Banking and Finance: 2 Volume Set. Chichester: John Wiley & Sons, 2011. Print. Safari, Meysam; Mohamad, Shamsher and Ariff, Mohamed. Sukuk Securities: New Ways of Debt Contracting. Hoboken, N.J: Wiley, 2014. Print. Read More