How to set sukuk free

Demand for islamic sukuk has been strong in recent years. The boom in oil prices has delivered a cash windfall for Middle Eastern investors at a time when they are becoming more meticulous in applying religious principles to their investments. Since its birth in 2002, the sukuk market has grown remarkably. Standard & Poor's recently estimated that the global market is worth over $80 billion.

The sukuk market is expected to continue to grow, as more businesses seek to tap the liquid petrodollars and the demand for shariah -compliant products. From an investor's perspective, sukuk are emerging as a notable asset class. In addition, non-Muslims who already own conventional bonds may see the acquisition of sukuk as introducing a new asset class into their investment strategy, one that brings diversity to their portfolio. In the past, most sukuk issues have been oversubscribed, showing the high demand from investors. But even though the market is developing rapidly, it faces several impediments. Most of these are interlinked, and timely initiatives would overcome them.

Illiquid secondary markets

Even though sukuk are listed on stock exchanges in the Middle East, south-east Asia and Europe, the secondary market for sukuk remains illiquid because no diverse investor pool or developed regulatory framework exists. This makes the market less attractive to new investors. But market observers are optimistic, and predict that the situation could soon change. In London, a number of companies have recently opened Islamic banking and finance brokerage desks. In the Gulf Cooperation Council (GCC), Liquidity Management Centre, Sukuk Exchange Centre (Tadawul) and SHUAA Capital have taken initiatives to provide secondary liquidity. If these entities succeed in enhancing the liquidity of sukuk, others may follow suit. Such developments would aid the growth of the secondary market.

Critical mass

A further hindrance to the expansion of the sukuk market is the lack of sufficient primary issues. Although market growth has been large, the market is still in its early stages. Until recently, sukuk issuances did not constitute a critical mass, and a strong secondary market for sukuk did not emerge. Specialists estimate that this critical mass is about $400 billion worth of issuance, amounting to some 270 individual deals globally. As a result, sukuk have become buy-and-hold instruments: investors hold on to them until maturity.

Ratings

Another potential impediment to the growth of the sukuk market is that a large number are not rated by the major ratings agencies. When compared with a conventional debt structure, the sukuk structure is complex, and the rating process is expensive and time-consuming. Although sukuk have tangible assets at their core, they do not govern credit performance. The credit risk is tied solely to the general creditworthiness of the sukuk issuer. Ratings agencies treat sukuk in the same manner as they do conventional bonds, where the only material risk is the credit risk of the borrower. Hence, the sukuk receive the same ratings as conventional unsecured bonds issued by the same entity.

Lack of standardisation

The absence of a uniform and universally accepted code of shariah principles contributes to the low trading level in the sukuk market. It makes it difficult for investors to know which Islamic principles are applied to the sukuk they invest in and it increases the costs of sukuk issuance. The lack of standardisation has also led to some sukuk not being accepted in every jurisdiction because shariah boards in different jurisdictions may have different interpretations of what is shariah -compliant. As a result, investors may be reluctant to buy sukuk issued out of a foreign jurisdiction. This reluctance has contributed to the lack of international convergence of the sukuk market. The formation of the International Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), and the recent initiatives of the International Capital Market Association (ICMA) and the International Islamic Financial Market (IIFM) to develop and establish standardised practices for the sukuk industry, are steps in the right direction.

Regulation

The legal, regulatory and tax environments in different jurisdictions pose another challenge to the growth of the sukuk market. Uncertainty and ambiguity remain about shariah principles, the governing law of the jurisdictions where the sukuk are issued, and the laws chosen by the parties to govern the transaction documents (usually English law or New York law). Investors may have tax concerns, depending on whether the sukuk transaction is categorised as a loan, an equity investment or an asset sale. Legislators may ask questions about the characterisation of the income. And the potential withholding taxes further complicate the situation. The transfer of the underlying assets in a sukuk can trigger double taxation in many jurisdictions; and sukuk may not be placed in the same category as a conventional bond. Rental pre-payments relating to a sukuk structure are not tax deductible in many jurisdictions, in the way that conventional interest payments are.

The US

Issuance and demand for sukuk is burgeoning worldwide, but the US, the largest economy in the world, remains an exception. There has been only one sukuk issuance in the US so far and none since mid-2006. In the US, the Islamic finance market in general is still in its infancy and the sukuk market is virtually non-existent. Potential investors are plentiful. But a lack of awareness of shariah -compliant products and their availability, coupled with an absence of trained Islamic scholars and lawyers, preventing the development of the Islamic finance market. For sukuk to become a global phenomenon, it must permeate the US. Perhaps now is the perfect time - it could offer a solution to the recent US credit crunch.

By Neeta Thakur, associate in the New York office of Clifford Chance LLP