What is Sukuk?

Sukuk is an Arabic term صكوك, plural of صك sakk, “legal instrument, deed, check” for a financial certificate or termed as an Islamic equivalent of bond.

In Islam, fixed income or termed as interest (riba’) bearing bonds are not permissible. Hence, Sukuk is considered as securities that comply with the Islamic law. Its investment principles prohibits the charging, or paying of interest. Financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability in the secondary markets. It is estimated that over RM3,500 billion of assets are managed according to Islamic investment principles.

Such principles form part of ‘Syari’ah’ (Islamic Law), but it is actually broader than its concept that it also encompasses the general body of spiritual and moral obligations and duties in Islam. Shariah-compliant assets worldwide are worth an estimated more than RM1,750 billion and have grown at more between 8-12 per cent per year over the past decade, and in the Gulf and Asia, Standard & Poor’s estimates that 20 per cent of banking customers would now spontaneously choose an Islamic financial product over a conventional one with a similar risk-return profile.

In classical period Islam sakk (sukuk) – which is cognate with the European root ‘cheque’- meant any document representing a contract or conveyance of rights, obligations or monies done in conformity with the Shariah. Empirical evidence shows that sukuk were a product extensively used during medieval Islam for the transferring of financial obligations originating from trade and other commercial activities.

On the other hand, the essence of sukuk, in the modern Islamic perspective, lies in the concept of asset monetisation – the so called securitisation – that is achieved through the process of issuance of sukuk (taskeek). Its great potential is in transforming an asset’s future cash flow into present cash flow. Sukuk may be issued on existing as well as specific assets that may become available at a future date. 

The sukuk market valued for more than RM175 billion (at the end of 2006) is due for an exponential rise in 2007 with every issue likely to be oversubscribed 5 to 6 times amid a fast growing interest in the western countries. 

One point to note here that Shari’ah requires that financing should only be raised for trading in, or construction of, specific and identifiable assets. Trading in ‘indebtedness’ is prohibited and so the issuance of conventional bonds would not be compliant. Thus all Sukuk returns and cashflows will be linked to assets purchased or those generated from an asset once constructed and not simply be income that is interest based. For borrowers to raise compliant financing they will need to utilise assets in the structure (which could be equity in a ‘tangible’ company). It is worth noting that Equity financing is Shari’ah compliant and fits well with the risk/return precepts of Islam.

In the eyes of Islamic Jurisprudence or As Shari’ah, money is a measuring tool for value and not an ‘asset’ in itself, it requires that one should not take or receive income from money (or anything that has the genus of money) alone or in other words “if money generates money per say” it will tantamount to riba’. This generation of money from money (simplistically interest) is ‘Riba’, and is forbidden. The implications for Islamic financial institutions is that the trading/selling of debts, receivables (for anything other than par), conventional loan lending and credit cards are not permissible. 

Now come the question of uncertainty or ‘Gharar’ principle. It is widely understood to mean the uncertainty in the existence of an underlying asset in a contract and/or uncertainty in the contractual terms and this is an issues for Islamic scholars to address when considering the application of derivatives. Syari’ah also incorporates the concept of ‘Maslahah’ (Public interest), denoting that, if something is overwhelmingly in the public good, it may yet be transacted – and so hedging or mitigation of avoidable business risks, may fall into this category but there is still much discussion yet to come.

Sukuk are widely regarded as controversial due to their perceived purpose of evading the restrictions on Riba. Conservative scholars do not believe that this is effective, citing the fact that a sukuk effectively requires payment for the time-value of money. This can be regarded as the fundamental test of interest. Sukuk offer investors fixed return on their investments which is also similar in appearance to interest in that the investor’s return is not necessarily dependent on the risks of that particular venture.

This seems to be similar but the fact is that it is not the same as the reality is that banks invest in assets and the return from these such as rent is evenly spread over the rental period and it is this stream of income which forms the basis of the “fixed” income stream and return to investors. Furthermore, given that there is an asset in the background, there is more security for the investor which makes sukuk increasingly appealing to global investors including both Muslims and non-Muslims. 

Sukuk financing can be quite mystifying for the outsider. A good analogy is one of ethical or ‘Green’ investing. Here the universe of investable securities is limited by certain criteria based on moral and ethical considerations. Islamic Finance is also a subset of the global market and there is nothing that prevents the ‘conventional’ investor from participating in the Islamic market.

Sourse: http://www.sukuk.me/news/articles/3/What_is_Sukuk_.html