Islamic Finance: Sukuk – The Next Growth Market?

Securities & Investment Institute CPD Seminars Thursday, 14 th February 2008

Contents

6.

7.

8.

9.

1.

2.

3.

4.

5.

The Islamic Market International Sukuk Universe Sukuk Issuer Demographics Sukuk Investor Demographics Islamic Financial Structures Islamic Financing Techniques Drivers For Secondary Market Liquidity Islamic Finance In The UK Conclusion 2

The Islamic Market

• The Islamic market in terms of invested assets is estimated to be worth

circa

US$750 billion globally, and is growing at 10% to 15% p.a.

• There are approximately 1.5 billion Muslims worldwide, accounting for 20% of the world’s population, of which 80% live outside the Middle East.

• Forecasts predict that the global Muslim population will grow to 2.5 billion people over the next 20 years, representing 30% of the world’s population.

• Current personal wealth in the Middle East is estimated to be US$1.5

trillion, and is the fastest growing sector in wealth management.

•

Sukuk

(“Islamic bonds”) issuance is estimated to total in excess of US$98 billion globally (including Malaysia).

Source: Standard & Poor’s and Bloomberg

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International Sukuk Universe

International Sukuk Universe 3 5 3 0 2 5 2 0 15 10 5 0 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6 2 0 0 7 Source: Bloomberg Currency Denomination 30000 25000 20000 15000 10000 5000 0 AED USD SAR BHD Other Profit Rate Profile Fixed Floating Convertible

4

Sukuk Issuer Demographics

18% 15% 8% 19% 8% 2% Sovereign Real Estate Source: Bloomberg Banks Energy 30% Corporates Quasi Transport

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Sukuk Investor Demographics

• Islamic investors: – Islamic banks – – HNWIs GCC institutional investors • Conventional investors: – Specialist convertible houses – Hedge funds • Investors demographics in selected Sukuk issues – Nakheel ($3.52bn) : • European (40%) • • Middle Eastern (38%) Rest of the world (22%) – Aldar Properties ($2.53bn): • International (70%) • Middle Eastern (30%) 6

Islamic Financial Structures

• It is acceptable for investors to make a financial return from: – Owning physical manufactured goods) assets (e.g.

commodities, real – – Leasing or renting physical assets Sharing of risk in a commercial venture estate and • Principles to be kept in mind when determining the Islamic acceptability of financing techniques: – – Speculation Unjust enrichment/ exploitation – – Interest Uncertainty 7

Islamic Financing Techniques

• • • • • • •

Murabaha

– The sale of goods with an agreed-upon mark-up on the cost (cost plus finance).

Tawarruq

– The purchase of goods for deferred payment and their subsequent sale for cash to a buyer other than the original seller at a lower price for the purpose of raising cash.

Ijara

– Islamic finance equivalent of leasing.

operating and finance lease.

Hybrid between conventional

Istisna

– A contract of sale of specified goods to be manufactured (construction financing).

Salam

– A contract for the purchase of a commodity for deferred delivery in exchange for immediate payment (financier pays in advance for the purchase of fungible assets).

Musharaka

– Joint venture, partnership whereby each party contributes capital in equal or varying degrees to establish a new project or to share in an existing one.

Mudaraba

– A partnership in profit between capital and work in which one partner contributes money and the other expertise, time and effort.

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Sukuk Al Ijara

• An

ijara

is a Sharia'a compliant lease.

• In an

ijara Sukuk

, the obligor (originator) sells certain physical assets to the issuer, funded by cash raised from the issue of Sukuk certificates.

• The issuer leases the asset to a third party, often the obligor itself, and enters into a management agreement with the obligor to manage those assets on its behalf.

• The obligor pays lease rentals to the issuer, which in turn uses this cashflow to pay the profit on the Sukuk certificates.

• The obligor gives a Purchase Undertaking to the issuer under which it promises to purchase the assets of the Sukuk at maturity in order for the Sukuk certificates to be redeemed.

• The cash raised by the obligor from the sale of the asset can be used for general corporate purposes.

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Sukuk Al Ijara (cont.)

4 Purchase Undertaking @ $100m Obligor 2 $100m Sale of Asset $100m 3 Lease Agreement

and

Management Agreement

1. Paying Agent 2. Investment Management

Issuer 1 $100m Certificates Sukuk holders

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Ijara vs. Finance Lease

Ijara

The

lessor

is responsible for major

maintenance

and

insuring

the asset. (The lessee may be appointed as Servicing Agent with responsibility for insuring the asset.) The

lessor

bears primary responsibility for

taxes

.

Finance Lease

The

lessee

is responsible for

insuring

asset the The

lessee

is often responsible for

taxes

.

On

destruction terminates

.

of the asset the

lease

The

lessee

is responsible for any

harm

caused to the asset due to the lessee’s misuse or negligence.

The

asset

may be

transferred

for a fixed price.

at maturity On

destruction continues

.

of the asset, the

lease

The

lessee

is responsible for any harm caused to the asset due to the lessee’s

misuse or negligence

.

The

asset

may be

transferred

for a fixed price.

at maturity 11

Sukuk Al Musharaka

• Musharaka, also known as a joint venture or partnership.

• Two distinct types of Musharaka arrangements: – Sharikat al-aqd is an agreement between two or more parties to combine their assets, labour or liabilities for the purpose of making profits.

– Sharikat al-milk arises when two parties pool their resources to jointly acquire/ own an asset.

• Unlike the sharikat al-aqd, a partner in a sharikat al-milk can give a binding promise to buy all the assets (i.e. the other partners’ share of the asset (s)) at a fixed price (which may be the face value).

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Sukuk Al Musharaka (sharikat al-aqd)

Purpose is to generate profits 6 Profit Distribution $100m 6 Profit Distribution Issuer 3 Management Agreement Musharaka 2 $100m $100m 4 5 Musharaka Management Agreement Purchase Undertaking [???] 2 Partner 1 Sukuk Sukuk holders

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Sukuk Al Mudaraba

• Mudaraba is a partnership in profit whereby one party, the rab al-maal, provides capital and the other party, the mudarib, provides labour.

• The parties agree on a profit share. The profit is distributed according to the profit share agreement.

• Final distribution should be made on the selling price of the assets after accounting for losses.

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Sukuk Al Mudaraba

Mudarib Expertise Profit share agreemen t Mudaraba Rab al-maal Funds

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Drivers For Secondary Market Liquidity

• Sharia’a jurisprudence • Environmental • Structural • Market dynamics • Price discovery 16

Islamic Finance In The UK

• Finance Act 2003: SDLT applicable to individuals.

• Finance Act 2005: Alternative finance arrangements - recognising mudaraba, and murabaha.

• Finance Act 2006: Alternative finance arrangements - diminishing musharaka and wakala. SDLT on companies.

• Finance Act 2007: Sukuk.

• 2008: ???

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Conclusion

• A nascent market with significant growth potential.

• Developments over the past year have been extremely positive.

• Key to enhancing liquidity will be to embrace international best practice without compromising Sharia’a integrity.

• Attract a wide range of investors (Islamic and non-Islamic).

• Innovative liquidity management tools and structured alternative assets.

• Develop uniform and standardised products and documentation.

• Increase use of sukuk.

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Disclaimer

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