Sukuk, the plural form of the word sakk, refers to an investment certificate that is deemed to be compliant with Islamic financing principles. In the past, sukuk were used to facilitate trade transactions among merchants by serving as promissory notes. Historical records show that these notes were widely traded and exchanged.

Contemporary sukuk are used to raise funds for investments in a manner compatible with Islamic principles. Given that some sukuk are similar to conventional bonds, they have often been called “Islamic bonds.” However, there are key differences between sukuk and conventional bonds.

Most importantly, the structure of sukuk has to conform to that of the religious principles of shari’ah. In practice, a shari’ah advisory board is usually set up and consulted to ensure that the sukuk being structured comply with Islamic principles. An overarching principle in Islamic finance is that transactions should be grounded in real productive economic activities. Transactions that are mostly monetary or speculative in nature are forbidden. Specifically, there are five forbidden activities that sukuk have to avoid:

• Prohibition against unjust enrichment (riba). This is more commonly known as the prohibition against the payment of interest. Under Islamic law, money is treated as a means of exchange rather than a store of value. Hence, there is no expectation of profiting from lending money. Instead profit should be the reward for entrepreneurs who are carrying out economically productive activities. Because of the prohibition
  against the payment of interest, Islamic financial contracts tend to be structured around real assets such as commodities and real estate.
• Prohibition against gambling or speculation (masir). Shari’ah also does not allow transactions that are based on speculation or luck rather than productive activity. This is because Islam views gambling as immoral. Hence, most conventional futures, forwards, and options contracts are not permissible under shari’ah.
• Prohibition against unnecessary risk (gharar). Under Islamic principles, there can be no uncertainty in a contract. All of a contract’s terms have to be spelled out to avoid either party from taking on unnecessary risk.
• Prohibition against taking unfair advantage (jahl). Islamic principles forbid one party in a contract to take unfair advantage of the other party. Hence, there should not be an attempt to exploit another party’s lack of knowledge or financial situation.
• Prohibition against corruption (rishwah). In addition for the structure of the financial transaction to comply with Islamic principles, the transaction also must not have unethical or illegal purposes. As a result, contracts cannot be written covering activities that are forbidden by Islam such as casino operations and many conventional financial services.

 

In an attempt to standardize the definition of sukuk, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in May 2003 defined sukuk as “certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects or special investment activity.” AAOIFI also distinguishes sukuk from conventional bonds by emphasizing that sukuk are not claims on cash flows and cannot be based on a pool of receivables. Instead, sukuk should be seen as investment certificates with claims on assets and the right to a share of the cash flow that accrues from the ownership of the assets.

AAOIFI has identified at least 14 types of permissible sukuk, ranging from instruments with equity-like characteristics to asset-backed securities. However, only several of the allowed sukuk structures are commonly used. They are murabahah, an arrangement where goods are sold at a mark-up and then payment is spread over a period of time; salam, an arrangement where the buyer prepays for an asset to be delivered in the future; ijarah, a lease arrangement where the use of an asset is leased out in return for regular payments; istisna, an arrangement used to finance the sale of an asset that is currently under construction or not yet built; mudarahbah, a partnership arrangement where one partner supplies capital and the other offers expertise; and musharakah, a joint venture arrangement where both parties provide capital.

The most important characteristic of sukuk is that they represent a claim on an existing or well-defined asset. Meanwhile, conventional bonds represent an obligation to make periodic interest payments and principal upon maturity. Hence, sukuk can be seen as more closely related to asset-based securities. The other important characteristic is that the underlying asset for the sukuk must be shari’ah compliant.  This means that the assets cannot be involved in activities that are not permissible under Islamic law such as gambling or the sale of alcohol.

Asia Bond Monitor
Asian Development Bank