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Sukuk Securities, Their Definitions, Classification and Pricing Issues

Islamic securities are specially tailored financial products that conform to a given set of legal-common- law-based (shari’ah) financial transaction principles, which are deemed strictly applied when designing financial contracting terms covering such products. These principles are quite different from those used in the design of conventional securities. The principles guiding the design of these securities evolved over some two and a half centuries without reference to such doctrine-based principles as are applied in designing Islamic financial products in historical times. From the time fractional reserve banking established a strong acceptance by regulators around 1800 ad some four decades after the Papal edict made interest rate-based lending permissible by the Roman Church, the lion’s share of production lending that existed for millennia on profit-sharing slowly gave way to a one-way contract where the profits and risk of a production loan became divorced. The entrepreneurs had to take the full risk of a venture, not the lender. This is not the case for the production of Islamic financial securities. The products thus designed under the Islamic label are found in publicly-traded bills, shares, debt-like sukuk and derivative markets or as privately-traded in financial institutions. Broadly defined, Islamic financial products could be classified into four types: (i) musharaka securities with ownership and control in the entire firm’s assets via share ownership, which makes this class very closely similar to common share securities with claims to profits only if profits are earned after sharing in the risk of the project being funded; (ii) sukuk securities, which are mostly finite-period debt or funding arrangement contracts mostly without managerial control of the project funded but with unique fractional ownership of a set of income-producing assets of a borrower set aside by the borrower as asset-backed or asset-based in a Special Purpose Company (SPC) owned by fund providers, whose pay-off is based on profit sharing from the assets of the SPC; (iii) a takaful contract, which is a risk transfer arrangement, an insurance contract with provisions that such insurance premiums as are collected from the insured party are to be invested only in approved (permissible by shari’ah) securities passing Islamic finance regulations; (iv) Islamic mutual funds, which are investment funds managed by managers on behalf of clients for a fee and recovery of costs incurred in management of portfolios, with provisions for return of profits after management costs. Among these four, takaful is an insurance transaction, but it uses mutual insurance principles, so excess profits are distributed at regular intervals to members based on a pre-agreed profit ratio. This simple four-category division of Islamic financial products may resemble similar respective conventional security classes, namely shares, bonds, insurance and mutual funds. But there are significant differences in terms of structuring Islamic financial products, in the mode of pricing them, and in collateralization as well as what form of economic production activities may have access to funds under Islamic finance. For example, pricing of Islamic securities is done via profit-sharing contracting, whereas conventional securities are priced by interest-based payments, usually pre-agreed, to investors or as dividend-based payments to shareholders. Some may have even special features, say, a strange form of diminishing principal cum profit payments called the ‘diminishing musharaka’. These and other characteristics make Islamic financial instruments very different from conventional instruments, and the appearance of similarity is somewhat exaggerated by critics not knowing the important structural differences meant to safeguard both borrowers and the lenders and to ensure ethics and doctrine-based funding arrangements. Since Islamic securities, once issued as public-traded instruments, are also traded in financial markets, we have to also include (v) Islamic capital markets as an area of research in Islamic finance. To this, one may add (vi) private equity or private sukuk or private takaful or mutual funds as a separate group of securities if such securities are not traded in public markets, so we may call them non-traded private Islamic securities. Thus, this is a simple and broad brush six category division of Islamic financial transaction modes which precedes our discussion in this chapter on only one of them, the sukuk. We proceed with this main task of this chapter by examining the sukuk securities as a class by itself. The rest of the chapter is organized as follows. Section 2.2 provides a simple introduction to the fundamental principles, in some detail, that are applied to sukuk securities to conform to doctrinally- required shari’ah provisions. The different definitions of this security will also be highlighted in that section. The origin of and contemporary design of the instrument is next described in section 2.3. Due to space constraints, we cover only six basic issued types out of the 14 potential sukuk securities reported as feasible in the literature. The cash flow patterns and a classification of sukuk securities are presented in section 2.4. Issues relating to valuation of sukuk are attempted in section 2.5 with a view to providing a good starting point on this important issue of valuation models for all sukuk securities. In sections 2.6 and 2.7, we provide a description of the worldwide sukuk issues across several markets, all adding up to about US$1200 billion in assets. The chapter concludes in section 2.8.