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Evolution in the Sukuk (Islamic Bonds) Structure: How do Market Demands and
Shariah (Islamic Law) Solutions Shape Them?

Article in Journal of Islamic Banking and Finance · January 2018

DOI: 10.15640/jibf.v6n1a2

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 Journal of Islamic Banking and Finance
June 2018, Vol. 6, No. 1, pp. 16-28
ISSN 2374-2666 (Print) 2374-2658 (Online)
Copyright © The Author(s). All Rights Reserved.
Published by American Research Institute for Policy Development
DOI: 10.15640/jibf.v6n1a2
URL: https://doi.org/10.15640/jibf.v6n1a2

Evolution in the Sukuk (Islamic Bonds) Structure: How do Market Demands and
Shariah (Islamic Law) Solutions Shape Them?

Rafisah Mat Radzi1

Abstract

The issuing of sukuk (or Islamic bonds)as an instrument in Islamic finance has grown in recent years. The
sukuk markets have advanced in the way of using tangible assets to receivables as an underlying asset.
Premised on this development, sukuk structures have shifted from asset-backed to asset-based to asset-light
and blended-assets. Given this evolution, this study will trace the development of innovation in the sukuk
structure. Observed here are changes or trends in the sukuk structure, including how market participants‟
demands and Shariah issues influenced such changes in the sukuk. The main issues that emerge are: firstly,
sufficient physical assets in response to the demands of issuers; and secondly, solutions offered by Shariah
advisors who play a role in shaping the issued sukuk structure.

Keywords: Shariah,sukuk, innovation, underlying assets

1.0 Introduction
Innovation occurs in every market and no market can survive without it. This applies to the sukuk2 market
which has been exceptionally innovative since being introduced to the financial market. A basic requirement for
Shariah compliance of any sukuk structure is that it shall be backed by tangible assets. Therefore, when the sukuk were
first developed in 1990, Shariah (Islamic law) prescribed s ukukas requiring 100% tangible assets to provide fully
backed assets to investors. Therefore, this study describes the changes in the sukuk structure and particularly in terms
of from asset-backed to asset-based and ultimately to a blended sukuk structure. This development is mostly
associated with the problem of insufficient physical assets when issuers demand to tap funds available in the Islamic
financial market. In the meantime, Shariah requirements and solutions offered by Shariah advisors also play a role in
shaping the is sued sukuk structure. The financial community adopted and refined the concept of sukuk and expanded
its scope to incorporate a wide range of commercial and financial activities.
The following sections will, in order, discuss sukuk and the requirements of underlying assets in its
transactions. Further, sukuk structure preference since the early days of Islamic civilization up the present day will be
discussed. Finally, an evolution in structuring sukuk with regards to underlying assets will be examined.
2.0Sukukand the requirements of underlying assets in its transactions
The Islamic capital market has become a global phenomenon with sukuk playing a substantial part in the
industry. Of all Shariah-compliance financing methods, the one that has received most public attention to date is
sukuk. As reported by Standard & Poor‟s(2008), sukuk totaled less than $500 million in 2001, but it was double this in
2007 and by the end of 2016 it was close to US$319 billion(IFSB, 2017). The sukuk market‟s growth is being fueled
mainly by corporates, sovereigns and financial institutions. Although corporates find that sukuk is an alternative form
of financing for businesses or projects, banks are turning to these financial instruments to sustain growth using stable
funding sources and curb maturity mismatches(Standard & Poor's, 2010).

1School of Distance Education, UniversitiSains Malaysia, 11800 Minden, Penang, Malaysia, [email protected], ph: +604 653 2314,
fax: +04 657 600
2These are Islamic investment certificates or participation certificates and also known as Islamic bonds from the Western

perspective.
Rafisah Mat Radzi 17

The Islamic debt securities market was developed to meet diverse risk-return profiles and the needs of issuers
and investors who looked for a type of asset that complied with Shariah. Conventional bonds or sukuk, both are
financial vehiclesattempting to mobilize the funds from surplus spending units to shortage spending units. A bond is a
contractual debt obligation that pays holders a coupon of fixed or floating interest. Most conventional bonds are
primarily concerned with the return on investment, not the actual object that is being financed. Hence the underlying
asset for corporate bonds is money (debt). Its whole premise is to provide holders with interest in return for their
capital investment. This kind of asset does not comply with Shariah, as they are in the form of interest-bearing loans.
There is a blanket prohibition on interest under Shariah. Therefore, interest is fundamentally tainted with riba. Shariah-
compliant transactions preclude making money with money because „no one should be able to earn an income from
money alone‟. In this sense, money itself may not be a source of profit because many scholars of Islamic economics
argue money has no intrinsic value within Islam (El-Gamal, 2000). The ultimate purpose of money, from their point
of view, is to help fulfil basic needs, such as food, clothes and shelter(Saeed & Salah, 2012).In this approach money
must be seen (and used) as a means of exchange only, not as a basic need in itself.
Given that use of money as a source of profit is forbidden by Shariah,the presence of underlying tangible
assets in the sukuk transaction is required. Following Shariah Standard No. 17 on Investment sukuk, the Accounting
and Auditing Organization for Islamic Financial Institutions (AAOIFI)states that sukuk are „certificates of equal value
representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the
assets of particular projects or special investment activity‟. The Council of the Islamic Fiqh Academy of the
Organization of Islamic Conference (OIC)in 1988 definedsukuk as “any combination of assets (or the usufruct of
such assets) can be represented in the form of written financial instruments which can be sold at a market price
provided that the composition of the group of assets represented by the sukuk consist of a majority of tangible
assets”. Meanwhile the Securities Commission Malaysia provides a guideline which states that an asset must be made
available for sukuk to be issued in the case of sukuk bay bithaman ajil(deferred payment sale), murabahah (cost-plus
financing), istisna’ (contract of exchange with deferred delivery) and ijarah (lease)3. These standards clearly underpin
that sukuk must be asset-backed and subject to compliant contract. Income from securities must be related to the
purpose for which the funding is used and securities should be backed by real underlying assets, rather than being
simply paper derivatives.
Since the issuance of sukuk is not an exchange of paper money for interest but rather an exchange of a
Shariah-compliant asset, the asset itself must be halal (permissible) in nature and being utilized as part of halal activity.
The Fiqh Academy (Jeddah) in its ruling No. 5, 1998, stated that any „halal‟ asset or collection of assets can be the
underlying asset for a note or sukuk.Such sukuk can also be sold (traded) provided that the underlying asset(s) consists
mainly of tangible physical assets with a minimal part of it being cash and/or interpersonal debts. Shariah
considerations dictate that the pool of assets should not solely be composed of debts from Islamic financial contracts
(e.g. murabahah, isitisna’) but also comprise real assets (Krichene, 2012). Clearly, all sukuk by definition must have an
asset that is tangible, although some fuqaha allow for a portion of the asset to be in intangible form, all jurists require
that there be an underlying asset (Bacha & Mirakhor, 2013).
While there are a number of other Islamic finance principles that must be borne in mind when structuring
Islamic-compliant deals4, Islamic scholars and practitioners view that the identification of the assets is the most
essential. According to Krichene(2012) and Radzi (2012) the identification of suitable assets is a key step in the
process of issuing sukuk for any entity that wants to mobilize their financial resources. The prominent and influential
Shariah scholar, TaqiUsmani (1999)emphasized that one of the most important characteristics of Islamic financing is
that it is an asset-backed entity. Islamic finance is justified in that it restricts finance to funding of trade or the
production of real assets. In fact, of all the rules that govern the structure of Islamic finance instruments, the rule that
transactions must be real asset-based is the most striking (Hoor & Kreemer, 2014).Where the funds raised are used to
finance a needed tangible asset, specificity of assets is important. That is, the assets being financed should be clearly
identified.

3 See Securities Commission Malaysia (2014) Guidelines on sukuk, Section 7.01.

4Some of the key concepts in Islamic finance are set as riba(interest), gharar(uncertainty), maisir(gambling), bay al-dayn (sale of debts
or monetary assets), bay al-inah (a sale of an asset followed by a buy-back at an increased price of that same asset). In the
meantime, there are many issues that arise in relation to sukuk structures and transactions. Some of them are: transfer of title,
nature of the assets, tax and zakat(a fixed portion of a Muslim‟s wealth which is required to be donated to charity in accordance
with Islamic law), governing law, capacity and authority, tradability of sukuk, liability management and types of
sukuk(O‟Callagahan et al. 2012).
18 Journal of Islamic Banking and Finance, Vol. 6(1), June 2018

This is because sukuk, unlike bonds, cannot be used to fund the issuer‟s general financial needs (Bacha &
Mirakhor, 2013). The role of underlying asset attached to sukuk will serve as a source of return to investors in the
form of sales, lease or partnership or business venture. In addition, sukuk holders should have asset ownership in the
assets as the important principle in sukuk securities because „rewards are given only if profits are earned‟. Thus the
concept of profit-loss sharing is extremely important in Islamic finance. It is an important differentiating feature of
Islamic finance and one that should be considered a source of strength since the requirement for an underlying asset
precludes the possibility of excessive leverage.
To sum up, the necessity for the underlying asset is a clear requirement in all Islamic financial transactions.
However, to what extent sukuk structures in practice truly behave according to their specific Shariah assets
requirement has raised serious doubts among scholars. Many current sukuk issuances have an asset somewhere in the
mix, but in mostcases, actual cash flows from the issuances are not derivedfrom that asset; they actually originate from
the rest of the structure. Thus, the presence of an asset gives the sukukthe “form” of an Islamically permissible
finance product, but not the “substance”(Howladar, 2009; Maurer, 2010, p.36).Following Al-Jarhi (2013, p.250)the
gap in theory and practice in Islamic economics arises in relation to Islamic financial assets and sukuk. Sukuk are
supposed to be Islamic financial assets that represent common undivided shares in Shariah-compliant real and
financial assets. However, sukuk have been entrusted to the financial engineering talents of a group of Shariah scholars
who view them not as Islamic financial instruments but are rather “Islamic bonds” or fixed income instruments that
have cleverly been made up to look Shariah-compliant(Al-Jarhi, 2013). These doubts lead to at least two critical issues
related to the underlying assets. First, should the underlying asset serve for backing the sukuk issuance or only just
serve for the basis of sukuk issuance? Second, does the underlying asset have to represent tangible assets only or
include intangible assets for example receivables? In response to these issues, this paper will examine sukuk structure
preference in the sukuk market and trace the evolution of sukuk structure with regards to assets‟ sukuk requirements.
3.0 Changing trends in sukuk structure preference in the sukuk market
Sukuk or sakk is not a new invention of the Islamic finance industry. As a concept it originated in the early
days of Islamic civilization. In the 1st century Hijri (corresponding to the 7th Century AD), the certificates for goods
or sakk al-bada’i (groceries) were used to pay thesalaries of government officers both in cash and in kind by the the
Umayyad Government(Kamali, 2002). The holders of sukuk were entitled to present the sukuk on their maturity date
at the treasury and receive a fixed amount of commodities. Some holders used to sell their sukuk to others for cash
before the maturity date (Haneef, 2009). This practice thus demonstrates that the concept of sukuk al-bada’i as a
tradable instrument was widely accepted in the Islamic world a very long time ago.
In February 1988, the Council of the Islamic Fiqh Academy of the Organization of Islamic Conference (OIC)
held its fourth session in Jeddah, Saudi Arabia, and laid the basis for the development of the sukuk market through the
issuance of a statement of such intruments. Shortly in 1990, one of the first sukuk was issued in Malaysia, based on the
principle of bay bithaman ajil, with a value of RM125 million (equivalent to $30 million). However, there were no active
issuances by other players or countries following this issuance(Dusuki, 2009).The sukuk market only became
important as a Islamic financial instrument in raising funds for long-term projectsin the year 2001. It witnessed the
first few sukuk issued in the international market in the form of being ijarah-based. The sukuk market went
international with the issuance of the very first international ijarah sovereign sukuk by the Government of Bahrain in
September 2001.This was closely followed by the first quasi-sovereign global sukuk by Kumpulan Guthrie, a
corporation based in Malaysia. It was also an ijarahsukuk, worth US$150 million with 5 years maturity and return of 6
months LIBOR + 1.5%.Then in 2002 the Malaysian government issued US$600 million ijarahsukuk that were listedon
the Luxembourg Stock Exchange and rated by Standard & Poor‟s and Moody‟s(IIFM, 2009). The issue was hugely
successful and was twice oversubscribed. The Malaysian sukukwas a significant development because it was able to
successfully fuse the concept of ijarahsukuk with conventional bond practices such as listing, ratings, dematerialized
scripts and centralized clearance. Consequently, there have been a number of successful sukuk issues, still based on
ijarah contract such as the State of Qatar‟s initial US$700 million ijarahsukuk and the Kingdom of Bahrain‟s US$250
million ijarahsukuk is sued in 2004 (IIFM, 2011).
Stemming from these issuances, the sukuk structure was initially based on the contract of bay bithamanajil
which basically revolves around buying and selling of financial instruments as the basis for creating a debt instrument.
Subsequently, the market moved to instruments based on an ijarah contract which involves tangible or physical assets
such as land and buildings; these are then sold and leased back.
Rafisah Mat Radzi 19

Initially, the issuance of sukuk was in response to the demands of issuers and investors in Muslim countries as
an alternative mode for their financing and investment needs that complies with Shariah requirements (Kusuma &
Silva, 2014). The market‟s immense growth required certainty in regard to Shariah-related matters and standardization.
Hence, in May 2003, the AAOIFI published the “Standard for investment sukuk”.Despite 14 Shariah-compliant sukuk
structures being officially recognized, only a few structures have been issued in the sukuk market. Specifically, these
are the following: ijarah, musharakah (joint venture), mudharabah (profit-sharing between entrepreneur and investors),
murabahah and istithmar (investment). These variations take up nearly 90% of the sukuk market share. Out of those,
ijarah has been the most popular structure used by international sukuk issuers whereas musharakah has been the most
used by domestic ones (Malim, 2010).In fact, ijarahsukuk have represented an important segment of the market and
remained the dominant structure from 2001 until 2005 when the first musharakah-based sukuk, the DMCC Gold
sukuk, was issued (IIFM, 2009). Since then, participatory structures such as musharakah and mudharabah exchangeable
trusts picked up the pace and even outstripped ijarah. In 2007, more than 40% of the primary market volume was
raised through sukuk structured on musharakahand murabahah contracts(IFSB, 2016).
However, the popularity of the musharakah and mudharabahsukuk structures has declined disproportionately
when compared to other structures in 2007. The decline was driven by comments by Sheikh TaqiUsmani, that 85% of
the structures of Gulf sukuk do not comply with Shariah. The comments mostly refer to mudharabah and musharakah
which are also known as equity sukuk or partnership-based sukuk, but also partly on sukuk ijarah. Sheikh Usmani
argued that most of these sukuk held “nearly all of the characteristics of conventional bonds” and were therefore
“inimical in every way to the higher purposes and objectives” of Islamic economics (Usmani, 2007). As a direct
consequence of the debate among some Shariah scholars regarding the Shariah compliance of most musharakah and
mudharabahsukuk which were previously issuedsukuk, the sukuk issuance declined by 83% and 68%, respectively(Hijazi,
2009, p.7).In this regard, ijarahsukuk returned as the most favorable structure of sukuk in 2008 in terms of dollar
amount and number of issues.Due to the market experiencing significant growth, sukuk issuance and trading became
an increasingly importance method of investment. However, the structure of sukukijarah limits the originator because
they cannot issue sukuk if they do not have enough tangible assets.
Subsequently, to meet the demands of investors, a hybrid form of sukuk emerged in the market. In a hybrid
sukuk structure, the underlying pool of assets can comprise istisna’ contracts, murabahah contracts and ijarah contracts,
which allows for a greater mobilization of funds. While such hybrids constituted only 2% of new issues in that market
between 2001 and 2010, the figure rose to 15% between 2011 and January 2013(IIFM, 2013). Although more complex
than the structures of other types of sukuk the key benefit of such a hybrid sukuk is that they allow a more efficient
utilization of a company‟s assets. They can, for example, be structured in such a way as to permit the use of real estate
assets within a sukuk structure without the need to register a legal transfer of the relevant real estate. Recently,
milestones achieved by the socially responsible sukuk were born as a new category of investment with the issue of
sukuk by International Finance Facility for Immunization, the World Bank linked entity and Khazanah National in the
form of Ihsan sukuk(IIFM, 2016).
4.0 An evolution in structuring sukuk with regards to underlying assets
The changes in sukuk structure since 1990 reflected the preferences of Islamic financial market participants.
The sukuk market shifted away from baibithamanajil to ijarah, towards hybrid structures to provide more flexibility with
respect to the types of assets being used. This innovative change was due mostly to having insufficient physical assets
in response to issuers‟ demands to tap funds available in the Islamic financial market. In the meantime, Shariah
requirements and Shariah advisors‟ solutions to problems also played a critical role in developing the advised sukuk
structure. The financial community implemented and further refined the concept of sukuk, expanding its scope to
include many commercial and financial products, services and activities.
4.1 Early stage sukuk development with 100% asset-backed sukuk
As noted earlier, a basic requirement for Shariah compliance of any sukuk structure is that it shall be backed
by tangible assets. The asset itself must fulfil the elements of subject matter of sales since the requirements of a valid
contract in Islamic law consist of the offer and acceptance, the seller and buyer and the subject (asset and price).
Therefore, when sukuk were first developed, the requirement was to have 100% tangible assets that were fully backed
for the benefit of investors, in addition to the true sale requirement of the underlying assets to sukuk holders. This
structure took the form of the first international ijarah sovereign sukuk issued by the Government of Bahrain in
September 2001.
20 Journal of Islamic Banking and Finance, Vol. 6(1), June 2018

The sukuk was backed by US$250 million worth sovereign asset. Similar to the next sukuk issuance, the quasi-
sovereign global sukuk by Kumpulan Guthrie, a corporation in Malaysia as it had the land parcels in Malaysia serving
as an underlying asset.
The existence of physical assets and true sale requirement in the sukuk structure which is also known as asset-
backed sukuk meets the criterion of conventional securitization. Following Dusuki and Mokhtar (2010), one of the
essential features of securitization is the „true sale‟ requirement. This means the sale of the originator‟s asset must
fulfill all accounting and legal requirements to remove the asset from the originator‟s books. The asset is completely
shifted towards a Special Purpose Vehicle for the purposes of a “true sale”. The transfer of the asset is ideal which
means the asset is protected from the risk of bankruptcy within the Special Purpose Vehicle. In other words the sukuk
holders enjoy the full backing of the underlying asset because there is true sale and legal transfer of the ownership of
the assets to them. As such, sukuk holders will have the guarantee of recourse to the assets to recover their capital in
the event that the obligor becomes insolvent or faces difficulties in meeting payments. As well as this arrangement,
Islamic securitization must be free from three prohibited practices, specifically riba (usury), gharar (uncertainty), and
maysir (gambling). Thus, anything leading to these practices is not tolerated such as debt and financial assets trading
(bay al-dayn), haram5 activities, interest-bearing collateral, etc. Islamic securitization must involve the funding or
production of real assets rather than financial securities, which causes irresponsible leverage as well as speculation
through derivatives lending (Wilson, 2004). In this sense, asset-backed sukuk represent the real form of securitization
because they expose sukuk investors to real value and risk of the underlying asset. Although the concept of asset-
backing is an essential part of Islamic finance, the concept of asset-backed sukuk presents its own challenges that have
led to the inevitable evolution in sukuk structure.
4.2 The emergence of asset-based sukuk
Initially, while sukuk should have tangible assets in their structures, a concern has been voiced by Islamic
market participants regarding the limited number of assets eligible for sukuk under the ownership of Islamic financial
institutions or corporations looking to raise capital (Al-Amine, 2008). Most of the sovereigns in the Middle Eastern
countries were reluctant to part with public assets due to the apprehension that the disposal of such assets to foreign
investors would generate public criticism. The corporates on the hand either did not have suitable assets, or the assets
were not sufficient or already encumbered, or such disposal was subject to transfer taxes (Haneef, 2009). Likewise,
sometimes the originator is not interested in permanently parting from his assets. Or the asset in question has strategic
value to the sukuk-originating governments (Wouters, 2011).Hence, initially although the ijarahsukuk was structurally
viable and legally possible, the product did not generate much interest in the Muslim world when it started(Haneef,
2009). The shortfalls in eligible assets including tax issues and legal restrictions on sale of assets to foreign investors
have challenged the asset-backed sukuk. In an asset-backed sukuk, the sukuk holders benefit by having some form of
security over the assets, enabling them to be at an advantage over other unsecured creditors(Howladar, 2006). This
structure created a huge legal hindrance since it was perceived to be a direct breach of the negative pledge clause that
prevents the bond issuers from issuing any future bonds that are not in pari-passu with the existing secured bonds,
which happened to the Malaysian government in 2002 (see Box 1).
Prior to the first issuance of sovereign sukuk being proposed in 2002, the government of Malaysia had
unsecured international bonds and some had not yet been redeemed. Therefore, in order to avoid a negative pledge, it
was considered that the sukuk would be backed by the ownership of the underlying assets, and beneficial ownership
of the assets to sukuk holders emerged as the solution proposed by Shariah scholars. A true sale element was not
required and instead beneficial ownership of the assets resolved the issue of not being in pari-passu with the existing
unsecured bonds. In the meantime, it met the Shariah requirements of asset ownership under ijarah principles.
Although the ijarah sukuk have assets in their structures, the arrangement only facilitates the transaction and does not
give investors legal rights to the assets. Consequently, sukuk holders cannot sell the asset to a third party in case the
borrower defaults. The sukuk holders only have recourse to the originator/obligor (or government of Malaysia).The
arrangement of ijarah sukuk US$600 million by the government was considered the first ever „asset-based sukuk‟ in the
market.
The characteristics of the asset-based structure demonstrated that the structure closely mirrors conventional
bonds. The debt-like structure was imparted to the asset-based sukuk by incorporating income and capital guarantees
into the sukuk structure(Abdullah, 2012).

5Forbidden according to Shariah.

Rafisah Mat Radzi 21

The income guarantee was incorporated into the sukuk structures by requiring issuers to pay investors a
specified amount of “dividends” on specific dates. The dividends are calculated as a percentage of the total amount
“invested” rather than as a percentage of total profits (similar to the way interest payments are determined as a
percentage of the total amount of a given loan).
Box 1 A closer look of the first issuance of asset-based sukuk: US$600 million ijarah sukukby the
government of Malaysia
Back in 2002, Malaysia was enthusiastic to help create the international sukuk market. Malaysia‟s government was
the first to issue sovereign sukuk for financing the public sector. This sovereign ijarah sukuk was backed by
sovereign assets worth US$600 million in the form of government administrative buildings, hospitals and
academic institutions. While the sukuk clearly have tangible assets, however, the asset-backed sukuk structure
created a major legal constraints for the Federation of Malaysia. The government had previously issued
international bonds and some of them were still unredeemed in 2002. All international bonds have a standard
negative pledge which restrains the bond issuers from issuing in the future any bond that is not in pari passu with
existing unsecured bonds. The standard negative pledge clause is usually worded as follows: “So long as any of the
Certificates remains outstanding, the Issuer has undertaken that it will not secure any of its present or future
indebtedness for borrowed money by any lien, pledge, charge or other security interest upon any of its present or
future assets, properties or revenues (other than those arising by operation of law).”
Given that the Malaysian international bonds were all unsecured bonds, the proposed sukuk issuance was seen as a
direct breach of the negative pledge clause given that the sukuk would be backed by the ownership of the
underlying assets. The sukuk became effectively a secured bond and would be given priority over all unsecured
bonds of the Federation of Malaysia. The Federation of Malaysia was advised not to proceed with the sukuk until
all outstanding bonds were redeemed. The development of the sukuk market almost came to a standstill. This
challenged called for a neat solution to avoid breaching the negative pledge. Therefore, with the help of a few
prominent Shariah scholars, under the revised structure, the sukuk holders would enjoy a beneficial ownership of
the assets held through the sukuk trustee during the life of the sukuk. This arrangement would meet the Shariah
requirements of asset ownership under ijarah principles. However, in the event of default by the Federation of
Malaysia, the sukuk trustee‟s sole recourse to the assets would be to dispose of the assets only to the government
of Malaysia and seek payment. The sukuk trustee would not have the power to retain or sell the assets to any third
party. Once the sukuktrustee had disposed of the assets to the Malaysian government, the sukukholders would in
law be treated as unsecured creditors. The revised sukukstructure therefore was not seen as asset-backed securities
although the sukukhad underlying assets. The Malaysian sukukbecame known in the market as asset-based
securities.
In June 2002, Malaysia successfully launched the world‟s first international sukuk issue. A Special Purpose Vehicle
(SPV) wholly owned by the government, namely Malaysia Global Sukuk Inc., was incorporated in Labuan and
issued the US$600 million 5–years Islamic bonds. The transaction was based on the ijarah concept. The structure
of the sukuk is underpinned by a portfolio of prime real estate assets owned by the Federal Land Commissioner of
Malaysia, which is sold to the SPV.The SPV then leases the assets to the government for five years, a period
equivalent to the tenure of the bonds. The lease payments paid by the government exactly match six monthly
distributions to investors and represent a senior unsecured obligation for Malaysia. On maturity, the SPV sells the
asset back to the Malaysian government at the original price (i.e. the face value of the bond issue). Proceeds from
the sale of the assets will be used to repay the investors, in terms of the principle amount of trust certificates.
Source: Labuan Offshore Financial Services Authority(2002)

Meanwhile, the capital guarantee was incorporated into the sukukstructures by requiring originators to refund
to investors their capital in full, on a specific day in the future, known as the maturity date. To comply with Shariah
law –at least in a formal sense – the refund was accomplished by requiring originators to repurchase the underlying
assets from investors on an agreed-upon date. The price at which the assets were repurchased was identical to the
price at which they were first sold to the investors. This had the effect of returning to “investors” exactly the same
amount they “invested” when they initially purchased the assets. Not only the ijarah but also partnership sukuk such as
the musharakah or mudharabah were structured to replicate debt instruments. As far as asset-based and asset-backed
structure is concerned, it should be noted at this stage that one cannot assess the risks associated with each issue by
merely understanding the sukuk structure such as mudharabah, musharakahor ijarahsince the actual legal structure behind
the „name‟ and the actual risk characteristics of the issue can vary significantly even within each structure.
22 Journal of Islamic Banking and Finance, Vol. 6(1), June 2018

Within musharakahsukuk for instance there can exist variations between asset-based and asset-backed sukuk–
each one yielding a wholly different risk profile. Asset-based sukuk are also commonly referred to as „Islamic bonds‟
and from a legal perspective in terms of taxation, are treated as bonds(Hasan, 2013). They enable Islamic investors to
own certificates that offer a return similar to a coupon-bearing instrument (such as conventional bonds) and that can
be traded in the secondary market.
Since 2002, the vast majority of sukuk in the market have been structured in such a way to be asset-based
sukukor Islamic bonds rather than asset-backed investments. Given investors‟ demands, the majority of issued sukuk
have been structured so that they have similar risk profiles and pricing to that of conventional debt bonds. Though
still Shariah compliant, they have essentially become debt obligations. In 2009, only 11 out of a total of 560
sukukissues as of 5th August 2009 (or around 2% of the total) qualified to be asset-backed because they fulfilled the
Shariah requirements of an actual sale of the underlying asset to investors (Dusuki & Mokhtar, 2010). Further, as
reported by Hijazi (2010)at the end of 2009, only 4% of the US$32 billion worth of sukuk rated by Moody‟s
represented secured „asset-backed‟ sukuk and this dominance of „unsecured sukuk‟ continued into 2010. By 2015,
asset-based structures still dominated the market while asset-backed structures were very few and far between(Dey,
2015).The dominance of asset-based sukuk structure is due to a few reasons: firstly, asset-based sukuk employ a more
suitable asset class thus encouraging product innovation; secondly, the personnel are more knowledgeable of asset-
based sukuk and not asset-backed sukuk; and thirdly, investors understand the structure of asset-based sukuk better
than asset-backed sukuk (Hasan, 2013). For this reason, asset-based sukuk are considered to be simpler than asset-
backed sukuk and the price tends to be more reasonable, which confirms its popularity. However, given asset-based
sukuk still require 100% physical assets despite the constraints, corporate as well as sovereign issuers devised
alternative blended assets.
4.3 The dawn of ‘blended assets’ sukuk
Blended assets sukuk are also known as hybrid sukuk or mixed-asset sukuk. As the name implies, the issuing
company is allowed to compose more than two or widely differing elements in the sukuk structure (Furqani,
2014).First, hybrid sukuk can combine some elements of equity and debt. It means that a hybrid sukuk is structured
with both debt and equity-linked features in the contracts that grant the holder the right to convert the sukuk
certificates into shares or equity ownership from the issuer (or the obligor), following the conversion of the sukuk.
Second, while previous sukuk had been predominantly structured using only one Shariah contract, e.g. istisna’,
murabahah, mudharabah and ijarah, hybrid sukuk allowa combination of two or more Islamic finance of these contracts
into the structure. Third and finally, the hybrid sukuk combine Shariah-compatible receivables (or intangibles assets)
and physical assets.
While the hybrid sukuk can comprise both physical assets and Shariah-compliant receivables, it is subjected to
condition that the proportion of the physical assets has to exceed that of the receivables for sukuk issuance and
trading. Since murabahah and istisna’ contracts cannot be traded on secondary markets, the proportion of untradeable
contracts in a pool of assets cannot exceed 49% of total assets(Gurulkan, 2010).This means that at least 51% of the
pool in a hybrid sukuk must comprise tradable Islamic instruments in the market such as an ijarahsukuk. The modus
operandi of issuing a mixed portfolio sukuk is an effective tool for converting non-marketable and illiquid assets to
negotiable instruments and can be traded in a secondary market. It is a strategy particularly suitable for investment
banks and development finance institutions. Since the first hybrid sukuk was issued in 2006, a large proportion of
sukuk issuances have been in the form of convertible and exchangeable sukuk. Interest has grown among issuers and
investors for hybrid sukuk due to them being equity-linked(Furqani, 2014).
4.3.1 The deviation of tangible assets in the sukuk structure
The emergence of blended assets sukuk has demonstrated that the sukuk market reduced the requirement of
100% physical assets in the sukuk structure. The dilution of required physical assets was evidenced by the sukuk issued
by the Islamic Development Bank in 2003. In that year the Islamic Development Bank issued the first hybrid sukuk
that was valued at US$400 million. Its underline assets comprised ijarahsukuk (65.8%), murabahah receivables (30.73%)
and istisna’ sukuk (3.4%). The ijarah assets had certain physical assets owned by the Islamic Development Bank and
were leased out to various counterparties(GIFR, 2010).Since the ijarah assets could be freely transferred at any price by
the Islamic Development Bank, by mixing the murahabah and istisna‟ receivables (dayn) with ijarah assets (ayn), the
Islamic Development Bank was able to transfer the receivables as well. Accounting for the fact that the Islamic
Development Bank had fewer physical assets and more Shariah-compatible receivables on its books, as other financial
institutions experienced, implementing the “blended assets” sukuk approach was the only viable solution.
Rafisah Mat Radzi 23

Such a structure makes it possible for the issuing company or entity to take into account the diversified
demands of various investors, allowing for a wider portfolio of assets classes that, in turn, aim at a greater
mobilization of funds.
The requirements for physical assets became further diluted when the Islamic Development Bank issued
sukuk again in 2005. While the earlier sukuk structure comprised 65.8% of certain physical assets owned by the Islamic
Development Bank, this time it was permitted to reduce the minimum physical assets to 30% in a mixed asset
portfolio. Previously, some Hanafi scholars have taken a more liberal view of the khultah (mixture of assets)principle.
They have not allocated any fixed percentage or quantity, but have left the matter to be decided on a case-by-case
basis. Hence, there may be circumstances where even if the non-compatible component is more than 50%, this can
still be on the whole considered Shariah-compatible (GIFR, 2010). Based on this view, the Islamic Development Bank
was permitted to sell a mixed portfolio consisting of only 30% physical assets.
Whilst the “blended assets” sukuk structure has been a tremendous boost for institutions like the Islamic
Development Bank and other Islamic financial institutions where the sukuk capital markets can be tapped, others
found the prevailing sukuk structure to be constraining and unviable. At that time, many of these corporations were in
an expansion mode fueled by the oil boom (2002 to mid-2008) that generated a large volume of revenues for the Gulf
Cooperation Council countries(Saif, 2009).While the corporations were keen to tap the ever-growing and liquid
Islamic finance market, they either could not meet the 30% physical assets requirement or they did not have any
Shariah-compatible receivables. The constraint of asset requirements for the sukuk issuance thus led to the emergence
of asset-light sukuk.
4.4 The temporary emergence of asset-light sukuk and its Shariah issues
To meet the growing demand of issuers who did not have the required minimum physical assets, an asset-
light sukukstructure was conceived. The development of asset-light sukuk does not require any physical assets at the
time of sukuk issuance. Its features are similar to those of the asset-based sukuk structure (Ismal, Muljawan, Chalid,
Kashoogie, & Sastrosuwito, 2015). The sukuk holders would only be able to dispose of the assets to the lessee and be
treated as unsecured creditors or ranked pari-passu with other unsecured creditors. These asset-light sukuk are based on
the equity-based sukuk, in particular mudharabah and musharakah arrangements between the issuer and the sukuk
holders. This kind of structure has become a market choice until equity-based sukuk were criticized by the Chairman
of the AAOIFI, Sheikh TaqiUsmani in 2007(see Usmani, 2007).
4.4.1 Shariah issues and equity-based sukuk transactions
In analyzing Sheikh TaqiUsmani‟s critical comments (see Table 1), it is evident that his statements on the
sukuk structure mainly pertained to three aspects of the sukuk structure. First, sukuk represent ownership shares in
assets yet the market has witnessed a number of sukuk in which there is doubt regarding sukuk holders‟ ownership
interest in the underlying assets. The criticism pertained to asset-based sukuk where there is no legal sale of the
underlying assets and as such no real transfer of ownership of the assets to sukuk holders from the originating
company. Legal documentation in asset-based sukuk indicates that sukuk holders do not have an interest in the
underlying asset, which conflicts with Shariah principles that require sukuk investors to have rights over the sukuk
assets. The other two criticisms focused mainly on the structural features of the musharakahsukuk and
mudharabahsukuk. Most of the sukuk that have been issued are identical to conventional bonds with regard to the
distribution of profits from the companies being fixed percentages of interest rates based on London Inter Bank
Offer Rate (LIBOR). The criticisms also highlighted the use of Shariah-compliantfunding to make up for any shortfalls
in actualprofit below the stipulated percentage to sukuk holders. Thepayment of any excess profit realized beyond the
expectedprofit percentage takes the form of incentive fees/incentive fee to the manager. This includes the use of
purchase undertakings to guarantee the sukukholders‟ principal where it is expected the issuerwill buy back the
underlying asset at the expiration date ofthe sukuk, or in the event of default at face value regardlessof their true value
on that day. Such practices convert theequity-based sukuk into debt-based structures whereby thesukuk are redeemed
at par value at the maturity date. Furthermore sukuk holders are paid a guaranteed periodic return on capital
throughout the duration of the sukuk.
Concerns about the prevalence of these practices were also raised by other prominent Shariah scholars, leading
to the release of an AAOIFI Shariah resolution on sukuk in 2008, which clarified the permissible structure as well as
the nature of issuer-investor rights and obligations (see Table 1).
24 Journal of Islamic Banking and Finance, Vol. 6(1), June 2018

There are six core principles that underline the structuring and implementation of sukuk transactions, it was these
principles that were often being disregarded in the larger or volume-based sukukstructures.
Table 1 Summary of AAOIFI’s sukuk criticisms and its ruling in relation to sukuk issuance
Issue Mechanism Criticism * Six recommendations by AAOIFI on proper
sukuk structures

1. Asset  Ownership Does not confer true 1. Sukuk, in order for them to be tradable, must be
ownership ownership owned by sukuk holders, together with all the right and
obligations. The manager of a sukuk issuance must
establish the transfer of ownership of such assets in its
books, and must not retain them as its own assets.
2. Regular  Management The prescribed
distribution Incentive fee incentive fee is not 2. Sukuk must not represent receivables or debt except
to linked to the expected in the case of a trading or financial entity selling all of
sukukholders  Liquidity profit of an enterprise its assets, or a portfolio with a standing financial
facility but to the cost of obligation.
financing
3. It is not permissible for the manager of sukuk to
This incentive system undertake to offer loans to sukuk holders when actual
defeats the purpose of earnings fall short of expected earnings. It is
the Islamic concept and permissible, however, to establish a reserve for the
practice of wealth purpose of covering such shortfalls to the extent
distribution possible, on condition that the same is mentioned in
This amounts to sale the prospectus.
linked to credit and is
therefore prohibited 4. It is not permissible for the investment manager,
partner, or investment agent to agree to re-purchase
assets from sukuk holders at nominal value when the
3. Guarantee  Purchase Promise to repurchase sukuk are extinguished at the end of their maturity. It is
of the undertaking asset at face value and permissible, however, to agree to purchase the assets
return of not market value. If the for their net value, or market value, or fair market
principal enterprise makes a loss, value, or for a price agreed to at the time of their
such losses will be purchase, in accordance with Shariah rules of
borne by the manager partnership and modern partnerships, and on the
subject of guarantees.

5. It is permissible for the lessee in a Sukuk Al-Ijarah to

agree to purchase the leased assets when the sukuk are
extinguished for their nominal value, provided that the
lessee is not also an investment partner, investment
manager, or agent.

6. Shariah supervisory boards should not limit their role

to the issuance of fatwa on the structure of sukuk, but
should also oversee its implementation and compliance
at every stage of the operation.

Sources: Usmani (2007) and AAOIFI‟s Resolution issued in February*

Some credit enhancements are prohibited in equity-based sukuk and in particular the use of: firstly, Shariah-
compliant funding to smooth out periodic income distribution amounts to sukuk holders; and secondly, purchase
undertakings to guarantee the return of the principal amount to sukuk holders at its par or nominal value. The
AAOIFI pronouncement only allowed purchase undertakings to repurchase the assets for their net value, their market
value, fair value or agreed price at the time of their actual purchase. As such, without an undertaking to buy the shares
Rafisah Mat Radzi 25

of the sukuk holders at par value, it is impossible to issue an asset-light sukuk. Consequently, there have not been any
asset-light sukuk offerings in the market since the AAOIFI ruling in February 2008 (Haneef, 2009). Therefore, this
ruling effectively put an end to the dramatic growth of asset-light sukuk issuance. Nevertheless, to what extent the
AAOIFI ruling resulted in a dramatic decline in new issues during 2008 is impossible to determine as in the meantime
the decline was attributable to the devastating Global Financial Crisis6. Similarly, many of the sukuk issued previously
would have had a three–to five–year tenure and therefore were repaid in 2008, with market conditions preventing
these from being rolled over (Norman, 2009).
4.5 Back to blended-assets sukuk
In the past few years, the sukuk market witnessed increasing acceptance of asset-light structures temporarily,
which reduced the proportion of fixed assets required. As many equity-based sukuk appeared to violate the principle
of risk and profit-sharing, the AAOIFI ban played a key role in shifting the market away from asset-light sukuk in
2008. As such, the asset-based sukuk by and large in the form of ijarah again became attractive options to issuers. In
2009, the first domestic sovereign retail ijarahsukuk which was worth US$464 million by the government of Indonesia
was issued. There was also ijarahsukuk worth US$750 million, issued Government of Bahrain and ijarahsukuk issued by
Petrolium Nasional Berhad (Petronas), Malaysia worth US$1,500 million(IIFM, 2011). However, in recent years, there
has been a change in issuer preferences relating to asset-based structures. Ijarah had been the most popular structure
for international issuances, but a sudden transformation occurred in sukuk with underlying wakalah (investment
agency) assets in 2015. The proportion of ijarah sukuk in the international market fell from 42% in 2014 to 14% in
2015, while wakalah accounted for 63% of issuances in 2015. The wakalah structure is also showing signs of taking
over from murabahah as the most issued type of sukuk since 2015, given that the latter is required to be held to
maturity in Gulf Cooperation Council markets(Thomson Reuters, 2017).
The unavailability of suitable assets for ijarahsukuk and the non-tradability of murabahahsukuk on the
secondary market7 remain challenges for sukuk issuers. These issues have constantly put pressure on market
participants and market scholars to devise innovative structures that rely less on physical assets and be widely
acceptable to investors, Shariah experts and stakeholders at large(Muhammad & Sairally, 2014).In this context,
wakalahsukuk have increased their popularity as they allow issuers, particularly those who prefer holding few tangible
assets, to use a smaller level of these assets, including financing assets such as ijarah which are asset-based
themselves(Thomson Reuters, 2017). Furthermore, the issuers can access a larger variety of diverse assets such as
equities and derivatives, provided they meet Shariah guidelines 8. In fact, certain assets that cannot be traded on the
secondary market such as murababah and istisna’ contracts can be part of the portfolio of sukuk assets, provided that
the overall sukuk portfolio includes a minimum of 30% of tangible assets (or more, depending on Shariah
approvals)(DIFC, 2009).This enables the wakeel (agent in the wakalahsukuk) to mix and match different types of assets
and effectively utilize those assets which, by themselves, may not comply with the tangibility criterion. Therefore, the
wakalahsukuk structure may be particularly useful for Islamic banks and financial institutions, which tend to have a
large number of commodity murabahah and istisna’ contracts on their balance sheets.
Although the wakalah structure is included as an asset-based structure, it functions in many cases as a hybrid
structure (Thomson Reuters, 2017) as witnessed by wakalahsukuk issued by the Malaysian Government in 2011. The
underlying asset pool for this US$2 billion dual tranche comprised 52% tangible assets consisting of lease assets which
will be redeemed at maturity and 48% murabahah receivables arising from the sale of Shariah-compliant commodities
which will be the initial investment.

6The record growth rates achieved by the Islamic Financial Services Industry (IFSI) and the sukuk market in particular during the
years preceding the 2008 Global Financial Crisis were unique with the market attaining its peak during 2007. In that year total
global sukuk issuance amounted to nearly US$49 billion. Nonetheless the global sukuk market was not spared the effects of the
crisis; it indeed witnessed with a substantial decline in sukuk issuance during 2008 and 2009 to US$18.6 billion and US$25.7
billion, respectively (IIFM 2011, p.6)
7Domestic Shariahrulings in Gulf Cooperation Council countries do not allow murabahahsukukto be traded in the secondarymarket,

in contrast to Malaysia where such tradability is permitted.

8The portfolio of assets may comprise a broad range of Shariah-compliant assets that will be selected by the wakeel for a period of

time corresponding to the duration of the sukuk. The criteria for the assets that may be included in the portfolio must be set or
approved by the relevant Shariah board that issues the fatwa. However, the range of assets may be fairly broad and could include
equities (which are issued by companies complyingwith certain Shariah guidelines or listed on Shariah-approved indices), other
Shariah-compliant assets (such asmurabaha, istisna’ or even other sukuk – see below). This could apply to other types of derivative
products, provided they meet the demands of Shariah guidelines (DIFC 2009, p. 57).
26 Journal of Islamic Banking and Finance, Vol. 6(1), June 2018

The obligor is appointed as an agent (wakeel) to invest and manage sukuk proceeds on behalf of the
sukukholders. The transaction attracted investors from a diverse group as it was well spread out globally with 29% of
the sukuk distributed to the Middle East, 27% in Malaysia, 22% to the rest of Asia, 14% to Europe and 8% to the
US(Parker, 2011). This structure has the added advantage of allowing issuances above the value of available physical
assets. Given that the wakalahsukuk structure demonstrates widespread acceptability, this confirms that the sukuk
market relies again on a blended asset structure based on the principle of khultah (mixture of assets). The market has
seen a shift away from the once-prevalent ijarah structure towards hybrid structures which provide more flexibility
with respect to the types of assets that can be used.
5.0 Conclusion
Sukuk structures have evolved from basic to innovative structures designed to serve specific needs and
demands in the marketplace. Nevertheless, not all innovation is positive as demonstrated by the failure of sukuk to
become a Shariah-compliant financing instrument and alternative to conventional bonds. The challenges in structuring
sukuk, in particular insufficient amount of physical assets to a certain extent have put Islamic market players under
pressure. As a consequence the Shariah standards became more liberal in their interpretation of these structures. What
has become a worrying practice is the „form over substance‟ compliance where the assets in the sukuk structure are
commonly used as a facade for Shariah compliance, or as industry jargon puts it, „compliance in the form‟ only and
ultimately has no bearing on the risk performance of the asset sukuk.
In structuring sukuk contracts, a dividing line needs to be drawn between financial innovations and deviations
from Shariah principles. Therefore, for better Shariah compliance that also accords with market requirements, there is a
demand for Shariah advisors to do more than just advise and approve the structure of the proposed issue. It is in fact
very important for them to constantly work with rating agencies, industry professionals, accounting and auditing
organizations and academics to ensure Islamic financial services do cater to customers‟ myriad requirements. It would
therefore be important to see ideas emerging for Islamic products that break away from conventional finance and
offer genuinely different ways of doing business.(O‟Callaghan, Ure, Jones, Byrne, & Nichols, 2012)

Acknowledgement
The support of Fundamental Research Grant Scheme (FRGS) [Grant Number: 203.PJJAUH.6711547],
Ministry of Education, Malaysia and Universiti Sains Malaysia are gratefully acknowledged.

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