Can the UK make the most of sukuk, the Islam-compliant bond?

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Earning interest, or Riba, is forbidden under Islamic law: “Allah allows trade, but forbids interest,” says the Qu’ran, the holy text that, along with the Hadiths and other scripture, underpin the Muslim faith.

This is why different forms of investment have been devised for the faithful; one such method is in sukuk, a bond-like product that operates on a profit share basis. Sukuk can take a range of different forms; among the most common is a sovereign bond, known as Al-Ijara. The idea behind Al-ljara is that investors purchase an asset, which is then leased back, as opposed to a traditional Western fixed-rate bond where the holders earn a predetermined amount of interest.

The UK Government was quick to realise the sizeable opportunity offered by serving the needs of the international Islamic finance market. In June 2014, the UK became the first country outside the Islamic world to issue a sovereign sukuk of £200m.

Demand in 2014 was fierce. Investors from the UK, Middle East and Asia all wanted in on the Islamic bond. Later that year Luxembourg also issued a sovereign sukuk – the first AAA-rated government to issue a euro-based Islamic bond

And then it all went a bit quiet. Hopes that the international sukuk market would enjoy exponential growth have not quite met with expectations.

One reason is that the oil market has been in the doldrums ever since; this has weighed on the wealth and exchange rates of many Muslim countries.

In a low interest rate environment, Western issuers are less interested by the diversification benefits of sukuk bonds and more worried about their lack of liquidity and higher costs, according to Khalid Howladar, managing director of Acreditus, a Dubai-based risk advisory firm.

“While the UK has some clear policy and political support to make it the European hub for Islamic finance, the Treasury is ultimately driven to secure the lowest cost of funding for the Government,” he says. “Ultimately, being a hub requires development of an ecosystem around Islamic financial services but many key players (Islamic banks, funds and corporates) are missing. In Malaysia, the government offered tax breaks and economic incentives to help the sector grow but the local (UK) demand needs to be there,” he adds.

Today, we’re still in a situation where some products could be labelled as sharia-compliant in one jurisdiction and not in another. That’s an impediment for the markets

According to S&P Global Ratings, Islamic finance assets reached $2 trillion (£1.5 trillion) by the end of 2016, this was below their forecast.

The ratings agency believes that the market is being hampered by a lack of standardisation. This is the result of a fundamental disagreement among Islamic scholars as to what, precisely, constitutes an Islamic-compliant financial product.

“Today, we’re still in a situation where some products could be labelled as sharia-compliant in one jurisdiction and not in another,” explains Mohamed Damak, senior director and global head of Islamic finance, S&P Global Ratings. “That’s an impediment for the markets. Legal documentation is still not standardised, and that slows down the process of issuing sukuk.”

There is no clearer illustration of the problems associated with this lack of standardisation than the ongoing Dana Gas case, which is taking place in London because deals underlying most sukuk are written under English law. The case rests on whether, or not, the United Arab Emirates-based energy company Dana Gas can, as it claims, restructure some $700m of its debt based on the fact the bonds it originally sold are no longer, according to some scholars, Islamic-compliant. Its investors include Goldman Sachs and BlackRock.

There are worries that the outcome could further chill the fledgling market. The global sukuk market totals around $400bn according to a range of estimates, and with 65 products worth of total of $48bn listed on the London Stock Exchange, the UK is a major centre for Islamic bonds.

Mr Damak believes organisations such as the Islamic Financial Services Board will help the drive towards standardisation. A key moment, he says, will be when it becomes just as easy to issue a sukuk bond as any other fixed income instrument.

The UK legal and regulatory system has significant influence, not only in the writing of sukuk agreements, as the Dana Gas case shows, but also in terms of wider regulation.

Omar Shaikh says that the UK Islamic Finance Council, of which he is a board member, studied how to use external sharia audits to ensure the compliance of financial products by introducing additional checks.

Since the report, the central bank of Bahrain has introduced standards for such external audits, and these have also been implemented by the state bank of Pakistan and the central bank of Oman.

Mr Shaikh argues that while sukuk in the UK may not have taken off at quite the pace some had hoped for, Islamic finance overall is thriving. “We’re seeing [in Parliament] a lot of discussion around the launch of [sharia-compliant] student loans. We’ve also seen the UK’s only stand-alone sharia retail bank, Al Rayan bank, take its balance sheet over £1bn and into profitability.”

Mr Shaikh also notes that not only is the Islamic finance scene in the UK growing apace, it’s also integrating and innovating, with “the world’s first joint venture between Islamic finance and the Church [of Scotland] to create an ethical finance solution open to everyone in society, regardless of faith or background and based on shared values of the faith traditions,” he says.

In April, the Bank of England announced plans for a fund-based, sharia-compliant, deposit facility; in September, the UK Government announced plans to reissue its sukuk once the bond matures in 2019.

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