Introduction to Islamic Finance and Sukuk

1
Introduction to Islamic Finance and Sukuk

• Presented by
• Tay Beng Chai
• Managing Partner
• Prepared by
• Ronald Tan
• Wong Poh Swan

2
Topics

• Understanding Islamic Finance
• Principles of Islamic Finance
• Examples of Islamic Finance Products
• Islamic Bonds in Malaysia
• Advantages of Islamic Bonds
• The Islamic Capital Market in Malaysia
• Conclusion

3

• UNDERSTANDING ISLAMIC FINANCE

4
Understanding Islamic Finance

• Islamic finance must comply with Islamic law or
  Syariah which aims for an equitable wealth
  distribution amongst its participants
• The central and distinctive feature of an Islamic
  financial system is the prohibition of the
  payment and receipt of interest
• Instead, Islamic finance is based on
  profit-sharing or trading contracts between the
  Islamic financial institution and the customer

5
Understanding Islamic Finance (cont.)

• Islamic finance mirrors conventional finance, for
  example
• a. Banking (eg. deposits and home loans)
• b. Capital Markets (eg. bonds or sukuks)
• c. Insurance and Reinsurance ( takaful and
  retakaful )
• d. Fund Management and Asset Management

6
Islamic Finance in Malaysia

• Emerged in the 1960s
• Globally recognised as the innovator of numerous
  Shariah compliant products and services in the
  Islamic capital market, notably Sukuk (Islamic
  bonds)
• The worlds leading issuer of Sukuk
• Has the worlds largest Sukuk market, estimated
  at US60.0 billion in 2007

7

• PRINCIPLES OF ISLAMIC FINANCE

8
The 5 core principles of Islamic Finance

• Prohibition on interest (riba)
• Prohibition on uncertainty or speculation
  (gharar)
• Prohibition on haram activities
• The mutuality of risk and profit sharing
  principle
• The asset-backing principle

9
1. Prohibition on interest (riba)

• Riba refers to an increase or excess which
  accrues to the owner by virtue of a loan
  arrangement, without providing any equivalent
  value to the other party
• This prohibition arises because money in Islam is
  perceived only as a medium of exchange, stored
  value and unit of measurement
• However, profits are permitted e.g. profits
  derived from trading and investments

10
2. Prohibition on uncertainty or speculation
(gharar)

• The terms and conditions of the financial
  transaction must be certain
• This is to prevent conferring an unfair advantage
  to one party over the other
• Ambiguity based on future events cannot be part
  of the financial transaction to avoid future
  conflicts

11
3. Prohibition on haram activities

• Certain businesses are incompatible with Islamic
  law and are thus not considered suitable for
  Islamic investing such as those related to
• a. alcohol
• b. pork-related products
• c. gambling joints / casinos
• d. pornography

12
4. The mutuality of risk and profit sharing
principle

• Parties must share the risk and profit to the
  financial transaction
• This promotes sound risk management practices to
  be adopted by the Islamic financial institution

13
5. The asset-backing principle

• Each Islamic financial transaction must link to a
  tangible and identifiable asset
• This is contrary to conventional banking which
  has complex products like collaterised debt
  obligations (CDOs) which has such remote link
  from the asset charged which may not be
  identifiable when a default occurs

14

• EXAMPLES OF
• ISLAMIC FINANCIAL PRODUCTS

15
Examples of Islamic Financial Products

• Mudharabah (Profit-sharing agreement)
• Musyarakah (Partnership / Joint Venture)
• Murabahah (Cost plus)
• Ijarah (Leasing)

16
1. Mudharabah (Profit-sharing agreement)

• An agreement between a capital provider and an
  entrepreneur
• To enable the entrepreneur to carry out business
  activities
• Profits made from the business will be
  distributed on a pre-agreed profit-sharing ratio
• If losses are made, losses will be borne by the
  capital provider

17
2. Musyarakah (Partnership / Joint Venture)

• A partnership or joint venture for a specific
  business
• Distribution of profits will be apportioned on a
  pre-determined ratio
• In the event of losses, both parties will share
  the losses based on their equity percentage

18
3. Murabahah (Cost plus)

• A contract of sale of goods at a price mutually
  agreed by both parties
• Conditions such as the sale and purchase price of
  the goods, the profit margin of the vendor and
  any other costs involved have to be set out
  clearly at the time of agreement of the sale is
  entered into

19
4. Ijarah (Leasing)

• An agreement where the lessor (owner) leases an
  asset to a lessee
• The lease rental and the duration of the lease
  period are agreed in advance
• The ownership of the leased asset always remains
  with the lessor

20
Islamic Bond Using Ijarah Structure
Lessee
(6) SPV leases the asset to Lessee
(7) Lessee makes periodic lease payments to SPV
(8) SPV uses lease payments to service
coupon/profit payment to investors
(2) SPV issues Islamic bonds / Sukuk to investors
(1) Sells asset to SPV
Islamic Bond Holders
(5) SPV pays Owner for the asset
Owner of asset (Vendor)
(4) SPV receives payments from investors
Special Purpose Vehicle (SPV)
(3) Investors subscribe
Source Malaysia International Islamic Financial
Centre (MIFC)
21

• ISLAMIC BONDS (Sukuks)

22
What are Islamic Bonds?

• Islamic bonds are tradeable securities that grant
  investors a share of the asset together with the
  cash flow and risks that commensurate from such
  ownership
• It is not simply a claim to cash flow but also an
  ownership claim
• Islamic bonds must comply with the principles of
  Islamic law e.g. prohibition of interest

23
Notable Islamic Bond Issuance in Malaysia
Source Securities Commission, Malaysia
24
Source Securities Commission, Malaysia Annual
Report 2004-2007
25
Announced Islamic Bonds in the Pipeline in 2008
by Sector
Source Islamic Finance Asia-August/September
2008 issue
26
Malaysian International Islamic Financial Centre
(MIFC)

• To cement its market leader and first-mover
  advantage, Malaysia in 2006 launched the MIFC
• Objective is to develop and internationalise the
  Islamic capital markets in Malaysia
• MIFCs strategies include
• a. Efficient legal and regulatory regime
• b. Tax incentives
• c. Ability to issue in foreign currencies
• d. Investors-friendly market

27

• ADVANTAGES OF
• ISLAMIC BONDS

28
Advantages of Islamic Bonds

• Certain and less risk prone
• Transparent and clear
• Flexible and open to all
• Ample liquidity in the market

29
1. Transaction is certain and less risk-prone

• The prohibition of interest in Islamic finance
  ensures that all transactions are backed by
  tangible and identifiable assets as opposed to
  intangible assets such as debt
• It deters the complexities faced by conventional
  banking which are heavily based on debts that are
  being passed on as promises to pay when it
  reality, there is nothing supporting any
  repayment in the event of default

30
2. Transaction is transparent and clear

• Full disclosure of the assets are given to the
  investors
• The accountability of the parties, subject matter
  and time of delivery are clearly set out in the
  contracts
• The ratio or percentage of the profit-sharing
  between the parties are disclosed and agreed upon
  in advance
• Issuers, arrangers, banks and investors are
  therefore obligated to manage risks well for the
  benefit of all parties

31
3. Flexible and open to all

• Islamic bonds are open to all not limited only
  to Muslim issuers, banks and investors
• In Malaysia, the Islamic capital market is open
  to not only Malaysian companies but also eligible
  foreign issuers
• Issuers are also given the option and flexibility
  to issue their Islamic bond either in Ringgit
  Malaysia (official currency of Malaysia) or in
  foreign currency

32
4. Ample Liquidity in the Market

• Massive liquidity pool especially from the Gulf
  Cooperation Council (GCC) countries from rising
  petrodollar receipts (estimated to exceed
  US600.0 billion)
• With narrowing options for financing due to the
  current global credit crunch, issuers are seeking
  alternative fund raising to tap this massive
  liquidity
• New players to the Islamic capital market, such
  as Singapore and Hong Kong, have taken steps to
  be Islamic financial centres to secure a sizeable
  portion of this lucrative Islamic capital market

33

• THE ISLAMIC CAPITAL MARKET
• IN MALAYSIA

34
The Islamic Capital Market in Malaysia

• Malaysia has scored many firsts in Islamic
  capital markets e.g.
• a. worlds largest Islamic bond market estimated
  at US60.0 billion in 2007
• b. worlds first global sovereign Sukuk of
  US600 million
• by the Government of Malaysia
• c. worlds largest exchangeable Sukuk of US850
  million
• d. worlds leading issuer of Islamic bonds

35
Islamic Bond Issuance by Country in 2007

• Source IFN

Note Total global issuance for Islamic bonds was
US87.0 billion in 2007
36

• CONCLUSION

37
Bright Outlook for Islamic Bonds

• The Malaysian government, the Central Bank, the
  Securities Commission and Bursa Malaysia have
  been working conscientiously toward a sustainable
  framework of rules, guidelines and legislation to
  encourage the rapid growth of Islamic Bonds
• With the recent subprime crisis and global credit
  crunch, the essence of Islamic finance which
  focuses on transparency, good corporate
  governance and fairness, many have and would
  resort to Islamic finance as an alternative
  cost-effective fund raising avenue

38
Bright Outlook for Islamic Bonds (cont.)

• Growing at a phenomenal annual rate of 20
• Expected to average US40.0 billion of new
  issuance annually from 2008 onwards
• Yet Islamic bonds represents not more than 15 of
  the US700 billion in total global Islamic
  assets an indication of its growth potential

39
THANK YOU