The UK became the first country outside the Islamic world to issue a sukuk, or Islamic bond, in June. A sukuk is an Islamic financial certificate, equivalent to a conventional bond, which must comply with Islamic law, the sharia.
The fundamental principle is that sharia prohibits the charging and paying of interest but accepts predetermined rental fees as well as the sharing of profits and losses of underlying instruments. Sukuk refers to a certificate issued by a beneficiary as evidence of the collected funds entitling rights in certain assets, debts, projects, business or investments.
Sukuk is considered to have great potential, especially in markets where Islamic principles affect investors’ decisions. An interesting development is that immigration has increased the number of people in Europe who are Muslims. Moreover, due to changing technology, more people from Islamic regions have access to Islamic products traded in European centres, such as London and Luxembourg.
The return on sukuk makes these instruments an attractive investment. The yield on the UK government sukuk has been set at 2.036%, in line with the yield on gilts of similar maturity. Many market participants, even investors from non-Islamic backgrounds, are choosing Islamic financial products over conventional ones. The British government says it sold £200 million ($330 million) of the newly issued sukuk, maturing on 22 July 2019, to investors based in the UK and elsewhere.
In the sukuk contract, the risk and the return associated with cash flows generated by underlying assets belong to the pool and are passed to the sukuk holders.
All performance and risks that refer to sukuk contracts are related to the associated risks that arise in underlying Islamic contracts. Market expectations play an important role in defining the performance of the underlying Islamic products. There are promises such as paying the rent and buying back the bonds at face value at a future date, which are expected to be kept by the counterparties. Behaviour of both markets and counterparties can be changed under volatile times which could cause unexpected performance of sukuk products.
It is worth noting that Islamic products are based more on fixed term than on variable market expectations. This provides a more stable income however the robustness under volatile markets reduces dramatically. Due to cultural factors, Islamic products seem to have less probability of default than conventional ones; however, a possible inability of the counterparties to fulfil their obligations may be hidden up to the time of a default event, which brings some additional challenges in counterparty risk analysis. Behaviour risk seems to be less unexpected and thus may have less of an impact on associated risks.
The financial industry must be able to map Islamic products by correctly identifying the input information needed in financial analysis. Institutions must be able to perform profitability and risk analysis for portfolios and accounts which contain Islamic instruments. There are special analysis elements in terms of market, counterparty, credit and behaviour risk factors that should be also considered. Analysis and reports in regards to value, liquidity and risk should be performed by applying the same techniques and methodologies as in conventional products. Considering firms need to comply with standard regulations and sharia laws, extra effort in compliance must be applied.
Ioannis Akkizidis is global product manager at Wolters Kluwer Financial Services
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