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ABOUT THE RESEARCH AND THIS REPORT. This research has been conducted by a research
collaboration of five researchers from three Universities in Malaysia namely University Malaya,
International Islamic University Malaysia (UM) and International Centre for Education in Islamic
Finance (INCEIF). The report provides findings on blockchain sukuk to investigate its legal, Shariah and
regulatory risks and the potential of using RegTech in its compliance. The research was conducted
under the Industry-Academia Collaborative Research Project between UM, and Quanta RegTech
Capital plc (QRC). Funding was provided under Grant No. IF057A -2018 by QRC. This Report was
prepared by the following researchers: Dr Sherin Kunhibava, Dr Aishath Muneeza, Dr Auwal Adam
Sa’ad, Dr Muhammad Ershadul Karim & Zakariya Mustapha. The information in this Report is updated
as of May 2021.
DISCLAIMER The content of this Report is the sole responsibility of its author(s) and any opinions
expressed herein should not be taken to represent an official position of UM, Faculty of Law of UM,
QRC or the external reviewer. This Report is intended for general guidance only. It is not intended to
be a substitute for detailed research or the exercise of professional judgment. The data used in this
Report may have been derived from third-party sources and UM, the Faculty of Law of UM have not
independently verified or validated such data and shall not be responsible for any loss whatsoever
sustained by any organization or person who relies on this publication.
An earlier version of Blockchain Sukuk section 3 has been published by the researchers in Kunhibava,
S., Mustapha, Z., Muneeza, A., Sa'ad, A, Karim, M. E., (2021). A Sukūk on blockchain: a legal, regulatory
and Sharī'ah review. ISRA International Journal of Islamic Finance. Emerald Online [EarlyCite].
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
transmitted in any form, or by any means electronic, mechanical, photocopying, recording or
otherwise, without the prior written permission of the authors, the Faculty of Law of UM and QRC.
For queries and input on this Report please contact:
Faculty of Law
University of Malaya
50603 Kuala Lumpur,
Malaysia.
Email: [email protected]
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Table of Contents List of Figures ............................................................................................................................. 5
List of Abbreviations .................................................................................................................. 6
Acknowledgement ..................................................................................................................... 9
Foreword 1 ............................................................................................................................... 10
Foreword 2 ............................................................................................................................... 11
Foreword 3 ............................................................................................................................... 12
Executive Summary .................................................................................................................. 13
1. Introduction ......................................................................................................................... 15
1.1 Background to Research ................................................................................................ 15
1.2 Research Objectives and Questions............................................................................... 17
1.3 Methodology of the research ........................................................................................ 18
2. Understanding Sukuk ........................................................................................................... 20
2.1 What is sukuk? ............................................................................................................... 20
2.2 Sukuk and Bond ............................................................................................................. 22
2.3 Classifications, Types and Structures of Sukuk .............................................................. 23
2.3.1 Classification based on Technical and Commercial Features ............................ 23
2.3.2 Classification based on Shariah contracts ......................................................... 26
2.4 Sukuk Issuance: The Parties and Processes .............................................................. 27
2.5 Sukuk Market at a Glance ......................................................................................... 29
2.5.1 Effects of Covid-19 Pandemic on Sukuk Market ................................................ 31
3. Blockchain Sukuk - Digitization and Sukuk .......................................................................... 35
3.1 Blockchain and blockchain bonds ................................................................................. 36
3.1.1 An overview of Blockchain Technology .................................................................. 36
3.1.2 Blockchain Bonds Case Studies ............................................................................... 38
3.2 Sukuk on blockchain ...................................................................................................... 42
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3.3 Blockchain Sukuk Case Studies .................................................................................. 43
3.3.1 Blossom Finance Blockchain sukuk - SmartSukuk ............................................. 43
3.3.2 Jibrel Network .................................................................................................... 47
3.4 Advantages of using Blockchain to issue sukuk ........................................................ 48
4. Risk ....................................................................................................................................... 51
4.1 Legal Risks in Sukuk ........................................................................................................ 52
4.1.1 Legal risk in transfer of asset & ownership ............................................................. 52
4.1.2 Legal Certainty and Enforceability when an SPV is Used ....................................... 54
4.2 Default Risk and Legal Issues arising .............................................................................. 57
4.3 Will issuing a Sukuk on Blockchain Eliminate the Legal Issues? .................................... 58
4.4 Would investors be more Secured in a Blockchain Sukuk Compared to a Classical Sukuk
in the event of a Default? .................................................................................................... 62
4.5 Shariah Risk .................................................................................................................... 63
4.5.1 Shariah Risks in Sukuk that have been mitigated through resolutions and
Guidelines of the respective Shariah Bodies. .................................................................. 64
4.5.2 Shariah compliance risks that arise through digitization .................................. 68
4.6 Cyber Risks in Blockchain Sukuk ................................................................................ 73
5. Regtech................................................................................................................................ 75
5.1 Increasing regulatory requirements and Cost of compliance ....................................... 75
5.2 Generations and Development of RegTech .............................................................. 76
5.3 Benefits of RegTech ................................................................................................... 78
5.4 Challenges and concerns in RegTech Adoption ............................................................. 79
5.5. RegTech Adoption: Regulatory sandbox ....................................................................... 80
5.5.1 Regtech Initiatives for Capital Markets .................................................................. 82
5.6 RegTech for Blockchain Sukuk ....................................................................................... 85
6.Key Takeaways of Report ...................................................................................................... 89
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6.1 Findings ..................................................................................................................... 89
6.2 Recommendations .................................................................................................... 91
6.3 Conclusion ................................................................................................................. 93
Appendix A - Interview Questions ........................................................................................... 95
Appendix B – Expert Interviewees ........................................................................................... 98
Appendix C – Sukuk Structures According to various Classifications/categorizations ............ 99
Glossary .................................................................................................................................. 117
References ............................................................................................................................. 123
List of Figures
Figure 2.1 General Sukuk structure
Figure 2.2 Types of Sukuk on the basis of Shariah Contracts
Figure 2.3 Parties/participants in classical sukuk transaction
Figure 2.4 Sukuk issuances 2016 to 2020
Figure 3.1 World Bank’s bond-i process
Figure 3.2 Blockchain Bond and the Allocation of legal and beneficial interest on Blockchain
Figure 3.3 Blossom Finance’s SmartSukuk Structure on Istisna’ and Ijarah for Construction
Project
Figure 3.4 Jibrel’s network infrastructure for sukuk issuance
Figure 5.1 Generations of Regtech
Figure C1. Asset-based (Financial Ijarah) Sukuk Structure
Figure C2. Cagamas Berhad Asset-backed Sukuk Structure
Figure C3. Islamic Development Bank (IDB) combination Sukuk (Trust Certificate)
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Figure C4. Cagamas Commodity Murabahah (BBA) with tawarruq
Figure C5. Bahrain Government’s Salam Sukuk Structure
Figure C6. Tabreed’s Istisna Sukuk Structure
Figure C7. General Mudarabah Sukuk Structure
Figure C8. Aabar Mudarabah Sukuk Structure
Figure C9. Musharakah Sukuk Structure
Figure C10. Imtiaz Sukuk II Berhad Musharakah Sukuk Structure
Figure C11. Wakalah Sukuk Structure
List of Abbreviations
A.H. - After Hijra
AML/CFT - Anti-Money Laundering/Combating or Counter Financing of Terrorism
ASIC - Australian Securities and Investment Commission
AUD - Australian Dollar
BNM - Bank Negara Malaysia [Central Bank of Malaysia]
CBA - Commonwealth Bank of Australia
CEO - Chief Executive Officer
COVID-19 - Corona virus disease 2019
DOI - Digital Object Identifier
E.g. - exempli gratia – For Example
Ed. - Editor
Eds. - Editors
e-KYC - Electronic Know Your Customer or Client
Et al. - Et alia - and others
EVP - Executive Vice President
EWHC - England and Wales High Court
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FCA - Financial Conduct Authority
GCC - Gulf Cooperation Council
I.e. - id est – that is to say
ICO - Initial Coins Offering
ICTs - Information and Communication Technologies
IEEE - Institute of Electrical and Electronics Engineers
IEO - Initial Exchange Offering
IFN - Islamic Finance News
IIUM - International Islamic University Malaysia
IMF - International Monetary Fund
INCEIF - International Centre for Education in Islamic Finance
IsDB - Islamic Development Bank
ISRA - International Shariah Research Academy for Islamic Finance
KYC - Know Your Customer or Client
KYD - Know Your Data
LOLA - Lodge and Launch – [in rules of unlisted capital market products]
MFI - Micro Finance Institution
NB - Nota Bene – Note Well
op. cit. - Opus Citatum or Opere Citato – the work cited or in the cited work
ors. - others
P. - Page
PBUH - Peace be upon him [Translation of Salla Allahu alayhi Wasalaam]
PoC - Proof of Concept
pp. - Pages
Q3 - Third Quarter of a year
QRC - Quanta RegTech Capital
SAC - Shariah Advisory Council
SAW - Salla Allahu alayhi Wasallam [Arabic (Peace be upon him)]
SC - Securities Commission
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SPV - Special Purpose Vehicle
UAE - United Arab Emirates
UK - United Kingdom
UNDP - United Nations Development Programme
US - United States
USD - United State Dollar
Vol. - Volume
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Acknowledgement
In the name of God, most Gracious, most Compassionate.
The research team would like to thank the staff of the Faculty of Law University Malaya for all
the contribution and assistance they have provided on this project, in particular the
researchers would also like to thank Associate Professor Dato Dr Johan Shamsuddin Bin
Sabaruddin, Puan Nur Husna Zakariya, Dr. Ainee Adam, Puan Nurin Hanani and Puan Fanty
Hardiana Binti Minto.
We would also like to thank QRC plc for funding the research.
The researchers are grateful to the experts who graciously allowed us to interview them in
the midst of the Covid-19 Pandemic in 2020 through online electronic communication
channels (in no particular order) - Dr. Farrukh Habib, Mr. Mathew Martin, Dr Alaa Alaabed,
Mrs. Nashwa Badeeu, Mr. Affendi Ariffin, Mr. Edmund Yong, Mr. Hisham Abdul Rahim, Mr.
Kevin Koo, Asst. Prof. Dr. Ziyaad Mahomed, Mrs. Shabnam Mokhtar, Professor Engku Rabiah.
The researchers are grateful to Mrs. Shabnam Mokhtar for reviewing the draft of this report.
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Foreword 1
Innovation in this industrial revolution 4.0 is exponential. At no time in our history have we
seen the pace today at which new technology is displacing technology which was a recent
craze.
In this fast-changing world of ours where information is easily disseminated and technology
is assessable, we need to evaluate the utility and risks which new technology brings. This
research has undertaken a two-year study on the capital market innovation of using
blockchain to issue sukuk which culminated in this report. Sukuk was first issued in 1990 in
Malaysia by Shell MDS Sdn. Bhd., but actually gained popularity as a financing vehicle from
the 2000s. Since those early days, cutting-edge sukuk structures have been created and used
to fund many projects and businesses. One of the latest advancements in sukuk is the use of
blockchain technology to issue sukuk. While sukuk is now mostly issued electronically the use
of blockchain is a novelty.
As blockchain sukuk is a recent phenomenon, not much research has been done on it
especially in relation to risks. To fill this gap, this research investigated the blockchain sukuk
and how the issuance of sukuk on blockchain will address the legal, Shariah and other risks of
sukuk. The research also reviews the use of RegTech in ensuring compliance of the relevant
regulatory requirements of blockchain sukuk. Key takeaways have been identified and
suggested in the last section of this report. This research does not however detail the
technical aspects of the blockchain sukuk nor RegTech. This research was undertaken mostly
during the Covid-19 Pandemic and thus data collection was conducted online.
We hope that this report unlocks further research areas in the area of blockchain sukuk and
RegTech.
Dr Sherin Kunhibava, Dr Aishath Muneeza, Dr Auwal Adam Sa’ad, Dr Muhammad Ershadul
Karim & Zakariya Mustapha.
Research Team
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Foreword 2
We at the Faculty of Law, University of Malaya have been researching on the regulatory needs
of blockchain applications with collaboration from the industry for the past few years. The
Blockchain Regulatory Report published in 2018 was the culmination of the first phase of our
research endeavour in this field. It was the first report that tackled regulatory issues relating
to blockchain technology in Malaysia. Thereafter, the second phase of our funding from QRC
PLC led to further undertakings including research in blockchain and the RegTech realm. This
report is one of the products of this second stage of funding.
We hope that the outcome of this report will further enhance knowledge in the field of
blockchain and RegTech.
Nur Husna Zakaria
Principal Investigator
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Foreword 3
Technology has made possible the continuation of education as the world continues to battle
the Covid-19 Pandemic. It was through the implementation of online teaching and learning
that schooling, traditionally through the Socrates method, continued successfully, albeit
differently. Technology has enabled us to continue living comfortably in a new normal. It is
thus pertinent that continued research in technology be undertaken even in faculties such as
the law faculty where research in technology is uncommon.
In line with this, research on regulatory issues in blockchain began here in 2017 through an
academia-industry collaboration. In 2018, the first Blockchain Regulatory Report was
produced by the Faculty of Law and thereafter this report is the second issued through high
skilled expertise on blockchain sukuk and RegTech.
The Faculty of Law, University of Malaya prides itself in conducting novel research and
producing excellent publications. Our research in blockchain which began as a pioneering
work has developed into deeper exploration into risks relating to blockchain sukuk and
RegTech. We encourage researchers, experts, students and the public to read and provide
feedback on this report and further develop research in technology. As for us at the Faculty
of Law, University of Malaya, we will continue to explore under researched and unresearched
areas.
Dato' Associate Professor Dr. Johan Shamsuddin Bin Dato' Hj. Sabaruddin
Dean Faculty of Law UM
Chairman Law Deans Council of Malaysia
Member Judicial Appointments Commission Malaysia
Board Member Malaysian Legal Profession Qualifying Board (LPQB)
Chairman Governing Council ASEAN Legal Information Centre
Director National Legal Aid Foundation Board
Vice-President Inns of Court Malaysia
Faculty of Law
University of Malaya
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Executive Summary
Technology is fast driving innovations and revolutionizing production and delivery of financial
service. The Islamic capital market has embraced technology in different forms that are used
to facilitate market operations with some of the latest developments seen in the application
of blockchain, a distributed ledger technology, for recording transactions using immutable
cryptography. The Islamic capital market is a crucial segment of the Islamic financial services
industry and sukuk is one of its principal product whose market is worth hundreds of billion
ringgit. The global sukuk market has been growing steadily as a viable source of financing for
public and private enterprises.
Structuring sukuk and sukuk transactions are, however, intricate with long duration to
complete necessary processes and functions that involve several stakeholders, expertise and
consume sizable resources. The stakeholders and/or experts include accounting, legal and
Shariah experts, trustee SPV, rating agent, book runner or underwriter, an investment
institution acting as arranger and so on. The structure of each sukuk is bespoke depending on
several factors such as obligor’s economic objectives and credit rating, nature of underlying
asset, jurisdiction’s legal framework and implication of tax regime on the structure. The
advent of blockchain technology is changing the marketplace and the introduction of
blockchain sukuk in the Islamic capital market sukuk heralds changes in the traditional or
classical sukuk narrative. Blockchain technology is used to provide leverage for digitization of
sukuk in furtherance of dematerialization in the Islamic capital. It is also understood to serve
as a catalyst for optimization of sukuk. Sukuk on blockchain utilizes smart contracts that
encode and execute sukuk functions including the issuance and settlement of the sukuk in a
transparent and reliable manner.
As with classical sukuk, blockchain sukuk transactions are prone to certain risks and challenges
as well. These include Shariah non-compliance risks, legal and regulatory risks in addition to
cyber risks and challenges peculiar to blockchain sukuk alone.
Researchers in this report asked numerous questions and interacted with Shariah scholars,
legal and financial experts in various interviews against the backdrop of blockchain sukuk and
its legal, regulatory and Shariah dimensions. These were examined from the perspective of
current legal regime of Malaysian jurisdiction. Findings and recommendations of the report
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are based in part on the views of the various scholars and experts interviewed and arrived at
through the researchers understanding and critical analysis of underlying issues that are
subject of the research.
Findings by the research establish that the blockchain technology has rendered certain issues
associated with traditional sukuk surmountable. Blockchain sukuk enjoys increased
transparency of underlying assets and cash flows. Blockchain sukuk enhances investment
decision-making given the wealth of information it makes available to investors. Blockchain
sukuk also provides real-time and a uniform view of transaction data, devoid of the need for
many reconciliations, decreases the intermediaries in its issuance and eases processes of due
diligence. This reduces costs and removes certain inefficiencies and frictions plaguing the
financial system so that blockchain sukuk will be not only be relatively cheaper in the long run
and efficient but also sustainable.
The research also finds that issuance of sukuk on blockchain does not address all known issues
in classical sukuk under the extant legal regime. The research ascertains the need for separate
and clear guidelines for blockchain-based sukuk for appropriate regulation of the innovation.
This research also recommends that applicable laws be amended to recognize blockchain as
the register for the transfer of legal title in all types of assets for the purposes of financing.
There should also be clear guidelines on the use of digital assets as the underlying for
blockchain sukuk. Further, there is need to enact Shariah guidelines or standards for
blockchain-based sukuk structure.
This research finds that the use of RegTech with sukuk blockchain will probably reduce the
cost of providing reports to regulators and improve burdensome processes like KYC, AML,
custodianship and whitelisting of different investors, and prevention of tax evasion and also
improve Shariah compliance and governance. This research thus recommends developing
RegTech for blockchain sukuk.
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INTRODUCTION
1. Introduction
1.1 Background to Research
Blockchain sukuk, also referred to as smart sukuk,1 is an innovation in the field of financial
technology whose structure, legal, regulatory and Shariah parameters have not yet been
ascertained in governance circle under extant financial regime. Blockchain sukuk is a digital
financial instrument where blockchain and its embedded smart contracts are used for
structuring and issuing of sukuk among other operations related thereto. A blockchain is a
decentralized, distributed and digital ledger that is used to record transactions across many
computers so that any record it involves, which is in form of a block, cannot be altered
retroactively without altering all subsequent blocks in the chain.2 A smart contract is
computer code written on the blockchain which self-executes the pre-agreed contractual
terms.3
The main factor driving the blockchain sukuk innovation is the quest to lower costs involved
in sukuk issuance by reducing the number of intermediaries involved in the sukuk4 structure.
In the same vein, the use of blockchain technology enhances transparency and eliminates
fraud and speculations in sukuk transactions.5 As such, for corporations and sovereigns
seeking finance, this innovation will assist them to raise finance via capital market in a
1 A sukuk is a debt investment instrument issued in capital market like a bond except that it complies with Islamic principles, i.e., sukuk is devoid of interest, uncertainty and speculation among other elements prohibited by Islam. 2 Acheson, N. (2018). How Bitcoin Mining Works. CoinDesk, 29 January. Available at https://www.coindesk.com/information/how-bitcoin-mining-works/, (accessed 9 Jan 2020). 3 Blockgeeks, (2020). Smart Contracts: The Blockchain Technology That Will Replace Lawyers. Available at https://blockgeeks.com/guides/smart-contracts/, (accessed 9 January 2020). 4 In this research, the term ‘classical sukuk’ or ‘traditional sukuk’ is sometimes interchangeably used to mean sukuk which is issued without the use of blockchain. 5 Murugiah, S. (2018). Sukuk industry could benefit from Blockchain technology, says S&P Global Ratings. The Edge, 25 October. Available at http://www.theedgemarkets.com/article/sukuk-industry-could-benefit-blockchain-technology-says-sp-global-ratings, (accessed 17 January 2020).
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convenient manner. According to S&P Global Ratings Global head of Islamic finance,
Mohamed Damak, blockchain can increase the transparency of cash flows and the underlying
assets in sukuk, while enhancing investors' decision-making through a greater supply of
information. Thus, the technology could pave way for more robust Shariah and financial
auditing of sukuk after issuance, thereby reducing the risk of default because of non-Shariah
compliance.6 This is viewed as a testimony of the benefit that blockchain sukuk can provide
and its great potential to the financial industry.
Conventional blockchain bonds have already gained popularity in the finance industry. For
instance, Telefonica Deutschland Holdings of Germany issued a EUR€ 50millon euro one year
tranche promissory note loan using blockchain in January 2018.7 Also, the World Bank in
August 2018 and August 2019 raised USD$81 million and USD$50 million respectively through
its first and second blockchain-based bond known as bond-i.8 In Islamic finance as well, the
general development in financial technology has informed the innovation of the Islamic
alternative of bonds, the sukuk, to be structured and issued on blockchain. Blockchain was
used in November 2018 in transacting a market deal by Al Hilal Bank for the sale and
settlement of part of its USD$500 billion five-year sukuk in United Arab Emirates (UAE).9 This
was said to be the world’s first blockchain-powered sukuk and, according to the bank’s CEO,
Alex Coelho, the use of smart contracts would, among other benefits, make the transactions
safer.10 More recently, in February 2021, Iran Fara Bourse, one of four exchanges in Iran
6 Ibid. 7 Telefonica, (2018). Telefonica Deutschland Holding AG: Announcement of promissory note loan as a combination of traditional placement and a Blockchain tranche. DGAP-News, 11 January. Available at https://www.telefonica.de/news/investor-relations-en/2018/01/dgap-news-telefonica-deutschland-holding-ag-announcement-of-promissory-note-loan-as-a-combination-of-traditional-placement-and-a-blockchain-tranche.html, (accessed 17 November 2020). 8 World Bank. (2018). Webinar on Blockchain Bond World Bank Treasury. Available at https://www.youtube.com/watch?v=lqYAcDTTAU0, (accessed 7 September 2020). 9 Kramer, M. (2018). Abu Dhabi’s Al Hilal Bank Uses Blockchain For Islamic Bond Settlement. Ethereum Investor, 26 November. Available at https://ethinvestor.net/abu-dhabis-al-hilal-bank-uses-blockchain-for-islamic-bond-settlement/, (accessed 17 January 2020). 10 Uti, T. (2018). World’s First Blockchain-Powered Sukuk Sale Held in UAE. Blockchain Reporter, 27 November. Available at https://blockchainreporter.net/2018/11/27/worlds-first-blockchain-powered-sukuk-sale-held-in-uae/, (accessed 27 January 2019).
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supervised by the Securities and Exchange Organization, disclosed that they will be issuing
sukuk through blockchain.11
The blockchain sukuk is however an endeavor yet to be deeply researched into. Meanwhile,
as Islamic capital market witnesses the emergence of blockchain-based sukuk, understanding
the phenomenon with respect to its governance and compliance becomes imperative in
investment and regulation spaces.
In the light of the foregoing, this research aims to delve deeper and explore the legal and
Shariah implications of the new and innovative blockchain sukuk in the context of Malaysia.
In this regard, the research seeks to present legal and Shariah viewpoints on sukuk structures
that are based on smart contracts via the blockchain mechanism wherein the sukuk is built,
issued and operated. The research also examines the possibility of introducing RegTech in
regulating the new digitized sukuk issuance and other related operations.
This research does not however, explain the technical aspects of blockchain or the technical
aspects of blockchain sukuk, instead it focusses on the legal, regulatory and Shariah related
issues on blockchain sukuk.
1.2 Research Objectives and Questions
The goals/objectives of the research are as follows:
1. To understand the nature and differences between blockchain sukuk and the classical
sukuk structures.
The research finds out the differences between the classical sukuk and blockchain sukuk
structures and the advantages if any of issuing sukuk on a blockchain.
2. To examine the legal, Shariah and other issues of blockchain sukuk.
Blockchain sukuk, as capital market instruments, are viewed in the light of securities law and
regulations. Legal, Shariah and other risks are explored in this research.
3. To explore how RegTech could be used to regulate blockchain sukuk.
11 Tamano, N. (2021). Iran Fara Bourse eyes blockchain Sukuk following launch of capital market initiatives. IFNFintech, 24 February. Available at https://ifnfintech.com/iran-fara-bourse-eyes-blockchain-sukuk-following-launch-of-capital-market-initiatives/, (accessed 7 May 2021).
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For regulating blockchain sukuk, the classical way of regulating the sukuk market might not
be sufficient. As such, this research attempted to explore the role that RegTech could play in
regulating blockchain sukuk.
Thus, to achieve the objectives this project explores the following research questions:
1. What are sukuk and blockchain sukuk?
2. What various risks e.g., legal, Shariah and so on faced by sukuk can be overcome by
issuing sukuk on a blockchain?
3. What role can RegTech play in blockchain sukuk issuance?
1.3 Methodology of the research
This research is exploratory in nature and therefore, qualitative research methodology,
suitable for this kind of research, was employed to attain the objectives of the research. The
data collection was conducted in 2020 during the COVID-19 pandemic, therefore all data
collection was done online and also, using electronic means. The research was conducted
through the following three different stages:
First stage (secondary data collection)
Literature Review: Desk-based study, using online databases and library materials, was
conducted to identify relevant scholarly literature, related regulation/policies and
authoritative materials on sukuk and bond issued and released by renowned organisations
and regulators of leading economies from around the world. Accordingly, relevant literature
comprising of published works, information, guidelines, policies and/or regulation were
collected, identified and reviewed based on international best practices and Malaysia’s legal
and regulatory histories. This helped in better understanding of the nature of sukuk and
blockchain sukuk as well as bonds that either used or promised to use blockchain.
Second Stage (primary data collection)
Qualitative individual interviews: In depth online interviews were conducted with
information-rich individual experts in Islamic finance/corporate finance with background on
technical issues in the capital market. This stage also involved consultation with the experts
that helped in understanding the technicalities and practicalities of issuing sukuk in the
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prospective capital markets using blockchain. From the literature review, a set of open-ended
questions were prepared and reviewed by the research team members. Keeping in mind the
objectives of this research, these questions were evaluated by the researchers and finalized.
Subsequently, these questions were shared with the respondents and due to the complexities
of the issue in research, they were given the opportunity to freely select and answer the
questions that fit their expertise. Through the interviews,12 views and opinions of experts13 in
the areas of sukuk, capital market and blockchain were understood, particularly with regard
to the issuance of bonds and sukuk. The interviews provided bases for understanding the
viability of blockchain or smart sukuk structures and the possible regulatory and other issues
or challenges that were foreseen to emerge in relation thereto. The possible use of RegTech
in blockchain sukuk were also explored during the interviews.
Third stage (data analysis and reporting)
The data collected by way of desk-based research were sorted and sifted, and interviews were
recorded and transcribed. The data, at this stage, was critically analyzed and based on the
analysis, the findings are presented in this research in a descriptive manner.
Including this introduction, the outcome of the research is broken up into six sections. The
next section lays the foundation for this research with the aim to bring meaning to the context
of our findings by explaining the sukuk and its position in the global financial market, while
further exploring the effect and impact of the Covid 19 Pandemic on the issuance and
sustainability of sukuk. Thereafter, the blockchain sukuk is explored where case studies are
presented on blockchain bonds and blockchain sukuk. Relevant opinions and insights of the
respondents shared through the interview are shared and evaluated here. The fourth section
explores the risks in relation to sukuk and attempts to explore whether issuing sukuk on
blockchain can overcome some of the existing risks and also explores some of the risks unique
to blockchain sukuk. Again, respondent interview findings were analysed and incorporated
where relevant. The fifth section explores RegTech and its role and relevance in blockchain
sukuk. Lastly, the sixth section concludes this report with findings and recommendations.
12 See Appendix A for the Interview Questions. 13 See Appendix B for a list of the experts interviewed.
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SUKUK
2. Understanding Sukuk
Section 2 lays down the foundation to understand sukuk before zooming in on blockchain
sukuk in section 3. To keep this section simple further explanations on sukuk are provided in
Appendix C. Issues relating to sukuk are found in section 4 of this report.
2.1 What is sukuk?
The word ‘sukuk’ is a plural form of the Arabic word ‘sak’ which literally means a certificate.
Sukuk has been defined by the Securities Commission Malaysia as ‘certificates of equal value
evidencing undivided ownership or investment in the assets using Shariah principles and
structures endorsed by the Shariah Advisory Council (SAC).’14 According to the Accounting
and Auditing Organisation for Islamic Financial Institutions (AAOIFI), sukuk are “certificates of
equal value representing undivided shares in the ownership of tangible assets, usufructs and
services or (in the ownership of) the assets of particular projects or special investment
activities.”15 As an Islamic capital market instrument, sukuk is frequently referred to as an
investment certificate which is developed as an Islamic alternative to bonds. Bonds are
evidence of loan from an investor to bonds issuer, similar to a loan that a bank provides to a
firm or individual. Repayment of bonds consists of a loan capital (principal) plus interest.
Considering the fact that in Shariah loans cannot receive any increment in form of interest
(riba) over principal, bonds are not permissible.16 To avoid interest and also ensure investors
obtain a return on their investment, issuance of a sukuk requires an exchange of a Shariah-
compliant underlying asset for a financial consideration through the application of various
14 Securities Commission, Malaysia, (2018). Guidelines on Issuance of Corporate Bonds and Sukuk to Retail Investors. Available at https://www.sc.com.my/api/documentms/download.ashx?id=7be24ad9-1846-4de9-8897-d5ed58ec0011, (accessed 19 August 2020). 15 The Accounting and Auditing Organisation for Islamic Financial Institutions, [AAOIFI] (2017). Shari'ah Standard No. 17: Investment Sukuk. Manama, Kingdom of Bahrain: AAOIFI, p. 468. Also available at http://aaoifi.com/shariaa-standards/?lang=en, (accessed 9 August 2020). 16 International Shariah Research Academy for Islamic Finance [ISRA], (2009). Islamic Financial System Principles and Operations, Kuala Lumpur, Malaysia: ISRA, pp. 390-395.
21
Shariah contracts such as ijarah, mudarabah, musharakah, murabahah, bai` bithaman ajil
(BBA), musharakah and others.17 In the sukuk issuance processes, sukuk holders constitute
undivided beneficial owners of the underlying sukuk assets.18 As undivided beneficial owners,
sukuk holders receive profits generated from the sukuk assets or an obligor and are entitled
to the proceeds obtained from selling or leasing of the sukuk assets.19 In practice majority of
Sukuk are structured as debt instrument using various Shariah contracts. Some Sukuk, like the
perpetual ones, have an equity or hybrid feature.
The underlying asset is crucial to every sukuk structure. The structure shall be reviewed and
approved by Shariah advisers to ensure its compliance with Shari’ah.20 Each sukuk structure
is unique and dependent on a number of factors, like economic objectives of an
obligor21/originator22, nature of underlying asset, credit rating of the obligor, legal framework
of the jurisdiction and tax implication of the sukuk structure.23 In addition, every sukuk
involves documentation whereby the whole transaction is prepared in accordance with
agreements and extant laws. This entails deciding on which country or jurisdiction’s law will
govern the sukuk transaction.24 The figure below illustrates the general structure of sukuk.
17 There are 14 types of Shariah structures for Sukuk securitization according to the AAOIFI. See AAOIFI, (2017). Shari'ah Standard No. 17: Investment Sukuk. Available at http://aaoifi.com/shariaa-standards/?lang=en, (accessed 9 August 2020). 18 Securities Commission, Malaysia, (2009), Sukuk, Thomas, Abdulkader (Ed.), Kuala Lumpur, Malaysia: Sweet and Maxwell, p. 21. 19 Ibid. 20 Securities Commission, Malaysia, (2009). The Islamic Securities (Sukuk) Market, Kuala Lumpur, Malaysia: LexisNexis, 14-21. 21 The term ‘obligor’ is used in asset based sukuk for the party who intends to raise financing. 22 The term ‘originator’ is used in asset backed sukuk for the party who intends to raise financing. 23 ISRA, (2009). Islamic Financial System Principles and Operations, Kuala Lumpur, Malaysia: ISRA, p. 399. 24 Ahmad, A. (2016). Regulation, Performance and Future Challenges of Sukuk: The Evidence from Asian Markets. In Mutum, D., Butt, M. and Rashid, M. (Ed.). Advances in Islamic Finance, Marketing, and Management, Bingley, England: Emerald Group Publishing Limited, pp. 35 et seq.
22
Figure 1
2.2 Sukuk and Bond
Sukuk bears certain semblances to bond in that both are investment instruments that can be
traded in the secondary market. However, they differ in terms of their nature and certain
operational requirements. Bond is a fixed income investment instrument issued as evidence
of loan in exchange for a regular payment of interest by the bond issuer (borrower or debtor)
to investors (lenders) over a fixed period.25 There are two cash flows for bondholders
(investors) created by purchasing bonds: face value and the coupon payment. As such, bonds
are papers which evidence indebtedness issued by the Issuer who is the borrower or an “IOU”
with a promise to pay debt at maturity date.
Some Sukuk, driven by commercial demands, may achieve very similar commercial features
to bond (fixed income, pre-determined profit payment, redemption of principal at maturity,
and unsecured claim on the asset). However, the underlying transaction will not be based on
an interest-based transaction. Instead, various Shariah contracts (sale, lease, partnership and
agency) are used to create the obligations which is discussed in the next section. Furthermore,
the underlying asset used in sukuk must be Shariah compliant and the proceed of the sukuk
shall only be used for Shariah compliant purposes. Therefore, it can be said that the main
25 Arnold, G. (2015). The Financial Times Guide to Bond and Money Markets. Harlow, England: Pearson Education Limited, pp. 5 – 6.
Sukuk holders [As Investors]
Obligor[fund raiser] As Seller of Co-ownership
interest
SPV – As Issuer of Sukuk and Trustee
Obligor [fund raiser] As Managing Agent of Assets
or Project
Obligor[fund raiser] As Purchaser of Co-ownership
interests (On maturity)
Payment of Periodic Return
and Principal Amount at Maturity
Purchase
Undertaking Deed
Buy-back
Proceeds Management
Agreement
Funds raised by
sukuk issuance
Master Purchase
agreement
Return on Co-
ownership/beneficial interest
Master Trust Deed
Subscription Payment
Agreement/Contract Cash flow
Figure 2.1 General Sukuk structure [Source: Authors]
23
difference between sukuk and bond is that in structuring sukuk, Shariah compliant contracts
are being used while ensuring that there is no element of Shariah non-compliant activities
involved in it. On the other hand, bond is a transaction based on money lending and
borrowing with a promise by the borrower to the lender to give more than the amount given
when the loan is returned, making the transaction tainted with riba and there are no
restrictions as to the type of activities to which the proceeds received from the bond issuance
can be used. Another difference between sukuk and bond is that in secondary trading of
sukuk, it is compulsory to adhere to Shariah rules while there is no such requirement in bond.
2.3 Classifications, Types and Structures of Sukuk
Generally, sukuk structures are classified from two different bases: on the basis of technical
and commercial features and the type(s) of Shariah contracts used to structure the same. On
the basis of technical and commercial features, sukuk are classified as asset-based and asset-
backed. On the basis of Shariah contracts, sukuk are classified as debt-based and equity-
based. Note that sukuk may accommodate several Shari’ah contracts in a single structure.
2.3.1 Classification based on Technical and Commercial Features
Asset-based Sukuk26
In asset-based sukuk, the source of payment to the sukuk holders are derived from obligor’s
cash flow and the sukuk assets will be recorded on the balance sheet of the obligor. The sukuk
holders will have only the beneficial ownership rights over the sukuk asset and they will have
no right to dispose the assets. Further, the sukuk holders in this case will have no recourse
over the sukuk assets; but they will have recourse only on the obligor and purchase
undertaking at par from obligor is the ultimate recourse.27 In the purchase undertaking, the
obligor will make a promise to buy back the assets from the issuer at the maturity of the sukuk
or happening of an event that requires them to do so as per the agreement, such as happening
of a pre-defined early termination event. In this case, the obligor will buy back the asset from
the issuer for an amount equivalent to the principle repayment and the true market value of
the asset is not considered. As such, at the end of the day, the sukuk holders in this case will
26 See Appendix Figure C1 for illustration of the structure of this sukuk type. 27 Herzi, A. A. (2016). A Comparative Study of Asset Based and Asset Backed Sukuk From the Shariah Compliance Perspective. The Journal of Muamalat and Islamic Finance Research, Vol. 13 No. 1, pp. 25-34.
24
have to rely solely on the financial capacity and capability of obligor to payback what they
invested using their own money or by borrowing it from a third party. In case where the
obligor is unable to buyback the assets as agreed, the sukuk holders are in “no preferential
position to any other creditors, or indeed in no weaker position to any other unsecured
creditor stressing the importance that the purchase undertaking ranks pari passu with any
other of the originator’s senior unsecured obligations.”28
It is essential to note that most of the sukuks offered today are asset-based securities where
the sukuk holders will not have any security interest over the assets though the sukuk has
underlying Shariah compliant assets and the sukuk holders in this case are considered as
senior unsecured securities similar to unsecured conventional bonds.29
Asset-backed sukuk30
Asset-backed sukuk (ABS) involve securities-formation process where sukuk holders are
granted a share of tangible income-generating asset or business coupled with equivalent
share of risk commensurate with ownership.31 A special purpose vehicle (SPV), held and
managed by a trustee who is legally under the control of the sukuk holders, owns the asset
under a true sale transaction with the originator. The function of the SPV is to hold the asset
on behalf of the investors or sukuk holders in trust by way of trust deed created over the
assets. In Asset backed sukuk, securitization32 of an asset involves the sukuk holders investing
in the certificate and would be able to have the underlying asset as security having a
preferential position over the unsecured creditors in case of default of sukuk or the originator
becoming bankrupt.
28 Lotter, P., West, M., Lawton, S., Howladar, K., and Bodard, E. d. (2007). Understanding Moody’s Approach to Unsecured Corporate Sukuk. Special Comment, pp. 5-6. Also, see Haneef, R. (2009). From Asset-backed to Asset-light Structures: The Intricate History of Sukuk. ISRA International Journal of Islamic Finance, Vol. No. 1, p. 104; Dusuki, A.W. and Mokhtar, S. (2010). Critical Appraisal of Shariah Issues on Ownership in Asset-Based Sukuk as Implemented in the Islamic Debt Market. ISRA Research Paper, 8/2010. Available at http://www.iefpedia.com/english/wp-content/uploads/2011/02/B108.pdf, (accessed 20 December 2020). 29 Haneef, R. (2009). From Asset-backed to Asset-light Structures: The Intricate History of Sukuk. ISRA International Journal of Islamic Finance, Vol. 1 No. 1, p. 110. 30 See Appendix C, Figure C2 for illustration of the structure of this sukuk type. 31 Shakil, M. H. (2017). Critical Assessment of the Legal Recourse for the Case of Sukuk Default for the Asset-backed Sukuk and Asset-based Sukuk Structures. European Journal of Islamic Finance, Vol. 7, Special Issue, pp. 1-7; Herzi, A. A., (2016). A Comparative Study of Asset Based and Asset Backed Sukuk from the Shariah Compliance Perspective, Journal of Muamalat and Islamic Finance Research, Vol. 13 No. 1, pp. 25-34. 32 Securitisation is a process of transforming illiquid asset into a liquid one. Contemporary Arabic terminologies for securitisation are Tawriq, Tasnid and Taskik.
25
As such, in asset backed sukuk, the source of payment comes from the revenue generated
from the underlying asset and the sukuk assets are held separate from the books of the
originator. The sukuk holders in this case will have the legal right over the sukuk asset with
the right to dispose of the asset. In case of default, the asset will play a genuine role as the
sukuk holders will have recourse over the sukuk assets.33
Combination Form of Sukuk with Mixed Assets34
Innovation and development in sukuk have resulted in combination sukuk whereby a mixed
portfolio is managed as underlying pool of assets comprising of intangible or receivables like
murabahah and tangibles assets like ijarah. Mixed assets portfolio appears attractive to some
investors which might make a particular project within the sukuk structure more appealing.
Thus, greater opportunity is provided for mobilization of funds. Additionally, combination
sukuk certificate is more flexible to trade in secondary market compared to the entirely debt-
based sukuk such as istisna and murabahah which may not be traded in the secondary market
of certain jurisdictions. An important point to note about combination form of sukuk is the
ratio of mixed portfolio of the underlying assets. By AAOIFI Shariah standards, a mixed
portfolio of not less than 51 percent tangible assets are required to float a combination
sukuk.35
Convertible/Exchangeable Sukuk
Convertible sukuk are those sukuk that carry the right for their holders to convert the
instruments into shares or other securities of the issuer from another entity (third party) that
are listed on a stock exchange. This conversion is to be affected by the sukuk holders during
the tenure of the sukuk or within a reasonable period or at maturity. Exchangeable sukuk are
instruments that give an option for their holders to change them to equity of an entity other
than the issuer of the sukuk. The issuer would decide when exchangeable sukuk are to be so
changed.36 In essence, both convertible and exchangeable sukuk involve option for
33 Herzi, A. A. (2016). A Comparative Study of Asset Based and Asset Backed Sukuk From the Shariah Compliance Perspective. The Journal of Muamalat and Islamic Finance Research, Vol. 13 No. 1, pp. 25-34. 34 See Appendix C, Figure C3 for illustration of the structure of this sukuk type. 35 AAOIFI, (2017). Shariah Standard No. 17: Investment Sukuk. p. 468. Available at http://aaoifi.com/shariaa-standards/?lang=en, (accessed 9 August 2020). 36 Securities Commission, Malaysia, (2012). Sukuk Guidelines, (revised and effective 28 December 2012) paragraph 1.06. Available at http://www.mifc.com/index.php?ch=39&pg=97&ac=247&bb=attachpdf, (accessed 20 August 2020).
26
substitution or swapping sukuk instruments into shares. The conversion/exchange offers the
benefits of fixed income sukuk and equity (shares) in the instruments.
Subordinated/Stapled Sukuk
Subordinated sukuk is an unsecured sukuk that ranks below other, more senior sukuk or
securities with respect to claims on assets or earnings which is also known as junior securities.
In case the sukuk issuer defaults, the sukuk holders who own subordinated sukuk will not be
paid out until after senior sukuk holders/creditors are paid in full. Stapled sukuk is when two
instruments are attached together and cannot be traded separately.
Project Financing Sukuk
In project financing sukuk, proceeds of the sukuk will be used to finance a specific project and
the repayment to sukuk holders in this case will come from the cash flow generated from the
project itself.
2.3.2 Classification based on Shariah contracts
In this classification, two main categories of sukuk are obtainable, i.e., debt-based Sukuk and
equity-based Sukuk.37 Debt-based sukuk are sukuk issued based on debt-related contracts. In
other words, they are Sukuk structured on sale-based Islamic contracts such as ijarah,
murabahah, salam and istisna. Equity-based sukuk on the other hand are based on shared
contribution between investors (sukuk holders) and originator, where both contribute capital
or labor or both according to the contractual terms and returns are determined on profit and
loss sharing.38 Equity-based sukuk contracts may involve musharakah, mudarabah and
wakalah contracts. The type of structures based on this classification are highlighted as
follows.
37 Hamzah, S. R., Bacha, O. I., Mirakhor, A., and Malim, N. A. K. (2018). Empirical evidence of risk shifting in bonds and debt-based sukuk. Journal of Islamic Accounting and Business Research, Vol. 9 No. 5, pp. 687-700. 38 IFSB. (2005). Guiding Principles of Risk Management for Institutions (Other than Insurance Institutions) Offering only Islamic Financial Services (IFSB-1 December). Available at https://www.ifsb.org/download.php?id=4357&lang=English&pg=/published.php (accessed 7 May 2021).
27
Figure 2.2 Types of Sukuk on the basis of Shariah Contracts [Source: authors]
From the above figure, the type of sukuk in accordance with Shariah contracts include
mudarabah sukuk, musharakah sukuk, wakalah sukuk, ijarah sukuk, murabahah sukuk, salam
sukuk and istisna sukuk, among others.39
2.4 Sukuk Issuance: The Parties and Processes
Structuring and issuance of sukuk involve several parties and or participants and each of them
handles a particular integral task in the process. The processes are undertaken and formalized
among the parties via contracts and related strategies at pre-issuance, issuance and post-
issuance of sukuk. The participants normally involved include an originator or obligor, special
purpose vehicle (SPV), rating agency, legal, Shariah and accounting experts, lead arranger,
underwriter(s), servicing banks and investors. It is the norm in capital market and standard
securities dealings procedures that these parties participate and play their respective roles in
securities operations especially bonds. For the fact that sukuk are Islamic equivalent of bonds,
some or all infrastructures required in bonds operations are required in standard sukuk
operations, in addition to Shariah requirements that are unique only to sukuk. The figure 2.3
below illustrates convergence of these parties and/or participants in typical classical sukuk.
39 See Appendix C under headings 2 and 3 for illustrations and explanations on the contractual structures of the types of sukuk highlighted under the two headings of debt-based and equity-based sukuk.
Categories of
Shariah Contracts
Partnership
Contract
Sale
Contract Lease
Contract
Agency
Contract
Ijarah
Sukuk Wakalah
Sukuk
Murabaha Sukuk Istisna
Sukuk
Musharakah
sukuk
Mudarabah
sukuk
Salam
Sukuk
28
1. Originator/Obligor: A sovereign, sub-sovereign (national government), corporate and
multilateral body that desires to raise funds through sukuk issuance. It functions as a seller,
lessee, obligor, servicing agent.
2. Special Purpose Vehicle (SPV): SPV is an entity that functions as an issuer of the sukuk and
a trustee for sukuk holders or investors in the sukuk. The SPV is often established by an
originator/obligor for the issuance of a particular sukuk. It can act as lessor depending on the
kind of contract used in structuring sukuk. SPV makes payment of periodic distribution of
profit (returns) and terminal payment of principal at maturity or dissolution. A third-party
guarantee may also be provided as a form of insurance to the SPV to ensure that all payments
are made by the originator/obligor to investors in fixed-income sukuk such as ijarah sukuk.
3. Shariah experts/advisers: Shariah experts or advisers are the backbone of sukuk structuring
processes. Shariah experts are needed to ensure compliance with Shariah requirements not
only in the structure but also operations of sukuk.
4. Legal advisors/lawyers: Lawyers undertake legal documentation and ensure compliance
with all applicable laws, regulations and governance standards as per chosen governing law(s)
of a particular jurisdiction.
5. Accounting experts/service: Accountants handle processes about the issuers financial and
business record pertaining to regulatory reporting, taxation and related matters for the
Figure 2.3 Parties/participants in classical sukuk transaction [Source: Authors]
Originator/ Obligor
Issuer & Trustee
SPV
Principal Advisr/Lead Arranger/lead manager
Legal Advisor
Rating Agency
Servicing Banks/Broker
age Firm(s)Underwri
ter(s)
Shariah scholars
Investors
Accounting Experts
Sukuk
29
purpose of public disclosure. Accountants take care of accounting information and necessary
disclosure obligations about the originator.
6. Rating agency: an independent institution that provides credit rating by verifying
creditworthiness of the originator and its commitment to financial obligations. It assesses the
credit risk of the sukuk and its originator. Rating facilitates investors’ decision towards
subscribing or investing in particular sukuk.
7. Principal Adviser/Lead Arranger/Lead Managers: Primarily introduces sukuk offer to the
market. It leads and facilitates a group of investors and assign parts of the sukuk to be issued
via syndication, getting the group to underwrite the full amount of the issuance. It can also
act as underwriter, book runner or managing underwriter, principal paying agent and advisor
on related matters. Also known as a mandated lead arranger, it may be a bank or related
financial institution.
8. Servicing Bank and/or Brokerage Firm: designated commercial bank(s) or brokerage firm(s)
assigned to provide various services related to collection and transfer of subscription monies,
sukuk certificate issuance etc.
9. Underwriter: acts as guarantor in sukuk issuance that undertakes to buy all or part of
unsubscribed sukuk (if any).
10. Investors: subscribers of sukuk or sukuk holders who can be individual or institutional
investors. Subscribers assume investment risks such as non-payment by the
originator/obligor.
Complex contractual arrangements bring together and bind these participants in one or
several relationships in sukuk operations. Appendix C explains in greater detail the structures
through case studies.
2.5 Sukuk Market at a Glance
In 2020, the sukuk market started actively with strong activities. However, an outbreak of a
coronavirus disease in December 2019 in China, known as Covid-19, became a global
pandemic that halted almost all businesses and human interactions in all parts of the world.
Consequently, sukuk market halted globally and slowed down at the end of the first quarter
30
through the second quarter of the year 2020. Thus, a significant drop was recorded in total
issuance in contrast to the same period the previous year. Earlier in the year, estimates by
Moody’s have placed total sukuk issuance for the year 2020 at around USD$ 170 billion, same
as 2019, due to low private or corporate issuances occasioned by the pandemic.40 The
projection appears to be on course as issuances began to rebound in the third quarter with
offsetting increases. Moreover, in contrast with the Moody’s “no growth” projection,
estimates by Refinitiv have projected 2020 total issuances to exceed the 2019 total.41
Remarkably, total issuance at the third quarter 2020 has reached USD135.5 billion, a marked
increase of 4.4% above total issuance of USD$ 129.8 billion recorded at the same period in
2019.42 Also, with sukuk outstanding already at over USD$ 600 billion early in the last quarter
of the year, it signals a strong prospect for growth in 2020 that surpasses 2019’s USD$ 543.4
billion.43 Additionally, going by past trends, the sukuk market has been recording growth in
terms of issuances and sukuk outstanding since 2015. Capital market experts and investors
have been optimistic this trend would continue in 2020 until the Covid-19 pandemic. So, the
resurgence in sukuk issuance has revived that optimism.
Sovereigns and corporates sukuk issuances have contributed to the resurgence of the sukuk
market in the third quarter of 2020 after the few months’ stagnation. As sovereigns sought to
make up for deficits in budgets via wider investor base in the third quarter, total sovereign
issuance increased by USD$ 29.15 billion to reach USD$ 83.2 billion. Major issuances were by
Saudi Arabia with total of USD$ 9.96 billion issued as at end third quarter, and Malaysia with
total issuance of USD$ 5.4 billion. Others were and UAE and Oman with respective issuances
of over USD$ 1 billion and USD$ 519 million.44 With respect to corporate issuance, an increase
of USD$ 13.9 billion was recorded in the third quarter which is about 40% of the total
40 Adilla, F., (2020). Moody's projects lower global sukuk issuance in 2020 due to pandemic, New Straits Times, 10 November. Available at https://www.nst.com.my/business/2020/11/639951/moodys-projects-lower-global-sukuk-issuance-2020-due-pandemic, (accessed 29 November 2020). 41 Zawya, (2020). Sukuk issuances will continue to grow in 2020 - Refinitiv, 21 October. Available at https://www.zawya.com/mena/en/business/story/Sukuk_issuances_will_continue_to_grow_in_2020_Refinitiv-ZAWYA20201021055616/, (accessed 2 December 2020). 42 Refinitiv, (2020). Sukuk Bulletin 2020, p. 1. Available at https://www.refinitiv.com/perspectives/wp-content/uploads/2020/12/Refinitiv-Sukuk-Bulletin-Q3-2020.pdf, (accessed 2 December 2020). 43 Zawya, (2020). Sukuk issuances will continue to grow in 2020 - Refinitiv, 21 October. Available at https://www.zawya.com/mena/en/business/story/Sukuk_issuances_will_continue_to_grow_in_2020_Refinitiv-ZAWYA20201021055616/, (accessed 2 December 2020). 44 Refinitiv, (2020). Sukuk Bulletin Q3 2020, p. 2. Available at https://www.refinitiv.com/perspectives/wp-content/uploads/2020/12/Refinitiv-Sukuk-Bulletin-Q3-2020.pdf, (accessed 2 December 2020).
31
corporate issuance of USD$ 34.6 billion since the year begins. Some of the largest issuers were
DP World, UAE (USD$ 1.5 billion) and Saudi British Bank, Saudi Arabia (USD$ 1.33 billion).
Others were Axiata, Malaysia (USD$ 500 million), Tenaga Nasional Bhd., Malaysia (USD$ 721
million) and Bedford Row Capital, UK (USD$ 50 million), a debut sukuk by the UK’s first
corporate issuer, targeted at the UK property market.45 Thus far, the global sukuk market is
led by sovereign and governmental issuers who remain the top issuers accounting for more
than half of annual worldwide issuances.46
Figure 2.4 below shows total annual value of sukuk, issued and reopened, over the course of
the last five years leading, 2016 to 2020. It is illustrative of the five years’ consecutive growth
in the sukuk market which underpins experts and stakeholder’s optimism that same may
continue in 2021 and most likely beyond.
Figure 2.4 Sukuk issuances 2016 to 2020 [Source: Refinitiv EIKON Thomson Reuters]
2.5.1 Effects of Covid-19 Pandemic on Sukuk Market
The Covid-19 pandemic has affected all aspects of the human life. The approach taken by the
world leaders to prevent the spreading out of the disease was lockdown of countries by
closing businesses and confining people to their homes to restrict movement and physical
interactions. This decision gives rise to a ‘new normal’ in the way of people’s dealings and has
45 Ibid. 46 IFSB, (2020). Islamic Financial Services Industry Stability Report 2020, pp. 25-26. See also Moody’s, (2020). Moody's - Sovereign sukuk issuance to rise more than expected in the second half of the year as market conditions recover, 11 August. Available at https://www.moodys.com/research/Moodys-Sovereign-sukuk-issuance-to-rise-more-than-expected-in--PBC_1240828, (accessed 2 January 2021).
32
affected businesses performance and forced many to reduce or retrench a number of
employees. It is estimated that around USD$1.6 billion informal workers lost almost 60% of
their incomes and became bereft of savings and access to social protection.47 Self-employed
people face the same problem as they could not work and earn a living from the confinements
of their homes. As time passed, many businesses collapsed. Financial institutions were
affected by the pandemic as much as capital markets in all jurisdictions. The pandemic has
created a domino effect by starting off as a health crisis and eventually led to economic and
financial crisis that turned into a human crisis. It is notable that the impact of the Covid-19
pandemic differs from one country to another. Generally, however, it has bred poverty and
created inequalities on a global scale. According to the International Monetary Fund (IMF),
the pandemic created an economic impact worse than the 2008 recession.48
On a more specific note, the Covid-19 shocks and setbacks have impacted Islamic capital
market and put to test its overall resilience and strength acquired over the years. Other
factors like sukuk market’s vulnerability to political blockades, oil price shock and economic
sanctions on certain sukuk issuing jurisdictions are to be reckoned with in this regard in
2020.49 The pandemic’s consequent lockdowns have made sukuk issuers and investors
cautious of coming to the sukuk market. This in turn affected investor sentiment and brought
about changes in liquidity as well as grave dislocation in financial and capital markets
generally. The pandemic occasioned delays in and cancelations of sukuk issuance in addition
to potentials of default cases. Consequently, the global sukuk market, having recorded strong
activities in the first two months of the year 2020, was brought almost to a standstill. Thus,
volume of sukuk issuance went down successively in the end of first quarter through the
second quarter of the year by 32% and 27% respectively, in contrast to the same period last
year.50 Despite the market rebounding by the third quarter, a further drop of about 14%, in
47 UNDP, (2020). Brief#2: Putting the UN Framework for Socio-Economic Response to Covid-19 into Action: Insights. Available at https://www.undp.org/content/undp/en/home/coronavirus/socio-economic-impact-of-covid-19.html, (accessed 28 November 2020). 48 Buana, G. K., (2020). Weighing in on the Role of Sukuk in Combating COVID-19. The World Financial Review. Available at https://worldfinancialreview.com/weighing-in-on-the-role-of-sukuk-in-combating-covid-19/, (accessed 27 November 2020). 49 IFSB, (2020). Islamic Financial Services Industry Stability Report 2020, pp. 1 and 6. 50 S&P Global Ratings, (2020). Virus, Oil and Volatility Will Put Sukuk Issuance into Reverse, 13 April. Available at https://www.spglobal.com/ratings/en/research/articles/200413-virus-oil-and-volatility-will-put-sukuk-issuance-into-reverse-11431049, (accessed 2 December 2020); S&P Global Ratings, (2020). Global Sukuk Market: A Window of Opportunity is Opening, 7 July. Available at
33
comparison with the second quarter, was recorded in sukuk with maturity greater than 18
months among jurisdictions in the GCC region, Indonesia, Malaysia, Pakistan and Turkey.51
According to reports, the sukuk market was more affected by the slowdown in activities than
bond market during the first and second quarters of 2020 due to its smaller size,
concentration and lesser liquidity.52 In the fixed-asset market, the pandemic affected the
ability of existing issuers to service outstanding obligations in terms of payment of return.
Certain sectors including airlines, hospitality/tourism, oil and gas, even though constitute a
very small segment with respect to global outstanding sukuk, have considerable amount of
sukuk that mature in months or few years that may need refinancing.53 This refinancing will
be challenging to issuers in liquidity stress due to the economic uncertainty. This resulted in
significant increase in funding cost and need for additional collateral in refinancing existing
sukuk by lenders.54 Likewise, uncertainty of businesses returning to pre-Covid-19 level in the
near future makes short- and medium-term projections no less than disquieting.
The pandemic’s economic shocks have impacted the global economy generally. It has
triggered widening of fiscal deficits and high borrowing needs among sovereigns to provide
healthcare, economic recovery and stimulus packages for families and businesses to mitigate
its direct and incidental consequences. Conversely, these have necessitated sovereigns to
look for funds through sukuk issuance in many Islamic finance jurisdictions. The sukuk market
has pulled through globally at the end of 2020 and surpassed 2019’s level despite the
unprecedented strain from the pandemic.55 Irrespective of optimism, alternative means of
https://www.spglobal.com/ratings/en/research/articles/200707-global-sukuk-market-a-window-of-opportunity-is-opening-11561119, (accessed 2 December 2020). 51 Fitch Ratings, (2020). 2020 Sukuk Volumes Resilient to Coronavirus Stress, 21 October. Available at https://www.fitchratings.com/research/islamic-finance/2020-sukuk-volumes-resilient-to-coronavirus-stress-21-10-2020#, (accessed 30 November 2020). See also Fitch Ratings, (2020). Global Sukuk Market Dashboard: 3Q20, 21 October. Available at https://www.fitchratings.com/research/islamic-finance/global-sukuk-market-dashboard-3q20-21-10-2020, (accessed 2 December 2020). 52 Fitch Ratings, (2020). Sukuk Issuance Picking Up after Coronavirus Slowdown. Available at https://www.fitchratings.com/research/islamic-finance/sukuk-issuance-picking-up-after-coronavirus-slowdown-20-07-2020, (accessed 27 November 2020). 53 IsDB, (2020). The Covid-19 Crisis and Islamic Finance: Response of the Islamic Development Bank Group. Available at https://www.isdb.org/sites/default/files/media/documents/2020-10/1. IsDB Group Report on Covid-19 and Islamic Finance__FINAL.pdf, (accessed 30 March 2021). 54 IFN, (2020). A new normal (Part 2): Corporate Sukuk take a hit — but coping mechanisms are already emerging. Islamic Finance News, Vol. 17 Issue 17, 29 April, p. 7. 55 Gulf News Report, (2020). Sukuk issuance seen recovering from COVID stress, 25 October. Available at https://gulfnews.com/business/banking/sukuk-issuance-seen-recovering-from-covid-stress-1.74806058, (accessed 28 November 2020).
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doing business are being urged by financial thought leaders to adopt the resultant ‘new
normal’ in financial dealings globally.56 Thus, technology is helping in pulling through the
pandemic which provided humankind with an opportunity to rethink the classical way of
dealings. Islamic market dealings are leveraging on technologies in this regard and responding
to the situation so that, instead of physical presence of people for transactions, which could
be a reason for spreading out of the disease, transactions are be done more electronically to
save lives costs.
56 UNDP, (2020). Brief#2: Putting the UN Framework for Socio-Economic Response to Covid-19 into Action: Insights. Available at https://www.undp.org/content/undp/en/home/coronavirus/socio-economic-impact-of-covid-19.html, (accessed 28 November 2020).
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BLOCKCHAIN
SUKUK
3. Blockchain Sukuk - Digitization and Sukuk
Digitization in this regard refers to the process of using technology to enhance the capital
markets. Digitisation of capital market activities is needed not only to avoid physical contact
of parties during transactions but to facilitate and take sukuk and related operations to the
required advance level. With fintech penetration in offering and delivering financial services,
digitisation of sukuk could no longer be an option but necessity in the digital era.
In fact, digitization of sukuk in the capital market has been ongoing for some time, it involves
the digitization of the sukuk from issuance to maturity, this is what companies like Wethaq
are pursuing, the end result is greater efficiency and certainty of the capital markets where
the sukuk is being issued.57 Dr. Farrukh explained the difference between a blockchain sukuk
and a sukuk which is digitized but not blockchain based:
Digital sukuk is something which is completely online but does not use any blockchain
at all. So, the platform is basically a normal database written on oracle maybe, or
maybe java; so, these are the languages they are using but specifically they are not
using blockchain itself.58
Digitization via blockchain technology on the other hand involves the blockchain technology
where issuance of the sukuk will be on the blockchain platform, this is discussed in greater
detail next.
57 From interviews with Dr. Farrukh Habib 22 June 2020, Mr. Martin 19 July 2020 and Dr. Alaa Alaabed 27th June 2020. Dr. Alaa Alaabed, the Chief Research Officer at Wethaq, explained how Wethaq was digitizing the issuance of sukuk but not actually using blockchain. 58 Interview with Dr. Farrukh Habib, 22 June 2020.
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3.1 Blockchain and blockchain bonds
3.1.1 An overview of Blockchain Technology
Blockchain is a distributed database of records which could be described as a public ledger of
transactions executed and shared among participating parties on a blockchain network.59 The
blockchain is distributed to nodes and miners around the world (if it is public). Any person can
see the sequence of the transaction from address to address. A blockchain is therefore a
record of each transaction and hashes that occurred from the very beginning of the
blockchain’s existence. Each and every transaction in the public ledger is verified by consensus
of a majority of the participants in the network where once information is entered it is near
impossible to be erased. The blockchain contains certain and verifiable record of every single
transaction ever made on it.60 If there is any attempt to change anything, the ‘hash values will
change and verification will fail’.61 Thus, a blockchain is described as an immutable record. It
does not allow anonymity, since the address of each transaction is recorded; however,
addresses are random numbers which cannot actually identify a person.62
Blockchain technology combines three concepts based on certain algorithms: cryptography,
smart contracts and distributed ledger design.63 The most prominent for all blockchain-based
transactions is the smart contract.64 The smart contract is a computer program that acts as a
self-executing contract and runs on the blockchain65 –the blockchain records the transactions
59 Pilkington, M. (2016). Blockchain Technology: Principles and Applications. In Olleros, F., and Zhegu, M. (Eds). Research Handbook on Digital Transformations, Cheltenham, England: Edward Elgar Publishing, 225-226.; Yu, L., et al. (2017). Modern Agricultural Product Supply Chain Based on Blockchain Technology, Transactions of the Chinese Society for Agricultural Machinery, Vol. 48, pp. 387-389. 60 Zheng, Z., Xie, S., Dai, H., Chen, X., and Wang, H. (2017). An overview of Blockchain Technology: Architecture, Consensus, and Future Trends. In Proceedings of IEEE International Congress on Big Data 2017 (BigData Congress), pp. 558-560. 61 Henry Berg, (2015). How Is Blockchain Verifiable by Public and yet Anonymous? Quora, 28 November. Available at https://www.quora.com/How-is-blockchain-verifiable-by-public-and-yet-anonymous, (accessed 20 August 2020). 62 Jesse H. Rigsby, (2016). Virtual Currency, Blockchain Technology, and EU Law: The ‘Next Internet’ in AML/CFT Regulation’s Shadow,’ Lund University, Lund. 63 Peters, G. W., and Panayi, E. (2016). Understanding Modern Banking Ledgers through Blockchain technologies: Future of Transaction Processing and Smart Contracts on the Internet of Money. In Paolo Tasca, Tomaso Aste, Loriana Pelizzon, and Nicolas Perony, (Eds.). Banking Beyond Banks and Money, Cham, Switzerland: Springer, pp. 239-278; Christidis, K., and Devetsikiotis, M. (2016). Blockchains and Smart Contracts for the Internet of Things, IEEE Access, Vol. 4, pp. 2292-2303. 64 Wang, S., et al. (2019). Blockchain-Enabled Smart Contracts: Architecture, Applications and Future Trends. IEEE Transactions on Systems, Man and Cybernetics: Systems, Vol. 49 No. 11, p. 2267. 65 Nakamoto, S. (2008). Bitcoin: A Peer-to-Peer Electronic Cash System. Available at https://bitcoin.org/bitcoin.pdf, (accessed 22 December 2020).
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and contract rules regarding payments and transfer of ownership.66 In other words the smart
contract is a computer program that is encoded on the blockchain which automates pre-
determined conditions agreed by the parties to the transaction.67 The pre-agreed terms are
encoded such that if the conditions are met the smart contract will allow the automatic
payment or transfer of the property, all this is recorded in the blockchain and forms as record
of the dealings.
The blockchain technology produces a world described as ‘trustless’ where trust is no longer
a basis of transactions with one another. Accordingly, parties will never need to know one
another or their reliability to conduct transactions that hitherto required trust or personal
knowledge of one another. Everything therein operates without human involvement, but a
series of incorruptible programmed rules. With that, blockchain technology keeps parties that
are strangers to one another, honest and consistent and do any transaction that can always
be traced based on digital evidence, without having to know one another.68
The emergence of blockchain technology and linking the same with developing financial
products and instruments have led to the invention of blockchain sukuk or sukuk on
blockchain. The blockchain sukuk is a sukuk where blockchain technology is used to structure
it using smart contracts to execute its functions and operation in a transparent and reliable
manner. Therefore, it can be said categorically that there is no difference between the
underlying Shariah contracts used to structure a blockchain-based sukuk and a classical sukuk.
The difference lies in the use of technology in executing the former.
66 Tapscott, D., and Tapscott, A. (2016). Blockchain Revolution: how the Technology Behind Bitcoin is Changing Money, Business and the World. New York: Penguin Publishing Group, pp. 1 et seq.; Babkin, A., Tyulin, A., Epifanova, O., and Kharitonova, N. (2019). Blockchain Technology and Stages of Infrastructure Support Development for Crypto Assets Market. In Proceedings of the 33rd International Business Information Management Association Conference, IBIMA: Education Excellence and Innovation Management through Vision 2020, pp. 8479-8480. 67 Mearian, Lucas. (2019). What's a smart contract (and how does it work)? Computer World. Available at https://www.computerworld.com/article/3412140/whats-a-smart-contract-and-how-does-it-work.html, (accessed 12 April 2021). 68 Calcaterra, C. and Kaal, W. A. (2020). Reputation Protocol for the Internet of Trust. In Compagnucci, M. C., et al. (Eds.). Legal Tech and the New Sharing Economy: Perspectives in Law, Business and Innovation, Singapore: Springer Nature Pte Ltd., 124-125. DOI: 10.1007/978-981-15-1350-3_8. See also Giancaspro, M. (2017). Is a ‘Smart Contract’ really a Smart Idea? Insights from a Legal Perspective. Computer Law and Security Review, Vol. 33 No. 6, pp. 826-828.
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The same is true for bonds and blockchain bonds, in fact the use of blockchain to develop and
issue bonds is emerging as an alternative to traditional bond issuance and this development
prompted in Islamic finance the exploration of blockchain sukuk.
Thus, to understand blockchain sukuk we will begin by explaining case studies of blockchain
bond issuances.
3.1.2 Blockchain Bonds Case Studies
World bank bond-i
On 23 August 2018, the World Bank, in partnership with Commonwealth Bank of Australia
(CBA) as sole arranger, issued the world’s first legally binding bond operating on a private-
permissioned blockchain platform.69 The value of the issuance was AUD110 million, with two
years maturity and a coupon of 2.25% paid semi-annually. The bond was named Bond-i, an
acronym for ‘Blockchain Offered New Debt Instrument’, which was also a reference to
Australia’s most iconic beach, Bondi Beach, in Sydney.70 A smart contract automation on a
private version of Ethereum blockchain was designed for bond-i at CBA’s Digital Innovation
Lab and replaced/performed registry, issuing, clearing and custodian processes.71 The bond
was therefore created, registered, allocated and transferred on the platform throughout its
life cycle. Settlement was however off-chain due to non-usage and absence of a Central Bank
digital currency for this purpose.72
Participants and investors were pre-authorized and authenticated by the World Bank and CBA
to access the system. The pre-authorized investors used their authentication key and entered
bids onto the platform through the application layer (web-interface) of the blockchain which
69 The World Bank, (2019). World Bank Mandates Commonwealth Bank of Australia for World’s First Blockchain Bond. Available at https://www.worldbank.org/en/news/press-release/2018/08/09/world-bank-mandates-commonwealth-bank-of-australia-for-worlds-first-blockchain-bond, (accessed 5 December 2020). 70 Sandre, A., (2019). The First Global Blockchain Bond, Hackernoon, 20 June. Available at https://hackernoon.com/the-first-global-blockchain-bond-38952bdf1dac, (accessed 6 December 2020). 71 The World Bank, (2019). World Bank Mandates Commonwealth Bank of Australia for World’s First Blockchain Bond. Available at https://www.worldbank.org/en/news/press-release/2018/08/09/world-bank-mandates-commonwealth-bank-of-australia-for-worlds-first-blockchain-bond, (accessed 5 December 2020). 72 HSBC and Sustainable Digital Finance Alliance, (2020). Blockchain: Gateway for sustainability-linked Bonds. Available at https://www.sustainablefinance.hsbc.com/-/media/gbm/reports/sustainable-financing/blockchain-gateway-for-sustainability-linked-bonds.pdf, (accessed 2 December 2020); World Bank Treasury, (2018). Webinar on Blockchain Bond: World Bank Treasury. Available at https://youtu.be/lqYAcDTTAU0, (accessed 19 September 2020).
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allowed for a Proof of Authority AuRa (Authority Round) protocol. The World Bank observed
the book building in real-time. Investors also saw their bids and allocation in real time.
Investors were able to update and did update their bids, supported by direct communication
with World Bank, this was enabled via an online communication function. Pricing was finalized
in this way and subsequently, using the same platform, the bond was offered on the
secondary market. The World Bank in August 2019 re-opened the original bond, increased
the issued size by AUD50 million to AUD160 million and allowed for additional investors.73
The World Bank’s bond-i deal was noted for its record of having the least intermediaries, more
immediate communication between issuer, and investors in addition to secure holding of
assets without custodians. Also, as same ledger was accessible by all the bond market actors,
no reconciliation of data was needed across, with resultant fast processing for investors.
Transparency of the transaction was unprecedented as having the capability of real time
reporting for the regulators via a node on the blockchain granted observer and supervisory
privileges.74 The figure below illustrates the process of the World Bank’s bond-i.
Figure 3.1 World Bank’s bond-i process
Source: World Bank Treasury, 2018.
73 World Bank Treasury, (2018). Webinar on Blockchain Bond: World Bank Treasury. Available at https://youtu.be/lqYAcDTTAU0, (accessed 19 September 2020). 74 Commonwealth Bank of Australia, (2021). Project Bond-i: Bonds on Blockchain. Available at https://www.commbank.com.au/business/business-insights/project-bondi.html, (accessed 25 February 2021).
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Nivaura issuance in FCA sandbox
Based in the UK, Nivaura is a fintech company that provides digital capital market solutions,
a specialist in automation of key capital market processes. In November 2017, Nivaura
assisted LuxDeco, a corporate entity, issue blockchain bonds under the UK Financial Conduct
Authority (FCA) regulatory sandbox that involved a pilot testing as well. In the
Nivaura/LuxDeco blockchain bond, two different blockchain bonds were issued: a control
bond as baseline and an experimental bond as pilot. The control bond, structured in the
normal way, was a regular registered Pound sterling denominated bond. In contrast to the
World Bank’s Bond-I, the control bond provided a prototype for tokenisation of fiat currency
(cryptocurrency). Tokenisation is generally a way of replacing confidential data with
distinctive recognition symbols that preserve the information about the data and ensure its
security. In the case under consideration, tokenisation enabled the substitution and linking of
fiat currency (pound sterling) to a token as nominal digital representation of the bond
security. Through the tokenisation technique, information about the fiat currency was
rendered tamper-proof and undecipherable as the tokenised fiat currency remains a
security.75 Thus, a tokenised pound sterling-denominated bond was issued to
holders/subscribers, and it was cleared, settled and registered on Nivaura’s blockchain
platform. The pilot or experimental bond was the world’s first digital currency (Ether)-
denominated bond that was fully registered, cleared and settled on an open public
blockchain.76 So unlike the World Bank issuance where settlement was off-block, in these two
deals, the settlement was on the block by using the tokenization of the fiat currency and
digital currency. It is interesting and noteworthy that in both the control bond and
experimental bonds, blockchain served as the register that registered the legal and beneficial
ownership of the bond.77
The approach used in the control and experimental bonds simplified the issuance of securities
and reduced costs and processes in several ways. Firstly, the legal fees and process complexity
75 Diego, O. Y., (2014). A Critical Review of the EMV Payment Tokenisation Specification. Computer Fraud & Security, Vol. 2014, Issue 10, pp. 5-6. 76 Cohen, R., Smith, P., Arulchandran, V. and Sehra, A. (2018). Automation and blockchain in securities issuances, Butterworths Journal of International Banking and Financial Law, March, pp. 145-146, available at: https://www.allenovery.com/global/-/media/allenovery/2_documents/news_and_insights/campaigns/blockchain/cohen_smith_automation_blockchain.pdf (accessed 30 March 2021). 77 Ibid.
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were both reduced because the structure and documents were simpler and there was a
reduction in the number of parties involved and quantity of documentation. This means
saving complexity, time and cost.78 Nevertheless, where the law of the land requires
registration of the legal title of the asset in a specialised register, this requirement will still
have to be satisfied regardless of the blockchain platform being able to record the transfer of
the asset. Also, other risks such as risk of breach of terms of contract, default risk and legal
risks remain in blockchain sukuk. This is explained in greater detail below under the section
4.
Figure 3.2 Blockchain Bond where legal and beneficial interest is allocated on Blockchain
Source: Nivaura, 2019.
Other recent developments
Bursa Malaysia Berhad in December 2020 announced that they had completed the bond on
blockchain proof-of-concept (“POC”) with Singapore’s Fintech technology provider, Hashstacs
Pte Ltd (“STACS”).79
The POC was developed to assist the issuance of blockchain bond and tokenisation of assets
in the Labuan Financial Exchange. The media release stated ‘the POC successfully
demonstrated that digital bonds could be issued and managed on a blockchain and its
78 Ibid., pp. 146-147. 79 Bursa Malaysia, (2021). Bursa Malaysia Completes Blockchain PoC to Facilitate Growth of the Labuan Bond Marketplace. Available at https://www.bursamalaysia.com/about_bursa/media_centre/bursa-malaysia-completes-blockchain-poc-to-facilitate-growth-of-the-labuan-bond-marketplace (accessed 26 February 2021).
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attributes of a single source of truth, smart contracts and automation allow for new service
expansion offerings.’80
Bursa CEO Datuk Muhamad Umar Swift noted the blockchain technologies can deliver
‘increased efficiencies, transparency, and trust that can benefit the bond market.’81
3.2 Sukuk on blockchain
Blockchain based sukuk (or smart sukuk) is a digital sukuk where blockchain technology is
used to ensure that digital records which are immutable is made where the long process of
issuing of sukuk which involves multiple intermediaries are eliminated making the process
shorter and cheaper by eliminating the risk of human errors. The process used in the smart
sukuk is tokenization. Via tokenization, digital sukuk issuance is made including the trading
and the management of it as well. In this process, the issuer’s sukuk structure in formation
will be first placed on the blockchain as a digital record and then smart contracts will be coded
on the blockchain with the rules of the sukuk where subsequently tokens are issued to
investors in digital form as sukuk. Settlement, trading, and post-issuance sukuk action
management like regular payments of profit to the investors will be completed by smart
contracts. Besides offsetting issuance costs, this automation offers accuracy among other
advantages.
It has been noted that issuing sukuk is more expensive compared to that of conventional
bond.82 Sukuk also involves mores processes than conventional bond and needs proper
structuring, in a Shariah compliant manner. In the pre-issuance stage, sukuk requires a
Shariah scholar who could be an individual or a committee of scholars, depending on
requirement by the law of the jurisdiction in which it would be issued. Furthermore, legal
compliance has to be ensured in addition to the Shariah approval required to proceed with
issuance process. These make the sukuk issuance process more complex than that of
conventional bond where only one main concern needs to be adhered taken care of i.e., legal
compliance. Therefore, to curtail constraints such as those experienced during the Covid-19
pandemic and related emergency situations, blockchain based digital sukuk issuance needs
80 Ibid. 81 Ibid. 82 Vizcaino, B. (2014). Sukuk issuance costs still above conventional bonds in Asia -ADB. Available at https://www.reuters.com/article/islamic-finance-adb-idUSL5N0ML00D20140324, (accessed 27 April 2021).
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to be developed and boosted. This entails automating the whole process of sukuk issuance
and standardizing it across jurisdictions and making the process less cheap and complicated.
Furthermore, blockchain and smart contract decrease the number of intermediaries involved
in structuring sukuk while dispensing with the required level of trust among the parties
involved in the process. Smart contracts on blockchain make transactions irrevocable and
immutable ensuring that there would be no fraudulent activities in the transaction and any
alteration in the process would only occur with the knowledge and consent of all the parties
involved. Therefore, this would reduce the cost of the transaction and will eventually create
a level playing field with conventional bond in terms of having a simple process with less
intermediaries without compromising the trust factor required to complete transaction
among stakeholders. Digitization of sukuk in this sense would definitely benefit all potential
issuers that need financing due to the Covid-19 economic shock or for any developmental
activities in addition to facilitating adoption to the new normal resulting from the Covid-19
pandemic generally.
3.3 Blockchain Sukuk Case Studies
3.3.1 Blossom Finance Blockchain sukuk - SmartSukuk
With the development of blockchain bonds in the conventional bond market, the term
‘blockchain sukuk’ also emerged and the idea to structure sukuk on the blockchain started.
The concept of smart sukuk was developed by Matthew Joseph Martin, founder and CEO of
Blossom Finance.83 The term “SmartSukuk” has accordingly been trademarked by the
Blossom Finance, a trademark of Blossom Labs Inc., Delaware U.S. After Martin founded
Blossom Finance as a start-up in October 2014, he relocated from San Francisco USA to
Jakarta Indonesia in 2015 and it became one of the first platforms to allow investors to invest
in microfinance institutions across Indonesia using bitcoin.84 Over time, Blossom developed a
technology platform supporting a wider range of Shariah compliant financial services and the
SmartSukuk is a prime demonstration of that development.85 Martin was said to have the idea
83 Tan, V., (2018). Blockchain Sukuk: The Smart way of doing it. IFN Fintech, 29 May. Available at https://ifnfintech.com/blockchain-sukuk-the-smart-way-of-doing-it/, (accessed 17 January 2020). 84 Ibid. 85 Ibid.
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of smart sukuk since he founded Blossom Finance in 2014. However, the technology for smart
contracts was not yet ready then until 2017 when he started the project which coincided with
the emergence of blockchain platforms such as T-zero for the issuance of conventional
bonds.86 Smart Sukuk is similar to smart bonds, but they differ in the same way sukuk differ
from bonds, that is, smart sukuk are Shariah compliant in every aspect.
Blossom Finance has two different sukuk structures on its platform. The first smart sukuk
structure launched by Blossom was a Mudarabah facility that supports microfinance
institutions (MFIs) in central Java, Indonesia. The issuer was an Indonesia microfinance
cooperative BMT Bina Ummah. The issuer used the capital to fund 280 micro-businesses or
social enterprises with the goal of poverty reduction in the region. With an annual net return
of 14.5%, the first tranche was a twelve-month facility of Rp715 Million (around $50,000
USD).87
The Blossom’s smart sukuk uses Ethereum smart contract in collecting funds and issues
ownership certificates to investors using ERC20 token standard (explained below), managing
payment back to the investors, disbursing payments appropriately based on relative
ownership stake, and paying Blossom’s share of profits as per agreement plus secondary
market tradability.88
During an interview with Mr. Martin,89 the following question was asked - do you have to
develop anything special to launch the smart sukuk or to facilitate the smart sukuk in the
capital market?
Mr. Martin answered:
Yes, even at the time when we started, there were many people doing debt-based
finance, conventional loan-based finance, especially peer-to-peer. That has been
86 Ibid. NB: A smart bond is an automated bond contract that is driven by blockchain database that operates as cryptographically-secure and transparent general ledgers. 87From Mr Mathew Martin in an email communication 10th May 2021. N.A (2021). BMT Bina Ummah 1
Variable Profit Rate Final Report.jpg. Available at
https://www.dropbox.com/s/cjykx8hemfkqymp/BMT%20Bina%20Ummah%201%20Variable%20Profit%
20Rate%20Final%20Report.jpg?dl=0 (accessed 10th May 2021). 88 Blossom Finance, (2018). Islamic Finance Upgraded: Smarter Sukuk Using Blockchain. Available at https://blossomfinance.com/press/islamic-finance-upgraded-smarter-sukuk-using-blockchain, (accessed 17 January 2020). 89 Interview was held through Zoom on Thursday 16 July 2020 3:00pm.
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around almost since the beginning of Ethereum and even before Ethereum people
have been using peer-to-peer finance using bitcoin blockchain. So, number one, what
is very critical for us to develop is a token that represents digital ownership certificate.
Number two, because our focus was on profit sharing principle, the mudarabah
principle, we had to develop a type of token that is based on profit sharing
arrangement, based on nisbah (ratio). So, that was really the challenge. And the other
thing that’s unique about blockchain sukuk al-mudarabah, is the parties who are
involved in the nisbah, the mudarib (entrepreneur) and rabbul mal (investor) will
share the profits, but the original capital will only return to the rabbul mal at maturity,
at the redemption date, right. So, when the mudarabah contract matures or ceases to
exist the mudarib must buy out the rabbul mal by paying back the principal capital.
So, this is very different from a model that you see in conventional based financing
role. ...The third thing is the development of infrastructure. What do I mean by
infrastructure? Well, when you have a capital market instrument, you need to not only
create the instrument, but you also need to do things operationally every month or
every quarter that are involved in the governance and sustaining the operation of the
sukuk. For example, the calculation, the payment, the periodic profit distribution etc.
So, we have to develop operational infrastructure to support all those aspects. And I
would say that was the biggest phase, that was probably eighty percent of the
challenge, was developing that infrastructure and, of course, all of this is on top of the
Ethereum blockchain. The third phase, I would say was the largest phase we had to
develop.
Blossom’s second sukuk structure, an asset-based lease sukuk, or sukuk al ijarah, does not yet
have active funds available for its launch, though Mr. Martin in the interview90 confirmed that
Blossom Finance has the technology ready and is waiting for potential issuers. In this case,
the sukuk would fund projects such as hospital construction: on completion, the hospital
operator would lease its facilities from the sukuk investors at a profit. Figure 3.3 below from
the Blossom Finance’s website illustrates the structure.
90 Ibid.
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Figure 3.3 Blossom Finance’s SmartSukuk Structure on Istisna’ and Ijarah for Construction
Project
Source: Blossom (2018)
The figure above (figure 3.3), illustrates how the Blossom’s platform collects and gathers
funds from investors in exchange for Smart Sukuk tokens that represent ownership of a
portion of the sukuk. When payment is made by the entity, the funds are automatically
distributed among the Smart Sukuk token holders via the blockchain according to rules of the
smart contract, thus dispensing with the need of conventional banks or intermediaries.91
The Smart Sukuk tokens support an industry standard protocol called ERC20. The standard
allows tokens to be traded globally on a variety of public cryptocurrency (also known as digital
exchanges) exchanges. Given this potential, smart contracts are noted as the most recent and
significant mechanisms for sukuk issuances. Also, with regard to crowd funding and financial
technology enhancement, smart sukuk could be the future of Islamic fundraising for
infrastructure and business developments.92
For commercial purposes, the world has just begun to discern the potential of blockchain
sukuk. However, from its current developments, it is understood that the full potential of this
type of sukuk is yet to be explored. In this regard, there are several initiatives (see below) in
91 Blossom Finance, (2018). Islamic Finance Upgraded: Smarter Sukuk Using Blockchain. Available at https://blossomfinance.com/press/islamic-finance-upgraded-smarter-sukuk-using-blockchain, (accessed 17 January 2020). 92 Sa’ad, A. A. (2018). Smart Sukuk Structure from Shariah Perspective: The Application of Mudarabah Smart Contract. E-Proceedings of the Global Conference on Islamic Economics and Finance 2018, 24th and 25th October 2018, Sasana Kijang, Kuala Lumpur, Malaysia. Available at https://islamicmarkets.com/publications/smart-sukuk-structure-from-shari-ah-perspective-the-application-of-mudarabah, (accessed 17 January 2020).
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the global Islamic financial services industry that are pilot testing one or two
products/services on the blockchain.
3.3.2 Jibrel Network
Based in Switzerland, Jibrel network is a financial technology start-up that is into
decentralized finance, asset tokenization and web3 piping.93 It is an open source web3
development company.94 In 2018, Jibrel Network used blockchain, in partnership with Al-Hilal
Bank Abu Dhabi, to conduct a secondary market transaction for US$ 500 million Senior Sukuk
of the Bank’s debut sukuk in Abu Dhabi, which is to mature in September 2023. This was said
to be the first instance globally where blockchain was used to execute a segment of a sukuk
transaction.95 Again in 2019, Jibrel Network, in partnership with the same bank and Abu Dhabi
Global Market (ADGM) created and structured a state-of-the-art smart sukuk in in Abu
Dhabi.96 The partnership ushered in smart sukuk that automated and standardized legal and
accounting requirements as well as payment disbursement of traditional sukuk offerings.97
Enabled by blockchain, participating entities were able to verify and share from one identical
source (a single blockchain), and updates were automatically provided on each sukuk with
respect to its ownership status and the condition of its underlying asset. In a single view, the
blockchain updates and provides records that are enforced via consensus mechanisms. Figure
3.4 illustrates the infrastructure that Jibrel employed to issue sukuk.
Figure 3.4 Jibrel’s network infrastructure for sukuk issuance
93 “Web 3.0 is a decentralized blockchain protocol that enables individuals to connect to internet where they can own and be properly compensated for their time and data, eclipsing an exploitative and unjust web where giant, centralized repositories are the only ones that own and profit from it.” Charles Silver, (2020). What Is Web 3.0? Forbes Technology Council. Available at https://www.forbes.com/sites/forbestechcouncil/2020/01/06/what-is-web-3-0/?sh=666a121c58df (accessed 12 March 2021). 94 Jibreel Network, (2020). We’re helping build a decentralized future. Available at https://jibrel.network/, (accessed 4 December 2020). 95 Albawaba (2019). World’s first blockchain sukuk transaction just happened in Abu Dhabi. Available at https://www.albawaba.com/business/world%E2%80%99s-first-blockchain-sukuk-transaction-just-happened-abu-dhabi-1219090, (accessed 4 December 2020). 96 Ibid. 97 Jibreel Network, (2020). We’re helping build a decentralized future. Available at https://jibrel.network/, (accessed 4 December 2020).
48
Source: Jibrel (2019)
As can be seen from the diagram above automation through smart contracts has taken over
the jobs of the bank/custodian.
3.4 Advantages of using Blockchain to issue sukuk
Altogether, blockchain in sukuk issuances increase transparency of underlying assets and cash
flows.98 Blockchain enhances investors’ decision-making given the wealth of information it
makes available to the investors. Also, the fact that blockchain provides real-time and a
uniform view of transaction data, devoid of the need for many reconciliations, goes a long
way in reducing costs and removing certain inefficiencies and frictions that plague the
financial system.99
Blockchain as a technology incorporates all the plus points that technology brings to the table.
The advantages that blockchain introduces can be summarized in the following points.
1. The efficiency of clearing and settlement processes of securities whereby blockchain helps
institutions save thousands of dollars in back office and operational costs.
98 Ibid. 99 Khan, N., Kchouri, B., Yatoo, N.A., Kräussl, Z., Patel, A. and State, R. (2020). Tokenization of sukuk: Ethereum case study. Global Finance Journal, [in Press]. DOI: 10.1016/j.gfj.2020.100539, (accessed 9 December 2020).
49
2. The reduction of risk exposure, particularly with respect to settlement, which is lowered by
more than 99%, bringing down costs dramatically. With settlement occurring in real time,
counterparty risk is dispelled as well.
3. The reduction of issuance cost because of removal of superfluous intermediaries and the
associated fees involved. Consequently, the operational risks and administrative burden of
the traditional sukuk issuance, which is often a manual and multi-tiered process, are lessened.
4. While there is a cost of creating the blockchain system its continued application is low.
5. The 24/7 uptime and availability of the system with absolute replication among
participants on the network, which ensures seamless and foolproof synchronisation within its
infrastructure.
6. The transparent, traceable and auditable nature of transactions on the system. These
enable a single record view to effect a faultless auditing process, enabling regulators to
observe more easily and intervening only when needed.100
7. Further, in an interview with Dr. Farrukh Habib, he remarked that blockchain sukuk had the
advantage of being easier to issue as a global instrument compared to a traditional or non-
blockchain sukuk.101
8. Finally, Mr. Martin added102 that blockchain sukuk facilitates financial inclusion:
What we are focusing on is enabling, providing an enabling solution for issuers
who currently cannot access capital markets for a variety of reasons. Could be
due to jurisdiction, could be the size is too small, could be other factors. But ...
the important thing that should differentiate us, is we are focused on issuers
who currently cannot access capital markets. For example, there are some
investors who currently cannot access capital market instruments as an
investment vehicle because the size is too small or they live in a country where
there's no, you know, there's no broker dealer who can sell them sukuk etc. So,
the reason blockchain is very important is because blockchain provides universal
100 Murugiah, S. (2018). Sukuk industry could benefit from Blockchain technology, says S&P Global Ratings. The Edge, 25 October. Available at http://www.theedgemarkets.com/article/sukuk-industry-could-benefit-blockchain-technology-says-sp-global-ratings, (accessed 4 December 2020). 101 In an interview on 22nd June 2020 with the researchers. 102 In an interview on 16th July 2020 with the researchers.
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infrastructure, globally, in the same way the internet provides universal
infrastructure and blockchain doesn't discriminate, blockchain doesn't
discriminate based on country, based on national origin, based on size.
Blockchain accepts any transaction you put into it. And it also is a global universal
standard. So, all the infrastructure is standardized, which is very important for
efficiency, especially for small transaction sizes. So, again, we're focused on
issuers and investors currently excluded from capital markets. That's the key
difference.
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RISKS
4. Risk
‘Risk’ is the possibility that the outcome of an event could result in an adverse result. And
more specifically in finance, ‘risk refers to the probable loss of income and asset value.’103
Sukuk are exposed to a number of risks, for example market risk, Shariah compliant risk, legal
risk and default risk.104 Further each of those sukuk structures use different type of Shariah
contract which have their own risks.105 Each category of risk is the possibility of suffering
adverse effects in that category. Thus, market risk includes foreign exchange risk -
unanticipated movements in exchange rates. 106 In the case of sukuk this would mean mark-
up or profit rate risks or changes in the net profit income as a result of changes in profits and
shifts in composition of assets and liabilities and commodity risk changes in the prices of
commodities. Sukuk that are benchmarked to interest rate benchmarks such as LIBOR would
indirectly be affected by the fluctuation of the rates in its financing.107 Shariah compliance
risk is closely related to legal risk, it is the possibility of the non-compliance with Shariah. In
the case of sukuk, Shariah compliance risk means the risk the sukuk structure and transaction
does not comply with the requirements of Shariah.
Legal risk means the risk that the legal rights of the parties in a transaction are not
enforceable. To overcome legal risk, it is important to ensure certainty and enforceability of
the sukuk structure. It is thus important to identify the legal issues that must be overcome.
103 Ismail, A. G. (2010). Money, Islamic Banks and the Real Economy. Singapore: Cengage Learning Asia Pte Ltd., pp. 227. 104 Financial Islam, (n.d.). Risks underlying Sukuk. Available at http://www.financialislam.com/risks-underlying-sukuk.html, (accessed 27 November 2020). 105 Alswaidan, M.W., Daynes, A. and Pasgas, P. (2017). Understanding and evaluation of risk in Sukuk structures. Journal of Islamic Accounting and Business Research, Vol. 8 No. 4, pp. 389-405. 106 Iqbal, Z. and Mirakhor, A., (2007). An Introduction to Islamic Finance: Theory and Practice. Singapore: John Wiley & Sons (Asia) Pte Ltd., pp. 230. See also Archer, S. and Karim, R.A.A., (2007). Islamic Finance: The Regulatory Challenge. Singapore: John Wiley & Sons (Asia) Pte Ltd., pp. 208. 107 Ibid.
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Default risk is the risk the debtor fails to make payment when installment payments or the
principle becomes due.
This section will explore three categories of risks in sukuk which are legal risk, Shariah risk and
default risk.
4.1 Legal Risks in Sukuk
Legal risks in sukuk surrounds certainty and enforceability of the sukuk.
4.1.1 Legal risk in transfer of asset & ownership
The underlying asset is crucial for a legal and valid sukuk structure.108 In every sukuk structure
there will be a transfer of the underlying property from the originator to the issuer or the
sukuk holders.109 Traditionally there are number of ways transfer of ownership of assets can
be done, for example by way of sale, trust, assignment, long term lease, or novation.110 Each
transfer and the legal issues are explained next:
a. Sale – Here a sale of the underlying asset takes place from the originator to the SPV (or
sukuk holders). However, an outright sale will give rise to tax consequences such as stamp
duty or similar tax and registration or notice of property. Where a sale of the underlying assets
takes place, it is known as a true sale. This is where all legal requirements are met, for example
there is registration of title of the underlying assets or notice as required under the relevant
jurisdiction or some other requirements which is peculiar to the relevant jurisdiction.111 This
type of sukuk is known as an asset backed sukuk. The legal and beneficial rights of the
underlying asset will move to the SPV. The legal recourse of the sukuk holders is not with the
originator but with the underlying asset. The payments for the sukuk holders will come from
108 Engku Rabiah Adawiah, Nermin Klopic, Muhammad Ramadhan Fitri Ellias, and Muhamad Nasir Haron, (2015). Application of the Concept of Beneficial Ownership in Sukuk Structures: An Islamic Legal Analysis. ISRA International Journal of Islamic Finance, Vol. 7, No. 2, p. 111. 109 Nazar, J. K., (2011). Regulatory and Financial Implications of Sukuk’s Legal Challenges for Sustainable Sukuk Development in Islamic Capital Market. Proceedings of 8th International Conference on Islamic Economics and Finance, Sustainable Growth and Inclusive Economic Development from an Islamic Perspective, Doha-Qatar. Available at https://www.isfin.net/sites/isfin.com/files/regulatory_and_financial_implications_of_sukuks_legal_challenges_for_sustainable_sukuk_development_in_islamic_capital_market.pdf, (accessed 29 November 2020). 110 Securities Commission, Malaysia, (2009). The Islamic Securities (Sukuk) Market, Kuala Lumpur: LexisNexis, p. 100. 111 ISRA, (2009). Islamic Financial System Principles and Operations, Kuala Lumpur, Malaysia: ISRA, p. 456.
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the performance of the assets.112 An example of such a sukuk was the East Cameron Gas
Sukuk.113 In this case the sukuk holders were pronounced by the court (as the originator had
gone into liquidation) as the owners of the underlying asset as a true sale of the asset had
taken place.114
b. Trust - Here the originator maintains the legal title of the underlying asset but transfers the
beneficial ownership to the SPV issuer. The originator can also declare a bare trust where it
holds the asset on trust for the benefit of the SPV or the sukuk holders.115 In this situation a
purchase undertaking (unilateral promise) will usually be provided by the originator
undertaking that it will purchase back the assets from the sukuk holders in the event of a
default or maturity. As can be seen from the structure, the legal recourse of the sukuk holders
is to the originator and not the assets themselves. In other words, in the event of default, the
sukuk holders would have to stand as creditors of the originator. Here, the legal issue would
be the enforceability of the credit enhancing facilities. These issues are further explored
below.
c. Lease – Here the head lessor leases a long-term lease (for example, Saxony Anhalt Sukuk,116
which had a head lease of 100 years) to the SPV who will sub-lease the property to a third
party. The SPV then issues the sukuk to investors. The sukuk represents a ‘pro-rata interest’
in the operating rights acquired by the SPV in the long lease from the lessor.117 This may raise
the Shariah issue here that this structure may be criticized as not being a complete transfer118
of the underlying assets.
112 Ibid. 113 Re East Cameron Partners, L.P., Case No. 08-51207. See also Hawkamah Institute for Corporate Governance, (2011). Policy Brief on Corporate Governance for Islamic Banks and Financial Institutions in the Middle East and North Africa Region. Available at https://www.lw.com/thoughtLeadership/corporate-governance-for-islamic-banks-in-mena, (accessed 30 November 2020). 114 Mashiyat Tasnia, Is’haq Muhammad Mustapha and Mohammad Hassan Shakil, (2017). Critical Assessment of the Legal Recourse for the Case of Sukuk Default for the Asset-Backed and Asset-Based Sukuk structures. European Journal of Islamic Finance, July, No. 7, p. 5. 115 ISRA, (2015). Islamic Capital Markets - Principles & Practices, Kuala Lumpur: ISRA, p. 431. 116 See Stimpfle, A., (2011) Islamic Finance Made in Germany: The 2004 Sukuk Issue by the State of Saxony-Anhalt. Munich: GRIN Verlag, pp. 7. Available at https://www.grin.com/document/176319 (accessed 17 March 2021). 117 Securities Commission, Malaysia, (2009). The Islamic Securities (Sukuk) Market, Kuala Lumpur: LexisNexis, p. 71. 118 Ibid., p. 99.
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d. Assignment – If the assets are contractual interests, then the transfer can be by way of
assignment. This is recognized under English law which recognizes assignment of current,
future and intangible assets. The ‘assignment must be in writing, signed by the assignor and
given to the debtor or other party.’119 The legal issue here would be that the jurisdiction that
governs the sukuk may not allow assignment.
e. Novation – This is the transferring of contractual rights and obligations. It occurs where a
new contract replaces the old and where the new parties substitute the old parties. The legal
issue here is that novation may not amount to a transfer of the underlying asset on its own in
the case of certain types of assets e.g. immovable property.120
Further legal issues that have been identified when a transfer takes place are as follows:121
● Ownership risks relating to the underlying property must be sorted out. Since the
sukuk holders are the owners of the assets there will be risks associated with the
property including costs for maintenance. It must be decided who will bear the risks
and the relevant clauses have to be inserted in the documentations.
● The transfer has to be recognised in the relevant jurisdiction so that the rights of the
sukuk holders in the event of default can be upheld.
● The SPV has to be a separate legal entity which is separate from the obligor so that
both entities will not be liable for another's debt or other liabilities.
4.1.2 Legal Certainty and Enforceability when an SPV is Used
In certain sukuk structures like the BBA sukuk, the sukuk is issued directly by the corporate
receiving the funds, and the assets are bought and sold back to the corporate issuer within a
short period of time, here there is no need of an intermediary as the sukuk evidences a debt
obligation of the issuer.122 However, where the underlying assets are to be owned by the
sukuk holders for the duration of the sukuk, like in an ijarah sukuk structure, an intermediary
is required. This is typically done by transferring the underlying assets to a SPV which holds
119 Ibid. 120 Ibid. 121 Ibid, pp. 99-103. 122 ISRA, (2015). Islamic Capital Markets - Principles & Practices, Kuala Lumpur: ISRA, p. 428.
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the assets on trust for the sukuk holders.123 The SPV to whom the underlying assets was
transferred will then lease it to the lessee (obligor) and then issue the sukuk to the sukuk
holders to raise funds.124
To ensure legal certainty for this transaction, that is, the legal rights of the sukuk holders and
the originator are secured, where SPV is present certain legal issues have to be solved. They
are as follows:
● Firstly, the trust and other financial contractual obligations must be legally recognized
by the respective jurisdiction
● Secondly there must be a legally valid transfer of the underlying asset to the SPV
● Thirdly in the event of default or breach of contractual legal rights of the sukuk holders
and obligor must be upheld.
The above legal issues will now be discussed in greater detail.
Creation of Trust and Conflict of Laws
The concept of trust law125 facilitates the splitting of two ownership rights, namely legal
ownership and beneficial ownership. What this means is that the one who has legal
ownership has the legal interest in the property and can hold the property but holds it in trust
for the benefit of the beneficial owner.126 In a sukuk this occurs when the investors purchase
the asset from the legal owner however legal title is not transferred only the beneficial
interest. The beneficial owner can enforce his rights on the property and is the true owner.
The benefit of this arrangement is that hurdles in terms of tax payments and registration
123 Securities Commission, Malaysia, (2009). The Islamic Securities (Sukuk) Market, Kuala Lumpur: LexisNexis, p. 94. 124 Ibid. 125 Trust here refers to where legal title to a property is held by one person for the benefit of another. Although the concept of trust is often explained to be from common law or English law, it was applied and accepted in Shariah under the concept of waqf prior to the common law trust. In fact, scholars have concluded that the common law concept of trust actually originates from Islamic law. See Cattan, (1955). The Law of Waqf, in Khadduri, M and Liebesny, H. J., (Eds.). Law in the Middle East: Origin and Development of Islamic Law, Washington, DC: Middle East Institute, Vol. 1, p. 293; Badr, G. M. (1978). Islamic Law: Its Relation to Other Legal Systems, The American Journal of Comparative Law, Vol. 26, pp. 196, and Gaudiosi, M. M., (1988). The Influence of the Islamic Law of Waqf on the Development of the Trust in England: The Case of Merton College, University of Pennsylvania Law Review, Vol. 136, pp. 1231-1261. 126 Zakaria, M. Z., Salleh, A. Z., and Abdul Aziz, A. Z., (2015). The Application of Beneficial Ownership in Asset-based Sukuk: A Shariah Analysis. Malaysian Journal of Syariah and Law. Vol. 3, December, pp. 1-26.
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requirements can be avoided.127 The jurisdiction within which the sukuk is to be enforced
must recognize the dual nature of ownership and trust law. It is generally understood that
jurisdictions that adopted the common law system recognize and enforce trust law, however
jurisdictions that follow the civil law legal system generally do not.128 To accommodate the
civil legal system some sukuk structures use the concept of agency. Where the SPV is
appointed as an agent or custodian to hold the assets on behalf of the sukuk holders ‘pro rata’
according to holdings of the sukuk holders.129 Then there are some civil law jurisdictions that
do not recognise trust but have passed law to recognise beneficial interest.130 Nevertheless,
even though there is such an option, often sukuk documentation is such that it is governed
by multiple laws.131
In the Dana Gas PJSC v. Dana Gas Sukuk Ltd & Ors [2017] EWHC 2928 (Dana Gas Case)
documentation for example “the trust deed, the trust certificates and the purchase
undertaking were governed by English law, while some other transaction documents,
including the Mudarabah agreement, were governed by the laws of the United Arab
Emirates.”132 The documentation was effected in such a way to ensure enforceability. The
lawyers foresaw that under UAE law the trust deed, trust certificates and purchase
undertaking may not have been recognized. However, the legal issue that surrounded this
case was predominantly due to conflict of laws. The UAE and England are not legally obliged
to recognize the court judgements of each other as they are not party to any arrangements
governing the mutual enforcement of judgements.133 Thus when the English court ruled that
the purchase undertaking was valid134 and enforceable the Sharjah courts did not
127 Securities Commission, Malaysia, (2009). The Islamic Securities (Sukuk) Market, Kuala Lumpur: LexisNexis, pp. 97-98. 128 Vera Bolgár, (1953). Why No Trusts in the Civil Law? The American Journal of Comparative Law, Vol. 2, No. 2 (Spring), p. 205. See also Joaquin, Garrigres, (1953). Law of Trusts, American Journal of Comparative Law, Vol. 2, pp. 25-35. Available at https://doi.org/10.2307/837993, (accessed 29 November 2020). 129 Securities Commission, Malaysia, (2009). The Islamic Securities (Sukuk) Market, Kuala Lumpur: LexisNexis, p. 96. 130 Such as Indonesia; see World Bank (n.d.). G-20 Anti-Corruption Working Group Guide to Beneficial Ownership Information: Legal Entities and Legal Arrangements. Available at https://star.worldbank.org/sites/star/files/g20_bo_country_guide_indonesia.pdf (accessed 30 April 2021); and Egypt, see Backer Mckenzi, (2020). Disclosure of Ultimate Beneficial Ownership now Required in Egypt. Available at https://www.bakermckenzie.com/en/insight/publications/2020/03/disclosure-beneficial-ownership-egypt (accessed 30 April 2021). 131 Azlin Ahmad, (2018). The Dana Gas Saga: The legal perspective, The IFN Asia Report, p. 42. 132 Ibid. 133 Ibid, p. 43. 134 Dana Gas PJSC v. Dana Gas Sukuk Ltd & Ors [2017] EWHC 2928.
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automatically enforce the judgement but instead were deciding on the enforceability of the
English court decision in the UAE. Before the decision could be made by the Sharjah court the
case was settled out of court.
Thus, here two legal issues are identified:
● Firstly, the legal concepts such as trust, purchase undertaking and other contractual
obligations have to be legally enforceable in the jurisdiction enforcing the sukuk
transaction
● Secondly, in cross border sukuk transactions that involve multiple jurisdiction
documentations, it must be ensured that the “underlying documents themselves are
compliant with and enforceable under each material jurisdiction involved.”135
4.2 Default Risk and Legal Issues arising
Default risk is the risk the debtor fails to make payment when installment payments or the
principle becomes due.136 Sukuk unlike conventional bonds represents the undivided
ownership of the underlying asset by the sukuk holders, and in theory is not a debt instrument
issued by the issuer.137 By right the underlying assets is owned by the sukuk holders and can
be used by them to obtain their investment capital and profits.
However, in reality sukuk are created to be similar to conventional bonds, especially where a
debt is owed by the obligor to the investors in the sukuk structure. This is what happens in an
asset based sukuk where it is the obligor’s obligation to ensure the scheduled installment
payments and payment of the investment capital. A simple example would be the BBA sukuk
where assets bought by the investors are resold to the obligor and thus the obligor owes a
debt to the investors. Another example can be seen in an ijarah sukuk, the assets that are
transferred to the SPV to hold on trust for the investors are still legally owned by the obligor.
In other words, no true sales takes place in an asset based sukuk and it is therefore doubtful
whether the sukuk holders’ interest in the underlying asset will be recognized.138 Instead in
135 Ibid. 136 Zakariaa, N. B., Md Isab, M. A., and Abidina, R. A. Z., (2012). The Construct of Sukuk, Rating and Default Risk. Procedia - Social and Behavioral Sciences, Vol. 65, p. 665. 137 ISRA, (2015). Islamic Capital Markets - Principles & Practices, Kuala Lumpur: ISRA, p. 464. 138 Ibid., p. 445.
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the sukuk documentation there will be mechanisms in place to ensure investors get back their
investment and are protected from risk of default. One such mechanism is the purchase
undertaking. This is a unilateral promise by the obligor that it will buy back the asset on the
occurrence of default, or at maturity. The purchase undertaking has been upheld to be valid
by the English courts in Dana Gas Case. Nevertheless, not all jurisdictions may follow this
decision.
In the case of an asset backed sukuk, due to a true sale, the asset itself would be owned by
the sukuk holders and will be remote from the bankruptcy of the obligor. This has been
established and recognized by the US courts in the East Cameroon case. Thus, a true sale
secures the rights of the sukuk holders.139 However, the risk profile in asset backed sukuk
(the risks associated with the asset) and the costs in terms of taxes and restrictions due to
legal title registration prevent the issuer from affecting a true sale. This legal obstacle has to
be overcome through a proper regulatory framework140 that enables sukuk structures to
ensure that a true sale takes place and at the same time not burden the parties to a sukuk
deal with costs and legal impediments.
4.3 Will issuing a Sukuk on Blockchain Eliminate the Legal Issues?
The legal issues highlighted above include the recognition of the transfer of assets,
safeguarding rights of the investors, ensuring the credit enhancing facilities like purchase
undertaking and ensuring conflict of laws do not affect the rights of investors or obligor.
Would a blockchain sukuk encounter these legal issues? This question was asked of the
experts during interviews and presented below are some of the views they expressed
individually –
Mr. Matthew Martin: 141
139 Saheed Abdullahi Busari, (2019). Juristic Analysis of Sukuk default: East Cameron Gas United States of America. Al Hikmah Journal, Vol. 2, No. 1, pp. 109-127, @125. Available at http://alhikmah.my/wp-content/uploads/2019/01/6-East-Cameron-%E1%B9%A2uk%C5%ABk-default.pdf, (accessed 29 November 2020). 140 Hafizi Ab Majid, Shahida Shahimi, Mohd Hafizuddin Syah Bangaan Abdullah, (2011). Sukuk Defaults and Its Implication: A Case Study of Malaysian Capital Market. Proceedings of 8th International Conference on Islamic Economics and Finance, Sustainable Growth and Inclusive Economic Development from an Islamic Perspective, Doha-Qatar, December. Available at http://www.iefpedia.com/english/wp-content/uploads/2011/12/Hafizi-Ab-Majid.pdf, (accessed 29 November 2020). 141 Founder of Blossom Finance, in an interview on 16th July 2020 with the researchers.
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So, everything I've told you about so far is just technology; has nothing to do with legal
and compliance. So that's what I understood your question to be about, the Ethereum
blockchain is focused on technology. So, compliance and legal is a completely separate
topic. There's almost no overlap between legal and compliance and blockchain. So, I'll
give you an easy example to conceptualize that. People use the Ethereum blockchain
to raise money for start-ups. People do it all the time. Many people. However, every
country has rules about funding for companies. There's their securities regulation, for
example, in the US. You have very strict limits about how you can advertise, the people
who can invest in start-ups, the amounts that you can collect from investors, etc. So,
if you add blockchain, it doesn't change the existing regulation. It doesn't absolve you.
It doesn't eliminate your responsibility to comply with all the securities regulations,
the law of the country, contract enforceability etc., right. (Emphasis added).
From the excerpt above, it is affirmative that Mr. Mathew believes legal compliance is
independent of and separate from the blockchain technology. This appears to be the opinion
of other experts that were interviewed. For example, Dr. Ziyaad Mohamed, a Shariah expert
and Associate Dean at INCEIF, stated that blockchain is at best an enabler and it depends on
how it is being coded to work for the sukuk issuers and investors. Thus, while the blockchain
sukuk ensures trust deficit is mitigated, it does not, on its own mitigate, legal risk.142 Likewise,
Mrs. Shabnam Mokhtar, Group EVP at SHAPE™ Knowledge Services,143 opined that the law
has to be complied with still, whether or not the sukuk is issued on a blockchain. The
blockchain will increase efficiency as a secure record of the assets but if the law of a country
requires registration of the transfer of assets, then this has to be complied with
notwithstanding the issuance of the sukuk on the blockchain.144
While elucidating on this issue, Kevin Koo, a legal counsel from Celebrus Advisory and Co-
founder of Lex Futurus, stated the following in an email interview:145
142 Online interview on 10th August 2020. 143 A Shariah advisory, consulting and training firm, SHAPE™ is an acronym that stands for ‘Shariah Alternative Products Enterprises.’ 144 Online interview on 20th August 2020. 145 In an email response to interview questions, June 2020.
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Although Sukuk is asset-backed [or asset-based], it is not free from legal issues.
Some of the event giving rise to legal issues are as follows:
Refusal to pay creditors by allegation of illegality. In 2017, Dana Gas issued Sukuk
under UK law based on assets in the UAE. It however refused to pay its creditors
the USD$ 700 million that it had promised through the “purchase undertaking,”
which was due upon maturity of the sukuk. It alleged that the investment
contract was void for illegality due to a change in the law. At a UK court, the
same argument was raised, along with an alternative argument of the
agreement being void for mistake. The judge, looking at the intention of the
parties when the contract was made, rejected this claim.146 Subsequently, a
settlement was reached in May 2018 in which sukuk holders were offered to
exchange their sukuk for a Shariah-compliant one, with lesser profit-sharing rate
and without option to convert to equity (unlike the original).147 The new sukuk
was sukuk wakalah (management of assets) rather than sukuk mudarabah. As of
April 2020, Dana Gas was trying to sell its assets in Egypt to pay off its sukuk
creditors.148
Management bordering on fraud. NMC Health PLC, the largest hospital chain in
Dubai, discovered that its founder and its former vice chairman had entered into
borrowing arrangements, which were undisclosed to the company.
Investigations uncovered hidden debt amounting to USD$ 2.7 billion, a massive
fraud on the company's creditors and investors. The company had previously
146 Dana Gas PJSC v. Dana Gas Sukuk Limited & 4 Ors. [2017] EWHC 2928. Available at http://www.sukuk.com/wp content/uploads/2017/11/Dana-Gas-judgment.pdf (accessed 30 August 2020). 147 Malay Mail, (2018). UAE’s Dana Gas agrees US$700m sukuk restructuring deal, 13 May. Available at https://www.malaymail.com/news/money/2018/05/13/uaes-dana-gas-agrees-us700m sukuk-restructuring-deal/1630400, (accessed June 2020). 148 Aoun, G., (2020). Dana Gas to use proceeds from Egypt assets sale to pay down sukuk. Zawya, 23 April. Available at https://www.zawya.com/mena/en/markets/story/Dana_Gas_to_use_proceeds_from_Egypt_assets_sale_to_pay_down_sukuk-ZAWYA20200423062241/, (accessed June 2020).
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reported $2.3 billion debt and declared that it was unaware of the borrowings.
The discovery meant that the company was at least $5 billion in debt.149
Bankruptcy. In October 2008, a U.S.-based sukuk issuer, East Cameron, filed for
bankruptcy, after only 2 years of its issuance. The question was how the sukuk
investors rights to the underlying oil revenue could be protected, in the event
the issuer was bankrupted.150 In the Louisiana court, the sukuk issuer argued
that the sukuk was a secured loan, not a "true asset sale". The court ordered for
the title of the ORRI (overriding royalty interest) to be transferred to the sukuk
holders. …
These are real problems which conventional sukuk cannot overcome; they fail
due to the shortcomings of men. Applying blockchain is one part of the equation
– the sukuk – without appropriate safeguards in the management of the
business itself, may be insufficient to protect the sukuk holders.
Thus, summing up if blockchain sukuk will overcome existing legal issues, the answer is
established in the negative. In other word, blockchain sukuk platform would not overcome
the current legal issues in classical sukuk, for instance, in relation to the need to register assets
when transferring same to an SPV and investors. If national law where the assets are situated
requires registration of the legal title of the assets to legally affect a transfer, then the
blockchain will not change this requirement. While the blockchain can act as a register to
record the transfer of title to the assets, if the national law requires registration of legal title
in their land registry or some other legal registry, this requirement has to complied with,
unless the law is amended151 to allow the blockchain to be the legal register for the transfer
149 Parasie, N., and Pham, L., (2020). Hidden $2.7 Billion Tips NMC Health into All-Out Scandal. Bloomberg, 11 March. Available at https://www.bloomberg.com/news/articles/2020-03-10/nmc-unauthorized-loan-facilities-boost-debt-to-about-5-billion, (accessed 22 June 2020). 150 Liau, Y.S. (2009). Sukuk: Safe Islamic Investments or Risky Business? Reuters, 5 November. Available at https://www.reuters.com/article/islamic-financial-sukuk-idUKLNE5A401220091105, (accessed 23 June 2020); Murdoch, G., (2009). Q+A - Structural risks - how safe are sukuk? Reuters, 5 November. Available at https://www.reuters.com/article/islamic-risks-assets-idUSKLR28939220091105, (accessed 23 June 2020); Zeineldin, H., (2014). East Cameron Gas Sukuk - A case study on sukuk default. Available at http://www.sukuk.com/wp-content/uploads/2014/04/East-Camerron-Case-Study.pdf (accessed 2 June 2020). 151 This was suggested by Shabnam Mokhtar in an online interview on the 20th of August 2020.
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of the title. Until that is recognized under the law of the land there will still be the separation
of legal and beneficial interest in cases where the assets are required to be registered under
the law of the land.
Further, blockchain will not be able to prevent mismanagement of the business by the
managers or agents of the obligor, even though it can act as a proof of wrong doings as
records cannot be changed in the blockchain. Again, in situation of conflict of laws in cross-
border transactions, the blockchain will not be able to improve the situation. However, where
there are legal issues relating to the records of the transaction, or forgery of the records,
blockchain sukuk would prevent such acts and thus provide a solution to this problem.
4.4 Would investors be more Secured in a Blockchain Sukuk Compared to a Classical Sukuk
in the event of a Default?
What about a situation where there is default by the obligor in a blockchain sukuk, would the
investors be more secured in a blockchain sukuk compared to a classical sukuk? This question
was posed to the experts in the course of the interviews. Overall, they opined no and played
down the notion.
According to Dr Ziyaad:152
A review of the major Sukuk defaults indicates that only one was on an issue
of record-keeping - the Sa'ad Sukuk. Fraud and negligence were not the
reasons for default in most. The rest were on issues of interpretation and
defaulting cash flows. Therefore, blockchain use would have provided limited
advantage for Sukukholders.
In a bit detailed response, Kevin Koo particularized and stated as follows:153
The events leading to default or potentially causing default, that I have
identified earlier (bankruptcy, mismanagement, deliberate refusal to pay)
show that the way sukuk is structured is more important in securing the
152 Associate Professor at INCEIF, in an interview on 10th August with researchers. 153 In an email response to the interview questions in June 2020.
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underlying assets. The legal rights of the parties are stated clearly in the
instruments being promoted as part of the sukuk.
In my opinion the underlying assets of the sukuk will not be on the blockchain;
they will not be blockchain tokens; and they cannot be manipulated or locked
up in a programmatic way using smart contracts. Until that happens, there will
be a need for intermediaries to play a role, to convert cash into a tokenized
representation; to send the tokens to the right address or generate new
tokens and administer them faithfully.
There is also a distinction of a sukuk that is asset-based versus one that is
asset-backed. The former (asset-based) is really a sukuk in which reliance is
placed on the credit strength of the borrower, whereas in the latter there is
reliance on the assets. In either case, if there is a default, you would need a
lawyer to get a court order to caveat the assets, freeze the accounts and
demand for payment to the creditors. And this court action would probably be
required, even if it is a blockchain-based sukuk. In actual fact, claims of how
blockchain can make the underlying assets “more transparent” would be
highly dependent on the implementation of the checks and balances in place.
I doubt that any business would want complete transparency of its business
accounts on a public blockchain. By the time the default is announced, it is
probably something management has known about, or would have at least
suspected for some time. By that time, the assets might have been drained. In
the end, unless there are new governance mechanisms for companies that link
them to the blockchain, a blockchain-based sukuk is only as good as the way
the sukuk is structured and the business is managed.
Accordingly, in mitigating risk of default, the blockchain itself being a technology will not
change status quo.
4.5 Shariah Risk
As stated earlier, Shariah compliance risk is the possibility of non-compliance with Shariah
rules that are imperative to be observed in a sukuk transaction. There are Shariah risks that
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exists in classical sukuk that have been mitigated through guidelines and resolutions of the
respective Shariah authorized bodies, these have been detailed below, these resolutions and
guidelines apply to sukuk that is issued on a blockchain as well.
Following this sub-section, the Shariah compliance risks that arise through digitization will be
explored.
4.5.1 Shariah Risks in Sukuk that have been mitigated through resolutions and Guidelines of
the respective Shariah Bodies.
Guarantee of Capital in Equity Based Sukuk
One Shariah issue in equity-based sukuk pertains to application of guarantee, where an issuer
guarantees sukuk investment capital to investors (sukuk holders). This is an issue because
Shariah requires sukuk capital and its return not be guaranteed in equity types of contracts
but be subject to the normal market and services trends.154 In relation to this, in 2007, a
renowned Shariah scholar, former Chief Justice of Pakistan and then chairman of Accounting
and Auditing Organisation of Islamic Financial Institutions (AAOIFI), Sheikh Taqi Usmani, made
an independent resolution that questioned the Shariah compliance of such sukuk structures.
The Shariah issue then was fixing of the price of underlying assets in equity type of sukuk.
Sheikh Taqi Usmani opined that fixing price of asset at time of contract is equivalent to
guaranteeing return to investors which is a Shariah non-compliant event in mudarabah and
musharakah sukuk, the main type of equity sukuk.155 This led to the six-point
recommendation by AAOIFI aimed at ensuring Shariah compliance of sukuk structures.156
154 However, scholars agree that the issuer may have an estimated benchmark for an anticipated return, so as to make the sukuk holder a bit aware of the kind of return to get from the sukuk investment. Mohammed Sawkat, Md Hamid Uddin Hossain, Sarkar Humayun Kabir (2018). Sukuk as a Financial Asset: A Review. Academy of Accounting and Financial Studies Journal, Vol. 22, No. 1. Available at https://www.abacademies.org/articles/sukuk-as-a-financial-asset-a-review-7134.html (accessed 21 February 2021). 155 Rashedul Hasan, Abu Umar Faruq Ahmad, and Tamiza Parveen, (2019). Sukuk Risks – A Structured Review of Theoretical Research. Journal of Islamic Accounting and Business Research, Vol. 10, No. 1, pp. 35-49. Equity types of sukuk are based on contracts of Mudarabah, musharakah and wakalah. The nature of the contract allows the parties to be partners and experience profit and loss. By fixing the price of the asset at the start of the sukuk it goes against the nature of equity as the capital of the investors are guaranteed. 156 The recommendations are: “(1) First - For Sukuk to be tradable, it must be owned by the Sukuk holders, along with all of the rights and obligations that accompany such ownership. The manager of a Sukuk issuance must establish the transfer of ownership of such assets in its books and must not retain them as its own assets. (2)
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The issue of guaranteeing capital of investors through a purchase undertaking was indirectly
used as a claim of Shariah non-compliance in the case of Dana Gas PJSC v. Dana Gas Sukuk
Ltd & Ors [2017] EWHC 2928 (Comm), (even though the true reason was cash flow problems).
Details of the non-compliance were not categorically explained. However, what followed
were a series of lawsuits which eventually culminated in a settlement through restructuring
the sukuk to ensure repayments to investors.157
Trading of a Debt
In debt-based sukuk, a Shariah issue pertains to sale of a debt.158 When a sukuk holder who
owns a debt-based sukuk, sells his sukuk in the secondary markets via a sale-based contract,
he is actually selling a debt. This sale of debt is prohibited in Shariah according to many Islamic
scholars.159 However, the Shariah Advisory Council of Securities Commission Malaysia has
sanctioned the principle of bai` al-dayn i.e., debt trading, as a concept for developing Islamic
capital market instruments.160
Second – Sukuk must not represent receivables or debt except in the case of a trading or financial entity selling all of its assets, or a portfolio with a standing financial obligation. (3) Third – It is not permissible for the manager of Sukuk to undertake and offer loans to Sukuk holders when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve for the purpose of covering such shortfalls to the extent possible, on condition that the same is mentioned in the prospectus. (4) Fourth – It is not permissible for the investment manager, partner, or investment agent to agree to re-purchase assets from Sukuk holders at a nominal value when the Sukuk are extinguished at the end of their maturity. It is permissible, however, to agree to purchase the assets for their net value, or market value, or fair market value, or for a price agreed to at the time of their purchase, in accordance with Shariah rules of partnership and modern partnerships, and on the subject of guarantees. (5) Fifth – It is permissible for the lessee in a Sukuk Ijarah to agree to purchase the leased assets when the Sukuk are extinguished for their nominal value, provided that the lessee is not also an investment partner, investment manager, or agent. (6) Sixth – Shariah supervisory boards should not limit their role to the issuance of fatwa on the structure of Sukuk but should also oversee its implementation and compliance at every stage of the operation - AAOIFI, (2008), Shariah Standards, p. 39. Available at http://aaoifi.com/?lang=en, (accessed 12 December 2019). 157 Dana Gas PJSC v. Dana Gas Sukuk Ltd & Ors [2017] EWHC 2928. 158 Sale of debt has two different applications, one in which the debt is sold to the debtor and where it was sold to a third party who has no prior connection to the debt. The use of one application or the other depends on whether debt is sold on the spot or is based on an installment plan. Firstly, selling debt based on an installment plan is called bay kali bil kali, which the messenger of Allah (SAW) prohibits this type of contract explicitly. Reported by Dar Qudni from Abdullah bin Umar and purified by Al-hakim based on Imam Muslims rules. See Imam al-Shaukani, (1995). Nayl al-Autar, Cairo: Dar al-Kutub al-`Ilmiyyah, Vol. 5 p. 156. It is also reported that scholars of Islamic jurisprudence are unanimous that bay’ dayn bi dayn is prohibited irrespective of where it is sold to the debtor or to a third party. An example of selling debt to a debtor is where a party says: “I wish to buy a kilo of wheat from you for a dinar where the payment and delivery of the wheat will take place in a month.” See Al-Zuhaili, Wahba, (1989). Al-Fiqhil Islamy wa Adillatuh, Beirut: Dar al-Fikr, Vol. 5 p. 89. 159 Al-Zuhaili, Wahba, (1989). Al-Fiqhil Islamy wa Adillatuh, Beirut: Dar al-Fikr, Vol. 5 p. 89. 160 Securities Commission, Malaysia, (2006). Resolutions of the Shariah Advisory Council [SAC] of the Securities Commission Malaysia, 2nd Edition, p. 16. Available at http://www.iefpedia.com/english/wp-content/uploads/2010/02/Resolutions_SAC_2ndedition.pdf, (accessed 30 June 2020).
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The SAC provided reasons for sanctioning debt trading after reviewing the opinions of the
different legal schools in Islamic law:
The SAC stated that, according to Hanafi school of thought, bai’ al-dayn is considered from
the perspective of potential risks to buyer, debtor and the nature of debt itself. It ruled that
bai al-dayn is not permissible on the ground that these risks cannot be overcome when debt
selling is executed.161 The SAC observed that the debt in this case is in the form of mal hukmi
(intangible assets) and the debt buyer in this case incurs a huge risk as he cannot own the
subject matter bought while the seller is unable to deliver what he sold.162 However, Maliki
school of thought allows selling of a debt to a third party only upon fulfilment of eight
conditions divided under three main categories: to protect the right of the debt buyer; to
avoid debt selling prior to qabadh (possession); and to eliminate riba.163 The eight conditions
are: (a) expediting payment in the purchase; (b) presence of debtor at the point of sale; (c)
the debtor confirms the debt; (d) the debtor belongs to the group that is bound by law so that
he is able to redeem his debt; (e) payment is not of the same type as dayn, and if it is so, the
rate should be the same to avoid riba; (f) the debt cannot be created from the sale of currency
(gold and silver) to be delivered in the future; (g) the dayn should be goods that are saleable,
even before they are received. This is to ensure that the dayn is not of the food type which
cannot be traded before the occurrence of qabadh; and (h) there should be no enmity
between buyer and seller, which can create difficulties to the madin (debtor).164 The Shafi’i
school of thought allows bai’ al-dayn to a third party provided that the debt was guaranteed
and was sold in exchange of goods which must be delivered immediately and in cases where
the debt is sold, it must be paid in cash or tangible assets as agreed by the parties.165 According
to Ibn al-Qayyim, since there is no direct Shariah injunction prohibiting bai’ al-dayn, he
allowed the practice and prohibited bai’ kali’ bi kali’ (a debt sale that is paid by debt).166
161 Ibid., p. 17. 162 Ibid. 163 Ibid., pp. 17-18. 164 Ibid. 165 Ibid. p. 18. 166 Ibid. For example, one buys food on credit for two months. When the time comes, he should redeem his debt. However, he says to the seller: “I still have no food to pay my debt, so sell it to me for another period.” The seller then sells it to him for another period and increases the price. In this case, the buyer did not receive anything in exchange when being charged for extending the period of payment.
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In consideration of the classical Shariah jurists’ views, the SAC ruled that bai’ al-dayn can be
used if there is a regulatory system that protects the buyer’s maslahah (public interest) in an
economic system.167 The SAC observed that the fears of risks as put forth by Hanafi and Maliki
schools of thoughts in this regard could be overcome by the fact that in the Malaysian context,
the regulatory authority overseeing bai’ al-dayn would be the Bank Negara Malaysia while
Securities Commission safeguards the interest of the parties involved in the transaction.168
Tangibility of Assets
Additionally, in a wakalah sukuk for instance, non-monetary ratio plays an important role in
attaining Shariah compliance of the transaction. It is a non-compliant event when not ensured
at the requisite moment. There are Shariah rulings to be observed while managing wakalah
investment portfolios.169 Fundamental one is that assets shall represent a minimum of 33%
of the value of the Wakalah Portfolio.170 This ratio is only applicable at the point of initial
investment for the Sukuk Wakalah, subject to the valuation principles set out in the Wakalah
Agreement and does not need to be maintained throughout the tenure of the Sukuk Wakalah.
However, the Wakeel (agent) shall ensure that the assets at all times remain a component of
the Wakalah Portfolio. For tradability purposes, the value of the tangible asset’s component
in the Wakalah Portfolio shall be not less than 33% particularly at the point of issuance of the
167 Securities Commission, Malaysia, (2006). Resolutions of the Shariah Advisory Council [SAC] of the Securities Commission Malaysia, 2nd Edition, p. 19. 168 Ibid. 169 In a sukuk Wakalah, pursuant to a Wakalah agreement between the Sukuk Trustee (acting on behalf of the investors (Sukukholders), the Sukuk Trustee (acting on behalf of the Sukukholders) shall appoint a party to act as its agent (Investment Wakeel) to perform services which will include investing the Sukuk proceeds in the Wakalah Investments. As defined under the Guidelines on Unlisted Capital Market Products under the Lodge and Launch [LOLA] Framework issued by the SC on 9 March 2015 (revised 30 June 2020) (as amended from time to time) (LOLA Guidelines) in Section A, Chapter 2, item 2.01: “Sukuk wakalah bi al-istithmar refers to certificates of equal value evidencing the certificate holders’ undivided ownership in the investment assets pursuant to their investment through the investment agent.” See Guidelines on Unlisted Capital Market Products Under the Lodge and Launch Framework, SC-GL/4-2015 (R4-2019). Available at https://www.sc.com.my/api/documentms/download.ashx?id=5dc363e4-de6a-4ab0-a4fb-f1548d88c2b8, (accessed 30 March 2021). AAOIFI, under its Shariah Standard No. 17, Item 5/1/5/8, states thus on Certificates of Investment Agency: “The issuer of these certificates is the investment agent, the subscribers are the principals, and the realised funds are the entrusted capital of the investment. The certificate holders own the assets represented by the certificates with its benefits and risks, and they are entitled to the profits, if any.” (See AAOIFI Shariah Standards for Islamic Financial Institutions 1439 A.H. - 2017, p. 475). 170 Forms of assets can be (i) Tangible asset, such as house; and (ii) Intangible asset, such as rights (e.g., right of intellectual properties) and usufruct (e.g., usufruct of an asset). See Securities Commission, Malaysia, (2020). Resolutions of the Shariah Advisory Council. p. 35. Available at https://www.sc.com.my/api/documentms/download.ashx?id=5f0c31dc-daa9-43c1-80ac-e7ecf70c8e44, (accessed 30 March 2021).
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Sukuk Wakalah.171 Failure to ensure this is a Shariah non-compliant event. However, it is up
to the investor and/or the issuer to adopt other requirements with regard to its tradability in
line with AAOIFI Shari’ah Standard No. 21 on Financial Papers (Shares and Bonds). In
particular, item 3/19 which states that:
If the assets of a corporation are composed of tangible assets, benefits, cash and
debts, the rule for trading in the shares of such a corporation will differ according
to the primary asset, which conforms to the objective of the corporation and its
usual activity. If its purpose and activity pertain to trading in tangible assets,
benefits and rights, trading in its shares is permissible without taking into
account the rules of Sarf or transactions in debts, with the condition that the
total market value of assets, benefits and rights should not be less than 30% of
the total assets value of the corporation including all assets, benefits, rights and
cash liquidity (the corporation’s debts, current accounts with others, and bonds
it holds which constitute debts) irrespective of their size as in such a case these
are secondary. If, however, the objective of the corporation and its usual activity
is dealing in gold, silver or currencies (Sirafah), it is obligatory to undertake
trading in its shares in the light of the rules of Sarf.172
Following this sub-section, the Shariah compliance risks that are unique to digitization will be
explored. This will be done through examination of the interviews with experts.
4.5.2 Shariah compliance risks that arise through digitization
Digitization and Shariah Requirements
With respect to blockchain sukuk, Professor Engku Rabiah Adawiah expressed the opinion
that blockchain sukuk is something doable from Shariah perspective and linking sukuk with
technology is not something new in the Malaysian sukuk market. Already sukuk issuance and
171 The following hadith, reported by Al-Bukhari and Muslim, is the basis of the decision for benchmark on ijarah assets as the minimum requirement for the tangibility ratio. In the hadith, the Holy Prophet (PBUH) said regarding portion of property to be disposed of via a will: "Make a will in one-third (of your property), and one-third is much (i.e., the will must not exceed one-third of the whole property)." This is the justification for the 33% used as benchmark for tangible assets representation in Sukuk Wakalah. See Imam Muslim Ibn Al-Hajjaj, (2007). Sahih Muslim, Book 13, Number 3991. Houston: Dar-Us-Salam Publications. 172 See AAOIFI, (2017). Shariah Standards for Islamic Financial Institutions, Standard No. 21, 1439A.H.-2017, p. 567.
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trading are being done online with fully automated tendering processes and real time
transfers. However, she cautioned that in using blockchain technology one should be cautious
about cyber security despite the fact that blockchain transaction is immutable, making it non-
reversible even in case information is required to be changed or there is fraud. She pointed
out that the way sukuk is currently issued and regulated in Malaysia is tamper-proof due to
the fact that multiple copies of transaction are shared with the parties and it is difficult to
change them without the acknowledgement or notice of other parties in the transaction. She
opined that using blockchain technology might not help sukuk transactions so much in
Malaysia except in terms of documentations and upholding Shariah requirement to evidence
obligations in writing as stated in Quran 2:282. In this regard, she was optimistic that
blockchain technology can take certainty of terms among parties in sukuk transaction to a
higher level and could shorten, in real time, clearance and settlement of sukuk transaction
cycles.173 She also stressed that blockchain technology, just like any other technology, will
have no Shariah compliance issue as long as the purpose for which it is used is Shariah
compliant.
In view of the forgoing, it can be said that sukuk transaction processes in Malaysia have been
largely digitized, however blockchain has not yet been added to the digitization of the
issuance of sukuk in Malaysia and in many parts of the world.
A concern highlighted by Professor Engku Rabiah Adawiah174 is whether blockchain’s
underlying smart contracts could perfectly effect parties’ obligations in the required sequence
for the execution of sukuk transaction in contrast to conventional bond transactions. This is
because the obligations of parties to sukuk transactions are required to be performed
manually upon execution of each part of the contract. For instance, in a Murabahah sukuk,
after the execution of sale contract, the goods need to be under the possession of the buyer
and then only can it be sold. The goods also need to be moved from one party to another
when their obligations become due. It is not possible to effect the underlying assets
movement obligation without human intervention in these kinds of sukuk structures. Failure
to observe this triggers Shariah issues in execution of contractual obligation which could
173 Efficiency and shortened real time transaction cycles have been established to be the case with digitisation in the practice of two conventional capital market instruments i.e., Nivaura bonds and World Bank’s bond-i. 174 Interview on the on the 28th of August 2020.
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otherwise result in default in the sukuk. As such, depending on the type of sukuk, the entire
process of sukuk transaction might not be automated using smart contracts since different
sukuk have different Shariah conditions governing them.
On her part, Mrs. Shabnam Mokhtar175 is of the view that certain errors in classical could be
mitigated using blockchain technology, including Shariah non-compliance error caused by
human interventions. Like Professor Engku Rabiah Adawiah, she also believes that it is not
every sukuk transaction that could be smoothly conducted without human the interventions.
Thus, Shariah experts raised concerns whether the Shariah requirements, such as transfer of
property could be automated to ensure Shariah compliance, it is opined that with the
combined use of tokenization and the use of smart contracts this can be achieved. As
Organisation for Economic Co-operation and Development (OECD) observed:
The electronification of financial markets and the use of automation for the
issuance and trading of financial instruments is not new. Securities have
existed in electronic-only format for a long time in what is described as
“dematerialised” form. Tokenised securities however could be seen as a form
of cryptography-enabled dematerialised securities that are based and
recorded on a decentralised ledgers powered by DLTs, instead of electronic
book-entries in securities registries of central securities depositories. The
decentralisation of tokenised securities, coupled with the ability to
automatically transact and settle without trusted intermediaries, may be
where most of the disruptive potential of tokenisation lies. Tokenised
securities eliminate the need for the use of intermediaries or proxies in the
distribution of dividends or votes, giving investors full control of the equity
they own.176
Digital Assets and Shariah Compliance
During the research interviews, issue of using digital or cryptocurrency instead of fiat currency
in blockchain sukuk was raised and Professor Engku Rabiah Adawiah gave an insight in that
175 Interview on the 18th of August 2020. 176 Organisation for Economic Co-operation and Development [OECD], (2020). The Tokenisation of Assets and Potential Implications for Financial Markets, p. 14. Available at: https://www.oecd.org/finance/The-Tokenisation-of-Assets-and-Potential-Implications-for-Financial-Markets.pdf, (accessed 28 June 2020).
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respect. When digital currencies are used for blockchain sukuk, then the question of their
acceptance will arise, legally and in Shariah.177 Many Islamic jurists do not sanction the legality
or lawfulness of digital currency, even though others have shared contrary viewpoint in favour
of cryptocurrencies.178 The professor stated that issues like exchange rate in converting
cryptos to fiat money will arise since crypto currencies are not acknowledge and accepted as
legal tenders by most central banks. Also, the fact that no authority regulates them adds to
the uncertainties of cryptos that can lead to injustice. So, controversy persists globally due to
the speculative and unstable nature of cryptocurrencies. In Malaysia, however, the Securities
Commission Shariah Advisory Council had in June and July 2020 ruled that digital assets are
Shariah compliant if approved as securities by the Securities Commission. This definitely
opens up possibilities of using them for blockchain sukuk and accordingly strengthens the
prospects of blockchain sukuk in Malaysia.179
With respect to kind of resources that could be used as underlying assets in blockchain sukuk,
Professor Engku Rabiah Adawiah expressed the opinion that there is a possibility of using
digital assets as underlying assets in sukuk.
According to Assistant Professor Dr Ziyaad Mohamed,180 a potential Shariah issue that could
arise in a blockchain-based sukuk transaction when tokenization is part of the process with
tokens representing underlying assets, is a situation he describes as “break-out.” This is where
a token could become detached from its underlying assets.181 Furthermore, he is of the view
that collecting funds for sukuk in cryptocurrencies could have Shariah issues, described in his
words, as follows:
177 Developments, however, are underway on the issuance and acceptance of central bank digital currencies (CBDC) as legal tender in certain countries. For example, by the People’s Bank of China, which is close to issuing and monitoring its own digital currency to replace some Yuan in circulation. See Bloomberg, (2019). China's PBOC Says Its Own Cryptocurrency Is ‘Close’ to Release, Bloomberg News, 12 August. Available at https://www.bloomberg.com/news/articles/2019-08-12/china-s-pboc-says-its-own-cryptocurrency-is-close-to-release, (accessed 14 August 2020). 178 For full discussion on viewpoints of Shariah scholars, see Yusuf Sani Abubakar, Ahamad Faosiy Ogunbado, Mpawenimana Abdallah Saidi, (2018). Bitcoin and its Legality from Shariah Point of View, SEISENSE Journal of Management, Vol. 1 No. 4, pp. 13-21. Available at https://doi.org/10.5281/zenodo.1400535, (accessed 14 August 2020). 179 Shariah Advisory Council, Securities Commission Malaysia (2020). Digital assets from Shariah perspective. Available at: www.sc.com.my/development/islamic-capital-market/resolutions-ofthe-sc-shariah-advisory-council, (accessed 4 December 2020). 180 In an online interview on 10th August 2020. 181 In the absence of Central Banks’ tokenised cash, platforms offering tokenisation services could use stablecoins.
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From a Shariah perspective, transactions are carefully dissected at every
juncture, to ensure compliance before issuance. Issuance is in the form of
certificates which may be built on a blockchain. If this is further developed
using tokenisation, where tokens represent ownership to facilitate ease of
investing and secondary market trading, Shari'ah issues may emerge.
Why? For example, someone purchases a digital asset, a token, that
represents the underlying asset value of a Sukuk and becomes a Sukukholder.
The token is linked to the underlying value - as a stablecoin. However, if the
token itself is traded as a digital asset and not on the value of the underlying
assets, this may be referred to as a 'breakout' or a decoupling from the real
value of the Sukuk, triggering Shari'ah issues.
Pricing of digital assets used in the sukuk could be an issue as it might be difficult to obtain
fair value of such assets. However, in terms of pricing of the underlying assets in the sukuk,
Shariah rules allow parties to agree to a price.182 Furthermore, the fundamental Shariah
requirement to be always observed is the same i.e., to be Shariah compliant, whether the
sukuk assets are digital or non-digital. This is in line with Shariah Advisory Council of Securities
Commissions Malaysia resolution wherein it states:
The underlying assets in `uqud mu`awadhat, ventures in `uqud ishtirak and
investments in wakalah bi al-istithmar which become the basis for these sukuk
structuring must comply with Shariah.183
As such, from a Shariah perspective of tokenization of digital assets in sukuk could be possible
as long as the underlying assets represented by the digital assets are Shariah compliant. With
182 For instance, The Asset Purchase Price under the Ijarah Assets Sale and Purchase Agreement as well as the Commodity Purchase Price under the Commodity Murabaha Investment shall be in compliance with the asset pricing requirements of the Resolutions of the SAC of the SC (31 December 2019) on page 99, as below: “(1) The asset purchase pricing of an identified asset for sukuk issuance that involve the sale and purchase of identified assets which are structured based on any Shariah principles is permissible subject to the requirements in item (2) below. (2) The asset purchase pricing of an identified asset in sukuk issuance must not exceed 1.51 times of: (a) the fair value of the asset; or (b) any other appropriate value of such asset. The asset pricing requirements in item (2) above are not applicable for sukuk which are structured based on any Shariah principles that does not involve sale and purchase of identified assets including but not limited to sukuk ijarah that involves the lease and lease-back of the identified assets.” 183 Securities Commission, Malaysia, (2020). Resolutions of the Shariah Advisory Council, p. 99. Available at https://www.sc.com.my/api/documentms/download.ashx?id=5f0c31dc-daa9-43c1-80ac-e7ecf70c8e44, (accessed 30 March 2021).
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tokens as digital representation of asset-backed securities as in sukuk, tokenization can be
viewed as a ‘proxy for their securitization on the blockchain.’184
Lastly cyber threats are discussed in relation to sukuk issued through blockchain.
4.6 Cyber Risks in Blockchain Sukuk
Cyber risks are definitely unique to blockchain sukuk. The Securities Commission of Malaysia
has issued regulations on cyber risks - the Guidelines on Management of Cyber Risk 2016
which applies to all capital market entities. The Guidelines lay down the roles and
responsibilities of the board of directors and management in management of cyber risk;
requires capital market entities to have cyber risk policies and procedures; requires the
entities to have comprehensive strategies and measures to manage cyber risk including
prevention, detection and recovery; and reporting breaches on the day of the cyber incident
to the Securities Commission. These guidelines are comprehensive and cover cyber threats.
It remains to be seen whether they will apply to blockchain sukuk.
Some experts, however, view blockchain-based transactions as insusceptible to cyber threats.
In this regard, Nashwa Badeeu, Head of International Business Operations at Finterra,185 had
this to say on robustness of sukuk on blockchain:
I would say that Blockchain Sukuk is quite immune from cyber threats.
Technology wise, blockchain offers maximum security since validation is given
to blocks by multiple peers. To break any block, it would not only require
attacking multiple peers, but would incur high cost due to high use of
electricity, equipment, etc. To access a block, a threat would require getting
through the personal digital signature (i.e., cryptography) of the peer and if
this is done, the entire peer network is alerted of the matter instantly. The
beauty of Blockchain is that it is decentralized. So, attacking one peer would
not break a blockchain, thus even if a threat does get through one peer, there
are multiple other peers that validate the one block, thus making blockchain a
very secure platform for financial transactions. For an instrument like Sukuk
184 Organisation for Economic Co-operation and Development [OECD], (2020). The Tokenisation of Assets and Potential Implications for Financial Markets, p. 15. 185 In an email interview in June 2020.
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that depends highly on its governing Smart Contract, blockchain offers a very
secure platform since it would require to break multiple blocks just to access
this Contract. So, I would say, blockchain is very immune to cyber threats since
there is no weak point for threats to attack.
This is definitely a positive view and upholds the unique characteristic of blockchain of being
immutable.
Compliance with traditional reporting requirements186 under extant laws and regulations is
mandatory for blockchain-based sukuk transactions.187 Accordingly, blockchain sukuk will
need peculiar regulations for its ongoing monitoring by regulatory authority. This needs to be
developed,188 and RegTech could provide some solutions in this regard.
186 For example, IFSB-19 Guiding Principles on Disclosure Requirements for Islamic Capital Market Products (Sukuk and Islamic Collective Investment Schemes). Available at https://www.ifsb.org/download.php?id=4375&lang=English&pg=/published.php, (accessed 14 August 2019). 187 Hussein Elasrag, (2019). Blockchains for Islamic finance: Obstacles & Challenges. Munich Personal RePEc Archive, 6 March. Available at https://mpra.ub.uni-muenchen.de/92676/1/MPRA_paper_92676.pdf, (accessed 12 August 2020). 188 Ibid.
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REGTECH
5. Regtech
This fifth section will explore RegTech, its definition, evolution, benefit and challenges in its
adoption and the use of Regulatory Sandbox to test its use. This section also discusses two
jurisdictions that are testing the use of RegTech in their capital market and finally this section
explains the potential of using RegTech in blockchain sukuk to automate compliance.
RegTech is a combination and short form of the terms “Regulatory" and "Technology” or
“Regulation Technology”. The Institute of International Finance defines RegTech as “the use
of new technologies to solve regulatory and compliance burdens more effectively and
efficiently.”189 In a plain language, the term ‘RegTech’ is used to denote the use of technology,
more specifically information and communication technologies (ICTs), in regulating market in
the context of – (a) compliance, (b) risk management, (c) identity management and control,
(d) regulatory reporting, (e) transaction monitoring, etc. In this regard, RegTech is sometimes
seen as a subset of financial technology (fintech) for improving and streamlining regulatory
processes.190
5.1 Increasing regulatory requirements and Cost of compliance
Compliance entails all processes of ensuring a company and its employees, products and/or
services are in accordance with extant standards, regulations and ethical practices applicable
to entities in a particular industry. In the corporate world, compliance is a crucial interface
that greatly informs of corporate adaptability of an entity to a regulatory environment.
Compliance function is regarded as integral to development and sustainability of modern
firms that have become inextricable in budgetary allocations with dedicated skilled
189 Institute of International Finance, (n.d.). Regtech. Available at https://www.iif.com/Innovation/Regtech (accessed on 4 December 2020). 190 Anagnostopoulos, Ioannis, (2018). Fintech and regtech: Impact on regulators and banks. Journal of Economics and Business, Vol. 100, pp. 7-25.
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resources.191 Since the 2008 global financial crisis, financial regulators have become stricter
on this function which comes at a huge cost to firms today. With huge and increasing legal
and regulatory changes in pursuit of standards, financial stability, safeguarding consumer
rights and addressing concerns on data privacy in business digitization, cost of compliance
increases, becoming a cause for concern among companies. This is because companies need
sufficient budgets for them to invest in daily compliance activities and to acquire necessary
skills for that purpose. Without such budgets and skills, growth and diversifications in
operations and/or productions come at risk of compliance with the ever changing legal and
regulatory environment; hence the idea of RegTech to offset such cost in addition to bringing
about incredible accuracy in compliance among other competitive advantages.192
Financial regulators around the world today impose stricter regulations on companies to
avoid, inter alia, recurrence of financial crisis like the ones of 2008. In measuring up to
developments in this regard, industry participants have started to explore the use of ICTs to
meet the legal, regulatory and compliance related needs and demands. This has accordingly
raised interest in RegTech as “one of the very few answers to the compliance risks and
challenges existing in the financial industry.”193 RegTech accelerates an evolution towards a
cooperative supervisory model, where supervisor guides financial institutions to comply with
the regulations satisfactorily and in turn, financial companies deliver necessary input for the
development of efficient guidelines, best practices and RegTech solutions.194
5.2 Generations and Development of RegTech
According to Douglas W. Arner, Janos Barberis and Ross P. Buckley, the evolution and
development of RegTech can be viewed in three stages or generations: RegTech 1.0, RegTech
2.0 and RegTech 3.0 as shown in the following figure.
Figure 5.1 Generations of Regtech
191 Thomson Reuters, (2020). Cost of Compliance 2020: New Decade, New Challenges. Available at https://corporate.thomsonreuters.com/Cost-of-Compliance-2020, (accessed 4 December 2020). 192 Evans, G. L. and John Mason, B. (2020). Regtech 2020 and Beyond – What Does the Future Hold? Refinitiv. Available at https://www.refinitiv.com/content/dam/marketing/en_us/documents/reports/regtech-2020-and-beyond.pdf, (accessed 4 December 2020). 193 Packin, Nizan Geslevich. (2018). RegTech, Compliance and Technology Judgment Rule. Chicago-Kent Law Review, Vol. 93, p. 193. 194 Colaert, Veerle, (2017). RegTech as a response to regulatory expansion in the financial sector. Social sciences Research Network, (SSRN). Available at https://ssrn.com/abstract=2677116, (accessed 4 December 2020).
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Source: Douglas W. Arner, Janos Barberis and Ross P. Buckley
RegTech 1.0–2.0 represent the digitization of regulatory processes, whereas RegTech 3.0 is
about a regulatory framework for the digital age. The first generation i.e., RegTech 1.0 (1967-
2008) was largely driven by industry, especially large financial institutions who integrated
technology into their internal processes to combat rising compliance costs and complexity, as
epitomized in the Basel II Capital Accord. However, these financial institutions were involved
in a partnership with regulators that was based on overreliance on quantitative internal risk
management systems.195
RegTech 2.0 or second generation RegTech (2008-2018) era was driven by financial market
participants and regulators who used technology to enhance regulatory compliance and
streamline its component processes. It evolved after the global financial crisis in 2008 when
financial regulators began to increase issuance of new regulations and requirements whose
implementation and compliance with required the industry participants to spend huge
resources.196
The third generation i.e., RegTech 3.0, exhibits the greatest potential of RegTech and its
development. It involves the use of technology to reconceptualize finance and its regulations
and to build a better financial ecosystem using data. As finance industry becomes datacentric
and use of technology becomes widespread, a progressive shift is being witnessed towards
data digitization and monetization that calls for rethinking of the regulatory framework for
195 Arner, Douglas W., Janos Barberis, and Ross P. Buckley, (2017). FinTech and RegTech in a Nutshell, and the Future in a Sandbox. CFA Institute Research Foundation, Research Foundation Briefs, Vol. 3 Issue 4, pp. 16-17. Available at https://www.cfainstitute.org/-/media/documents/article/rf-brief/rfbr-v3-n4-1.ashx, (accessed 30 May 2020). 196 Ibid.
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financial services; so that new technological concepts such as bigdata, smart contract,
algorithm supervision, blockchain and artificial intelligence can be accommodated. However,
the ability of regulators in processing the huge data volume generated by these innovations
is limited, hence the RegTech 3.0. According to findings of a research commissioned by CFA
Institute Research Foundation, the true potential of RegTech lies in its ability to effect a
profound transition from a “know your customer” (KYC) to a “know your data” (KYD)
approach, underpinned by efficient and effective processes for the collection, formatting,
management and analysis of reported data, accompanied by a fundamentally datacentric
mindset.197 RegTech 3.0 entails promising solutions. However, RegTech companies and
financial organisations will face some challenges in terms of data governance regime such as
under the EU General Data Protection Regulation, considered the global standard on personal
data protection, which has stricter provisions against violation.
5.3 Benefits of RegTech
A properly developed and deployed RegTech can offer benefits to both industry participants
and regulators. For the industry participants on one hand, a RegTech product promises, inter
alia, efficiency (in terms of easier management and time savings), cost reduction, risk
anticipation, security and better creativity. It empowers financial institutions by controlling
costs and mitigating risks more effectively. It offers financial institutions automated solutions
that can speed up the cumbersome process of vetting clients and transactions which is
necessary to prevent money laundering and other financial crimes. It presents new
opportunities for FinTech startups, advisory firms and tech companies. For the regulators on
the other hand, RegTech facilitates the development of continuous-monitoring tools to
identify problems as they develop and reduce the time it takes to investigate compliance
breaches. Regulators can also get more standardized digital transaction reports from financial
institutions to spot potential fraud more reliably and with fewer staff. RegTech also fosters
the development of simulation systems and sandboxes, which can identify the likely
consequences of proposed reforms and new approaches.
Additionally, as financial market evolves to rely more on data, RegTech’s potential
transformative capacity will enable real-time monitoring to facilitate the reconceptualization
197 Ibid.
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of financial regulations. In this regard, institutions with the most data on borrowers will be
best placed to assess their credit risk and extend credit to them, and those institutions are
increasingly more likely to be large tech companies (e.g., Google, Alibaba, Apple) or retail
conglomerates operating customer loyalty schemes, rather than traditional financial
institutions. So, the emergence of these new forms of financial services providers, in turn,
demands further evolution of RegTech as the market moves from reliance on KYC-type of
information to a KYD paradigm, with consequentially transformative effects on finance and
its regulation.
5.4 Challenges and concerns in RegTech Adoption
There are some challenges to deal with for the successful implementation of RegTech. For
instance, due to existing obstacles pertaining to human factor, RegTech may not provide
solution to all corporate governance problems. RegTech alone cannot eliminate all undesired
and unethical business practices or resolve related issues resulting from corporate culture as
technology can also be used to evade regulations and frustrate regulators. Also, technology
operates based on opaque programmed reasoning that may often be biased and reflects
altered interpretations of law and regulations. According to Dr Ziyaad, “it is something that is
designed by human beings and it is definitely going to be with flaws which are exposed only
after continuous investigation and analysis… Even though you've programmed it very
specifically with an algorithm, but it interprets one little transaction in that whole process
incorrectly or, according to its algorithm correctly, but according to human incorrectly.”198 So,
reliance exclusively on this would hinder human input and good judgment in governance and
risk management decision-making processes. With increasing concern about data security in
the cyber-space, internet-dependent RegTech could expose financial institutions and other
users to cyber risks. Financial and technical competence of regulators is another issue in legal
and regulatory settings among countries where various regulators perform overlapping
duties. Moreover, some RegTech applications may use highly complex and sophisticated
Artificial Intelligence (AI) algorithms which are designed to learn and evolve based on data
patterns. Compliance and business professionals need to acquire the technical skills to
understand in detail how these algorithms function. Similarly, auditing the methodology or
198 Asst. Prof. Dr Ziyaad Mahomed, INCEIF, text of online interview, Monday 10 August 2020.
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logic used by an AI-algorithm to generate a specific output or decision can be challenging.
Also, with expanding regulatory requirements and their costs, including the ever-increasing
information requests from regulators, many of the RegTech’s automation and efficiency gains
may not be easily utilized.199 Given these obstacles, effective market adoption of RegTech
would be difficult.
5.5. RegTech Adoption: Regulatory sandbox
Sandboxes are virtual environments used to test and examine the impacts of innovative new
processes or technologies in isolation.200 The UK’s Financial Conduct Authority (FCA) has led
progress in this area with its Project Innovate unit announcing that sandboxes are a “safe
space in which businesses can test innovative products, services, business models, and
delivery mechanisms without immediately incurring all the normal regulatory consequences
of engaging in the activity of question.”201 The FCA’s sandbox has three core objectives: (1) to
reduce time-to-market, (2) to improve access to finance, and (3) to encourage innovation.202
Regulatory sandbox provides opportunity for RegTech firms and innovators in the financial
services industry to test their algorithm behind a particular RegTech solutions before they are
offered to the mass market. So, through a sandbox, RegTech firms could be allowed to make
their product, solution or platform available to a restricted number of user or client financial
institutions. To safeguard the process, once the RegTech solution is deployed, but before
execution, regulators would review it. This enables regulators and RegTech firms to learn
how the user or client financial institutions interact with the solution or platform and how, in
comparison with human assessment, the algorithm performs.203 Establishing a regulatory
sandbox for a particular capital market innovation requires consideration of some key issues
which determines the success of an innovation. First is ascertaining regulatory barriers, if any,
to introducing and testing a new idea in a market. Second is safeguarding consumers and the
199 See, generally, Packin, N. G. (2018). RegTech, compliance and technology judgment rule. Chicago-Kent Law Review, Vol. 93, p. 193. 200 Goo, J. J. and Heo J. Y. (2020). The Impact of the Regulatory Sandbox on the Fintech Industry, with a Discussion on the Relation between Regulatory Sandboxes and Open Innovation. Journal of Open Innovation: Technology, Market and Complexity. Vol. 6. No. 43, pp. 1-18. DOI: 10.3390/joitmc6020043. 201 Financial Conduct Authority, (2015). Regulatory Sandbox, p. 1. Available at https://www.fca.org.uk/publication/research/regulatory-sandbox.pdf (accessed 20 January 2021). 202 Ibid. p. 1 203 Ibid. p. 2
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financial system while introducing and testing the new idea. Third is understanding extant
legal framework to tailor new ideas/products in line with applicable and relevant regulatory
arrangements.204
Regulatory authorities in several jurisdictions such as Abu Dhabi, Australia, Malaysia, Hong
Kong, Singapore, Switzerland and Thailand have expressed an openness to the use of
sandboxes. Among these jurisdictions, several capital market services and products have been
developed and tested via regulatory sandboxes. In addition to regulatory sandbox, some
potential governance strategies that capital market operators may consider when adopting
RegTech tools include the following -
- Establishing a cross-functional technology governance structure. A cross-disciplinary group
may need to be involved in the development, testing and implementation of RegTech tools.
Testing of various scenarios and outputs generated by the tools with input from a cross-
functional group may help limit potential issues.
- Maintaining summary of RegTech tools. Maintaining a simplified summary describing the
underlying algorithms and related strategies may enable non-technical staff to understand
the intended functions of the tools and algorithms so that they are better able to assess
results that do not align with expectations.
- Systematic Data quality risk management. Data integrity and control is of paramount
importance for many RegTech tools, particularly those that employ Artificial Intelligence (AI)
to deliver desired results. Developing an appropriate data quality risk-management program
is vital to helping ensure accuracy, completeness, and consistency of the data that is used to
support the RegTech systems.
- Automating malfunctions or errors Identification and Mitigation. Firms may benefit from
having appropriate policies and procedures in place to identify, respond to and mitigate
material risks that may manifest in the event errors or malfunctions arise in association with
the use of a RegTech tool. This may include establishing alternative processes that can be
readily employed in the event the RegTech tool fails.
204 Ibid. p. 3
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- Training of personnel. Firms would benefit from developing appropriate policies and training
for compliance, supervisory and operational staff on the use of the RegTech tools they
adopt.205
5.5.1 Regtech Initiatives for Capital Markets
The need to automate monitoring and compliance activities in financial transactions has been
established in several studies.206 RegTech as a mechanism for automation of capital market
operations is however largely at an experimental stage now and so there is no data on
RegTech for Islamic capital market. RegTech is potentially emerging in market regulation to
address compliance imperatives, ensure accuracy and efficiency of regulated entities and
regulators. As capital market enterprises become digitised and data-centric, regulators would
consequently consider RegTech indispensable for enterprises in pursuit of compliance and
monitoring functions. This section discusses regulators’ initiatives in two jurisdictions, UK and
Australia, for the use of RegTech in their financial market.
UK’s Financial Conduct Authority RegTech Sprint
The UK’s Financial Conduct Authority (FCA) in conjunction with the Bank of England
hypothesised and confirmed the hypothesis that regulatory reporting and compliance tasks
can be automated via standards-based RegTech for cost-effective and efficient savings by
financial enterprises. At its Technology Sprint in November 2017 (RegTech Sprint), the FCA
examined the possibility of digitising regulations with a view to developing digital regulatory
reporting. This was done in conjunction with fifty participants across the UK’s finance
industry, comprising regulators from the FCA and Bank of England, law firms, academics from
205 Financial Industry Regulatory Authority, (2018). Technology-Based Innovations for Regulatory Compliance (RegTech) in the Securities Industry. Available at https://www.finra.org/sites/default/files/2018_RegTech_Report.pdf, (accessed 9 December 2020). 206 See for instance Kavassalis, P., Stieber, H., Breymann, W., Saxton, K., and Gross, F.J., (2018). An innovative RegTech Approach to Financial risk Monitoring and Supervisory Reporting. The Journal of Risk Finance. Vol. 19 No. 1, pp. 39 - 55; Nasir, F., and Saeedi, M. (2019). ‘RegTech’ as a Solution for Compliance Challenge: A Review Article. Journal of Advanced Research in Dynamical and Control Systems, Vol. 11 No. 11, pp. 912-919; Butler, T. and O’Brien, L. (2019). Understanding RegTech for Digital Regulatory Compliance, in Lynn, T., Mooney, J.G., Rosati, P., and Cummins, M. (Eds.). Disrupting Finance: FinTech and Strategy in the 21st Century. Cham: Palgrave Macmillan – Springer Nature, pp. 85-102; Arner, D.W., Barberis, J. & Buckley, R.P. (2018). RegTech: Building a Better Financial System. In Chuen, L. D. K & Deng, R. (Eds.). Handbook of Blockchain, Digital Finance, and Inclusion, Volume 1: Cryptocurrency, FinTech, InsurTech and Regulation, London: Academic Press.
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university ICT centres, RegTech solution and industry firms including JWG-RegDelta,
Regnosys, Santander, Hitachi Ventara, Governor Software etc.207
The RegTech Sprint produced a Proof of Concept (PoC) that made possible and, to a practical
extent, demonstrated the viability of a straight-through regulations processing and
automated reporting termed ‘Digital Regulatory Reporting.’ The process was in phases. Using
artificial intelligence (AI) and semantic technologies, the PoC initially processed regulatory
provisions to provide regulatory alerts in addition to rendering FCA’s regulatory provisions
into machine-executable or machine-readable for the creation of digital regulatory alert. This
alert identifies regulatory provisions’ themes and their target products/activities. Following
the initial phase was digitalisation of regulations applying semantic technology that targets
certain vocabularies in regulatory provisions (e.g., those pointing at possibility, necessity,
impossibility) as well as rules (e.g., those specifying permissions, obligation, prohibitions). It
also employs standard business rules and vocabulary and enables experts in that regard to
capture and express peculiarities. This was tested and proved with only a subset of reporting
requirements and rules as per FCAs handbook.208 On that scale, it enables experts to
transform legislation, regulatory rules, guidelines, standards and create a machine-
executable and human-readable regulatory language presented via a simple web interface.
With these and other supporting programs/softwares, required data were extracted,
transformed and loaded. Relevant calculations were also done in like manner and relevant
regulatory reporting documents were filled and submitted to FCA and other regulators.209
Regardless of negligible issues observed during the testings and trials at the Regtech Sprint,
the PoC is said to have remarkably achieved digital regulatory reporting.210 The initiative is
yet to be operationalised or deployed into any of the regulators’ practices in market
207 Financial Conduct Authority, (2017). Model Driven Machine Executable Regulatory Reporting, TechSprint. Available at https://www.fca.org.uk/events/techsprints/model-driven-machine-executable-regulatory-reporting-techsprint. (accessed 12 April 2020). 208 Ibid. See also Micheler, E., and Whaley, A. (2020). Regulatory Technology: Replacing Law with Computer Code. European Business Organization Law Review, Vol. 21 No. 2, pp. 349-377; Buckley, R. P., Arner, D. W., Zetzsche, D. A., and Weber, R. H. (2020). The Road to RegTech: the (astonishing) example of the European Union. Journal of Banking Regulation, Vol. 22 No. 1, pp. 26–36. 209 Butler, T. and O’Brien, L. (2019). Understanding RegTech for Digital Regulatory Compliance, in Lynn, T., Mooney, J.G., Rosati, P., and Cummins, M. (Eds.). Disrupting Finance: FinTech and Strategy in the 21st Century. Cham: Palgrave Macmillan – Springer Nature, pp. 85-102. 210 Micheler, E., and Whaley, A. (2020). Regulatory Technology: Replacing Law with Computer Code. European Business Organization Law Review, Vol. 21 No. 2, pp. 349-377.
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regulation. It is noteworthy that the UK’s initiatives are meant to encompass all the financial
services industry including money and capital markets.
Australian Securities and Investment Commission RegTech Initiatives
Australian Securities and Investment Commission’s (ASIC) has produced a more specific
RegTech innovation that is purposefully tailored for capital market during its Regtech
Initiatives 2018-2019 and 2019-2020. The Regtech Initiatives encompassed series of projects
that involved developments, experiments, tests and trials of various RegTech programmes
and applications that would help the ASIC adopt RegTech in carrying out its mandates.211 For
this purpose, ASIC in collaboration with RegTech solution firms partook in those
developments, experiments, tests and trials in stages and invented different resolutely-built
prototype RegTech solutions for different aspects of market regulatory requirements. The
initiatives were in two phases, starting in 2018-2019 and continued in 2019-2020. The initial
phase involved the developments, experiments, tests and trials of the RegTech prototype
that can be deployed in Monitoring Financial Promotions and for Financial Advice, among
others.212
At the initial phase, ASIC called for applications from RegTech solution firms with the
technical know-how and necessary resources to develop desirable RegTech for monitoring
financial promotions in market to ensure such “promotions are clear, balanced, not
misleading or deceptive and meet specific disclosure obligations.”213 Five firms were selected
in accordance with the strength and workability of their proposed solution and worked with
a curated set of data on financial promotions of credit services. The selected firms
demonstrated the operation of the developed RegTech solutions at a problem-solving
symposium. Thorough analyses of financial promotional material from those data set were
undertaken; risk and non-compliance characteristics were identified in about 90 percent of
211 Australian Securities and Investments Commission, (2017). Report 523: ASIC’s Innovation Hub and our approach to regulatory technology. Available at https://download.asic.gov.au/media/4270022/rep523-published-26-may-2017.pdf. (accessed 12 March 2021). 212 Australian Securities and Investment Commission, (2019). ASIC’s Regtech Initiatives 2018-19 Report 653. Available at https://download.asic.gov.au/media/5424092/rep653-published-20-december-2019.pdf. (accessed 8 March 2021). 213 Ibid., p. 7.
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the examined cases.214 This RegTech provides reviews on monitoring advertisements and its
compliance.
For Financial Advice, ASIC focused on how market operators or licensees would be better
monitored and supervised while providing personal financial advice. Six RegTech firms were
selected, among them was IBM Research, in accordance with the strength of their proposed
solution. At their demonstration symposium, the firms tested the operation of their
inventions via review of client files that determined compliance level of advice to clients.
Combining rule-based expert systems, natural language processing (NLP) and artificial
intelligence (AI), the review processed large volumes of client files with the highest accuracy
level possible. The demonstration identified several compliance issues in financial advice files
that ASIC provided for the trial. This proved RegTech promising. Overall, the ASIC RegTech
initiatives discovered violations of compulsory disclosure requirements in near real-time and
with accuracy; established conduct violations in financial advice files i.e., statements of
advice; detected instances of poor sales practice and more.215
These RegTech prototypes demonstrated success as prospective solutions to the problems
sought to be addressed. They are however still in the testing, trial and/or demonstration
phase. The ASIC initiatives, when fully operationalised in the market, are meant to reform and
transform market regulation in its entirety. ASIC’s second phase of the initiatives would cover
financial services digital record-keeping; public companies digital financial recording;
monitoring via machine learning of credit providers’ lending obligations; tools for non-
financial risk and/or programs to be used by executives and boards.216
5.6 RegTech for Blockchain Sukuk
As the world moves towards digitization, so also financial services. With the advent of fintech,
development and offering of Islamic financial products/services are fast becoming digitized.
214 Ibid. 215 Ibid. See also Chanthadavong, A. (2019). ASIC wants to see more adoption of regtech by Australia's financial sector. Available at https://www.zdnet.com/article/asic-wants-to-see-more-adoption-of-regtech-by-australias-financial-sector/. (accessed 12 March 2021). 216 NB: Activities for undertaking the second phase of the ASIC’s initiatives were billed for 2019-2020 but suspended due to Covid-19 pandemic. See Australian Securities and Investment Commission, (2020). ASIC’s Regtech Initiatives 2019-2020 Report 685. Available at https://download.asic.gov.au/media/5937756/rep685-published-20-january-2021.pdf (accessed 8 March 2021).
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As sukuk moves from manual processes to a digitized/blockchainised automation, a suitable
RegTech would be a required step to appropriately bring the same within regulators’ purview.
This research proposes that a RegTech solution that appropriately ensure compliance with
legal, regulatory and Shariah requirements surrounding blockchain sukuk can be developed
for the blockchain sukuk. In addition, governance and sustainability of concerns of blockchain
sukuk and/or digitized Islamic capital market could be tackled via RegTech. As a financial
expert put it:
Regtech in this regard can be tailored to address issues peculiar to blockchain
Sukuk. Also, with information securely shared with regulators on the blockchain,
a foundational layer of security is ensured so that the consumer can be protected
against fraud. Thus, RegTech is considered to offer a strengthened investor
protection as those who invest in unregulated sukuk on blockchain run the risk
that their investment is not protected.217
On the role RegTech can play to facilitate blockchain sukuk development, Dr. Ziyaad
Mahomed views such role a natural progression in the financial services industry generally.
He opined thus:
Regtech is going to be a natural progression where issues around KYC are involved.
KYC is becoming quite cumbersome for institutions without substantial IT
infrastructure. For example, I had a personal experience recently of spending
more than 90 minutes to open an account at a local bank due to the number of
forms and regulatory compliance. RegTech will hopefully streamline that process,
and e-KYC would be the first level of the implementation of RegTech. In fact, the
reporting process between banks or financial institutions and the regulators is
often cumbersome. RegTech will hopefully reduce the cost of providing reports to
the regulators and provide them in a more standardised manner. Much time is
lost due to the back and forth between institution and regulator due to gaps in
expectation.
217 Hisham Abdul Rahim, Head of Islamic Finance, Access Blockchain Association, text of answers to interview questions through email, June 2020.
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Shariah governance with RegTech will be a significant as RegTech supports Shariah
governance requirements. We expect that RegTech will also reduce the potential
for Shariah non-compliance emanating from procedural issues.218
In the same vein, Dr Farrukh Habib shared the view as Dr Ziyaad expressed in the foregoing
citation when the former stated:
I think RegTech is very good, and it is going to basically lessen processes like
KYC, AML, custodianship and, with the whitelisting219 of different investors,
tax evasion as well. These kinds of concerns in sukuk can be addressed
through RegTech. It is a very good tool.220
With respect to Shariah governance in traditional sukuk, scholars have established that a gap
exists in compliance monitoring between launching of the sukuk and its maturity. According
to Dr Ziyaad:
Sukuk today are structured in the form that a Shariah advisor approves the
structure initially and then the actual implementation of that Sukuk over a
period is not monitored by a Shariah advisor, except for a few, and so you
don't even know if a Shariah advisor has stepped out or has stopped, proving
that all he has done in the process is approved an original set of legal
documents. This is a big problem, and it is the reason we have issues like in
Dana Gas Sukuk.
This gap can be bridged by automating Shariah compliance function via RegTech type of app
programmed to monitor compliance and thus perform a sort of Shariah advisory work
throughout the sukuk life cycle. In the words of Dr Farrukh:
If you have products, for example, which are quite uniform in the sense that
like there is not much difference, like when you talk about murabaha, because
218 Asst. Prof. Dr Ziyaad Mahomed, Shariah scholar, INCEIF, text of online interview, Monday 10 August 2020. 219 Whitelisting is a cybersecurity strategy which only allows users to take such actions as the administrator has allowed. Fruhlinger, J. (2020). Whitelisting explained: How it works and where it fits in a security program, CSO. Available at https://www.csoonline.com/article/3562429/whitelisting-explained-how-it-works-and-where-it-fits-in-a-security-program.html, (accessed 14 April 2021). This can be taken care of through RegTech. 220 Dr Farrukh Habib, ALIF Technologies, text of online interview, Monday 22 June 2020.
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same terms and conditions are there in traditional murabahah sukuk as in
blockchain sukuk. So, a murabahah is a murabahah and the structure is the
same, then RegTech can be used to automate it. So, whenever you can find a
pattern, a repetitive process, of course you can automate it; you can digitize it
and RegTech can be used for that purpose. But again, saying that does not
mean that the scope of Shariah scholars in sukuk would be banished.221
In subscribing to the idea of automating or digitizing Shariah requirements for the purpose of
their compliance in blockchain sukuk, Prof. Engku Rabiah Adawiah stressed that Regtech
provides an avenue for that. As the erudite Professor stated:
It is okay to automate to ensure compliance throughout the sukuk; because
there are requirements on issuing entities like maintaining certain ratio of
liquid and illiquid assets, I mean debt and cash ratio as opposed to the tangible
assets…. So, you can actually put RegTech in so that it will be easy to support
compliance, and make sure the requirements are being met throughout
without having to do manual checking of that. You can automate that, and this
can be done also for other regulatory requirements by the SC that need to be
observed throughout.222
Thus, RegTech would seem to be favored by the experts for use in blockchain sukuk, as a
means to ensure compliance with regulations, Shariah continuous monitoring and even
investor protection. It is thus recommended that RegTech be developed for sukuk blockchain
to enhance its efficiency, transparency and utility. Additionally, RegTech could be very
significant to the supervisor role of regulators in blockchain sukuk.
221 Ibid 222 Prof. Engku Rabiah Adawiah, IIUM and member SACs of BNM & SC, text of online interview, Tuesday 28 August 2020 at 3:30 pm.
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KEY TAKEAWAYS
6.Key Takeaways of Report
6.1 Findings
The main difference between sukuk and sukuk that is issued via blockchain is that, in
blockchain sukuk, blockchain connects all parties, participants or stakeholders in whatever
capacity relevant to the sukuk issuance. This connection of all parties in a sukuk issuance is
missing in a classic sukuk issuance.
Since blockchain is a ledger where all needed information is available to all the parties in the
sukuk transaction, there is information symmetry and thus transparency. At the same time,
the information is cryptographically secured and changing it on the blockchain is near
impossible.
This research has revealed a number of advantages of blockchain sukuk over classical sukuk.
Apart from greater transparency and security, efficiency is also increased as information is
easily visible and available. Also, certain intermediaries can be done away with the use of
blockchain. For example, in a World Bank Treasury webinar,223 Mr. Andarea Dore, Head of
Funding, Capital Markets Division of World Bank Treasury, explained how the World Bank
issued a blockchain bond named Bond-i224 in collaboration with the Commonwealth Bank of
Australia (this is explored in section 3 above). Mr. Andarea explained how, under the Bond-i,
investors were enabled to directly place their order on a blockchain web-based platform, and
the World Bank, as issuer, observed in real-time the book building process without the need
for underwriters who traditionally are the intermediaries between the issuer and the
investors. In the Bond-i issuance, the World Bank was able to communicate directly with the
investors through a communication layer of the blockchain allowing it to finalise the bond
223 World Bank. (2018). Webinar on Blockchain Bond World Bank Treasury. Available at https://www.youtube.com/watch?v=lqYAcDTTAU0 (accessed 7 September 2020). 224 This issuance is explained under the subsection on blockchain sukuk in this report.
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prices and for investors to adjust where necessary. This not only rendered unnecessary the
role of an intermediary (the underwriter) but also allowed for better transparency and
efficiency of the whole process as compared to traditional bond issuance. With increased
transparency and efficiency and reduction in intermediaries, costs are significantly reduced
too.
This research establishes that Sukuk on blockchain also allows for micro issuances of sukuk
which facilitates financial inclusion. Additionally, this research has ascertained that RegTech
could be very significant for ensuring compliance of blockchain sukuk with regulatory and
Shariah requirements in a cost effective and efficient manner.
However, the research observed that despite the advantages of blockchain in the issuance of
sukuk, there is an inertia in using blockchain to issue sukuk. In an interview with Dr. Farrukh
Habib,225 the learned scholar highlighted two hurdles that were causing this inertia. The first
one being that, even though issuers are interested in using blockchain, they view it as an extra
burden and cost in implementation (although once implemented the cost would be lower but
getting it to work in a particular jurisdiction would incur more work and possible costs). So,
since sukuk is currently in high demand, there is no immediate necessity or value addition to
use blockchain to issue sukuk. The second one being that the regulatory requirements for
issuing sukuk on blockchain is not very clear in many jurisdictions and thus issuers are not
keen to be the test case or experiment in testing which regulations to comply with.
On legal issues, findings of the research show that issuing sukuk on a blockchain platform
does not overcome the current legal issues that exist in sukuk relating to the need to register
the assets when transferring them to an SPV and investors. If national law where the assets
are situated requires registration of the legal title of the assets to legally effect a transfer,
then the blockchain will not change this requirement. While the blockchain can act as a
register to record the transfer of title to the assets, if the national law requires registration of
legal title in land registry or some other legal registry, this requirement has to complied with,
unless the law is amended226 to allow the blockchain to be the legal register for the transfer
of the title. Until that is recognized under the applicable law of the land there will still be the
225 Interview with researchers on 22nd June 2020. 226 This was suggested by Mrs. Shabnam Mokhtar in an online interview on the 20th of August 2020.
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separation of legal and beneficial interest in cases where the assets are required to be
registered under the law of the land.
On Shariah issues this research finds that the existing Shariah opinions on sale of debt,
tangibility ratio of underlying asset, requirements of underlying asset and innovation in
general do not prohibit the use of blockchain sukuk for reason that it could be Shariah non-
compliant. By adhering to the existing Shariah opinions on those issues when structuring a
blockchain sukuk, there would be no Shariah issues. The juristic opinions broadly cover
classical and blockchain sukuk.
This leads to recommendations of the research.
6.2 Recommendations
Firstly, there is a need to clarify the regulations that are actually applicable to blockchain
sukuk. While there are presently comprehensive regulations governing classical sukuk, the
question arises as to whether these regulations suffice?
Kevin Koo227 believed that separate guidelines maybe necessary because:
[…] blockchain sukuk would be a meeting point of two emerging asset classes:
crypto assets as well as Islamic finance. Not only does the assets underlying
the sukuk need to be properly secured, but the token holders’ rights would
also need to be protected in case of loss of their tokens. There may also be
need for blockchain oracles (external sources of data) to be recognised as
playing a role in legally triggering certain smart contract events.
The researchers agree, just as digital banks require separate guidelines, notwithstanding the
respective Acts governing banking and Islamic banking, so would blockchain-based securities
need clear guidelines. This is to ensure market participants have certainty when dealing in
such financial products. In essence, innovations in this regard should be regulated by
appropriate laws.
227 In an email interview in June 2020.
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Secondly, findings of the research show that issuing sukuk on a blockchain platform does not
overcome the current legal issues that exist in sukuk relating to the need to register the assets
when transferring them to an SPV and investors.
Thus, it is recommended that the applicable laws be amended to recognise blockchain as the
register for the transfer of legal title in all types of assets for the purposes of financing.
Thirdly, in relation to Shariah risks that could arise from the blockchain sukuk, this can be
mitigated by choosing a structure which is compatible with the technology. Sukuk is a flexible
instrument that can be structured in different ways depending on the needs of the parties.
As such, the potential issues that could lead to Shariah non-compliance risk could be mitigated
by ensuring that Shariah requirements of the sukuk structure used is adhered to. In this
regard, it is recommended for the regulatory authorities of Islamic capital market and Shariah
standard setting bodies such as the SAC and AAOIFI enact Shariah standards that would be
followed in blockchain-based sukuk for each and every Shariah contract used to structure it
and for tokenization of underlying assets. Unlike conventional bond, which is a generic
structure used to raise financing, sukuk itself is a financial instrument that needs
customization depending on the needs of the parties. There should also be clear Shariah
guidelines on the use of digital assets as the underlying for blockchain sukuk.
Fourthly, this research finds that the use of RegTech with sukuk blockchain will probably
reduce the cost of providing reports to regulators and improve burdensome processes like
KYC, AML, custodianship and whitelisting of different investors, and prevention of tax
evasion228 and also improve Shariah compliance and governance.229 RegTech would seem to
be favored by the experts for use in blockchain sukuk, as a means to ensure compliance with
regulations, Shariah continuous monitoring and even investor protection. It is thus
recommended that RegTech be developed for sukuk blockchain to enhance its efficiency,
transparency and utility. Additionally, RegTech could be very significant to the supervisor role
of regulators in blockchain sukuk.
Fifthly, a solution is required for the practical problem where the loss of a private key could
result in losses to the sukuk token holder. Lawyer Kevin Koo explains:
228 Dr Farrukh Habib, ALIF Technologies, text of online interview, Monday 22 June 2020. 229 Asst. Prof. Dr Ziyaad Mahomed, Shariah scholar, INCEIF, text of online interview, Monday 10 August 2020.
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If the blockchain sukuk is truly decentralized and each sukuk holder holds the
ERC20 tokens, it will enable easy transactions among interested parties.
However, with increased decentralization comes the issue of blockchain projects
whereby token holders are responsible for their own private keys. Loss of the
private keys may mean irrecoverable loss of the ERC20 tokens held in their
blockchain wallets. Another aspect is that unless the private key is known to the
token holders’ family, they may never recover the funds in the blockchain
address, if he passes away. However, since the profile of a sukuk investor,
especially for Islamic microfinance, may be your average guy, it is highly likely
that this kind of responsibility may be too much for him to bear. The regulators
would probably want a failsafe mechanism in which, even if the sukuk tokens
(which are linked to the smart contracts) cannot be recovered , the pay out of
the periodical profit-sharing rate and the final purchase payment are
guaranteed. That might work if the blockchain wallet address has been linked to
the identity of the sukuk holder.230
The regulator would thus need to create a solution to safeguard investors who inadvertently
lose their private key.
6.3 Conclusion
Blockchain is a technology that has made possible innovative changes to financial
intermediation, including within the Islamic capital market and in sukuk. Nevertheless, care
needs to be exercised while incorporating innovative technologies in issuing sukuk, as in any
other Islamic financial product, to guard against legal risk, regulatory risk, Shariah risk and
other risks. This research highlights how sukuk market would benefit from blockchain
technology.
Even though blockchain has its advantages, certain risks are, however, observed that are
unique to blockchain sukuk. These risks have to be overcome, and the research has proffered
recommendations accordingly. As for RegTech in this regard, it requires regulators to
collaborate closely with business entities and related inter-governmental agencies. The
230 Email interview with Kevin Koo Celebrus Advisory – Legal Counsel /Lex Futurus – Cofounder in June 2020.
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researchers understand that further research is required in this area for proper development
of the proposed recommendations. Nevertheless, as a first step, the advantages of blockchain
sukuk, the legal, Shariah and other risks associated therewith as well as the need for RegTech
in the capital markets and its usage in blockchain sukuk have been identified.
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APPENDIX
Appendix A - Interview Questions
Introduction
Blockchain sukuk is a recent innovation of Industry 4.0. It is where sukuk is developed and
issued via a blockchain platform, in the Islamic capital market. Regulatory technology or
RegTech , is a component of financial technology (fintech) that facilitates financial institutions
and corporations to comply with reporting and compliance requirements imposed by the
regulatory authorities. Regtech employs technologies such as blockchain, artificial
intelligence and cloud-based services to comply with the regulations by managing risks in a
transparent manner while providing better services. The objective of our research is to
explore the sukuk blockchain and the prospect of developing RegTech for blockchain-based
sukuk.
We are a research collaboration of five researchers231 from three Universities in Malaysia
namely University Malaya, International Islamic University and INCEIF
We appreciate your acceptance to be interviewed and welcome any feedback or comment
on the following questions:
Understanding Blockchain Sukuk
1. Is a blockchain Sukuk a normal crowdfunding platform?
2. With Blossom Finance’s debut SmartSukuk in 2018, issuance of blockchain sukuk is
lately making headlines in the Islamic capital. To your knowledge, is there any statistics
as to how much worth of blockchain sukuk has so far been issued globally?
3. From your understanding what are the differences of Blockchain sukuk and the
classical sukuk in the Islamic Capital markets ?
4. In your view, what benefit(s) (or disadvantages) do the issuers and investors of
blockchain sukuk stand to gain over and above classical sukuk?
231 Sherin Kunhibava, Aishath Muneeza, Auwal Adam Sa’ad, Muhammad Ershadul Karim & Zakariya Mustapha. Email Addresses: [email protected], [email protected], [email protected], [email protected], [email protected]
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5. Do you foresee a sukuk being issued purely on digital assets232 as the under lying
assets?
6. Malaysia has recently issued regulation on digital tokens offerings through a platform
– i.e., via Initial Exchange Offering (IEO). IEOs are basically the same as ICOs except
that it is done through digital exchanges instead of the token issuer themselves. The
Guidelines are in draft form to allow potential issuers, platform operators and
investors to familiarise themselves with the requirements in the Guidelines. Do you
think that this is like the blockchain sukuk? Would such a platform make redundant
the blockchain sukuk?
7. Given the robustness of the blockchain technology, how immune can blockchain sukuk
be from the issue of cyber threats?
Legal Issues
1. Are you aware of any possible legal issue(s) that the Islamic instrument of sukuk would
have when issued on the blockchain? How can such legal issue(s) be possibly
addressed?
2. Should regulation be different for blockchain sukuk as compared to classical sukuk? If
so how?
3. In your opinion, could the blockchain platform record both the beneficial and legal
interest in the property for sukuk?
4. In the event of default in blockchain sukuk by the issuer, would the interests of the
investors be automatically secured?
5. In your opinion are investors more secured in a blockchain sukuk compared to a
classical sukuk?
Shariah Issues
1. In your opinion what are the possible Shari’ah issues for Sukuk issuances based on the
blockchain technology?
2. In your opinion, how would the blockchain technology ensure overall compliance with
Shariah in sukuk structure that operates on blockchain?
3. Would there be any role for Shariah advisers and legal personnel in a blockchain sukuk,
and how are their respective roles (if any) to be played and/or integrated in the
operation of blockchain sukuk?
4. Tokens are used in blockchain sukuk – is there any legal or Shariah issues in relation
to this?
Regtech
232 The Financial Action Task Force (FATF) has defined virtual asset as follows: A virtual asset is a digital representation of value that can be digitally traded, or transferred, and can be used for payment or investment purposes. Virtual assets do not include digital representations of fiat currencies, securities and other financial assets that are already covered elsewhere in the FATF Recommendations. This definition lays down the attributes of a digital asset – 1. It is digital, 2. It has a value 3. It can be traded or transferred in the virtual realm 4. It can be used for payment or investment.
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1. What in your opinion would the role be of RegTech in the Islamic capital market?
2. Are you aware of any developments in using RegTech in ensuring compliance in the
Islamic capital markets?
3. What is your opinion on using RegTech for regulating sukuk on blockchain?
4. Could RegTech be used for Shariah advisory work?
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Appendix B – Expert Interviewees
Name Date of Interview in 2020
Position Mode of interview
Dr. Farrukh Habib
22 June 2020, 11 am (UAE) time
Co-Founder / Managing Director Alif Technologies, Dubai, UAE Expert in Shariah | Finance | FinTech Adviser | Consultant | Trainer | Researcher | Speaker | Writer
Zoom
Mathew Martin
Jul 16, 2020 3pm – 3:30pm (Indonesia)
Founder of Blossom
zoom
Dr Alaa Alaabed – 27 June 2020 6:00pm (UAE)
Chief Research Officer [email protected]
zoom
Nashwa Badeeu
June Head of International Business Operations Finterra
Affendi Ariffin
24 June Treasurer Access Blockchain Association
Edmund Yong
24 June Cofounder Celebrus Advisory
Hisham Abdul Rahim 24 June Access Blockchain Association Head of Islamic Finance
Kevin Koo
24 June Celebrus Advisory – Legal Counsel Lex Futurus – Cofounder Access Blockchain Association
Asst. Prof. Dr. Ziyaad Mahomed
10 August 2020 10:56pm (KL)
Associate Dean/Director, Executive Education & E-Learning
zoom
Shabnam Mokhtar August 18, 2020 03:30 (Kuwait)
Group EVP SHAPE™ Knowledge Services [Shariah Alternative Products Enterprises]
Zoom
Professor Engku Rabiah August 28 3pm (KL)
Professor and Shariah Advisor IIUM IBF
Zoom
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Appendix C – Sukuk Structures According to various
Classifications/categorizations
1. Sukuk structure based on Underlying Assets
I. Example of an Asset-based Sukuk Structure: US$600 million Malaysian First Global Sukuk
Structure
Figure C1. Asset-based (Ijarah) Sukuk Structure [Source: Securities Commission 2009a]
Description of the structure
Malaysian government wants to raise money – so it decides to sell its assets and lease them
back, using a sukuk.
1. The Federal Land Commissioner (FLC) holds the title to Malaysian government landed
properties. To enable the Sukuk issuance, FLC sold the beneficial title of the Prime
Ministers Departments staff quarters in Jalan Dato Onn and two hospitals in Klang to
a special purpose vehicle (SPV), Malaysia Global Sukuk.
2. The SPV funded the purchase by issuing the Sukuk representing beneficial ownership
of the asset to investors.
3 & 4. The proceeds from the sale of assets is paid to FLC.
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5a. The SPV (acting on behalf of the investors) then leased the asset to the Malaysian
government.
5b. In addition to the lease contract, the Malaysian government also gave an irrevocable
undertaking (purchase undertaking – PU) to the SPV, which says that at maturity or
event of default, it will buy back the assets.
6 & 7. As lessee, the Government of Malaysia paid rental semiannually to the SPV, which in
turn paid semi-annual distributions to investors.
8 & 9. Only at maturity (5 years) the investors obtained back their principal amount.
II. Example of an Asset-backed Sukuk Structure: Cagamas Asset-backed Sukuk (Mortgage-Backed)
Figure C2. Cagamas Berhad Asset-backed Sukuk [Source: Securities Industry Development
Corporation 2009]
Description of the structure
1. Funding for the acquisition of asset is derived from investments evidenced by the
sukuk issued by the SPV (Cagamas MBS).
2. The asset is purchased from the originator (government of Malaysia) under a true sale
arrangement.
3. The true sale isolates the asset completely from the originator and at the same time
all rights and obligations in the said asset are thus transferred to the SPV.
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4. All obligations on the Sukuk i.e. the income stream attached fall on the government of
Malaysia (originator) who now plays the role of a servicer, i.e., undertaking to
administer the assets and perform such other services on behalf of the SPV as required
in the securitization transaction.
III. Simplified Combination Sukuk Structure: Islamic Development Bank (IDB) combination
Sukuk
Figure C3. Islamic Development Bank (IDB) combination Sukuk (Trust Certificate) [Source: Lahsasna, A. et al. 2018]
Description of the Structure
Islamic Development Bank issued the first combination Sukuk of assets comprising 65.8%
Sukuk al-Ijara, 30.73% of Murabaha receivables and 3.4% Sukuk al-Istisna. This issuance
required the IDB’s guarantee in order to secure a rating for international marketability. The
$400 million Islamic Sukuk was issued by Solidarity Trust Services Limited (STSL), a special
purpose company incorporated in Jersey Channel Islands. The Islamic Corporation for the
Development of Private Sector (ICD) played an intermediary role by purchasing the asset from
IDB and selling it to The Solidarity Trust Services Limited (STSL) at the consolidated net asset
value.233 Under the structure of this combination sukuk, the originator IDB transfers tangible
233 Dar Al Istithmar. (2006). Sukuk: An Introduction to the Underlying Principles and Structure. Oxford, UK: Dar Al Istithmar, p. 33.
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assets as well as murabahah deals to the SPV. The SPV issues certificates of participation to
sukuk holders and receives funds. The Islamic finance originator uses the funds. The IDB
purchases these assets from the SPV over the agreed period of time and investors (sukuk
holders) receive fixed payment of return on the assets.234
2. Debt-Based Sukuk Structures based on Shariah Contracts
Debt-based sukuk are generally structured on sale-based Shariah contracts which include
Murabahah or bai bithaman ajil (BBA), bai Salam, Ijarah, Bay Inah, Istisna. Often, the purpose
of a transaction for which a particular contract could be used differ from one jurisdiction to
another. For instance, the use of murabahah and/or BBA contract in Malaysian market to
structure Islamic commercial papers - Murabahah Notes Issuance Facilities (MuNIF), utilized
for short-term issues, and BBA with Islamic Debt Securities (BaiDs) for long-term issues. These
are however more of a market setup than strictly Shariah arrangement.235
a. Murabahah/Bai Bithamin Ajil (BBA) Sukuk
Murabahah, also known as bai bithaman ajil (BBA), is a cost-plus sale where an Islamic bank
or any other financial institution enters into an agreement and purchases an item or goods
for a client who purchases same from the bank or financial institution on an agreed markup,
i.e., actual purchase price which is disclosed to the client plus profit. Murabahah is also known
as organised tawarruq or a reverse murabahah. It serves as a monetization method and
mechanism for Islamic cash financing whereby a client to an Islamic bank or any other
financial institution, after a murabahah purchase of asset on credit/deferred payment basis,
sells it on cash basis to a third party. Murabahah sukuk are mostly primary market instruments
due to their nature of being debt owing from subsequent buyer of the commodity which
renders them impermissible for secondary market trading.236 Regardless, they could be
negotiable where they constitute a smaller part of underlying asset portfolio based on a more
234 Lahsasna, A., Hassan, M. K., and Ahmad, R. (2018). Forward Lease Sukuk in Islamic Capital Markets: Structure and Governing Rules, Cham: Springer International Publishing AG, p. 67. 235 Securities Commission, Malaysia, (2009). Sukuk. Islamic Capital Market Series. Abdulkadir Thomas (Ed.). Kuala Lumpur: Sweet & Maxwell Asia. p. 130 236 AAOIFI, (2017). Shariah Standard No. 59, Sale of Debt (Bay’ al-Dain).
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liberal interpretation of the rule against sale of debt as practiced in Malaysian jurisdiction.237
Murabahah sukuk arrangement typically goes with tawarruq and the instruments are
therefore issued for the purpose of financing purchase of goods or asset with holders of the
sukuk as owners of the murabahah product.
Murabahah sukuk transaction uses bai al-inah as a supporting contract, an arrangement that
involves sale and buy-back of an asset between contracting parties. The sale is on cash basis
while the buy-back is on deferred basis at a higher price than the cash sale. Bai al-inah may
be effected where an owner sells asset to a buyer (customer) at a deferred sale price and
subsequently buys back the asset on cash basis at a price lower than the deferred sale. Bai al-
inah is a debatable contract among Shariah scholars and its implementation in Malaysia
requires fulfilment of several Shariah conditions related to sale transactions. These include
executing the sale and purchase of the assets in two separate contracts without a condition
for resale or repurchase of the assets. Both transactions shall be properly sequenced and
executed at different times with appropriate transfer of ownership and holding possession
(actual or constructive) of the assets.238
Cagamas Berhad (Cagamas) Murabahah/Tawarruq Sukuk Structure
In murabahah/Tawarruq sukuk arrangement, an entity desirous of raising funds to purchase
commodity (fund user) issues sukuk via an SPV. The SPV receives sukuk proceeds from
subscribers. The sukuk subscribers are owners of the commodity and entitled to the sukuk
final sale price at redemption. Two separate brokers would be involved, A and B, and the SPV
purchases the commodity from broker ‘A’ on spot basis, at a purchase price, using the
proceeds received from the subscribers. Obligor then purchases the commodity from the SPV
at a markup and pays up over a specified period. Afterward, the commodity is sold to broker
‘B’ by the fund user at a purchase price. A periodic return is made by the Obligor to the SPV
who in turn makes corresponding payments of profits to the investors (sukuk holders). At
237 Dar Al Istithmar. (2006). Sukuk: An Introduction to the Underlying Principles and Structure. Oxford, UK: Dar Al Istithmar, p. 18. Available also at http://www.sukuk.com/wp-content/uploads/2014/03/Sukuk-Structures.pdf, (accessed 20 December 2020). 238 Securities Commission, Malaysia (2018), Resolutions of the Shariah Advisory Council [SAC] of the Securities Commission Malaysia, pp. 8 - 13. Available at https://www.bursamalaysia.com/sites/5bb54be15f36ca0af339077a/assets/5cd169eb39fba251c3695bad/Resolution_SAC_2018.pdf, (accessed 20 December 2020).
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maturity, the Obligor redeems the sukuk and reimburses the sukuk holders at purchase price
via the SPV.
The figure below illustrates the structure of Cagamas Berhad sukuk commodity murabahah
with tawarruq.
Figure C4. Cagamas Commodity Murabahah (BBA) with tawarruq [Source: ISFIRE Insight 2014]
Description of the Structure
(1) Cagamas, as agent (Wakil) of Sukuk Investors, purchases commodity (Crude Palm Oil) on
a spot basis from Vendor ‘A’ at Purchase Price.
(2) Cagamas (Issuer) issues Sukuk to Investors to evidence their ownership of the commodity.
(3) & (4) Proceeds received from the Sukuk Investors are used or deemed to have been used
to pay the purchase price of the commodity.
(5) Sukuk Trustee, on behalf of the Sukuk Investors, sells the commodity to Cagamas at Sale
Price repayable on a deferred payment basis.
(6) & (7) Cagamas sells the commodity to Vendor ‘B’ on a spot basis at Selling Price. Proceeds
received from the sale of commodity are used to fund Cagamas’ Islamic operations.
(8) & (9) Cagamas makes periodic profit distribution (e.g. semi-annual basis) to the Sukuk
Trustee on account of its obligation to pay the Deferred Sale Price Upon maturity, Cagamas
will pay the Sukuk Trustee the principal to redeem the sukuk.
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b. Salam Sukuk
Salam or bai salam is literally a contract to purchase commodity on deferred basis for present
price. Accordingly, a salam contract arises where contracting parties agree for a sale of goods
for which immediate cash payment is made on executing the agreement, but they would be
delivered in future time. As a financing mechanism in Islamic banking, salam is defined as “an
agreement whereby an Islamic banking institution purchases from an obligor a specified type
of commodity, at a predetermined price, which is to be delivered on a specified future date
in a specified quantity and quality.”239 So, in a salam arrangement, an Islamic bank will make
payment of price in full at the execution of the contract and stand as a purchaser of a
commodity to be produced. There is also a ‘parallel salam’, an arrangement ensuring a buyer
is secured for the salam commodity, whereby an Islamic bank would, after sealing a salam
contract with an obligor, enter a separate sale agreement with a buyer through wa’d
(purchase undertaking). Salam sukuk are issued under a salam contract to mobilize funds for
financing and/or purchasing salam commodity or asset.
Salam Sukuk Structure
In this illustration, an SPV sources Salam asset from a party that needs fund. Meanwhile, an
offtaker undertakes to buy the asset at maturity for profit. The obligor could be the SPV’s
wakeel to source for the offtaker. The SPV issues salam sukuk and proceeds realised
therefrom are passed on to the obligor in exchange for the salam asset on forward basis. At
maturity, the obligor delivers the asset which will be sold to the offtaker at a profit. The sale
may be done via the obligor as wakeel of SPV/sukuk holders (owners of the asset). The sukuk
holders receive the sale proceeds. By rule and nature, salam is a receivable in kind. So salam
sukuk cannot be traded in the secondary market as it is not permissible to sell an item before
possession (physical or constructive).240 The structure is illustrated using Bahrain
Government’s salam sukuk in the figure below.
Bahrain Government’s salam sukuk
239 Bank Negara Malaysia, (2018). Capital Adequacy Framework for Islamic Banks (Risk-Weighted Assets), Paragraph 2.73. 240 Lahsasna, A., Hassan, M. K., and Ahmad, R. (2018). Forward Lease Sukuk in Islamic Capital Markets: Structure and Governing Rules, Cham: Springer International Publishing AG, pp. 73 - 74.
106
Figure C5. Bahrain Government’s Salam Sukuk Structure [source: Lahsasna, A. et al. 2018]
Description of the Structure
The Bahrain Government designated aluminium designated as the underlying asset for its
Salam-based sukuk, where it promises to sell the aluminium to offtaker (buyer) at a specified
future date in return of a full price payment in advance. Bahrain Islamic Bank (BIB) was
nominated to represent all banks that participate in the Salam contract (the sukuk). The BIB
signed the contracts and all other necessary documents on behalf of the other banks in the
syndicate. The buyer at the same time appoints the Government of Bahrain as an agent to
market the appropriate quantity at the time of delivery through its channels of distribution.
The Government provided an additional undertaking to BIB (as a representative) to market
the aluminium at a price that will provide a return to the Salam sukuk holders equivalent to
those available through other conventional short-term money market instruments.241
c. Ijarah Sukuk
Ijarah is a lease contract whose subject matter involves the transfer of real asset, usufruct
and/or services in exchange for rent. Ijarah sukuk are popular tradable Islamic instruments
that gave sukuk holders the right to receive rent, own and dispose of real asset. The asset
may not be yet constructed or built, at this point the sukuk ijarah will not be traded until the
construction of the asset started. The Ijarah description should be fully addressed in the
241 Dar Al Istithmar. (2006). Sukuk: An Introduction to the Underlying Principles and Structure. Oxford, UK: Dar Al Istithmar, p. 17
SPV Sources Asset and Buyers
Bahrain Govt (Obligor) Sells Asset (aluminum) on Salam basis
Sukuk holders [Investors]
Offtaker Purchase Undertaking of Asset for
Investors
1a. Undertaking
4. Asset Sales Proceeds
5. Asset Sales Proceeds 1b. Sukuk Proceeds
3. Asset
2. Salam Proceeds
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contract and the lessor is able to acquire, construct or buy it by the agreed date for its delivery
to the lessee. In order to generate return, all sukuk largely rely on the performance and
contractual arrangement of their underlying assets. In this regard, ijarah sukuk are particularly
valuable as their assets can be employed in such a way (lease, forward lease) that they ensure
regular payment of return throughout their tenure. Purchase undertaking in ijarah enjoys
wider acceptability among Shariah experts. Moreover, sukuk ijarah are flexible in tailoring
payment profile with fixed income profit generation. These features of ijarah make it a
popular Shariah contract to structure sukuk on.
Ijarah Sukuk Structure.
The structure normally involves the following processes. An obligor would engage a financial
institution (an investment bank) with regard to issuing sukuk and create an SPV for that
purpose. A particular asset, such as building complex, is then sold at a pre-determined
purchase price by the obligor to the SPV. Money equal to the purchase price is raised by the
SPV through issuing ijarah sukuk to investors. The asset is then leased back to the obligor as
lessee via an agreement between the SPV and obligor for fixed amount of rent over a specified
period. SVP receives periodic rentals from obligor and distribute same among sukuk holders
(investors). At termination, the asset is sold back to the obligor. The structure explained was
used in Malaysian global Sukuk of July 2002 worth USD 600 million. See the diagram and
description as explained above under Figure C1.
d. Istisna’ Sukuk Structure
Istisna literally means requesting a production or manufacture. Technically, it is a construction
contract that involves a contractor (developer, manufacturer), client and the object to be
constructed.242 Istisna sukuk are quite useful for financing large infrastructure projects.
Generally, Istisna sukuk are issued by a manufacturer or developer and the proceeds realised
are used to pay a contractor to construct a particular object (subject matter of the sukuk).
Subscribers are the buyers of the intended object, while funds realized from subscription are
the production cost of the object. On completion of the object, it can be sold to a third party
or leased, and the sukuk holders will get either the sale price in case of sale or rental payment
in case of lease. In the case of sale, the buyer of the sukuk asset can be the sukuk issuer (buy-
242 Majallat Majma Al-Fiq Al-Islamy 1992, No. 7 Vol.2 p. 777.
108
back) or a third party. A parallel istisna (subcontracting) can be incorporated in the istisna
sukuk arrangement to provide flexibility in the financial intermediation of the sukuk. Thus, a
financial institution that undertakes a construction project for a deferred price can
subcontract the work to a developer company to carry it out. The Sukuk holders possess the
project and are entitled to the sale price of the sukuk, or the sale price of the project sold on
the basis of a parallel Istisna. Return is generated by these sukuk from the difference between
the cost of manufacturing the object and its selling price. Tabreed, on behalf of National
Central Cooling Company, UAE, used this istisna structure to issue a five-year global corporate
Sukuk. The structure involved two-stage structure of istisna’ (construction) and ijarah (lease)
contract as illustrated below.
Tabreed’s 2006 Istisna’ Sukuk Structure
Figure C6. Tabreed Istisna Sukuk Structure [source: authors]
Decription of the structure
At the istisna stage, the SPV (Tabreed 2006 Financing Corporation) issued sukuk to the sukuk
holders and stood to act as a trustee on behalf of the Sukuk holders. The issuance proceeds
were paid into the SPV’s account as agreed. The SPV then entered into an istisna agreement
with the obligor (Tabreed) for the construction and delivery of specified cooling plants. During
the term, the SPV paid Tabreed the istisna purchase price as per agreed installments and at a
specified time. During the construction period, Tabreed as the istisna contractor paid the SPV
a completion cash guarantee on a periodic basis. The completion cash guarantee was equal
to the periodic distributions payable to the sukuk holders and calculated based on a pre-
SPV Developer/Tabr
edd [Initial
Issuer/Obligor]
Sukuk holders [Initial buyers]
Lease or sale, proceeds go to investors
Project [to be produced]
Cooling Plants
Subcontractor
3. Buys
Asset
4. Sells
Asset 2. Sukuk
Istisna
1. Sukuk
Proceeds
5. Re-acquires Asset via lease or Purchase
7. Delivery of Project/Asset
6. Subcontract in Parallel Istisna
8. Rental and/or Sale Proceeds
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agreed formula. Were the construction of the cooling plants not completed within the time
specified in the istisna contract, Tabreed would continue paying the completion cash
guarantee on a periodic basis until completion was achieved (subject to terms of the purchase
undertaking).
3. Equity-based Shariah Contracts and Sukuk Structures
Shariah contracts used to structure equity-based Sukuk are generally equity-based contracts
and include musharakah, mudarabah, wakalah.
a. Mudarabah Sukuk
The AAOIFI defines Mudarabah as a contract based on trust whereby one party is a rab al-mal
(capital provider) and the other party is a mudarib (manager of the provided capital). The
essence of a mudarabah transaction is a joint venture on a trust relationship, whereby the
rab al-mal entrusts capital to the entrepreneur or Mudarib in a trust role while the Mudarib
applies his skills and knowledge in managing a legitimate endeavor and securing a profit.243
One or more of the partners can be appointed as mudarib for the management of a given
project or business operation according to the parties agreement. In this arrangement, profits
generated in running the venture are shared in accordance with the parties’ agreement. Loss
recorded in the ordinary course of business, without negligence or breach on the part of the
mudarib is however born by the capital provider alone; the mudarib receives nothing for his
labour in this regard. In essence, all rules of mudarabah contract are applicable to mudarabah
sukuk.244 Mudarabah sukuk enable a large pool of investors to be part of investment projects
and their holders are capital providers and owners of specific mudarabah investment
project(s). It is noteworthy that manager of a mudarabah project cannot be required to
guarantee the mudarabah capital or profit. However, guarantee on capital can be provided in
practice by a third party through contingency arrangement with a takaful (insurance)
institution to save the sukuk holders’ interest. In mudarabah sukuk, profit is distributed in
accordance with percentage of ownership share in the project(s), hence fixed profit is not
permissible. Mudarabah sukuk are structured on mudarabah profit sharing partnership and
243 Ibid. 244 Securities Commission Malaysia, (2009). Sukuk, Islamic Capital Market Series, Abdulkader Thomas (Ed.). Kuala Lumpur: Sweet & Maxwell Asia, p. 223.
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represent undivided mudarabah equity or projects/activities established and managed on a
mudarabah arrangement. Mudarabah sukuk are structured on mudarabah profit sharing
partnership and represent units of ownership in an undivided mudarabah equity or
projects/activities established and managed on a mudarabah arrangement. Below is a general
mudarabah sukuk structure.
Figure C7. General Mudarabah Sukuk Structure [source: authors]
Aabar Mudarabah Sukuk Structure
Figure C8. Aabar Mudarabah Sukuk Structure [source: Lahsasna, A. et al. 2018]
Originator
[As Mudarib (Manager)]
Sukuk holders [Investors]
Loss Profit
Mudarabah
Agreement
Mudarabah
Enterprises
Issues Sukuk
Pay for Sukuk [as capital]
Periodic Profit & Redemption fee
Loss is born by Capital Provider
Profit Shared According to Agreed Ratio
Profit Shared According to Agreed Ratio
Manages
Capital/Enterprise Capital/Enterprise
SPV [As Rab al-Mal]
Provides Capital Originator Redeems
Enterprise at
Maturity from
Investors
SPV Receives
Redemption fee
at Maturity
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Description of the Structure
The structure entailed agreement between Aabar Sukuk Limited, a charitable trust-owned
company incorporated in Cayman Islands, as rab al-mal, an issuer or project owner and Aabar
Petroleum Investments Company as mudarib. An SPV was created which issued sukuk and
raised capital for investment projects. The issuer contributes to the capital for the Mudarabah
and the Mudarib invests the capital in Aabar’s business activities in accordance with an
investment plan prepared by the Mudarib. The mudarib runs and manages the project;
distributes profits generated therefrom to investors (sukuk holders) who were handed over
the project upon its completion. Profit sharing ratio was 1%: Mudarib and 99%: Issuer (if profit
payable is greater than Periodic Distribution amount, the Mudarib is entitled to keep the
excess as incentive fees). On maturity (4 years tenor), the sukuk are redeemed by the
originator as obligor, who purchased the Issuer/rab al-mal’s Mudarabah/Trust Assets for a
sum equal to USD460 million (said to be disposed of or sold at the securities market). Below
is an actual deal illustration of Aabar Mudarabah Sukuk Structure.245
b. Musharakah Sukuk
Musharakah is a form of a joint enterprise or partnership with capital contributions thereto
by partners either in cash or kind. The partners carry out investment activities that are
governed by a musharakah agreement, which entails a detailed business plan. Musharakah
sukuk are issued for the purpose of mobilizing and using funds to establish new projects,
develop an existing ones or finance a business activity on the basis of musharakah partnership
contract. Musharakah sukuk represents proportionate equity stake in the project, business or
pool of assets contributed by partners, typically the issuer of the musharakah sukuk and the
originator, either on a permanent or declining basis.246 See Appendix for illustration of
musharakah sukuk structure.
General Musharakah Sukuk Structure
The structure generally involves a musharakah agreement (between SPV and originator)
whereby sukuk are issued by an SPV on behalf of originator and subscribed by investors. Trust
245 Dar Al Istithmar. (2006). Sukuk: An Introduction to the Underlying Principles and Structure. Oxford, UK: Dar Al Istithmar, p. 27 246 Securities Commission Malaysia, (2009). Sukuk, Islamic Capital Market Series, Abdulkader Thomas (Ed.). Kuala Lumpur: Sweet & Maxwell Asia, p. 188.
112
is declared over the proceeds realised from the sukuk issuance which represent underlying
assets by the SPV who holds same in trust for subscribers. By an agreement, a sale and
purchase are conducted between the originator and SPV for the former to sell and the latter
to purchase the underlying assets. The musharakah agreement initially entered between the
SPV and originator constitutes the originator as a manager of the musharakah enterprise
established the sale and purchase. The originator acts as manager of the underlying
assets/enterprise/project to which it contributes in either cash or kind with such assets as
land, equipment and/or industrial plant. The originator and sukuk holders then constitute
joint owners of the musharakah project, asset and business activity according to their
respective shares therein. On periodic basis, the originator shares return generated from the
musharakah venture with sukuk holders in accordance with an agreed ratio. Loss (if any) is
born by the respective partners in accordance with their capital contribution. At maturity of
the sukuk or occurrence of default, the SPV sells, and the originator buys back (redeems) the
musharakah project. The originator pays redemption fee/dissolution amount to investors
through the SPV.
Figure C9. General Musharakah Sukuk Structure [source: authors]
Imtiaz Sukuk II Berhad Musharakah Sukuk Structure
The Imtiaz II Musharakah Sukuk comprises of an Islamic commercial paper (ICP) and an Islamic
medium-term notes (IMTN) programme with a combined limit of up to RM9.0 billion in
nominal value and a sub-limit of RM1.0 billion in nominal value for the ICP based on the
Sukuk holders [Investors]
Loss
Musharakah
Agreement
Mudarabah
Enterprises
Issues Sukuk
Pay for Sukuk [as capital]
Periodic Profit & Redemption fee
Profit Determined by an
Agreed Ratio, Loss by Capital
Contribution
Contributes Capital, Manages Enterprise
Capital/Enterprise
SPV [As Partner]
Provides Capital Originator as a
Partner Redeems
investors Shares in Enterprise at
Maturity
Profit
Profit Determined by an Agreed Ratio, Loss by Capital Contribution
Originator
[As Managing Partner]
SPV Receives
Redemption fee
at Maturity
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Shariah principle of Musharakah. The ICP and IMTN are collectively referred to as the Sukuk
Musharakah. The actual deal of the structure is described below.
Figure C10. Imtiaz Sukuk II Berhad Musharakah Sukuk Structure [source: Imtiaz Sukuk II
Berhad Prospectus 2013]
Description of the structure
(1) Bank Rakyat was appointed as obligor who identified the business used as underlying asset
for the particular Musharakah transaction and held same as trust.
(2) The issuer SPV (Imtiaz Sukuk II Berhad) issued the Sukuk to investors and the proceeds
received therefrom the Sukukholders arising from the subscription of the Sukuk were
invested into the Musharakah Venture.
(3) The sukuk holders received return from the yields of the Musharakah up to the maturity
date and/or redemption. The income was payable to the Sukukholders based on their interest
in the Musharakah Venture's undivided, proportionate interest in the Business.
(4) Pursuant to the purchase undertaking for the Sukuk granted by the Obligor in favour of
the issuer, (acting on behalf of the Sukukholders), Bank Rakyat purchased the Sukukholders'
interest in the Musharakah Venture through sale agreement maturity and/or redemption
date of the Sukuk.
c. Wakalah contract
Wakalah, literally translated as agency, is an arrangement where one party (principal)
entrusts to another (agent) the authority to act on its behalf. In essence, a wakalah contract
involves two main parties, i.e. a principal (capital provider or investor) and an agent (wakil)
whereby the former appoints the latter to use its expertise and manage or invest given capital
114
into a pool of investments for a given duration. Wakalah sukuk are trust certificates that are
issued by a party in order to raise capital to acquire or invest in Shariah compliant assets
(tangible and intangible), goods or services. Thus, underlying assets in sukuk wakalah can
comprise a pool or portfolio of investments. These investments are entrusted to an agent
(wakil) for management on behalf of the issuer and sukuk holders (principal). The relationship
between the principal and the agent is governed by an agency agreement that stipulates
terms of appointment, scope of services, related fees and payments in accordance with rules
of agency as approved by Shariah. These sukuk provide its holders with ownership or equity
participation in the underlying assets, goods or services. Sukuk holders take the risk of the
investment and its acquisitions and are entitle to any profits generated therefrom. This
includes risk of capital loss in the absence of any credit enhancement.247
Wakalah Sukuk Structure
In this structure, an SPV (trustee to investors) acting as a principal, entrusts proceeds realised
from sukuk issuance to an agent via a wakalah agreement according to which the agent
invests the proceeds. The agent then purchases wakalah assets/investments portfolio from
one or more third party seller(s). These assets/investments are held and managed by the
agent to generate an expected profit, as may be agreed with the principal on behalf of
investors, which is shared as periodic return among the investors. Payment for the agency
and related services is made from the profit. To cater for shortfall in expected return, a
purchase undertaking is made with the third-party seller(s) to purchase certain a specified
portion of the wakalah investment at regular interval. Exercise price paid for this purpose is
used to offset the amount of the periodic return to the investors. At maturity or the
occurrence of default event, the originator as obligor will purchase the assets from the SPV
under a purchase undertaking at an amount equal to dissolution or redemption price plus any
profit already accrued but unpaid. With these, the sukuk are redeemed and investors or sukuk
holders are accordingly settled. Here is an illustration of the structure.
247 Ibid., p. 250
115
Figure C11. General Wakalah Sukuk Structure [Source: authors]
Medjool Wakalah Sukuk (Emirates Airlines)
For an actual deal with wakalah structure, Medjool Wakalah Sukuk (Emirates Airlines) is used
to illustrate the structure here.
Figure C12. Medjool Wakalah Sukuk Structure [Source: Medjool Limited Prospectus 2013]
Sukuk Holders [Investors]
Originator [As Obligor]
SPV [As Issuer
and Trustee]
Seller(s) Agent
Wakalah
Assets/Investments
Issues
Sukuk Purchase
Proceeds Periodic
Return Sukuk
Proceeds
Return on Investments
Purchase Undertaking
Sukuk Proceeds Wakalah Deed
Exercise Price
Wakalah Assets
Return on Investments
Sukuk
Proceeds
Sale of Assets
116
Description of the Structure
The Dubai-based state-owned Emirates Airlines issued these Sukuk in March 2013 via SPV
Medjool Limited. Emirates launched a USD1 billion amortising Sukuk maturing in 2023. The
10-year Sukuk carries an average weighted life of five years and was launched at 300 basis
points over five-year midswaps. The Sukuk are utilized to encourage the Islamic economy and
support the initiative of Dubai in becoming a world capital of Islamic economy. They are
multipurpose Sukuk, one of which is financing part of a aircraft purchasing deals worth USD5
billion where 25 aircrafts will be delivered, one every five weeks.248
The Medjool wakalah involves Periodic distribution payments and partial dissolution
distribution payments to certificate (sukuk) holders via the trustee (Intertrust SPV), an entity
based in Cayman Islands. Deutsche Bank AG, London Branch is designated by the trustee as
principal paying agent. Proceeds of the issue of the Certificates are paid by the Trustee to
Emirates (as Seller) as purchase price for the Rights to Travel. Emirates and the Trustee enter
into a service agency agreement pursuant to which Emirates was appointed as servicing agent
by the Trustee (as principal) to manage the aggregate Allotted Rights to Travel (measured in
ATKMs) held by the Trustee or by Emirates on its behalf that have not been sold pursuant to
the Service Agency Agreement and Additional Rights to Travel. By a purchase undertaking,
Emirates will irrevocably purchase in favour of the Trustee and the Delegate, from the
Trustee, all or part of the Outstanding Rights to Travel and, following a Dissolution Event
and/or Additional Rights to Travel. There is corresponding sale undertaking on part of the
trustee. All arrangements are laid in the sukuk structure as illustrated in the figure below.
248 Lahsasna, A., Hassan, M. K., and Ahmad, R. (2018). Forward Lease Sukuk in Islamic Capital Markets: Structure and Governing Rules, Cham: Springer International Publishing AG, p. 30.
117
Glossary
Arabic and/or Shariah terms are written in italic.
A AAOIFI - Accounting and Auditing Organization for Islamic Financial Institutions - A private
sector standard setting body, based in Bahrain, with the aim of producing international
accounting standards within the Shariah framework for Islamic banks and financial
institutions. Within the organization, there is a Financial Accounting Standards Board
consisting of 22 voluntary members representing Islamic banks, users of financial
statements of these banks, practicing accountants, academics, Shariah scholars and
regulatory bodies. The Board is assisted by a Shariah committee, which reviews proposed
pronouncements and advises the Board on their compliance with the Islamic precepts.
There is an Executive Committee for Planning and Follow-up, which recommends
priorities to the Board and draws up its agenda. The Supervisory Committee of the
organization consists of 17 voluntary members and has the responsibility, besides
oversight, to raise funds for the organization. The AAOIFI follows an extensive due process
of eight phases which governs the production of its standards.
Arranger: – a financial institution that arranges for a loan between a borrower (a company,
governments, government agency, multilateral institution) and a syndicate of lenders
by conducting credit assessment of the borrower, syndication of the loan to the lenders,
appointment of lenders' attorney and negotiation of the loan documentation.
Artificial Intelligence (AI): A technological simulation of human intelligence in machines that
enables them to think like and mimic human in their actions. A trait programmed into
machines enabling them to exhibit human qualities including learning and problem-
solving.
Asal: an original case on which a Shariah ruling is given in the Islamic text (Quran or Sunnah)
and which an analogy seeks to extend the ruling to a new case, on which no ruling exist at
all, but has the same causative effect as the original case.
Aqd: - a central term in Islamic financial and commercial jurisprudence that essentially means
‘contract.’
B
Bai‘ or bay’: A contract of sale. Technical: Sale of definite goods or property with the free consent of parties for a definite price. It involves proposal (’ijab) and acceptance (qabul ). It has many types.
Bai‘ al Dayn: It refers to Sale of debt.
Bai’ kali’ bi kali’: It refers to a debt sale that is paid by debt.
Bai‘ al Sarf: It refers is a contract where an exchange of money for money of the same or a
different type takes place.
118
Basel II Capital Accord: Second of regulations known as Basel Accords issued by the Basel
Committee on Banking Supervision, published in 2004 and intended to amend
international banking standards that controlled how much capital banks are required to
hold to guard against the financial and operational risks they face.
Beneficial interest: a beneficial interest or ownership is the right to receive benefits on assets held by another party. The beneficial interest is often related to matters concerning trusts.
C
Conflict of laws: rule governing application of laws to a case or transaction that has
connections to more than one jurisdiction; the difference between laws of two or more
jurisdictions with connection to a case or transaction with foreign element in a local
jurisdiction, such that the outcome depends on which jurisdiction's law will be used to
resolve issue(s) in dispute.
Cost of compliance: all expenses that a company incurs to adhere to industry regulations.
Cyber risk: exposure to harm or loss resulting from breaches of or attacks on information or
communication systems related to technical infrastructure or use of technology within an
organization.
D
Dayn: a debt; a fiduciary obligation that comes into existence as a result of a contract or credit
transaction incurred by way of rent, sale or purchase.
Datacentric: An architecture or system of software where data is the primary and permanent
asset, and applications can be mounted thereon; an architecture in which data model
precedes the implementation of any given application and will remain valid after it is gone.
Data governance: a strategy, process and practices that ensure data quality and safety
through the lifecycle of data; managing the availability, usability, integrity and security of
the data.
E
Electronification: It refers to conversion to or adoption of an electronic mode of operation or
production.
e-KYC: An initialism for ‘electronic Know Your Customer or Client,’ a digitalized conception of
KYC [know your customer or client]; an identification process of customer or client
through electronic means without the need of physical or face-to-face identification.
ERC20: Ethereum Request for Comments – It is a standard protocol that is used for smart
contracts on Ethereum’s blockchain for implementation of Ethereum tokens (Ether). It
defines certain rules for the Ethereum tokens to enable developers predict interaction
between the tokens. It has a simple deployment procedure and high potential for
119
interoperability with other ETH (Ethereum) tokens. The suffix “20” represents its unique
proposal ID.
F
Far’: a new incident or unprecedented case on which no ruling exists; a ruling is sought by
recourse to analogy with another case that has clear Shariah ruling in the Islamic text
which has the same causative effect as the new case.
Fatwa: a religious opinion concerning Islamic law; a formal response issued by an expert in
Shariah [faqih].
FinTech: short form of ‘financial technology;’ describes any technology that seeks to improve
and automate the delivery and use of financial services and helps companies, business
owners and consumers to better manage their financial operations and processes.
H
Hadith: a tradition containing sayings of the prophet Muhammad (PBUH) and accounts of his
daily practice (the Sunna), which constitute a major source of Shariah for Muslims apart
from the Quran.
I
IFSB: – Islamic Financial Services Board – An international standard-setting body of regulatory
and supervisory agencies with vested interest in ensuring soundness and stability of
Islamic financial services industry, which is defined broadly to include banking, capital
market and insurance. To advance this mission, the IFSB promotes the development of a
prudent and transparent Islamic financial services industry through introducing new or
adapting existing international standards, including those issued by Basel Committee on
Banking Supervision, International Organisation of Securities Commissions, consistent
with Shariah, and recommend them for adoption. As at December 2020, the IFSB has 188
members, comprising of 80 regulatory and supervisory authorities, 10 international inter-
governmental organisations and 98 market players (financial institutions, professional
firms, industry associations and stock exchanges) operating in 57 jurisdictions. Malaysia,
the host country of the IFSB, has enacted a law known as the Islamic Financial Services
Board Act 2002, which gives the IFSB the immunities and privileges that are usually
granted to international organisations and diplomatic missions.
ISRA: - International Shariah Research Academy for Islamic Finance – a research institution
established by the Central Bank of Malaysia on 26 March 2018 to promote applied
research in the area of Shariah and Islamic finance. As a part of the International Centre
for Education in Islamic Finance (INCEIF), ISRA acts as a repository of knowledge for
120
Shariah views (fatwas) and undertakes studies on contemporary issues in the Islamic
financial industry.
Issuer: an issuer is a legal entity that develops, registers and sells securities. Issuers are legally
responsible for the obligations of the issue and for reporting financial conditions, material
developments and any other operational activities as required by the regulations of their
jurisdictions.
K
KYC: Know Your Customer or Client – a process of mandatory check to identify and verify
customer or client's identity when dealing with financial institutions and periodically over
time to ensure that financial institutions’ clients are genuinely who they claim to be.
KYD: An initialism for ‘Know Your Data,’ that entails how data is used throughout an
organization for various purposes via documentation, processes and control mechanisms
for tracing the origin and managing the entire lifecycle of data used in any transaction.
L Lead arranger: or mandated lead arranger (MLA), an investment bank or underwriter firm
that facilitates and leads a group of investors in a syndicated loan for major financing via new security issuance. Lead arranger assigns parts of the new issue to other underwriters for placement and often takes the largest part itself.
Legal documentation: recording material (on paper, online or on digital or analog media) to provide official information or evidence or that serves as a record for legal purpose; a formal process of execution of written documents that formally express a legally enforceable contract, right and obligations of parties thereto.
Legal interest: The legal interest in a property refers to the right to possess or use property. It belongs to the legal owner, i.e., the person who is registered at the Land Registry on the title deeds. Legal interest gives the owner a right of control over the property, which means they can decide to sell or transfer the property.
M
Mal: property; wealth, money, any valuable thing that can be possessed.
Mahal al-`aqd: asset and/or usufruct that forms the subject matter of lease.
Mal Hukmi: It refers to intangible assets.
Maslahah: public good or benefit; a consideration used for deriving Islamic juristic rules.
O
121
Obligor: An obligor, also known as a debtor, is a person or entity who is legally or contractually
obliged to provide a benefit or payment to another. In a financial context, the term
"obligor" refers to a entity who is contractually bound to make all principal repayments
and interest.
Originator: an entity that requires funds, typically a government, financial institution or
specialist entities set up for securitization purposes, and offers securities for subscription
to creditors, often via an SPV.
Q
Qabadh: It refers to possession.
R Rating: an assessment tool assigned by an analyst or rating agency to a security; an evaluation
of the credit risk of a prospective issuer of securities (debtor), predicting their ability to
pay back the debt and forecasting likelihood of the debtor defaulting. The rating assigned
to a security indicates its level of investment opportunity.
Rating agency: a company that assesses the financial strength of companies and governments
or government agencies and multilateral entities on their ability to meet debt obligations.
RegTech: short form of ‘regulatory technology;’ any technology for the management of
regulatory process in the financial services industry for the purpose of reporting,
monitoring and compliance by financial institutions.
Regulatory Sandbox: A framework set up by a regulator that allows financial
technology startups and other innovators to conduct live experiments in a controlled
environment under a regulator’s supervision.
Riba: interest, usury or unjust, exploitative gains made in trade or business. Riba is prohibited
in Shariah and strongly condemned in several verses in the holy Qur'an.
Risk: the possibility that the outcome of an event could result in an adverse result.
S Sarf: currency exchange; the exchange of gold for gold, silver for silver and gold for silver or
vice versa. Such exchange is to be concluded at par and on the spot in Shariah. Securitization: is a process of transforming an otherwise illiquid asset into a liquid one. In
more technical terms, securitization can be defined as ‘the process of packaging financial promises and transforming them into a form whereby they can be freely transferred among a multitude of investors. The goal of securitization is to transform the promises of individuals and corporations to make future payments into freely transferable securities that are appealing to investors.
Shar’: of or relating to a Shariah ruling. Shariah non-compliance risk: the chance that an Islamic financing transaction would be
challenged on grounds that it does not comply with Shariah or Islamic law; risk of loss that arises from the failure of Islamic financial institution to comply with the Shariah rules and
122
principles determined by its Shariah board or any relevant body in the jurisdiction it operates.
Special Purpose Vehicle: (SPV) is a separate legal entity created by an organization. The SPV is a distinct company with its own assets and liabilities, as well as its own legal status. Usually, they are created for a specific objective, often which is to isolate financial risk. As it is a separate legal entity, if the parent company goes bankrupt, the special purpose vehicle can carry its obligations.
Stamp duty: a levy or tax applied to some property purchases or legal documents; a stamp is fixed upon the documents to show that the levy has been paid to make the purchase or document legally effective. Many modern version of stamp duty do not require actual stamp for their validity.
Subscription: purchase and payment by an investor for designated number of shares, bonds or securities offered for sale once the offering is complete.
T
Time-to-market: the length of time it takes from a product being conceived until it is made
available for sale.
Tokenization: In blockchain it refers to the issuance of a blockchain token, also known as a
security or asset token. Blockchain tokens are digital representations of real-world assets.
Trust: a mechanism of law whereby legal title to a property is held by one person for the benefit of another.
Trust deed – or deed of trust, is a legal document in which a trust-maker (or settlor) transfers property to a trustee (who will manage it for beneficiaries) under a trust. In a financed real property transaction, trust deed represents an agreement between borrower and a lender to have the property held in trust by a neutral and independent third party until the obligation is settled off.
True sale: a sale of the underlying assets takes place; it is known as a true sales.
U
Underwriter – an entity that pledges to buy all the unsold or unsubscribed securities in an
issue. Underwriting services are provided by large financial institutions, such as banks,
insurance companies and investment houses who guarantee payment in case of
undersubscription of securities or financial loss therefrom and accept the financial risk for
liability arising from such guarantee.
`Uqud ishtirak: It refers to contracts that entail sharing in ventures/ businesses and profits.
`Uqud mu`awadhat: It refers to contracts in which parties make an exchange.
W
Wakalah bil Isthismar: It refers to investment made through an agent.
123
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