Islamic Economics & Finance

Sukuk is the Arabic name for a financial certificate but can be seen as an Islamic equivalent of bond. However, fixed income, interest bearing bonds are not permissible in Islam, hence Sukuk are securities that comply with the Islamic law and its investment principles, which prohibits the charging, or paying of interest.

The Need for Tangible Assets

Shari’ah requires that financing should only be raised for trading in, or construction of, specific and identifiable assets. Trading in ‘indebtedness’ is prohibited and so the issuance of conventional bonds would not be compliant. Thus all Sukuk returns and cashflows will be linked to assets purchased or those generated from an asset once constructed and not simply be income that is interest based. For borrowers to raise compliant financing they will need to utilise assets in the structure (which could be equity in a ‘tangible’ company). It’s worth noting that Equity financing is Shari’ah compliant and fits well with the risk/return precepts of Islam.

The Problem with Interest or ‘Riba’

As Shari’ah considers money to be a measuring tool for value and not an ‘asset’ in itself, it requires that one should not be able to receive income from money (or anything that has the genus of money) alone. This generation of money from money (simplistically interest) is ‘Riba’, and is forbidden. The implications for Islamic financial institutions is that the trading/selling of debts, receivables (for anything other than par), conventional loan lending and credit cards are not permissible.

The Problem of Uncertainty or ‘Gharar’

This principle is widely understood to mean uncertainty in the contractual terms and/or the uncertainty in the existence of an underlying asset in a contract and this causes issues for Islamic scholars when considering the application of derivatives. Shari’ah also incorporates the concept of ‘Maslahah’ or ‘Public benefit’, denoting that, if something is overwhelmingly in the public good, it may yet be transacted – and so hedging or mitigation of avoidable business risks, may fall into this category but there is still much discussion yet to come.

Controversy

Sukuks are widely regarded as controversial due to their perceived purpose of evading the restrictions on Riba. Conservative scholars do not believe that this is effective, citing the fact that a Sukuk effectively requires payment for the time-value of money. This can be regarded as the fundamental test of interest.

Summary

With its Arabic terminology and unusual prohibitions, Sukuk financing can be quite mystifying for the outsider. A good analogy is one of ethical or ‘Green’ investing. Here the universe of investable securities is limited by certain criteria based on moral and ethical considerations. Islamic Finance is also a subset of the global market and there is nothing that prevents the ‘conventional’ investor from participating in the Islamic market.

Further reading:

Managing Financial Risks of Sukuk Structures

Explanation of the mechanics behind a Sukuk