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Sukuk as an Alternative to Bonds in Financial Markets

Disclaimer: The views expressed are that of the individual author. All rights are reserved to the original authors of the materials consulted, which are identified in the footnotes below.


By Ubaidullah Kazi

Section Editor for Middle East



Since the inception of time, the human race has witnessed many significant developments in the business and financial industry - from the barter system to the creation of fiat money, and then the introduction of tools such as bonds and stocks under newly-recognised 'Investment Vehicles' which are major components in dealings in Western finance. However, a new domain bearing the title of Islamic finance, whose principles link to Sharia Law, has gained recognition in recent times. Under Islamic finance, the concept of Riba, which roughly means usury or the practice of charging interest, is completely dismissed. Broadly speaking, compliance with sharia means that:


1. any profits derived from these funding arrangements must be derived from commercial risk-taking and trading only;

2. all forms of conventional interest income are prohibited; and

3. the assets that are subject to the funding arrangement must, themselves, be permissible (halal).[1]


An example of an essential component of Islamic finance is 'Sukuk' which can be defined as “Certificates of equal value representing individual shares in ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity.”[2]Essentially, sukuk represents financial transactions in which assets are collectively present and certificates that represent certain interests in the collection of assets are given to the investors. There are similarities between sukuk and western bonds - both provide investors with payment streams and may be used to raise capital for firms, and are considered as safer investment options than equities. The distinction between the two, however, is quite clear in the sense that apart from the obvious absence of interest rates in the former, conventional bonds are debt obligations and their yields depend strictly on such rates. Furthermore, the sukuk can appreciate if the asset backing it appreciates, and hence it does not have to rely on a credit rating for determining a price.[3]


Some significant advantages of possessing sukuk are that they provide an ideal way of financing large projects for the public good which would have otherwise not been possible, so institutions can fund their projects without falling into interest-based debt.[4] Since the value and risk associated with sukuk relate to the traceable and tangible asset rather than on values proposed by speculation, there is very less scope for artificially manipulating their debt and credit ratings, hence endorsing it as a relatively more stable tool and a suitable solution for managing risk effectively.


Although sukuk are more attractive and convincing for investors to participate in, there are certain drawbacks present in the system. Firstly, the number of assets that can currently be used to trade for sukuk in the secondary market are very limited in supply, since fresh issuers initially have a limited number of Sharia-compliant assets which reach maturity after a while, only after which they can proceed with new issuances. Moreover, the standardisation of documents used to issue sukuk has been a slow process, leading to rather adverse effects on the time, money and efforts spent in its development. Added to this is the fact that tax considerations regarding sukuk would be dissimilar to those regarding conventional bonds, especially if the implementation of sukuk as an alternative would spread from the Middle East to financial markets which have a western approach.


Nevertheless, the incorporation of sukuk seems to become increasingly viable nowadays, especially as investors are now changing in their mindsets to think from a philanthropic perspective rather than focusing only on the profits and risks involved in their investments. With many realising the need to make a positive change and contribute to the welfare of society, the concept of sukuk is being recognised with greater importance. Therefore, it may only be a matter of time that sukuk may replace bonds with the help of advancements in technology and financial laws, possibly even transforming the way the markets work in the process.



 

Sources

[1] Debashis Dey, ‘Sukuk on the World Stage’ (ACT Middle East Treasurer, Winter 2014) <https://www.treasurers.org/system/files/Winter15MET_sukuk15-17.pdf> accessed 22 November 2020


[2] Mustapha Abubakar, ‘Sukuk - Meaning, Benefits and Challenges’ (Saray Consultancy, 29 January 2019) <https://saraycon.com/sukuk-meaning-benefits-and-challenges/> accessed 21 November 2020


[3] Akhilesh Ganti, ‘Sukuk’ (Investopedia, 7 September 2020) <https://www.investopedia.com/terms/s/sukuk.asp> accessed 20 November 2020


[4] Naveed Mohammed, ‘The Main Benefits That Result From Sukuk’ (Islamic Finance Foundation, 26 December 2014) <https://www.sukuk.com/article/main-benefits-result-sukuk-3529/#/?playlistId=0&videoId=0> accessed 21 November 2020


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