A new proposed standard for sukuk issuance could transform the market into one akin to securitization rather than unsecured bonds, creating problems for all those issuing, structuring and buying the Islamic finance instrument, according to market participants.
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is considering market feedback on ‘Standard 62’, a new set of guidelines that alters the fundamental structure of sukuk.
AAOIFI is an Islamic non-profit organisation based in Bahrain that prepares accounting, auditing, governance, ethical and Sharia standards for Islamic financial institutions and the wider Islamic finance industry.
The sukuk market acts like the bond market. Regular fixed income investors can buy the notes, and those who structure and sell sukuk for issuers are largely the same people who handle issuers’ conventional bonds. But Standard 62 would change this.
“The key requirement of the new standard is that the ownership and risk of the assets would be transferred to the sukuk holders, and that is different to how it functions today,” said Mohamed Damak, global head of Islamic finance at S&P in Dubai.
The head of investment banking at an Islamic bank in the Middle East said the new proposal was “a bit of a dampener when you’re trying to attract people to Islamic finance”.
The sukuk market has grown exponentially since the first sukuk was issued nearly 25 years ago. In 2010, just $11bn of sukuk was issued. In 2014, this rose to $41bn of new public sukuk. This year $66bn has been issued, according to Dealogic. That is already level with any previous full year, setting up 2024 to be a record for Islamic issuance.
The first ever public sukuk in dollars was in 2006, from UAE district cooling company Tabreed. Today sukuk issuance is widespread and does not just come from Islamic countries: governments, banks and companies all issue to Islamic investors — last week, US-Irish aircraft leasing company AerCap launched a sukuk.
“Standard 62 appears to be advocating securitization, as that asset performance risk is Shariah-compliant,” said Debashis Dey, a partner at law firm White & Case in Dubai, one of the leading legal advisers on sukuk issuance.
“What people are thinking about Standard 62 is how the guidelines will be interpreted,” he continued. “Are we genuinely going to do asset-based securitization, as that would be a pretty profound change? The complexity is in the detail of how things are interpreted, as these will be guidelines. How it is interpreted is unknown.”
AAOIFI had not responded to a request for comment from GlobalMarkets at the time of publication.
Sukuk sea change
One of Standard 62’s most important changes is the introduction of loss sharing.
Sukuk use profit sharing structures, as the interest payments a conventional bond makes to investors are not permitted under Shariah.
An issuer puts assets into a special purpose vehicle (SPV) which issues the sukuk, and then the issuer acts as an obligor for the SPV. In lieu of a coupon, investors receive a share of the profits generated by the assets, the rate of which the issuer and investors have agreed on. But while sukuk investors share in the profits from the assets, they do not share in any losses.
Standard 62 proposes to end that.
“Investors may be exposed to asset-related risk, such as destruction, nationalisation and the loss of market value,” said Damak. “And for sovereigns there could be some risk, in that sukuk might become akin to privatisation of assets.”
The principles of Islamic finance dictate that for an instrument to be tradeable an investor needs to take some ownership in the risk and the reward of tangible assets, said Dey. If those assets suffer a lack of performance, investors have to share in that too.
“That is what Islamic principles say a sukuk should be,” said Dey. “But current structures mitigate that asset performance risk through the structuring, because the investment industry wants the risk profile to be similar to a senior unsecured instrument, not an asset-backed instrument.”
Islamic scholars have said current sukuk structures form “a halfway point” between what is Shariah-compliant and what is not, added Dey.
“What they [scholars] meant by that was an instrument that is asset-based but has the performance and risk profile of a senior unsecured fixed income instrument,” Dey said. “You can say that a sukuk is pari passu with a senior unsecured bond, and under Standard 62 guidance that is not satisfactory.”
Standard 62 is just one of many guidelines AAOIFI has handed down since the first sukuk was issued in 2001.
“Standard 62 is the ultimate destination, where investors will have to take on all of the risk related to the assets,” said Damak.
Securitization
If sukuk investors were forced to take on full profit and loss sharing positions, sukuk would move from an instrument resembling unsecured fixed income to one closer to securitization.
That is a profound change, particularly in regions where securitization activity is very low, if not non-existent, such as the Middle East.
“Were it to become an asset-backed instrument, you would be starting a market tomorrow for sukuk that did not exist yesterday,” said Dey.
It is not just Islamic banks that buy sukuk. Conventional emerging market bond funds can buy them, and they may not want to buy sukuk if they are no longer traditional fixed income instruments.
Bank desks in the Middle East have little experience in arranging standard securitization instruments, let alone with the added complexities of Islamic finance and ensuring instruments are Shariah-compliant.
“There is no meaningful securitization in the bond market in areas where sukuk is active,” said Bashar Al Natoor, head of Islamic finance at Fitch in Dubai. “There just is not the regulation, the law or the frameworks to allow for securitization. And even in countries which do have that, it is untested. And that is just with bonds, let alone sukuk.”
Asset-based funding is a fundamentally different way of funding from conventional bonds.
“Think of the education required by rating agencies, bank trading desks, risk assessors and investors,” said Dey. “It would require a ramp-up of legislation, or exemptions.”
Higher costs
Under Standard 62’s new asset-backed structure, investors would take on more risk than they have in the past.
“Current sukuk investors don’t want the assets, what they want is a senior unsecured risk position,” said Damak.
One sukuk fund manager in the United Arab Emirates said the proposed Standard 62 was “more of an irritant rather than an incentive”.
“We have seen investors sell sukuk, temporarily and permanently, because of previous standards, because they thought they’d be exposed to risk they did not want,” said Damak.
One of the biggest attractions of sukuk for issuers is they are cheaper to issue than conventional bonds. An investment grade issuer in the Middle East, for example, can save 10bp-15bp, but the savings for a speculative grade borrower can be much bigger.
If sukuk investors have to take on losses, they will ask for more return from issuers — potentially erasing sukuk’s price benefit or even making them more expensive than conventional bonds.
“Investors buy the sukuk based on the issuer’s credit risk,” said the sukuk fund manager. “That is how it is priced, not on the performance of the assets in the sukuk.”
That would change under an asset-backed structure.
Aside from the increase in cost, Standard 62 presents other unwelcome headaches for issuers.
Sovereigns, for example, would need to hand assets to investors, which could be politically unpalatable or even impossible.
“Under the strictest interpretation of Standard 62, sovereigns would not be able to do a sukuk without an exemption,” said Dey. “They can never dispose of assets: it would never happen practically.”
For banks, hiving off assets from their balance sheets would be unwelcome.
“Can a regulated bank sell assets worth billions without affecting their balance sheet positions?” said Dey. “You cannot cherry-pick your best assets and get rid of them when doing an asset-backed sukuk, without regulatory oversight.”
Bank regulators typically do not like banks to choose good assets to securitize — known as cherry-picking — because that would tend to lower the quality of the assets kept on balance sheet.
Murky future
Sukuk market participants now face uncertainty over when, and in what form, AAOIFI’s new guidelines will arrive.
AAOIFI stopped accepting comments on Standard 62 at the end of July, after extending the deadline a few times. The earliest any proposals will come through is 2025 and they may well not appear until 2026, Damak said. The market would also be given a year or two to adjust.
The good news is that a mass default, should all existing sukuk be declared non-compliant with Shariah, is unlikely.
In 2017, Sharjah-based natural gas company Dana Gas said a $700m sukuk it had issued was no longer Shariah-compliant and therefore unlawful in the UAE, and that it would not repay it at maturity. It offered shareholders the chance to swap the sukuk for a new Shariah-compliant instrument. At the time, Moody’s said the new instrument’s rates were inferior to those of the original sukuk.
The case ended up in His Majesty’s High Court, which ruled that Dana Gas had to pay up. It ended up restructuring its sukuk with the consent of investors.
Since then, sukuk documentation has included enhanced warranties and waiver clauses to prevent obligors, such as Dana Gas, from challenging the enforceability of sukuk on Shariah grounds.
“If you want to change any terms you need the consent of the sukuk holders,” said Al Natoor. “We will see if they [investors] are happy to change the risk profile from the entity issuing the sukuk to the pool of assets. It’s unlikely they’ll accept it.”
Sukuk splitting
Fragmentation of the market is also a risk if some jurisdictions adopt AAOIFI’s proposals in full and others do not.
The UAE is a strong backer of AAOIFI, so an issuer must ensure its sukuk is AAOIFI-compliant if it wants a UAE bank to run the trade or UAE-based investors to buy it.
“Who will implement it?” said Al Natoor. “And will they do so to the full extent? Over 20 jurisdictions claim that they adopt AAOIFI Shariah standards, but adoption varies significantly between countries and entities. As for Standard 59, the UAE took the lead in implementing it, and a number of other jurisdictions followed.”
If Standard 62 is adopted as proposed, it could put sukuk issuance at risk. The market might also close down while participants adapt to the changes.
“We may see,” said Damak, “if the standard is adopted as proposed, a stopping in the sukuk market for a while as structurers work out a way to restore the fixed income characteristics, while complying with the new standard.”