Clerics’ rule change threatens to throw Islamic debt market into turmoil
Proposed new standards could reshape sharia-compliant bonds and hit growth of $1tn market
The issuance of Islamic bonds could seize up over a new and controversial set of proposals from religious clerics, say credit rating agencies, which warn that the fast-growing $1tn market could fragment as a result of the plans.
Saudi Arabia and other Muslim-majority states are awaiting the outcome of a consultation by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the industry’s main standards-setting body, on its plans for issuers of Islamic bonds to transfer the legal ownership of assets that underpin them to investors.
AAOIFI says the move is required to harmonise issuance across several jurisdictions and ensure they more closely adhere to Islamic principles of risk-sharing in contracts. The body said in hearings this month that it would bring in the measures, known as Standard 62, this year, although issuers are expected to be given between one and three years to implement them.
Analysts have warned that the proposals represent a seismic change that would add huge legal complexity and raise transaction costs for Islamic bonds, known as sukuk. They say this could put off investors and stymie issuance, and lead to different countries following different standards.
“There will be an immediate impact,” said Reza Baqir, former governor of Pakistan’s central bank and a managing director of sovereign advisory services at Alvarez & Marsal. “There’s a risk it will stratify the market and delay the [wider] adoption of sukuk.”
Sukuk provide a means of working around the Muslim prohibition on partaking in transactions involving interest, by putting a borrower’s asset into an independent trust that then pays investors a pre-determined income rather than a fixed coupon.
The market for these bond-like instruments has grown rapidly, with issuance forecast to reach $200bn this year, according to S&P Global. Foreign currency issuance has climbed 24 per cent over the past year, as borrowers start to tap investors in the US and Europe.
However, AAOIFI’s scholars have been concerned that the market in its current form does not adhere to the spirit of Islamic financial jurisprudence. Many clerics want to see something more akin to an equity investment, where ownership of the underlying asset is transferred for the length of the contract.
Islamic law is open to interpretation and there is no single agreed-upon set of rules, with AAOIFI providing guidance based on the consensus view of 21 senior scholars in Islamic law and finance.
In 2008, in a seminal moment for the industry, AAOIFI’s chair Sheikh Muhammad Taqi Usmani said 85 per cent of the market breached key principles of Islamic law by not adequately sharing risk between obligor and lender. This triggered a transition to more asset-backed securities.
Rating agencies S&P Global and Moody’s say bond investors would be put off, either temporarily or permanently, because of AAOIFI’s proposal, as the new structures would no longer mimic a conventional bond. The latter has also said the move could “significantly” dampen sukuk issuance in 2025 if adopted in its proposed form. Fitch has said further moves towards a quasi-equity structure could render the instruments unrateable.
”If sukuk ceases to be a fixed income instrument, you will lose investors,” said Mohamed Damak, global head of Islamic finance at S&P Global.
Analysts have also said that rules blocking foreigners from owning land and property in some Middle East states could make it difficult for sovereigns to transfer ownership as part of any debt issuance, even on a temporary basis.
Saudi Arabia is now the biggest issuer of sukuk, having sought foreign investment to help finance crown prince Mohammed bin Salman’s ambitious Vision 2030 plans to modernise the kingdom. Islamic bonds make up around 60 per cent of its total debt issuance, according to data provider Dealogic.
Multiple lawyers involved in structuring Islamic sukuk contracts said they expect Saudi regulators to apply rules based on a looser interpretation of Islamic law, rather than comply with AAOIFI’s strict interpretation, splintering the market.
“If you interpret the rules in the most rigid and black and white way, it will be an own goal, because it will shrink the market,” said Debashis Dey, a partner at law firm White & Case.
Dey added that Standard 62 could lead to the creation of a range of structures, including a covered bond-like instrument — ultra-safe debt that give investors recourse both to the issuing bank and an underlying pool of assets — at one extreme and an equity-like instrument at the other.
Despite AAOIFI’s Standard 62 being laid out as guidance, religious scholars have grown wary of the various routes practitioners adopt to bypass intended changes.
“Sukuk do not look very different to conventional bonds any more and the market [needs] to move back to its roots, which is in trade not debt,” said Harris Irfan, former head of Islamic finance at Deutsche Bank and founder of Cordoba Capital.
“There will be a painful transition period. Some sovereigns might say that ‘we’re not playing this new game’ . . .[but] there’s no reason why institutional investors can’t participate,” Irfan added.