If you kept stacking dollar bills vertically, one on top of another, a trillion dollars would reach the moon – that is about the current size of Islamic finance. However huge it may sound though, the industry is just one per cent of the total global finance market despite the 10 to 15 per cent growth it has enjoyed in the past few decades.
"Despite its big potential and huge growth in the recent past, Islamic finance is still a small, niche market. The main question is how do we [take it] mainstream and standardise it," said Dr Nasser Saidi, DIFC chief economist, adding that the share of listed Islamic securities in the whole pie is only $54 billion (Dh198bn) or five per cent.
Sukuk, or Islamic bonds, have consistently been tapped as a forerunner of Islamic finance and the financial crisis has only served to increase the size of the world's debt markets, including sukuk. In 2009, bond issuance by corporate bodies was about $1.7trn, 80 per cent of which was investment grade, according to Bank Sarasin.
Debt issuance increased as corporates found it difficult to borrow from banks, and as investors were lured by attractive corporate bond returns.
In line with this, new sukuk issuance in 2009 increased to $23.3bn compared to $14.9bn in 2008, with a marked resurgence in Asia in general, and Malaysia in particular, with 54 per cent of the total volume.
Saudi Arabia saw an increase to $3.1bn in 2009 compared to $1.7bn in 2008, figures from Standard & Poor's show. This growth is expected to continue because there are 1.57 billion Muslims in the world, or 23 per cent of the global population, and most of them prefer Shariah compliant solutions.
"Out of this, 60 per cent are in Asia which has low banking penetration. In Egypt, for example, only one out of 10 households have a bank account," Saidi said.
To service this population and match growing economies, long-term funding needs to be put in place. Meed estimates that the GCC would need $2.8trn worth of infrastructure projects over the next 15 years.
Fluctuations in the oil and gas markets and the probability of banks to offer loans with long-term tenures makes it less ideal for these states to depend on oil revenues and even on the loan market.
Saidi said governments should issue securities according to the tenor of investments rather than obtaining short-term funds to fuel long-term projects and be stuck with the pressure of rolling over the debts each time the obligation matures. Thus, governments should introduce sukuk as a part and parcel of their overall public finance programmes.
"Unless we see the government and central banks use Shariah concepts we'll not be able to grow the market," he said.
But this is just one of the hurdles. Experts agree that unless a list of pressing issues in Islamic finance – sukuk in particular – is addressed, the market will grow at a much slower rate than expected.
First among the many unresolved issues is whether sukuk are Islamic or not. Sukuk are widely regarded as controversial due to their perceived purpose of evading the restrictions on riba, or interest. Conservative scholars do not believe that this is effective, citing the fact that sukuk effectively require payments for the time-value of money, which can be regarded as the fundamental test of interest.
Sukuk offer investors fixed returns on their investments, which is also similar in appearance to interest, in that the investors' returns are not necessarily dependent on the risks of the particular venture.
Sukuk can be structured using different techniques. While a conventional bond is a promise to repay a loan, a sukuk constitutes partial ownership in a debt (sukuk murabaha), asset (sukuk al ijara), project (sukuk al istisna), business (sukuk al musharaka), or investment (sukuk al istithmar).
Such structures can be listed on exchanges and be made tradable through conventional organisations like Euroclear or Clearstream – settlement systems for securities transactions, covering both bonds and equities.
Some interpretations say that under Shariah law, certificates of debt are not tradable – hence certain structuring elements for sukuk al musharaka, sukuk al mudaraba and sukuk al istithmar have been criticised.
Debt certificates can be only bought before the actual financing occurs and then held to maturity from an Islamic perspective, which is critical on debt trading at market value, regarding any difference in price as prohibited interest on money.
As Shariah considers money to be a measuring tool for value and not an asset in itself, it requires that one should not receive income from money [or anything that has the genus of money] alone. This generation of money from money is riba and is forbidden.
"Most sukuk are structured to replicate the economic effects of a conventional bond… These may be hard words but this is the reality. I've picked up a few sukuk documents recently and that, it seems to me, is what is actually going on," Peter Casey, Director, Policy & Head of Islamic Finance, DFSA, said.
While sukuk offer a useful potential mechanism for secondary market resource mobilisation, they also open the way for sale of debt receivables as minority share in a general sukuk issue.
"Since the sale of debt, except at its face value, is not generally acceptable by scholars, the use of sukuk where debt receivables are a noticeable proportion remains suspect from a Shariah point of view," Dr Munawar Iqbal, former Chief of Research, Islamic Banking and Finance, Islamic Development Bank Group, said.
Furore had also broke out when it was incorrectly reported that Sheikh Taqi Usmani of AAOIFI declared that 85 per cent of sukuk were not Shariah-compliant. Usmani had said no such thing and his remarks were directed towards certain malpractices in structuring sukuk based on partnerships (musharaka). But the controversy demonstrated investor insecurity regarding the sukuk market.
Iqbal said such remarks sent shock waves into the sukuk market around the globe, pushing issuance down to $14bn in 2008, compared to some $50bn in 2007. Though Standard & Poor's estimated in September 2008 that the sukuk market in its entirety would exceed $100bn by 2009 with the latest hiccup, "no reliable" statistics exist that can confirm that their estimates were fulfilled, he said.
"Damage control efforts have started earnestly, but my view is that even if the sukuk market witnesses some recovery, it will in the short run be only due to excess liquidity in the market," he said.
Iqbal added that sukuk will remain "under cloud for some time" and there is a big challenge for financial engineers to come up with new sukuk structures that can reassure investors about their Shariah-compliance.
While the issue of being Shariah-compliant remains in the hands of scholars to debate, the fact that some sukuk have begun to default is not debatable.
"Default and potential default is an issue," Saidi said. "How do you deal with insolvency? The debt bond market has been here for 180 years and has been tested, but the system to deal with sukuk default is not yet developed." The industry is still waiting to see what will happen on the bankruptcy filing by East Cameron Partners in the United States, which was behind the issuance of the US's first and only sukuk.
Since this is largely uncharted territory, sukuk holders will be keen to see where they appear on the list of creditors.
Another issue that remains to be resolved is the default by The Investment Dar (TID) of Kuwait on a sukuk payment that matured in 2009. The case is on-going and has been controversial because the issue involves whether an instrument is Islamic or not.
The case started when a Lebanese bank, Blom Developments Bank, provided TID with $10 million in funds, the principal amount, through a wakala or agency-based deposit/investment structure. It was intended that TID would ultimately return the principal amount along with an expected amount of profit based upon an anticipated profit rate for each investment transaction.
When TID failed to pay the expected profit and to return the principal amount at the end of the investment period, Blom sued TID on the grounds of breach of agreement.
TID however countered that the arrangements were void because the wakala did not comply with Shariah. The English court issued a summary judgment ordering TID to pay to Blom the principal amount but not the expected profit in respect of which the court felt there was a case to be argued. TID elected to appeal the summary judgment with a view to overturning the order to pay the principal amount to Blom. "The TID-Blom litigation is an important and timely reminder to legal practitioners and other stakeholders in the Islamic finance industry that the importance of an obligor's own approach to Shariah compliance should not be overlooked," law firm Clifford Chance said.
"In practice, it seems inevitable that this will lead banks, both Islamic and conventional, to conduct a closer examination of the capacity and authority side of transactions that they enter into with Islamic clients," it added.
Nakheel was also feared to default on a $3.52bn sukuk, which matured in mid-December 2009, together with an approximately $500m profit payment on the sukuk.
While some observers have speculated that refinancing the sukuk would be expensive, the Dubai Department of Finance advised Zawya Dow Jones in September 2009 that defaulting on the sukuk "isn't an option". The Nakheel sukuk was nevertheless paid on time with support from Abu Dhabi.
And just last month, Saad investors have agreed to dissolve the $650m sukuk. The dissolution may allow investors to claim assets used to back the Islamic securities sold in May 2007 by the Saad Group's Golden Belt 1 Sukuk Co BSC.
Because of these cases, sukuk are no longer viewed as havens that offer predictable returns with minimal risk. "The market is unlikely to grow until default and bankruptcy situations are clarified," Sarasin-Alpen said.
"If we don't address this, sukuk will be viewed as unduly riskier," Saidi added.
While sukuk typically have underlying assets, two questions need to be resolved about these, according to a senior regulator.
"The first one is, can those assets be accessed by the sukuk holders if they wanted to make that claim? And the second: if they could, would they want to?" asked Peter Casey, Director, Policy & Head of Islamic Finance, DFSA.
He said assets often include real estate in jurisdictions whose worth is likely to have dived and where sukuk holders may have difficulty of access.
"Put yourself in the position of a sukuk holder who has a choice between trying to make good of the assets or trying to make good of the claim against the ultimate obliger. The best you could do is take and sell them," he said, adding that a platform to stage this move has not yet been established.
Another issue relates to continuing disclosures, which he said, will be "trickier" going forward. He said the easier way is for regulators to put a full set of disclosures for both but it may result in overburdening the market. "I think regulators would choose to specify the disclosures initially on very broad risk terms before specifying them precisely. However, with very limited experience in asking for disclosures and imposing them in the market, there will be bound to be some teething troubles," Casey said.
On May 2, Nasdaq Dubai suspended select sukuk and other securities from the official list for not disclosing their 2009 financial statements and annual reports to the exchange. The list of suspended sukuk and other securities includes IIG Funding, Nakheel Development 2, Nakheel Development 3, TID Global Sukuk I, Dubai Holding Commercial Operations MTN.
Continuing corporate governance also needs to be addressed, Casey said. In principle some investors will invest on the basis that underlying investments are, and will remain, Shariah compliant.
"It's quite possible [this] might be breached, which would have an impact on the market," he said.