Contents1. ETHICS IN ISLAMIC ECONOMICS

2. ISLAM AND ISLAMIC ECONOMICS

2.1. DEFINITION OF ISLAM

2.2. DEFINITION OF ISLAMIC ECONOMICS

2.3. MAIN FEATURES OF ISLAMIC ECONOMICS

2.4. THE RISE OF ISLAMIC ECONOMICS

3. ETHICAL ENDOGENEITY IN ISLAMIC ECONOMICS

4. ISLAMIC PRINCIPLES

4.1. THE UNITY OF GOD

4.2. GOD’S OWNERSHIP OF THE UNIVERSE

4.3. BELIEF IN THE HEREAFTER MUSLIM

4.4. THE ECONOMIC ROLE OF THE STATE

5. THEORY OF ISLAMIC BANKING

5.1. OVERVIEW OF THE GLOBAL ISLAMIC BANKING INDUSTRY

5.2. PRINCIPLES OF ISLAMIC BANKING

5.3. FINANCIAL PRODUCTS OFFERED FROM ISLAMIC BANKING

5.3.1. Musharakah

5.3.2. Mudarabah

5.3.3. Murabaha

5.3.4. Ijara

5.4. RIBA (INTEREST)

6. ACCOUNT AVAILABLE TO CUSTOMERS

6.1. DEMAND DEPOSIT ACCOUNT

6.2. SAVING ACCOUNT

6.3. INVESTMENT ACCOUNT

7. REGULATORY AUTHORITIES

8. SUKUK....................................................................................................................................................................20

9. BENEFITS AND FEATURES......................................................................................................................................20

10. USES OF SUKUK FUNDS.........................................................................................................................................21

10.1. PROJECT SPECIFIC SUKUK..............................................................................................................................21

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10.2. ASSETS SPECIFIC SUKUK.................................................................................................................................21

11. TYPES OF SUKUK....................................................................................................................................................21

11.1. MUDARABA SUKUK.......................................................................................................................................21

11.1.1. Salient Features:....................................................................................................................................22

11.1.2. Steps involved in the structure:.............................................................................................................23

11.1.3. Mudaraba Sukuk in practice..................................................................................................................23

11.2. MUSHARAKA SUKUK......................................................................................................................................23

11.2.1. Steps involved in the structure..............................................................................................................23

11.2.2. Musharaka Sukuk in Practice.................................................................................................................25

11.3. MURABAHA SUKUK.......................................................................................................................................25

11.3.1. Steps involved in the structure:.............................................................................................................26

11.3.2. Murabaha Sukuk in Practice..................................................................................................................26

11.4. SALAM SUKUK...............................................................................................................................................26

11.4.1. Steps involved in the transaction:..........................................................................................................27

11.4.2. Salam Sukuk in Practice.........................................................................................................................27

11.5. IJARA SUKUK..................................................................................................................................................28

11.5.1. Overview of Structure............................................................................................................................29

11.5.2. Key Features of the Underlying Structure..............................................................................................30

11.5.3. Required Documentation......................................................................................................................31

11.5.4. Features of Ijarah sukuk........................................................................................................................33

11.5.5. How Has Sukuk Al-Ijara Benefitted Islamic Finance?............................................................................33

11.5.6. Criticisms of Ijarah Sukuk.......................................................................................................................34

11.5.7. Examples of Ijarah Sukuk Issuance In practice.......................................................................................35

11.6. ISTISNA SUKUK..............................................................................................................................................35

11.6.1. Overview of Structure............................................................................................................................37

11.6.2. Key Features of the Underlying Structure..............................................................................................38

11.6.3. Required Documentation......................................................................................................................39

11.6.4. Istisna Sukuk in Practice............................................................................................................................41

11.7. HYBRID SUKUK...............................................................................................................................................41

11.7.1. Steps involved in the structure:.............................................................................................................41

11.7.2. Hybrid Sukuk in practice........................................................................................................................42

12. SUKUK PRACTICE AT KUVEYT TÜRK........................................................................................................................42

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12.1. Kuveyt Turk completes highest sukuk issue in TL (09.10.2014)........................................................................42

12.2. Kuveyt Türk’s US Dollar Sukuk Issuance Receives High Demand (26.06.2014).................................................43

12.3. Long-term rising ratings of Kuveyt Turk promotes the development of capital market instruments such as SUKUK (27.12.2010)..................................................................................................................................................44

12.4. Kuveyt Turk issues the first SUKUK of Turkey-(23.08.2010).............................................................................45

12.5. Kuveyt Türk’s Sukuk Deal in Malaysia (08.04.2015)..........................................................................................46

13. REFERENCES..........................................................................................................................................................47

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EXECUTIVE SUMMARY

This project provides an analysis and evaluation of the current Islamic Development Banking system and Sukuk Financing in the world.Methods of analysis include definitions , financial mediary interaction graphics, comparision table of Islamic banking system and western banking system.

Islamic banking started in 1970s with the personal initiative of concerned Muslims to address the problem of interest (riba). Islamic banking is known for its interest free concept and Islamic banks are now well established in most countries in the Middle East and in many countries in Asia and Europe. Moreover, Pakistan, Iran and Sudan have “Islamized” their whole banking system while others like Bahrain, Turkey, Malaysia and Jordan have adopted a heterogeneous banking system in which one or more Islamic banks compete with Western-type commercial banks.

In Islamic Banking system interest (riba) is prohibited and considered as a major sin, in both payment and receipt of interest. Prohibition of interest is a way to establish justice between the financer and entrepreneur.the rate of interest is replaced with the rate of return on real activities, which has variety of techniques ,and instruments based on risk and profit sharing.In many Muslim countries, Islamic banks operate in an environment where competitive banks predominate, but in some cases such as Egypt or Turkey, they are governed by a special legislation.

Nowadays, the Islamic economic model is in vogue not only in Muslim countries but even in non-Muslim ones. The most evolving part of Islamic economics is especially Islamic finance. Islamic financial assets have soared from less than $600 billion in 2007 to more than $1.3 trillion in 2012, an expansion rooted in the growing pool of financial assets in Muslim-majority countries driven by consumer demand for products that comply with religious codes.Companies in the United States are also considering Islamic finance to fund business ventures and infrastructure projects. Demand for new Islamic investments is expected to outstrip supply by as much as $100 billion by 2015, an imbalance that could translate to much-needed liquidity in some tight markets.

Sukuk is a kind of bond which refers to Islamic investment certificate that is by nature Sharia (Islamic rule) compliant. It is an asset-backed trust certificate. Simply, Sukuk is a certificate evidencing ownership of an asset created in the purpose of world’s demand for a Sharia compliant debt instrument. The development of Sukuk was in response to Sharia’s prohibition on earning returns from loan contracts which returns are based on interest, because conventional bonds that rely on profiting holders by providing returns based on interest were unavailable to Muslims.

The Islamic banking and finance market is one of the fastest-growing global niche markets. The Sukuk market is expanding since the launch of the first Sukuk a few years back. Today, it is estimated that US$20 billion worth of Sukuk certificates have been issued up to date. The global primary sukuk market has outperformed in the first half of 2014 enabling the primary market’s volume to reach USD66.2bln, 8.2% higher than the comparative USD61.2bln volume in the same period last year.

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GCC – Gulf Co-operation Council, Malaysia and Turkey are the biggest sukuk markets in the world. By structure, Murabahah and Ijarah still remain the popular choice among issuers in 2014.

1. ETHICS IN ISLAMIC ECONOMICS

In Islam, economic behaviours and transactions cannot be separated from ethics and values. The Islamic principles are intended to govern, direct and control human beings’ behaviours in their daily economic lives. They are aimed at helping people to distinguish between good and bad things while they do any economic activity. It is worth noting that the moral values in Islamic economics are derived from the main sources of Islam namely: the Quran (the holy book of Islamic religion) and Sunnah. Both of them represent the principal pillars of Shariah (Islamic laws and guidelines), which is seen by Muslims as the proper way to happiness, not only in economic life but in all aspects of life.

Ethics constitutes the cornerstone of Islamic economics. The teachings of Islam aim to enable moral values in all aspects of human life including economic activity. Islam, as a religion, is not restricted to worship – praying and fasting. Islam is seen as a complete way of life since it recognizes both the secular and the spiritual. True piety does not consist in turning your faces towards the east or the west - but truly pious is he who believes in God, and the Last Day; and the angels, and revelation, and the prophets; and spends his substance – however much he himself may cherish - it - upon his near of kin, and the orphans, and the needy and the wayfarer, and the beggars, and for the freeing of human beings from bondage and is constant in prayer, and renders the purifying dues; and they who keep their promises whenever they promise, and are patient in misfortune and hardship and in time of peril: it is they that have proved themselves true, and it is they, they who are conscious of God. Islamic economics stand primarily on faith and belief. In fact, a Muslim does his economic activities in light of what his religion recommends as guidelines and instructions. He follows the latter because he strongly believes that they help him to distinguish between Good and Bad; between what is allowed and what is forbidden. Justice, freedom, moderation, compassion and brotherhood are among the values that helps Islam establish itself in the daily life of Muslim society as well as mankind as a whole. To do that, Islamic economics offers a number of alternative instruments that can help attain those values. For example, a Muslim gives periodically Zakat and charity to needy people and orphans, he has to avoid Riba (interest), Israf (extensive use of resources through extravagance) and Iktinez (hoarding wealth) etc. This paper intends to shed some light on the role of ethics in Islamic economics; it aims to explore the inter-relationships between moral values and economic behaviours in Muslim society. It focuses equally on of the principle of the ethical endogeneity in the Islamic economics.

2. ISLAM AND ISLAMIC ECONOMICS

2.1. Definition of Islam

Islam is a monotheistic religion articulated by the Quran, a book considered by Muslims to be the verbatim word of God (Allah in Arabic) and by the teachings and normative example (called the Sunnah and composed of Hadith) of the prophet Muhammad, the last prophet of God. Muslims believe that God is one and incomparable and the purpose of existence is to worship God.

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Muslims also believe that Islam is the complete and universal version of a primordial faith that was revealed before many times throughout the world, including notably through Adam, Noah, Abraham, Moses and Jesus, whom they consider prophets. They maintain that the previous messages and revelations have been ETHICS IN ISLAMIC ECONOMICS 113 partially misinterpreted or altered over time, but consider the Arabic Quran to be both the unaltered and the final revelation of God. Religious concepts and practices include the five pillars of Islam, which are basic concepts and obligatory acts of worship, and following Islamic law, which touches on virtually every aspect of life and society, providing guidance on multifarious topics from banking and welfare, to warfare and the environment. Based on official statistics, Islam is the second largest religion in the world. According to the World Network of Religious Futurists, the U.S. Center for World Mission, and the controversial Samuel Huntington, Islam is growing faster numerically than any other religion; this growth is attributed to a higher birth rate, and a higher rate of conversion than other religions. In the U.S., more people convert to Islam than any other faith, especially amongst African Americans.

2.2. Definition of Islamic Economics

According to Hasanuz Zaman, ‘Islamic economics is the knowledge and application of injunctions and rules of the Shariah (Islamic Principles) that prevent injustice in the acquisition and disposal of material resources in order to provide satisfaction to human beings and enable them to perform their obligations to Allah (God) and society’. Islamic economics could be defined also as a branch of knowledge which helps realize human well-being through the allocation and distribution of scarce resources which is in conformity with Islamic teachings without unduly curbing individual freedom or creating continued macroeconomic and ecological imbalances. Based on these definitions, one can define Islamic Economics as the Islamic way and philosophy regarding economic life: It is economics that is governed by Islamic rules and principles which tend to achieve the well-being for individuals and society as a whole. The Quranic verse denotes that: who will enjoin upon them the doing of what is right and forbid them the doing of what is wrong, and make lawful to them the good things of life and forbid them the bad things, and lift from them their burdens and the shackles that were upon them.

2.3. Main Features of Islamic Economics

Islamic Economics is characterized by its own features which make it different from any other kind of economics:

It is divine: Islamic economics is ultimately based on faith and belief because its rules and principles represent the teachings of the Islamic religion. This is also because Muslim people refer to the divine orders when they deal with economic issues; i.e. they obey Allah whenever and wherever they practice any kind of economic activity.

It is ethical: Islamic economics is primarily based on ethics and morale. According to Islam, economics cannot be separated from ethics. This latter is a crucial component of the Islamic philosophy of life, because Islam is primarily an ethical massage from Allah to Mankind. The prophet Muhammad (PBUH) said: ‘I have been sent just to complete the moral values’. The link between economics and ethics manifests clearly in different Muslim economic activities such as

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production, consumption, distribution and so on. For instance, a Muslim cannot produce or consume what is forbidden, like drugs or alcohol since they can damage his health.

It is humanistic: Islamic economics is divine, as pointed out earlier, but at the same time it is humanistic and there is no contradiction between these two features; while the sources of Islamic economics are basically the Quran and Sunnah, their teachings are a priori addressed to a human being who is both the means and the end of them. The humanistic aspect of Islamic economics is represented in a set of values which have been highlighted by Islam such as: Freedom, Justice, Brotherhood, cooperation compassion, private ownership, dignity and so on.

It is moderate: the spirit of Islamic economics is the principle of moderation and equilibrium. In fact, the Islamic economic system mediates capitalism and socialism. While capitalism, for instance, places a great importance on the individual rather than society, socialism, by contrast, reverses the picture. Islam aims to make equilibrium between the individual and society; it allows both private and public ownership.

2.4. The Rise of Islamic Economics

Nowadays, the Islamic economic model is in vogue not only in Muslim countries but even in non-Muslim ones. The most evolving part of Islamic economics is especially Islamic finance. Islamic financial assets have soared from less than $600 billion in 2007 to more than $1.3 trillion in 2012, an expansion rooted in the growing pool of financial assets in Muslim-majority countries driven by consumer demand for products that comply with religious codes.

Figure 1. Islamic banking assets growth trend

Assets are concentrated in the Muslim countries of the Middle East and Southeast Asia, but the sector appears poised to enter Western markets and complement conventional financing. Prime Minister David Cameron announced in 2013 that the United Kingdom will issue a £200 million ($327 million) Islamic bond, or Sukuk (Islamic Bonds), making it the first non-Muslim country to tap into Islamic financing.

Companies in the United States are also considering Islamic finance to fund business ventures and infrastructure projects. Demand for new Islamic investments is expected to outstrip supply by as much as $100 billion by 2015, an imbalance that could translate to much-needed liquidity in

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some tight markets. But the industry remains small and will need to expand considerably to have a significant impact on global financial markets.

Islamic banks are the main providers of Shariah-compliant services and are being entrusted with the majority of Islamic capital/financial assets, which likewise makes financial stability dependent on their success. Islamic banking has been the major driver of industry growth over the past decade, taking the largest share of financial assets.

3. ETHICAL ENDOGENEITY IN ISLAMIC ECONOMICS

The Islamic economic system is perhaps the only known social order that has strong features of ethical endogeneity. This is due to the unique goals and principles of this system and the set of endowed policy instruments for attaining these goals.

In fact, ethics are an endogenous component of Islamic economics since they represent the fundamental pillars on which it stands. Unlike other economic systems, the Islamic economic system relies on the religious teachings that constitute an eternal ethical structure. Therefore, it is often described as an ethico-economic system. The latter represents today the scope of the study of so-called Humanomics. The main Islamic principles are namely Unity of God, belief in the Hereafter, and God’s ownership of the universe. But for financial instruments, Islamic teachings contain many of them. In the holy Quran, one fifth of its verses are devoted to Muaamalat (transactions). Mirath (inheritance) abolition of Riba (interest) Islamic finance charity Zakat (alms giving).

Figure 2. Ethical endogeneity in Islamic economics

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The spiritual factor is strongly present in Muslim daily life in general and in its economic activities in particular. Since Muslims believe that Allah (God) is one and that He is the only creator of the universe including human beings, so they must obey what their creator, Allah, asked them to do. In Islam, all the guidelines and orders aim to establish a better life that stands on morals and ethics; humankind cannot live happily in this world without divine teachings. Meanwhile, every Muslim knows that there will be a hereafter (life beyond death) where he will be asked and judged. If he neglects the divine orders in his life, he will be punished. This evidence spurs Muslims to behave correctly in their economic activities according to the Islamic guidelines. They will be committed to do only what is good and avoid all that is bad. The Quranic verse attests ‘Allah (God) commands justice, the doing of good, and generosity to fellow men, and He forbids all shameful deeds, and injustice and rebellion’.

4. ISLAMIC PRINCIPLES

4.1. THE UNITY OF GOD

In Islam, God (Allah) is one; he is the creator of human being and all things in this universe. Therefore, people have to obey His orders. All economic activities should follow the orders of Allah including ownership, working time, modes of work, etc.

4.2. GOD'S OWNERSHIP OF THE UNIVERSE

This principle is related to the preceding one since the unity of God implies that all that exists in this universe belongs to God. Indeed, He is the real owner of all creatures. Although human beings are part of this latter group, they have to behave in conformity with the teachings of God’s holy book (the Quran). Allah says in His holy book that: He created the heavens and the earth in true (proportions). He makes the night overlap the day and the day overlap the night. He has subjected the sun and the moon (to His law).

4.3. BELIEF IN THE HEREAFTER MUSLIM

People believe in the hereafter and they know that they will be questioned and judged about everything they have done in their lives; have they followed God’s teachings or not? This principle helps people avoid bad behaviours and commit to good ones in practice, and hence maintain values in society. Thus, people will not be punished but rather will enter paradise. The following instruments are derived from the Islamic sources and every Muslim has to apply them in his economic life. Besides, the state is invited to play its role in order to maintain values in society: Zakat: it is one of the five pillars of Islam, as well as a pillar of public finance for an Islamic state. It is an annual payment ranging from 2,5 per cent to 20 per cent of the value of specified types of property owned by the wealthy, with the primary object of alleviating poverty. It is a clear illustration of the use of wealth to pursue spiritual goals, since it is explicitly intended to create sympathy with and compassion for the poor amongst the wealthy.

Mirath (inheritance): Islam has not left the distribution of inheritance to the whims of a person. In Islam a person cannot favour one relation over another for temporary or subjective reasons as is

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the rule in the West. Islam distributes inheritable property among several groups of people: a) children, b) husband/wife, c) parents, d) brothers and sisters in certain situations.

Riba (interest): It is defined as an increase, which in a loan transaction or in exchange of a commodity accrues to the owner (lender) without giving an equivalent counter value or recompense in return to the other party. It covers interest both on commercial and consumer loans, and is prohibited according to Islam. The Quran states: Believers, have fear of God and waive what is still due to you from Riba, if your faith be true; or be warned of war declared against you by God and His Messenger. If you repent, you have the right to your capital sums (principal), suffering no loss and causing loss to none.

Charity: Islam stimulates Muslims spend money in order to help the needy, Muslim or non-Muslim. The charity is a powerful tool to enable social coherence and brotherhood. It helps tackling inequality within society. The Quran mentions charity in many places among which is the following verse: ‘(Allah will help) Those who, if We give them power in the land, establish regular prayer and give regular charity, enjoin the right and forbid wrong’.

Islamic finance: As an alternative to Riba, Islamic economics offers many financial instruments that can fund economic activities with equitable and fair results.

Among these instruments, there are Murabaha, Mudaraba, Musharaka, Qard al hasan and Ijara. In this context, Islamic Banking can play a major role in enabling these instruments. Islamic finance is unique because it can fund only productive activities that contribute to the creation of wealth. Also, Islamic finance cannot fund forbidden activities such as drug and cigarette production, since they damage health, or any activity that can damage the environment. This is a contract sale between the bank and its client for the sale of goods at a price, which includes a profit margin agreed by both parties.

Table 1. Islamic financial instruments

4.4. THE ECONOMIC ROLE OF THE STATE

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The state in Islamic economics is committed to implementing and maintaining ethics in society. For instance, the state is responsible for gathering Zakat and distributing it in favour of the needy. Also, it has to ban and prevent dealing with Riba among people and firms.

The state is responsible for supervising and controlling the market. It has equally to intervene in order to avoid monopoly and injury. To sum up, the state must play its ‘educative’ role as well as its other roles.

Since Islamic economics stems from the religious teachings of Islam, so its main objective is a priori to establish an economic life that stands on moral values. In other words, Islamic economics without ethics would be vain and meaningless. This evidence suggests that ethics are ultimately endogenous in the Islamic economics and they could never be separated from each other. Therefore, Islamic economics is obviously different from Western economics, which considers ethics as exogenous phenomena; Milton freedman, for instance, has strongly argued in favour of economic science being independent of value judgments and ethical values.

The values that Islamic economics tends to realize in economic life are indeed universal, like justice, freedom and brotherhood, but its instruments are unique and specific. It offers a variety of instruments such as Zakat, Mirath, Israf, Iktinez and a ban on Riba.

Furthermore, it presents alternatives to finance projects such as Murabaha, Musharaka, Mudarabah and Ijar. They are intended to make all economic behaviors basically ethical. In summation, the purpose of Islamic religion in economic field is to show clearly the right and the wrong way. Therefore, Muslims are called and recommended to follow the former and to avoid the latter in order to live happily while they exercise their daily economic activities.

5. THEORY OF ISLAMIC BANKING

Islamic banking is now a well-known term and has emerged as one of the most important industries worldwide. Islamic banking is known for its interest free concept and operates in many countries including Bahrain, Pakistan, Jordan, Iran, Sudan, United Kingdom, Singapore and Malaysia. Islamic banking and finance has undergone rapid transformation and growth from an industry striving to satisfy the Muslim community needs, to a multibillion dollar industry upholding Islamic principles. Over recent decades the Islamic banking industry has emerged as one of the fastest growing industries and has spread to all corners of the globe, receiving wide acceptance from Muslims and non-Muslims.

5.1. OVERVIEW OF THE GLOBAL ISLAMIC BANKING INDUSTRY

Islamic banking started in earnest in the 1970s with the personal initiative of concerned Muslims to address the problem of riba. Islamic banks are now well established in most countries in the Middle East like Bahrain, Kuwait and in many countries in Asia and Europe. Moreover, Pakistan, Iran and Sudan have “Islamized” their whole banking system while others like Bahrain, Turkey, Malaysia and Jordan have adopted a heterogeneous banking system in which one or more Islamic banks compete with Western-type commercial banks.

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The General Secretariat of the Organization of the Islamic Conference (OIC) defines an Islamic bank as a financial institution whose statutes, rules and procedures expressly state its commitment to the principle of shariah, and the banning of the receipt and payment of interest on any of its operations.

The Islamic Banking Act 1983 states that an Islamic bank is a company which carries on Islamic banking business. Islamic bank business here means banking business in which the operations do not involve any element that is not approved by the Islamic religion. Othman and Owen (2000) defines an Islamic bank as a non interest based financial institution that complies fully with Islamic Laws and has creative and progressive financial engineering to offer efficient and competitive banking.

Islamic banking performs the same essential functions as banks do in the conventional system, except Islamic banks need to do business in accordance with the rules and principles of Islam. Islamic banking is based on interest free banking that conforms to the Islamic law or shariah that prohibits interest on all types of loans. The principle of interest free banking is profit and loss sharing. Both the supplier of the capital and the borrower share the risk and both suffer together when returns are poor. Islamic banks will fit only if one replaces “interest rates paid” with “profit-shares and fees”.

Islamic banking and prohibition of interest was not founded on the principles of economics. It was developed as a result of a decree sent by the almighty creator Allah. With the elimination of riba, appropriate mechanisms need to be developed to make feasible the workings of the Islamic financial system. Brenden Nelson, Global Chairman of KPMG, stated that Islamic finance has developed into a global phenomenon, which is highly dynamic and growing rapidly (KPMG 2006). There are now around 270 Islamic Financial institutions worldwide with assets estimated at more than USD265 billion, financial investments above USD400 billion and growth estimated to be around 15%. (KPMG, 2006). The prospects of Islamic banking have also encouraged some conventional banks to move into Islamic banking.

5.2. PRINCIPLES OF ISLAMIC BANKING

Before getting in confuse part, Islamic bank is mixture of commercial and investment bank, but they operate with Islamic norms. “The core of this is that, as a mechanism for allocating financial resources, the rate of interest is replaced with the rate of return on real activities, which has variety of techniques and instruments based on risk and profit sharing (Profit and Loss Sharing- PLS)”.

PLS work in a very simple way that profit is shared between the bank and the business partner and then the banks profit is shared between the bank and the holders of investment deposits.

The four principles for Islamic banking

“All funds should preferably finance socially productive activity There must be some risk, whether funds are used in commercial or productive venture. Interest is forbidden in that it is a predetermined, fixed sum owed to the lender irrespective

of the outcome of the business venture in which the fund is use. Financial risk must lie solely with the lender of the capital and not with the manager or

agent who works with the capital”.

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Islamic bank can be defined as financial, investment and social institution that drives its logic and beliefs from Islamic principles in all its operations. In Islamic bank framework there is a triangular relationship between three parties.

The general process as follow:

Figure 3: Process of Islamic BankAs an alternative interest free techniques have been developed by Islamic banks. The main reason for the twentieth century re-development and growth of the Islamic banking system is the conventional banking system’s reliance on interest-based financing. The conventional financial system depends on interest but the Islamic economic system is based upon a number of principles founded in Islamic law. Islam prohibits doing business with riba or usury/interest.

The prohibition of interest means that Islamic banks cannot incur or earn interest in any of their financial transactions. Islamic financing is based on two principles that are profit and loss sharing (PLS) and the mark up principle.

The PLS principle allows the bank to earn a return on invested funds, provided that the bank shares the risk of investment and bears the loss if the investment fails. Participatory finance through musharakah was one of the earliest forms of financing involving a partnership between the provider of the capital and the user or entrepreneur.

The mark up principle is considered as the reward of the risk for the financer. In the mobilization of funds, Islamic banks depend on four main sources including shareholders’ funds, current accounts, investment accounts and savings accounts. There are more than 40 Islamic financial products and services offered by Malaysian banks based on Islamic concepts and in compliance with shariah principles.

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5.3. FINANCIAL PRODUCTS OFFERED FROM ISLAMIC BANKING

5.3.1. Musharakah

According to Usmani, Musharakah is Arabic word which means sharing. Whereas in the context of business and trade it means a joint enterprise in which partners share the profit and the loss of the joint venture. According to Usmani, this an ideal alternative way for interest based financing. “Musharakah can play a vital role in an economy based on Islamic norms”. Moreover, musharakah does not have fixed rate of return, the rate of return is based on actual profit earned by the joint venture and it can suffer loss if the joint venture fails to succeed. According to Usmani, the returns of the financer in musharakah are linked directly with actual outcome acquired by the enterprise. Higher the profits of the enterprise, higher rate of return to the financer.

Furthermore, According to Usmani, Musharakah is a relationship which is established through mutual contract between the parties. The contract is done with free consent of the parties without any fraud or misrepresentation. Moreover, according to Usmani, the proportion of profit is distributed between partners is agreed at the time of contract of musharakah, if it is not decided at that time the contract of musharakah is not valid. Furthermore, the ratio of profit is determined with proportion to the actual profit to the business and is not divided with proportion of capital invested by the individual or partner, profit will not be given more if the invested capital is more for the other. It will be divided on the basis of agreement. It is not allowed to fix a lump sum amount or give the profit on fix rate to any one of the partner, or any rate of profit proportion to the investment of the partner in contract of musharakah.

Moreover, according to Usmani (1999), in contract of musharakah, if loss occurs in the business then the loss is shared according to the ratio of the investment, for example if investor has invested 30 percent of the capital in the business then the partner must suffer 30 percent of the loss, not more or less otherwise the contract will get invalid. The profit ratio can vary from the investment accordingly to the contract agreement between the partners whereas loss must be divided between the partners in exact proportion of investment. According to Usmani, “Profit is based on the agreement of the parties, but loss is always subject to the ratio of investment”.

Further, according to Usmani, the nature of the capital in musharakah invested by each partner should must be in a liquid form, which means that the contract of musharakah is only based on the money and not on any other commodities. Moreover, in terms of management of the business every partner has a right to work or take part in it. However, the partners should agree on the condition that management should be carried from one of the partners and no other partner should work for the musharakah.

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According to Usmani (1999), Musharakah can be terminated by any partner at any time after giving his partner a notice. If the assets are in cash form they will be distributed between the partners and if they are not in liquidated form then the partners agree either to liquidate the assets or distribute it or partition of assets as they are and if they assets are such which cannot be distributed i.e. machinery than they should be sold and money should be distributed. In addition, if any partner dies during the musharakah the contract of musharkah can be continued or terminated by the heirs of the partner.

5.3.2. Mudarabah

According to Imtiaz (1990), Mudarabah is an agreement between the investor (the rabb-ul-maal, is the investor) and the entrepreneur (the mudrib, the one who takes the loan or bank), under which investor provides the funds to the entrepreneur who employ those funds to either setup a business from scratch or expand existing business with an intention to make profit. The profit is shared between both the parties according to a fixed ratio, however in the occurrence of loss the investor has to take the strain alone.

According to Usmani (1999), in mudarabh investor acts as a sleeping partner and has no right to participate or has a role in the management of the business. It is only carried out from the bank. Further, the loss of the investment is only beard from the investor and not from the manager, but in case if the loss has been done by the mistake of the manager then the loss is beard by the manager of the bank. Such as if labour has been in vain and his work has not brought any success. Moreover if investor want to sell the investment or terminate the contract, manager don.t get his share of working until the business is sold in profit and therefore manager is not entitled to claim his share.

5.3.3. Murabaha

According to Imtiaz (1990), Murabaha is an agreement between a seller (bank) and the buyer (lessee), and refers to a type of sale contract where the price of the goods includes the profit margin agreed ahead of time by both the seller and the buyer. The disclosure of selling price, purchase price, profit margin and other costs is required at the time of sale agreement. It may consider bank as a middleman and the profit margin it earns should be considered as compensation for the time value of money. The payments under Murabaha may be deferred, upfront or paid in installments over a certain period of time but the bank is not compensated monetarily in case of any late payments.

According to (Zineldin, M. 1990), the title of ownership of the equipment remains with the bank until all the money is paid to the bank, much similar to “rent to own” agreement in conventional banking.

5.3.4. Ijara

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According to Imtiaz (1990), Ijara is a contract where Islamic bank purchases an asset and leases it to a client and the contract of lease specify the leasing period, amount, timing of the payments and the responsibilities of both parties during the life of the lease.

“Ijara financing, where the bank purchases the asset and allows the entrepreneur to use it for a fixed charge. The ownership of the asset either remains with the bank or is gradually transferred to the entrepreneur in a rent-to-own contract. Ijara financing is the traditional contract for what is known as leasing today”. (Aggarwal & Yousef, 2000, p.97).

According to Imtiaz (1990), the Islamic banks Ijara contract differentiates between the financing and operating lease. In operating lease Islamic bank acts as warrantor of the asset and client makes the undertaking of the utilization of the asset and its maintenance with full responsibility. On the other hand, in financing lease, “client must deal with the manufacturer and supplier directly in matters relating to leased assets and risk of losing on possession in terms of stipulations of the lease contract” (Imtiaz, 1990, p.267).

5.4. RIBA (INTEREST)

According to Holy Quran, interest (riba) is prohibited and considered as a major sin, in both payment and receipt of interest. Prohibition of interest is a way to establish justice between the financer and entrepreneur. With interest financer is assured of a positive return without sharing the risk.

There are three main reasons for prohibition of interest according.

Riba is unfair Traditional relationship between borrower and lender is on interest, borrower has chance to receive all the profit or the risk to face all the losses that occur, whereas lender earns money what so ever.

Riba is exploitative It is exploitative because favoring rich, as surplus of money and it force needy and poor to borrow.

Riba is unproductive Money should be used in economic ventures and contribute to the economy and enhance welfare.

6. ACCOUNT AVAILABLE TO CUSTOMERS The opening of account in Islamic banking is different than the normal western banking style which has ordinary debtor and creditor relationship, but it is a partner relationship. In which shareholders, depositors, borrowers and investors will participate on partnership basis.

The main accounts available to customers according to:

I. Demand deposit accounts (known as current accounts)

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II. Saving accounts III. Investment accounts

6.1. DEMAND DEPOSIT ACCOUNT

These kinds of account in Islamic bank don‟t earn any income from depositor directly or indirectly. “The Islamic bank receives these funds as a loan and their repayment to the current account customers is absolute and unconditional on its part. If these funds are used by the Islamic bank for productive purpose, the Islamic bank and the customer bears the risk and reward and the former assumes full responsibility for all consequence of their use. The Islamic bank may, if conditions require charge fees to cover expense to service current account customers. Balance in current accounts is direct liabilities of the Islamic bank”.

6.2. SAVING ACCOUNT

According to, in this account customer usually wants to save some funds and to earn income. In Islamic banking these funds are used in short range investment projects and ventures and can be withdrawn at any time. Government guarantees at the nominal value of the deposits. The risk will be there, no guaranteed profit will be there. Depositor will not receive any premium if the bank incurs a loss on its investment projects.

6.3. INVESTMENT ACCOUNT

In this kind of account investor deposit their money and want to be invested by Islamic bank, under their supervision. It is done on trust basis with terms and conditions between investor and Islamic bank, dependent on relationship. Investors have to consider all risk and rewards in these investments. Islamic bank receives fixed amount of percentage from the profit earned from the investment of investor, which can be assume as management fees and Islamic bank can forego the part of its share of profit for the benefit of the investors.

Whereas on the other hand for any case investment acquire by Islamic bank obtain a net loss, “it is borne by investors on a pro rata basis”. At that time Islamic bank will waive the management fees as such kind of fees is only applicable on the profit obtained. Furthermore, “Islamic bank is liable for loss only in the event of its gross negligence in the performance of its trust functions, if it is proved as such”.

7. REGULATORY AUTHORITIES

The specificities of Islamic banks that have been highlighted induce features in the regulation of the financial systems that integrate a more or less a large part of Islamic financial institutions. This goes from conventional systems that marginally adapt their legislation to allow the development of an Islamic financial embryo; this is the case of London; to countries that have more or less completely changed their banking system such as Pakistan, Iran or Sudan. Intermediary cases

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exist such as Persian Gulf countries or Malaysia that are familiar with dual systems. However, the role of the Central Bank is the same everywhere in the world.

The Central Bank's mission is:

- To adjust the money supply to avoid fluctuations in inflation and employment;

- To facilitate the mobilization of savings and optimal allocation of resources;

- To regulate the activity of commercial banks;

- To ensure a role of lender as a last resort;

- To apply the government’s exchange rate policy. Monetary policy seeks to regulate the distribution of loans either through price mechanisms, or by public restrictions. In an Islamic environment, this regulation may be difficult because of:

- The use of interest rates is prohibited in principle. This prohibition is sometimes discussed for the monetary market because it especially concerns the relations between the Central Bank and second-tier banks. It is true however that the use of a refinance rate affects all banking operations and ultimately the situation of the banks’ clients. Therefore, the Central Bank cannot use discount rates to refinance banks using a tool that impacts the money markets in general.

This instrument is essential in the “closed” financial systems which are largely based on open financial markets. But many Muslim countries still know administered banking systems akin to "economies of debt". In this type of governance, it is more efficient to use instruments that control in a more direct manner, like mandatory reserves or even the supervision of loans.

All these instruments are usable from an Islamic point of view.

- Some operations are acceptable for some of the Islamic banks, but not for others, due to the differences of opinion between the Islamic lawyers on the admissibility of different contracts (El-Gamal, 1999). It is therefore important to distinguish the relevant aspects of Islamic law that can govern the sale and resale of commercial securities and public bills of exchange, and those which are accepted in practice. It is also important to see the effectiveness of these operations in the execution of an open market policy; In Western countries, Islamic finance does not benefit from the common law exemption regime.

Islamic banks remain poorly developed and are not in a net debtor situation towards the Central Bank or the banking system. Therefore they remain outside the usual refinancing process even if they are subject to common monetary regulations. 13 In many Muslim countries, Islamic banks operate in an environment where competitive banks predominate, but in some cases such as Egypt or Turkey, they are governed by a special legislation. Islamic banks have committees (shariah boards) in which sit specialists in Islamic law, that decide on the conformity of the financial products with Islam. Literature emphasizes the fact that a global Islamic control system is missing as well as a more precise standardization of operations. Numerous publications focus on the institutions created to develop, standardize and regulate the profession and IDB (Islamic Development Bank), is the leading agency in the Islamic financial system created in 1975 in the wake of the first oil crisis.

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Regulatory difficulties are related to the heterogeneity of Islamic finance and the lack of precise data on the risks associated with different operations or products. These risks do not disappear with Islamic finance and they can be just as important as in conventional finance. One of the questions is whether Islamic finance should develop its own accounting standards or align itself with international practices. Another issue is that of Islamic Corporate Governance principles: respect of rights of ownership, truthful and correct accounting practices, transparency etc.

In Western countries, financial agreements are established on the basis of the legal rules of each nation. If the ethical principles of Islam can be taken into account in the creation of financial products, they can in no way substitute the law in effect. In the French case, there is a regulatory framework favorable to the growth of Islamic finance (bearing in mind that Roman law is closer to the Islamic law than the Anglo-Saxon law). It is possible to find connections between Islamic principles and the French legal system.

Table 2. Similarities between Sharia law and French law

8. SUKUKSukuk in general may be understood as a shariah compliant ‘Bond’. In its simplest form sukuk represents ownership of an asset or its usufruct. The claim embodied in sukuk is not simply a claim to cash flow but an ownership claim. This also differentiates sukuk from conventional bonds as the latter proceed over interest bearing securities, whereas sukuk are basically investment certificates consisting of ownership claims in a pool of assets.

Sukuk (plural of word sak) were extensively used by Muslims in the Middle Ages as papers representing financial obligations originating from trade and other commercial activities. However, the present structure of sukuk are different from the sukuk originally used and are akin to the conventional concept of securitization, a process in which ownership of the underlying assets is

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transferred to a large number of investors through certificates representing proportionate value of the relevant assets.

9. BENEFITS AND FEATURES Tradable shariah-compliant capital market product providing medium to long-term fixed or

variable rates of return. Assessed and rated by international rating agencies, which investors use as a guideline to assess risk/return parameters of a sukuk issue.

Regular periodic income streams during the investment period with easy and efficient settlement and a possibility of capital appreciation of the sukuk.

Liquid instruments, tradable in secondary market.

10.USES OF SUKUK FUNDSThe most common uses of sukuk can be named as project specific, asset-specific, and balance sheet specific.

10.1. PROJECT SPECIFIC SUKUKUnder this category money is raised through sukuk for specific project. For example, Qatar Global sukuk issued by the Government of Qatar in 2003 to mobilize resources for the construction of Hamad Medical City (HMC) in Doha. In this case a joint venture special purpose vehicle (SPV), the Qatar Global sukuk QSC, was incorporated in Qatar with limited liability. This SPV acquired the ownership of land parcel, that was registered in the name of HMC. The land parcel was placed in trust and Ijara-based Trust Certificates (TCs) were issued worth US$700 million due by October 2010. The annual floating rate of return was agreed at LIBOR plus 0.45 per cent.

10.2. ASSETS SPECIFIC SUKUKUnder this arrangement, the resources are mobilise by selling the beneficiary right of the assets to the investors. For example, the Government of Malaysia raised US$ 600 million through Ijarasukuk Trust Certificates (TCs) in 2002. Under this arrangement, the beneficiary right of the land parcels has been sold by the government of Malaysia to an SPV, which was then re-sold to investors for five years. The SPV kept the beneficiary rights of the properties in trust and issued floating rate sukuk to investors.Another example of Asset-specific sukuk is US$250 million five-year Ijarasukuk issued to fund the extension of the airport in Bahrain. In this case the underlying asset was the airport land sold to an SPV.

10.3. BALANCE SHEET SPECIFIC SUKUKAn example of the balance sheet specific use of sukuk funds is the Islamic Development Bank (IDB) sukuk issued in August 2003. The IDB mobilised these funds to finance various projects of the member countries. The IDB made its debut resource mobilization from the international capital market by issuing US$ 400 million five-year sukuk due for maturity in 2008.

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11. TYPES OF SUKUKSukuk can be of many types depending upon the type of Islamic modes of financing and trades used in its structuring. However, the most important and common among those are ijarah, shirkah, salam and istisna. Among the fourteen eligible sukuks identified by the AAOIFI, following are more common:

11.1. MUDARABA SUKUKThese are investment sukuk that represent ownership of units of equal value in the Mudaraba equity and are registered in the names of holders on the basis of undivided ownership of shares in the Mudaraba equity and its returns according to the percentage of ownership of share. The owners of such sukuk are the rabbul-mal. (AAOIFI). Mudarbasukuk are used for enhancing public participation in big investment projects

11.1.1. Salient Features:Following are the salient features of mudarba sukuk:

1. Mudarbasukuk (MS) represent common ownership and entitle their holders share in the specific projects against which the MS has been issued.

2. The MS contract is based on the official notice of the issue of the prospectus which must provide all information required by shariah for the Qirad contract such as the nature of capital, the ratio for profit distribution and other conditions related to the issue, which must be compatible with shariah.

3. The MS holder is given the right to transfer the ownership by selling the deeds in the securities market at his discretion. The sale of MS must follow the rules listed below:a. If the mudarba capital, before the operations of the project, is still in the form of

money, the trading of MS would be like exchange of money for money. In that case the rules of bay al-sarf would be applied.

b. If muqarda capital is in the form of debt then it must satisfy the principles of debt trading in Islam.

c. If capital is in the form of combination of cash, receivables, goods, real assets and benefits trade must be based on market price evolved by mutual consent.

4. The Manager/SPV who receives the fund collected from the subscribers to MS can also invest his own fund. He will get profit for his capital contribution in addition to his share in the profit as mudarib.

5. Neither prospectus nor MS should contain a guarantee, from the issuer or the manager for the fund, for the capital or a fixed profit, or a profit based on any percentage of the capital. Accordingly;a. The prospectus or the MS issued pursuant to it, may not stipulate payment of a specific

amount to the MS holder,b. The profit is to be divided, as determined by applying rules of shariah; that is, an amount

access of the capital, and not the revenue or the yield; and

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c. Profit and Loss account of the project must be published and disseminated to MS holders.

6. It is permissible to create reserves for contingencies, such as loss of capital, by deducting from the profit.

7.  The prospectus can also contain a promise made by a third party, totally un-related to the parties to the contract, in terms of legal entity or financial status, to donate a specific sum, without any counter benefit, to meet losses in the give project, provided such commitment is independent of the mudarba contract.

On the expiry of the specified time period of the subscription, the Sukuk holders is given the right to transfer the ownership by sale or trade in the securities market at his discretion.

11.1.2. Steps involved in the structure: Mudarib enters into an agreement with project owner for construction/commissioning of project. SPV issues sukuk to raise funds. Mudarib collects regular profit payments and final capital proceeds from project activity for onward

distribution to investors. Upon completion, Mudarib hands over the finished project to the owner.

11.1.3. Mudaraba Sukuk in practiceShamil Bank of Bahrain raised 360 million Saudi Riyal investment capital through the Al Ehsa Special Realty Mudaraba, representing an investment participation in a land development transaction with a real estate development company in the Kingdom of Saudi Arabia. The investment objective of the Mudaraba is to provide investors with annual returns arising from participation in the funding of a land financing transaction Profits due to investors will be accrued on the basis of returns attained from investing the subscriptions.

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11.2. MUSHARAKA SUKUKThese are investment sukuk that represent ownership of Musharaka equity. It does not differ from the Mudarabasukuk except in the organization of the relationship between the party issuing such sukuk and holders of these sukuk, whereby the party issuing sukuk forms a committee from the holders of the sukuk who can be referred to in investment decisions (AAOIFI).

MusharakaSukuk are used for mobilizing the funds for establishing a new project or developing an existing one or financing a business activity on the basis of partnership contracts. The certificate holders become the owners of the project or the assets of the activity as per their respective shares. These Musharaka certificates can be treated as negotiable instruments and can be bought and sold in the secondary market.

“These are certificates of equal value issued with the aim of using the mobilized funds for establishing a new project, developing an existing project or financing a business activity on the basis of any partnership contracts so that the certificate holders become the owners of the project or assets of the activity as per their respective shares, with the Musharaka certificates being managed on the basis of participation or Mudaraba or an investment agency.” (AAOIFI Standard 17, 3/6)

11.2.1. Steps involved in the structure Corporate and the Special Purpose Vehicle (SPV) enter into a Musharaka Arrangement for

a fixed period and an agreed profit-sharing ratio. Also the corporate undertakes to buy Musharaka shares of the SPV on a periodic basis.

Corporate (as Musharik) contributes land or other physical assets to the Musharaka a & b. SPV (as Musharik) contributes cash i.e. the issue Proceeds received from the

investors to the Musharaka The Musharaka appoints the Corporate as an agent to develop the land (or other physical

assets) with the cash injected into the Musharaka and sell/lease the developed assets on behalf of the Musharaka.

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In return, the agent (i.e. the Corporate) will get a fixed agency fee plus a variable incentive fee payable.

The profits are distributed to the sukuk holders. The Corporate irrevocably undertakes to buy at a pre-agreed price the Musharaka shares

of the SPV on say semi-annual basis and at the end of the fixed period the SPV would no longer have any shares in the Musharaka.

11.2.2. Musharaka Sukuk in PracticeUS$550 million sukuk transaction for Emirates airline, the seven-year deal was a structured on a Musharaka contract. The Musharaka or joint venture was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai's airport which will ultimately be leased to Emirates. Profit, in the form of lease rentals, generated from the Musharaka venture will be used to pay the periodic distribution on the trust certificates.

Sitara Chemical Industries Ltd, a public limited company, made a public issue of profit-and-loss sharing based term finance certificates (TFC’s) worth Rs 360 million which were subscribed in June 2002. The TFC’s had a fixed life tenor of five years and profit and loss sharing was linked to the operating profit or loss of the Chemical Division of the company.

Kuwait Finance House (KFH), Liquidity Management Center (LMC) and Al Muthanna Investment Company (MIC), the mandated lead arrangers launched US$ 125 million Lagoon City Musharakasukuk to support the Lagoon City residential and commercial real estate development as part of Kheiran Pearl City project.

11.3. MURABAHA SUKUKIn this case the issuer of the certificate is the seller of the Murabaha commodity, the subscribers are the buyers of that commodity, and the realised funds are the purchasing cost of the commodity. The certificate holders own the Murabaha commodity and are entitled to its final sale price upon the re-sale of the Commodity. The possibility of having legally acceptable Murabaha-based sukuk is only feasible in the primary market. The negotiability of these Sukuk or their trading at the secondary market is not permitted by shariah, as the certificates represent a debt owing from the subsequent buyer of the Commodity to the certificate-holders and such trading amounts to trading in debt on a deferred basis, which will result in riba.

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Despite being debt instruments, the MurabahaSukuk could be negotiable if they are the smaller part of a package or a portfolio, the larger part of which is constituted of negotiable instruments such as Mudaraba, Musharaka, or IjaraSukuk. Murabahasukuk are popular in Malaysian market due to a more liberal interpretation of fiqh by Malaysian jurists permitting sale of debt (bai-al-dayn) at a negotiated price.

11.3.1. Steps involved in the structure: A master agreement is signed between the SPV and the borrower SPV issues sukuk to the investors and receive sukuk proceeds. SPV buys commodity on spot basis from the commodity supplier. SPV sells the commodity to the borrower at the spot price plus a profit margin, payable on

installments over an agreed period of time The borrower sells the commodity to the Commodity buyer on spot basis. The investors receive the final sale price and profits.

11.3.2. Murabaha Sukuk in PracticeArcapita Bank, a Bahrain-based investment firm has mandated Bayerische Hypo-und Vereinsbank AG (“HVB”), Standard Bank Plc (“SB”) and WestLB AG, London Branch (“WestLB”) (together the “Mandated Lead Arrangers”), to arrange a Five Year Multicurrency (US$, € and £) Murabaha-backed Sukuk. Sukuk will have a five-year bullet maturity and proposed pricing three month LIBOR +175bps.

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11.4. SALAM SUKUKSalam sukuk are certificates of equal value issued for the purpose of mobilising Salam capital so that the goods to be delivered on the basis of Salam come to the ownership of the certificate holders. The issuer of the certificates is a seller of the goods of Salam, the subscribers are the buyers of the goods, while the funds realized from subscription are the purchase price (Salam capital) of the goods. The holders of Salam certificates are the owners of the Salam goods and are entitled to the sale price of the certificates or the sale price of the Salam goods sold through a parallel Salam, if any.

Salam-based securities may be created and sold by an SPV under which the funds mobilized from investors are paid as an advance to the company SPV in return for a promise to deliver a commodity at a future date. SPV can also appoint an agent to market the promised quantity at the time of delivery perhaps at a higher price. The difference between the purchase price and the sale price is the profit to the SPV and hence to the holders of the Sukuk.

All standard shariah requirements that apply to Salam also apply to Salam sukuk, such as, full payment by the buyer at the time of effecting the sale, standardized nature of underlying asset, clear enumeration of quantity, quality, date and place of delivery of the asset and the like.

One of the Shariah conditions relating to Salam, as well as for creation of Salam sukuk, is the requirement that the purchased goods are not re-sold before actual possession at maturity. Such transactions amount to selling of debt. This constraint renders the Salam instrument illiquid and hence somewhat less attractive to investors. Thus, an investor will buy a Salam certificate if he expects prices of the underlying commodity to be higher on the maturity date.

11.4.1. Steps involved in the transaction: SPV signs an undertaking with an obligator to source both commodities and buyers. The

obligator contracts to buy, on behalf of the end-Sukuk holders, the commodity and then to sell it for the profit of the Sukuk holders.

Salam certificates are issued to investors and SPV receives Sukuk proceeds.26

The Salam proceeds are passed onto the obligator who sells commodity on forward basis SPV receives the commodities from the obligator Obligator, on behalf of Sukuk holders, sells the commodities for a profit. Sukuk holders receive the commodity sale proceeds.

11.4.2. Salam Sukuk in PracticeAluminum has been designated as the underlying asset of the Bahrain Government al Salam contract, where by it promises to sell aluminum to the buyer at a specified future date in return of a full price payment in advance. The Bahrain Islamic Bank (BIB) has been nominated to represent the other banks wishing to participate in the Al Salam contract. BIB has been delegated to sign the contracts and all other necessary documents on behalf of the other banks in the syndicate. At the same time, the buyer appoints the Government of Bahrain as an agent to market the appropriate quantity at the time of delivery through its channels of distribution. The Government of Bahrain provides an additional undertaking to the representative (BIB) to market the aluminum at a price, which will provide a return to al Salam security holders equivalent to those available through other conventional short-term money market instruments.

11.5. IJARA SUKUK

The most commonly used sukuk structure (based on volume of issuances during 2008) is that of sukuk al-ijara. The popularity of this structure can be attributed to a number of different factors; some commentators have described it as the classical sukuk structure from which all other sukuk structures have developed, whilst others highlight its simplicity and its favor with Shari’a scholars as the key contributing factors. In the Islamic finance industry, the term “ijara” is broadly understood to mean the ‘transfer of the usufruct of an asset to another person in exchange for a rent claimed from him’ or, more literally, a “lease”.

In order to generate returns for investors, all sukuk structures rely upon either the performance of an underlying asset or a contractual arrangement with respect to that asset. The ijara is particularly useful in this respect as it can be used in a manner that provides for regular payments throughout the life of a financing arrangement, together with the flexibility to tailor the payment profile - and method of calculation - in order to generate a profit. In addition, the use of a purchase undertaking is widely accepted in the context of sukuk al-ijara without Shari’a objections. These characteristics make ijara relatively straightforward to adapt for use in the underlying structure for a sukuk issuance.

Structure of Ijara Sukuk is as follows:

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11.5.1. Overview of Structure

1. Issuer SPV issues sukuk, which represent an undivided ownership interest in an underlying asset or transaction. They also represent a right against Issuer SPV to payment of the Periodic Distribution Amount and the Dissolution Amount.

2. The Investors subscribe for sukuk and pay the proceeds to Issuer SPV (the “Principal Amount”). Issuer SPV declares a trust over the proceeds (and any assets acquired using the proceeds – see paragraph 3 below) and thereby acts as Trustee on behalf of the Investors.

3. Originator enters into a sale and purchase arrangement with Trustee, pursuant to which Originator agrees to sell, and Trustee agrees to purchase, certain assets (the “Assets”) from Originator.

4. Trustee pays the purchase price to Originator as consideration for its purchase of the Assets in an amount equal to the Principal Amount.

5. Trustee leases the Assets back to Originator under a lease arrangement (ijara) for a term that reflects the maturity of the sukuk.

6. Originator (as Lessee) makes Rental payments at regular intervals to Trustee (as Lessor). The amount of each Rental is equal to the Periodic Distribution Amount payable under the sukuk at that time. This amount may be calculated by reference to a fixed rate or variable rate (e.g. LIBOR or EIBOR) depending on the denomination of sukuk issued and subject to mutual agreement of the parties in advance.

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7. Issuer SPV pays each Periodic Distribution Amount to the Investors using the Rental it has received from Originator.

8. Upon:1. an event of default or at maturity (at the option of Trustee under the Purchase

Undertaking); or2. the exercise of an optional call (if applicable to the sukuk) or the occurrence of a tax

event (both at the option of Originator under the Sale Undertaking),Trustee will sell, and Originator will buy-back, the Assets at the applicable Exercise Price, which will be equal to the Principal Amount plus any accrued but unpaid Periodic Distribution Amounts owing to the Investors.

9. Payment of Exercise Price by Originator (as Obligor).10. Issuer SPV pays the Dissolution Amount to the Investors using the Exercise Price it has

received from Originator.11.Trustee and Originator will enter into a service agency agreement whereby Trustee will

appoint Originator as its Servicing Agent to carry out certain of its obligations under the lease arrangement, namely the obligation to undertake any major maintenance, insurance (or takaful) and payment of taxes in connection with the Assets. To the extent that Originator (as Servicing Agent) claims any costs and expenses for performing these obligations (the “Servicing Costs”) the Rental for the subsequent lease period under the lease arrangement will be increased by an equivalent amount (a “Supplemental Rental”). This Supplemental Rental due from Originator (as Lessee) will be set off against the obligation of Trustee to pay the Servicing Costs.

11.5.2. Key Features of the Underlying StructureSet out below is a summary of the basic requirements that should be considered when using ijara as the underlying structure for the issuance of sukuk:

The consideration (Rentals) must be at an agreed rate and for an agreed period; The subject of the ijara must have a valuable use (i.e. things without a usufruct cannot

be leased); The ownership of the asset(s) must remain with the Trustee and only the usufruct right

may be transferred to the originator (therefore anything which can be consumed cannot be leased by way of an ijara);

As ownership of the asset(s) must remain with the Trustee, the liabilities arising from the ownership must also rest with the Trustee (as owner) - an asset remains the risk of the Trustee throughout the lease period (in the sense that any harm or loss caused by the factors beyond the control of the Originator is borne by the Trustee);

Any liabilities relating to the use of the asset(s), however, rest with the Originator (as lessee);

The Originator (as lessee) cannot use an asset for any purpose other than the purpose specified in the ijara (or lease) agreement (if no purpose is specified, the Originator can use such asset for the purpose it would be used for in the normal course of its business);

The asset(s) must be clearly identified in the ijara (and identifiable in practice);

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Rental must be determined at the time of contract for the whole period of the ijara. Although it is possible to split the term of the ijara into smaller rental periods where different amounts of rent may be calculated for each such rental period, the amount of rental must be fixed at the start of each such rental period and Shari’a will consider each rental period as a separate lease;

If an asset has totally lost the function for which it was leased, and no repair is possible, the ijara shall terminate on the day on which such loss (a “Total Loss”) has been caused. If there has been a Total Loss, the Trustee may have the right/ability to substitute or replace the affected asset - although, in reality, it would only look to do so if the Originator (as service agent) is able to use the insurance (or takaful) or any other total loss proceeds to procure substitute or replacement assets;

If a Total Loss is caused by the misuse or negligence of the Originator, the Originator will be liable to compensate the Trustee for depreciation in the value of the affected asset, as it was immediately before such Total Loss; and

In the event that an asset has only suffered partial loss or damage, the ijara will continue to survive with respect to that asset.

The above requirements are based on the principles set out in Accounting and Auditing Organization for Islamic Financial Institutions (the “AAOIFI”) Shari’a Standard No. 9 (Ijarah and Ijarah Muntahia Bittamleek) and other established principles relating to Ijara.

11.5.3. Required DocumentationDocument Parties Summary/Purpose

Sale and PurchaseAgreement

Originator (as Seller) and Trustee (as Purchaser)

From Trustee’s (and the Investors’) perspective, this is the document that gives ownership of revenue-generating assets (i.e. the Assets).

From Originator’s perspective, this is the document under which it receives funding.

Lease (Ijara) Agreement

Trustee (as Lessor) and Originator (as Lessee)

Trustee leases the Assets back to Originator in a manner that: gives Originator possession and use of the

i. Assets so that its principal business can continue without interruption; and through Rentals it generates a return for

ii. Trustee (and the Investors).

Service Agency Agreement

Trustee (as Lessor / Principal) and

Allows Trustee to pass responsibility for major maintenance, insurance (or takaful) and payment of taxes (i.e. an owner’s obligations) back to

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Document Parties Summary/Purpose

Originator (as Servicing Agent)

Originator. Any reimbursement amounts or service charges payable to Servicing Agent are set off against (i) a corresponding ‘supplementary rental’ under the Ijara or (ii) an additional amount which is added to the Exercise Price (payable under the Purchase Undertaking or the Sale Undertaking, as applicable).

Purchase Undertaking (Wa’d)

Granted by Originator (as Obligor) in favor of Trustee

Allows Trustee to sell the Assets back to Originator if an event of default occurs or at maturity, in return for which Originator is required to pay all outstanding amounts (through an Exercise Price) so that Trustee can pay the Investors.

Sale Undertaking (Wa’d)

Granted by Trustee in favor of Originator (as Obligor)

Allows Originator to buy the Assets back from Trustee in limited circumstances (e.g. the occurrence of a tax event), in return for which Originator is required to pay all outstanding amounts (through an Exercise Price) so that Trustee can pay the Investors.

Substitution Undertaking (Wa’d) - OPTIONAL

Granted by Trustee in favor of Originator (as Obligor)

Allows Originator to substitute the Assets (which it may need to sell or otherwise dispose of) for some other assets having at least the same value and revenue-generating properties.

The growth of the sukuk market has led to the development of a number of ‘hybrid’ structures around the sukuk al-ijara model in order to provide additional flexibility - particularly when selecting underlying assets. A few of these developments are summarized below:

In order to enable investors to receive compensation where an asset is still under construction, certain Shari’a scholars have permitted the use of the forward lease arrangement (known as ijara mawsufah fi al-dimmah). This forward lease agreement is normally combined with an istisna contract (or procurement agreement), under which construction of the asset is commissioned. This structure is discussed in more detail later in this Chapter 2 (Sukuk Structures) at Part 5: Sukuk al-Istisna; and

If legal and/or registered title to a particular asset exists and (due to, by way of example, the prohibitive cost implications or tax implications of registering such a transfer of title) it is not possible to transfer that legal / registered title, certain structures have been approved that allow an ijara to be put in place despite the fact that the trustee does not have outright legal ownership of that asset. For example:

o It may be possible, depending on the asset type and the view taken by the relevant Shari’a scholars, to rely upon the concept of beneficial ownership in structuring a sukuk al-ijara transaction. The sale and purchase agreement (in the sale and leaseback

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structure discussed above) would document the sale and transfer to the trustee of the beneficial ownership interest in the underlying asset - and such beneficial ownership interest would be sufficient to enable the trustee’s entry into the leaseback arrangements contemplated in the example above;

o Where the usufruct of an asset is recognized by the underlying legal and regulatory regime, it may be possible to create different categories of usufruct and for the sale of a usufruct to be relied upon for the Related Structures / Structural Developments 19 purposes of structuring a sukuk al ijara transaction. An example of this is through the grant of a musataha interest (a right in rem), the holder (or musatahee) is given the right to use and develop land with such rights over that land in a manner that allows the holder to be the outright owner of the buildings constructed on that land during the period of the musataha. It should however be noted that a musataha provides an interest less than freehold or absolute ownership. The musataha right, when created, is granted by the owner of the freehold property to the holder. The right, while not a leasehold interest, is quite similar to a leasehold interest. Certain Shari’a scholars consider this sufficient to enable the holder (or musatahee), in turn, to lease the land and any buildings thereon to the originator under an ijara arrangement. Basically, a musataha contract replaces the sale and purchase agreement in the sale and leaseback structure discussed above; and

o It is also possible for a head-lease arrangement to be used instead of the sale and purchase agreement (in the sale and leaseback structure discussed above), such that the trustee is granted a long-term right to use an asset under the head lease, thus allowing the trustee to enter into a sub-lease (the ijara).

These are sukuk that represent ownership of equal shares in a rented real estate or the usufruct of the real estate. These sukuk give their owners the right to own the real estate, receive the rent and dispose of their sukuk in a manner that does not affect the right of the lessee, i.e. they are tradable. The holders of such sukuk bear all cost of maintenance of and damage to the real estate. (AAOIFI)

11.5.4. Features of Ijarah sukuk http://ifresource.com/2010/04/27/how-sukuk-works-introduction-structuring-and-application-of-sukuk-bonds/

It is necessary for an ijarah contract that the assets being leased and the amount of rent both are clearly known to the parties at the time of the contract and if both of these are known, ijarah can be contracted on an asset or a building that is yet to be constructed, as long as it is fully described in the contract provided that the lessor should normally be able to acquire, construct or buy the asset being leased by the time set for its delivery to the lessee (AAOIFI, 2003: 140-157). The lessor can sell the leased asset provided it does not hinder the lessee to take benefit from the asset. The new owner would be entitled to receive the rentals.

Rental in ijarah must be stipulated in clear terms for the firs term of lease, and for future renewable terms, it could be constant, increasing or decreasing by benchmarking or relating it to any well-known variable.

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As per shariah rules, expenses related to the corpus or basic characteristics of the assets are the responsibility of the owner, while maintenance expenses related to its operation are to be borne by the lessee.

As regards procedure for issuance of ijarah sukuk, an SPV is created to purchase the asset(s) that issues sukuk to the investor, enabling it to make payment for purchasing the asset. The asset is then leased to third party for its use. The lessee makes periodic rental payments t the SPV that in turn distributes the same to the sukuk holders.

Ijara sukuk are completely negotiable and can be traded in the secondary markets. Ijara sukuk offer a high degree of flexibility from the point of view of their issuance

management and marketability. The central government, awqaf or any other asset users, private or public can issue these Sukuk.

11.5.5. How Has Sukuk Al-Ijara Benefitted Islamic Finance?The Islamic financing industry has seen an incredible growth in the last ten years. The number of Islamic financial institutions has increased from only a few till about three decades back to close to 500 in about 100 countries of the world. What is more, these institutions are not only concentrated in the Middle East and the South-East Asian countries, but have also spread to the USA, the U.K., and other parts of Europe. According to Standard and Poor’s, the total worth of the Islamic financing industry is more than $500 billion and the net value of its assets has been increasing at a steady rate of 10% since the last decade, recession notwithstanding.

It is noteworthy in this context that the sukuk mode of financing and in particular, the sukuk al-ijara contract came into prevalence towards the beginning of the last decade and since then has grown in popularity in leaps and bounds. The growth and development of Islamic financing in the last decade along with the emergence of thesukuk methods of financing are telling pieces of evidence. They definitely point to the role that sukuk al-ijara has played in charting the path and shaping the growth of Islamic finance.

11.5.6. Criticisms of Ijarah Sukuk There are some disadvantages regarding the Ijarah sukuk structure. Not every potential issuer has access to the needed underlying asset. Ijarah sukuk carries high transaction costs such as maintenance and insurance costs, because Shari’ah requires the asset to be operable, otherwise the lease will be suspended until the asset is fixed; Shari’ah fees and audits which are not only expensive, but also time consuming; and penalties for the lessee or borrower if the lease payment is not paid on time. However, the major criticism is related to the use of interest rate as benchmark, because it is often the case that the return of Ijarah sukuk is benchmarked to LIBOR (London Inter Bank Offer Rate) on US$ funds, or the equivalent local rate of issue. Although the interest rate is only used for pricing, the close between interest-based pricing and riba worries Shari’ah scholars (Sen, n.d.).

According to Vogel and Hayes (1998) :Islamic scholars do not recognize any difference between nominal and real rates of return. However, in the process of articulating an expected rate of profit

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for the assumed rate of investment, Muslims end up incorporating implicit inflation assumptions when they set profit expectation as a function of other conventional capital market returns on comparable risk. Since interest rate is usually used as a basis of cost of capital and a benchmark against interest rate of return (IRR), in an economy without any interest rate there is no mechanism to calculate the cost of capital, and the efficiency of an investment project cannot be evaluated. To solve the problem associated with use of interest rate for pricing the Ijarah sukuk, Mirakhor (1996) suggested a procedure that utilizes Tobin’s q in a calculation of the cost of capital and investment. This calculation is done without resort to a fixed and predetermined interest rate; equity financing becomes the only source of financial capital and the economy’s financial system becomes equity based. In an economy without debt, the stock capital is valued in the market for equities and the relationship between the supply price of capital and the rate used by the shareholder to discount the expected future earnings can be derived. Tobin’s q defines the supply price of capital as the rate of return which is required by a shareholder to absorb the existing capital stock to their portfolio. Incentive for companies to invest depends on the prospective profitability relative to the cost of capital. Investment is expected to occur when the demand price as reflected in the financial valuation exceeds the supply price as measured by the cost of physical capital. In other words, a company is expected to accept investment where the return will exceed the cost of capital (Mirakhor, 1996). The q theory of investment relates investment to the ratio of market to the replacement value of capital.

11.5.7. Examples of Ijarah Sukuk Issuance In practiceThere are a number of different structures used for this instrument. One example will be discussed here: the Ijarah sukuk issued by Qatar Global Sukuk as illustrated by Tariq (2004); that issued by RH Capital PTC (2004), and the hypothetical case of an Ijarah sukuk issued by a Ministry of Defence, as illustrated by Al-Amine (2001). The Government of Qatar issued US$ 700,000,000 Ijarah sukuk through the Qatar Global Sukuk, an SPV established by the government of Qatar, Qatar International Bank and HSBC. The Ijarah sukuk was issued in 2003 and will mature in 2010. The proceeds will be used to finance the construction and development of Hamad Medical City. The Ijarah sukuk structure can be summarized by the graph below:

1. The government of Qatar as a borrower sold a land parcel to the SPV amounting to $700,000,000.

2. The purchase price was given to the borrower. 34

3. The borrower leases back the asset from the SPV. 4. he lease payments are given to the SPV periodically, which reimburses these to the sukuk

holders. At maturity, the asset will be repurchased by the borrower and the principal given to the sukuk holders (6 and 8).

5. To finance the asset purchase, SPV issues sukuk to sukuk holders and receives the proceeds of the sukuk from them

6. The lease payments or the periodic distribution given to the sukuk holders is calculated by a floating rate as follows: For the first four distribution dates, the lease payments are For the remaining distribution dates, the lease payments are (x is days in return accounting period, A is an amortization payment)

11.6. ISTISNA SUKUK

Alternatively referred to as the “Islamic project bond”, the structure of sukuk al-istisna has not been that widely used. Although, at first glance, the structure appears ideal for the financing of greenfield development, certain structural drawbacks have proven difficult to overcome and, as a result, sukuk al-istisna has not featured as an alternative source of Islamic funding on multi-sourced project financing in the manner once predicted.

Of particular significance is the prevailing view that sukuk al-istisna are not tradable during the construction period. In addition to this, the different approaches taken by Shari’a scholars to advance rentals and istisna termination payments have also led structures to consider other more ‘flexible’ structures (such as sukuk al-musharaka).

Broadly speaking, istisna translates as being ‘to order a manufacturer to manufacture a specific good for the purchaser’. Under an istisna, it is important that the price and specification of the good to be manufactured are agreed at the outset.

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In the modern day context of Islamic finance, the istisna has developed into a particularly useful tool in the Islamic funding of the construction phase of a project – it is often regarded as being similar to a fixed-price ‘turnkey’ contract. In order to enable investors to receive a return during the period where assets are being constructed under an istisna arrangement, some Shari’a scholars have permitted the use of a forward lease arrangement (known as ijara mawsufah fi al-dimmah) alongside such istisna arrangement. Accordingly, sukuk al-istisna often combines an istisna arrangement with a forward lease arrangement – whilst the istisna is the method through which the investors can advance funds to an originator, the ijara provides the most compatible payment method to those investors.

The use of staged payments (a common feature in istisna construction arrangements – see further below) may however result in an unutilized amount of sukuk proceeds being held in the structure for a prolonged period during construction (pending the achievement of the relevant milestones). Accordingly, it may be necessary to consider investing these amounts in Shari’a-compliant investments in order to mitigate negative carry (i.e. periodic distributions continue to be payable whilst cash remains unutilized – a position which is likely to be unacceptable to the originator). It should, however, be noted that this approach to investment of the unutilized sukuk proceeds has received some criticism.

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Structure of Istisna Sukuk is as follows:

11.6.1. Overview of Structure

1. Issuer SPV issues sukuk, which represent an undivided ownership interest in an underlying asset or transaction. They also represent a right against Issuer SPV to payment of the Periodic Distribution Amount and the Dissolution Amount.

2. The Investors subscribe for sukuk and pay the proceeds to Issuer SPV (the “Principal Amount”). Issuer SPV declares a trust over the proceeds (and any assets acquired using the proceeds - see paragraph 3 below) and thereby acts as Trustee on behalf of the Investors

3. Originator enters into an istisna arrangement with Trustee, pursuant to which Originator agrees to manufacture or construct certain assets (the “Assets”) and undertakes to deliver those Assets at a future date, and Trustee agrees to commission those Assets for delivery at such future date.

4. Trustee pays a price (typically by way of staged payments against certain milestones) to Originator as consideration for the Assets in an aggregate amount equal to the Principal Amount.

5. Trustee undertakes to lease the Assets to Originator under a forward lease arrangement (known as ijara mawsufah fi al-dimmah) for an overall term that reflects the maturity of the sukuk.

6. Originator (as Lessee) makes payments of: (i). Advance Rental prior to the delivery of the Assets; and(ii). Actual Rental following the delivery of the Assets, at regular intervals to Trustee (as Lessor) in amounts which are equal to the Periodic Distribution Amount payable under the sukuk at that time. These amounts may be calculated by reference to a fixed rate or variable rate (e.g. LIBOR or EIBOR) depending on the denomination of sukuk issued and subject to mutual agreement of the parties in advance.

7. Issuer SPV pays each Periodic Distribution Amount to the Investors using the Advance Rental or, as the case may be, the Actual Rental it has received from Originator.

8. Provided that delivery of the Assets has occurred, upon:(i). an event of default or at maturity (at the option of Trustee under the Purchase Undertaking); or(ii). the exercise of an optional call (if applicable to the sukuk) or the occurrence of a tax event (both at the option of Originator under the Sale Undertaking),Trustee will sell, and Originator will purchase, the Assets at the applicable Exercise Price, which will be equal to the Principal Amount plus any accrued but unpaid Periodic Distribution Amounts owing to the Investors. Any termination occurring prior to the delivery of the Assets will be dealt with under the istisna arrangement - with a refund and compensation amount (an “Istisna Termination Payment”) being requiredin order to leave Issuer SPV with a claim against Originator for an amount sufficient to cover the Dissolution Amount (taking into account that the Issuer SPV will also be required

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to refund Advance Rentals to the Originator (as Lessee) under the forward lease arrangement – see further below).

9. Payment of Exercise Price by Originator (as Obligor) or, if termination occurs prior to delivery of the Assets, payment of the Istisna Termination Payment by Originator (as Contractor).

10. Issuer SPV pays the Dissolution Amount to the Investors using the Exercise Price (or, if termination occurs prior to delivery of the Assets, the Istisna Termination Payment) it has received from Originator.

11. (-12)Trustee and Originator will enter into a service agency agreement whereby Trustee will appoint Originator as its Servicing Agent, on and from delivery of the Assets, to carry out certain of its obligations under the forward lease arrangement, namely the obligation to undertake any major maintenance, insurance (or takaful) and payment of taxes in connection with the Assets. To the extent that Originator (as Servicing Agent) claims any costs and expenses for performing these obligations (the “Servicing Costs”) the Actual Rental for the subsequent lease period under the forward lease arrangement will be increased by an equivalent amount (a “Supplemental Rental”). This Supplemental Rental due from Originator (as Lessee) will be set off against the obligation of Trustee to pay the Servicing Costs.

11.6.2. Key Features of the Underlying Structure

Set out below is a summary of the basic requirements that should be considered when using a combination of istisna and forward leasing as the underlying structure for the issuance of sukuk:

The price and specifications for the good or asset need to be specified at the outset; It is quite common for the purchaser to split the purchase price (paid in advance) into staged

payments that correspond to certain milestones that are agreed upfront with the contractor; Although it is not necessary to fix the time of delivery under the istisna, the purchaser may

elect to fix a maximum time for delivery - this essentially means that, if the contractor delays delivery after the scheduled completion date, the purchaser will not be bound to accept the goods and to pay the price;

Liquidated damages provisions may be included in order to incentivise the contractor to deliver on schedule (and to mitigate late delivery risk);

Although not universally accepted, the majority of Shari’a scholars consider forward leasing permissible on the understanding that: advance rentals are taken into account (as rental which has been paid) and have to be refunded in full if the assets are never actually delivered for leasing. Such matters have to be carefully addressed in the documentation in order to ensure that the commercial deal is not disturbed: for example, by careful calculation of any termination payments that are triggered if a termination occurs pre-delivery (i.e. it becomes necessary to ensure that the amount payable by the contractor upon termination of the istisna arrangement is sufficient to cover the Dissolution Amount); and

Following delivery of the asset(s), the basic requirements of an ijara discussed earlier in this Chapter 2 (Sukuk Structures) at Part 1: Sukuk al-Ijara in the section titled ‘Key Features of the

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Underlying Structure’ would otherwise apply. The above requirements are based on the principles set out in AAOIFI Shari’a Standard No. 11 (Istisna and Parallel Istisna) and other established principles relating to istisna.

11.6.3. Required DocumentationIn addition to the offering, trust and listing documentation (the requirements of which are discussed in more detail in Chapter 3 (Issuing Sukuk from the DIFC) and Chapter 4 (Listing Sukuk on NASDAQ Dubai)), the following documentation is typically required for a sukuk al-istisna transaction:

Document Parties Summary/Purpose

Istisna Agreement

Originator (as Contractor) and Trustee (as Purchaser)

From Trustee›s (and the Investors›) perspective, this is the document that gives ownership of revenue generating assets (i.e. the Assets) at a future date.

From Originator’s perspective, this is the document under which it receives funding.

Certain termination rights are granted to Trustee such that, prior to delivery of the Assets, Trustee is able to claim a refund and compensation amount (by way of an Istisna Termination Payment) sufficient to cover the Dissolution Amount.

Forward Lease (Ijara Mawsufah fi al-Dimmah) Agreement

Trustee (as Lessor) and Originator (as Lessee)

This contains an undertaking to lease such that, following delivery of the Assets, Trustee leases the Assets to Originator in a manner that:

i. gives Originator possession and use of the Assets so that its principal business can continue without interruption; and

ii. through Actual Rentals it generates a debt based return for Trustee (and the Investors).

Prior to delivery of the Assets, Advance Rentals are paid by Originator in order to generate a debt-based return for Trustee (and the Investors).

Service Agency Agreement

Trustee (as Lessor / Principal) and Originator (as Servicing Agent)

On and from delivery of the Assets, this allows Trustee to pass responsibility for major maintenance, insurance (or takaful) and payment of taxes (i.e. an owner’s obligations) back to Originator. Any reimbursement amounts or service charges payable to Servicing Agent are set off against (i) a corresponding ‘supplementary rental’ under the Forward Lease or (ii) an additional amount which is added to the Exercise Price (payable

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Document Parties Summary/Purpose

under the Purchase Undertaking or the Sale Undertaking, as applicable).

Purchase Undertaking (Wa’d)

Granted by Originator (as Obligor) in favor of Trustee

Allows Trustee to sell the Assets back to Originator if an event of default occurs or at maturity, in return for which Originator is required to pay all outstanding amounts (through an Exercise Price) so that Trustee can pay the Investors. Applies only on and from delivery of the Assets.

Sale Undertaking (Wa’d)

Granted by Trustee in favor of Originator (as Obligor)

Allows Originator to buy the Assets back from Trustee in limited circumstances (e.g. the occurrence of a tax event), in return for which Originator is required to pay all outstanding amounts (through an Exercise Price) so that Trustee can pay the Investors. Applies only on and from delivery of the Assets.

The following structural refinements are possible in respect of the sukuk al-istisna structure described above:

If legal and/or registered title to a particular asset exists and (due to, by way of example, the prohibitive cost implications or tax implications of registering such a transfer of title) it is not possible to transfer that legal / registered title, it may be possible, depending on the asset type and the view taken by the relevant Shari’a scholars, to rely upon the concept of beneficial ownership in structuring a sukuk al-istisna transaction. The istisna agreement (in the structure discussed above) would document the transfer to the trustee of the beneficial ownership interest in the underlying asset – and such beneficial ownership interest would be sufficient to enable the trustee’s entry into the forward leasing arrangements contemplated in the example above; and

Some Shari’a scholars regard the istisna arrangement as one that has to be entered into strictly between the purchaser and the contractor – and that the contractor has to be the person who will actually construct or manufacture the asset. Adopting this approach, the Trustee would be required to have a relationship directly with the ultimate contractor / manufacturer and not the Originator. In order to avoid the difficulties of such an analysis, it is sometimes necessary to re-characterize the istisna arrangement as a procurement arrangement, whereby the Originator is obliged to procure the construction / manufacture and delivery of the underlying asset(s). The Originator thereby retains the direct contractual relationship with the ultimate contractor / manufacturer.

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11.6.4. Istisna Sukuk in PracticeTabreed’s five-year global corporate Sukuk (on behalf of the National Central Cooling Company, UAE) provided a fixed coupon of 5.50%. It is a combination of Ijara Istisna and Ijara Mawsufah fi al dhimmah (or forward leasing contracts). The issue was launched to raise funds to retire some existing debt, which totals around US$136 million, as well as to finance expansion.

The Durrat Sukuk will finance the reclamation and infrastructure for the initial stage of a broader US$ 1 billion world class residential and leisure destination known as 'Durrat Al Bahrain', currently the Kingdom of Bahrain's largest residential development project. The return on the Sukuk is 125 basis points over 3 months LIBOR payable quarterly, with the Sukuk having an overall tenor of 5 years and an option for early redemption. The proceeds of the issue (cash) will be used by the Issuer to finance the reclamation of the land and the development of Base Infrastructure through multiple project finance (Istisna) agreements. As the works carried out under each Istisna are completed by the Contractor and delivered to the Issuer, the Issuer will give notice to the Project Company under the Master Ijara Agreement and will lease such Base Infrastructure on the basis of a lease to own transaction.

11.7. HYBRID SUKUKConsidering the fact that Sukuk issuance and trading are important means of investment and taking into account the various demands of investors, a more diversified Sukuk - hybrid or mixed asset Sukuk - emerged in the market. In a hybrid Sukuk, the underlying pool of assets can comprise of Istisna, Murabaha receivables as well as Ijara. Having a portfolio of assets comprising of different classes allows for a greater mobilization of funds. However, as Murabaha and Istisna contracts cannot be traded on secondary markets as securitised instruments at least 51 percent of the pool in a hybrid Sukuk must comprise of Sukuk tradable in the market such as an Ijara Sukuk. Due to the fact the Murabaha and Istisna receivables are part of the pool, the return on these certificates can only be a pre-determined fixed rate of return.

11.7.1. Steps involved in the structure: Islamic finance originator transfers tangible assets as well as Murabaha deals to the SPV. SPV issues certificates of participation to the Sukuk holders and receive funds. The funds are

used by the Islamic finance originator. Islamic finance originator purchase these assets from the SPV over an agreed period of time. Investors receive fixed payment of return on the assets.

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11.7.2. Hybrid Sukuk in practiceIslamic Development Bank issued the first hybrid Sukuk of assets comprising 65.8% Sukuk al-Ijara, 30.73% of Murabaha receivables and 3.4% Sukuk al-Istisna. This issuance required the IDB’s guarantee in order to secure a rating and international marketability. The $ 400 million Islamic Sukuk was issued by Solidarity Trust Services Limited (STSL), a special purpose company incorporated in Jersey Channel Islands. The Islamic Corporation for the Development of Private Sector (ICD) played an intermediary role by purchasing the asset from IDB and selling it to The Solidarity Trust Services Limited (STSL) at the consolidated net asset value.

12. SUKUK PRACTICE AT KUVEYT TÜRK

12.1. Kuveyt Turk completes highest sukuk issue in TL (09.10.2014)Kuveyt Turk has performed the issue of Sukuk (rent certificate) denominated in TL with the highest amount ever sold in a single transaction to domestic investor using together the financial leasing assets, Treasury rent certificate and commodity murabaha contained in its portfolio.Kuveyt Turk has performed the Sukuk issue with the highest amount ever sold to the qualified domestic investor. As part of the sukuk issue that has taken place at a time when markets are

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highly fluctuating, Kuveyt Turk raised resources at a competitive cost and further strengthened its strong position in Sukuk market achieving a yield rate of 9,16 percent p.a. for its 91-day issue and 9,95 percent p.a. in its 175-day issue.

Enjoying remarkable demand from portfolio management companies, investment companies and mutual funds as well as qualified individual clients, Kuveyt Turk has sold 150 million TL sukuk exercising its additional sales right as part of the deal.

Kuveyt Türk’s Geo Mr. Ufuk UYAN was quoted as saying as regards the high demand received for Sukuk issuance: “We have led the way successfully believing that pioneering is only possible with innovation. We have performed that issue through a structure used for the first time in the domestic market. Accordingly, we have performed a rent certificate issue denominated in Turkish Lira, using together the financial leasing assets, Treasury Rent Certificate and commodity murabaha for the first time. Investors have once again displayed their confidence toward Kuveyt Türk and their appetite for taking the risk of Kuveyt Türk for any maturities. We will contribute to the development of the participation banking aiming at more and more successful domestic and international Sukuk issues at each time.”

Commenting on the issues performed by Turkish banking sector, Dr. R. Ahmet ALBAYRAK, the Deputy Managing Director in charge of Corporate & Investment & International Banking and Treasury said “As we compare our issue to the developments in the sector, it is evident that our deal with a maturity of 175 days has been carried out with an additional yield of 61 points over the indicative rates while our deal of 91 days remains even below the indicative rates. Our sukuk deal has been widely attracted by qualified domestic investors and promised growth for future issues. Kuveyt Turk will continue its rent certificate issues during the forthcoming periods as part of its issue ceiling of 1 billion TL.”

12.2. Kuveyt Türk’s US Dollar Sukuk Issuance Receives High Demand (26.06.2014)Kuveyt Türk Participation Bank has issued a five-year benchmark Sukuk of $500 million.Kuveyt Türk, the largest participation bank in Turkey in terms of total assets, has today announced the issuance of a five-year USD denomination Reg S Sukuk. The total amount of the issuance was $500 million with a return rate of 5.162 percent while total demand rose over six-fold due to high investor interest despite the competitive pricing. The issuance drew great interest from international investors in Europe and Asia as well as the Middle East, receiving orders from over 170 accounts, a clear indication of Kuveyt Türk’s well-diversified investor base. The closing of the order books provided for a 45% allocation to Middle East investors and 55% to other international investors comprising 20% UK, 17% Asia, 12% Switzerland, 5% Europe and 1% other international accounts.

Commenting on the transaction, Mr. Ufuk UYAN, the CEO of Kuveyt Türk, said “We are extremely pleased with the level and wide geographical diversity of demand for Kuveyt Türk’s third international issuance of Sukuk certificates. The certificates are likely to be more liquid as compared to those issued previously and set a new benchmark for Sukuk offerings out of Turkey. As with prior issuances, international investors have reiterated their confidence and medium to long term risk appetite in Kuveyt Türk and Turkey. The continued support and development of the

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participation banking sector in Turkey has been instrumental in making such international Sukuk issuances a great success.”

Emphasizing the importance of Sukuk instruments for the further development of longer term funding alternatives in the Turkish participation banking sector, Dr. R. Ahmet ALBAYRAK, Executive Vice President of International & Corporate Banking, stated that “The issuance is very much in line with our growth objectives in the medium to long term funding space for quality corporates and project finance in Turkey. The solution based structuring approach by our Corporate & Investment Banking Divisions has gained much traction among Kuveyt Türk’s existing and new corporate customers. More regular issuances of Sukuk in the future will certainly complement this growth. ” Mr. ALBAYRAK further noted that the appointment of Kuwait Finance House Investment Company as the Sole Global Coordinator for the issuance provided the transaction with international strategic oversight as well as ensuring a smooth and timely execution.

Kuwait Türk had appointed Citigroup, Emirates NBD Capital, HSBC, Kuwait Finance House Investment Co. and Standard Chartered Bank as Joint Lead Managers / Book Runners; ADIB, DIB & QNB Capital LLC as the Joint Lead Managers; and Commercial Bank International PSC, QInvest LLC as Co-Managers.

12.3. Long-term rising ratings of Kuveyt Turk promotes the development of capital market instruments such as SUKUK (27.12.2010)

The local currency long-term rating at an internationally investible level of Kuveyt Turk Participation Bank has been raised by the international rating institution, FitchRatings. According to the new regulation, the long-term rating in TL of Kuveyt Turk has been raised from “BBB-“ to “BBB” and announced to be positive in outlook.

On the other hand, Kuveyt Turk’s foreign currency long-term rating has been reaffirmed as “BBB-“ and outlook has been revised from stable to positive by Fitch. The CEO of Kuveyt Turk Participation Bank, Ufuk Uyan, stated that the increase in ratings by FitchRatings was both of high importance in terms of creating long-term resources and transferring resources to the financing of investments and positive in terms of the development of affordable and long-term capital market instruments such as SUKUK.

Referring to the latest tax regulations in bank bonds by the Ministry of Finance, Uyan reminded that they expected the withholding costs applied on bond-like capital market instruments of Participation Banks to be reduced and long-term indexed tax reductions on such products to enter into force.

12.4. Kuveyt Turk issues the first SUKUK of Turkey-(23.08.2010)

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Upon this issuance for which LMH (Liquidity Management House) and Citibank act as joint lead regulators, Kuveyt Turk has introduced to Turkey this financial product which has a wide range of application especially in the Gulf region and Malaysia. The demand from a wide geography for the first SUKUK of Turkey was 1, 5 fold of the amount of issuance. On the prompting of the issuance, which was 5.25% of the final return, an Iftar dinner was held yesterday evening at Les Ottomans Hotel with the participation of the Turkish Minister of Finance, Mehmet Şimşek. Speaking at the dinner, Chairman of Kuveyt Turk, Mohammed Al-Omar, emphasized that the interest in SUKUK as a method recently adopted by many governments, financial institutions and companies from Europe to the Far East to secure funds from international markets had risen rapidly all over the world in the last ten years. A total of $120 billion SUKUKs were issued throughout the world in the last ten years. Expressing that the total amount of SUKUKs issued globally had reached $120 billion in the last ten years and reminding that the issuance of SUKUKs had been on Turkey’s agenda for a long time, Mr. Al-Omar noted Turkey had not gotten a share until that day from that market having a volume of more than one hundred billion dollars. “We hope that this issuance encourages issuance by other financial institutions and corporations. In this respect, we shall have brought a new financial product in the Turkish economy with all its benefits and advantages. This issuance should be considered a highly significant development for international investors looking to invest in interest-free products. If this product becomes widespread, funds from global markets shall flow into Turkey, as the Gulf region takes the lead” said Al-Omar. Underlining the fact that SUKUK was a key instrument to meet Turkey’s need for long-term financial resources, CEO of Kuveyt Turk, Ufuk Uyan, said “With this first step, we aim at making new issuances follow the on-going issuance of $100 million. As Kuveyt Turk, our objective is to play a leading role in generalizing this financial instrument.” Announcing that the bond would be traded at the London Stock Exchange, Uyan said that they not only had rapidly increased the number of service channels in Turkey but also had brought different initiatives in foreign markets. He noted that they continued to develop many new products in a wide spectrum from retail banking, project finance, and investment banking to Treasury instruments and added “In line with our vision for the future, our aim is to sustain our innovative approach and provide our customers with new products and services in interest-free banking.”

12.5. Kuveyt Türk’s Sukuk Deal in Malaysia (08.04.2015)Having pioneered the introduction of sukuk to the Turkish capital markets, Kuveyt Türk has maintained its leading role in interest-free capital markets with its lease certificate (sukuk) issue in Malaysia. Establishing a 2 billion Ringgit sukuk program in Malaysia, Kuveyt Türk has opened a new window into the sector by realizing the first tranche issuance of sukuk under the program on 31 March 2015.

Completed in the amount of 300 million Ringgit Malaysia with a tenure of 5 years, the sukuk deal has been marked as the lowest-cost Ringgit sukuk deal ever realized by a Turkish company.  The deal is also the first asset-based sukuk traded in the secondary markets on an interest-free basis as realized in Malaysia by a Turkish issuer. With the completion of this sukuk transaction, the Bank has optimized its funding costs, extended its investor base and diversified its sources in the capital markets. 

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The issuance, globally coordinated by KFH Investment and managed by CIMB Investment Bank Berhad, Kuwait Finance House (Malaysia) Berhad and Maybank Investment Bank Berhad, provides an annual yield of 5,8 percent for its investors with a maturity date of 31 March 2020. Kuveyt Türk has reduced its funding costs in USD for the five year issuance to 4,4% annually by swapping the funds raised in Ringgit Malaysia to US Dollars as of the date of issue. It is planned to allocate the funds raised under the program with favorable conditions and costs in financing the long term requirements of its corporate, commercial and SME clients as well as in the financing of foreign trade and financial leasing transactions.

In addition to numerous domestic sukuk issuances, Kuveyt Türk has already completed several international sukuk issuances including a three year USD 100 million in 2010 and further five year issuances of USD 350 million in 2011 and USD 500 million in 2014.

13. REFERENCES

Quran (The holy book). Al-Ashker, A.F.A., Wilson R., Islamic Economics: A Short History, Hotei Publishing, Leiden 2006.

Alqaradawi, Y., The Role of Values and Ethics in Islamic Economics, Wahiba Library Editions, Cairo 1995.

Chapra, M.U., What is Islamic Economics?, Islamic research and training institute, 2 nd edition, Jeddah, Saudi Arabia, 2001.

Choudhury M.A., The Humanomic Structure of Islamic Economic Theory: A Critical Review of Literature in Normative and Positive Economics, “Islamic Economics” 1990, vol. 2, pp. 47-65.

Islamic Financial Services Board, Islamic Financial Services Industry, Stability Report 2013, http://www.ifsb.org/docs/IFSB%20-%20IFSI%20Stability%20Report%20 2013%20(Final).pdf.

Nasution M.E., Islamic Spirit and Morale in Economics, “Journal of International Development and Cooperation”, vol. 15, No. 1-2, 2009, pp. 113-124.

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Nienhaus V., Islamic economics: Dogma or science [in:] The Islamic World and the West, ed. Kay Hafez, translated by M.A. Kenny, Leiden 2000.

Sergie M.A., The Rise of Islamic Finance, http://www.cfr.org/economics/rise-islamicfinance/p32305?cid=rss-fullfeed-the_rise_of_islamic_finance-013014.

Tlemsani I., R. Matthews, Ethical Banking: the Islamic View, www.nzibo.com/riba/ethi cal%20banking.pdf.

Zaman S.M.H., Definition of Islamic Economics, “Journal of Research in Islamic Economics” 1984, vol. 1, No. 2, pp. 49-50.

Zaman A., Islamic Economics: A Survey of Literature, MPRA Paper No. 11024, posted 11th October 2008

Arif, M. (2007), “Islamic Banking: A Variation of Conventional Bank”. Monash Business Review, 3 (1), 1-8.

KPMG, (2006), Growth and Diversification in Islamic Finance: KPMG Advisory Financial Services Edition.

http://www.kuveytturk.com.tr/news4.aspx

http://www.ekovizyon.com/haber/kuveyt-turks-sukuk-deal-in-malaysia-11494.html

http://www.global-islamic-finance.com/search/label/Hybrid%20sukuk#ixzz3WHFolZuT

https://www.difc.ae/sites/default/files/attached/5712/6707/6429/islamic.pdf

http://kantakji.com/media/7719/f114.pdf

http://www.sukuk.com/wp-content/uploads/2014/03/Sukuk-Structures.pdf

[http://www.internationalconference.com.my/proceeding/icber2012_proceeding/212_201_3rdICBER2012_Proceeding_PG3107_3120.pdf]

http://drazman.net/wp-content/uploads/2013/03/Sukuk-Structuring-Dr-Azman-Paris-280511.pdf

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