Critical Factors for Stimulating Private Sector Sukuk Markets

In my paper “Critical Factors for Stimulating Private Sector Sukuk Markets”, available here, I explore sukuk markets. Sukuk markets are the success story of contemporary Islamic finance. Sukuk have been instrumental in infrastructure development in the Middle East and Southeast Asia, including through the course of the recent economic downturn. The sukuk markets are dominated by issuances that are dependent upon sovereign credits. In 2014, 63% of all issuances, globally, were by sovereigns and 22% were by quasi-sovereigns.  An informal sampling of the remaining issuances (classified as “corporate”) suggests a deeper, albeit indirect, reliance on sovereign credits. Without diminishing the contributions that sukuk have made, appropriate conclusions are that there are gaps in the sukuk success story. In addition, the Islamic finance industry must address the more arduous undertaking of developing private sector sukuk issuances, especially outside the financial services sector.

The dearth of private sector sukuk issuances is due, in large part, to difficulties in obtaining ratings from international ratings services for issuances from jurisdictions within the Organisation for Islamic Cooperation (OIC). Those difficulties, in turn, result from (a) the inability of lawyers to render satisfactory legal opinions regarding certain substantive legal elements of sukuk transactional structures, and (b) a group of systemic legal infirmities and constraints. The problematic legal elements pertain to bankruptcy and insolvency principles (particularly “true sale” and “substantive consolidation” determinations) and collateral security regimes. The systemic legal infirmities involve challenges to the formation of special purpose entities to act as issuers in sukuk transactions and a range of factors that increase outcome uncertainties in enforcement proceedings.

My paper summarizes some of these impediments to growth of the private sector sukuk markets and suggests approaches for stimulating private sector issuances in both the short-term and the long-term. 

The short-term is designed to build a large and sustainable transaction flow in the immediate future. It requires a change in vision and orientation for the Islamic finance industry. It involves shifting sukuk issuance foci to markets where ratings requisites are already well developed and rated private sector securitization issuances are commonplace (despite frequent mischaracterizations, sukuk are securitizations, not bonds).

The long-term suggestion relates to substantive and systemic reforms in OIC jurisdictions that build upon a series of recent initiatives of UNCITRAL, the European Bank for Reconstruction and Development, the World Bank and the International Finance Corporation with respect to collateral security, bankruptcy-insolvency, and other commercial and financial law matters. These institutional initiatives provide the Islamic finance industry with a unique opportunity to lead in shaping relevant substantive law and related procedural mechanisms from inception, rather than as a piecemeal amendatory process that is reactive to laws and mechanisms that are already fully formed based upon interest-based financing concepts.

This post comes to us from Michael J.T. McMillen of Curtis, Mallet-Prevost, Colt & Mosle and the University of Pennsylvania Law School. It is an abstract of a paper that is freely available here, and which, without endnotes, was published by International Investor in connection with the Global Islamic Finance Forum 5.0 in Kuala Lumpur (10-12 May 2016).