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The contracts, structures and pricing mechanisms of sukuk: A critical assessment

Siti Sarah Razak
By Siti Sarah Razak
3 weeks ago
The contracts, structures and pricing mechanisms of sukuk: A critical assessment

Ijara, Islam, Islamic banking, Mudarib, Murabaha, Riba, Shariah, Sukuk, Tawarruq, Wakalah

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  1. Available online at www Borsa _Istanbul Review _ Borsa Istanbul Review 19-S1 (2019) S21eS33 Full Length Article The contracts, structures and pricing mechanisms of sukuk: A critical assessment* Siti Sarah Razak a, Buerhan Saiti b,*, Yusuf Dinç b a Institute of Islamic Banking and Finance, International Islamic University Malaysia, Malaysia b Istanbul Sabahattin Zaim University, Istanbul, Turkey Received 29 May 2018; revised 2 October 2018; accepted 5 October 2018 Available online 12 October 2018 Abstract The existing literature focuses only on the contacts and structures of sukuk, but the pricing of sukuk is largely ignored. This paper examines the contracts, structures and pricing mechanism of sukuk. More specifically, this study examines several sukuk instruments, reviews the existing structures, demonstrates sukuk pricing mechanisms and discusses critical issues of each type of sukuk. The paper also considers possible solutions for those issues discussed in this study. By doing so, the readers are able to understand the important technical elements of sukuk and can differentiate sukuk from the conventional bonds and appreciate the spirit of Islamic finance. _ Copyright © 2018, Borsa Istanbul Anonim S¸irketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NCND license ( JEL classification: G12; G20; Z12 Keywords: Islamic finance; Islamic capital market instrument; Sukuk; Structure of sukuk; Pricing of sukuk 1. Introduction The sukuk (Islamic bond) market has recorded fluctuating performance since its first issuance in 1990 in Malaysia by a non-Muslim company called Shell MDS. The fluctuations show a big growth of sukuk issuance from 2012 onwards (Abbasher Hassan, 2012). The sukuk market is likely going to experience year-over-year growth, and the future of the market looks bright. As the market develops, the private sector will become increasingly interested. The market is expected to maintain high levels of liquidity, which will continue to drive * The authors are deeply grateful to Prof Ali Kutan (the editor) and the anonymous reviewers for their helpful comments which improved the quality of the paper greatly. The authors acknowledge and assume responsibility for any other mistakes or errors within the manuscript. The remaining mistakes belong to authors. * Corresponding author. Department of Islamic Economics and Finance, Istanbul Sabahattin Zaim University, Istanbul, Turkey. E-mail address: (B. Saiti). _ Peer review under responsibility of Borsa Istanbul Anonim S¸irketi. interest among financial institutions. Furthermore, according to Abbasher Hassan (2012), many corporations are currently sitting on the sidelines to venture into the sukuk market, as they start to seek a more diverse investor base beyond the traditional bank lending market. Nowadays, the functions of sukuk have differed. A simple explanation of modern sukuk is that sukuk are financial instruments that allow market players to obtain a large amount of cash or capital from investors. It can be done via developing a various structure of sukuk with underlying property or assets. The bonds process involves lenders and borrowers while the sukuk process involves the sukuk issuers and the investors via Islamic contracts. Sukuk issuers will securitise assets to issue sukuk. Investors who are interested to subscribe or buy the sukuk will get a certificate which represents ownership of the asset, risk, and cash flows. Upon maturity, those investors are entitled to get money equivalent to the value of the sukuk. The value of sukuk could be varied according to the value of the asset that is backing them. That criteria differentiate sukuk from bonds. _ 2214-8450/Copyright © 2018, Borsa Istanbul Anonim S¸irketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-ND license (
  2. S22 _ S .S. Razak et al. / Borsa Istanbul Review 19-S1 (2019) S21eS33 Today, sukuk are known as Islamic capital market instruments with distinctive features. As far as we concerned, the very first definition of modern-day sukuk was given in February 1988 during the fourth session of the Council of the Islamic Fiqh Academy in Jeddah. This resolution was on Mudarabah sukuk (trust-based Islamic bond). Global sukuk issuance has continued to develop after 2010. The sukuk market experienced a massive increase in issuance in 2011 and 2012. According to IIFM Sukuk Report (2016), the years 2010e2012 recorded the biggest increase in global sukuk issuances while in 2014 and 2015 the sukuk market slowed to just USD 100 Billion. The global sukuk issuance continued to drop in 2015. The entry of other issuers such as power producing companies, project financing entities, corporate, quasisovereign, entry of several jurisdictions and re-issuance by sovereign issuers have kept the sukuk market active. Even though the existing literature focuses on the empirical (Alam, Hassan, & Haque, 2013; Mohamed, Masih, & Bacha, 2015; Zulkhibri, 2015; Nienhaus & Karatas, 2016; Naifar, 2016; Najeeb, Bacha, & Masih, 2017; Bhuiyan et al., 2017; Reboredo & Naifar, 2017; Smaoui & Khawaja, 2017; Hassan, Paltrinieri, Dreassi, Miani, & Sclip, 2018 and among others) or legal, Shariah, regulation, supervisory (for example: Oseni & Hassan, 2014; Oseni & Hassan, 2015; Oseni, 2015, pp. 111e147; Hanif, 2016; Saiti & Abdullah, 2016; Oseni, Ahmad, & Hassan, 2016) or other aspects of research (Bo, Engku, & Saiti, 2016), the pricing of various sukuk and their critical assessment are largely missing. Therefore, by examining and evaluating contracts, structures and pricing mechanism of various sukuk, this study provides fundamental research on the sukuk so that the readers can understand the important technical elements of sukuk and can differentiate sukuk from the conventional bonds and appreciate the spirit of Islamic finance. 2. General model of pricing in sukuk Sukuk is a structured financing/loan from the sukuk holder to the sukuk issuer. The general concept of pricing in sukuk is similar to bonds. Sukuk is using time value of money where the present value is the price of sukuk while sukuk will be redeemed at future value or face value at maturity and yields income. The yields income may be fixed or variable when incomes are linked to some index or returns of some asset. The coupon will determine whether the yields incomes are fixed or variable. When the coupon is fixed, the sukuk is called fixedincome security (Krichene, 2013). Table 1 presents a simple example of sukuk pricing. 2.1. The yield to maturity The yield to maturity (y) is also called the internal rate of return (R) (Krichene, 2013). If the present value of the sukuk (V), (C) its coupon payment, and (n) is maturity are given, (y) will be able to compute the corresponding value of a sukuk. Table 2 presents the example of calculating the yield to maturity. Table 1 The general pricing model of the sukuk.  Face value (A): $100  Rate of return (R): Year 1 (0.05) Year 2 (0.06) Year 3 (0.07) Year 4 (0.072)  Redeemable in 4 years with annual coupon  Coupon (C): $5 Time Cash Flow Rate of return Present Future t¼0 t¼1 C R (0,1) t¼2 C R (0,2) t¼n CþA R (0,n) Solution: 1. In order to find sukuk price, we need to identify its present value. Therefore, the formula is as follows: $5 $5 $5 $5 Sukuk Price ¼ þ þ þ þ ð1 þ 0:005Þ ð1 þ 0:06Þ2 ð1 þ 0:07Þ3 ð1 þ 0:072 Þ4 $ 100 ¼ $92:8013 ð1 þ 0:072Þ4 2. The above calculation happens if the discount rate is variable. If the discount rate is constant, the sukuk price is given as: n P C C CþA C A þ ¼ þ …þ n ¼ tþ 2 ð1 þ RÞ ð1 þ RÞ ð1 þ RÞ ð1 þ RÞn t¼1 ð1 þ RÞ 2.2. The par yield Another pricing situation of sukuk is the par yield. The par yield is a situation where the sukuk price equals its face value. In other words, (V) equals (A). If the maturity equal to (n), (R) is the rate of return and (C) is the coupon, the equation will look like this (Krichene, 2013): C C CþA þ n 2þ…þ ð1 þ R ð0; 1ÞÞ ð1 þ R ð0; 2ÞÞ ð1 þ R ð0; nÞÞ n X C A ¼ tþ ð1 þ R ð0; nÞÞn ð1 þ R ð0; 1ÞÞ t¼1 A¼ 2.3. Zero-coupon sukuk This type of sukuk pays no coupons, and it is redeemable at face value at maturity. This sukuk is also called ‘zeros’. Coupon sukuks have the same portfolio of zero-sukuk (Krichene, 2013). Each coupon is a zero-sukuk to be redeemed at maturity of the coupon. At the maturity of the coupon sukuk, the last coupon is a zero-sukuk too. Table 2 Calculation of the yield to maturity. A sukuk has a face value of $100, redeemable in four years with annual coupon (C) ¼ $5. Let the present value of sukuk (V) ¼ $96.5555. As the present value is given, we will be able to compute the yield to maturity (y) $5 $5 $5 $5 $ 100 þ þ þ þ 96:5555 ¼ ð1 þ yÞ ð1 þ yÞ2 ð1 þ yÞ3 ð1 þ yÞ4 ð1 þ yÞ4 Therefore, y equal to 0.059939 or 5.99%.
  3. _ S .S. Razak et al. / Borsa Istanbul Review 19-S1 (2019) S21eS33 When C increases, the value of sukuk (V) increases. However, when the yield rate (y) increases, the value (V) of the sukuk decreases, and reciprocally, when the yield rate decreases, the value of sukuk increases. Other than that, when y exceeds the coupon rate (C/A), the sukuk sells at premium which means V > A. If y is below the coupon rate, the sukuk is a discount sukuk, which means V < A. If y is equal to coupon rate, the sukuk sells at par V ¼ A. The sukuk holders benefit from such sukuk as the price of sukuk is lower than face value (redemption amount). If the sukuk holder waits until the maturity date, the value of sukuk would increase when it approaches the maturity date (it is also called positive capital gain). Put differently, the return sukuk holders is only from capital gain, not from coupon payments. 3. Specific sukuk structures and pricing mechanisms In this section, we will examine the concepts, the structures and the pricing model of various types of sukuk. At the end of each type of sukuk, there is some critical assessment which lays down some issues regarding the particular sukuk. According to IIFM Annual Sukuk Report (2018), based on data from 2001 to 2017, Wakalah and Ijarah are the two most preferred structures by most of the issuers where Sukuk AlWakalah shares increased to 75%. For example, in the case of corporate sukuk, the issuance size of Wakalah, Ijarah, Musharakah, Murabahah, Mudarabah sukuk is more than 90% (IIFM report, 2018. page 52). Therefore, we have limited our focus on these popular sukuk structures. 3.1. Mudharabah sukuk These are certificates that represent projects or activities that are managed on the basis of a mudharabah (partnership based on trust) contract. There will be one party or partner called the mudarib who will manage the project. Besides the mudarib, there is another partner called robbul-mal (owner of capital) who is the capital provider of the project. In this transaction, the issuer of these certificates is the mudarib (the managing partner), the subscribers are the capital owners and the mobilised funds are the mudharabah capital. The certificate holders own the assets of mudharabah and share the profit as per the agreement. They are also the capital providers and bear the losses if any. 3.1.1. Structure of mudharabah sukuk (Cagamas Mudharabah Bond) We chose Cagamas Mudharabah Bonds (CMB) as an example of mudharabah sukuk. The sukuk was introduced to the market since 1994. They involve the purchase of Islamic housing financing and Islamic hire purchase from some Islamic financial institutions that offer Islamic house financing and Islamic hire purchase products. Mudharabah is the underlying concept of this sukuk. Bay al-dayn is also applied in the sukuk, which is to purchase the housing debt from financial institutions whereas mudharabah concept is used to issue the CMB. Under this agreement, the sukuk holders and the S23 Cagamas will share profits according to the profit share ratio that has been agreed in the agreement. The structure of the sukuk starts when Cagamas Berhad purchases housing debts, let's say amounting RM 30 billion from Bank Islam Malaysia Berhad. The agreement pertaining to the purchase of housing debt will be sealed between Cagamas Berhad and Bank Islam Malaysia Berhad. Upon receiving the RM30 billion Islamic housing debt, Cagamas Berhad will issue Islamic bond/sukuk worth RM30 billion to financial institutions that offer Islamic banking. The structure is shown in Fig. 1: 1. The process starts when the approved seller (let's say, Bank Islam Malaysia Berhad, BIMB) provides financing to customers 2. The customers will then pay the financing amount to the bank via instalment payment 3. Later, BIMB sells the Islamic housing debt to Cagamas Berhad 4. Cagamas pays cash to BIMB 5. Cagamas issues CMB to sukuk holders 6. Sukuk holders invest in CMB 7. During the post-sale period, Cagamas appoints BIMB as the servicer 8. Cagamas remits the instalments from BIMB 9. The investors receive the coupons 3.1.2. Pricing of Mudharabah sukuk In this section, we still use Cagamas Mudharabah Bond (CMB) as an example to demonstrate the pricing calculation for Mudharabah sukuk. There are two steps in pricing this sukuk (Bacha & Mirakhor, 2013; Saiti, Hasan, & Ali, 2016). The first step is described by the following formula is with a face value basis of RM100. " À À ÁÁ#   100 100 þ CÂE CÂ t 365 À Â TÁ P ¼ À FV 36500 100 þ r 365 where, P Price per RM100 face value C Indicative coupon for current coupon period E Number of days in the current coupon period T Number of days from the transaction date to next coupon payment day r Yield to maturity t Number of days from last coupon payment date to the value date FV Face value of SMC transaction (RM100) The second step is the transaction value or proceeds. It can be determined as:   NV Â P C Ât Proceeds ¼ þ NV Â 100 36500
  4. S24 _ S .S. Razak et al. / Borsa Istanbul Review 19-S1 (2019) S21eS33 arguments among Shariah scholars from around the world. As a result, we notice the obvious ups and downs of the practice of bay al-inah in some countries. In Malaysia, the application of bay al-inah in Islamic finance instruments was high. However, due to the new law and restriction set up by the government, IFI started to phase out bay al-inah practice in most of its banking instruments. Fig. 1. The process of Cagamas Mudharabah Bond. 3.1.3. Critical assessment of Mudharabah sukuk The issuances of Mudharabah sukuk are becoming less popular in the capital market for the past four to five years. According to the IIFM Sukuk Report Third Edition (2013), only about 1% of international sukuk and 3% of domestic sukuk issuance occurred between 2011 to January 2013. The sukuk seem particularly advantageous for the Islamic banks rather than the investors. It is because the sukuk assets could be falling below the par value which would likely lead to a reduced payout at maturity. Nevertheless, there are different structures of mudharabah sukuk available in the market which were not the evidence to the above disadvantage. Mudharabah sukuk is an equity-based sukuk structure where profits and losses are shared between the partners. Besides that, investment from a Shariah viewpoint does not allow a fixed return as well as the guaranteed principal amount at maturity to the investors. However, several instruments fixed the periodic returns over the sukuk and guarantee the principal amount of the sukuk holders. The periodic returns were often fixed. In the case the actual profits realised were less than the promised returns, the originator provided funding, whereas when there were excess profits or surplus, the originator took it as an incentive. This characteristic seems against the nature of the Mudharabah concept as losses were borne by the originator and the periodic returns to the sukuk holders were fixed, regardless of the performance of the underlying project. Besides that, in the matter of CMB, as far as the Shariah issue is concerned, debates about bay al-Inah (sale and buy back between two parties) are ongoing. The loopholes and conflicts in mudharabah sukuk have led us to recommend market players to issue a new and fresh contract of sukuk, such as partnership contract sukuk. The sukuk market is experiencing an increase in the issuance of sale-based contract sukuk. It could be a good time for the market players to consider partnership contract sukuk given its strong development potential. 3.2.1. Concept of BNMN-i sukuk As mentioned earlier, bay al-inah is a sale concept where a commodity is sold for a deferred payment (Thaman mu'ajjal ) and then resold to the seller on a cash basis with a price lower than the deferred price. At the end of the transaction, the owner of the commodity will receive the commodity together with the payment (deferred payment) while the other party will obtain cash. There are two types of agreement involved in bay al-inah. The first agreement is sale agreement. It is usually the first transaction in bay al-inah where party A sells the commodity to party B on deferred payment. The purchase agreement is the second agreement in bay al-inah. It is where party B sells the same commodity to party A on spot/cash. The structure is shown in Fig. 2. 3.2.2. Structure BNMN-i sukuk This section describes the structure of Bank Negara Monetary Notes-I (BNMN-i). BNMN-i as an Islamic sovereign instrument of Islamic security issued by Bank Negara Malaysia to replace the previous security called Bank Negara Negotiable Notes (BNNN) for managing liquidity in the Islamic monetary market. The instrument was issued using the principle of bay al-inah. The maturity of this new security is also lengthened from one year to two years. Therefore, the new issuances of BNMN-i may be issued either on a discounted or a coupon-bearing basis depending on the demand of the investors. The process of BNMN-I is presented in Fig. 3. 1. BNM identifies the Shariah-compliant asset 2. The BNM sells it Shariah-compliant assets to principal dealers on a tender basis at a discount from par value 3.2. Bank Negara Monetary Notes (BNMN-i) sukuk BNMN-I was created on the concept of bay al-inah. The practice of bay al-inah (sale and buy back between two parties) concept in Islamic finance products has created many Fig. 2. Modus operandi of bay al-inah.
  5. _ S .S. Razak et al. / Borsa Istanbul Review 19-S1 (2019) S21eS33 S25 Fig. 3. The process of BNMN-i. 3. The BNM subsequently buys the assets back at par value which to be paid at maturity 4. Once the debt is created, BNMN-I will be issued 5. The BNM allots BNMN-I via the Real-time Transfer of funds and Securities System (RENTAS) BNMN-I is issued to the principal bidder via a tender process. The information will be displayed in Bank Negara's system called Fully Automated System for Tendering (FAST). The participant who tendered the highest price for the asset offered will be the successful buyer/bidder. BNMN-i issued in the primary market is using the concept of bay al-inah. It is also tradable on the secondary market which applies to the bay al-dayn contract. 3.2.3. Pricing of BNMN-i We demonstrated the structure of BNMN-i which is the example of bay al-inah sukuk. The following formula is used in order to calculate the pricing of BNMN-i (Bacha & Mirakhor, 2013).   r Ât P ¼ FV Â 1 À 36500 where: P ¼ Price of instrument FV ¼ Face value or redeemable amount at maturity r ¼ Required profit/return (discount factor) t ¼ Number of days left to maturity 3.2.4. Critical issues on the practice of BNMN-i sukuk The use of bay al-inah in Islamic finance has been a controversial practice. Many Shariah scholars are debating the matter. Bay al-inah is not found in any Islamic commercial law. Nevertheless, it is a legal sale according to the Shafi'i Mazhab. According to Imam Shafi'i, the intention is not a significant point to determine the validity of the contract. The contracts involved in bay al-inah are valid contracts based on external evidence. An unlawful intention does not invalid the contract (Naim, 2010). Islamic scholars who oppose bay al-inah believe the contract is a planned agreement created by the parties. At the end of the agreement, one of the parties will obtain immediate cash against a future obligation settling a higher amount. It seems that both parties have no intention to commit to the sale contracts and to use the asset as any consumer does. It betrays one principle of contract in Islam, which is the objective of the contract (maudu ‘ul aqdi). They also believe that the contract is a legal device (hilah) that uses Islamic commercial law to obtain cash with committing riba. The idea of sales is a gateway from interest payments and receipts. In other words, this contract is believed to be a back door for interest. Those might be the reasons why market players do not prefer to issue bay al-inah sukuk. Besides that, the bay al-inah contract is often used in consumer banking instruments such as house financing and personal financing. According to IIFM Sukuk Report Third Edition (2013), no bay al-inah international sukuk were issued from 2001 to 2013 and only a few bay al-inah sukuk were issued after that. The controversy of bay al-inah practice has led Malaysia to slowly eliminate its practice. The country started to issue with other sale-based contracts sukuk such as murabaha and ijarah contract sukuk. This practice has received recognition and placed Malaysia as a leader in the global sukuk market. 3.3. Al-ijara sukuk The al-ijara contract is a rental contract. Al-ijara sukuk (rental based Islamic bond) are among the most significant sukuk in the market. The IIFM Sukuk Report Third Edition (2013) found that 48% of international sukuk issued between 2011 and 2013 were Al-ijara sukuk. 3.3.1. Concept of al-ijara sukuk The ijara (rental or leasing) contract is an exchange contract. It is a popular contract among IFIs due to its similarity to a conventional lease. In ijara contract, one party purchases and leases the equipment required by the client for a rental fee.
  6. S26 _ S .S. Razak et al. / Borsa Istanbul Review 19-S1 (2019) S21eS33 The duration of the rental and the fee are agreed in advance, and ownership of the asset remains with the lessor. An example of the application of ijara in Islamic banking product can be seen in house financing. The bank purchases a house for a customer. The customer then pays a rental fee until the total cost has been paid, at which point the asset is transferred to the customer. The expected return on some forms of ijara may not be completely fixed and determined in advance since there might be some maintenance and insurance expenses that are difficult to determine up front. This characteristic has made the contract become negotiable and can be traded on the secondary market. Now it is time to understand how al-ijara sukuk works. Ijara sukuk refers to the securities representing ownership of well-defined existing and known assets tied up to a lease contract of which is the return payable to sukuk holders. Payment of ijara rentals can be unrelated to the period of taking usufruct by the lessee. It can be made before the beginning of the lease period, during the period or after the period so long as both parties have mutually decided. This flexibility can be used to evolve different forms of contracts and sukuk that may serve different purposes. In ijara sukuk, an issuer is usually in the form of a special purpose vehicle (SPV) or a trust issues sukuk to finance a purchase of one or more assets from the obligor, the financed party. The assets will then be leased to a lessee whose lease payments will be in the form of periodic payments to the investors (sukuk holders). At maturity, the asset will be repurchased by the obligor at a predetermined price, and the proceeds of this sale will be transferred to the sukuk holders (Goud, 2010). 3.3.2. Structure of al-ijara sukuk (sukuk Bank Negara Malaysia Ijarah) This section expounds the structure of Sukuk Bank Negara Malaysia Ijara (SBNMI). This sukuk is based on ‘sale and lease-back’ contract which is popular in the Middle East. This sukuk was introduced on 16 February 2006 with the first issue of RM400 million. BNM issues this facility on a regular basis and the issues range from RM 100 million to RM 200 million. The sukuk process starts with the establishment of a Special Purpose Vehicle (SPV) by BNM to issue the ijara sukuk. The proceeds (the cash flows from the investors) will be used to buy the assets from the BNM. Then, the assets will be leased to BNM for rental payment, which is distributed to investors as a return (coupon) on a semi-annual basis. At maturity, by the time of ending the rental tenure, the SPV will sell the asset to BNM at a predetermined price (principal). The structure of SBNMI is shown in Fig. 4. 3.3.3. Pricing of al-ijara sukuk In typical ijara sukuk, investors will receive two types of inflows. The value or price of sukuk will be the present value of cash flows that one can receive from investing from sukuk. The present value is simply the aggregate discounted value of each future cash flow. The discount rate would not be the interest rate commonly used in conventional finance but an opportunity cost applicable to the investor. This opportunity Fig. 4. The structure of Sukuk Bank Negara Malaysia Ijarah (SBNMI). cost could be risk-adjusted, where a higher opportunity cost of funds would be applied to sukuk issued by entities perceived to have a higher risk. Using the appropriate discount rate, one would determine the present value of the periodic lease payments. The aggregate of this is added to the present value of a single proceed from the sale of the underlying asset to the mudarib. If the sale price is predetermined, then one merely finds the present value of the amount given and the time when the cash flow will occur. Nevertheless, if the sale price is not predetermined, an estimate of the expected sale price has to be made. There are several ways to handle this estimation process. One of the ways would be to assign probabilities to each potential sale price. The weighted average of this value is then taken to be the ‘expected’ sale price. Here is the formula (Bacha & Mirakhor, 2013): Expected sale price ¼ S ðPt : SPi Þ where, Pt ¼ Probability of the event/scenario happening SPi ¼ Sale price of the asset under the scenario. For example, there are five possible sale prices with the probabilities as shown in Table 3. The price of the basic sukuk Al-ijara will be the sum total of the following items: Total PV of periodic payments received þ PV of expected sale price of underlying asset at maturity 3.3.4. Critical assessment of al-ijara sukuk Al-ijara sukuk is a preferred sukuk by many issuers due to its flexibility. The instrument uses the most accepted Shariah principle, which is ijarah mutahiyah bi al-tamlik (rental ending with sale). However, it does not mean the sukuk are free from Shariah issues or criticism from Shariah scholars and market players. In the ijara contract, there have been concerns about a true transfer of ownership, specifically the
  7. _ S .S. Razak et al. / Borsa Istanbul Review 19-S1 (2019) S21eS33 Table 3 Expected sale price of sukuk al-ijara. Scenario Potential Sale Price 1 2 3 4 5 $ $ $ $ $ Probability 450 480 500 520 550 million 0.10 million 0.15 million 0.50 million 0.15 million 0.10 P Therefore, Expected Sale Price ¼ [(0.10 Â $450 mil) þ (0.30 Â $480 mil) þ (0.20 Â $500 mil) þ (0.20 Â $520 mil) þ (0.40 Â $550 mil)] ¼ $500 mil moving of assets off the issuer's balance sheet as opposed to transferring only beneficial ownership of the underlying assets. The concerns have led the Dubai financial market to create a rule on the requirement of genuine sale (transfer) to the sukuk holders. All privileges of ownership must be conducted legally. The acts include all acts of disposal, transferring its title from its seller to the sukuk holders from both legal and Shariah perspectives. Other than that, its viability as a money market instrument is questionable. Supposedly, the issuance requires the availability of assets to back the issuance. This scenario may not be possible all the time (Saiti et al., 2016). In terms of limitation, the assets used in ijara sukuk may limit the amount of financing. It is due to the fact that real estate is the most expensive asset which can be transferred to ijara sukuk. Real estate has a financial value limit both from sale and rental income, especially for corporate issuers for whom typically their most valued real estate will be their headquarters. 3.4. Government Investment Issues (GII) The issuance of GII involves several contracts, which are bay al-dayn, qard hassan (benevolent loan) and bay al-inah. This section covers only one of the contracts which is bay aldayn. Bay al-dayn sukuk is another debatable type of sukuk. Its basic concept is about the sale of debt. This sukuk has been arguably between Malaysia and some Middle Eastern countries. As the result, its issuance became slower today. 3.4.1. Concept of bay al-dayn sukuk Bay al-dayn came from the Arabic word Bay’ means sale while dayn means debt. It is a type of sale contract in which the creditor sells his payable right upon the debtor either to the debtor himself or to a third party. The purpose of this contract is to avoid any kinds of gharar (uncertainty) which may arise at the level of the inability of a buyer from possessing what he has bought as it is not permitted for the buyer to sell before receiving the receipt of the purchased item. Many sukuk in Malaysia are issued and traded based on the combination of bay al-inah and bay al-dayn. There are three steps involved in the creation of bay al-dayn sukuk. The first is the securitisation process, which is about the creation of bay al-inah assets. Then (the second step), the issuance of Islamic debt certificate will be done. This is where bay al-dayn takes place. This usually occurs in the primary market wherein its S27 settles the debt. The issuing company will sell debt certificates or sukuk to investors. Debt certificates are valid only when it is supported by an asset. Otherwise, the bond must be securitised. The same sukuk can be traded on the secondary market for liquidity purposes. When debt is securitised, it now becomes the property, and hence it can be traded. The sukuk can be sold by investors to the issuer or third party. This trading or sale and purchase of the debt certificates is called bay al-dayn, and it is the third step in creating bay al-dayn sukuk. In Malaysia, the practice of bay al-dayn sukuk at a discount is allowed while in the Middle East, Muslim scholars considered it invalid even though it is supported by underlying assets. According to them, any profit created from sale and purchase of debt is riba and hence is forbidden. 3.4.2. Structure GII The Government Investment Issues (GII) is a hybrid sukuk where it combines several contracts which are qard hassan, bay al-inah and bay al-dayn. GII which is also known as Government Investment Certificates were introduced in 1983 with the establishment of Islamic banks. The security is issued by the government of Malaysia for funding development projects initiated by the government. It is issued through a competitive auction conducted by Bank Negara Malaysia (BNM) on behalf of the government (Malaysia, p. 2012). The government issued non-interest-bearing Government Investment Certificate for the first time to meet the needs of IFI and other corporations who are interested in the securities. According to the Shariah, IFIs are forbidden from holding interest-bearing government securities. Nevertheless, there is a serious need for IFIs to hold appropriate liquidity to meet statutory liquidity requirements as well as to park its idle funds. As a result, the Malaysian parliament passed the Government Investment Act in 1983 to enable the government of Malaysia to issue non-interest GII. The structure of GII is displayed in Fig. 5. 1. In order to get the required finance, firstly, the government will sell its Shariah-compliant assets, for example equities to financial institutions for immediate cash payment. 2. Once the sale is completed, financial institutions will subsequently sell the assets back to the government at profit paid on deferred until later, and GII will be issued by the government as evidence of the indebtedness. 3. Profit from the sale will be paid periodically according to the coupon of GII. 3.4.3. Pricing of GII The pricing of GII is calculated as follows (Bacha & Mirakhor, 2013; Saiti et al., 2016): " # " # K ¼1 X RV c Price ¼ þ NÀ1þ TE NÀ1þTE ð1 þ rÞ N ð1 þ rÞ
  8. S28 _ S .S. Razak et al. / Borsa Istanbul Review 19-S1 (2019) S21eS33 Fig. 5. The process of government investment issues. Note: if profit is paid semi-annually, the r and c need to divide by two (r/2, c/2).where: RV: Redemption amount or value at maturity c: Coupon rate r: Market yield for a similar maturity period N: Number of coupon payments between the value date and maturity date T: Number of days from the value date to the next interest payment date E: Number of days in the coupon period after which settlement takes place 3.4.4. Critical assessment of GII The combination of bay al-inah and bay al-dayn in GII has made it difficult to practice it in the market. This is due to the introduction of amendments to the practice of bay al-inah made by the government of Malaysia. The guidelines have made it much more difficult or perhaps impossible to practice. Those issues have to be sorted out as an instrument like GII is needed by IFI. The issue of bay al-dayn arises when the sukuk are traded on the secondary market at a discount. It is because buyers in the secondary market are usually speculators and do not intend to possess the bond for long-term investment. Their objective is to make a quick profit from market liquidity and interest rate movement. Bay al-dayn would not encounter any issue if it is traded at par value. Shariah permits the sale of debt only when it is equivalent in quantity and time of maturity (Naim, 2010b). This characteristic is allowed by all schools of Islamic law with a condition that it is paid in full and thus gives no benefit to the purchaser. The rationale for the ruling is that any financial transactions that involve debt should never allow for a lengthy payment more than the period of the loan. Otherwise, it will be regarded as riba and hence it is prohibited. Most of the schools of Islamic law are against the practice of bay al-dayn. However, the Shafi'i school allows the practice with some restrictions. According to Imam Shafi'i, a sale of debt is allowed as long as it is a confirmed debt and was sold in exchange for a good that must be delivered immediately. Countries practicing the Shafi'i school such as Malaysia are practicing bay al-dayn contracts in their financial instruments. In Malaysia, the practice of bay al-dayn is regulated closely by the Central Bank of Malaysia and Securities Commission to safeguard the parties involved. This situation has solved the concern of the Maliki and Hanafi Mazhab towards the practice of bay al-dayn. The Maliki Mazhab has imposed several conditions in order to practice bay al-dayn for deferred payment. The conditions are created to protect the rights of the debt buyer and to avoid riba. While for Hanafi jurists, their concern regarding the sale of debt to the third party is the fear that the buyer will have to bear greater risk. This instrument is another financial instrument using debatable Islamic contracts. Therefore, there is a need to think about changing the types of contract. Instead of using salebased contracts, this instrument could use a partnership contract. Partnership contracts such as Musyarakah Munataqisah (diminishing partnership) is said to be risky to some parties. However, we believe there is another way to practice Musyarakah Mutanaqisah. Therefore, further research is recommended to evaluate the ability of some partnership contracts to be used in sukuk. 3.5. Murabaha sukuk As for the murabaha sukuk (cost plus profit sale-based Islamic bond), it is an Islamic trust contract where the original price and the markup need to be disclosed. Murabaha sukuk can be created for asset acquisition purposes. It can be structured via a combination of other contracts for example bay alinah and tawarruq (a sale contract which invloves three parties). 3.5.1. Concept of murabaha sukuk Murabaha comes from the Arabic word ribh, which means an increase. Since it is a sale and an Islamic trust contract, the seller must disclose the markup to the purchaser as per the seller's purchase price for a trust-sale of a certainly specified asset. Murabaha contract is valid if the profit is made through one of these methods. The first method is called bay al-musawamah (bargaining sale). In this method, price to the seller is specified followed by the method of price negotiation. The second method is called bay al-amanah (trust-based sales). It happens when the seller reveals the actual cost of the good, and then the buyer proposes the fair price to offer the seller based on the seller's cost. It is called murabaha when the good was bought more than the cost (which is the norm). Murabaha sukuk is defined as securities issuances where the underlying contract between the issuer and obligor is a sale then purchase of an asset at a markup. Murabaha sukuk can be formed through several methods. The first method is a factual purchase and sale involving three basic parties where the asset moves from seller to buyer. The second method is a pre-
  9. _ S .S. Razak et al. / Borsa Istanbul Review 19-S1 (2019) S21eS33 arranged sale and buy back between the seller and buyer. This transaction is similar to bay al-inah. Another method is a three-party agency sale applying commodity murabaha, which is also called tawarruq. 3.5.2. Structure of murabaha sukuk Several methods can be used in murabaha sukuk. Two of the methods will be discussed in this part. The first method is murabaha sukuk based on bay al-inah transaction. The general structure is illustrated in Fig. 6. 1. The process of murabaha sukuk starts when a company sells an identified asset for cash to the SPV, who is the issuer of sukuk. 2. SPV then issues sukuk to raise fund from investors to buy the asset. 3. SPV sells the asset back to the company at a markup for a deferred price. 4. The company makes periodic payment to the SPV which then distributes the payment to the investors. The example of this type of sukuk is Sunway City sukuk issued in 2007. Sunway City is a property developer in Malaysia. There is no SPV involved in this structure. Sunway City is the issuer of this sukuk. The company obtained approval from the SC in October 2007 to issue RM 500 million murabaha sukuk under a medium-term-note. This allows Sunway City to raise sukuk in different amounts within the period of 15 years. Besides Sunway City, HSBC bank is another party associated in the sukuk. HSBC bank is the facility agent that acts on behalf of the investors. The sukuk begins with the sale of an identified asset from Sunway City to HSBC bank. At this point, the Asset Purchase Agreement will be signed. The investors will purchase the asset and HSBC will pay the purchase price to Sunway with the proceed raised from the issuance of sukuk. When the investors own the asset, they will then sell it to Sunway City through HSBC on a deferred basis, and the Asset Sale Agreement will be signed. The deferred selling price will S29 be higher than the spot purchase price. Lastly, Sunway City issues murabaha sukuk as evidence of their obligation to pay to the investors. Once the sale contract has taken place, the investors are no longer the owner of the asset. Hence, they are not entitled to any transactions of the asset. Nevertheless, the investors have rights to the sale price which is to be paid by Sunway City. Another type of murabaha sukuk is murabaha sukuk based on tawarruq transaction. In this sukuk transaction, there is no buying and selling transaction between two parties, but there is an arranger who acts as wakeel on behalf of the issuer. The structure of Murabaha sukuk based on tawarruq transaction can be seen in Fig. 7. 1. It starts with SPV, who acts on behalf of company issues sukuk 2. SPV purchases commodity from broker A 3. SPV will then sell the commodity to the company on a deferred basis with cost plus profit 4. Once company owned the commodity, they sell it to Broker on a spot basis 5. After receiving the payment from Broker B, the company pays periodic payment to SPV 6. Then, SPV pays the payment to the investors 3.5.3. Critical assessment of murabaha sukuk Murabaha sukuk has positioned themselves as the lowest number of issuance for the majority of types of international sukuk between 2001 and 2015. According to IIFM Fifth Edition (2016), murabaha sukuk is titled as the smallest number of international corporate sukuk, international quasisovereign sukuk and international sovereign sukuk issuance with the recorded percentage of 9%, 2% and 0.24%. Ironically, different figures are recorded for murabaha domestic sukuk. Murabaha sukuk played a bigger role in domestic sukuk where they were ranked as the second and largest number of corporate and quasi-sovereign sukuk issuance between 2001 and 2015. Fig. 6. Murabaha sukuk based on bay al-inah.
  10. S30 _ S .S. Razak et al. / Borsa Istanbul Review 19-S1 (2019) S21eS33 Fig. 7. Murabaha Sukuk based on Tawarruq transaction. As explained earlier, bay al-inah is a debatable transaction. Therefore, the practice of muarabaha sukuk based on bay alinah transaction is not agreeable to many countries, especially Middle Eastern countries. These countries applied murabaha sukuk based on tawarruq instead and named it murabaha sukuk. Another concern regarding murabaha sukuk is the characteristic of not being able to be traded in the secondary market (Saad, Ibrahim, & Napiah, 2016). Trading murabaha sukuk on the secondary market is considered as a sale of debt or bay aldayn. As discussed in the bay al-dayn section, this transaction has raised arguments among Muslim scholars, and most of them do not allow its practice. Nevertheless, Malaysian scholars are of the opinion that sale of debt is permissible. The opinion is based on the argument from Ibn Qayyim Aljawziyyah. He demonstrated that the majority of Islamic jurists are unanimous in accepting the general rules of bay al-dayn, they only disagree on the opinion about selling debt to the third party because they agree the seller will not be able to deliver the sold debt to the buyer. Murabaha sukuk may also be structured to facilitate real asset acquisition for companies. This may occur when the company has an intention to own the asset which is the object of sale. Nonetheless, the objective of most murabaha sukuk is to provide cash to a company or sovereign. This objective can be achieved via murabaha sukuk based on bay al-inah and tawarruq transaction, as illustrated in Figs. 6 and 7. 3.6. Al-wakalah sukuk Al-wakalah sukuk (agency based Islamic bond) is among the famous sukuk in the global Islamic finance market. It is recorded by IIFM Sukuk Report Fifth Edition (2016) that this type of sukuk is the most popular sukuk (internationally) after al-ijara sukuk between the periods of 2001e2015. 3.6.1. Concept of al-wakalah sukuk Al-wakalah sukuk is structured according to the Islamic concept of wakalah. Wakalah is an arrangement between two parties where one of the parties will act on behalf of another party. This concept is thereby akin to an agency agreement. In al-wakalah sukuk, a principal (the investor) appoints a wakeel or agent to invest his funds into a pool of investments or asset. The appointed wakeel lends his expertise to manage the fund in order to generate an agreed profit return within a specified time. Both principal and wakeel will enter into a wakalah agreement so that all wakalah conditions can be fulfilled. The principal, which is usually an SPV, uses the profit return to fund periodic distribution amounts payable to the investors. Any surplus of the periodic distribution amount will be paid to wakeel as an incentive fee. Upon maturity of the sukuk, the investment manager will liquidate the sukuk portfolio and pays the proceed of liquidation to the principal. The principal will then pay dissolution amount to the investors. This type of sukuk has similarities with the mudharabah structure. The only difference is that there is no pre-agreed profit ratio in a wakalah structure. The wakeel will only be given performance or incentive fee from the excess of the agreed profit. 3.6.2. Structure of al-wakalah sukuk The general structure of the sukuk can be seen in Fig. 8. 1. The structure starts with a relationship established between investors and SPV through trust certificates. 2. SPV, which is the issuer of this sukuk enters into a wakalah agreement with wakeel. 3 & 4. SPV issues sukuk which represent an undivided ownership interest in the wakalah assets. SPV also represents a right of investors to get payments of Periodic Distribution Amounts and Dissolution Amounts. The investors subscribe to the sukuk in
  11. _ S .S. Razak et al. / Borsa Istanbul Review 19-S1 (2019) S21eS33 Fig. 8. Structure of Al-Wakalah Sukuk. return for a fixed principal amount (sukuk proceeds) payable to SPV. 5. The wakeel who has legally agreed to act on behalf of SPV, invests the sukuk proceeds in a pool or portfolio of investments, chosen by the wakeel following specified criteria 6. The sukuk proceeds will be used by the wakeel to buy wakalah asset from one or more sellers. 7. The wakeel on behalf of SPV will manage the asset to generate specified returns agreed by the principal and within a specific duration. The wakala assets will generate profit return, which will be held by wakeel on behalf of SPV 8 & 9. The profit payment will be used to pay Periodic Distribution Amounts payable by SPV to investors. Any excess from the profit return will be given to the wakeel as an incentive or performance fee. Notes: There is a possibility that the wakalah assets may generate returns less than the Periodic Distribution Payment. Therefore, one possible mechanism that was used before to overcome the issue, is for the obligor to agree (under purchase undertaking) to purchase a certain portion of the wakalah assets at regular intervals to exercise price equals to the Price Distribution Amounts. However, according to AAOIFI statement, the general view among Shariah scholars does not permit the obligor to agree to purchase the wakalah assets for fixed or variable amounts. This is because the practice seems akin to the guarantee of profit. The mechanism is only allowed by the AAOIFI if the seller and Obligor are in different entities. 10 & 11. Upon maturity, SPV or Obligor will exercise their options (according to situations) under the purchase undertaking to require the obligor to purchase at an exercise price that is equal to the dissolution amount payable to the investors. SPV, in its capacity as trustee, will pay dissolution amounts to investors using the exercise price received. At this point, trust is dissolved. S31 3.6.3. Critical assessment of al-wakalah sukuk Based on our observation from figures provided by the IIFM Sukuk Report (third and fifth edition) the issuances of alwakalah international sukuk is increasing from 2001 to 2015, except for the sovereign sukuk type. Additionally, the issuances of al-wakalah domestic sukuk is also experiencing a slight increase from 2001 to 2015, except for the sovereign sukuk type as well. Those figures show that this type of sukuk is among the popular sukuk nowadays. There are several advantages of adopting al-wakalah structure. The first one is that it allows the originator of the sukuk (which may also be a wakeel ) to build its balance sheet by acquiring the investments comprised in the portfolio. Besides that, they may also utilise those investments as an underlying asset for sukuk issuance. In al-wakalah sukuk, wakalah assets are used for the investments. The wakalah assets could be created from a tangible and intangible asset, as long as 30% of them are the tangible asset (for example Ijara or equities or any asset-based sukuk). Therefore, wakalah sukuk would allow the originator to utilise certain assets that cannot be traded on the secondary market. Debt arrangements like murabaha and istisna contracts are the example of products that cannot be traded on the secondary market and it is unsuitable as underlying assets for a sukuk issuance for trading purposes. It seems like Shariah scholars emphasise and encourage parties involved to ensure the portfolio of assets comprised of tangible assets. The AAOIFI prescribed that 30% of the portfolio of assets should comprise tangible asset while in some cases, they have prescribed up to 51% may be required by certain Shariah scholars. 4. Discussion and conclusion Sukuk have successfully performed themselves throughout the challenges that we discussed earlier. It is true that along the journey, all the obstacles gave impacts to the instrument and slow their growth. However, sukuk instruments managed to maintain their development in the financial market, in fact, it is expanding over the world gradually (Fathurahman, 2013). The awareness of sukuk has increased, not only among Muslims but also among non-Muslims. Non-Muslims are able to relate to the application of sukuk as the instruments are akin to the conventional bond with respect to cash flows and risk. Nonetheless, it is different in certain basis which makes it better compared to conventional bond (Bhuiyan, Rahman, Saiti, & Ghani, 2018; El Mosaid & Boutti, 2014; Shahar & Jamlus, 2014). The first reason that makes sukuk better than conventional bonds is the return on sukuk is expected from a principal asset (Shahar & Jamlus, 2014). This characteristic is opposite to the conventional bonds where their return is based on fixed interest. In some situations, sukuk investors supposedly able to get more return such as in the case of capital appreciation. Sukuk investors are given return through the profit sharing grow from the asset while the return for conventional bonds investors is paid from interest payments.
  12. _ S .S. Razak et al. / Borsa Istanbul Review 19-S1 (2019) S21eS33 S32 Table 4 The main issues and recommendations. Type of sukuk Main issues Recommendations Mudharabah Cagamas Bond BNMN-I The application of bay al-dayn and bay alinah in the sukuk Muslim scholars still debating about the validity of the contract The application of Bay al-dayn contract in the instrument It is time to look at the partnership contracts as a replacement to these controversial contracts Encourage the use of less- controversial contracts, such as Murabaha and Ijara contract Further research is recommended on Musyarakah Mutanaqisah or other partnership contracts to replace Bay al-dayn contract in GII GII Secondly, sukuk is said to be less volatile. The financial crisis in Dubai in 2010 shook the confidence of sukuk investors. Nevertheless, the crisis turned out to be proof that Islamic finance products (such as sukuk) are more reliable than conventional products. Through the analysis during the crisis, it showed that sukuk are safer and more resilient than conventional bonds. Besides having Shariah investment screening process which makes sukuk more resilient, sukuk also provide liquidity to the investors as they may trade it in the secondary market. Another feature that makes sukuk more special than conventional bonds is the ability of investors to compensate for their investment if bad circumstances take place. This could be done as the investment is sheltered by the asset-based contract sukuk. Other than that, sukuk are also more transparent than the conventional bonds. Usually, investors find it difficult to obtain certain information due to lack of accessibility of information and complexity of the information itself. Fortunately, sukuk investors would less experience this kind of situation as sukuk provide information disclosure to the investors. It is shown in the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) requirement. FAS 7 of AAOIFI stated the requirement for disclosure in sukuk in order for users such as investors to have more information in their decision making. In today's world, sukuk have become among the strongest instruments in Islamic finance, and they have been accepted by people in the conventional market. The instrument is not only benefitting Muslim but non-Muslim too, as mentioned earlier. It is expanding to most Muslim countries, and its acceptance among non-Muslim and its flexibility of structuring have formulated sukuk to have a bright potential to be developed and to become the strongest financial instrument in both Islamic and conventional market. In order to achieve the goals, market players must play their role in promoting, encouraging and educating people regarding Islamic banking products. A group of Islamic banking experts from around the world may be formed to focus on the global education and promotion of Islamic banking products. This research may be one of the strategy tools in promoting and educating sukuk and we hope this research would not only benefitting the newcomers of Islamic finance industry but benefitting anyone who is keen to discover further about sukuk. This sukuk research has identified the main issues of each type of sukuk. We also recommended solutions to some of those issues (Table 4). Nevertheless, those recommendations require further research to be applicable in the Islamic capital market. Conflict of interest None. References Abbasher Hassan, K. (2012). Comparison between sukuk and conventional bonds: Value at risk approach. Available at: SSRN abstract¼2215194 Alam, N., Hassan, M. K., & Haque, M. A. (2013). Are Islamic bonds different from conventional bonds? International evidence from capital market tests. 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