The global authority for Islamic finance is holding off on a planned change to rules for sukuk securities after an outcry from investors that the move would upend the $1 trillion market.
To address those concerns, the Accounting and Auditing Organization for Islamic Financial Institutions will hold at least one more round of talks with key stakeholders — including central banks, major issuers, rating companies and lawyers — before making a decision on its Standard 62 proposal, its Secretary General Omar Mustafa Ansari said in an interview with Bloomberg News.
"We have put it on hold," Ansari said via Zoom, after earlier planning to make the change this year. "We are willing to delay the process to make the market more ready for it."
At the heart of the debate is a clash between how the market views sukuk — a type of security that complies with Islamic law's prohibitions against interest — and how Islamic scholars believe it should function. Sukuk are currently treated as part of the bond ecosystem, with similar cash flows. Investors and rating companies assess the securities using the same measures of risk and financial stability.
Yet with Islamic law forbidding interest being charged on debt, sukuk represent partial ownership in an asset, with payments to investors acting as a share of the revenues or profits. The Bahrain-based financial authority wants issuers to transfer ownership of the underlying assets to investors, so that the structure is truly compliant with Islamic principles.
Industry players warn that would turn sukuk into equity-like instruments, alienating bond investors and making it harder for rating companies to assess them. That could even mean sukuk might no longer qualify for fixed-income portfolios, which would be a huge setback for a market that's witnessed heady growth in the past five years.
"A strict implementation would materially change the nature of sukuk from being bond-like to becoming more akin to asset-backed securities," said Amol Shitole, head of fixed income at Mashreq Capital in Dubai. "This shift could have significant consequences," he said, pointing to risks such as variable income, greater complexity and reduced liquidity, which could all hurt demand for sukuk.
The delay to AAOIFI's proposal to change the rules, known as Standard 62, doesn't mean dilution of the concept, Ansari noted. The core Islamic principle barring interest-bearing transactions will be upheld at any cost, he added.
"Anybody who wants a pure bond should go to the conventional market," he said. "Sukuk can never be a conventional bond. We want to resolve issues, but at the same time Sharia is paramount for us."
Issuers rarely transfer ownership of underlying assets when raising funds through sukuk — a practice AAOIFI scholars say makes the instruments behave like bonds, since payments resemble interest rather than profit.
Fragmentation risk
Investors have already voiced their concerns at the body's previous public consultations. Mehdi Popotte, executive director and senior sukuk portfolio manager at Arqaam Capital Ltd. in Dubai, sees three key problems. Firstly, issuers — particularly sovereign states — may not want to transfer assets. Meanwhile investors may seek non-AAOIFI compliant sukuk, creating a fragmented market. Finally, AAOIFI itself does not keep official records of which sukuk it approves of.
"I believe AAOIFI is aware of those very critical challenges and as a result is taking extra time to review those and find the best compromise," Popotte said.
AAOIFI is encouraging investors to also look at the risk of default — in a truly asset-backed structure under Standard 62, it argues investors would be able to take over or liquidate the assets quickly as owners rather than mere financiers.
"What happens in the event of default — that is the question," Ansari said.
As negotiations continue, both sides are working toward a solution that will buttress the Islamic character of sukuk. Efforts are focused on structuring it in a way that routine cash flows would reflect a debt-type instrument, while a default would immediately invoke equity-like characteristics.
Other concerns are whether existing sukuk would have to change to comply with the new norm, and how much time national regulators will get to implement the standard. Ansari said investors and issuers needn't worry about either.
"One part is clear: the standard is not being finalized in a haste or hurry," he said. "Even when it's finalized, it will provide a reasonable transition period, as well as 'grandfathering': those already issued will not be impacted."
