Islamic Fin, REPORT

8/3/2019 Islamic Fin, REPORT

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SECURITIZATION OF ASSETS

For a Lay man, Securitization is the process of transforming a non-liquid asset into a

marketable security that has the ability to generate cash. It has such ability because

securities are tradable financial instruments therefore these are more liquid than the

underlying asset against which it has been generated. For example, a bunch of

consumer loans are changed into a publically issued debt security. Securitization of

assets is done to reduce risk, to create and improve liquidity, and for improving

economic efficiency or marketability.

When Companies go for Securitization of Assets they issue certificates of ownership

against a pool of investment. It is the process of transforming a loan or mortgage into a

tradable market security by issuing a bill of exchange or other negotiable paper in place

of it.

This process, in conventional banking, Securitization indicates sale of such assets that

create cash flows from the company that owns them, to another institution whose only

job is to issue notes against these assets. The notes issued by this second institution

are backed by the cash generated by the original assets of prior company.

The first company, owner of the cash generating asset, is called the originator. The

other company mentioned in this explanation which purchases the cash flow generating

assets is known as the Special Purpose Vehicle (SPV). The SPV shall hold the assets

purchased from the originator as collateral for the securities issued and sold to theinvestors.


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ISLAMIC SECURITIZATION

The basics of Islamic securitization are specifically described as a legal structure that

meets with the conditions of the basics of Islamic Finance and also fulfills the economic

traditional objective of an asset-based securitization structure. In the conventional

securitization process the rights of ownership on revievables are shifted from the

originator to an SPV. This SPV, further releases notes that can be sold to investors

then.

Whereas Islamic Finance relates to the transfer of assets from an originator into a trust

or similar SPV with the issuance of a fund under the name ofSukuk and the return on

this Sukukresulting from the cash inflow from the transferred assets.

Here there is a similarity observed in the Islamic and conventional securitization, these

can follow the same principle. As we know, in Islamic finance most transactions areasset based, the basic concept of securitization and its economic aspect is particularly

in harmony with the basic concepts of Islamic Finance. The underlying asset pool or a

combination of receivables, in an Islamic securitization must be according to the

accepted Islamic financing schemes. For instance, conventional mortgages and credit

cards, which are typical conventionally securitized assets, do not comply with Sharia, as

they are interest-bearing loans. For a structure to comply with Sharia, some degree of

ownership must be transferred to the investor. Transfer of registered title is not

necessary, rather a collection of ownership rights that would allow the investors to

perform duties related to ownership (if desired) or rights granting access (subject to

notice) over the asset would be sufficient to satisfy Sharia.

The assets placed in the securitization pool generate some profits or losses that are

shared by the investors. Since the core concept of Islamic Finance does not allow

financing that is interest-based, the investors can support or invest on the basis of

partnership, but not on the basis of interest

So Islamic Securitization is the creation of securities (orSukuk) that enables investors

to participate in a pool of tangible assets, or in a pool of combination of both, tangible

and intangible assets, that creates cash flow along with the rights or other specifications

that promises the servicing or timely distribution of proceeds to the security holders.Further, the terms of security holders transfer into cash after a specified and limited

period of time.


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After a brief definition, we now would like to move on with the structure of Islamic

Securitization. While talking about the structure, we will also try to put the differences

between the conventional and Islamic securitization structures and by doing so; we will

be seeking the answer of the question Why there is a need for Islamic securitization

while we already have quite improved securitization structures?

STRUCTURE OF ISLAMICSECURITIZATION

There are a number of parties involved in the securitization of assets, the key players

involved are as follows:

ORIGINATOR: The originator or the issuer ofSukuk, who sells its assets to the

SPV and uses the realized funds. Originators are mostly governments or big

corporations, but they could be banking or non-banking Islamic financial

institutions. The issuers may charge a fee or commission or a consideration for

servicing for the arrangement of this issue.

SPV: The SPV is an entity set up specifically for the securitization process and

for managing the issue. The basic function it serves is the purchase of assets

from the originator and funds the purchase price by issuing Sukuk. It is also

called as Issuer at few occasions.

INVESTMENT BANKS: These banks serve as issue agents. These serve the

functions of underwriting; lead managing and book-making services for Sukuk

against any agreed-upon fee or commission. These services are provided by

syndicates of Islamic banks and big multinational banks operating Islamic

windows.

INVESTORS: Subscribers ofSukuk mostly central banks, Islamic banks and

non-bank financial institutions and individuals who subscribe to securities issued

by the SPV.

This list shows us the fact that an Islamic securitization structure perfectly mimics a

conventional securitization in relation to the parties involved.


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EXAMPLE:

A widely used Islamic securitization structure, which also illustrates the exact same

structure with the Sukuk issue made by the German state of Saxony-Anhalt in

2004,170would resemble the following scenario:

The originator of the assets (e.g. the owner of office buildings) sells the assets toan SPV.

The SPV raises financing to purchase the assets by issuing Ijara Sukuk171(i.e.

leasing bonds) to investors. The amount raised by issuing the Sukuk is equal to

the purchase price.

The Ijara Sukukrepresent equity interest in the SPV, and in turn, in the assets.

The SPV leases the assets back to the seller/originator. The seller makesperiodic lease payments to the SPV, which should match the SPVs obligations

under the Ijara Sukuk.

At maturity, the SPV sells the assets back to the originator (i.e. lessee or

previous seller/owner of the assets). The amount should cover any liabilities

owed by the SPV under the Ijara Sukuk.

The figure below illustrates how an Islamic securitization structure based on ijara

basically works:


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COMPARISON OF ISLAMIC ANDCONVENTIONAL SECURITIZATION:

The cash flow produced is similar to any bond. The lease payments are similar tocoupons and the repurchase proceeds paid at the end of the term constitute the

principal.

Unlike conventional securitization, the implementation of Islamic securitization requires

a two-stage fundamental verification process, which assesses the Sharia compliance

of (i) the type of assets in the underlying reference portfolio and the generation of

investment returns, and (ii) the transaction structure, which includes the configuration of

credit enhancement (and other forms of credit and liquidity support) and the form of

ownership conveyance.

Securitization under Islamic law bars interest income and must be structured in a way

that rewards investors for their direct exposure to business risk, i.e., investors receive a

share of profits commensurate to the risk they take on the basis of pre-determined

interest. However conventional securitization, which originated in non-Islamic

economies, invariably involves interest-bearing debt. Note holders would typically hold

(secured) contingent claims on the performance of securitized assets, which entitle

them to receive both pre-determined interest and the repayment of the principal amount.

Apart from that, one should know that equity in contrast to interest-bearing bonds

appears to be a permissible financial asset that can form part of the pool, such equity

must not represent ownership of an institution dealing with interest or manufacture of

any prohibited (haram) items, such as alcohol or gambling. For Islamic institutions,

underlying assets that can be securitized include lease financing (e.g. of housing,

aircraft, equipment, household items, cars etc.), equity ownership (in Sharia compliant

assets) and, in certain cases, Murabaha receivables (provided that the Murabaha

receivables comprise less than 50% of any asset pool).

The relationship between an underlying obligor and the originator should fall within one

of the usual accepted Islamic financing schemes (Murabaha, Mudaraba, Ijara, Istisna,

etc.)

It should also be noted that to comply with Sharia principles, for a traditional Sukuk

issuance, the structure to be used must involve a transfer of minimum level of

ownership in the assets before Sharia scholars can be satisfied and approve the

issuance.


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To sum up, securitization in Islamic Finance is better referred to as monetization of the

underlying assets. While the sale of conventional receivables is a sale of debts, the sale

ofSukuk is a sale of shares of an asset. However, irrespective of religious conditions,

Islamic securitization offers the same economic benefits conventional structured finance

promises to generate.

Sukuk

Sukuk is an Islamic investment product that is not very old to the market. It was first

introduced in 2002 in Malaysia, when they introduced a government-backed Sukuk, the

first of its kind.

Sukuk is derived from the plural of the word Sak, or Sanadat, that means certificate of

investment or simply a certificate. These are certificates that represent the holdersproportionate ownership in an undivided part of an underlying asset where the holder

assumes all rights and obligations to such asset.

The Accounting and Auditing Organization for Islamic Financial Institutions

("AAOIFI") has issued the Standard for Investment Sukuk. Under the AAOIFI Sukuk

Standard, Sukukare defined as certificates of equal value put to use as common shares

and rights in tangible assets, usufructs, and services or as equity in a project or

investment activity. The AAOIFI Sukuk Standard carefully distinguishes Sukuk from

equity, notes, and bonds. It emphasizes that Sukukare not debts of the issuer; they are

fractional or proportional interests in underlying assets, usufructs, services, projects, orinvestment activities. Sukukmay not be issued on a pool of receivables. Further, the

underlying business or activity, and the underlying transactional structures (such as

lease), must be Sharia-compliant (that is, the business or activity cannot engage in

prohibited business activities). To sum up, the AAOIFI standard stipulates that Sukuk

must demonstrate that:

Any income generated must derive from the underlying activities for which

the funding has been used, and not simply comprise of interest;

The Sukuk must be backed by real underlying assets and these assetsmust be Halal [that is, allowable under Sharia] in nature and will be

utilized as part of a Halalactivity; and

There must be full transparency as to rights and obligations of all parties.


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It is important to note that, contrary to popular perception, whilst a securitization

can be achieved via Sukuk, most Sukuk that have been issued to date are not

securitizations.

Types of SukukUntil now there have been 14 different types ofSukukstructures most common ones of

which are Sukuk al-Ijara, Sukuk al-Istisna, Sukuk al-Murabaha, Sukuk al-Musharaka

and Sukuk al-Mudaraba. The list of 14 different types ofSukukis not an exhaustive list

since other forms ofSukukcan be issued such as by copyright owners, so continuing

innovation in this field is expected.

IJARA SUKUK:

Ijara (lease) is a contract according to which a party purchases and leases outequipment required by the client for periodic rental payment. The duration of the rental

and the amount payable are agreed in advance, and ownership of the asset remains

with the lessor.

If a lessor, after executing an Ijara contract, wishes to recover his cost of

purchase of the asset to get liquidity or for the purpose of profit, he can sell the leased

asset wholly or partly, either to one party or to a number of individuals. The purchase of

proportion of the asset can be evidenced by issuing certificates, which may be called

Ijara certificates or Sukuk. The certificates must represent ownership of the pro rata

undivided parts of the asset with all related rights and obligations. Hence, Ijara Sukuksare the securities representing ownership of well-defined and known assets tied up to a

lease contract, rental of which is the return payable to the Sukukholders.

Unlike some otherSukuktypes, Ijara certificates can be negotiated and traded freely in

the market and can serve as an instrument easily convertible into cash. Sukuk

representing tangible assets or usufruct of such assets can be traded in the secondary

market, depending upon the quality, risk and profitability of the securitized assets.

Ijara Sukuk Structure: A single or a group of assets that are admissible for

ijaracontract are selected. The originator creates an SPV with separate independent

legal personality to whom it sells the asset(s) with the understanding that the originator

will lease back the asset(s) from the SPV. Rent is negotiated and a term specific lease

contract is signed. The SPV then securitizes its assets by issuing ijara Sukukfor sale to

investors. These are certificates of equal value representing undivided shares in

ownership of tangible assets. The Sukuksale proceeds provide funds to SPV to pay for

the asset(s) purchased from the originator. A rent-pass-through structure is adopted by


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the SPV to pass on the rents collected from the originator-cum-lessee to Sukukholders.

These returns along with low risk and exit possibility through secondary market

(liquidity) constitute the incentives for investors to buy Sukuk. At the expiry (or

termination) of the lease deed the flow of rents would stop and ownership of the asset

pool would be with the Sukuk-holders as a group. The Sukukcontract embeds a put

option to the Sukuk-holders that the originator is ready to buy the Sukukat their face

value on maturity or dissolution date.

The figure below well explains the concept of an ijara Sukuktransaction

MUDARABA SUKUK:

Mudaraba means an agreement between two parties according to which one of the two

parties provides the capital (capital provider) for the other (mudarib) to work with on the

condition that the profit is to be shared between them according to a pre-agreed ratio.

These types ofSukukplay a vital role in the process of development financing, because

these are related to the profitability of the projects.

Mudaraba Sukuk can be instrumental in enhancing public participation in investmentactivities in any economy. These are certificates that represent projects or activities

managed on the Mudaraba principle by appointing any of the partners or any other

person as Mudarib for management of the business. As regards the relationship

between the parties to the issue, the issuer of Mudaraba certificates is the Mudarib,

subscribers are the owners of the capital and the realized funds are the Mudaraba


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capital. The certificate holders own the assets of the Mudaraba and the agreed upon

share of the profits belongs to the owners of capital and they bear the loss, if any.

The figure below illustrates how Mudaraba Sukukstructure works:

This type of sukuk is of interest to originators who do not have assets that they can

easily make available for an ijara SukukorMusharaka Sukuk, but which needs finance

for additional business investments or activities. It is critical for Sharia compliance that

the mudarib is entitled to a share in the profits rather than a flat fee. A mudarib can also

be paid an incentive fee.

Mudarbah Sukuk Structure:

Steps involved in the structure:

The Sukuk issuer enters into a Mudaraba agreement with the project manager

(mudarib) for construction/commissioning of a project;

The SPV issues Sukuk to raise funds, the proceeds of which are given to the

mudarib;

The mudarib undertakes the project and collects regular profit payments from the

activity for onward distribution to investors; and

Upon completion, the mudarib, in its capacity as obligator, purchases the assets

of the project from the issuer.

Islamic Financial Institutions can offerMudaraba Sukukor certificates to the investors

who would subscribe and participate in the investment transactions. The funds


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mobilized would be the variable capital (class B share) of any bank to be marketed

regionally through the selling of the issued Mudaraba Sukuk.

Mudaraba Sukuk may be issued by an existing company (which acts as mudarib) to

investors (who act as partners, or rab al-mal) for the purpose of financing a specific

project or activity, which can be separated for accounting purposes from the companysgeneral activities. The profits from this separate activity are split according to an agreed

percentage amongst the certificate holders. The contract may provide for future

retirement of the Sukuk at the then market price, and often stipulates that a specific

percentage of the mudaribs profit share is paid periodically to the Sukuk holders to

withdraw their investment in stages.

MUSHARAKA SUKUK:

In a Musharaka transaction, partners contribute capital to a project and share its risks

and rewards. Profits are shared between partners on a pre-agreed ratio, but losses areshared in exact proportion to the capital invested by each party. Thus a financial

institution provides a percentage of the capital needed by its customer with the

understanding that the financial institution and customer will proportionately share in

profits and losses in accordance with a formula agreed upon before the transaction is

consummated.

In securitizing a Musharaka arrangement, every subscriber can be given a participation

certificate, which represents his proportionate ownership in the assets of the venture or

project for which financing is being raised. Subsequent to the acquisition of substantial

non-liquid assets, these Musharaka certificates can be treated as negotiableinstruments and can be bought and sold in the secondary market.

Musharaka Sukukwhich is based on an underlying Musharaka contract is quite similar

to mudaraba Sukuk. The only major difference is that the intermediary will be a partner

of the group of subscribers. Almost all of the criteria applied to a Mudaraba Sukukare

also applicable to the Musharaka Sukuk.

In the structure shown below, the parties respective interests in the Musharaka are

represented by contractual units held by each party. The issuer will make a funding

contribution to the Musharaka from funds it raises from the Sukuk issue. The

Musharaka party will make an in-kind contribution to the Musharaka (usually includingsome tangible assets). The issuer and the Musharaka party also enter into a purchase

undertaking pursuant to which the issuer can require the Musharaka party to purchase a

set amount of units on set dates during the term of the Sukuk. The issuer will receive

profit distributions from the Musharaka and proceeds from sales of the units to the

Musharaka party. The amounts received are distributed to the Sukuk holders in


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accordance with a set formula. This structure is viable when the Musharaka party can

use its in-kind contribution for a profit-generating venture. 219

The figure below is an illustration of how Musharaka Sukukstructure works:


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After the project is started, these Musharaka certificates can be treated as negotiable

instruments. Certificates based on Musharaka/Mudaraba can be bought and sold in the

secondary market, subject to the condition that the portfolio of Musharaka comprises

non-liquid assets valuing more than 50 %. Profit earned by the Musharaka is shared

according to an agreed ratio. Loss is shared on a pro rata basis. Whenever there is a

combination of liquid and non-liquid assets, it can be sold and purchased for an amount

greater than the amount of liquid assets in the combination or in the pool.221

The Musharaka structure is considered more equitable and also safer for the investors

than the Mudaraba structure, as it involves both profit-and-loss-sharing between the

fund manager and the Sukuk holders, not only profit-sharing. In addition, Musharaka

Sukukholders will have added comfort and security from the cushion provided by the

managers participation in the Musharaka capital. 222

An example of Sukuk al-Musharaka is as follows: Emirates, Dubais national airline,

issued a $550 million Sukuktransaction for seven years. The deal was a structured on aMusharaka basis. The Musharaka, or joint venture, was set up to develop a new

engineering centre and a new headquarters building on land situated near Dubais

airport which was ultimately leased to Emirates. Profit, in the form of lease returns,

generated from the Musharaka were used to pay the periodic distribution on the trust

certificates. Emirates then purchased the leased assets on maturity of the transaction.

223

3.3.1.4 Murabaha Sukuk

Murabaha Sukuk are issued on the basis of murabaha sale for short-term and

medium-term financing. As mentioned earlier, the term murabaha refers to saleof goods at a price covering the

purchase price plus a margin of profit agreed upon by both parties concerned. The

advantage of this mode of financing is that, if the required commodity in the murabaha

is too expensive for an individual or a banking institution to buy from its own resources,

it is possible in this mode to seek additional financiers. The financing of a project costing

$50 million could be mobilized on an understanding with the would-be ultimate owner

that the final price of the project would be $70 million, which would be repaid in equal

installments over five years. The various financiers may share the $20 million murabahaprofit in proportion to their financial contributions to the operation.224

A commonly accepted view among Sharia scholars in a number of Islamic jurisdictions

is that murabaha debt cannot be securitized, thus making Sukuk backed by pools of

murabaha debt impermissible. This is because the sale of a document representing


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money is akin to the trading of monies, which is prohibited under the rules of riba.

However, the prevailing view among Malaysian scholars (in contrast to Sharia advisers

in more conservative jurisdictions) is that so long as the underlying receivable is

connected to a true trade transaction or to a commercial transfer of a non- monetary

interest, such a receivable can be traded freely for purposes ofSharia. 225

However, it is generally accepted that a pool of receivables consisting of only

Murabaha receivables cannot be securitized for creating negotiable Sukukto be traded

in the secondary market. The purchaser on credit in a Murabaha transaction signs a

note or paper to evidence his indebtedness towards the seller. That paper represents a

debt receivable by the seller. Transfer of this paper to a third party must be at par value

and subject to the rules ofHawala 226, meaning that its assignment also has to be at

face value. A mixed portfolio consisting of a number of transactions, including

Murabaha, may issue negotiable certificates subject to certain conditions. For this

purpose, the pool of the assets should consist ofIjara or other fixed assets valuing more

than 50% of its total worth. However, if the Hanafi227 view is adopted, trading will beallowed even if the non-liquid assets are more than 10% of its total worth

Now, let us see how a direct murabaha Sukukstructure works:


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1. Company seeks advice from Investment Bank regarding issue of securities; an

SPV is created for the purpose;

2. SPV issues securities to investors;

3. SPV collects funds from investors;4. SPV pays to Vendor for purchase of Assets;

5. Company as agent of SPV takes delivery of Assets;

6. Company purchases Assets from SPV on deferred payment basis and makes

payment of installments to SPV;

7. SPV passes them on to investors after deducting mudarib share/wakala229

fee for itself.230

The following constitutes a practical example how a negotiable murabaha Sukukcan be created: Arcapita Bank B.S.C (Bahrain) issued five-year multicurrency

Murabaha-backed Sukuk in 2005 with a five-year bullet maturity. The proceeds of the

Sukukare used for sale and purchase of assets via a series of commodity Murabaha

transactions. As Murabaha may yield a fixed return, the Sukuk holders have been

offered a return equivalent to three-month LIBOR + 175 bps. The SPV will have full

recourse to Arcapita and, therefore, the Sukukare a freely transferable instrument on

the basis of a mechanism approved by Arcapitas Sharia supervisory board. It is

presumed that the SPV will be maintaining a sufficient amount of inventory or fixed

assets, making its Sukuknegotiable. 231

3.3.1.5 Salam Sukuk

As we noted earlier, a salam is deferred delivery contract. It is essentially a

forward agreement where delivery occurs at a future date in exchange for spot payment

of price.

Salam Sukuk are certificates of equal value issued for the sake of mobilizing

capital that is paid in advance in the shape of the price of the commodity to be delivered

later. The seller of the Salam commodity issues the certificates, while the subscribers

are the buyers of that commodity, i.e. they are the owners of the commodity whendelivered. Salam sale is attractive to the seller, whose cash flow is enhanced in

advance, and to the buyer, as the Salam price is normally lower than the prevailing spot

price.232

Salam-based securities may be created and sold by an SPV under which the funds

mobilized from investors are paid as an advance to the company SPV in lieu of a


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promise to deliver a commodity at a future date. All standard Sharia requirements that

apply to salam contractalso apply

to salam Sukuk, such as, full payment by the buyer at the time of effecting the

sale, fungibility or standardized nature of underlying asset, clear enumeration of

quantity, quality, date and place of delivery of the asset and the like. At the same timethe SPV can appoint an agent to market the promised quantity at the time of delivery

perhaps at a higher price. The difference between the purchase price and the sale price

is the profit to the SPV and hence, to the holders of Sukuk. Such Sukuk obviously

involve market risk as the price of the underlying asset may go down instead of moving

up in future.233The steps involved in Salam Sukuktransaction may be summarized as

follows:

1 SPV signs an undertaking with an obligator to source both commodities

and buyers. The obligator contracts to buy, on behalf of the end-Sukuk holders, the

commodity and then to sell it for the profit of the Sukukholders.

2 Salam certificates are issued to investors and SPV receives Sukuk

proceeds.

3 The Salam proceeds are passed onto the obligator who sells

commodity on forward basis

4 SPV receives the commodities from the obligator

5 Obligator, on behalf of Sukukholders, sells the commodities for a profit.

6 Sukukholders receive the commodity sale proceeds.234

The market risk or price risk for the investors can be mitigated if a third party

makes a unilateral promise to buy the commodity at a predetermined price at a future

time period. Since the SPV representing investors need not participate in the market, it

would be insulated from price risk. This third party may be one of the prospective

customers of the company. The unilateral promise is binding on this customer. Once therights resulting from the promise are transferred to the SPV, it assumes the role of seller

to the third party customer at the specified future date. The SPV is able to realize a

higher predetermined price without participating in the market. The risk mitigation can

some times come through sovereign guarantees, as is the case with recent issue of

Sukuk-al-salam by the Bahrain Monetary Agency (BMA)


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3.3.1.6 Istisna Sukuk

We already mentioned that istisna is a contractual agreement for manufacturing

goods, allowing cash payment in advance and future delivery or a future payment and

future delivery of the goods manufactured, as per the contract.

Istisna contracts can be securitized to raise funds on the basis of the rental

income that the asset (for example, a building or bridge) will generate. In that case it will

generate fixed return securities, or it can be securitized on the basis of variable income

(such as a toll tax on the bridge), generating variable-return securities.241

241 Khan, M. Fahim, Islamic methods for government borrowing and monetary

management, Handbook of Islamic Banking, ed. by Hassan, M. Kabir, Lewis, Mervyn

K., Edward Elgar Publishing, Inc., 2007, p. 294 242 Obaidullah, Islamic Financial

Services, supra, p. 165 243 Mannan, Islamic Capital Markets, supra, p. 111

Under such a scheme the SPV representing investors becomes seller-contractor-manufacturer of an asset to a buyer (say, the government) and uses back-to-back

istisna for creation of the facility. In other words, the SPV takes upon itself the legal

responsibility of getting the facilities constructed, and sub-contracts the work to

manufacturers/contractors. The deferred price that the buyer will pay may be in the form

ofSukuk that are an evidence of indebtedness whose total face-value exactly equals

the total deferred price. These Sukuk may have different maturities to match the

installment plan that has been agreed upon by the two parties. They represent buyers

debt and hence, Sharia precludes sale of these debt certificates to a third party at any

price other than the face value of such certificates. Steps involved in the structure:1 The SPV issues Sukukcertificates to raise funds for the project;

2 Sukuk issue proceeds are used to pay the contractor/builder to build and

deliver the future project;

3 Title to assets is transferred to the SPV;

4 Property/project is leased or sold to the end buyer. The end buyer pays

monthly installments to the SPV; and

5 The returns are distributed among the Sukukholders.243

The prohibition ofriba precludes the sale of these debt certificates to a third party at any

price other than their face value. Therefore, such certificates, which may be cashed only

on maturity, cannot have a secondary market. As noted above, they can be transferred

at face value to a third party.244


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244 Ayub, Introduction to Islamic Finance, supra, p. 405 245 Mannan, Islamic Capital

Markets, supra, p. 111 246 Ibid, pp. 111-112

An example ofSukuk al-istisna is as follows: The Durrat Al Bahrain, a $1 billion world-

class residential and leisure destination situated in the Kingdom of Bahrain, issued the

Durrat Sukuk to finance the reclamation and infrastructure for the initial stage of theproject. The Sukukwas structured to provide quarterly returns with an overall tenure of

five years and an option for early redemption. The proceeds of the issue (cash) were

used by the issuer to finance the reclamation of the land and the development of base

infrastructure through multiple project finance (istisna) agreements. As the works carried

out under each istisna were completed by the contractor and delivered to the issuer, the

issuer gives notice to the project company under a Master Ijara Agreement to lease

such infrastructure on the basis of a lease to own transaction. During the istisna period,

the istisna receivable (amounts held as cash) was only subject to trading at par value.

Later, upon completion of the istisna period and when lease agreements were put in

place, the Sukukbecame tradable. 245

3.3.1.7 Hybrid

Considering the fact that Sukuk issuance and trading are important means of

investment and taking into account the various demands of investors, a more diversified

Sukuk - hybrid or mixed asset Sukuk - emerged in the market. In a hybrid Sukuk, the

underlying pool of assets can comprise of Istisna, Murabaha receivables as well as

Ijara. Having a portfolio of assets comprising of different classes allows for a greater

mobilization of funds. However, as Murabaha and Istisna contracts cannot be traded on

secondary markets as securitized instruments at least 51 percent of the pool in a hybridSukukmust comprise ofSukuktradable in the market such as an Ijara Sukuk.

Steps involved in a hybrid Sukukstructure are as follows:

1 Islamic finance originator transfers tangible assets as well as

Murabaha deals to the SPV.

2 SPV issues certificates of participation to the Sukuk holders and

receive funds. The funds are used by the Islamic finance originator.

3 Islamic finance originator purchases these assets from the SPV over an

agreed period of time.

4 Investors receive fixed payment of return on the assets.

A prominent example of such mixed portfolio Sukuk are Islamic Development Banks

(IDB) Solidarity Trust Sukuk for $ 400 million issued in 2003. Solidarity Trust Services


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(STS) served as trustee to issue the fixed-rate trust certificates that were issued to

purchase a portfolio ofSukukassets comprising Ijara, Murabaha and Istisna contracts

originated by the IDB. Each certificate represented an undivided beneficial ownership in

trust assets and rankedpari passuwith other trust certificates. Most of the assets (over

50 %) would, at all times during the period, comprise Ijara assets. If, at any time, the

proportion of assets evidenced by Ijara contracts fell below 25 %, a dissolution event

would occur, and IDB, by virtue of its separate undertaking, would be obliged to

purchase all of the assets owned by the trustee pursuant to the terms of the purchase

undertaking deed. Profit on Sukukassets, net of expenses of the trust, would be used

to give a periodic return to the certificate holders. Certificates would be redeemed at

100% of their principal value. In the case of any early dissolution event, the redemption

would be according to adjustment, keeping in mind the return accumulation period.

Principal amounts ofSukuk would be reinvested in Ijara and Musharaka contracts to

form a part ofSukukassets.

The modus operandi of issuing mixed portfolio Sukuk is an effective tool for converting

non-marketable and illiquid assets to negotiable instruments having a secondary

market, particularly suitable for investment banks and development finance institute.

USES OF SUKUK FUNDS

There are three major categories where Sukuk funds are used. These are

1. Project specific

2. Asset specific

3. Balance sheet specific

1. PROJECT-SPECIFIC SUKUK

Under this category money is raised through sukuk for specific project. For

example, Qatar Global sukuk issued by the Government of Qatar in 2003 to

mobilize resources for the construction of Hamad Medical City (HMC) in Doha. In thiscase a joint venture special purpose vehicle (SPV), the Qatar Global sukuk QSC, was

incorporated in Qatar with limited liability.

This SPV acquired the ownership of land parcel that was registered in the name of

HMC. The land parcel was placed in trust and Ijarah-based Trust Certificates

(TCs) were issued worth US$700 million that were due by October 2010. The annual

floating rate of return was agreed at LIBOR plus 0.45 per cent.


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2. ASSETS-SPECIFIC SUKUK

Under this arrangement, the resources are mobilize by selling the beneficiary right of

the assets to the investors. For example, the Government of Malaysia raised US$ 600million through Ijara sukuk Trust Certificates (TCs) in 2002. Under this arrangement, the

beneficiary right of the land parcels has been sold by the government of Malaysia

to an SPV, which was then re-sold to investors for five years. The SPV kept the

beneficiary rights of the properties in trust and issued floating rate sukuk to investors.

Another example of Asset-specific sukuk is US$250 million five-year Ijarah sukuk issued

to fund the extension of the airport in Bahrain. In this case the underlying asset was the

airport land sold to an SPV.

3. BALANCE SHEET-SPECIFIC SUKUKAn example of the balance sheet specific use of sukuk funds is the Islamic

Development Bank (IDB) sukuk issued in August 2003. The IDB mobilized these funds

to finance various projects of the member countries. The IDB made its debut resource

mobilization from the international capital market by issuing US$ 400 million five-year

sukuk due for maturity in 2008.


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