Islamic Capital Market 4

Islamic Development Bank Group
Islamic Research and Training Institute
Islamic Capital Market Products: Developments and

Challenges
Salman Syed Ali
Occasional Paper No. 9

1425H / 2005
‫ﺑﺴﻢ اﷲ اﻟﺮﺣﻤﻦ اﻟﺮﺣﻴﻢ‬
‫‪iii‬‬
CONTENTS
Foreword.................................................................................................... xi
Acknowledgements ................................................................................... xiii
Executive Summary ................................................................................... xv
1. INTRODUCTION ............................................................................. 1
2. THE CAPITAL MARKETS—LANDSCAPE ................................... 5

2.1 Market Penetration ................................................................ 7
2.2 Corporate Earnings ............................................................. 10
2.3 Market Liquidity ................................................................. 10
2.4 Too Few Listings ................................................................ 13
3. SURVEY OF SELECTED ISLAMIC CAPITAL MARKET

PRODUCTS ..................................................................................... 15
3.1 SHARES AND EQUITIES .................................................. 18
3.1.1 Shariah compatibility of underlying business of the
company .......................................................................... 18
3.1.3 Shariah compatibility of various trading practices.......... 25
3.1.4 Performance of Islamic Equity Market ........................... 26
3.1.5 Issues in Stability of Islamic Equity and Equity Index ... 26
3.2 IJARAH-SUKUK .......................................................................... 28
3.2.1 Structure of Existing Ijarah Sukuk .................................. 30
3.2.2 Other forms of Sukuk ...................................................... 34
3.2.3 Current Size of Ijarah based Sukuk Market .................... 35
3.2.4 Players (originators and holders)..................................... 44
3.2.5 Risk Factors of Sukuk...................................................... 45
3.2.6 Advantages and Disadvantages of Sukuk ........................ 47
3.2.7 New Potential Sukuk Structures ...................................... 48
3.2.8 Development of Infrastructure for Sukuk ........................ 49
3.2.9 Shariah Issues in Ijarah Sukuk ........................................ 52
3.3 ISLAMIC DEPOSITORY RECEIPTS (IDR) ........................ 56
3.3.1 Possible advantages of IDR on shari[ah compatible stocks
and sukuk......................................................................... 58
vii
4. CASE STUDIES IN PRODUCT DEVELOPMENT ....................... 61
4.1 Mudarabah Companies an Innovation-Case Study of Pakistan 61
4.1.1 Lessons for product development ............................................ 62
4.1.2. Use of mudarabah as SPV for off-balance sheet transactions 70
4.2 Participation Term Finance Certificates—Pakistan .................72
4.3 Product Development—Case Study of Malaysia ....................74
4.4 Product Development —Case Study of Sudan........................75
4.5 Lessons Learned for Product Development ............................81
5. ISSUES IN FURTHER DEVELOPMENT ...................................... 85
Select Bibliography ................................................................................... 89
List of Tables
Table-1: Market Size in terms of Market Capitalization...................... 8

Table-2: Trading Volume and Market Liquidity................................ 11
Table-3: Number and Proportion of New Listings............................. 14
Table-4: Kinds of Capital Market Products Available....................... 17
Table-5: Market Capitalization of Shari[ah-compliant stocks........... 23
Table-6: Chronological List of Sovereign Sukuk ............................... 37
Table-7: Corporate Ijarah based Sukuk.............................................. 42
Table-8: Summary of Risk Characteristics of Sukuk ......................... 55
Table-9 Mudarabah Sector - Key Statistics...................................... 67
Table-10: Performance of Mudarabahs versus other NBFIs in Pakistan
............................................................................................. 69
Table-11: Statistics on GIC.................................................................. 80
Table-12: Countries where Islamic Capital Market Products are Offered
............................................................................................. 86
List of Figures
Figure-1: Structure of a generic Ijarah-Sukuk.................................... 32

Figure-2: Istisna based Ijarah Sukuk ................................................. 34
Figure-3: Term Structure of Sovereign Ijarah Sukuk.......................... 40
Figure-4: IIFM Shari[ah Authentication Process................................ 51
viii
LIST OF ABREVIATIONS
AAOIFI Accounting and Auditing Organization for Islamic

Financial Institutions
BBA Bay[ Bi-saman Ajil
BMA Bahrain Monetary Agency
CMC Central Bank Musharakah Certificate
DJIMI Dow Jones Islamic Market Index
FTSE Financial Times Stock Exchange Index
FTSE-GII FTSE Global Islamic Index
GDR Global Depository Receipt
GIC Government Investment Certificates
GMC Government Musharakah Certificate
IDB Islamic Development Bank
IDR Islamic Depository Receipts
IFSB Islamic Financial Services Board
IIFM International Islamic Financial Markets
IIRA International Islamic Rating Agency
IOSCO International Organization of Securities Commissions
IRTI Islamic Research and Training Institute
LMC Liquidity Management Centre
MC Mudarabah Certificate
MCo Mudarabah Company
NBFI Non-Bank Financial Institution
PTC Participation Term Certificate
SEC Securities and Exchange Commission
SECP Securities and Exchange Commission of Pakistan
SFSC Sudan Financial Services Company
ix
FOREWORD
Capital markets and interest-free financial products are integral part of

Islamic financial system and also important for the growth of other Islamic
financial institutions. Islamic Research and Training Institute have
therefore pursued an active research interest in this area. Previously the
Institute has published studies on various aspects of Islamic financial
instruments and markets.
Financial markets in a number of IDB-member countries are growing fast,

while other member countries are also actively trying to develop vibrant
capital markets. New products and Islamic sukuk have been offered both
by the public and private corporate sectors in local and international
markets. In this backdrop the Institute took the initiative for the present
paper “Islamic Capital Market Products: Developments and Challenges”
which is prepared by Salman Syed Ali. It is hoped that the paper will serve
to increase the understanding in developments and challenges of the new
products for Islamic financial markets. The ideas explored in it will help
expand the size and depth of these markets.
Bashir Ali Khallat

Acting Director
Islamic Research and Training Institute
xi
ACKNOWLEDGEMENTS
I would like to gratefully acknowledge the support, information, and

helpful discussions from many people during the writing of this paper. I
am thankful to Mr. Isam Elzein Elmahi, General Manager Khartoum Stock
Exchange; Mr. Mir Ghani Saad Muhammad, Deputy General Manager,
Sudan Financial Services Company and his staff; and Dr. Awatif Yusuf for
information on Sudan.
To Mr. Muhammad Shoaib and Mr. Muhammad Umair Chauhan of Al-

Meezan Investment Management for helpful discussion as well as useful
information on the size of shari[ah compatible portion of stock market in
Pakistan. Very informative discussions were held with Mr. Muhammad
Yasin Lakhani and Mr. Muhammed Yacoob Memon, respectively the
Chairman and the General Manager of Karachi Stock Exchange; as well as
with Mr. Etrat H. Rizvi, Mr. Shahid Ghaffar, and Mr. Rashid I Malik
Commissioners in the Securities and Exchange Commission of Pakistan.
An early discussion on the issues was made with Dr. Taha Tayyib of
Bahrain Institute of Banking and Finance. Information on Bahrain was
provided by various people in Bahrain Monetary Agency (BMA).
Telephonic and e-mail discussions were also held with Dr. Bashir al-
Ameen of IIFM in Bahrain. Helpful information on Bursa Malaysia was
obtained from the Securities and Exchange Commission Malaysia and Dr.
Musa Al-Habshi.
Comments made by the participants in the Policy Committee Meeting and

colleagues Dr. Tariqullah Khan, Dr. Sami Al-Suwailem, and Dr. Ahmed
Zubair provided the opportunity for refinements. The remaining errors and
deficiencies in exposition are my own without implication of others.
The opinions expressed in the paper reflect the views of the author which
does not necessarily reflect the opinion and views of IRTI or IDB.
xiii
EXECUTIVE SUMMARY
The development of Islamic capital markets is integral part of development

of capital markets in general. Such markets are essential for efficient
resource mobilization and allocation. It is more so in an Islamic economy
because prohibition of interest implies greater reliance on equities and
asset based financing.
The paper focuses on the state of equity and stable income products
(sukuk) in Islamic capital markets. Taking Bahrain, Malaysia, Pakistan,
and Sudan as sample it surveys the size of the markets for stocks and
ijarah sukuk and highlights the issues in their development. [Excluded
from the analysis are the other products, the regulatory issues, and the
aspects of market micro-structure]. This is done with the purpose to
understand how to enhance the proportion of Islamic products in the
capital markets of the IDB-member countries. Availability of appropriate
products will induce the firms to use the markets in the member countries
for raising the funds and investing them there.
Proportion of shari[ah compliant stocks in total market capitalization

considerably varies between countries: ranging from 6.4 per cent in
Bahrain to 51 per cent in Pakistan. Malaysia uses a different criteria under
which this proportion comes to 57.7 per cent. This small portion shows
that more is needed to transform the market by inducing changes in the
businesses and their capital structure. At the same time, the criteria for
determining shari[ah compliance of stocks needs further refinement and
unification across jurisdictions. The shari[ah admissible set of stocks
constructed using the debt to capitalization ratio criteria is quite sensitive
to market trend. It is a source of stability if the set of shari[ah compliant
stocks is large but a source of instability if it is small.
Sukuk are another class of products in the capital markets which have
gained acceptance. It has great potential as financing and risk management
tool both for corporate and government sectors. During the past three and a
half years (2001-2005) the market for sovereign ijarah sukuk has
witnessed 18 issues amounting to USD5.6 billion; and that for corporate
ijarah sukuk 10 issues amounting to USD1.599 billion. However, these are
still very small as compared to market needs.
xv
The primary market for ijarah sukuk is expected to grow further. However,
its secondary market has not yet developed. Targeting sukuk towards more
diversified group of investors can help create its secondary market due to
variable and non-correlated liquidity needs of such investors.
There are some un-resolved shari[ah issues in the design of many ijarah
sukuk such as the buy-back arrangement; terminal pricing on maturity; and
assignment of maintenance costs of the underlying-asset. These issues
need to be resolved quickly for the stability and continued investor
confidence in sukuk.
The paper also proposes new ijarah sukuk structure based on IDB and
member country joint asset pool for financing of projects in the IDB-
member countries.
Presently, market for Islamic capital market instruments is segmented

across countries and regions this reduces the effective available size and
risk-return spanning possibilities for investors. A system of Islamic
Depository Receipts is therefore proposed to expand the market for Islamic
products.
Case studies on the evolution of various other Islamic products in Pakistan,

Malaysia, and Sudan provide a number of lessons for product
development. Successful product development requires: tax neutrality
across products; managerial incentives; management of adverse selection
(and favorable selection) of issuers of the new product; and timing with the
state of economic and financial market conditions. Liquidity of the product
is an important aspect which is adversely affected by non-standard or un-
familiar terms and conditions. Therefore, simplicity of the product and
investor education both are required. While care must be taken for all these
in designing of the product, the ultimate test of the product as well as
refinements come through market after its launch. It is therefore important
that the issuer remain active in product refinement as well as in creating
investor awareness and education.
The paper concludes with medium-term strategic issues and other longer-
term issues to enhance share of Islamic capital market products.
xvi
INTRODUCTION
The issue of development of Islamic capital market is not separate from

the issue of development of capital market in general. Capital market plays
a vital role in attracting savings and channeling them for productive
purposes. Both primary and secondary markets are important in this
regard. While the primary market directly effects the supply of funds for
investment, the secondary market does the same indirectly. The function of
secondary market is multi-fold. It provides liquidity to the assets by
providing early exit opportunity; prices the assets and their associated risks
on continuous basis incorporating relevant new information as it arrives.
The liquidity and efficient pricing of risk and return encourages small
savers to save more, and entrepreneurs to invest more in efficient manner.
This is achieved when market correctly rewards the performance of the
entrepreneurs by appreciation (or depreciation) of stock value. The savers
(investors) and the entrepreneurs, both groups, gain to the proportion of
stocks they hold. Moreover, the individual instruments as well as the static
and dynamic portfolios constructed from these instruments provide
opportunities to diversify risk across the society and over time. These
features are attractive both to the suppliers and users of capital. In short,
the capital market provides long-term capital through a series of short-term
contracts.
The importance of capital markets in Islamic financial system also stems

from the fact that Islam prohibits interest and encourages trade. Therefore,
even the banking sector would tend to rely to a greater extent on financial
markets. The banks would be either intermediating between savers and
entrepreneurs through the markets or they would be directly financing their
clients through fixed return1 or equity based instruments. Thus they would
have a non-negligible equity based assets in their asset portfolio. These
factors would put banks in direct competition with the markets (as market
substitutes) to the extent they intermediate directly between savers and
entrepreneurs. It will also put them into a complementary role with the
market to the extent the banks intermediate through the market.
1
Murabaha, ijarah, istisna[, salam, are examples of fixed return contracts.
1
Another dimension which has started to bring capital markets to
prominence in many countries is the increasing role of private capital
flows. The economic growth previously relied on domestic financial
sources of funding or foreign aid. This has changed with time, now private
capital flows from abroad have also become an important financial
contributing factor.2 The importance of capital markets in tapping domestic
as well as foreign financial resources have therefore increased manifold.
Businesses and governments needing to finance their operations through
Islamic modes cannot remain aloof to this development. Providing public
finance through market based instruments in Islamic system remains a
challenge for which well performing capital markets would be crucial.
The subject of development of Islamic capital markets is very broad. It can

include a variety of aspects such as: the state of regulatory system and
possible approaches for further development; market micro-structure and
practices; product range and product development; nature and preferences
of market players; identification and development of support institutions;
market performance evaluation; cost benefit analysis of market expansion
and integration; designing of incentive and corporate governance system;
evaluation of the nature and role of Islamic capital markets in the overall
Islamic financial system; and many other dimensions. The present study
attempts to discuss only a subset of these issues involved in development
of Islamic capital markets. Its primary focus is on products and product
development. More specifically, the equity and stable income products like
sukuk; and their implications for the future of capital market. When further
focus is needed we have relied on examples from four countries namely,
Bahrain, Malaysia, Pakistan, and Sudan.
The second section gives the landscape of capital markets. The third
section discusses at length the two types of capital market products,
equities in subsection-3.1 and sukuk in subsection-3.2 evaluating their
nature and market size. These subsections survey the existing state of the
two kinds of products, analyze their risks and risk mitigating potentials, as
well as suggest some new innovation possibilities. The subsection-3.3
discusses the issue of standardization of products and procedures and
proposes issuance of Islamic Depository Receipts which can help in
achieving the convergence across different jurisdictions. The fourth section
2
Just to give an example from Kruger (2003), the net capital inflows to emerging
markets were under US$48 billion in 1990 (about 0.8 per cent of their GDP).
These flows had reached US$212 billion by 1996 (i.e., about 3 per cent of their
GDP).
2
provides short case studies of product innovations from Bahrain, Malaysia,
Pakistan, and Sudan highlighting the successes and challenging issues.
This section brings out some lessons in product development. The
concluding section summarizes the paper with recommendations and
directions for the future.
3
4
2: THE CAPITAL MARKETS—LANDSCAPE
Islamic capital markets are supposed to perform all the useful functions of
conventional capital markets with justice and equitable distribution of
benefits. The subjective nature of justice and equity are bound to involve
social welfare judgments that could lead to unsettled debates in societies
(particularly when financial dealings are involved). However, the guidance
provided in the Quran and Hadith on the moral rules and behavior along
with the well defined boundaries of prohibitions and compulsory
obligations narrow down this debate and these are fundamental to the
concept of justice and welfare in Islam. Prohibition of interest is one such
boundary applicable in financial and economic matters. Allah has
prohibited receiving and giving of interest3. He has also prohibited
obtaining each others property by wrongful means. Therefore, an Islamic
capital market is to function without interest and without malpractices
tantamount to grabbing others’ property by wrongful means.
Islam also prescribes a compulsory financial obligation which is zakah: a

financial/wealth obligation to be taken from the rich and given to the poor.
Among the many purposes of zakah (and fay) one that is described in
Quran is ‘so that the wealth does not circulate only among your rich folk.’4
Therefore, if capital markets are not growing to allow for increase in
wealth and economic growth or if the growth is skewed resulting in
concentration of wealth, then it is an indication of some weakness which
needs correction.
With this view when we survey capital markets in the OIC-member

countries, we find various issues needing attention. In some countries these
markets are quite young while in some others they have a long history.
Irrespective of their age, all these markets have found new vigor and an
emerging role since 1990s. This is out of the globalization and move
towards financial liberalization in the world. However, many of these
markets are not growing fast enough to achieve a critical mass; and those
3
Ayat of Quran prohibiting riba are at following five set of instances in Quran. (i)
al-Roum 30:39, (ii) al-Nissa’ 4:160-162, (iii) Ale-Imran 3:130-136, (iv) al-
Baqarah 2:275-277, and (v) al-Baqarah 2:278-281.
4
al-Hashar 59:7.
5
that are growing are not contributing enough towards economic
development and balanced distribution of wealth. A number of
observations can be cited to back these claims. For example, (i) despite
economic growth in some countries companies are not seeking listing at
their domestic stock exchanges, and little capital is raised through these
markets. This is an indication of lack of confidence in the market by the
market players. (ii) A large number of companies that are listed are closely
held which allow only limited free float. (iii) Investor base is very small
and stagnant.5 This is true even for those Muslim countries where the
markets have witnessed bullish sentiments. (iv) Most of the exchanges are
run by brokers or few dominant players for their own interest, creating a
closed club mentality rather than promotion of social interest.6 (v) The
proportion of traded scrip out of the total listed scrip is very small, thus
market liquidity depends on few stocks acting as volume leaders. (vi) The
above factors leave investors vulnerable to different forms of market
abuses. Thus allegations of price manipulation, front running, insider
trading, and blank selling are heard more often. (vii) Regulatory rules exist
in a number of markets but the enforcement is weak. To further add to the
negation of Islamic objectives, practice of borrowing and lending on
interest for carry over transactions past the settlement dates, short-selling,
and trading of debt instruments are also prevalent in many markets.
These factors call for a review of capital markets with a focus to develop
them with Islamic orientation and growth objectives. There are also some
issues specific to efficient functioning of Islamic capital markets, which
also need to be addressed. These current issues include: (i) product
development to cover wider range of maturity structures and risk-return
spanning possibilities by shari[ah compatible products, (ii) Product
standardization and fiqh convergence, (iii) measures to decrease market
segmentation and their consequences, (iv) contract enforcement and
protection of investors, (v) designing capital market products for
participation of Islamic financial institutions in the capital markets, (vi)
designing of infrastructure institutions to support shari[ah compatible
products and shari[ah confirming market practices. It is hoped that a
capital market that will thus evolve will better cater to the investment
5
For example in Pakistan, less than 1 per cent of adult population owns shares
traded in the domestic stock markets. (Reported in Securities and Exchange
Commission Pakistan (2004)).
6
This is now changing, for example stock markets in Malaysia has been
integrated and demutualized and same is likely to happen in Bangladesh, Pakistan,
and some other countries.
6
needs and wider circulation of wealth in society and it will directly
contribute to economic growth.
Below we discuss in some detail few obstacles to overall growth of capital

markets as well as the impediments to their Islamic orientation in context
of a sample of markets in four selected countries. Namely, Bahrain,
Malaysia, Pakistan, and Sudan each representing a different region while
each is intending to transform its financial markets in Islamic direction.
2.1 Market Penetration:
To what extent the capital markets are relevant in the economies of our
sample countries? This relevance is measured by various ratios. Market
capitalization as percentage of GDP is one of them. This ratio serves as a
proxy for stock market penetration in the economy when used along with
other indicators. The ratio of market capitalization to GDP has been low
for Pakistan and Sudan while it is close to international benchmark of
above 100 percent for Bahrain and Malaysia. Table-1 below displays this
ratio for the four countries over last few years.
The theoretical relation between market capitalization and economic

growth is not simple and often not very clear. Market capitalization can
increase by (i) increase in stock prices, (ii) increase in new capital
formation (economic investment) through stock markets, and (iii) by
increase in flow of financial capital towards stock markets (asset
substitution, i.e., increase in savings held in the form of stocks). A
common link between market capitalization and the GDP is corporate
earnings. An increase in expected corporate earnings directly contribute to
increase in GDP and at the same time increases market capitalization
through increase in stock prices and increase in new capital formation. The
ratio of market capitalization to GDP is also affected by structure of
financial system and liquidity in the stock markets. A higher liquidity
enables the investors to buy and sell stocks easily. A liquid stock market
reduces investment risk thus attracting financial flows and hence
increasing market capitalization. The difficulty, however, is that corporate
earnings is only but one of the many factors that affect market liquidity.
Therefore, ratio of market capitalization to GDP has to be supplemented
with other indicators to measure stock market penetration in the economy.
7
Table-1
Market Size in terms of Market Capitalization
Panel-A: Main Sample
Market Capitalization USD Market Capitalization

billion as per cent of GDP
(2002) (2003) (2004) (2002) (2003) (2004)
Bahrain 7.58 a 98.7 a 120 b 122.2c
Malaysia 122.9 168.6 190 130.0 171.8

(KLSE)
Pakistan 9.7 16.26 24.7 13.5 19.7 26.0
(KSE)
Sudan 0.593 0.734 1.4 4.0 4.3
a. Calculation based on data from BSE Annual Report on Mkt Cap and IFS data for exchange rate and
GDP.
b. Calculation based on the value of Mkt Cap reported in BMA Annual Report 2003 and GDP for 2003
(at constant prices) reported in MBA Islamic Finance Review, Jan 2005 issue 8.
c. Calculation based on value of Market Capitalization as of Sep. 2004 reported in Bahrain Stock
Exchange 3rd Quarter Highlights 2004 and GDP at current prices (local currency) 2004 reported by
IMF World Economic Outlook Database.
Data for Pakistan (KSE) is from State Bank of Pakistan (SBP) Financial Markets Report (2004),
Chapter-4. Conversion into USD is made using Average Exchange Rates for each year given in SBP
Annual Report 2004.
8
Table-1 (Continued)
Panel-B: Size Comparison with some other OIC countries and World
Country Market Capitalization S&P/IFC

Investable
Index
% change in
Million USD % of GDP
price index
1990 2004 1990 2003 2003 2004
Bangladesh 321 3,317 1.1 3.1 15.4 104.3
Egypt 1,760 38,576 4.1 32.8 79.3 126.4
Indonesia 8,080 73,251 7.1 26.2 69.7 39.3
IR Iran 34,300 34,444 -- 25.1 -- --
Jordan 2,000 18,383 49.7 111.2 65.4 55.0
Kazakhstan -- 2,425 -- 8.2 -- --
Kyrgyz Rep. -- 31 -- 1.6 -- --
Lebanon -- 2,321 -- 7.9 0.9 53.5
Morocco 966 25,064 3.7 30.1 44.0 18.3
Oman 1,060 6,325 9.4 19.7 47.0 25.2
Palestine -- 6,292 -- 182.1 -- --
Saudi Arabia 48,200 306,248 36.7 73.2 49.5 83.6
Tunisia 533 2,641 4.3 9.8 14.9 4.2
Turkey 19,100 98,299 12.7 28.4 113.2 32.9
UAE -- -- -- 11.4 -- --
WORLD 9,403,525 32,436,350 48.0 89.7
LIC 46,543 319,611 10.5 37.3
MIC 328,522 2,534,088 19.4 44.5
HIC 9,028,460 29,582,653 51.6 100.1
LIC: Low Income Countries; MIC: Middle Income Countries; HIC: High Income Countries
Source: Complied from World Development Indicators (2005) Table 5.4 Stock Markets. World Bank.
9
2.2 Corporate Earnings:
The data on corporate earnings is not available in consistent format for all
the sample markets. The fragmented data that we have indicates that
corporate earning has increased in past three years.
Bahrain: Of the 32 companies only 6 did not pay cash dividend in the year
2004. In the same year the average cash dividend per company was 19.05
per cent; average dividend yield per company was 2.99 per cent; and
average Price-to-Earning ratio was 16 per cent.
Pakistan: Profit after tax in the corporate sector has increased by 26.5 per
cent in 2004 (Rs. 106.359 billion) as compared to that in year 2003
(Rs.84.048 billion). However, out of 661 listed companies in 2004, about
20 per cent (141 companies) had not paid any dividend for the last three
consecutive years.
2.3 Market Liquidity:

A second complementary measure we report is the Turnover Ratio which
is the ratio between number of securities transacted daily divided by total
number of outstanding securities in each market. (It is same as Value of
Transaction Volume divided by Market Capitalization). This is used as an
indicator of market liquidity. For healthy growth the market liquidity
should grow in conjunction with market capitalization to GDP ratio.
10
”Table-2
Trading Volume and Market Liquidity
Trading Volume Trading Value Turnover Ratio

(No. of shares in millions) (Value of Transactions) (Percent)
2002 2003 2004 2002 2003 2004 2002 2003 2004
Bahrain 353.13 405.60 288.42* 80.905 mil 102.261 363.01 1.78 1.74 2.69
BD mil BD mil USD
Malaysia --- 116,853.1** 122,680.4 --- 195.373 243.862 --- 30.5 33.8
bil RM** bil RM
Pakistan 41,627.20 76,380.08 51,413.60 805 bil Rs 2270 bil 4925 bil 135.3 238.7 346.5
(KSE) Rs Rs
Sudan 4,060.23 9,745.45 2,185.99 24.906 24.41 44.772 16.0 13.0 12.0
billion SD billion billion
= USD95 SD SD
mil
* End of Nov. 2004.
** 11 month period Feb-Dec 2003
Data Sources:
Data for Bahrain: Bahrain Monetary Agency, Annual Report, various years; Bahrain Stock Exchange, Annual Report, various years; BMA,
Islamic Finance Review, various issues.
Data for Malaysia: Calculated from data from KLSE Website
Data for Pakistan: are from SBP, Financial Markets Report, Chapter 4, Capital Markets. It covers only KSE for Fiscal Year (i.e. July of a year
to June next year); IMF Pakistan Financial Sector Assessment 2003.
Data for Sudan: from annual reports of Khartoum Stock Exchange.
11
Table-2 (Continued)
Panel-B: Liquidity & Listing Comparison with some other OIC

countries and World
Country Market Liquidity Turnover Ratio Listed Domestic

Companies
Value of Shares Traded
Value Traded as as
Number
% of GDP % of Market
Capitalization
1990 2003 1990 2004 1990 2004
Bangladesh 0.0 0.6 1.5 36.1 134 250
Egypt 0.3 4.0 -- 17.3 573 792
Indonesia 3.5 7.1 75.8 43.3 125 331
IR Iran -- 3.9 30.4 21.7 97 370
Jordan 10.1 26.4 20.0 36.3 105 192
Kazakhstan -- 1.4 -- 22.0 -- 41
Kyrgyz Rep. -- -- -- 58.1 -- 17
Lebanon -- 0.7 -- 10.3 -- 13
Morocco 0.2 1.6 -- 9.1 71 52
Oman 0.9 2.6 12.3 31.5 55 96
Palestine -- 1.7 -- 1.7 -- 27
Saudi Arabia 1.7 74.1 -- 204.1 59 73
Tunisia 0.2 0.7 3.3 9.2 13 44
Turkey 3.9 41.4 42.5 182.3 110 296
UAE -- 0.0 -- 3.4 -- --
WORLD 28.5 83.4 57.2 72.4 25,424 50,038
LIC 5.0 42.5 48.2 130.5 3,321 7,988
MIC 5.1 21.6 -- 60.9 4,370 14,456
HIC 31.4 96.8 59.4 110.1 17,733 27,594
LIC: Low Income Countries; MIC: Middle Income Countries; HIC: High Income Countries
Source: Complied from World Development Indicators (2005) Table 5.4 Stock Markets. World Bank.
12
As can be observed the turnover ratio has increased in all four sample
markets between 2003 and 2004. However, it is still very small in Bahrain
and Sudan. While it is better in Malaysia but still less than benchmark of
80 per cent or more for the developed markets with similar market size.
However in Pakistan, this ratio is quite high 346.5% in 2004 relative to the
low market capitalization ratio. This suggests the possibility that high
turnover is speculative in nature.7
2.4 Too Few Listings:
With the exception of Malaysia, too few companies are listed in the stock
exchanges of the other three countries. This is true both in terms of the
proportion of listed companies out of the total newly registered private
limited companies, and in terms of percentage of new listings to the stock
of existing total listed companies. The table below provides a comparison
between the four selected member countries and some other developed
markets. Low proportion of listings are also expected to be a norm in other
OIC countries. While a number of internal firm specific factors determine
the choice of firm to raise funds through internal or external resources the
access to and confidence in financial markets also matters in this choice.
Even those firms that are listed have weak financials and not actively
traded in the market, where the activity is concentrated in only few shares.
7
SECP (2004) Report of the Expert Committee, page 39, commenting on
speculative trade in the three stock markets of Pakistan points out that less than 10
per cent of trade settles with delivery. “As much as 90% of the traded volume is
squared up within the day or carried over and squared up later on.”
13
Table-3
Number and Proportion of New Listings
Country Description of Variable 2002 2003 2004

Pakistan New Companies Listed (R1) 4 6 17
Total Number of Listed 711 701 661
Companies (R2)
Percentage of New Listed 0.56% 0.86% 2.57%
Companies in the Total Listed
Companies (R3) = R1/R2 x 100
Malaysia New Companies Listed 51 58 72
Companies
Companies
Bahrain New Companies Listed --- 4 1
Companies
Percentage of New Listed 9% 2.2%
Companies
Sudan New Companies Listed --- 1 1
Companies
Companies
Panel-B: Comparison with other countries

Country Percentage of New Listed Companies in the Total Listed
Companies in 2003
Singapore 10.71%
Shanghai 08.59%
Australia 07.27%
Notes:
1. Data reflects total number of companies after new listings and de-
listings from the market.
2. Data for Singapore, Shanghai, and Australia from WFE Annual Report
2003.
14
3: SURVEY OF SELECTED ISLAMIC CAPITAL
MARKET PRODUCTS
The Islamic capital market with its distinct character is a natural outcome
of the growth of Islamic financial services industry. The very initial
entrants in the field of Islamic finance were Islamic savings and
investment companies at small level. Mit GhimarBank (1961) in Egypt,
earliest Islamic bank, is an example of it. Investment in stocks of shari[ah
compatible businesses was always deemed fit in Muslim societies. If a
firm is conducting halal (permissible) business then sharing in it through
stocks is perfectly legitimate. However, the participation of masses in such
activity was low and carried out at individual level or mostly through
government operated mutual funds that invested in state-owned
enterprises. National Investment Trust (NIT) in Pakistan is an example of
it. Similar examples are found in other countries. On the whole the stock
markets as such were not very vibrant.
In the later decades of 1970s and 1980s the creation of many Islamic
banks, investment companies, and takaful companies gave rise to the need
of products for their liquidity management requiring more structured
involvement of Islamic finance in financial markets. The boost in capital
markets of the Muslim countries came about after financial liberalization
which allowed for foreign investment, repatriation of profits, and flow of
funds. In Malaysia such moves started in the 1980s while in Bahrain,
Pakistan, and some other countries in early 1990s.
Developments in Islamic capital market products have come about in

response to the growing needs of the Islamic financial industry. An
important stimulus is also provided by liberalization of financial sector in
many countries which opened up new avenues as well as new concerns.
Table-4 lists the major kinds of products that are currently available in the
capital markets of four selected countries. For the purpose of this study we
will focus only on few products: equities, and stable income products such
as ijarah sukuk which are a recent phenomenon.
Trade in stocks or shares of companies having businesses not incompatible

with shari[ah was always deemed possible. However, in the 1990s it
15
became more structured by the entrance of Islamic banks, investment
companies, and Islamic funds into stock markets. As a result various
Islamic market indices were launched.
In the following section we discuss in some details two key products in

Islamic capital markets (1) Equity and (2) Sukuk. We also propose new
structures in sukuk, and propose introduction of (3) Islamic Depository
Receipts as means to expand market and bring convergence in product
standards, shari[ah rulings, and regulatory structures.
16
”Table-4
Kinds of Capital Market Products Available (in various markets)
Bahrain Malaysia Pakistan Sudan
Ordinary Stocks Ordinary Stocks Ordinary Stocks Ordinary Stocks
Preferred Stocks Preferred Preferred
Stocks/Warrants Stocks/Warrants
Mudarabahs (or
Mudarabah Sukuk)
Futures Single Stock Futures
Index Futures
Contracts (if
underlying asset
is shari[ah
approved)
Bonds Bonds Bonds and Term
Finance Certificates
(TFC)
Ijarah Sukuk Ijarah Sukuk Ijarah Sukuk (issued
but not available in
local market)
Partnership Sukuk
(Participation Term
Certificates)
Salam/Istisna[ Salam/Istisna[ Salam/Istisna[
based Sukuk based Sukuk based Sukuk
Special Gov Inv
Cert.,
Central Bank
Musharakah
Certificates,
Government
Musharakah
Certificates
Mutual Funds Mutual Funds Mutual Funds
(Islamic/ (Islamic/ (Islamic/
Conventional) Conventional) Conventional)
Discounting
Products
Murabaha Bonds
(Securitized
Debt)
Use of SPV Use of SPV Use of SPV structures Use of SPV
structures to structures to trap to trap liabilities structures to trap
trap liabilities liabilities liabilities
17
3.1 SHARES AND EQUITIES:
Main shari[ah issues pertaining to trade in stocks relate to (i) the business
of the company whose stocks are to be traded, (ii) the form of stock/share
contract, and (iii) shari[ah compatibility of trading practices pertaining to
stocks. While some systematic screening has started on the basis of (i)
above very little work has been done on (ii) and (iii) pertaining to form of
the contract and elimination of shari[ah non-compliant trading practices.
Conscious individuals and firms use their own judgment in such matters.
We discuss current state of shari[ah screening criteria below.
3.1.1 Shari[ah compatibility of underlying business of the company:
A very early review and identification of shari[ah-compliant stocks was

undertaken in 1983 by Bank Islam Malaysia Bhd., which led to
introduction of a centralized process of such identification under Securities
Commission of Malaysia in June 1997. The first Islamic equity index was
launched in Malaysia by RHB Unit Trust Management Bhd. in May 1996.
It was followed by Dow Jones Islamic Market Index (DJIMI) in February
1999, Kuala Lumpur Shariah Index (KLSI) in April 1999, and Financial
Times Stock Exchange Global Islamic Index (FTSE-GII).8 Various global,
regional, and country specific Islamic index have been introduced since
then by these companies. The most recent one being DJIM Turkey Index
launched in September 2004.
In case stocks of the companies whose core business activity violates

shari[ah restrictions there is consensus for non-permissibility of trade in
those stocks. However, when it comes to mixed activity businesses then
different jurisdictions and stock exchange players apply different criteria
for screening of stocks. Three such criteria are compared below. The
DJIMI at global level and Meezan Group in Pakistan’s markets use
screening criteria that screen stocks not only for the permissibility of
underlying business of the company using source of income benchmarks
(requiring information generally found in incomes statement); but also
apply balance sheet composition bench marks to validate re-trading in
them.9 They however differ in their levels of benchmark for tolerance.
8
IOSCO (2004) p. 28.
9
A discussion with some Islamic fund managers revealed that they have to rely on
much more deeper company level information than what is found in the income
statements and balance sheets of the companies in order to correctly screen the
stocks.
18
Whereas in Malaysia only income statement bench marks are used. No
debt or liquidity ratio benchmarks are used. It can be seen that some of
these criteria are ad hoc and agreed as a second best arrangement.
However, the objective criteria serve better than subjective criteria.
Screening Criteria Differences
Screening Criteria of SEC Malaysia

Screening for shari[ah complaint stocks is done at central level by the
Shariah Advisory Council (SAC) of the Securities and Exchange
Commission (SEC). A list of permissible stocks is issued by the SAC
twice a year. The screening criteria is mainly activity or income based.
No debt or liquidity screens are used. Thus screening will require
income statements but not the balance sheets of the companies.
Individual funds or investment companies do not make their own
shari[ah screening criteria. Following screening criteria are used:
1. Core Activities: The core activities of the companies should not be

shari[ah incompatible. Therefore companies with following as their core
business activities are excluded: Financial services based on riba
(interest); gambling; manufacture or sale of non-halal products or
related products; conventional insurance; entertainment activities that
are non-permissible according to shari[ah; manufacture or sale of
tobacco-based products or related products; stockbroking or share
trading in shari[ah non-approved securities; and other activities deemed
non-permissible according to shari[ah.
2. Mixed Activities: For companies with activities comprising both

permissible and non-permissible elements, the SAC considers two
additional criteria:
a) The public perception or image of the company must be good; and
b) The core activities of the company are important and considered
maslaha (public interest) to the Muslim ummah (nation) and the
country, and the non-permissible element is very small and
involves matters such as umum balwa (common plight and
difficult to avoid), uruf (custom) and the rights of the non-
Muslim community which are accepted by Islam.
3. Bench Marks of Tolerance: Applicable in case of mixed activities. If

the contributions in turnover or profit before tax from non-permissible
activities of a company exceed the benchmark, the securities of the
company are classified as shari[ah non-approved. The benchmarks are:
19
a) The five-percent benchmark Applied to assess the level of mixed
contributions from the activities that are clearly prohibited such
as riba (interest-based companies like conventional banks),
gambling, liquor and pork.
b) The 10-percent benchmark Applied to assess the level of mixed
contributions from the activities that involve the element of
‘umum balwa” which is a prohibited element affecting most
peopled and difficult to avoid. For example, interest income
from fixed deposits in conventional banks.
c) The 25-percent benchmark This benchmark is used to assess the
level of mixed contributions from the activities that are
generally permissible according to shari[ah and have an element
of maslaha (public interest), but there are other elements that
may affect the shari[ah status of these activities. For example,
hotel and resort operations, share trading etc., as these activities
may also involve other activities that are deemed non-
permissible according to the shari[ah.
4. Debt and Liquidity: No restrictions on the proportion of debt or

proportion of liquid assets in total assets.
Dow Jones Islamic Index Screening Criteria

1. Screens for Acceptable Business Activities:
Activities of the companies should not be inconsistent with shari[ah
precepts. Therefore, based on revenue allocation, if any company has
business activities in the shari[ah inconsistent group or sub-group of
industries it is excluded from the Islamic index universe. The DJIMI
Shariah Supervisory Board established that following broad categories
of industries as inconsistent with Shari[ah precepts: Alcohol, Pork-
related products, Conventional financial services (banking, insurance,
etc.), entertainment (hotels, casinos/gambling, cinema, pornography,
music, etc.), Tobacco, and Weapons and defense industries.
2. Screens for acceptable financial ratios

After removing companies with unacceptable primary business
activities, remove companies with unacceptable levels of debts or
impure interest income.
2.1.Debt to Assets:
Exclude companies if Total Debt divided by Trailing 12-Month Average
Market Capitalization is
greater than or equal to 33%.
(Note: Total Debt = Short-Term Debt + Current Portion of Long-Term
20
Debt + Long-Term Debt)
2.2.Liquid Assets to Total Assets:
Exclude companies if the sum of Cash and Interest Bearing Securities
divided by Trailing 12-
Month Average Market Capitalization is greater than or equal to 33%.
2.3.Receiveables to Assets:
Exclude companies if Accounts Receivables divided by Total Assets is
greater than or equal to 45%.
(Note: Accounts Receivables = Current Receivables + Long-Term
Receivables)
Companies passing the above screens are included as components of the

Dow Jones Islamic Market Index.
Meezan Islamic Fund Criteria

It under takes investment in Equities, Mudarabahs, Islamic Sukuks, and
other shari[ah-compliant fixed income securities. The shari[ah
screening criteria for equities and other securities is given below:
Equities – Shari[ah compliant investments in equities would meet the

following five criteria, which have been researched upon and approved
by Meezan Islamic Fund’s shari[ah adviser:
1. Business of the Investee Company
The basic business of the Investee Company should be Halal.
Accordingly investment in shares of conventional banks, insurance
companies, leasing companies, companies dealing in alcohol, tobacco,
pornography, etc. are not permissible.
2. Debt to total assets
The total interest bearing debt of the Investee Company should not
exceed 45% of the total assets.
3. Net illiquid to total assets
The total illiquid assets of the Investee Company as a percentage of the
total assets should be at least 10%.
4. Investment in Shari[ah non-compliant activities and income from
Shari[ah non-compliant investments
The following two conditions will be observed for screening purposes:
The total investment of the Investee Company in Shari[ah non-
compliant business should not exceed 33% of the total assets.
The income from Shari[ah non-compliant investment should not exceed
5% of the gross revenue. (Gross revenue means net sales plus other
income).
21
5. Net liquid assets vs. share price
The net liquid assets (current assets minus current liabilities) per share
should be less than the market price of the share. The Shari[ah
compliance criteria represent the minimum acceptable criteria for
investment by MBF.
After initial screening of the companies on the above criteria, MBF will
invest in short-listed companies:
which provide opportunity to earn regular income in the form of
dividends,
which have good growth prospects in terms of future expansion, or
which are liquid so as to provide the ease of entry and exit.
Note: Valuation of assets is by market capitalization not by book value.
3.1.1.1 Size of Islamic Equity Market
An important aspect for many purposes, including policy making for

development, is to gauge the size of Islamic stock market. Market
capitalization of Global DJIMI as of March 31, 2005 was estimated to be
USD 10.65trillion, and the universe of shari[ah compliant stocks was 1942
stocks10. Since the Global DJIMI takes up only those stocks in which an
international investor can invest and repatriate the proceeds they exclude
many local stocks. Given the various restrictions of ownership and capital
repatriation in the countries the Islamic capital market is not that global; it
is rather segmented. Therefore we applied the DJIMI criteria to local
markets to assess the comparative size of shari[ah acceptable stock
market. Table-5 below shows the existing size of the Islamic market in
terms of the universe of shari[ah compatible stocks available in a sample
of countries.
10
Dow Jones Islamic Market website at
http://www.djindexes.com/mdsidx/index.cfm?event=showIslamicStats.
22
Table-5
Market Capitalization of Shariah-compliant stocks (USD Million)

Year Bahrain Malaysia Pakistan Turkey
M-cap of % of total M-cap of % of total M-cap of % of total M-cap of % of total
Shari[ah- market Shari[ah- market Shari[ah- market Shari[ah- market
compliant capitalization compliant capitalization compliant capitalization compliant capitalization
stocks stocks stocks stocks
1998 411.8 6.13% 55,982.8 56.00% --- --- --- ---
1999 462.7 6.46% 70,082.4 48.00% --- --- --- ---
2000 647.3 9.77% 65,129.3 54.70% --- --- --- ---
2001 612.9 9.30% 75,131.6 59.20% --- --- --- ---
2002 603.2 7.98% 76,426.3 57.55% --- --- --- ---
2003 621.2 6.40% 102,926.3 57.70% 7,007.7 42.27%
2004 --- --- --- --- 14,824.3 51.78% 11,700 12%
Data sources:
Bahrain and Malaysia: IOSCO (2004) Report of Islamic Capital Market Task Force.
Turkey: DJIMI and Istanbul Stock Exchange11
Pakistan: Meezan Islamic Fund and Karachi Stock Exchange.
11
The DJIM Turkey Index also includes some stocks from neighboring countries. The market capitalization of Istanbul Stock
Exchange in 2004 was USD97,354 million which is used to obtain per cent of market capitalization of Islamic market in Turkey.
23
Malaysia has the largest segment of shari[ah compliant market (57.7 per
cent) within its domestic stock market in terms of market capitalization.
Bahrain, the next important hub for Islamic finance in the OIC countries,
has only 6.4 per cent of its market capitalization from shari[ah compatible
securities. In case of Turkey the percentage of shari[ah compliant stocks
in total domestic market capitalization stood at 12 per cent.12 In Pakistan
the Karachi Stock Exchange (KSE) comprised 42.27 per cent (during
2003) and 51.78 per cent (during 2004) of capitalization from shari[ah
compliant stocks when DJIM screening criteria for financial ratios are
used. The low proportion of shari[ah compatible market is the
manifestation of high debt to equity ratio in the financial structure of
corporate firms in majority of third world countries as pointed out earlier.
Therefore, for all practical purposes the Islamic funds in KSE use a more
lenient financial screening criteria allowing up to 45 per cent of debt to
market capitalization ratio. The size of Islamic market in KSE using the
lenient criteria comes to 55 per cent of total market capitalization of KSE
in 2003; and 60.23 per cent in 2004.
3.1.2 The shari[ah compatibility of the form of share contract:
There is a general consensus among the scholars on permissibility of

ordinary shares as they represent undivided ownership in the business of
the company by the share holder. <see AAOIFI shari[ah standards>.
However, as for the preferred shares and warrants that promise a definite
return to its holder (e.g. during low profit years) while same is not
available to other shareholders is considered shari[ah incompatible. It is
also acceptable that shares may have different classes defined by degree of
intervention in the business decision it allows to its holders. Similar to the
familiar class-A and class-B shares other share classes based on other
attributes and rights can be created. However, in all cases the liability of
loss has to be strictly according to the financial contribution of each share.
While partnerships can be of many types in terms of conditions on tenure,

transferability with or without detailed negotiations, limited or unlimited
12
This number is based on the market capitalization of DJIM Turkey Index
divided by market capitalization of Istanbul Stock Exchange. The estimate is
biased slightly downwards because DJIM Turkey Index universe is defined as all
stocks in the Dow Jones Emerging Europe Index that are traded on the Istanbul
Stock Exchange.
24
liability etc. What matter most for a successful and brisk share market are:
(i) limited liability of the firm, (ii) possibility of exit without foreclosure
(non-binding partnership), and (iii) standardized form of shares. These
factors simplify the trade in shares by making price and/or quantity the
only market negotiated variables.
AAOIFI shari[ah standard no.12 pertains to various forms of partnerships.

It covers the rules for conventional fiqh nominate partnerships as well as
various forms of modern partnerships. These rules allow for staggered
profit sharing ratio (shari[ah standard 12/3/1/5/9) that permit different
profit sharing ratios for different levels of profit subject to conditions
(described in shari[ah standard 12/3/1/5/3) which ensure that the variable
ratio shall not preclude a party from sharing in profit.
3.1.3 Shari[ah compatibility of various trading practices:
While various pieces of literature in fiqh, Islamic economics and finance

have highlighted the shari[ah incompatible practices in stock trading that
are in vogue in different stock markets, no binding shari[ah compatibility
standards on the practices have been issued. OIC fiqh academy provide
some guidelines. As for AAOIFI shari[ah standards (e.g. standard 12 on
shirakah) it explicitly states that the standard only deals with contractual
form it does not deal with regulatory policies and procedures required for
operations in the market.
Likewise in the research arena, size of Islamic capital markets based on

practices criteria has also not been analyzed. At present different
individuals and financial entities, depending upon their degree of
consciousness for shari[ah compliance, are voluntarily adopting or
avoiding certain practices.13 This also shows why standardized practices
are important for reduction in transaction costs as well as risks. There is a
clear need to develop mechanisms to phase out shari[ah incompatible
trade practices. One way to implement shari[ah compatibility of trading
practices is to construct a carefulness rating ladder which test for the
existence of standardized written procedures for operations and their actual
practice in the companies.
13
For example, the management of an Islamic Fund informed that they participate
in stock futures market as seller (through salam contract) but do not buy futures in
stocks because the counter party may not be adhering to the rules of salam in their
transactions with others in the futures market which results in increased credit risk
for the Islamic Fund.
25
3.1.4 Performance of Islamic Equity Market:
Various studies have been done on the performance of Islamic equity

market. Most of these studies deal with how good the Islamic market
indices (such as DJIMI or FTSE-GII) performed in comparison to the
entire market indices that does not apply a screening criteria. Hussain
(2004) finds that FTSE Global Islamic index performed at least as good as
FTSE All-World Index. During a bull market the Islamic index performed
better than the All-World index, however during the bear market its
performance was lower than that of All-World index. Thus he concludes
that it is a general expectation of the many that an ethical index which
applies various ethical criteria for screening and reduces the size of
available universe would perform poorly than the unscreened index. But
contrary to this expectation ethical index like FTSE Global Islamic Index
performed at least as good as the overall market on the aggregate level
during the period July 1996 to July 2003.
3.1.5 Issues in Stability of Islamic Equity and Equity Index:
The present approach in some jurisdictions of defining the Islamic portion

of market as a subset of the larger stock market and leaving this set to
develop on its own is not very conducive for its growth. If there is no
conscious effort to develop the Islamic portion into the dominant portion
of the market some stability issues will arise. For example, suppose the
Islamic portion of the market is small in terms of number of companies
that qualify various shari[ah-financial tolerance ratios (such as debt to
market capitalization). This assumption is not unrealistic in the present
state of Islamic capital markets. Let us call the set formed by the
companies that qualify shari[ah screening as the shari[ah-admissible set.
Now suppose that the overall market is facing a bearish trend hence stock
prices in general are declining. It is likely that the market capitalization of
companies would be declining in general including those in the shari[ah
admissible set. The companies at the higher end of debt to market
capitalization ratio (i.e., boundary) in the shari[ah-admissible set will start
to become disqualified as this ratio grows. Therefore, all the Islamic
mutual funds and shari[ah conscious individuals will try to avoid buying
or start to offload these securities in anticipation and re-adjust their
portfolios. This mass behavior (or correlated behavior) has the potential to
drive the prices of these boundary shares further down and quicken their
exit from the shari[ah-admissible set. Thus the shari[ah-admissible set
26
will shrink. If this set was initially small a further shrinkage in its size will
reduce the profit sharing investment choices of Islamic investors leaving
them either to choose from less diversified and more volatile set of equities
or to rely on the fixed return contracts like murabaha etc.
The effect of bear and bull market will not be symmetric in magnitude of
price fluctuations and risk on the Islamic portion of the market as long as
the set of shari[ah-admissible stocks is small.
During a bull run when stock prices start increasing some stocks will move
from shari[ah-non-admissible set into shari[ah-admissible set by
qualifying the debt to capitalization criteria. However, there is no direct
role of shriah conscious investors in bringing them into the set as these
investors do not invest in them until these stocks qualify for admissible set
either by exogenous rise in price or by a change in the financial structure
of the firm. Further, as the shari[ah-admissible set grows it provides better
diversification opportunities to Islamic investors.
These issues are not of a concern when the shari[ah-admissible set of

stocks is very large. Therefore, it is important to maintain a reasonable size
of shari[ah-admissible stocks as long as the above financial ratio based
Islamicity criteria is used.
Another point to note with the current criteria is that with the present
approach the shares of Islamic banks (if any) remain out of the shari[ah
admissible set due to high concentration of murabaha receivables on the
asset side of Islamic banks. This means their stocks cannot be traded on
the stock market. This also implies that market discipline on these banks
will not work through market for corporate control.
27
3.2 IJARAH-SUKUK:
Ijarah-Sukuk are the latest product in the market that is rapidly gaining
ground in the capital market. It has emerged as a different asset class
among the Islamic financial products. It has gained acceptance among
shari[ah scholars and high in demand by large investors and Islamic
financial institutions. On the supply side, many governments have found it
useful to raise funds for their fiscal needs and long-term financing of big
projects. Corporate entities are also finding it useful to generate funds for
their project specific needs. Initially, the cost of issuance was very high
because of uncertainty of the untried product, large documentation
requirements, rating expenditures, and various fees such as legal,
underwriting, and investment banking services required in the issuance
process. However, these expenditures have since come down because
ijarah-sukuk has become a replicable product. Each new sukuk now is
copy of the previous one with some changes to suit the needs of the issuer
or the nature of the market.
The idea of ijarah-sukuk in the form of asset-ijarah-bonds was first

proposed by Monzer Kahaf in his various writings culminating in his
important paper “The Use Of Assets Ijarah Bonds for Bridging the Budget
Gap” published in Islamic Economic Studies as well as in Ahmed and
Khan (1997) edited Islamic Financial Instruments for Public Sector
Resource Mobilization. Usefulness of asset-ijarah bonds in long-term
financing of non-revenue generating public projects was also suggested in
IIIE’s Blueprint of Islamic Financial System (1999) that was presented to
the Shariat Appellate Bench of the Supreme Court of Pakistan during its
deliberations on judgment on riba. In the same publication ideas on some
other forms of sukuk were also presented. However, the practical issuance
of the ijarah-sukuk is the result of two factors. The first factor was the
birth of the concept which was within shari[ah parameters and a forceful
presentation of its viability as developed in the literature that has been
cited above. The second factor had been the rise of the use of asset
securitization in the financial markets. The concept of securitization had
gained currency in 1980s in the conventional finance and by early 1990s it
had already been utilized in various structured financing deals by Islamic
investment banks in the context of partnerships or projects however, not in
structured ijarah finance. Because of such experience, both the finance
professionals in Islamic banks and the shari[ah scholars were familiar to
some extent with the securitization concept and its practical requirements.
Thus the concept of asset-ijarah bond and the familiarity with operational
details of asset securitization resulted in development of ijarah-sukuk.
28
There are some useful legal and economic characteristics of ijarah contract
that distil into its securitization in the form of Asset Ijarah Bonds. It
provides flexibility of sale and ownership of the underlying asset without
affecting its ijarah contract, independence from synchronization of
usufruct and payment flows, flexibility in setting the rent, its term,
combination with other contracts, and initiation of the contract without the
asset in place.
Legal and Economic Features of Ijarah contract and Asset Ijarah Bonds14
Asset Ijarah Bonds (AIB) Definition:
“The AIBs are securities of equal denomination for
each issue, representing physical durable assets that are
tied to an ijarah contract as defined in the shari‘ah”.
Economic features of shari[ah nominate Ijarah contaract:
1. Flexibility of sale: Ijarah contract in shari‘ah does not restrict the

right of lessor to sell the leased asset.
2. Independence of ownership: Persons who share the ownership of a
leased asset can dispose of their property by, say, selling it to new
owners individually or collectively as they may desire.
3. Flexibility in timing of inflows and outflows: It is not necessary that
the flow of usufruct benefits should coincide with the timing of rent
payments.
4. Flexibility in initiation: Shari‘ah does not require that the asset-
subject of ijarah contract, should be in existence at the time of the
contract.
5. Flexibility in length of term: The ijarah contract can be of any length
as long as the asset which is the subject of the ijarah contract remains in
existence and renders its usufruct.
6. Flexibility in determination of rent: In an ijarah contract, it is
necessary that rent must be known. But it can be determined by a variety
of flexible ways.
7. Possibility of hybrid with wakalah: An ijarah contract is open for
combination with the wakalah contract.
8. Restriction on liability for maintenance: Maintenance expenditures
related to the basic characteristics of the asset are the responsibility of
the owner, while maintenance expenses related to its operation are to be
taken care of by the lessee.
9. Ijarah contract is amiable to securitization in the form of a bond. The
14
Summarized from Kahaf (1997).
29
idea of an ijarah bond stems from the ability of transforming leased
assets into financial assets.
10. Decision No.5 of the 4th Annual Plenary Session of the OIC Fiqh
Academy, held in Jeddah 18-23/6/1408H (6-11/2/1988G), asserts that (a)
any combination of assets can be represented in a written note or bond,
and (b) this bond or note can be sold at a market price provided that the
composition of the group of assets, represented by the bond, consists of a
majority of physical assets and financial rights, as compared to a
minority of cash and interpersonal debts. Furthermore, the decision
clearly mentions that assets that can be grouped together for the purpose
of securitization may consist of any combination of the following four
types of assets:
i) physical assets,
ii) financial rights (such as the usufruct in ijarah),
iii) interpersonal debts, and
iv) money.15
3.2.1 Structure of Existing Ijarah Sukuk:
There are different variants of ijarah-sukuk but a generic structure is as

depicted in figure-1. There are three parties to the structure: the originator
or (beneficiary) of ijarah-sukuk; the Special Purpose Vehicle (SPV) the
issuer of ijarah-sukuk; and the investors (sukuk holders). A single or a
group of assets that are admissible for ijarah contract are selected. The
beneficiary (initiator) creates a Special Purpose Vehicle (SPV) [or Special
Purpose Entity SPE] with separate independent legal personality to whom
it sells the asset(s) with the understanding that the beneficiary will lease
back the asset from the SPV16. Rent is negotiated and a term specific lease
15
The OIC Islamic Fiqh Academy Resolutions and Recommendations, pp. 60-63.
The above mentioned resolution requires that if the majority of securitized assets
is in the form of money and debts, the negotiability of the representing security
must follow the rules of currency exchange and transfer of debts as known in
shari‘ah. This essentially means that debts and money can only be exchanged at a
price equal to their face value.
16
Shari[ah scholars in general are of the opinion that these two contracts (sale
and ijarah) should be independent of one another. They accept the combination as
long as they are legally two different contracts, however in substance they are
interdependent. AAOIFI shari[ah standard no.9 (paragraph 9/8/8/1) on Ijarah
calls for complete independence of the two contracts.
30
contract is signed.17 The SPV then securitizes its assets by issuing ijarah-
sukuk for sale to investors. These are certificates of equal value
representing undivided shares in ownership of tangible assets. The sukuk-
sale proceeds provide funds to SPV to pay for the asset(s) purchased from
the beneficiary (originator). A rent-pass-through structure is adopted by
the SPV to pass on the rents collected from the originator-cum-lessee to
the sukuk holders. These returns along with low risk and exit possibility
through secondary market (liquidity) constitute the incentives for investors
to buy the sukuk.
At the expiry (or termination) of the lease deed the flow of rents would
stop and ownership of the asset pool would be with the sukuk-holders as a
group. If the underlying asset has a market value the sukuk-holders can
realize capital gain (or loss). However, if the underlying asset is a public
good or if it has no ready market then the sukuk-holders are certain to incur
capital loss. This would either discourage investment in sukuk or raise the
cost of finance for the originator. Likewise, sometimes the originator is not
interested in permanently parting away with his assets. Or the asset in
question has strategic value to the sukuk originating governments. In these
cases the supply of ijarah-sukuk will be discouraged. Therefore, to close
the ijarah-sukuk structure with features attractive for both supply and
demand the sukuk contract embeds a put option to the sukuk-holders that
the originator is ready to buy the sukuk at their face value on maturity or
dissolution date. However, there is a shari[ah objection to this last
arrangement. As per AAOIFI shari[ah standard no. 17 para5/2/2
“In the case of negotiable Sukuk, it is permissible for the issuer to

undertake, through the prospectus of issue, to purchase at market
value, after the completion of the process of issue, any certificate that
may be offered to him, however, it is not permissible for the issuer to
undertake to purchase the Sukuk at their nominal value.”
17
The ijarah-bi-zimmah contract can be signed between SPV and the beneficiary
even before the sale of asset to the SPV.
31
Figure-1 Structure of a generic Ijarah-Sukuk
Put option with investors.

Exchange of Asset at an Exercise Price
Assets
SPV
Originator Sukuk
Price (Issuer)
Rent Price
Rent
Investors
Assets Leased
32
Most sukuks issued so far are similar to each other in their structures,
however some are quite different in utilizing ijarah, istisna[ and murabaha
to suit the needs of the originator. In the following we briefly discuss three
such other structures:
1. IDB Sukuk: These sukuks are innovative in isolating and defining

the underlying asset. The underlying asset of IDB sukuk is not a
particular physical asset but a pool of real and financial assets;
comprising of leased assets (ijarah)18 and receivables from
murabaha and istisna[ contracts. Such that the portion of leased
assets is dominant (more than 50 per cent) in the total asset pool
separated for the sukuk issue. Dominance of non-financial assets
make its sukuk admissible for trade in secondary market.
2. Caravan Sukuk: These are ijarah sukuk against existing moveable
property –rental cars and trucks- and securitizes their receivables
for the rent-a-car company. The innovative part is the use of IT
technology to link the earnings from each automobile in the fleet
to the rent passed through to the sukuk holders. Another
distinguishing aspect was involvement of cross-border parties in
issuance. The issuer and the underlying assets were in different
countries.
3. Darrat Sukuk: These are innovative in several aspects. These are
sukuk against assets which do not exist at the time of
securitization. A combination of istisna[ and then ijarah is used in
the structure of the contract to first create the asset and then to rent
it back to the originator. There are four parties to the contract:
originator, SPV, sukuk holders, and construction contractor. The
lease contract employed between the SPV and the originator is the
lease-ending-with-ownership of the originator (ijarah muntahi bi-
tamleek) contract. The proceeds of rents and by-out price
installments are passed on to the sukuk holders. The sukuk are
initially pure debt hence not tradable until physical asset is created
through istisna[ and delivered to the SPV. Further, the
construction project is broken into several
portions/segments/phases with separate istisna[ and the ijarah
contracts for each portion under a master agreement, which
generates an early income stream for sukuk holders and also
enables the secondary market tradability of the sukuk as the project
18
Leased assets whose ownership was with the IDB at the time of sale of the
asset pool to the SPV.
33
progresses. Lastly, the surplus cash proceeds of sukuk sales with
the SPV waiting for istisna[ payment in the queue will be utilized
in commodity murabaha and the earnings will become part of the
sukuk capital.
Figure-2 Istisna[ based Ijarah Sukuk (Example of Darrat Sukuk)
Customers Sale Darrat Khaleej Al Bahrain

Company B.S.C (c)
5. Constructed 6. Ijarah
Project leased to payments
own
1. Sale
Investment
Investment SPV Sukuk
Opportunity Darrat Sukuk Company B.S.C (c) Holders
2. Sukuk
Certificates
4. Constructed 3. Istisna
Project payments
7. Periodic rents
+ redemption
Contractors
Notes:
The numbers a each arrow represent sequence of steps.
The dashed lines show non-essential part of the sukuk structure but utilized to increase earnings or payment
capacity.
3.2.2 Other forms of Sukuk:
Ijarah sukuk are only one form of investment sukuk, other forms and their
variants are also possible. The Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI) in its shari[ah standard no. 17 has
defined ‘investment 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
34
activity, however this is true after receipt of the value of sukuk, the closing
of subscription and the employment of funds received for the purpose for
which the sukuk were issued.” The standard gives example of fourteen
different types of investment sukuk:
1. Certificates of ownership of leased assets (ijarah sukuk)
2. Certificates of ownership of usufruct:
(i) of existing assets
(ii) of described future assets
(iii) of services of specified party
(iv) of described future services
3. Salam certificates
4. Istisna[ certificates
5. Murabaha certificates
6. Musharakah certificates
(i) Participation certificates
(ii) Mudharabah certificates
(iii) Investment agency sukuk
7. Muzara[ah (share cropping) certificates
8. Musaqah (irrigation) certificates
9. Mugharasa (agricultural/seed planting) certificates
Most of them are shari[ah admissible for trade in secondary market except
the salam, istisna[, and murabaha certificates; and in some particular cases
of muzara[ah and musaqah certificates when certificate holder does not
own the land.19
This shows that there is no dearth of possibilities in creating financial

instruments suitable for capital markets. However, it would not be a good
strategy of product development to try to replicate each product of
conventional finance by stretching shari[ah principles. The philosophies of
the conventional and Islamic system of finance are not the same therefore
the financial instruments are bound to differ in their emphasis. A better
approach is to design shari[ah compatible products according to the
current and future needs of the market, keeping in view the objectives of
Islamic financial system and a plan for the future market structure.
3.2.3 Current Size of Ijarah based Sukuk Market
At present ijarah sukuk are floated by governments as well as some

corporate firms. These warrant separate discussion of the two.
19
For details see AAOIFI shari[ah standard no. 17 paragraphs 5/2/14 to 5/2/18.
35
3.2.3.1 Sovereign Ijarah based Sukuk:
There has been so far eighteen such sukuk totaling to US$5.650 billion
over a span of past three and a half years. These are issued by Bahrain,
Dubai, Malaysia and its states, Pakistan, Qatar, and Saxony-Anhalt state of
Germany. Almost all the sovereign sukuk are rated and they were rated as
the rating of the country. It is note worthy that initial ijarah sukuk issued
by Government of Bahrain were non-rated and they were meant for the
local market. It was however Malaysia that took the lead in launching first
Global Ijarah Sukuk (GIS) with international rating. For the ijarah sukuk
to have global appeal and secondary markets in multiple jurisdictions it is
necessary that they follow some common standard in design, shari[ah
validation rules, and investor protection. In order to provide a wider
shari[ah acceptance to this issue Malaysia did not structure it on the usual
Murabaha or Bay[ Bi-saman Ajil (BBA) principles commonly used in
Malaysian domestic market but used the ijarah structure.
There has been oversubscription of almost all sovereign ijarah based

sukuk. Further, there is a tendency of their buyers to hold them till
maturity. No secondary market trade of any ijarah sukuk has been
witnessed so far. These facts show that the supply is far shorter than the
demand for such sukuk. This also raises the question whether the price of
these sukuk is right? Given the sovereign backing, attached guarantees of
performance, and over-collateralization these sukuk probably could have
been offered at much lower rates of return than currently offered and still
could clear the market. We are experiencing a sukuk trap phenomenon—to
coin a term similar to liquidity trap. Whereby the supply of more sukuk is
not pushing the price of sukuk down because its buyer financial institutions
are just hording the sukuk. That is there is almost infinite demand for sukuk
at the offered rates.
Another thing to note is that the rating of sovereign sukuk of each country
is same as the rating of conventional sovereign bond of that country. This
shows that isolation of specific assets through the SPV structure has no
significant net effect on the rating of sovereign sukuk. This is a logical
outcome of the facts that in almost all cases (i) the rents payable to sukuk
holders are not necessarily generated from the use of sukuk assets but from
general revenues and other earnings of the state enterprises; and (ii)
therefore what matters is the aggregate payback capacity of the
government given its existing obligations, political stability and
commitment to pay. Which is essentially the sovereign rating.
36
Table-6
Chronological List of Sovereign Sukuk
Issue Size
Issue Size
Issue (Source Margin or
Issuer (US$’MM Tenor Rating /Listing Comments
Date currency Return
equivalent)
MM)
Govt. of S&P: A /
February
Bahrain - BD 45 119 4.5% fixed 5 Years Bahrain Stock Oversubscribed by 50%
2005
BMA Exchange (BSE)
Initial issue was for USD500
Pakistan mil. Oversubscribed by 233%
International January 6m LIBOR + S&P: B+ (USD 1.2 billion)
USD 600 600 5 Years
Sukuk Co. Ltd. 2005 2.2% Luxembourg SE
(Govt) M-East 47%, Asia 31%, &
Europe 22%
Sarawak
December 6m LIBOR +
Corporate USD 350 350 5 Years S&P: A- / Three times oversubscribed
2004 1.1%
Sukuk (Govt)
Dubai Global Govt. rating
November 6m LIBOR +
Sukuk USD 1000 1,000 5 Years applicable -
2004 0.45% /
(Govt)
Dubai Civil Govt. rating
November 6m LIBOR +
Aviation USD 1000 1,000 5 Years applicable A2 -
2004 0.45%
(Govt) implied
37
Govt. of S&P: A- /
Bahrain - July 2004 BD 40 106 5.125% fixed 10 Years Bahrain Stock -
BMA Exchange (BSE)
Govt. of S&P: A- / BSE,
6m LIBOR + Land Europe-offshore US
Bahrain – June 2004 USD 250 250 5 Years Luxembourg &
0.45% 22%, Asia 12% &M. East 66%
BMA Lubuan SE
Saxony-Anhalt
State
EURIBOR + S&P: AAA
Properties June 2004 Euro 100 145 5 Years -
1% Fitch: AA /
(Govt)
(Europe)
Govt. of
December 6m LIBOR +
Bahrain – USD 50 50 3 Years S&P: A- / BSE Oversubscribed by 60%
2003 0.30%
BMA
S&P: A+ /
Government September 6m LIBOR + 72% Middle East, 14% Asia,
USD 700 700 7 Years Lubuan &
of Qatar 2003 0.4% 13% Europe, 1% US offshore
Luxembourg SE
Govt. of
6m LIBOR + Airport Oversubscribed by
Bahrain – May 2003 USD 250 250 5 Years S&P: A- / BSE
0.60% 40%
BMA
Govt. of
April
Bahrain – USD 100 100 3.75% fixed 5 Years S&P: A- / BSE Oversubscribed by 13%
2003
BMA
Govt. of
February
Bahrain – USD 80 80 3.00% fixed 3 Years S&P: A- / BSE -
2003
BMA
38
Govt. of
November
Bahrain – USD 50 50 3.00% fixed 3 Years S&P: A- / BSE -
2002
BMA
Govt. of
August
Bahrain – USD 80 80 4.00% fixed 5 Years S&P: A- / BSE Oversubscribed by 110%
2002
BMA
Government
6m LIBOR + S&P: A- / BSE
of Malaysia June 2002 USD 600 600 5 Years Govt. property
0.95% & Lubuan
Global Sukuk
Govt. of
February
Bahrain – USD 70 70 4.25% fixed 3 Years Not Rated Oversubscribed by 60%
2002
BMA
Govt. of
September
Bahrain – USD 100 100 5.25% fixed 5 Years Not Rated -
2001
BMA
Total Number
18 5,650
of Sukuk
Source: Liquidity Management Centre Website (with amendments and corrections by the author).
39
Figure-3 Term Structure of Sovereign Ijarah Sukuk
6
5
4
3
2
Rate of Return
1
0
0 20 40 60 80 100 120
Months to Maturity
The Figure-3 shows pseudo term structure of sovereign ijarah sukuk. For the purpose of construction we assumed that:
1. sovereign rating of all sukuk issuing countries is the same, and
2. that all sovereign sukuk are available for investment to global investors.
3. For the floating rate benchmarked sukuk we used 6 month LIBOR= 3.408 and 6m EURIBOR=2.103 in May 2005.
4. Time to maturity is calculated from May 2005 on the existing sukuk.
40
3.2.3.2 Corporate Ijarah based Sukuk:
So far there has been eleven issues of ijarah sukuk by corporate and non-
government sector institutions amounting to US$1.601 billion. Except for
the IDB sukuk, Ample Zone (Malaysia) sukuk, and Ingress (Malaysia)
sukuk none have been internationally rated; and still all of them were
oversubscribed. Unlike sovereign sukuk each of the corporate sukuk have
some innovative structure differentiating it from the other. This shows not
only the potential but viability of various other structures in the market.
41
Table-7
Corporate Ijarah based Sukuk
Issue Size
Issue Size
(Source Margin or
Issuer Issue Date (US$’MM Tenor Rating /Listing Comments
currency Return
equivalent)
MM)
S&P: AAA
IDB (Corporate) April 2005 USD 500 500 Fixed rate 5 Years 1st stage of $1BN program
Fitch: AA /
Bahrain Financial
March/April
Harbour USD 170 170 TBA 5 Years Not rated -
2005
(Corporate)
Durrat Al Bahrain 3m LIBOR +
January 2005 USD 152.5 152.5 5 Years Not Rated Oversubscribed by $32.5 MM
Sukuk (Corporate) 1.25%
Ample Zone MARC: AAA

Berhad 6% - 9% fixed MARC: AA
January 2005 RM 150 39.5 2 – 7 Years -
(Corporate) MARC:A
(Malaysia)
First Islamic General Corporate use

1.25% +
Investment Bank October 2004 EURO 76 103 2 Years Not Rated
EURIBOR
(Corporate) Oversubscribed by €26 MM
Tajeer (Saudia) Floating 5% net
USD 1.6 1.6 2 years Not listed
Ijarah Sukuk IRR
Initially the issue was for US$50mm and
then increased to $65MM.
Emaar 6m LIBOR +
July 2004 USD 65 65 5 Years Not Rated
(Corporate) (UAE) 0.7%
Related to financing for commercial
buildings.
42
Ingress Sukuk
Barhad 6.45% - 7.6% MARC: A+
July 2004 RM 160 42.1 3 Years -
(Corporate) fixed
(Malaysia)
Caravan 1 Limited
Not Rated /
(Corporate) March 2004 SAR 102 27.3 6% fixed 3 Years -
(UK)
Tabreed Not Rated /

January 2004 USD 100 100 6% fixed 5 Years -
(Corporate) (UAE) Luxembourg SE
Initially issue was for US$300MM and
S&P: AAA then has been increased to US$400MM
Fitch: AA /
IDB (Corporate) July 2003 USD 400 400 3.738% fixed 5 Years
Lubuan & 1/3 of sukuk placed in UAE FI’s –
Luxembourg SE Others included central banks of Saudi,
Bahrain, Pakistan, Qatar & Kuwait
Malaysian Global Floating
First Guthrie Co., reference rate on
USD 150 5 years
(plantation underlying
company)** Ijarah
Total Number of
11 1,601
Sukuk
Source: Liquidity Management Centre Website (with amendments and corrections by the author).
** This sukuk is listed as ijarah sukuk in the literature (e.g. Arsalan 2004) but the issue documents does not reflect such. Our understanding is that
this is a murabaha based, not ijarah based, sukuk. Therefore, not counted in aggregation in last row.
43
3.2.4 Players (originators and holders)
Originators:
Most of the sukuk originators are governments while only few are
originated by corporates. In terms of amount raised through sukuk the ratio
is 3.5:1 between sovereign and corporate sukuk. The market is currently
accessible for floatation to only very large companies owing to high costs
of rating, contract documentation, investment banking and distribution fee
involved in such issue.
Islamic banks are not among the sukuk originators, except two banks,
including IDB. This is the case because a large proportion of the assets of
Islamic banks are in short-term murabaha and istisna[ receivables. Sukuk
against these assets, if issued, are not tradable at prices other than the face
value. Thus sukuk option is not attractive to majority Islamic banks.
Moreover, these banks have surplus liquidity.
IDB on the other hand possesses substantial tangible/tradable assets on its

balance sheet. It also wants to increase its funding for expanding the
developmental operations. The securitization of its tangible/tradable assets
is therefore a suitable option for generating such funds.
Investment banking and other service providers in sukuk:

Most of the investment banking, underwriting, lead managing, and book
making services for the sukuk are currently provided by Islamic banks in
cooperation with conventional banks that have Investment banking arm
and Islamic window operations. It is felt that there are only few full-
fledged Islamic Investment banks.
Subscribers and investors in sukuk:

The subscribers of these sukuk are large financial institutions like central
banks, private sector Islamic banks and non-bank financial institutions.
These institutions are flush with surplus liquidity that does not have
alternative places for parking. Therefore they tend to hold these sukuk
dearly, so much so that no secondary market is forming in ijarah sukuk.
Secondary market trade occurs due to heterogeneity in the nature,
opportunities, information and beliefs/expectations of the players.
Therefore, an alternate way to create a secondary market in ijarah sukuk is
to increase its distribution to a wider class of investors by creating a
special sukuk class for ordinary investors which the banks are not allowed
to hold. Yet another way is to lower the returns on the ijarah sukuk.
44
3.2.5 Risk Factors of Sukuk
Sukuk carry certain types of risks and at the same time they also help in
mitigating and managing other types of portfolio risks. Sukuk transform
different kinds of assets and contracts into financial certificates therefore
each sukuk structure can have different risk transformation properties
which depends upon the type of underlying contracts; the nature and
composition of underlying assets; and whether within or cross jurisdiction
services are provide.
3.2.5.1 Risks in Sukuk:

For the purpose of analysis risks can be classified in various ways. In
terms of their implication for the system it can be classified as systemic
risk and idiosyncratic (firm specific) risk). In terms of the sources of risk it
can be classified in various other components. Tariq (2004) discusses risks
inherent in various kinds of sukuk structures which are summarized in
Table-8. He classified risk according to its source as market risk
(comprising of rate of return risk, foreign exchange risk, price risk); credit
risk; and other risks (such as liquidity risk, shari[ah compliance risk, and
infrastructure rigidity risks).
In fact the sukuk risks depend on:

a) Fixed or flexible return structure in the contract between issuer
and investor.
b) Nature of fixed or flexible rate contract between issuer and
originator.
c) Time to maturity.
d) The composition and nature of the underlying asset.
e) Put or call option given to the originator or the investor.
f) Payment capacity of the originator or its guarantor.
g) Tradability and liquidity of the sukuk.
The rate of return risk is faced in all fixed rate ijarah sukuk and affects the
investor and originator in opposite ways. The severity of this risk is
directly proportional to the change in market rents and the term to maturity
of the sukuk. In case of flexible rate ijarah suku20 where the returns are
tied to LIBOR, an increase in the benchmark rate will increase the
payment obligations of the originator which may or may not be
20
A genuine shari[ah compatible flexible rent contract is essentially periodic
revision or re-contract with revised rents combined with an exit opportunity to the
lessee and the lessor (which ever is the effected party).
45
sustainable. This is more pronounced when the paying capacity of the
originator depends largely on income from a pool of assets with substantial
proportion earning fixed returns. For example, when the underlying assets
comprise a substantial portion (say the maximum 49 per cent) of
murabaha, and istisna[ contracts.
3.2.5.2 Risk Management Properties of Sukuk:

Sukuk also have risk management potential in various ways for the investor
and the originator, some of these possibilities are listed below.
From the perspective of originator:
1. Sukuk mitigate liquidity risk of an otherwise illiquid asset.
2. If an SPV serves multiple originators by buying their individual
isolated relatively small assets, pooling them and then securitizing
the pool. It can reduce the cost of finance to the originators,
mitigate the liquidity risk of their assets, and provide new source
of funding for them thus reducing the funding risk. In this sense it
works as a reverse bank: collecting fragmented investment
opportunities consolidating them into a sizeable pool and
delivering them to the providers of fund (investors) for investment.
3. Sukuk takes the assets off the balance sheet of the originator while
providing it its use through ijarah. Therefore, if appropriate assets
are isolated for securitization through ijarah sukuk it can, without
loss of its use to the originator, serve as a tool for streamlining the
balance sheet: by matching the assets and liabilities of the
originator to minimize risk in maturity mismatch, currency
mismatch risk, liquidity risk etc.
From the perspective of the investor:
1. If the underlying assets in the pool is denominated in terms of
multiple currencies it reduces the foreign exchange risk of the
investor.
2. Likewise, if the underlying assets are a pool of diversified assets
(or have heterogeneous risk factors) then the diversification
reduces the earnings risk of the investor particularly in case of
mudarabah sukuk.
3. As opposed to conventional bond the tradability feature of sukuk
stems not from the rental returns that sukuk holder is entitled to but
from the ownership in the underlying asset. This is an added
protection which can enhance liquidity of sukuk. Moreover, the
risk characteristic of rentals ( a credit risk of the originator) may
be different from the risk characteristic of the underlying asset in
which sukuk holder possesses an undivided joint ownership. The
46
two risks may have different sensitivities to external factors which
contribute to reduction of risk faced by the investor.
3.2.6 Advantages and Disadvantages of Sukuk
1. Increase the liquidity of the originator and investor. This will reduce
risk premium in the other products of the capital market and hence
contribute to lower cost of funding to entrepreneurs.
2. Increase the flow of funds to the securitized asset market
3. Can tap new and diversified source of funding through the capital
market. Institutional investors and passive investors would find it more
attractive.
4. Can help development of capital markets by allowing thinly capitalized

market players who may have specialization in securitization and issuance
to participate in the capital market.
5. With development of sukuk markets specialized issuers for different

kinds of sukuk in different kinds of asset/contract pools will emerge which
will again lower the cost of funding.
6. At the moment sukuk have become an avenue for parking of the excess
liquidity available with Islamic banks. By this the buyers directly
participate in some useful economic activity generated through their
finance. The facility is for relatively long term with an option to exit at any
time through secondary market. It is a better economic alternative than the
commodity murabaha used by Islamic banks. In commodity murabaha the
bank purchases some metal in bulk on spot payment from a metals
exchange and sell these to another trader on deferred price marked-up by a
percentage over the cost. This is a very inefficient way of earning on its
liquidity by indulging in an trade that is neither needed by the bank nor by
its client. It therefore has gross productive and allocative inefficiency.
7. The ijarah sukuk are limited use liquidity management instruments, at

least until a large supply with periodic issuance becomes the norm and a
secondary market in them develops. Because as opposed to commodity
murabaha that (in vibrant metals and commodity market) can be initiated
at the will of the Islamic bank the ijarah sukuk route has to wait until an
issue is offered by the issuer. A way to develop ijarah sukuk based
liquidity management instruments for Islamic banks is to offer some ijarah
47
sukuk series specially for the Islamic banks with periodic issues spaced at
regular interval on or before maturity of each issue.
8. The initial structuring and issuance cost of ijarah sukuk at the moment is
quite high. It requires a large size of isolatable assets, upfront legal, rating,
and investment banking fee, as well as lots of documentation. Only large,
credible, and more transparent institutions are so far able to participate in
ijarah sukuk deals.
3.2.7 New Potential Sukuk Structures
Credit Enhancing Structured Ijarah Sukuk for Project Financing:21
As known and in practice, Ijarah sukuk can be issued by a sovereign

country on the basis of its own capacity to meet the obligations of rent, and
the commitment to buy back the asset. If the underlying asset is marketable
and productive enough to generate the rent obligation then the sukuk can
be issued on more favourable terms and lower cost. Another way for a
country to raise funds through sukuk is to use a third party guarantee of
another country or a multilateral institution like Islamic Development
Bank (IDB) to enhance the credit rating. Again lowering the cost of funds.
Islamic Development Bank (IDB) is mandated to contribute in the

development needs of its member countries. For this purpose it has started
issuing ijarah sukuk by isolating some of its assets. The objective of this
securitization is to increase the pool of funds that the IDB will use to help
finance development projects in its member countries through other
Islamic modes of finance such as murabaha, istisna[, and ijarah. In raising
money by sukuk it is usually the better assets which are utilized; as their
use can reduce the cost of funds. However, in ijarah sukuk process the
same better quality assets of IDB get tied up for the duration until
maturity. These assets are also taken off from its balance sheet until they
are bought back. The funds raised indeed increase the liquidity of the bank
but the sukuk process also increases the off-balance sheet commitments of
the bank. Moreover, the composition and risk profile of the asset side will
also change, more likely towards deterioration. Therefore, the sukuk issue
process has its own limits, while the development needs of the member
21
The structure is proposed in Khan, Tariqullah (2005). “Resource Mobilization
for Islamic Development Bank: A Note”, mimeo. April. Other alternate structure
based on sukuk on donated assets can also be found in that note.
48
countries are large. The funds issued by existing sukuk process are not
earmarked for specific projects.
An alternative proposal for financing specific development projects in a

member country is to use some good assets of the member country
requesting finance, along with some assets of the IDB to form the asset
pool of a SPV. This asset pool is securitization through ijarah sukuk for
utilization of funds in that specific project.
This will have the advantage that (i) IDB will be able to spare some of its
good assets from getting tied-up for long period. (ii) The member country
asset will be securitized which may not be liquidate-able on stand alone
basis at low cost. (iii) The member country will directly participate in the
fund raising which will create better incentives to utilize the funds
efficiently so as to pay the obligation and get back its assets.
Another way to achieve same goal is for the member country to first
transfer some good quality unencumbered assets to the IDB balance sheet.
The IDB then securitize it in a pool of its assets. Thus the ijarah sukuk is
issued on the full balance sheet strength of IDB. This second procedure has
all the advantages of the previous proposal with the addition that (iv) the
credit enhancement role of IDB is further played out. Thus more cheaper
funds can become available. However, the proposal hinges on sovereign
members willingness to transfer some of their assets to IDB or to a SPV.
Other alternative structures are also possible on similar lines involving

assets obtained on donation. For details the reader is referred to Khan
(2004).
3.2.8 Development of Infrastructure for Sukuk
• There are complex legal and other infrastructure requirements for

securitization of tangible assets through sukuk. These requirements
further increase if securitization of usufruct or services is involved. In
general, the laws must specify rights of each party, cover each stage of
transaction, and enforcement must be strong. Some degree of
standardization is needed in the underlying assets, its valuation
process, rating process, shari[ah approval process, and in the
documentations that are required at each stage. Similarly, servicing
standards have to be considerably standardized. These elements speed
up the securitization process, save costs, help valuation of instruments,
49
avoid ambiguities, help coordinate the expectations that build
confidence of all parties in the market and the instruments.
• In the context of currently available legal infrastructure for sukuk it may
be noted that many steps involved in ijarah sukuk are covered by local
laws in many of the jurisdictions that have issued sukuk. It is however
the trust law (the law that covers the issuance and relation of the SPV
with the originator) which is often chosen to be governed under
English law as implemented in the jurisdiction of issue; which in most
cases is a foreign market. A partial reason for this is the
underdeveloped state of trust laws in the local market. Some degree of
standardization is appearing in the structure of sovereign sukuk
partially because it is a copy able product and one model is replicated
by others. And also because the same set of investment banks and legal
firms are involved as advisors and underwriters in most of the issues.
However, given the few number of issuances, the contracts and
processes at various stages of the sukuk issue have not converged yet.
• Importance of starting on the right foot in terms of product types,
characteristics and standards for each type, and international
acceptance.
• AAOIFI shari[ah standards for investment certificates cover sukuks. A
positive development.
Shari[ah supervision in Sukuk issuance and monitoring overtime through
its different stages is initiated by the originators. A positive step. For
greater acceptability and investor confidence they are also involving
shari[ah boards of other parties to the contract. For example, shari[ah
board of the underwriters, of arrangers, as well as of institutional
investors. This is also positive. A better and cost effective way will be to
create shared institutions. One such shari[ah authentication institution is
IIFM. Another step would be to streamline, standardize (not necessarily
unify), and write out the shari[ah authentication and monitoring
procedure. IIFM has done it as follows, and created a benchmark of
practice.
50
Figure-4 IIFM Shariah Authentication Process
Sukuk Issue Sukuk Issue

Documents Documents Shari’a Supervisory
Committee (SSC)
SSC members will

receive docs. Visa e-
mail, fax or hard copy
Review
comments of
SSC members
Review docs. And give
feedback to IIFM prior
to meet
ISSUER/ARRANGER
IIFM SECRETARIAT
FATAWA
Signed FATAWA
Signed
SSC Meeting
Endorsement
Certificate Endorsement
Signed Certificate
Signed
Approved Not
Approved
IIFM Invoice
PAYMENTS
CORRECT & REVERT BACK TO ISSUER

SUBMIT ARRANGER THROUGH IIFM
DOCS. AGAIN
Source: IIFM Website
51
3.2.9 Shari[ah Issues in Ijarah Sukuk
Shari[ah scholars have discussed shari[ah compatibility of various kinds

of sukuk, including ijarah sukuk, with qualifying conditions for each.22
However, sukuk as a new product has acquired some controversial features
during its development phase that were not part of the original asset-ijarah
bond. These features induce the risk that the shari[ah acceptance of the
ijarah-sukuk may become shaky in future if the product is perceived by the
public to be contradicting shari[ah rules.
The most controversial feature in most of the sukuk is the buy-back

arrangement in explicit form or in implicit form as a unilateral promise by
the originator.
The purpose of SPV in conventional securitization involving private sector

business is to create:
(i) a limited liability device for the investors who will provide
funds and
(ii) a commitment device for the company that it will use the
funds in the particular way it has announced.
Thus on one hand SPV creates bankruptcy remoteness from the many
other businesses of the originator company, and on the other hand
increases the credit-worthiness or trust in the company: both features
which will attract investors and allow for cheaper funds. But in case of a
sovereign like a government an SPV is not a credit enhancer because
unless a more credible multilateral institution or a more credible foreign
government is the trustee the bankruptcy remoteness is as high as possible
in the given country for a private investor in the government projects.
Similarly, the SPV structure in case of government projects is also not a
proper commitment device. Other kinds of commitment devices such as
constitutional amendments, curtailment of executive powers and
enhancement of judiciary’s authority and independence, enhancement of
collective decision making etc are the right commitment devices in case of
governments. Thus the use of SPV in Islamic financing of government
projects becomes only a device to create a buy-back arrangement without
explicitly statement.
By creating an SPV and selling rentable assets to it with a unilateral

promises that government is ready to buy back the asset at face value after
a certain period if the SPV so wishes (giving put option to SPV)
22
AAOIFI Shari[ah standard no. 17 is an example of such conditions.
52
government ensures that the assets are reverted back to it on maturity.
Since the SPV is creation and dependent of the government itself,
therefore it is obliged to exercise the option of selling the asset to the
government at face value even if the market price of the asset at maturity
date were higher than its face-value.
The problem can be highlighted with following extreme example. If the

unilateral promise has binding implications then a very simple and more
efficient structure can be devised without the SPV. To see this suppose we
drop the SPV and let the government sell a mundane asset like a barren
mountain, a garbage dump, or a barren piece of small land at inflated price
to the public and offer to lease it back on a inflated rent (which can be tied
to LIBOR with periodic revisions on each extension of the lease). At the
same time it gives a unilateral firm promise to buy the asset at face value
from whoever is willing to sell it at a certain future date (maturity date).
Since the asset is of lesser market value than its face value at maturity (in
fact throughout the contract period) this is in-the-money put option for the
investors and they will always exercise it on maturity. Thus the
government does not have to worry about loosing any strategic asset.
Hence an ijarah suk can be devised without involvement of any useful
asset to meet the financial needs of the government.
Some ijarah sukuk have rightly stated that the originator unilaterally
promises to buy the asset at its market value that will prevail at the time of
maturity. But in case of public good nature of the underlying asset (or a
specific purpose asset), which is the case in most of the sovereign sukuk,
its market may not exist. How to evaluate the fair value of such underlying
asset and who will do it is not clear, as those sukuk which stipulate this
condition have not matured yet.
Another shari[ah issue in some ijarah-sukuk is that they put all

maintenance expenditures on the lessee while it should have been the
responsibility of the lessor. To see this let us examine the terms of a typical
sovereign sukuk contract:
The master lease agreement stipulates the parties agree to execute

consecutive semi-annual leases of the property between the start and
dissolution period of Sukuk and lessee pay rents semi-annually. Being a
lease contract it states that the “Ordinary Maintenance and Repairs” cost
will be borne by the lessee (Gov.) while “Major Maintenance” costs will
be borne by the lessor (Issuer). But effectively it is the lessor who is
incurring both types of costs because:
53
(i) the amount of rental payment by the lessor into the Transaction
Account is defined in the contract as the amount what is equal to the
amount of Periodic Distribution to Certificate holder from the Transaction
Account.
(ii) And, the first priority in distribution from Transaction Account is
given to the Certificate holders.
By implication there remains nothing in the account for major

maintenance.
Such shari[ah issues in the existing sukuk structures are a source of legal
uncertainty needing the attention of finance professionals and shari[ah
scholars. In order to streamline the practices in sukuk issuance, their
secondary trade, and their retirement a shari[ah audit system is necessary.
It is particularly important because the sukuk products are in their
formative period which will set precedence and standards for the future of
sukuk.
54
Table-8
Summary of Risk Characteristics of Sukuk
Types of Description of Sukuk Credit Risk Rate of return FX risk Price risk Other risks
Sukuk structure (Interest rate risk)
Zero coupon Istisna’, Murabaha debt Unique basis of credit Very high due to If all other Price risk relates to Liquidity riskis
Sukuk certificates – non-tradable risks exist, see, Khan fixed rate, remains conditions are the prices of the serious as far as the
and Ahmed (2001) for the entire similar, FX risk will underlying non-tradable Sukuk
maturity of the issue be the same for all commodities and are concerned.
Fixed Rate Securitized Ijara, certificate Default on rent Very high due to cases of Sukuk. assets in relation to Business riskof the
Ijara Sukuk holder owns part of asset or payment, fixed rate fixed rate, remains However, those the market prices. issuer is an
usufructs and earns fixed makes credit risk more for the entire Sukuk which are Ijara Sukuk are most important risk
rent – tradable serious maturity of the issue liquid or which are exposed to this as underlying Sukuk as
Floating Securitized Ijara, certificate Default on rent Exists only within the relatively short term the values of the compared to
Rate Ijara holder owns part of asset or payment, floating rate time of the floating in nature will be less underlying assets traditional fixed
Sukuk usufructs and earns floating makes default risk lesser period normally 6 exposed. The may depreciate incomes.
rent indexed to market serious – see previous months composition of faster as compared to Shari’ahcompliance
benchmark such as LIBOR case assets in the pool market prices. risk is another one
– tradable will also contribute Maintenance of the unique in case of
Fixed rate Securitized pool of assets; Credit risk of debt part Very high due to to the FX risk in assets will play an Sukuk.
Hybrid/ debts must not be more than of pool, default on rents, fixed rate, remains different ways. important part in this Infrastructure
Pooled Sukuk 49%, floating rate fixed rate makes credit for the entire Hence this can be process. Liquidity of rigidities, i.e.,non-
possibility exists – tradable risk serious maturity of the issue very useful tool to the Sukuk will also existence of efficient
Musharakah Medium term redeemable Musharakah has high Similar to the case of overcome the FX play an important institutional support
Term musharakah certificate default risk (see Khan the floating rate. This risk by diversifying part in the risk. increases the risk of
Finance based on diminishing and Ahmed 2001), is however, unique in the pool in different Salam is also Sukuk as compared
Sukuk musharakah – tradable as however, MTFS could the sense that the rate currencies. exposed to serious to traditional fixed
(MTFS) well as redeemable be based on the strength is not indexed with a price risks. incomes, see
of the entire balance benchmark like However, through Sundararajan, &
sheet LIBOR, hence least parallel contracts Luca (2002)
exposed to this risk these risks can be
Salam Sukuk Securitized salam, fixed- Salam has unique credit Very high due to overcome
rate and non-tradable risk (see Khan and fixed rate
Ahmed 2001)
Source: Ali Arsalan (2004)
55
3.3 ISLAMIC DEPOSITORY RECEIPTS (IDR):
While aggregate volume of shari[ah compatible products for capital

markets is increasing, their markets are segmented between countries and
regions.23 At present, large scale high frequency cross boarder trade in
assets is a rarity among many OIC member counties. Various factors such
as capital account restrictions, nationality based ownership policies,
economic and political risks, and high risks and costs of such transactions
count towards it. The situation is gradually changing. A number of OIC
countries with fast developing capital markets have eased or removed
restrictions on capital flows, business ownership, repatriation of capital
and profit.24 In order to expand the market for Islamic products and make
them available at global level efforts are also underway to cross list
shari[ah compatible products across the markets.25
However, the high transaction cost is still an issue which stems from
differences in regulatory and listing requirements, different trading
platforms and trading rules, exchange rate instability, lack of support
institutions for cross-border transactions, as well as a spectrum of shari[ah
compatibility criteria.
Under similar difficulties involved in cross-listing, use of a system of

depository receipts have evolved in the conventional emerging capital
markets. Instruments such as Global Depository Receipts (GDR),
European Depository Receipts (EDR), and American Depository Receipts
(ADR) have emerged. For example, ADR “are foreign currency-
denominated derivative instruments, issued by international banks like
Bank of New York or Citibank, representing home securities held with a
local custodian.” (Claessens, et al., 2002a). These are cost effective and
easy to increase or decrease as per requirement of the issuer. A depository
receipt is a negotiable and transferable instrument that is traded on the
23
This situation restricts the utilization of economies of scale and scope that are
otherwise possible in larger markets; increases the operational costs; and restricts
the benefits of the infrastructure institutions created at global level for Islamic
finance.
24
For example in the four countries of our focus—Bahrain, Malaysia, Pakistan,
and Sudan—restrictions on capital flows have either been completely removed or
they are removed for certain kinds of assets.
25
For example, some Malaysian and Bahraini sukuk are cross-listed in Labuan-
Malaysia and Bahrain. Similarly, Sudan Telecom has been cross listed in Bahrain.
56
stock exchange of a country (or jurisdiction) but represents a stock that is
listed and issued by a firm in another country (or another jurisdiction).
On the similar pattern there are suggestions to increase the possibility of

tapping capital markets across countries through issuance of Islamic
Depository Receipts (IDR) (IOSCO, 2004 p.67) which will increase the
liquidity of Islamic markets at lower the cost of funds. A system of Islamic
Depository Receipts (IDR) on shari[ah compatible products will prove to
be very useful and appears promising in expanding their markets and
integrating them.
Box-1
How a depository receipt system works?
Let X be a foreign country and Y the domestic country. Our investor is

based in (domestic) country Y while the firm of our interest is based in
(foreign) country X. A stock broker of country Y through its agent in
country X purchased the stock of the country X firm. These shares do not
cross border but are deposited and frozen on trust in a foreign country
branch of the domestic (country-Y) bank. Selection of domestic bank is to
increase the level of confidence. After getting the confirmation from the
bank the custody of shares has been completed the stock broker in country-
Y issues Depository Receipts (DR) through a due process of country-Y
stock exchange. These receipts are issued on some determined ratio
between the DR and the underlying stock, which does not have to be 1:1,
and after converting the value of underlying stock from foreign to
domestic currency at appropriate exchange rate. Thus the listing in
domestic market takes place of the DR and not of the underlying stock of
the foreign firm which are however backed by foreign assets. The DRs are
traded in domestic market under domestic trading rules and any change in
material information about the underlying asset is reported by the domestic
broker in the domestic market.
In short, as the central depository in a stock market helps in

dematerialization of shares by keeping custody of the physical certificates
which reduces clearance and settlement risks the DR system does same for
cross-border transactions.
The pricing of DRs is affected by domestic factors of supply and demand,

and the performance of underlying stocks of the foreign firm. However,
57
the foreign country’s market pricing factors influence the price of DRs in
domestic markets through the degree of cross-border price arbitrage and
the extent of such arbitrage trading activity.
3.3.1 Possible advantages of IDR on shari[ah compatible stocks and

sukuk.
3.3.1.1 Advantages for the foreign (country-X) firm i.e., the originator of
the underlying asset:
• A firm can expand its investor base and obtain funding from other
country markets if X-country market does not have sufficient funds or
appetite for it.
• If the Y-country market is more liquid in terms of higher turnover and
trading volume the originating firm may find it cheaper to raise funds
from Y-country market than from the market in its own country.
• If the transparency and trading requirements in Y-country market is
stronger than in the X-country market, the firm can signal to local X-
country investors that it is a better quality risk by having its IDRs
traded in the Y-country market. This signaling can reduce cost of
funding to the firm as well as increase its valuation.
• Depending on market conditions, the IDR structure can also be used to
raise funds in foreign exchange while the payouts can still be in
domestic currency. Thus reducing the foreign exchange mismatch risk
involved in direct cross-listing.
3.3.1.2 Advantages for the domestic (Y-country) investor:
• Investor can diversify his portfolio of assets by tapping into equities

and sukuk in other markets
• Investor can hold and trade using his own country trading system and
rules with which he is more familiar.
• Higher return and higher risk assets of other jurisdictions can be held
without exposing oneself to additional risks of directly investing in
foreign markets. Similarly, clearance and settlement risks of less
developed foreign financial market can be reduced.
• While exchange rate risk cannot be avoided in IDR, the investor avoids
high costs of small and/or frequent cross-border transactions that he
would otherwise incur in adjusting his portfolio. This is an added
58
benefit for small investors for whom the cross-border transactions
would otherwise not be feasible.
3.3.1.3 Advantage for the system and development of Islamic capital

markets:
There are multiple advantages in IDR for the development of Islamic

capital markets if such instruments are strategically used. Given that at
present cross-listing possibilities exists only across few Muslim countries
therefore IDR offers a good alternative to start with.
While cross listing has often been successfully used between emerging and
developed markets, one of the consequence has been migration of liquidity
to the developed market.26 This is particularly the case if the trading
activity in less-developed market was concentrated in few companies
before the cross-listing. It is usually only the good companies that seek and
qualify for cross-listing. As a result a substantial portion of liquidity is
affected in the domestic market. If in response to reduced liquidity, the
firm moves altogether out of the emerging market then market
development suffers. In case of IDR liquidity migration effects are
possible but the domestic firm will not altogether leave the domestic stock
market.
A consequence of IDR will be that the jurisdictions with better investor

protection laws, better run stock exchanges, and better reputation for
shari[ah compliance will be rewarded by attracting more trade.
A more important aspect of IDR will be that it can lead to regulatory

competition between jurisdictions.27 with each jurisdiction trying to
improve the level of investor protection as well as shari[ah compliance.
This will also result in much needed convergence of product standards as
well as shari[ah applications.
How this convergence can be achieved?
It is the originators who choose to issue IDR. But it is the investors who
choose to buy. Originators’ and issuers’ choices are governed by market
liquidity, cost, and reputation considerations. While investors’ choice of
26
Claessens, et al. (2002b). For analysis of investor behavior in context of
American Depository Receipts see Aggarwal, et al. (2005).
27
See Coffee (2002) for regulatory competition between jurisdictions; how it
prevents emergence of super-exchanges on one hand and contributes to improved
corporate governance of firms on the other.
59
Islamic securities, and IDRs are governed by investor protection as well as
shari[ah compliance. If the investor demand certain degree of corporate
governance and certain degree of shari[ah compliance in the underlying
asset of the IDR, then those that do not meet the required levels will not
benefit. This will force the individual firms to improve corporate
governance and the regulators to amend the regulations towards more
converging views.
In the long-run such competition will not necessarily produce identical

rules, practices and governance standards but more of specialization with
each jurisdiction specializing in certain kinds of products and the rules
governing those products will be accepted.
What is important in starting this phenomenon and continuing with it is the

selection of shari[ah compatible instruments for IDR issue. Authenticating
and shari[ah approving institutions like IIFM can play a role. Similarly,
the central banks of individual Muslim countries can promote such
convergence.
An often discussed and lamented aspect in Islamic finance is non-

standardized products and procedures as well as varying application of
shari[ah opinions. This is often cited as obstacle to growth and integration
of markets. This small step of IDR can promote the much needed
convergence.
60
4: CASE STUDIES IN PRODUCT DEVELOPMENT
A way to increase the share of shari[ah compatible products in the capital

market is to develop new products that suit different kinds of users—i.e.,
issuers and investors of varying characteristics. Experiments in
development of shari[ah compatible products for general use in the capital
markets reveal that product development and its market acceptance is a
complex issue. In this section we survey a few selected products form our
sample of the four countries. The products surveyed are: Mudarabahs, and
Participation Term Finance Certificates of Pakistan; various categories of
public finance certificates of Sudan; and Cagamas of Malaysia. These
case studies provide details on these products as well as bring out a few
lessons for product development.
4.1 Mudarabah Companies an Innovation—Case Study of

Pakistan:28
Mudarabah (management) Companies (MCo) are unique innovation for

Islamic financial sector in Pakistan, they evolved and increased their
activities since 1984. They face tough market competition from incumbent
and new market players such as the leasing companies; as well as from
established textile and pharmaceutical companies which started offering
financial products similar to mudarabahs offered by MCo to raise new
finance. The evolution, practices, and performance of mudarabah
companies as they operated under “Mudarabah Law” can provide useful
lessons of do and do-not for the development of Islamic capital market
products and institutions.
Mudarabah contract is historically well-known and used in various forms

in present day Islamic financial industry. However, the new aspect of the
mudarabah companies (MCo) in Pakistan is that on one hand they issue
mudarabah certificates (MC) to raise funds which is invested using
various Islamic modes of finance (including musharakah, mudarabah,
28
This section draws heavily on Khan, Tariqullah (2004) “Modaraba Companies
of Pakistan: Profile and Analysis”. While Khan in his paper focuses on the profile
and ways to revive the Mudarabah (management) Company sector, we have used
his data and analysis to derive lessons for Islamic product development.
61
leasing, murabaha etc.); on the other hand the companies are themselves
listed on the stock market where their shares are traded.
Theoretically this structure is similar to an open ended mudarabah based

mutual fund. However, as opposed to mutual funds it was not necessary
for MCos to diversify investments. Rather, the MCos were expected to use
their specialization and experience in some lines of business to generate
profit and share it with their certificate holders. The stock exchange listing
and tradability feature of the certificates provided the possibility for the
certificate holders of full realization of the value in the form of profits as
well as capital gains. The MCo sector had great potential to direct finance
to productive enterprises.
However innovative, a majority of MCos were not able to perform up to

the expectations. Whereas the product – mudarabah – have been
successful as evidenced by its replication by other Non-Bank Financial
Institutions. There were many reasons for the less than optimal
performance of MCos. We briefly elaborate these factors below to point
out the importance of enabling regulatory environment, incentives, and
level playing field for success in Islamic product development.
The MCos still exist and some have performed very well. Their success
factors have also been pointed out below. The potential of the mudarbah
sector can be enhanced by providing more scope and space either for
funding choices or for fund retention. More innovative structured products
using mudarabah will go a long way in creation of successful capital
market products.
4.1.1 Lessons for product development:
The principal reasons for less than optimal performance of MCos can be
attributed to the following factors which also provide lessons for
development of new products:
1. Over-regulation and incentive distortion.

2. Regulation by multiple regulatory bodies.
3. Law centered—rather than market centered—conceptualization of the
operational requirements that stifled growth.
4. Competition from other market segments where the regulations were not
stifling.
5. Lack of on-going shari[ah supervision structure.
6. Scarcity of human capital and expertise to run mudarabah business.
62
These are discussed below in some detail.
4.1.1.1 Governing laws that over-regulate or distort incentives:
At the outset it is useful to understand the nature of MCos and their scope
as defined in the regulation. The establishment and operations of the
Mudarabah Companies are governed by the Modaraba Companies and
Modaraba Floatation and Control Ordinance 1980 and the subsequent
amendments and guidelines issued by the regulating authority. Most recent
of which was issued on January 28, 2004 by the Securities and Exchange
Commission of Pakistan (SECP) entitled as “Prudential Regulations for
Modarabas”29. A Mudarabah is defined in the Ordinance as, ‘a business in
which a person participates with his money and another with his efforts or
skill or both his efforts and skill and shall include Unit Trusts and Mutual
Funds by whatever name called’.
Mudarabah Companies (MCos) are like a special purpose vehicle (SPV).

These are separate companies formed for multi-purpose or specific
purpose operations by an existing registered company or a private
company or a public corporate body. The MCos are then registered under
Companies Ordinance 1984 as either a private or a public company. These
MCos then issue Mudarabah Certificates (MCs) to raise funds. If these
certificates are to be issued and traded through stock market then MCo
also have to be listed on the stock exchange, otherwise it can do private
placement. In all cases the MCos are also required to be registered with the
Registrar of Mudarabahs.
Other salient features of the Mudarabah Law are:

• Mudarabah Certificates (MCs) issued by MCos are non-voting shares
of common stock in the MCo. (However no compensating benefits are
specified for the MC holders).
• The minimum capital requirement for a multi-propose MCo is Rs. 7.5
million, and for a single-purpose MCo it is Rs. 5 million.
• In both cases, the MCo has to contribute the initial 10 percent of the
subscribed capital.
29
As cited in Khan (2004) the related guidelines are available from the Website of
Securities and Exchange Commission of Pakistan at http://www.secp.gov.pk
63
• The MCo, as a manager (mudarib), will charge not more than 10
percent of total annual profits as its remuneration, besides the returns
on its capital contribution to the MCo.
• The MCo can issue rights, stock dividends and distribute cash
dividends.
• The MCo cannot involve in any activity prohibited by the Shari[ah.
• At least 75 percent of the MCo’s operations must be kept in the main
line of its business.
The low capital requirement, tax advantages, the non-voting nature of

MCs, and other features provided existing businesses the incentive to
create Mudarabah Companies which worked as their captive financing
arms.
4.1.1.2. Multiple regulatory bodies:
The process of registering and commencing of business for MCo

is complicated and lengthy without much value added through the process.
For example, to register as MCo the initiators have to apply to Securities
and Exchange Commission which evaluates the application on the basis of
above law. If approved for registration by SECP it applies for registration
and permission for commencement of operations to Registrar of
Mudarabahs. The application is also evaluated by Religious Supervision
Board for shari[ah compliance. When cleared from these entities;
registered; and permission for operation is obtained; it applies to
Controller of Capital Issue and the Stock Exchange for listing and flotation
of Mudarabah Certificates which bring in the investment funds.
The State Bank of Pakistan (SBP) has no separate regulations for the
MCos or for the floatation of Mudarabah but a common Prudential
Regulations for Non-banking Financial Institutions which also applies to
MCos. Some of which are difficult to abide by the MCos given their small
size and capital. Some salient features of these regulations are given in
Box-2.
64
Box-2
Salient features of regulations for Non-bank financial institutions

which also affect the MCos.
• Each Mudarabah will establish a reserve fund equivalent to its own paid up
capital with the SBP. This reserve fund will be established by annual
contribution of at least 20 percent of the after tax profits of the Mudarabah
floated. Once the reserve fund equals the paid-up capital, the annual
contribution will be decreased to 5 percent of after tax profits. Stock dividend
is considered as an appropriation for this purpose.
• At least 15 percent of the liabilities of the Mudarabah must be invested in the
National Investment Trust Certificates (NIT Units) or in securities of public
corporations.
• For initial two years, the debt/equity proportion of the Mudarabah will be 1:7,
thereafter, it can be 1:10 and may be further changed with the consent of the
concerned regulatory authorities.
• A Mudarabah will not be entitled for any financial assistance if its
debt/equity ratio remains below 60:40 on long-term basis. This level of
debt/equity ratio must be maintained by all energy sector Mudarabahs.
• Current assets/current liabilities ratio will have to be maintained at 1:1 of the
Mudarabah’s equity.
• A single business group cannot be financed by more than 20 percent of the
Mudarabah’s equity.
List taken from: Khan (2004).
4.1.1.3. Law centered rather than market centered conceptualization:
As can be seen from the rules governing the establishment and operations
of MCo the regulators were focused on traditional structure of mudarabah
as found in fiqh literature. Which is essentially a restricted or unrestricted
mudarabah concluded by liquidation. Therefore the very early law (which
was changed later) restricted mudarabahs to operate only with their paid-
up capital. The law also accounts for perpetual mudarabah which is in the
context of a mutual fund. It thus allowed MCo to float Mudarabah
Certificates (MC). The regulation also promoted mudarabah by tax
incentives. However, a few important market realities were ignored. (i)
Growth of MCo or any company cannot take place without capital
expansion. Requiring the firms distribute large portion of their profits in
65
dividends while their own capital is small is counter productive for growth.
Short of cash and wanting to preserve their capital the MCo heavily relied
on issuing rights shares instead of paying cash dividends. (ii) The laws
ignored the possibility of regulatory and tax arbitrage created for the firms
in other sectors on account of lower capital requirement and lower tax in
mudarabah sector. Companies in other sectors which neither have
shari[ah supervision requirement nor restricted in raising funds through
alternate sources were able to avoid restrictions in one sector by tapping
the benefits of the other sector. (iii) As mentioned earlier the specific
purpose mudarabah came under companies law and capital market
regulatory authority, however the general purpose mudarabah fringed into
non-bank financial institutions framework. This forced the mudarabah
companies to restrict their choices to a few areas of business such as
leasing and murabaha financing. (iv) The compensation or payment
structure for the executives and board members of the mudarabah were
such that the management could claim it as cost instead of share in actual
profit. This also resulted in creation of multiple mudarabahs launched by
the same management.
The dynamics of the evolution of MCos shows the impact of not taking the
market centered approach in design and implementation of mudarabah
regulations. Initially the MCos attracted a considerable demand from the
general public who readily provided the funds. The strong demand,
lucrative tax incentive, low capital requirement, and executive
compensation structure resulted in coming into being a large number of
MCos within a short time. Starting with only 2 MCos in 1985, their
number went up to 52 in 1994 which was a few years after liberalization of
financial sector. However, by the end of 2004, only 30 Mudarabahs
remained listed.30 The financial strength of the Mudarabah sector has
continuously weakened over the last decade. Table-9 summarizes the
temporal performance of Mudarabah sector between 1998 and 2003. The
data shows that this sector, as a whole, has not regained its due vigour and
growth. The regulators have tried to strengthen the capital of Mudarabahs
by encouraging mergers and mandatory capital enhancement but it has not
helped the sector.31
30
The reduction in number of Mudarabahs is brought about by merger of four and
closure of others.
31
Khan (2004).
66
Table-9
Mudarabah Sector - Key Statistics (Million Rs.)
1998 1999 2000 2001 2002 2003
Paid up 6,799 6,828 6,867 6,648 7,859 7,600
Capital
Total Assets 18,849 14,899 15,103 15,216 17,243 15,800
Total Income 3,577 3,911 4,021 4,127 3,930 4,235
Net Profit after 272 25 687 97 636 1,072
Tax
Earning per 0.47 0.03 0.91 0.13 0.82 1.29
certificate
(Rs.)
Debt Leverage 0.94 1.1 1.11 1.36 1.3 1.02
(x)
Return on 4.59 0.36 9.58 1.5 8.28 13.65
Equity
(percent)
Return on 2.37 0.17 4.55 0.63 3.6 6.76
Investment
(percent)
Dividend per 0.49 0.79 0.88 0.72 0.75 0.75
certificate
(Rs.)
Source: Khan (2004).
4.1.1.4 Competition from other market segments:
Mudarabahs are classified as Non-Bank Financial Institutions (NBFIs)

under the regulations and face competition from other NBFIs in
investment allocation. The other NBFIs include leasing companies,
investment banks, brokerage houses, and mutual funds. All of these are
regulated under same regulations — now overseen by the Securities and
Exchange Commission of Pakistan (SECP). However, Mudarabahhs are
restricted in their funding sources as compared to other NBFIs which is
considered to be a drag on their competitiveness.
Table-10 provides a comparative assessment of Mudarabahs and other

NBFIs. It shows that average capital and average number of shares of
Mudarabahs are similar to those of Leasing Companies and Investment
67
Banks. However, their average assets are significantly lower than those
Leasing Companies and Investment Banks—indicating a low leverage.
Likewise, their average profits are also less than other NBFIs indicating
their weak performance.
Out of all the Mudarabahs listed in the KSE (32 in number), the
top ten Mudarabahs constitute more than 60 percent of the sector in terms
of paid-up capital, total assets and total profits. The funding sources of
most of these Mudarabahs is diverse — the funding items include
certificates of Musharakah (COM), payables on the basis of Murabaha
and Ijarah. Whereas, most Mudarabahs which are not among the top ten
have one significant common feature – that they rely on Mudarabah
certificates as a sole funding source.
68
Table-10
Performance of Mudarabahs versus other NBFIs in Pakistan, 2003
(Amount in Mill.Rs)
Mutual Mudarabahs Leasing Investment
Funds Companies Banks and
TOTAL Companies
No. of 15 32 19 14
Institutions
Paid-up 10,705.778 6,762.805 3,888.533 2,982.530
Capital
No. of Share 1,080.628 746.252 388.853 298.253
Equity 19,828.437 7,223.981 6,529.433 12,147.354
Total Asset 21,259.890 15,752.426 43,551.337 33,092.377
Profit After 4,189.830 828.156 971.948 5,085.252
Tax
AVERAGES
Assets/Capital 1.99 2.33 11.20 11.10
Profit/Share 3.87 1.11 2.50 17.05
Paid-up
Capital/firm 713.7185 211.337 204.659 213.038
No. of
Share/firm 72.042 23.320 20.466 21.304
Equity/firm 1321.896 225.749 343.654 867.668
Total
Asset/firm 1417.326 492.263 2292.175 2363.741
Profit Before
Tax/firm 279.359 27.254 54.729 375.735
Taxation/firm -0.0367 -1.374 -3.574 -12.503
Profit After
Tax/firm 279.322 25.879 51.155 363.232
Source: Khan (2004).
4.1.1.5. Lack of ongoing shari[ah supervision
The Religious Supervisory Board (RSB) would examine the product and
the company only at the time of establishment. Afterwards there was no
mechanism of shari[ah audit and supervision of actual practices of the
MCo. This created shari[ah compliance issues.
69
4.1.1.6. Scarcity of human capital and lack of expertise to run mudarabah
business
Most of the managers of MCos did not have background in venture capital
business. Their experience was of pure financial intermediaries. Therefore
mudarabahs were not used to start a new business or to finance a venture
enterprise. They were mostly used as a subsidiary of an established
business to raise funds for its needs or the MCo applied the funds in fixed
income contracts like leasing and murabaha. Thus lack of diversified
human capital narrowed the scope of business activities undertaken by
MCos.
4.1.2. Use of mudarabah as SPV for off-balance sheet transactions
MCo structure also has a strategic regulatory advantage that has been
exploited very successfully in one context. Since a MCo can be registered
for a specific purpose activity/business, the MCs issued by it does not give
voting and control rights to its holders which remain with the MCo.
Therefore, it is an ideal entity to serve as SPV for raising funds through
flotation of MCs on mudarabah basis; use the funds to finance
construction (or expansion) of plant; and then lease (or leas-to-own) it. The
MC holders receive a regular stream of income in the form of rents. The
strategic advantage is that the originator can raise funds without issuing
new shares which otherwise would have diluted the value of the shares for
existing shareholders. Because the MC are not on the balance sheet of the
originator. This is the structure very successfully employed by Fayzan
Manufacturing Mudarabah. A case study of it with some details are given
in Box-3.
Box-3
Case Study: Fayzan Manufacturing Mudaraba
A relevant case study is Fayzan Manufacturing Mudaraba in Pakistan,

which was exclusively formed to finance ICI Pakistan’s US$ 200 million
Polyester Fibre (PSF) expansion plans.
The transaction was uniquely structured to fulfill the off-balance financing

requirements of the company, which was highly leveraged, in view of their
ensuing Balancing Modernization and Replacement (BMR) activities. A
consortium of banks and financial institutions formed an independent
Mudaraba Management Company (Mudarib) that floated the Fayzan
Manufacturing Mudaraba (FMM).
70
The Mudaraba was responsible for construction and operation of the plant.
The share capital of FMM represented proportionate shareholding of the
sponsors with representation in the board of the FMM.
The FMM had the legal capacity to leverage its balance sheet and raise
equity in the local capital markets. Having agreed to float an industrial
Mudaraba, the sponsors were faced with a number of risks associated with
this project that broadly included:
Construction Risk; delay in commissioning, design defects, damage to

machinery during transit/commissioning etc.
Business Risk; profit margins, competitors, regional situation, government

Policies etc.
Asset Risks; obsolescence, machinery breakdown, damage, sub-optimal

production etc.
Transaction was structured in a way that ICI Pakistan and the sponsors of
the project shared these risks jointly. ICI Pakistan assumed business risks,
and the FMM took on asset and construction risks. FMM owned the Plant,
while land was leased by ICI to FMM.
ICI provided raw materials (Polymer), electricity and packing material to

FMM for conversion to PSF and FMM manufactured PSF under a toll
manufacturing arrangement with ICI at a fee dependent on the quantity
processed. ICI operated the plant under an Operation and Maintenance
Agreement, which covered supervision, personnel and plant maintenance
arrangements. Utilities and consumables were supplied by ICI to FMM
under a separate arrangement.
The legal agreements gave ICI the right to own and sell PSF produced by
FMM’s plant. The toll fee received on the basis of profit sharing
arrangement by FMM formed the basis of return to the investors. A
separate agreement to sell the plant to ICI was signed, the tenor and
pricing of which were determined in consideration of the internal rate of
return requirement of the investors.
Source: Akbar, Salman. 2003. “Islamic Securitization-from a practitioner’s

perspective” in BMA Quarterly Newsletter, October 2003, p.4-7.
71
4.2 Participation Term Finance Certificates—Pakistan
Another product that has been used in the capital market of Pakistan is
Participation Term Finance Certificate (PTC). Whereby an investor shares
in the profits of a business for a specified time through his investment. The
initial experience with this product was not successful with respect to two
aspects. First, certain conditions of PTC were not fully shari[ah
compatible thus reducing its appeal to its purchasers. Second, taking
advantage of weak regulatory and corporate governance environment a
large number of issuers of PTC declared losses at the time of profit
sharing.
However, a large business group operating in chemical industry issued a

shari[ah compatible PTC in the form of Musharakah Term Finance
Certificate (MTFC) with staggered profit sharing ratio and other features
that proved very successful. The details of this product in given in Box-4
below.
Box-4
Case Study: Musharaka Term Finance Certificates
The Sitara Group, one of the high profile conglomerates in Pakistan

formally decided
to free its balance sheet from all conventional exposures and restructure its
balance sheet in line with Shariah. Over the course of the last few years,
the company issued two successful Musharaka based term finance
certificates (MTFC) worth a total size of PKR 510 million (US$ 9 million).
These were both privately placed and listed on the Karachi Stock
Exchange.
The certificates carry a fixed tenor with profit payments linked to the
operating profit or loss of the company. The profit sharing ratio has been
structured in a slightly unconventional way. The level of yearly operating
profit is divided into two broad categories under the heading of Level 1
Profit and level 2 Profit. Level 1 Profit is levied on the first PKR 100
million of operating profit that the company would make at a profit rate of
12% of the outstanding principal and Level 2 profit levied at 2% of the
outstanding principal on each subsequent PKR 100 million operating
profit.
The profit sharing ratio was worked back according to the projected
profitability results of the company and the expected level of internal rate
of return (IRR) that the company is willing to provide to the investors.
72
However, this at best remains expected since the actual IRR would depend
on the actual profitability of the company, hence the analytical rigour in
financial projections is key to structuring the profit sharing ratio at the
outset. Semi annual profit is made on account payment (provisional) on the
basis of projections irrespective of profit and loss and the final profit
payment is determined on the basis of annual audited accounts of the
company and adjustments made accordingly.
In the event of continuous dismal performance of the company, the

investors risk losing their entire investment. That is, in case of genuine
business losses, verified by the separately appointed auditors. Under such
circumstances, the investors will have no recourse to the security, which is
hypothecated in their favour, the call of which is only warranted in case of
fraud and negligence proven in the banking court.
To mitigate the risk of loss for the MTFC holders, the company created
and maintained a Takaful reserve, contributed both by the issuer and
investor that run till the entirety of the issue. On the contrary, in case the
company performed better than anticipated the potential IRR to the
investors on their investment would be significantly higher than a
comparative conventional fixed corporate bond of similar risk.
Source: Akbar, Salman. 2003. “Islamic Securitization-from a practitioner’s

perspective” in BMA Quarterly Newsletter, October 2003, p.4-7.
73
4.3 Product Development—Case Study of Malaysia
Case Study of Cagamas Malaysia
From Chiquier, Loïc; Olivier Hassler; and Michael Lea (2004) “Mortgage
Securities in Emerging Markets” World Bank Policy Research Working
Paper 3370, August 2004.
Cagamas Berhad was created in 1987 following a recession and liquidity

crunch that restricted credit for housing, particularly for moderate income
households. The purpose of Cagamas was to provide more liquidity to
mortgage lenders, reduce market risks, assist social housing finance,
sustain construction sector, and develop private fixedincome markets.
Cagamas purchases mortgage loans (the principal balance outstanding)
from mortgage originators, with full recourse to the primary lenders, at a
fixed or floating rate for 3 to 7 years. This is in effect a secured financing
with Cagamas looking first to the credit of the financial institutions when
mortgage loans default.
Cagamas issues debt securities to investors, in the form of fixed or floating

rate bonds, Cagamas notes, or Cagamas Murabaha (Islamic) Bonds. The
debt is amortized independently of the mortgages. Cagamas is the largest
non-government issuer of debt in Malaysia. Its securities are rated AAA by
the Malaysian Rating Agency and subject to only a 10% risk weight for
bank investors. As of the end of 2002, Cagamas had outstanding debt
securities exceeding 24.9 billion Ringgit (approximately $6.6 billion)
[Cagamas Berhad 2002].
Cagamas has successfully pioneered a number of products in the market

including fixed and variable rate, longer maturities, recourse and non-
recourse, Islamic debt, and leasing/commercial property lending.
Cagamas receives a number of significant privileges from the Malaysian

government, without which its refinancing activities would not have been
perceived as sufficiently attractive for primary lenders. Loans sold to
Cagamas are not subject to the Central Bank reserve requirements. Its
securities are eligible as liquid assets (banks and finance companies must
keep an additional 10% of assets in liquid form). Cagamas securities carry
a risk weighting of 10%, compared with a 50% rating for housing loans,
for investing credit institutions.
74
4.4 Product Development —Case Study of Sudan
Sudan Financial Services Company (SFSC): The SFSC came into being in
1998. Its initial issuance was Central Bank Musharakah Certificates
(CMCs), which were well received with high demand. These certificates
represented Bank of Sudan’s assets (ownership) in the commercial banking
sector. These assets formed a closed-end Fund, managed by SFSC. The
primary purpose of CMCs was to serve as monetary policy tool. However,
they have been discontinued for several reasons. First, they proved to be
costly for monetary management. Being an equity instrument which
carried some risk for its holders it required payment of high rate of return.
Second, their issue volume was limited by the size of the underlying asset
– a monetary tool suitable for open-market operations needs relatively
unconstrained availability. Third, the constraint on issue volume became
quickly binding because the commercial bank assets were mostly
murabaha receivables which cannot be re-traded in the secondary market
for a price different from its face value. Doing so would have resulted in
violation of shari[ah rule.
The SFSC also started a series of Government Musharakah Certificates

(GMC) which are claims on the government owned enterprise and tradable
in secondary market. These certificates were started in 2001. Since then 24
issues have been made. Now GMC are also being withdrawn and they will
ceased to exist by 2007. A gradual withdrawal process has already been
started by not reinvesting the profit in the new issues as the older securities
mature. The GMCs are of short-term maturity instruments that mostly
ranged from 3 to 6 months but some are also for a year. The net total
amount raised under GMC scheme during various years (end December)
had been: 12.9 billion Sudanese Dinar (SD) in 2004; SD 9.36 billion in
2003 [0.21 per cent of GDP]; and SD 5.18 billion in 2002 [0.13 per cent of
GDP].32
4.4.1 Structure of GMC:
Certificates represented partnership in an identified set of state-owned

enterprises. This set of enterprises formed the underlying asset pool of the
32
Author’s calculation based on data from Sudan Financial Services
Company; Bank of Sudan; and Central Bureau of Statistics, Ministry of
Finance and National Economy, Government of Sudan websites.
75
partnership through GMCs. The partnership was for a limited time,
expiring on maturity of the certificate. The certificates were issued through
Sudan Financial Services Company (SFSC). The sale of certificate would
transfer a part of the ownership of the group of state-owned enterprise to
the certificate holder. Only Sudanese nationals were allowed to participate.
The holder of the certificate would receive a proportion of the profit
generated by the enterprises in the GMC asset pool. At the expiry of the
term (i.e., at maturity) the government redeems the GMC on a
contractually pre-agreed price which normally were the face value of the
certificate. In a sense GMCs were a kind of protracted or temporary
privatization instrument in which the administration and control remain
with the government but the ownership and the related financial flows pass
in the private hands for a specific term.
4.4.1.1 Success Factors:
Given the meager alternate opportunities of investment to small savers and

risky investment avenues otherwise available to the rich but passive
investors the GMCs offered a good prospect. It was safe being backed by
government and profitable (the first series ended up paying 32 per cent
returns). The certificates were also very attractive to banks as a large
number of banks had very small base of major-clients. Most banks had
only 4 to 5 major-clients whom they trusted for large investments.
Therefore GMC allowed them to avail of earnings with safety.
4.4.1.2 Controls:
A maximum limit was prescribed for banks’ investment in GMCs.
4.4.1.3 Client base:
GMCs were very popular among individuals as well as banks. However,

due to a high amount of its minimum denomination of 50,000SD the
clientele were mostly institutions and wealthy individuals.
4.4.1.4 Problems:
GMCs were mostly short-term. Therefore government had to issue a new

issue every now and then.
76
4.5 Government Investment Certificates (GIC):
Government Investment Certificates (GIC) are new instruments that has
been introduced since 2003. Learning from experiments with earlier
instruments CMC and GMC as well as changed economic needs are
behind the development of this new instrument. Major Differences
between Government Musharakah Certificate (GMC) and Government
Investment Certificate (GIC) are:
GMC GIC
1. Purpose of GMCs Purpose of GICs is to finance trade,
was to finance procurement, and development projects of the
government budget government.
deficit.
2. Based on Based on partnership for financing of the state
Musharakah in the owned enterprise through ijarah, murabaha,
(set of) state owned and istisna[. With ijarah having a dominant
enterprises. portion in the contract pool.
3. Holders of GMCs The SFSC is a mudarib for GIC holders in a
become owner of restricted mudarabah which allows it to deal
the assets in only in government assets and projects.
proportion to their
investments. The SFSC becomes owner of the specific
assets which it procures from the market or
get them manufactured before it sells them on
murabaha or rents them out (as the case may
be); while it works as mudarib for the GICs
holders. Therefore, GIC holders as rabb al-
mal have undivided ownership in the business
(or asset and contract pool) of the SFSC but
not in the specific assets.
4. Bullet payment of Stream of profits paid at regular intervals
principal and profit (semi annually). Profit sharing ratio 95% for
at maturity. GIC holders (rabb al-mal) and 5% for SFSC
(the mudarib).
5. Tradable in the Redeemable only on maturity at the then
secondary market assessed market value of the asset pool. In
(from immediately between GIC is tradable in the secondary
after issuance). market (after transformation of proceeds into
real assets).
6. Short-term maturity Maturity of larger range from few months to
ranging from 6 to 12 several years.
months.
77
7. Large denomination Small denomination 10,000SD minimum.
50,000SD
minimum.
8. Foreigners cannot Foreigners can invest.
invest
Why government is replacing GMC with GIC?
1. The government budget deficit has narrowed since last few years due to
multiple factors such as: rise in tax revenue, increase in government
income through rise in oil prices, increased remittances and financial
inflows after 9/11. These factors not only decreased government deficit but
also increased the availability of hard currency. Therefore government
does not have a pressing need to raise funds to finance budget deficit.
2. GMC were more costly for the government due to their short maturity
and bullet payment structure of the principal and the profit. While at the
same time the proceeds from sale of GMC were not necessarily generating
income as it were used for financing of current expenditures of the
government. Where as the GIC are of longer maturity and payment
structure is such that the government has to worry only about periodic
profit payment in short-term. And in the long-run the investment
allocations in development and construction have positive economic
effects.
3. Government faced difficulty in using GMC as a monetary policy

instrument because of constrained supply of certificates due to limited
asset base against which these could be issued. Moreover, the rate of return
is known ex post. While conduct of monetary policy requires ex ante
knowledge of rate of return.
4.5.1 Structure of Government Investment Certificates (GIC):
There are three parties to the contract:

1. Investors or certificate holders who are the rabb al-mal
2. Sudan Financial Services Company (SFSC) which acts as mudarib
(agent). It is an investment company.
3. The Ministry of Finance of the Government of Sudan which is the
users of finance.
78
Figure-5: Structure of GIC
Trade and Leasing relationship Mudharabah relationship
Periodic Periodic
payments payments
Price of GIC
SFSC
MoF Investors
Ijarah, Certificates
Murabaha,
Istisna
Liquidation
payment at
Maturity
Secondary
Mkt. for GIC
Government Investment Certificates are essentially mudarabah certificates

that represent mudarabah capital in the business of Sudan Financial
Services Company (SFSC). The SFSC can be though of as an investment
company (or what is called a mudarabah company in Pakistan) that
finances government’s projects through ijarah, murabaha, and istisna[ –
all fixed return modes. The government is a party in the contract and being
a sovereign entity it has the highest credit rating which reduces credit risk
to SFSC. Thus the returns to the certificate holders through SFSC become
almost guaranteed. SFSC retains 5 per cent as mudarib and passes on 95
per cent of the earnings to the certificate holders. To further reduce the risk
an additional measure is taken in the form of a binding promise from the
MoF (on behalf of the government) that it will utilize through ijarah,
murabaha, and istisna[ the entire amount raised by GICs for a period not
less than the maturity of the certificates. To keep the certificates shari[ah
compliantly tradable in the secondary market the SFSC chooses ijarah as
the dominant form of the three contracts. The tradability feature provides
exit and liquidity features which are attractive to the investors. The
dominance of ijarah also reduces credit risk but introduces business risk
(or price risk).
79
Table-11
Statistics on GIC
GIC Amount in Issue Date Maturity Annual Frequency
Issue billion SD Expected of Profit
No. Profit Rate Distribution
1. 6.0 1-5-2003 2 years 20% 6 months
2. 1.0 25-8-2004 3 years 20% 6 months
3. 11.8 2-11-2004 6 years 16% 3 months
4. 22.8 Subscription 5 years
open
Composition of Subscribers of GIC:

The first issue was largely subscribed by foreign individuals and foreign
banks (about 60 per cent of the issue) while Bank of Sudan was the largest
single domestic subscriber (23 per cent). Domestic financial institutions
formed rest of the subscribers.
The second issue of GIC, which came out almost a year after the first
issue, was for a smaller amount but of longer maturity. It was
predominantly subscribed by foreign individuals (about 99 per cent).
Domestic individuals subscribed only a negligible amount (0.2 per cent).
The third issue, almost twelve times the size of the second issue and of
longest maturity (6 years) with quarterly income stream, was
predominantly subscribed by Bank of Sudan (86.7 per cent). This was a
major change from past trend. Foreign individuals were the second largest
group (9.8 per cent), while domestic individuals were still marginally
represented (0.2 per cent). The remaining portion was subscribed by other
financial institutions.
The subscription for the fourth issue is not closed yet which started on 15-
2-2005. At the time of writing (mid March 2005) only 14.9 billion SD out
of targeted 22.8 billion SD (65.6 per cent of the issue) has been subscribed
so far. It seems that more individual subscribers are coming forward this
time.
80
4.5 Lessons Learned for Product Development.
(Pakistan):
1. Tax neutrality across products is important for product development.

Depending on its nature a differential tax can change the return and risk
characteristics of a product relative to other products. Such implications
should be carefully considered because it sometimes create un-intended
consequences.
2. Adverse selection is also an unintended consequence of new products.

That is, instead of a balanced group of agents all high risk economic agents
get attracted to it either as issuer or as investor. As a result the market
performance of the product is adversely affected. Fine tuning of the
product characteristics and regulatory measures are needed which takes
time to develop.
3. Sometimes the product’s use can come from unusual sources not
anticipated at the launch of the product, which exerts a healthy impact on
expansion and growth of the product—a case of favorable selection.
Regulatory arbitrage, special circumstances of some firms, and other such
reasons can become the underlying factors in attracting a few big players
in the market to support the product. The issuance of Fayzan
Manufacturing Mudarabah in Pakistan is an example of such case, where a
big multinational company due to its special financial circumstances found
regulatory advantage in issuing mudarabah product (See Box-3 for
details). The move helped the growth of the mudarabah sector.
4. An upshot of the discussions made in the above three points is that

while care should be exercised in developing the right kind of features of a
new product its launch should not be delayed too much for perfection. The
true test and further refinement of the product takes place in the market.
The issuer should be active in refining the products and the regulatory
environment should be supportive of such refinements and changes.
5. State of the economy and the going interest rates in the conventional
financial markets are important factors in the success of Islamic product
innovations and its repeat issuance. For example, Islamic (Participation)
Musharakah Term Finance Certificate (PTFC) of Sitara Chemicals in
Pakistan was a successful product innovation in the sense that it combined
many new ideas and proved attractive to the investors (see Box-4).
However, the product (or its variants) have not been replicated by others in
81
the following years. This is possibly due to the fact that interest rates have
gone down since then and banks flushed with liquidity are willing to lend
on easy terms. Therefore, the big businesses who are the potential issuers
of Participation Term Finance Certificates are finding bank borrowing
much cheaper than to use capital market or to innovate a financial product
for the market.
(Sudan):
1. Putting a product in practice brings out its good and bad features and
allows for improvement. Initiation of Central Deposit Certificates led to
development of other products like GMCs and now GICs while earlier
products are phased out.
2. It is important that the issuers remain active in refining the products and
the regulatory environment be supportive of innovation and retracting of
the older products.
3. Education of investors and general public is also very important as it

counts towards creating a demand for the product and informed investment
decisions. Such education will contribute towards keeping new products
forthcoming and ensuring shari[ah compatibility of innovations.
4. Simplicity of the product is also important for its acceptability in the

market.
5. A slight change in the familiar (or standard) terms and conditions can
have big effect on liquidity of the product. Therefore implications of new
features of the product for its liquidity are important considerations in
product development. Investors do not quickly shift from an older product
with which they are more familiar to a new one either because of some
unattractive features in the product’s design or because of lack of their
awareness. And it is sometimes hard to distinguish which factor is more
likely cause. Similar issues are also important for inducing more firms to
supply or replicate a product design. In Sudan the demand for the new
product GIC is not as forthcoming from individuals as it was for GMC
which the government wants to phase out.
6. Private benefits and public will both are important for development of
Islamic capital market products. Private sector and public sector both can
develop successful products in their spheres of activities.
82
(Malaysia):
1. Starting on the right foot is important in terms of standard setting

features of the products. Malaysia has developed murabaha based, bay[-
bisaman-ajil (BBA) based, ijarah-suma-bay[ (ISA) based, and receivables
discounting sukuk. All of them on the premise of tradability of certain
kinds of debt. However, this is not an acceptable premise in the fiqh
understanding of rest of the Muslim world. Thus the scope of such bebt
based sukuk has become restricted to the East-Asian markets. Islamic
product development therefore should look for more wider acceptable fiqh
premises, as correctly set standards create their own positive spillover
benefits. The Global Ijarah Bonds from Malaysia that were targeted to tap
a wider investor base is therefore constructed on the wider acceptable
contract of ijarah rather than murabaha or BBA concept.
2. Shari[ah authentication process for a product in Malaysia is centralized

and performed by Shariah Advisory Council (SAC) of Securities Exchange
Commission. It helps curtail the cost of issuance for the issuers of a
product. However, centralization also gives SAC tremendous powers. A
delicate balance is therefore required in minimizing type-I and type-II
errors in authentication of the products and setting of the standards.
83
84
5: ISSUES IN FURTHER DEVELOPMENT
Every system develops its own culture; and the culture it develops helps
perpetuate the system. Dominance of interest based finance is the result of
interest based culture in the present financial system. Establishment of
Islamic finance on firm ground will require a cultural change in the
thinking, practices, products, and institutions of finance. While some
aspects of this change will depend on collective behaviour of the society,
some other aspects are in the control of policy makers and financial
institutions themselves. Here we focus on these controllable policy aspects
to promote Islamic capital market products.
It is important to note that financial sectors in different Muslim countries

are at different stages of development. The spectrum ranges from very
weak to financially strong banking sector; rudimentary to sophisticated
electronic payment systems; and non-existent to vibrant capital markets.
The reasons for such differences lie in the macroeconomic and institutional
factors of each country.33 In such circumstances one policy cannot be made
to fit all. Since the focus of this paper is on Islamic capital market
products to the exclusion of other Islamic financial institutions and tools
following can be said in brief.
In countries where capital markets are underdeveloped (or non existent)

due to scarcity of capital and low levels of economic activity, the focus
should be on development of market for micro and small-to-medium
enterprises. Simple listing and disclosure requirements to promote an over-
the-counter (OTC) market would be useful. In countries where economic
activity is high but the capital market weaknesses are due to institutional
factors the focus has to be on basic institution building. Experience of
Eastern European and Central Asian countries after the communist rule
may provide some useful lessons.
In countries where some form of active capital markets exist the question
of how to increase the share of Islamic capital market products in the
33
See for example Seelig (2004) for diversity of financial development in less
developed countries. Also see Zeinelabdin (1991) for level of stock market
development in some OIC countries.
85
aggregate market takes a different dimension. This is a larger group of
countries for which the present study is more relevant. At present, within
this larger group one or more kinds of Islamic capital market products are
offered in 21 countries. Following are some recommendations and
observations for development and enhancement of the share of Islamic
capital market products.
Table-12
Countries where Islamic Capital Market Products are Offered

Asia Middle East Africa Europe Americas
Bangladesh Bahrain Egypt Luxembourg Canada
Indonesia Dubai South Africa UK USA
Iran Jordan Sudan
Malaysia Kuwait
Pakistan Qatar
Singapore Saudi Arabia
Siri Lanka UAE
Source: IOSCO (2004)
5.1 Strategic Issues to Enhance Share of Islamic Market Products:
• Starting on the right foot is important. If good precedence of product

standards, trading practices, and regulatory rules are set then it
becomes helpful in the long-run development. This is particularly
important for creating sufficient liquid markets. Contrary to that if a
wrong start is made and bad precedence are set then it is very hard to
change them later. There are network externalities that make
corrections difficult to make.
• There is a need to add market products that are suitable for Islamic
banks. Entry of Islamic banks into the primary market will help both
the markets and the economic investment.
• Investment banking offers greater opportunities for innovation and

new product development to suit the needs of the customers. Later on
the products can be adopted for general use in the capital markets.
However, very few Islamic banks are active in Investment banking and
in-house product development. Of recent more Islamic banks are
moving into retail and consumer banking. This trend is not
encouraging for capital market products development.
86
• There is a need for product development and facilitation centres in
each country. The Islamic financial institutions, their associations,
security market regulators, and the central banks should all be
encouraged to have at least one such centre in each country.
• Targeting the ijarah sukuk towards smaller investors would create

secondary market. Otherwise the liquidity surplus banks and
institutional investors will acquire the lions share and they are not
interested in secondary market trading. The other route is to lower the
return on sukuk which will also provide incentives to trade in
secondary market.
• Issuance of Islamic Depository Receipts (IDR) on suitable underlying

Islamic instruments has potential to expand the market size, investor
base, and liquidity of the products and markets. There is a need to
study this aspect from operational side as well as to come up with
shari[ah and market rules for such activity.
• Tax neutrality across various assets is very important for acceptance of

new products in the market. The finance and fiscal managers of the
countries can play an important role in this regard.
• Risk characteristics of the products and the markets change over time.
IRTI in cooperation with IIFM or IFSB can institute an annual risk
evaluation surveys of the Islamic capital market products and of the
markets in order to benefit the industry. Other players in the market
(investors, issuers, and other for profit institutions) may not be able to
initiate such surveys as neutrally as can be performed by IRTI, IIFM
or IFSB. Later on after 3 or 4 years of successful issues the risk
evaluation exercise can be sold to some for-profit institution or to
some association of stock exchanges to continue and improve upon the
annual surveys.
5.2 Issues needing long-term attention:
It is important to create a benchmark for standardization of market tradable

products.
Creation of necessary infrastructure institutions for Islamic capital markets

is important. Progress has been made in this direction in the form of
creation of institutions such as AAOIFI, IIFM, IFSB, LMC, IIRA, etc.
87
Need is to assess the performance of these institutions and chalk out
medium- and long-term development plans for each.
Many product developments in the conventional finance has come about

from efforts to find ways to circumvent the regulations and finding
loopholes to create value. This approach is incorrect for designing
‘shari[ah compatible’ products. Because both the form and objective of
the Islamic product should confirm to shari[ah.
Investor education is very important for acceptability of new product.

Similarly, financial expertise along with shari[ah knowledge is necessary
for product development. It is also important for efficient working of the
market. Teaching and training programs and human capacity building
should be encouraged.
5.3 Long-run desirable goals (not necessarily in control of market

players):
Development of a conducive investment climate is very important for

capital markets to grow and perform a strong role in economic
development. This is achieved by creating law and order, enforcement of
rules, providing investor protection, and political stability. These are some
important factors. Muslim countries currently lack in one or the other of
these aspects.
88
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Rating Agency Malaysia Berhad: Kuala Lumpur, Malaysia.
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Depository Receipts (ADR) Holdings of U.S. Based Emerging Market
Funds”, World Bank Policy Research Working Paper 3538, March
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Akbar, Salman. 2003. “Islamic Securitization—from a practitioner’s

perspective” in Bahrain Monetary Agency Quarterly Newsletter,
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Kingdom of Bahrain, Arabian Printing Press: Bahrain.
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Bank Negara Malaysia. 2001. Financial Sector Master-plan, Bank Negara

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Carmichael, Jeffrey and Michael Pomerleano. 2002. The Development and

Regulation of Non-Bank Financial Institutions. Washington, .D.C.:
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Chiquier, Loïc; Olivier Hassler; and Michael Lea. 2004. “Mortgage
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Management, Document No. 18. Geneva: UNITAR. November.
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FTSE Islamic Index”, Islamic Economic Studies, Vol.12, no.1
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IOSCO. 2004. Islamic Capital Market Fact Finding Report. Report of the
Islamic Capital Markets Task Force of the International Organization
of Securities Commissions, July.
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Expenditure: An Islamic Perspective, Occasional Paper No.7, IRTI,
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Private Sector Development in IDB Member Countries,” Occasional
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Innovation and Growth, Euromoney Books and the Accounting &
Auditing Organization for Islamic Financial Institutions: London, UK.
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Analysis” presented at International Seminar on Islamic Non-Bank
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92

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Islamic Development Bank Group

Islamic Research and Training Institute

Islamic Capital Market Products: Developments and

Salman Syed Ali

Occasional Paper No. 9

2. THE CAPITAL MARKETS—LANDSCAPE ................................... 5

3. SURVEY OF SELECTED ISLAMIC CAPITAL MARKET

5. ISSUES IN FURTHER DEVELOPMENT ...................................... 85

Select Bibliography ................................................................................... 89

Table-1: Market Size in terms of Market Capitalization...................... 8

Figure-1: Structure of a generic Ijarah-Sukuk.................................... 32

AAOIFI Accounting and Auditing Organization for Islamic

Capital markets and interest-free financial products are integral part of

Financial markets in a number of IDB-member countries are growing fast,

Bashir Ali Khallat

I would like to gratefully acknowledge the support, information, and

To Mr. Muhammad Shoaib and Mr. Muhammad Umair Chauhan of Al-

Comments made by the participants in the Policy Committee Meeting and

The development of Islamic capital markets is integral part of development

Proportion of shari[ah compliant stocks in total market capitalization

Presently, market for Islamic capital market instruments is segmented

Case studies on the evolution of various other Islamic products in Pakistan,

The issue of development of Islamic capital market is not separate from

The importance of capital markets in Islamic financial system also stems

The subject of development of Islamic capital markets is very broad. It can

Islam also prescribes a compulsory financial obligation which is zakah: a

With this view when we survey capital markets in the OIC-member

Below we discuss in some detail few obstacles to overall growth of capital

2.1 Market Penetration:

The theoretical relation between market capitalization and economic

Panel-A: Main Sample

Market Capitalization USD Market Capitalization

Malaysia 122.9 168.6 190 130.0 171.8

Country Market Capitalization S&P/IFC

2.3 Market Liquidity:

Trading Volume Trading Value Turnover Ratio

Panel-B: Liquidity & Listing Comparison with some other OIC

Country Market Liquidity Turnover Ratio Listed Domestic

2.4 Too Few Listings:

Country Description of Variable 2002 2003 2004

Panel-B: Comparison with other countries

Developments in Islamic capital market products have come about in

Trade in stocks or shares of companies having businesses not incompatible

In the following section we discuss in some details two key products in

3.1.1 Shari[ah compatibility of underlying business of the company:

A very early review and identification of shari[ah-compliant stocks was

In case stocks of the companies whose core business activity violates

Screening Criteria Differences

Screening Criteria of SEC Malaysia

1. Core Activities: The core activities of the companies should not be

2. Mixed Activities: For companies with activities comprising both

3. Bench Marks of Tolerance: Applicable in case of mixed activities. If

4. Debt and Liquidity: No restrictions on the proportion of debt or

Dow Jones Islamic Index Screening Criteria

2. Screens for acceptable financial ratios

Companies passing the above screens are included as components of the

Meezan Islamic Fund Criteria

Equities – Shari[ah compliant investments in equities would meet the

Note: Valuation of assets is by market capitalization not by book value.

3.1.1.1 Size of Islamic Equity Market