Could a new Shariah standard disrupt the sukuk market in 2025?

The sukuk market could potentially face significant disruption next year with the uptake of a new Shariah standard, industry experts say. 

It could question the viability of sukuk as an asset class and raise questions for the broader landscape, too. 

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Bahrain-based body responsible for setting Islamic finance standards, released the draft standard that seeks to redefine the concept of sukuk and its underlying structure. The draft aims to enhance the transparency, risk-profiling and Shariah-compliance of financial instruments.

The body had originally defined sukuk as 'securities of equal denomination representing individual ownership interests in a portfolio of eligible existing or future assets.'

In its present form, a sukuk transaction involves an issuer selling certificates to investors, with the proceeds used to purchase underlying assets.

The returns to investors are based on the performance of these assets or a predetermined rate. While maintaining Shariah compliance, sukuk share some similarities with conventional bonds but differ in their underlying structure. Nonetheless, the creditworthiness of the issuer remains a key factor in determining the risk and return profile of the sukuk.

AAOIFI published the exposure draft of the Shariah standard 62 in November 2023. It was released to gauge market feedback till the end of the first quarter. The review period was extended until July 31. 

However, the publication and effective date of the standard remains undisclosed. 

Industry stakeholders posit that the new standard, if implemented in its present form, could possibly convert sukuk into a complex and expensive financial instrument, dampening issuances as well as raising challenges for both existing issuers and investors.

AAOIFI Shariah standards are adopted as mandatory regulatory requirements in many countries and jurisdictions across the globe such as Bahrain, Jordan, Krygyzstan, Mauritius, Nigeria, Qatar and Qatar International Financial Centre (QIFC), Oman, Pakistan, Sudan, Syria, the UAE and Yemen. However, the level of enforcement varies from market to market.

The UAE, which is a key sukuk and Islamic finance market, could prove to be a litmus test. It is expected that the UAE Central Bank, which adopts AAOIFI Sharia standards via its Higher Sharia Authority, will implement and enforce the new directive on all nation-wide Islamic banks and relevant entities engaged in Islamic finance activities by mid-2025. 

Shariah-alignment
The new standard calls for several provisions, including genuine ownership of the underlying assets. It stipulates that sukuk ownership should be clearly defined, legally enforceable and must reflect a genuine transfer of possession. 

Furthermore, the risk and return of sukuk must be directly tied to the performance of the underlying asset and must not rely solely on the credit worthiness of the issuer. The standard also prohibits a guaranteed payment mechanism to ensure that sukuk does not replicate the functionalities of a conventional bond.

Practitioners argue that whilst the new benchmark inches the sukuk closer to the true Shariah principles, it will make the issuance and investment process of the instrument expensive and complexed. 

An S&P Global report issued in July predicts that adopting the guidelines as they have been presented could disrupt the market and result in further market fragmentation, dampen issuer and investor appetite and delay issuance until sukuk structurers figure out a middle ground. It could reduce issuance volumes over the medium term if it materially alters the nature and risk characteristics of sukuk instruments. 

If the standard is approved later this year, the adaptation will likely begin next year.

“This will not affect 2024 issuance but will likely be a consideration from next year. The standard will transition the industry toward asset-backed sukuk by requiring the real transfer of underlying assets to investors,” the agency added. 

Rizwan Kanji, partner at law firm Akin Gump in Dubai cautious that Standard 62 would mark a significant paradigm shift. 

“It [Standard 62] would entirely alter the risk profile of sukuk exposing the investors to the performance risk of the underlying assets,” he says. 

“The change in the risk profile would likely dampen primary issuance as well as the appetite for sukuk from investors. Approximately 90% of global sukuk issuances are asset based (i.e. corporate risk) and the market and investor community has not yet evolved to adopt an asset backed instrument. Any such developments may take time.”

Total sukuk issuance reached $91.9 billion over the first six months of 2024, which is on a par with last year but marks an upward trend in foreign currency-denominated issuances, according to the S&P report.

Altering the credit and risk profile of sukuk from an asset-based fixed income instrument - which currently shares several traits with a conventional bond - to a complex securitised instrument will lead to its own set of challenges including tax, accounting and legal considerations.

Khalid Howladar, managing partner of credit & sukuk advisory at Acreditus, says that sincere ‘asset-backed’ instruments are securitisations - which are a very different asset class to unsecured debt/sukuk. 

“They are more complex and expensive from a structuring perspective but easier from a Shariah standpoint given that the asset now has a very clear economic role in the sukuk performance,” adds Howladar.

Abdul Kadir Hussein, head of fixed income asset management at Dubai-based Arqaam Capital, points to three potential challenges for investors. 

“The cost to issuers will be a challenge. The transfer of assets may attract duties and fees. Secondly, the enforceability is tough for foreigners to own assets in some of these countries that issue sukuk. Thirdly, borrowers will most likely feel they are off the hook in that they have contributed the assets to cover the borrowing. If asset values decline, they will say it’s not our problem.”

Bashar Al Natoor, Islamic finance head at Fitch Ratings, adds that there are still some unanswered questions, like the specific details of the final standard, its level of implementation and the overall enforcement.

However, a UAE-based banker, who requested anonymity, believes that from a religious perspective, it is the right direction to pursue. “From a Shariah perspective, this what sukuk should be. We were structuring a lot of these kind of sukuk and financing solutions, but we were light on Shariah.” 

“Now these are going to be very solid Shariah-compliant structures. Much like in ESG, you have light green or dark green [denoting the level of sustainability] - the similar will apply here. However, that doesn’t mean the market is going to like it or move pass it,” the banker adds. 

The road ahead

A consortium of entities, comprising UAE banks, both Islamic and conventional, international lenders as well as law firms wrote a letter to AAOIFI last month, documenting their specific concerns regarding the new benchmark. The letter highlights challenges for issuers and investors as well as potential risks for the market if the standard is implemented in its current form. 

Nonetheless, Fitch’s Al Natoor, says that the Islamic finance market has previously demonstrated the capability to adapt to changes, as this is not the first time sukuk has experienced challenges. 

“We have to wait and see what the final standard contains and how it is enforced, before jumping to conclusions,” he notes.

“Historically, the market has adapted to shocks like AAOIFI's Taqi Usmani 2008 statement criticising the sukuk market, Dana Gas in 2017, and AAOIFI Standard 59 in 2021, to name a few.”