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Islamic Capital Markets: A Selective Introduction

Michael J T McMillen, Curtis, Mallet-Prevost, Colt & Mosle LLP

Michael J T McMillen, Curtis, Mallet-Prevost, Colt & Mosle LLP

In the third quarter of 2012, for the first time, sukuk issuances (US-dollar volume) exceeded bond issuances in the countries of the Gulf Cooperation Council (GCC). In 2012, total issuances globally were $143.4 billion, up 54 per cent from 2011; miniscule in comparison to total global bond issuances ($6 trillion to $8 trillion of issuances, plus massive rollovers and refinancings). However, the comparative issuance trend is notable as a harbinger of the future in the GCC and in the 53 countries of the Organisation for Islamic Cooperation (OIC). The sukukissuance figure is also a notable trend indicator, historically considered. Some examples: the first sukukissuance occurred in 2002–2003, some six or seven years after the inception of modern Islamic finance. The total cumulative issuance volume from industry inception to November 2008 was approximately $89 billion.Sukuk issuance is the fastest-growing component of the activities constituting “Islamic finance”. And Islamic finance may be the most rapidly growing component of finance, considered globally.

While interesting, that summary provides little information and raises more questions than answers. What aresukuk? How are they structured? How do they operate? Who is involved? What are the Islamic capital markets? Where do sukuk fall within Islamic finance (and what is that anyway)? This note attempts to provide a selective and rudimentary introduction to the Islamic capital markets.

Contextually, and from the practitioner’s vantage, it is important to note the following: Islamic finance is ethical finance. Its principles mirror those of other ethical funds and programmes (eg, Roman Catholic, Lutheran, Talmudic, secular, etc). Involvement with certain categories of activities are impermissible (eg, pornography, prostitution, weapons of mass destruction, alcohol and pork for human consumption, interest-based banking and finance, non-mutual insurance and certain others). Islamic finance is structured finance, in terms of risk and cash flow structuring (rather than derivatives). Islamic finance contractual structures (eg, leases, partnerships, sales agreements) are very similar – indeed, almost identical – to their conventional equivalents. Islamic finance, although somewhat different and based in religion, is not a realm of mystery. What’s more, it is encountered in every jurisdiction – and this will only increase.


Conceptually, modern Islamic finance is comprised of four areas of commercial and financial activity, each conducted in compliance with current interpretations of Islamic shariah. These are: banking; investments; finance, including capital markets; and takaful (insurance). Islamic finance is an outgrowth of the post-World War II devolution of the Islamic states from colonial powers after a long interregnum in which interest-based commerce and finance were dominant. Islamic banking began in the 1970s and developed erratically until the mid-to-late 1990s, when its focus expanded from deposit-side activities to include investment and finance activities. Investment and finance activities commenced in the mid-1990s and have grown continuously at an accelerated rate ever since. Takaful started in the early 1980s and has been slower to develop.

In each case, growth has been somewhat disorganised and sporadic – with the notable exception of Malaysia, which introduced organisational formalities (including laws) in the early 1980s.

The shariah is commonly considered to be Islamic law, but this is a woefully inaccurate characterisation. Theshariah is the path or guide by which a Muslim leads his or her life, in every facet, activity and detail of life. It is religion, ethics, morality and much more, including aspects that constitute “law”. The principles are embodied in the revealed sources: the Qur’an (Islam’s holy book); and the Sunna (practices, examples and decisions of the Prophet Mohammed). Principles are also discerned by other methods, most importantly (particularly in Sunni Islam) the consensus of the community of shariah scholars (ijma) and analogical deduction and reasoning (qiyas). The shariah is not a monolithic construct. There are multiple schools of Islamic jurisprudence: for example, the four main orthodox schools of Sunni Islam dominantly effect modern Islamic finance.

Interpretation of the shariah as applied in contemporary Islamic finance is performed by shariah scholars, most frequently sitting on shariah supervisory boards comprised of at least one scholar (commonly three). These scholars are retained by individual investors, banks, financial institutions, family offices, standard-setting organisations and other industry participants to provide advice and fatwas, or opinions, on commercial and financial transactions, activities and entities, including structures and documentation. Fatwas are rendered specifically to the retaining entity in respect of discrete and definable transactions and activities. Standard-setting organisations also have shariah boards that issue and approve advisory standards for the industry. Many such standards pertain to contracts and structural arrangements used in Islamic finance transactions and activities. An example of a prominent standard setting organisation is the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).


The Islamic capital markets are comprised of an equity side and a “debt” or finance side. The equity side commenced in 1998, after issuance of a fatwa by the shariah board of Dow Jones Islamic Market Indexes (DJIMI fatwa), which set forth parameters and principles for the screening of equities for shariah compliance and inclusion in Dow Jones indices. In so doing, it also institutionalised certain principles allowing for “permissible variances” from (or “permissible impurities” regarding) strict interpretations of relevant shariahprinciples; and methods of “cleansing” or “purifying” impurities. For example, until issuance of the DJIMI fatwa, a strictly observant Muslim could not purchase non-controlling positions in equity securities because virtually every business entity either paid or received interest, both of which are forbidden under current shariahinterpretations. The balance-sheet ratio tests set forth in the DJIMI fatwa allow investments in permissible equity securities if certain ratios are satisfied. The ratios relate to debt to market capitalisation; cash and marketable securities to market capitalisation; and accounts receivable to market capitalisation. No ratio can exceed 33 per cent. Cleansing is obtained by donating any interest income to charity. The “conglomerate” issue (an entity that directly or indirectly conducts impermissible or haram business activities) was also addressed: investments are impermissible if such activities constitute “core” activities of the entity.

The DJIMI fatwa may be the most influential fatwa issued in the history of modern Islamic finance and is one of seven critical factors enabling the growth of modern Islamic finance (a grouping that also includes sukuk and the bifurcated lease structures discussed below). The permissible variance, cleansing and core business activities principles set forth in the DJIMI fatwa have been applied in a broad range of contexts and have been instrumental in allowing Islamic finance to exist, and thrive, in Western markets and in transactions involving Western interest-based participants. Thus, for example, application of the “core business activities” principles may allow, as permissible tenants in buildings owned by shariah-compliant investors, automatic teller machines owned and operated by interest-based banks; supermarkets that sell pork and alcohol; and back office operations of interest-based banks, among others. Permissible leases to these tenants may include nonconforming provisions relating to default interest, non-takaful insurance, and non-compliant structural maintenance. “Single Islamic tranche” project financings may be incorporated in structures that also include conventional interest-based debt. And “bifurcated lease structures” that utilise structurally isolated interest-based debt are almost standard throughout the world.

Sukuk are the most important and most rapidly expanding component of the finance side of the Islamic capital markets. Sukuk are not “bonds”, despite their persistent characterisation as such by the press. They are either asset securitisations or whole business securitisations, in each case akin to their conventional counterparts in that they are structured with asset isolation and servicing of the securitisation instrument (thesukuk) from cash flows from those assets. They resemble pass-through certificates of the early 1980s: fractional undivided ownership interests, albeit with cash flow restructuring. They must be structured around tangible assets, usufructs or services. Under the relevant AAOIFI shariah standard, which is widely followed in the industry, there are 14 categories of permissible sukuk. Five involve lease arrangements. These pertain to existing or to be acquired tangible assets or leasehold estates and presales of services. One relates to construction funding; another to the production or provision of commodities or goods at a future date (a forward-sale contact). One relates to acquisition funding of goods for future sale (a murabaha contract), although this structure has been stretched to almost any type of financing and debt generation. Two relate to capital participation in a project or business (mudaraba, or service-capital partnership, and musharaka). One relates to asset management (wakala or agency) and three relate to land and agricultural activities.

Malaysia has consistently been the global sukuk issuance leader, with 69–77 per cent of global issuances. In recent years, it has been followed by Saudi Arabia, Qatar and the United Arab Emirates, which is reflective of their infrastructure development programmes. Bahrain’s central bank is a consistent issuer of sukuk that function as short-term commercial paper equivalents. Domestic offerings constitute a huge portion (91 per cent) of all issuances, which is indicative of extensive risk concentrations due to, and loan-substitute nature of, purchases by domestic banks and financial institutions. Viewed historically, lease-based sukuk are the most common structures. However, since the onset of the 2007 financial crisis, the use of murabaha-based sukukhas increased dramatically. A murabaha is a cost-plus sale, and murabaha-based sukuk frequently make use of metals or palm oil murabaha transactions in which the commodities serve solely as a vector for debt generation. Musharaka (partnership or joint venture) structures experienced a high point just before the financial crisis, and were the subject of stringent criticism by shariah scholars because they were structured to be, essentially, bonds rather than profit-and-loss-sharing instruments. Government issuances dominate, at approximately 65 per cent of all issuances. Government-owned corporate issuances comprise the great bulk of the remaining issuances. True asset securitisations are rare. Malaysia is the exception: private corporate issuances constitute notably larger percentages. Apart from infrastructure-related issuances, the primary categories of issuances are in the financial services and real estate sectors. However, that pattern varies over time, economic cycle and region.

As the trend data illustrates, sukuk issuances will continue to dominate the Islamic capital markets, and the issuance rate will accelerate, even if governments, quasi-governmental entities and government-owned corporates remain the primary issuers. The explosion in sukuk issuance will occur if private entities can access the domestic and international capital markets. The undertaking to achieve that result is daunting. It will entail significant legal, regulatory, tax, administrative and financial reform in OIC jurisdictions. Examples of concepts, regimes and constructs that will need to be developed and implemented are, among many others:

• true sale concepts;

• insolvency and bankruptcy regimes;

• legal, regulatory, financial, administrative and substantive law constructs and regimes that recognise the distinctive elements of securitisation;

• corporate governance principles;

• lien laws and recordation systems, particularly regarding perfection and prioritisation;

• regimes for issuance and publication of judicial opinions;

• regimes that infuse stare decisis concepts into legal systems;

• trust concepts, even in jurisdictions based upon civil law;

• concepts that clarify the definition and role of the shariah in each jurisdiction; and

• regimes that implement and strengthen the elements and clarify the role of the rule of law.

There is evidence that, directly and indirectly, Islamic finance – and particularly the growing reach and power of the Islamic capital markets – may provide the necessary impetus to effectuation of some of the necessary reforms in OIC jurisdictions, even where similar reforms based upon secular efforts have stalled or been rejected or deferred. Consider the adoption of trust concepts in Bahrain and a mortgage and lien recordation regime in Saudi Arabia.

Hopefully, the eminent practitioners listed in this volume will undertake to contribute to this reform programme, whether in self-interest or a broader commitment to global legal reform. In any such case, the benefits to the entirety of commerce and finance, the global community, global understanding and tolerance, self-knowledge and awareness, and individual legal practices will be profound.

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