By Hassan Jivraj

The United Kingdom is preparing to issue its second ever Sukuk. Whilst the exact timing of the Sterling-denominated deal is unknown, the Sukuk will form part of the Debt Management Office (DMO) funding strategy.

This issuance follows the UK’s debut Sukuk issuance five years ago. At the time, the deal received much fanfare from the financial media and practitioners. It signalled that Sukuk would become a mainstream asset class in the UK and an ethical alternative to bonds.

What is Sukuk?

Sukuk (singular. Sak) are widely labelled as the Islamic equivalent to a bond because of its bond-like characteristics. However, while it may appear that Sukuk share similarities to conventional bonds, there are some notable differences.

The term ‘Sukuk’ refers to the ownership (through certificates) of an asset, a pool of underlying assets or the revenues of an enterprise. Unlike traditional bonds which pay their holders interest, Sukuk pay their certificate holders the profits generated from the underlying assets or revenues from the enterprise.

Issuers of Sukuk range from governments to companies. There are a variety of structures that can be employed depending on asset availability. Sukuk structures are either asset backed or asset based.

The most notable difference with conventional bonds is that Sukuk must adhere to Shariah principles. This means that Sukuk are not permitted to be related to industries that violate Shariah, such as alcohol, pork, pornography, weapons and gambling.

There are three core Islamic financial principles with which Sukuk must follow:

·         Riba (interest): any kind of interest component is prohibited

·         Gharar (uncertainty): excessive risk or uncertainty is not permissible in transactions

·         Maysar (gambling): gambling or speculation where one party gains at the expense of the other party is not permissible

As a result, the concept of risk and profit/loss sharing among the various parties involved is a key feature of Sukuk.

The UK’s Sukuk story

The UK issued its first ever Sukuk in 2014. The issue came after seven years of debate and legislative changes that addressed legal gaps including taxation and the availability of assets.

The UK’s Sukuk followed an Ijara structure. An Ijara is an Islamic financial contract whereby a financial institution purchases an asset (usually real estate or property) on behalf of a customer and leases it to them for an agreed sum over a specific period. It then transfers ownership to the customer upon maturity.

Ijara is the most common structure among sovereign and new issuers. This is because of the ease of understanding as it resembles the concept of a sale and leaseback agreement.

In the UK Sukuk, the authorities used the Sukuk proceeds to buy the lease of specific land and buildings from the Secretary of State for Communities and Local Government (DCLG).[1] These assets were then leased back to the DCLG in return for the DCLG making rental payments. As a result, the sovereign then used the rental income to make payments to the Sukuk certificate holders.

While small in size, the UK’s £200 million Sukuk was oversubscribed 10 times. The transaction paid a profit rate of 2.036% which was equivalent to yields on Gilts (British government bonds) of a similar maturity.[2]

The UK became the first nation to issue such a financial instrument outside of the Muslim world. Other countries including Luxembourg, South Africa and Hong Kong followed by issuing their own respective sovereign Sukuk.

The Sukuk boosted London’s reputation as a European centre for Islamic banking and finance. This ambition was highlighted in 2013 at the World Islamic Economic Forum (WIEF), when then Prime Minister David Cameron declared interest in London becoming a centre for Islamic finance, complementing hubs like Dubai and Kuala Lumpur.

Following the sovereign Sukuk, the UK Export Finance (UKEF), the government’s credit export agency (ECA), guaranteed Emirates Airline’s Sukuk issue to purchase aircrafts in 2015.

However, since that deal there have been few Sterling-denominated Sukuk transactions from either the sovereign or UK-based corporates. This is despite over USD 50 billion of international Sukuk being listed on the London Stock Exchange.

The most recent Sterling-denominated sukuk came in February 2018 from Al Rayan Bank, the UK’s sole retail Islamic bank. Al Rayan issued a debut £250m Sukuk, which followed a Shariah-compliant equivalent to a residential mortgage-backed security (RMBS). The Sukuk securitised the bank’s mortgage portfolio.

What does the second Sukuk mean?

The UK’s second sovereign Sukuk will be welcomed by the country’s Islamic banks because it provides a new high quality Sterling liquidity management instrument.

Over the last few years, the UK has introduced measures to support the domestic Islamic finance environment. The creation in 2018 of the Bank of England (BoE)'s Alternative Liquidity Facility is a notable example of this.

However, according to a 2018 study by CityUK, the UK continues to lack a comprehensive and efficient range of Shariah-compliant financial instruments for banks to manage their liquidity. The same study said that the BoE is unlikely to address this.

Nonetheless, the UK’ Sukuk is symbolic and reflects the government’s continued commitment to develop the British Islamic finance industry.

The Sukuk may also offer the opportunity to one of the UK’s Islamic banks to have a more prominent role such as an Arranger as compared to the maiden issue, where they were notably absent.

UK policymakers will likely regard Islamic finance as a strategic industry, particularly in a post Brexit economy. UK authorities can capitalise on London’s position as a global financial centre by attracting international investors seeking Shariah-compliant investments. Furthermore, London’s reputation as a Fintech hub and the increasing number of UK-based Shariah-compliant start-ups will contribute to the growth of the industry.

What does the Sukuk mean for retail investors?

The UK’s Sukuk will continue to generate awareness among institutional investors to consider investing in Sukuk. Muslim retail investors, or those seeking ethical alternative investments, will also be glad to know - that unlike conventional bonds - Sukuk generally deliver stable and consistent returns during market volatility.

This article is written by Hassan Jivraj.

Hassan is a writer: he has spent a number of years writing on the global Islamic finance industry and Middle Eastern fixed income markets.

You can follow him on Twitter @HassanJivraj or connect with him on LinkedIn.