Plain language about securities. Sukuk: a bridge to the Islamic financial system

What you need to know about sukuk and the feasibility of their use in Ukraine

The National Securities and Stock Market Commission (NSSMC), together with LIGA.net, has prepared a series of publications to explain the essence and specifics of financial instruments and mechanisms for their use in a simple and accessible manner.

In the previous publication, we discussed personal investment accounts and the prospects for their introduction in Ukraine. In this publication, we are moving on to another instrument that may become an additional channel for raising funds from Shariah-compliant countries – sukuk.

Prerequisites for its appearance

The unstoppable development of the global financial market and the constant asymmetry of national financial systems (e.g., different tax rates, differences in currency control and regulatory requirements, currency stability, etc.) are a prerequisite for international capital flows.

To create a «bridge» between different financial systems, new financial instruments or even entire structures are often created to transform cash flows to meet the requirements of both parties (donor and recipient of capital).

Today we are going to talk about an instrument that is unusual for our capital markets, called a sukuk (sometimes called an Islamic bond).

The peculiarities of the Islamic financial system are based on religious law (Shariah), which prohibits lending money at interest and financial speculation. These basic principles make it impossible to use traditional and familiar debt financing instruments.

What is a sukuk?

A sukuk is an Islamic financial instrument (certificate of participation) that is a kind of reincarnation of the bond we are so used to. Sukuk gained popularity at the end of the last century in Malaysia, where their first issue took place.

The prospects of this instrument can be easily assessed through the prism of its market capacity – according to the Islamic Financial Services Board (IFSB), in 2021, the total volume of sukuk in circulation amounted to more than $700 billion. In other words, this instrument has great potential in terms of raising capital by domestic companies.

What are the types of sukuk and examples of their use?

Regardless of the specific type of sukuk, they all have the following common features:

• кelationship between the parties to the sukuk must be a partnership;
• there must be certainty regarding the subject matter of the partnership;
• money cannot arise from money (money cannot be a commodity itself);
• income must arise from investments or trade;
• income should not be random;
• a special project company (sukuk issuer) is used.

In accordance with the standards of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), there are 14 types of sukuk, among which the most common (more than half of all issues) is sukuk murabaha.

Sukuk al-Murabaha is based on a murabaha contract, which is the equivalent of a commodity loan that we understand. It works as follows: a special project company is created to issue sukuk. The proceeds from the placement of sukuk are used to purchase a certain asset (real estate, equipment, corporate rights, etc.), which is sold to another party with a margin on payments.

Now let’s analyze what happened in the above example:

• the borrower did not receive funds on credit, but immediately an asset that he wanted to purchase;
• the issuer of the sukuk will receive not interest income for the use of funds, but income from the sale of an asset that is determined in advance (the contract price);
• installment payments under the contract represent the debt repayment schedule;
• the investor will directly receive dividends from the issuer’s trading activities.

Thus, all parties have achieved their goals and at the same time have not violated Shariah requirements.

Also worthy of note is Sukuk al-Mudaraba, whereby one party (financial partner) provides capital (funds) and the other (managing partner) provides a business idea, human resources, etc. This type of sukuk is suitable in cases where there is no one specific asset, but rather a business.

The distribution of profits is based on the initial agreement, but usually has a ratio of 90:10. If the business project suffers losses, each party risks the amount of the contribution it has made: one party – the money it has invested, and the other – the effort it has expended.

A similar type of sukuk to the previous one is the Sukuk al-Musharaka, which provides for joint financing and participation in the management of both parties. Profits and losses from such projects are distributed between the parties in proportion to their contributions.

The first issue of sukuk in Europe (in Saxony-Anhalt, a federal state in Germany) took place in 2004 in the amount of EUR 100 million in the form of Sukuk al-Ijara, which is based on a leasing agreement. The structure of these sukuks was as follows: The Ministry of Finance sold several buildings to a special project company (established in the Netherlands) and leased them back.

This was the first successful case of issuing sukuk in a non-Muslim country. Today, the United Kingdom is the leader in issuing sukuk in Europe for at least two reasons: first, this country has close historical and economic ties with the Gulf countries; second, the UK’s strong financial infrastructure has ensured its role as a cash flow transformer – the London Stock Exchange is the largest exchange for sukuk in Europe.

Prospects for the use of sukuk by Ukrainian companies

A key factor in successful fundraising using sukuk is understanding the limitations of investors’ activities and their attitude to financial speculation.

Given the specifics of this instrument, Ukrainian companies intending to raise funds through sukuk should build their financial models on a cross-border basis, i.e., individual participants in the process should be located in different countries. At the same time, the Ukrainian side will receive funds in the form of usual investments in the authorized capital of companies or as part of trade operations.

In this context, the services of investment firms and advisors capable of structuring such transactions are of particular importance to Ukrainian companies.

By the way, Ukraine has already made an attempt to raise funds using sukuk. For example, in 2009, it was planned to issue €500-600 million worth of sukuk to finance the construction of an 86 km long European-style railroad section from Lviv to the Polish border (the Eurocology project).

Given that the amount of sukuk issuance is measured in at least tens of millions of dollars (and for investors from countries such as the UAE and Saudi Arabia, the amount of issuance must be at least $100 million), this tool may also be of interest to small and medium-sized businesses in the case of so-called “holding companies. Such companies are used when it is impossible to carry out a transaction in the interests of only one company due to too small an amount of funding «in one hand». Usually, such companies are banks or investment firms that raise funds on their own behalf and then distribute them among various small and medium-sized business projects (this is a fairly common model for project financing in Kazakhstan).

Conclusions.

Sukuk is an effective and understandable financial instrument for investors from Shariah-compliant countries, due to the participation of such investors in a project company that carries out investment or trading activities. For Ukrainian companies in need of capital to restore or expand their operations, this is an additional instrument on a partnership basis that will allow them to diversify their sources of funding.

Text prepared by the NSSMC specially for LIGA.net