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  2. 2. CONTENT1. ACKNOWLEDGEMENTS 12. INTRODUCTION 2 2.1 How Sukuk Developed 2.2 The Different Between Sukuk And Conventional Bond3. BODY 3.1 Step And Procedures Of Inssuance Sukuk 4 3.2 Characteristic Of Sukuk 8 3.2.1 Bond holders ownership of enterprise assets 3.2.2 Regular distribution to sukuk holders 3.2.3 Guaranteeing the return of principal 3.3 Advantages Of Issuance Sukuk 11 3.4 Restrictions In Trading Of Notes In Malaysia 13 3.5 Responsibilities Of Issuance And Paying Agent 14 (Authorized Depository)4. CONCLUSION 165. RECOMMENDATION 176. BIBLIOGRAPHY 187. APPENDIX 19 2
  3. 3. 1. ACKNOWLEDGEMENTSAll praise to Allah (swt) the most Gracious and most Merciful, by whose grace and blessing toNuzul Akhtar Binti Baharudin, our lecture of subject Futures and Options, due to theopportunities to us in discussing about sukuk.We also thankfully to our college (Selangor International Islamic University College) forallowed us to learn and have the knowledge in this subject matter. And to all the Librarians ofour university college in their co-operations helping us regarding some journal and books.We also take this opportunity, while relying on the instruction of the Prophet to the effect that:“whoever does not thank people does not thank Allah”We are indebted to our discussion from online journal, articles and books as supporting to theidea and get all the information from it while writing the assignment.We have given all our effort to this paper work and we hope that this paper work will providelessons and information which will complete the need of this assignment and also answering allthe question of Islamic derivative.May Allah (Almighty) reward them all for their contribution and consider our efforts for his sakeonly. 3
  4. 4. 2. INTRODUCTION2.1 How Sukuk DevelopedThe word sukuk (plural of the Arabic word sakk meaning certificate) reflects participation rightsin the underlying assets. The term sukuk is already recognize in the traditional IslamicJurisprudence.The design of sukuk is very similar to the process of securitization of asset in conventionalmarkets where a wide range of asset types of securitized. This asset types include mortgages,auto loans, accounts receivables, credit card payoffs, and home equity loans.just as inconventional securitization, a pool of assets is built and securities are issued against this pool.Sukuk are participation certificates against a single asset or a pool assets.Sukuk were made as early as in 1978 in Jordan where the government allowed the Jordan IslamicBank to issue Islamic bonds known as Muqaradah bonds. This was follow by introduction of theMuqaradah Bond Act of 1981. Similar effort were made in Pakistan where a special law calledthe Mudharabah Companies and Mudharabah Flotation and Control Ordinance of 1980 wasintroduced.Howerver, due to lack of paper infrastructure and transparency in the market this securityactivities not successful. The first successful introduction of sukuk was by theMalaysianGovernment in 1983with the issuance of the Government Investment Issue (GII).It was not till the late 1990s that a weel-recognizedstructure of an asset-backed security in theform of a sukuk was developed in Bahrain and Malaysia. This structure is attracting the attentionof borrowers and investors and is considered a potential vehicle to develop Islamic capitalmarket.Sukuk market can provide much needed liquidity to institutional investors and financialintermediaries , who become better equipped with portfolio and risk management.Finally, in many cases, payoff of sukuk resemble a conventional fixed-income debt security,which is popular among conventional investors. In this respect, sukuk can also serve as anintegrating tool between Islamic and conventional markets. 4
  5. 5. 2.2 The Different Between Sukuk And Conventional BondThe prime difference between sukuk and conventional bonds are the absent of interest elementand the existence of an underlying permissible transaction. There is no annual coupon rateattached to the sukuk and thus its characteristic is of zero coupon bonds.For example, if a customer A owes RM 10 million to Bank A, apart from the legal documents, an“IOU”, a form of promissory notes is created to evidence this debt. In this case, customer Adraws the notes onto Bank A. Bank A may then sell this debt to Bank B, bank C or otherinterested institutions.In conventional banking these tradable certificates or securities are issued for a loan with interestto raise funds. In additional to this annual coupon rate is introduced for the securities.Other different between sukuk and conventional bond represents pure debt of the issuer but asukuk represent , in additional to the risk on the creditworthiness of the issuer, an ownershipstake in an existing or well defined asset or project. Also, while a bond creates a lender/borrowerrelationship, the relationship in sukuk depends on the nature of the contract underlying thesukuk. For example, if a lease (Ijarah) contract underlies a sukuk, then its create a lessee/lessorrelationship, which is different from the typical lender/borrower relationship. 5
  6. 6. 3.1 STEP AND PROCEDURES OF INSSUANCE SUKUK Fund Mobilizing Entity Credit Enhancement SPM Balance Sheet Pool of Asset Special Purpose Asset Liabilities (Ijarah/Leases) Mudarabah Ijarah Asset Sukuk “SPM”/ “SPV” (Leases) Certificates Servicing Investor: IFIs, Conventional Institutional investors, pension funds, etc. Source: Iqbal (1999)In above show the process and linkage among the different players involved instructuring a Sukuk. This process is a generic process and there will be differencesdepending on the type of underlying instrument used to acquire the asset. The processof structuring a Sukuk involves the following step: 6
  7. 7. Step I: An asset is identified, which is currently held by the entity wishing to mobilizeresource and raise funds. In simple cases, this asset needs to be a tangible asset suchas an office building, land, highway, or an airport. But in other cases, a pool could bemade from a set of heterogeneous assets combining tangible and non-tangible asset,i.e. financial asset. Once the assets to be securitized are identified, these assets aretransferred to a special purpose Mudarabah (SPM) for a predetermined purchase price.SPM is established only for this particular purpose and is a separate legal entity thatmay not be affiliated to the issuer. By establishing an independent SPM, the certificatescarry their own credit ratings, instead of carrying the credit ratings of its original owner.Also, by transferring the asset to this special entity, the asset is taken off the issuer’sbalance sheet and is therefore immune to any financial distress the issuer may face inthe future. Thus, the existence of an SPM provides confidence to the investors (Sukukholder) about the certainty of cash flows on the certificates and therefore enhances thecredit quality of the certificates. SPM also enjoys special tax status and benefits. SPM isconsidered a bankruptcy remote entity.Step II: The underlying asset is brought on the asset side of the SPM by issuingparticipation certificates or Sukuk on its liability side to investors in an amount equal tothe purchase price. These certificates are of equal value representing undivided sharesin the ownership of the asset. The proceeds from the sale of certificates are used topurchase the asset. The holders of the Sukuk participate in the equity interest of theSPM’s assets, which are jointly owned. 7
  8. 8. Step III: The SPM either sells or leases the assets back to a lessee- an affiliate of theseller, or directly back to the seller itself- in exchange for a future payment or periodiclease payments. For example, in case of a lease, the asset will be leased to a lessee orto the issuer who will be responsible for making future rental payment on the lease.These future cash flows in the form of rental income are passed through to the holdersof Sukuk. The cash flows are subject to deduction of minor administrative, insurance,and debt servicing fees.Step IV: In order to make the certificates investment-quality and to enhance theirmarketability, an investment bank may also provide some form of guarantee. Thisguarantee may be in the form of a guarantee to buy or replace the asset in the event ofdefault. The investment bank or guarantor charges a few basis points as premium forthe guarantee. This credit enhancement makes the certificates investment gradesecurities and therefore makes them attractive to institutional investor.Step V: During the course of the life of the Sukuk, periodic payments are made by thebenefactor of the asset, i.e., lessee, which is transferred to the investors. These periodicpayments are similar to coupon payment and Sukuk payment is that whereas bondcoupon accrues irrespective of the outcome of the project for which the bond wasissued,Sukuk payments accrue only if there is any income out of the securitized asset.However, the interesting point is that in the case of lease-based Sukuk, since thecoupon payments are based on rental income and there is low probability of default onrental income, investors consider these coupons with high expectations and low risk.Anyone who purchases Sukuk in the secondary market replaces the seller in the prorata ownership of the relevant asset and all the rights and obligations of the originalsubscriber are passed on to him/her. The price of Sukuk is subject to the forces of themarket and depends on the expected profitability. However, there are certain limitationsto the sale of Sukuk in the secondary market. 8
  9. 9. Step VI: At maturity, or on a dissolution event, the SPM starts winding up, first byselling the asset back to the original seller/owner at a pre-determined price and thenpaying back to the certificate holders or investors. The price is pre-determined to protectcapital loss to investors. Otherwise, the sale of the underlying asset at the market valuemay result in capital loss for the investor, which may not be acceptable to the investor. Itis a common practice that the Sukuk contract embeds a put option to the Sukuk-holdersby which the issuer agrees to buy the asset back at pre-determined price, so that atmaturity the investors can sell the Sukuk back to the issuer at the face value. At thecompletion of Sukuk, the SPM is dissolved and it ceases to exist since the purpose forwhich it was created is achieved. 9
  10. 10. 3.2 CHARACTERISTICS OF SUKUK The characteristic of sukuk is the objective of liberalizing to the none other than toprovide convenience in attracting international investors in investing with the corporation issuingthe sukuk. In liberalizing the characteristics is including the issuance of sukuk in foreigncurrencies outside the issuer’s country. It can be facilitated by making available the shariah, legalframework and conducive tax income. In sukuk, they have the negotiated that bank shall the principal term andconditions of facility with customer. The term and conditions of the facility is that shall thencharacteristics of facility which usually include the followings: o The tenor of this facility o The collateral of facility o The yield of this facility o The mode and related subject matter of the permissible underlying transaction to accommodate the basis for the issuance of sukuk.In Islamic, the characteristics as we know they are not found in Islamic sukuk at least as directly.Today the issuer of Islamic sukuk has to attempt to distinguish sukuk but indirectly they aremany same characteristics. The reason is they are developed a variety of mechanism. Thesesmechanism is in light into three points:  Bond holders ownership of enterprise assets  Regular distributions to sukuk holders  Guaranteeing the return of principal 10
  11. 11. 3.2.1 Bond Holders Ownership Of Enterprise Assets The bond holders ownership is the majority of sukuk are clearly different in this respectform interest-based bonds. Sukuk represent generally for the ownership shares in assets thatbring profits or revenue foe example leased asset, commercial or industrial enterprise. That is theone characteristic that distinguishes sukuk from conventional bonds. However, the market haswitnessed the number of sukuk in which there is doubt regarding their representation ofownership. For example the asset in sukuk may be share of companies that do not confer trueownership but which merely offer of sukuk holders to the right return. Sukuk are no more than the purchase of return from shares and this is not lawful fromshariah perspectives. For example is the certain of sukuk that are based on mix between ijarah,istisna’ and murabahah contract that are undertaken by Islamic bank or institutions these are thepackaged and sold to sukuk holders who hope to obtain the return from these operations.3.2.2 Regular Distribution To Sukuk Holders Based on this point, most of sukuk have been issued are identical to conventional bond withregard to the distribution of profits from enterprise at fixed percentages based on interest rate(LIBOR) . In order to justify the practice, the issuer include a paragraph in the contract whichstate that if the actual profits from the enterprise exceed the percentages based on the interest ratebut then the amount of excess shall be paid in its entirely to the mudarib or partner or investmentagent as an incentive for the mudarib that manage effectively. The structured of sukuk that they do not state the such excess will become the right of themudarib as an incentive but instead they state no more than the holder of sukuk will be entitledto a fixed percentages based on upon the rate of interest at the time of regular distribution. If theactual profit is less than the prescribed percentages based on interest rate, then the mudarib maytake the upon himself to pay out the difference (between actual profits and prescribedpercentages) to sukuk holders, as an interest free loan to the sukuk holders. 11
  12. 12. 3.2.3 Guaranteeing The Return Of Principal As the third point, virtually all sukuk issued today guarantee the return of principal to thesukuk holders at maturity, in exactly the same way as conventional bonds. It means a bindingpromise from either the issuer or the mudarib to repurchase the asset represented by sukuk at thestated price at which these were originally purchased by the sukuk holders at the beginning ofprocess, regardless of their true or market value at maturity. Then the mechanism of sukuk are able to take on the same characteristics asconventional, interest-bearing bonds since they do not return to investors more than a fixedpercentages of the principal based on interest rate. The guaranteeing of return for investors is atprincipal maturity. About the mechanism firstly is from the perspective of the Islamicjurisprudence and second from the perspective of the higher purpose of Islamic finance andeconomics. Based on the shariah perspective they are three questions: 1. Stipulating the amount in excess of the price interest for the manager of enterprise under the pretense this an incentive for good management. 2. The manager commitment, if the actual profits are less than the yield from the fixed rate of interest during any of the times for distribution to lend the amount of the shortfall to the holders of sukuk. The amount of such loans will be recovered either through the actual profits of the enterprise at the times of following distributions or through the sale of the enterprise assets at maturity. 3. The binding promise by the manager that he will purchase the assets represented by the sukuk at their face value and not at their market value on the day they are redeemed. 12
  13. 13. 3.3 ADVANTAGES OF SUKUKa) Un existent of uncertainty (gharar) Sukuk is based on an underlying transaction which creates a close link between financialand productive flows. The financing must be channeled for productive purposes such as projectfinancing, rather than for speculative activities. Thus, the risk exposure is to the project and notto the uncertainties or activities that have no real economic benefits. This contributes to greaterstability of the financial system. Moreover, under the risk-sharing principle required, there is anexplicit sharing of risk by the financier and the borrower. This arrangement will entail theappropriate due diligence and the integration of the risks associated with the real investmentactivity into the financial transaction. The real activity is expected to generate sufficient wealthto compensate for the risks. In contrast, conventional bonds generally separate such risks from the underlying assets.As a result, risk management and wealth creation may, at times, move in different or evenopposite directions. Conventional bonds also allow for the commoditisation of risks. This has ledto its proliferation through multiple layers of leveraging and disproportionate distribution, inturn, could result in higher systemic risks, thus, increasing the potential for instability in thefinancial system. 13
  14. 14. b) Full disclosure and affairs In addition, transparency represents a basic tenet underlying all Islamic financialtransactions. The profit-sharing feature of Islamic financial transactions imposes a high level ofdisclosure in the financial contract. The accountabilities of the respective parties involved in thetransaction are clearly defined in the contract. Issuing sukuk also give access to a wider investor base as the instruments attract not onlythe Islamic investors but also conventional investors. Sukuk is also considered as a new assetclass with a relatively attractive pricing. The growing demand for sukuk is attributed by growingawareness, increased in petrodollars, wealth and reserves as well as the massive development ofinfrastructure projects.c) Cost Saving In Malaysia, there in incentive in the form of cost saving in term of Stamp dutiesexemption on issuances of Islamic private debt securities including sukuk, therefor it will reducethe burden of the investor.d) Diversify Investment Islamic bonds may be structured in a variety of ways, but typically fall into one of fourcategories: Ijarah, or leasing arrangements; Murabaha, a transaction where the seller explicitlydeclares his cost-plus-profit margin; Mudharabah, a structure similar to a joint venture whereprofits are shared between a fund raiser and investor; and Musharakah, a joint venture whereprofits and losses are shared. 14
  15. 15. 3.4 RESTRICTIONS IN TRADING OF NOTES IN MALAYSIAThe secondary market trading of the notes are confined to the following bodies. i. Prescribed corporations as defined under Section 38(7) of the Companies Act, 1965. ii. Insurance companies. iii. Statutory bodies established by an Act of Parliament or Enactment of any state in this country. iv. Pension funds approved by the Director General of the Inland Revenue provided under Section 150 of the Income Tax Act, 1967. v. Such other corporations as may be acceptable to the issuer after taking into considerations the relevant provisions of the Companies Act, 1965.In addition to the above, there should be no physical delivery of the notes be allowed. All notesshall be deposited with the authorized depository of the facility. Usually, the authorizeddepository shall also act as principal dealer providing two way quotation for the notes. 15
  16. 16. 3.5 RESPONSIBILITIES OF ISSUANCE AND PAYING AGENT(AUTHORIZED DEPOSITORY)The responsibilities of the issuing agent are as follows. i. An issuing agent shall have to ensure the correct quantity of the executed notes. ii. An issuing agent shall also ensure such notes are numbered and dated with the issue number, serial number, the maturity date and the issuing date. iii. An issuing agent shall ensure that all notes be duly executed by the authorized signatories of the issuer and the agent. iv. An issuing agent shall within 10 business days of the issue date or date of cancellation or destruction of the notes communicates with the issuer by issuing a certificate confirming the following.  The number of notes issued  The face value, serial number, the date of issue and maturity date of such notes  The number of notes cancelled and destroyed (if any) and their serial numbers.The responsibilities of the paying agent are as follows. i. A paying agent has to maintain promissory notes register containing full and complete records of all issuance, redemptions and cancellations. ii. A paying agent is to ensure the issuer is instructed within two business days of any maturity date, to place the redemption amount in a designated account at the latest before 11.00 a.m. on the maturity date. iii. A paying agent is to pay the face value of the notes to the owners of the notes as appeared on the promissory notes register on the maturity date. iv. A paying agent shall cancel and return to the issuer all notes paid and redeemed within 30 days of the date of cancellation. 16
  17. 17. v. A paying agent shall only allow replacing notes which are mutilated or destroyed upon receipt of the following.  Cost of replacement  Evidence of destruction or mutilation  Submission of safe custody receipt vi. A paying agent shall track out of pocket expenses (legal, cable and postages) incurred and bill it onto the issuer.The responsibilities of the authorized depository agent are as follows. i. An authorized depository agent shall keep track of the security cover which shall be 130% of the security amounts at all times. ii. An authorized depository agent shall ensure customer to respond within 7 days of notice for additional security. iii. An authorized depository agent can act as market maker for the notes by providing a two way quotation at all times on inquiry by the public. iv. An authorized depository agent shall help the notes holder to dispose his notes in the event he decides to sell. v. An authorized depository agent shall help the note holder to dispose his notes in the event he decides to sell. vi. An authorized depository agent shall ensure that the total number of note holder does not exceed 10 at any one time and restricted to the following entities as defined under section 38 (1B) of the Companies Act, 1965.  Prescribed corporations such as banks and other corporations gazette by the ministry of finance.  Insurance companies  Statutory bodies established under Act or any Enactments  Corporation incorporated outside Malaysia  Pension funds approved by director general of Inland Revenue under section 150 of income tax act. 17
  18. 18. 4. CONCLUSIONFrom what have we found, it is clear that the Islamic alternative of resource mobilization throughIslamic bonds is not only possible but also has proven to be practical through the implementationof several successful projects using Islamic bonds or as tool of monetary management.However what is more important is that Muslims jurists and economists must intensify theirefforts to explore the different forms of Islamic bonds based on the acceptable types of contractin Islamic laws for that purpose such as musharakah, muqaradah and ijarah.Similarly the possibility of having negotiable certificates based on salam should not be excludedtotally and a systematic analysis of the possibility of reselling salam before taking possessionneeds to be explores by Muslim jurists especially at the Islamic Fiqh Academy level.Especially when the whole issue of prohibiting resale before taking possession is based on theargument that such a sale may lead to gharar or even riba and to what extent this possibility ispresent nowadays. 18
  19. 19. 5. RECOMMENDATIONControversial of Sukuk tradingIn this present we have seen the rapid success of Islamic bond in the market. The success ofMalaysia in Islamic Finance has attracted whole the world eye. Malaysia is the biggest holder ofthe sukuk market and it absolutely has encouraged the development of Malaysia economics.However in the early development of sukuk in Malaysia, the conformity of sukuk with Shariahprincipal has being conflict in ulama conversation.Disagreement among ulama is one of the troubles in trading the sukuk in capital market andgenerally, the Muslim scholars have different views on the legality of sukuk trading. Some of theview said that sukuk is not complied with shariah principal and it just the converted of theconventional product. Therefore as the initiative Malaysia has develop Sha’riah AdvisoryCouncil (SAC) as the effort to solve the issues. The characteristic of conventional capital marketwhich is involve the riba(interest) and gharar (uncertainty) is one of the factor that cause some ofthe view unconfident with the conformity of sukuk with shariah principal, therefore Sha’riahAdvisory Council is develop to facing this problem trough the research and discussion among theprofessional in Shariah Advisory Council. Shariah Advisory Council is the corporations developby government by employ all Islamic professional and Ulama as the group in the Sha’riahAdvisory council and this group was responsible to ensure the status permissible of sukuk andother Islamic finance product.The success of SAC in the trading of Islamic finance product should be admit because Malaysianow has being the attraction of whole the world and Malaysia able to be the most success ofsukuk trading in world, however the trading sukuk by Malaysia is still not able to increase itsacceptance among other Islamic country as Mesir and other. The main factor that causes theproblem is because of the different Scholar, as the Sha’fie scholar follower the trading of sukukin Malaysia will be quite different compare to other country as the follower of the HambaliScholar and Maliki Scholar. As the solution, Malaysia need to have deeper research anddevelopment to increase and develop product that might able have larger acceptance variable ofIslamic bond. 19
  20. 20. BIBILIOGRAPHYDr.Mohd Daud Bakar, D. R. (2008). Essential Readings In Islamic Finance. CERT PublicationSdn Bhd.Mirakhor, Z. I. (2007). An intro to islamic finance theory and practice. wiley finance.Mohd Nasir Mohd Yatim, A. H. (2007). The principle and practices of islamic banking andfinance . Prentice Hall.Usmani, M. T. (n.d.). Sukuk and their contemporary application .Yatim, M. N. (2009). sukuk(islamic bonds):a crucial financial instrument for securitisation ofdebt for the best-holders in shariah-compliant capital market . 20
  21. 21. APPENDIX 21