This article is abridged from a chapter provided by DDCAP to the International Islamic Financial Market for its Overview of the Global Sukuk Market 2015

Introduction

The Islamic Financial Market continues to outgrow and outpace its conventional counterparts despite the economic slowdown globally. According to the TheCityUK 2015 Islamic Finance Report, the global demand for Islamic financial services, as measured by Sharia’s compliant assets, increased by 12% in 2014 to a record $2trillion and tripled even in the face of the post economic crisis since the 2007/2008 periods.

Indeed, the growth of Sharia’s compliant assets during this period was no coincidence, as the demand for products such as Sukuk and Sukuk funds was predicated on the availability of a more resilient alternative to conventional finance after the problems encountered in the conventional space which led to the 2007/2008 economic crisis.

Within this context, Sukuk continue to play an active role in the Islamic finance space with increasing demand and interest from sovereigns, multilateral agencies and corporates for their financing needs. The importance of Sukuk cannot be under emphasised as investors and issuers view it as a platform to manage liquidity, provide asset and infrastructure financing in the real economy and, lastly, as diversification to achieve insulation from the volatility of other asset classes.

Sukuk have in recent times become dominant in the development of the Islamic capital market. The demand has been driven largely by increasing awareness that Sukuk are a valuable source of liquidity for sovereigns, quasi-sovereign and corporate issuers. The last three years has seen this dominance in real terms with Sukuk issuances surpassing the USD100billion mark and the addition of sovereign issuers from both Muslim and non Muslim jurisdictions.

The issuance of the first Ijara Sukuk by the United Kingdom government in 2014 in the amount of GBP200 Million followed by the governments of Luxembourg EUR200 Million, Senegal XOF100 Billion, Hong Kong USD1 Billion and South Africa USD500 Million puts the above issuance statistics into context. Although, the vast majority of Sukuk issuances are still in the domain of sovereign and quasi-sovereign, there are strong indications that, with increasing awareness, the market anticipates demand coming from the corporate sector as well, including Europe, where recent experience of tightening of liquidity in the conventional markets caused a re-appraisal of other forms of funding.

Unsurprisingly, the traditional Sukuk markets of Malaysia, Saudi Arabia, Bahrain, and Dubai, although slightly subdued recently, still represent collectively the highest levels of Sukuk issuance in the world. Dubai recently surpassed Malaysia in Sukuk issuance due in part to the Malaysian Central Bank’s (Bank Negara Malaysia (BNM)) decision to stop issuing short dated Sukuk (up to three month maturities), as the BNM believed there was sufficient liquidity in the country’s Islamic capital markets, and that their issuances were being primarily used by foreign banks to manage their liquidity needs, therefore doing little to improve the liquidity needs of the domestic market. Given the growing familiarity and utilisation over many jurisdictions, Sukuk are likely to become a key component of the financial landscape in both developed and emerging markets. Factors contributing to this development include the on-going requirements for infrastructure financing globally and sovereign liquidity needs. Sukuk instruments are well placed to close this funding gap.

The European Perspective

Historically, the speed of development of the Islamic capital market in terms of Sukuk issuances has often been driven by the key dominant jurisdictions of Malaysia and the GCC. More recently there has been a gradual and sustained effort in Europe to promote Islamic finance particularly in the UK, Luxembourg and Ireland.

In this regard, the UK has been by far the most pro-active, due in part to London’s pre-eminent status and role in global finance, plus it’s historical links with the core Sharia’s finance markets of the GCC and Malaysia, alongside meeting the needs of Britain’s own Muslim population. The UK was recently identified as an important destination for Islamic finance with the country given an index value of 16.2 (above the global average of 10.3) in the latest ICD Thomson Reuters Islamic Finance Development Report. This figure represents the value given to important global centres of Islamic finance based on their offerings in terms of education and research, governance, corporate social responsibility and awareness. The UK was the highest ranked non majority Muslim country.

The Sukuk market is an essential part of the Islamic finance market, and London as a major centre for international bonds is an important centre for the issuance and trading of Sukuk. The outstanding value of international bonds issued in the UK at the end of 2014 was USD3.3 trillion representing about 15% of the global total and second only to the US. London is also the leading centre for international bond trading with an estimated 70% of secondary market turnover.

As already noted, the UK became the first western country to issue a sovereign Sukuk in 2014. The UK government sold £200 million Sukuk, maturing in 2019. This debut sovereign Sukuk was oversubscribed more than eleven times with strong demand and orders amounting to approximately £2.3 billion from both domestic and international investors. The Sukuk was allocated to a wide array of investors including sovereign wealth funds, central banks, local and foreign financial institutions. It was listed on the London Stock Exchange (LSE) which is a key global venue for the issuance of Sukuk having been involved with 57 listings with a total value of USD51 billion. In terms of global Sukuk listings, the Nasdaq Dubai Report revealed that in June 2015, there was a change in the dynamics of Sukuk listings in the traditional centres of Malaysia, Ireland and London. The Dubai Exchange (comprising of both the Nasdaq Dubai and Dubai Financial Market) had total current listings of USD36.7 billion ahead of Malaysia’s Bursa Malaysia and the Labuan Free Trade Zone (USD26.6 billion), the Irish Stock Exchange (USD25.7 billion), and the London Stock Exchange (USD25.1 billion) respectively.

The UK sovereign Sukuk was issued by the British government with a number of objectives in mind. These objectives included not only the opening up of alternative sources of funding at an all-in cost equivalent to conventional gilts, thereby ensuring value for money to the British public and taxpayers, but the provision of a HQLA, which could be utilised by domestic Islamic banks as part of their regulatory liquidity and capital requirements. A further objective was to set a precedent that demonstrated to the corporate sector that a proven platform and infrastructure is in place in the United Kingdom so that Sukuk can be issued comparably to conventional bonds, thereby paving the way for Sukuk to become an instrument of choice for raising corporate finance.

Two major developments followed quickly after the UK sovereign Sukuk issuance. One significant milestone for Sukuk market development was the UKEF (UK Export Finance) announce- 13 ment of its provision of guarantees for Sharia compliant financings involving British exporters. In March 2015 it was announced that UKEF would provide a guarantee in support of the USD913 million Sukuk issued by Dubai’s Emirates Airline. This was a “triple first” in its own right. Not only were they the first Sukuk certificates guaranteed by an export credit agency (ECA); it was the largest debt capital markets offering, conventional or Islamic, in the aviation sector with an ECA guarantee to date and, lastly, it was the first time a Sukuk had been issued to raise finance prior to delivery of an aircraft. This has had a demonstrable effect on the issuance of “buyer credits” with ECA backing for exporters wishing to provide medium term funding to markets within the Organization of Islamic Conference (“OIC”) countries as part of their overall project bids. Given that the UKEF guarantee ranks parry passu with that of the UK government, this sophomore issue further reinforced the commitment of the government to deepening the Islamic capital market, through encouragement of regular or recurrent issues by major European and international issuers.

The second development was initiated in late 2014 through further innovation, wherein the International Finance Facility for Immunization (IFFIm) tapped the international capital markets to raise finance to accelerate the availability of funds for immunization programs and health systems through GAVI, the Vaccine Alliance.

IFFIm currently has nine sovereign donors, the UK being one of them, having pledged £1.63 billion, or 46% of total pledges over a twenty-three year period. Alongside the UK’s donations are those of several other European governments. In late November 2014, IFFIm issued its inaugural Sukuk, raising USD500million for GAVI. Deemed to be the first benchmark sized Sukuk primarily focused on social impact, it provided institutional investors with a socially responsible investment opportunity that will help vaccinate and protect tens of millions of children against preventable diseases. This Sukuk was listed on the LSE and was oversubscribed with global interest from a wide investor base.

Underpinning the UK Government’s ambition to become a key player in Islamic finance in the Western world is a supportive architecture which has acted as an enabler to ensure this objective is realised. For example the numerous leading law firms and professional service firms, with a specialisation in all aspects of Islamic finance, in the City of London has greatly added to the ability of advising and structuring Islamic financial products globally from the UK.

Collectively, Europe has also become an important listing destination for international Sukuk for both Asian and Middle Eastern firms seeking to widen their investor base and simultaneously promote secondary market activity in Sukuk. This feature has often been missing in traditional Sukuk markets where the securities tend to be held to maturity. European exchanges including the LSE, the Irish Stock Exchange (ISE) and the Luxembourg Stock Exchange (LuxSE) have been able to attract Islamic issuers with their efficient and transparent listing processes and market liquidity profiles.

With respect to funds, Europe has seen a steady growth of Islamic funds domiciled within the European Union (“EU”). According to the Malaysia International Islamic Financial Centre’s (“MIFC”) report on Islamic Finance in Europe, there are approximately USD14 billion in Assets under Management (“AUM”) in the EU as at 2014. This accounts for approximately 20% of the global aggregate of Sharia’s compliant AUM, up from 12% in 2012.

Generally, the appeal of European domiciles for fund management lies in the attractive combination of tax benefits, regulatory sophistication, operational efficiency and diversification. All of the above factors contribute to a universe of choices for fund and asset managers in their mission to satisfy their customers’ preferences. More importantly, where these factors are lacking in other asset managers immediate local or regional markets, it persuades them to approach the European markets for their investment portfolio needs.

As alluded to earlier, the traditional fund management domiciles in Europe such as Luxembourg, the Channel Islands and Ireland, have tended to be amongst the favoured locations for the incorporation of Islamic funds and offer provision of ancillary services for local regulatory requirements. Distribution of many of these funds has largely come from London and other core, Islamic financial hubs where there is a huge depth of experienced local and international firms available to ensure successful distribution on a global basis.

Conclusion

The future development of the Sukuk fund market from a European perspective remains dependent upon the volume of new, global Sukuk issuance by all types of market issuers i.e. Sovereign, Supranational and corporates. However, given the ever-growing international reach and the apparent mainstreaming of Sukuk in Europe, along with the enabling environment already in place and the industry focus of numerous international governments, the prospects of further issuance, listings and wider market development looks extremely promising. Often previously referred to as predominantly a feature of the South East Asian and GCC markets, there are now increasing signs that both the Islamic capital market and its Sukuk funds subsector have found a complimentary and expanding platform in Europe.

Most importantly, in the UK and in wider Europe, the demand for infrastructure development continues to grow rapidly and the need for alternative and efficient sources of funding for significant, national projects cannot be over emphasised and Sukuk funds may have a part to play in the provision of such funding. In the UK, Islamic finance has played an important role that is illustrated by its inclusion in the financing arrangements and solutions utilised in the development of infrastructure and infrastructure related projects around London including providing development finance for The Shard; London Gateway and the Olympic Village, the redevelopment of Chelsea Barracks and regeneration of Battersea Power Station. Currently, the domestic footprint of the projects deemed relevant to Islamic investment and funding is growing and, with the proactive support of the British government is ultimately likely to result in the UK Islamic capital markets providing a financial platform for regeneration, development and project funding across the British Isles.