Islamic Securitisation & Bonds - The Challenges
There has been increasing interest in Islamic securitisation and Islamic capital markets generally. Many articles have been published on these topics, and they have been the topic of choice at finance conferences around the globe. One of the key rules of the Shariah (Islamic law) is the prohibition on charging interest (“Riba”) on money. Traditional capital market instruments such as bonds, commercial paper and medium-term notes have interest and principal as fundamental components.
At first glance this does not make capital markets and securitisation and Islamic law natural partners.
The Ijara Solution for Bond Issues
A reasonably well-established Islamic financing structure known as the “Ijara” (lease financing), which has been considered acceptable by Islamic scholars for other financing transactions, seems to overcome the problem of Riba for an Islamic bond issue. An Ijara-based structure utilises the income stream generated by the asset to produce a return to the lessor that is characterised as rent rather than interest by the Islamic scholars. The right to receive a rent by virtue of a beneficial interest in the asset underpins the Ijara Sukuk.
Using Ijara in a Capital Markets Context
A good example of successfully adopting the Ijara structure for a global capital market issue was the Malaysian government’s issue of Sukuk Trust Certificates (“Sukuk” is an Islamic finance term used to describe Islamic capital market instruments), in August 2002. In this instance, a special purpose company was incorporated in Labuan called Malaysian Global Sukuk Inc (MGS).
MGS issued Sukuk to investors. MGS used the funds raised from investors to purchase a number of parcels of land in and around Kuala Lumpur from another Malaysian state entity. MGS then leased those parcels of land to the Federation of Malaysia. On expiry of the term of the lease, the Malaysian government has agreed to purchase the parcels of land from MGS at the face value of the initial issue amount of the Sukuks. Pursuant to a declaration of trust, the land parcels are held by MGS in favour of the Sukuk holders. All returns made on the land parcels are conveyed to the Sukuk holders (including lease payments and the final repurchase proceeds to be paid by the Federation of Malaysia). The lease payments have the economic effect of coupons, and the repurchase proceeds paid at the end of the term that of the principal component of a bond. A simple diagram of the structure is shown on the opposite page.
Ijara Sukuks are freely tradable
As trading in debt above or below par will breach the Islamic finance principle of not charging interest, and the ability to trade freely in capital market instruments is critical to investors, there is a potential problem.
However, since Ijara Sukuks represent an interest in the underlying assets and not debts, they can be traded above or below par freely without breaching any Islamic principles. The Ijara Sukuk is by far the most popular structure in the market at the moment as it allows Islamic investors unrestricted trading.
The Ijara Sukuk does, however, suffer from some major commercial disadvantages for the issuer, namely finding an appropriate underlying asset; potential stamp duty and taxation costs associated with introducing the asset into the structure; having the underlying asset tied up for the term of the transaction and the costs associated with ongoing Shariah audits of the asset.
The above limitations could hinder a potential issuer from entering the market. Alternative structures are being contemplated based upon other well-known Islamic financing methods (such as Istisna, Musawama, Murabaha and Musharaka). The biggest challenge that these potential structures face is producing an instrument that can be traded freely in the secondary market without breaching the fundamental Islamic principle of not trading in debt above or below par. It is only a matter of time before a viable structure is developed that does not suffer from the commercial disadvantages of the Ijara Sukuk and is widely accepted by Islamic scholars and the Islamic and international bond markets.
Islamic Securitisations
The issues of concern mentioned above in relation to Islamic capital market instruments are also relevant when structuring Islamic securitisations. A securitisation in the traditional sense usually involves an orphan Special Purpose Vehicle (SPV) purchasing receivable debt obligations (Receivables) from a financial institution (the Originator) and issuing bonds secured over this pool of Receivables.
For an Islamic securitisation, obviously the bonds issued have to be structured as Sukuk that are not paying interest. However, before we discuss the capital market side of the structure, we have some fundamental challenges to deal with in transferring Receivables to an SPV in an Islamic context.
It is common in conventional securitisations to have some form of credit enhancement in the structure. One popular form of credit enhancement is the Originator selling the Receivables to the SPV at a discount.
As mentioned above, the trading of debt above or below par is prohibited. If the underlying Receivables are Islamic financings which have a debt component (such as Murabaha contracts) this will prevent the structure being appropriately “Islamic”. Some innovative solutions are currently being worked on to resolve this problem for Murabaha and similar debt-based products.
If the underlying Receivables, on the other hand, derive from Ijara financing and the underlying Ijara tangible assets are being transferred to the SPV, this problem is avoided as the SPV is not purchasing debt below par but tangible assets.
A key issue in any securitisation is achieving an appropriate rating, and the legal or equitable transfer of the ownership of the Receivables is a fundamental concern for Rating Agencies in rating securitisation transactions if the underlying bonds are to have a higher rating than the Originator’s rating. The Rating Agencies usually require a true sale legal opinion from relevant counsel. This can be an issue in those jurisdictions where the laws are subject to the Shariah. Counsel from these jurisdictions will understandably qualify their legal opinion as they are usually not Shariah scholars themselves, and this qualification is an issue for the Rating Agencies.
Under the laws of many Western jurisdictions, the Originator can sell the Receivables without having to notify its underlying customers that it has done so. The Originator remains the “face” to its customer during the term of the transaction. The position in relation to this is not always clear in some Muslim countries. Notifying underlying customers could make a true sale non-viable from a commercial perspective to some Originators.
Alternative asset transfer solutions have to be (and in fact are being) developed to solve this issue.
Assuming the Receivables are transferred to the SPV, the SPV will need to issue Sukuk which will represent an undivided beneficial ownership in some income generating asset of the SPV. Given the SPV is an orphan SPV set up for the purposes of the transaction, the main assets of the SPV will be the Receivables. If the underlying Receivables are Ijara financings along with their underlying assets, then issuing Sukuk will not be problematic as the Sukuk will represent an undivided beneficial ownership in tangible income-generating assets. The same principles applying to the Ijara Sukuk (discussed above) will be applicable, allowing the Sukuk to be freely tradable.
If, on the other hand, the Receivables are Islamic debt obligations (such as completed Murabaha contracts), then the Sukuks notionally represent an undivided beneficial ownership in debt obligations and may be Shariah non-compliant if traded above or below par.
Solutions to this issue are in the “pipeline”.
Conclusions
Despite the challenges facing Islamic securitisations and bonds, there seems to be a strong desire to come up with solutions that will open up these product areas and a number of leading investment banks (and law firms) are working hard to find Shariah-compliant solutions. Given investor appetite in the Gulf region and in the Far East for Halal investment opportunities and the need of many Islamic financial institutions to securitise their underlying financings, we believe that solutions will be rapidly developed that address these challenges, and these markets will prove fertile ground for all participants.
CHRISTIAN PARKER AND ABRADAT KAMALPOUR
NORTON ROSE
Entry Filed under: Alternative Investment, Islamic Finance