Vol 7 Issue 28 14th July 2010
The World’s Global Islamic Finance News Provider
Challenge begets growth
Hong Kong, one of the world’s leading
international financial centers and most
densely populated areas, is not to be left
behind in the advancement of Islamic
finance. Apart from being a doorway to China,
the special administrative region is taking the
necessary steps to capitalize on its elevated
financial status and establish Islamic finance
as a viable fund-raising and investment
alternative. Our country report outlines the
challenges and latest developments in this
territory.
Sukuk, one of the more popular modern
Islamic financial instruments has its own set
of challenges. The current debate on whether
it is a type of bond or a debt instrument or not,
is worsened by the notion that the structuring
of Islamic financial instruments is doomed
for as long as Islamic financial institutions
operate within conventional or interest-based
financial systems. Our sector report looks at
Sukuk and the risks associated in the event
of a default.
Swiss Re takes us on a comprehensive
analysis of the fundamentals required for the
growth of the Takaful and re-Takaful industry
in this week’s market report. It demonstrates
the different hurdles faced by Takaful and re-
Takaful practitioners, how to overcome them
and turn them into opportunities.
Legal uncertainty is another facet of Islamic
finance that needs to be continually overcome.
By virtue of its organic and interpretative
nature, Shariah law often leads to ambiguous
and varying outcomes regardless of the
contract in question.
We focus on The Investment Dar vs Blom
Bank case as an example of how agreements
Register now - It’s free
may not be upheld in the event of a dispute,
and we list possible steps to take to avoid a
similar fate.
If there is political will, there is a way, as
demonstrated by Bermudan deputy prime
minister, Paula Cox who recently led a
delegation to Bahrain to cement relations
and seal the double taxation agreement (DTA)
signed between the two countries.
The DTA opens up a series of possibilities
even as some see that the country may not
be ready yet to welcome Islamic finance to its
shores, as reported in one of our IFN reports.
Two countries testing the waters in Islamic
finance are Albania and Libya, both of
which are taking tentative steps to set up
a semblance of Islamic financial service
offerings. The Islamic Development Bank
looks to play a big part in the infrastructural
development of Albania. Libya too has begun
to open up to foreign and Islamic banking
presence in the country. Read about them in
our IFN reports.
Last but not least, we feature Nick Barisheff
of Bullion Management Group, responsible
for the BMG BullionFund, Canada’s largest
Shariah compliant mutual fund and the
second largest in North America.
As we go to press, the government of
Indonesia has announced the appointment
of Citigroup, HSBC and Standard Chartered
as underwriters for the US$650 million
Sukuk it aims to raise in October this year.
Islamic Finance news reported last week on
the potential appointment of the latter two
banks.
AL
ER
TS
In this issue
IFN Rapid ..................................................... 2
Islamic Finance News ................................ 3
Takaful News ................. .............................9
Rating News ................................................ 9
IFN Reports:
A long way still for Islamic banking...... 10
Bankers concerned on unhealthy
liberalizing .................................................10
DTA doubles potential .............................11
Articles:
Recent Islamic Finance Developments
in Hong Kong ..........................................12
Thoughts on Sukuk and the Risk of
Default ....................................................14
Legal Uncertainty in Islamic Finance . 16
Challenges and Opportunities for the
re-Takaful Industry................................. 17
Meet the Head ..........................................19
Nick Barisheff, President and CEO of Bullion
Management Group
Termsheet ..................................................20
NBAD Ringgit-Denominated Sukuk under NBAD
RM3 billion (US$937 million) program
Moves ......................................................... 21
Deal Tracker ..............................................23
Eurekahedge Funds Tables ..................... 24
S&P Shariah Indexes ...............................25
Dow Jones Shariah Indexes ....................26
Dealogic League Tables........................... 27
Thomson Reuters League Tables ...........30
Events Diary...............................................33
Company Index .........................................34
Subscription Form ....................................34

www.islamicfinancenews.com
Thoughts on Sukuk and the Risk of Default
By Zhamal Nanaeva and Rauf Mammadov
Since the mid 70’s, the number of Islamic Financial Institutions
(IFIs) has mushroomed to more than 300 in 51 countries. The rate
of growth is impressive, approximately 20% to 30% a year. Research
by McKinsey and Company suggests that assets of IFIs will exceed
US$1 trillion in 2010. Ernst & Young in a report by Morgan Stanley
estimated this number to exceed US$2 trillion. According to the
International Monetary Fund (IMF), Sukuk is the most popular modern
Islamic financial instrument.
Sukuk shares some features with, and therefore often resembles,
conventional bonds. But Sukuk has a different underlying structure
and provision. It is the trust certificate, which gives its holder an
undivided proportion of ownership in the underlying project/asset
and right to receive cash flows from this underlying. Returns on Sukuk
derived either from the performance of an underlying asset or the
contractual agreement based on this asset.
The main principles underlying Sukuk issuance can be defined as
follows: all rights and obligations should be clearly defined; the income
from Sukuk should be related to the project, which was financed by
this issue; and Sukuk should be backed by real assets. Sukuk are
issued through the special purpose vehicle (SPV), which serves as an
obligor of the Sukuk issue. Returns on Sukuk should be calculated
using expectation of profit from the project, rather than based on
market interest rate.
Compared with bonds, Sukuk has a very short history. The first
sovereign Sukuk was issued in Malaysia in 1995. Since then, Malaysia
remains an active player in the Islamic capital market, marking 46% of
the total value of issues according to the Collaborative Sukuk Report
2009. Although the GCC countries joined later, they have matched
Malaysia in terms of the value of issuance, marking 49% of the total
issue value as of September. Real growth in the Sukuk market started
in 2003 when AAOIFI had issued a standard on investment Sukuk.
According to Ernst & Young, the period between December 1996 and
September 2009 witnessed 747 Sukuk issues with a total value of
US$106.6 billion.
However, 2008 and 2009 were very difficult years for the Islamic capital
markets. In October 2008, US$167 million East Cameron Gas Sukuk
filed for bankruptcy. Later, in May 2009, Dar Al Kuwait failed to meet
its obligation on US$100 million Sukuk. Saudi Arabia’s Saad Group is
another example of failing to meet Sukuk payments in June 2009.
The abovementioned defaults, as well as Nakheel’s troubles in meeting
its Sukuk repayments, have generated a new wave of discussion. A
series of questions relating to the robustness of the Islamic financial
system, and the Sukuk market in particular, have been raised by the
conventional investors and the industry practitioners with limited
knowledge of the Islamic finance.
Risk of default
Due to fact that Shariah prohibits trading of debt, any rescheduling
of debt for higher markup is forbidden under Sukuk. This prohibition
makes risk of default higher for Sukuk compared with conventional
bonds, since Sukuk issuers would be more inclined to default.
Moreover, while conventional bonds represents a debt obligation,
© Page 14
SECTOR REPORT
Sukuk is a certificate of ownership, so in the case of default Sukuk
holders have a very limited possibility to recover their initial investment.
The managers of Sukuk can bear responsibility for any Sukuk default
only within the limits of their control and capabilities. Therefore, in
case of default due to external factors, such as force major or global
financial crisis, all losses under Sukuk will be borne by Sukuk holders.
However, some issues of Sukuk do not provide for legal ownership of
underlying asset(s), but rather right of return, which is not Shariah
compliant. In the same way, some types of hybrid Sukuk can be
classified as non compliant with Shariah due to the presence of debt-
based instruments within their structure.
With regard to the risk of default, one should also mention the
question of a guarantee of return of principal amount. Prior to the
AAOIFI statement in 2008, Sukuk managers were promising to buy
back underlying assets at the price equal to the face value of Sukuk. It
can also be done by the third party, the government for example.
Some scholars think that such a purchase undertaking can be
permissible, and until recently Sukuk Mudarabah and Musharakah
were issued using this kind of guarantee. They believe that any
guarantee of the principal amount is unlawful in Shariah, whether the
originator of Sukuk acts as Mudarib (manager of the capital), Wakalah
(agent) or partner.
The AAOIFI statement has classified such a type of guarantee as non-
compliant with Shariah. Under the new statement, underlying Sukuk
assets should be bought at the end of Sukuk life either by the third
party or manager of Sukuk at a market value of underlying asset. Thus,
Sukuk holders bear a market risk when the underlying asset can be
sold at a price lower than their initial investment.
Since there is no possibility to define the market value of the underlying
asset at the time of Sukuk issuance, the set of procedures to define
its fair market value can be agreed upon. The parties should also
clarify the ways of defining the market value as well as procedures
and valuation techniques. The Sukuk manager can pay the difference
between the market value of underlying asset and face value of Sukuk,
if the loss was occurred due to the manager’s poor performance. But
the question is, how are we to define the quality of Sukuk management?
What are the criteria of poor versus good performance?
Hassan Hussein mentions the following actions as the manager’s
misconduct and reasons for him/her to compensate the face value of
Sukuk to investors: embezzlement and mismanagement of the capital;
negligence in protecting the capital; committing gross errors in taking
investment decisions; breach of the terms of contract. All these reasons
require further clarification in every individual case. The scholar claims
that in a situation when loss occurs due to circumstances beyond the
manager’s control, investors (Sukuk holders) should fully bear a risk of
possible loss in the face value of an underlying asset.
Credit risk assessment is complicated by an absence of proper
international rating of the most of Sukuk issues. Conventional bonds
are rated by one of the major international rating agencies in order to
continued...
14th July 2010

www.islamicfinancenews.com
Thoughts on Sukuk and the Risk of Default (continued)
obtain access to the financial markets. Sukuk issues often lack this
requirement.
According to Ernst &Young (2009) only half of all Sukuk issues have
been rated. Malaysian regulation requires the rating of new issues by
the local agencies, while most of the GCC issues remain unrated. It is
probably due to this that most of the recent issues were sovereign or
quasi-sovereign. The government link was perceived as a guarantee
and a substitute to adequate rating. These sovereign guarantees can
explain the large size of recent issues in spite of the absence of issues’
ratings.
The other problem with the rating of Sukuk is the absence of Islamic
rating agencies. Today Sukuk issuances are rated by conventional
rating agencies using conventional rating methodologies. This is
done in spite of the fact that the rating agencies are fully aware of
the differences in structures of conventional and Islamic bonds. This
kind of attitude can lead to incorrect rating results. For example, when
rating Sukuk, the rating agency evaluates the guarantor’s credibility,
rather than the risk of underlying asset.
In light of recent AAOIFI statements relating to guarantees of Sukuk,
such rating can be highly inappropriate. An organization that deals with
Islamic ratings — Islamic International Rating Agency, is established in
Bahrain. It rates both credit risks and Shariah compliance of Sukuk.
At this stage, both investors and regulators should coordinate their
efforts to enforce use of Islamic ratings as a necessary pre-requisite
for Sukuk issuance.
Managing the risks
While conventional bond holders have a variety of instruments to
manage their risks, IFIs lack this opportunity. For example, there is
an on going discussion of permissibility of using options in Islamic
finance. While most of derivatives are clearly prohibited by Shariah
scholars, there are some options that can be attached to certain
Islamic financial instruments.
For example, call and put options can be used for hedging purposes.
Scholars suggest an analysis of option by stipulation and option of
determination as possible risk management instruments in Islamic
finance. There is also the suggestion to use embedded options as
a tool for Sukuk risk reduction. The argument is that Shariah, while
prohibiting debt trade, allows its exchange for real goods, assets and
services. Thus, Sukuk holders can have an option to exchange his
“zero-coupon” Istisnah Sukuk, for example, to an apartment (after a
certain period) instead of waiting for the Sukuk’s maturity.
There is also the possibility of using swaps of floating-rate Sukuk
with zero-coupon-fixed-rate-embedded Sukuk as a Shariah compliant
instrument. Most academics argue that the options allow for decreasing
excessive risk (Gharar), which should be avoided under Shariah ruling,
but despite this are currently present at the highly volatile market. And
while most academics agree that such detachable and non-trading
options should be permitted in Islamic finance, and urge Shariah
scholars to come up with collective fatwas, the latter seem to be
reluctant to give such permission.
In 2007, Dubai’s Ports Customs and Free Zone Corporation issued the
world’s first convertible Sukuk allowing the conversion of initial Sukuk
into common shares of the originator. In 2007 Khazanah Nasional
© Page 15
SECTOR REPORT
(Malaysia) issued exchangeable Sukuk with an option to exchange
them for existing shares of one of subsidiaries of the originator. These
issues attracted high interest both from investors as well as potential
issuers of Sukuk as examples of risk reduction alternatives.
While financial experts discussed the possibility of further innovation
in Sukuk, such as mandatory exchangeable/convertibles, contingent-
convertible Sukuk, reserve convertible Sukuk, and such, most of
the scholars have forbidden these kind of innovations, due to their
similarity with derivatives and excessive uncertainty.
Another recent discussion among scholars is about permissibility of
third party guarantees in some Sukuk issues. Proponents of such
guarantees, usually issued by governments, claim that there is no clear
prohibition of such action in any Islamic source. Thus, according to this
group, as long as the guarantor is financially and legally independent
from both contracting parties involved in Sukuk transaction, he can
guarantee the entire investment or part of it without obtaining any
fees for this operation. Opponents of such guarantee argue that it can
open a possibility for riba and highlight the Shariah prohibition of any
kind of guarantee of the capital. Hence, there is no common opinion
on whether such guarantees can be used as a risk management
instrument.
Conclusion
It is worth noting Sheikh Taqi Usmani’s statement that the system of
Islamic finance should be based on principles of justice and equal
distribution of financial resources within a society. However, keeping
in mind that IFIs currently operate within conventional/ interest-
based financial systems, scholars have allowed some flexibility in the
structuring of Islamic financial instruments, provided that the banks
gradually develop and adopt full Shariah compliance.
Unfortunately, the recent trend shows that new products and modes
of financing introduced by the IFIs tend to imitate conventional
instruments, further distancing the industry from core Islamic
principles. In the case of Sukuk, justification for principal guarantee
and fixed returns was given by the fact that international rating
agencies would otherwise not rate Sukuk properly. This reinforces the
pressing need to develop and promote Islamic rating agencies.
It has been more than 15 years since the launch of the first Sukuk. The
valid question remains on whether Sukuk structuring should go back
to its basics and follow the approved modes of financing, or whether
the market should go after the growing demand for Islamic financial
instruments and engineer new forms and structures.
Rauf Mammadov
Department of economic development
Government of Dubai
Email: RMammadov@post.harvard.edu
Rauf has 10 years of experience in Islamic banking and has authored
several articles on Islamic finance.
Zhamal Nanaeva
Independent researcher
Email: jnanaeva@gmail.com
Zhamal has an MSc in Finance and Banking with a final dissertation
focusing on Sukuk.
14th July 2010