Sukuk are commonly described as Islamic bonds, trust certificates or Islamic securities and are structured and traded in the capital market in accordance with the requirement of Islamic law ("Shari'ah").

Despite the global credit crunch affecting the world economy, the emerging Islamic Sukuk market remains robust. According to Moody's in its special report entitled "2007 Review & 2008 Outlook: Islamic Finance", the Islamic bond market is now estimated to have reached US$700 billion worldwide. It is the fastest-growing segment of the world's capital market, increasing at a staggering average rate of 40 percent per annum. One obvious explanation for this phenomenal growth is that the continuing surge in crude oil prices (from US$28 a barrel in January 2001 to US$146 a barrel in mid-July this year), is generating a vast pool of liquidity in the Middle East, leading to the resulting boom in the global Islamic finance industry. But more importantly, the Sukuk success story is the consequence of recent innovations in contemporary Islamic jurisprudence, which have allowed the development and engineering of Shari'ah-compliant financial products and instruments that can be traded in the global market.

Ireland has already opened its door to the fast-growing Islamic capital market. The Irish Financial Regulator has approved in October 2006 an issuance by a Kuwaiti corporate issuer, through its special purpose vehicle ("SPV") - NICBM Sukuk Limited - of US$100 million Sukuk al-musharaka trust certificates (the "NICBM Sukuk"). The NICBM Sukuk have also been admitted to the official list of the Irish Stock Exchange ("ISE") and to trading on its regulated market.

This article will be of particular interest not only to issuers/ potential issuers of Islamic bonds but will appeal to conventional investors, financial institutions and many other market participants looking to exploit alternative investment opportunities.

Securitisation in emerging Islamic debt capital markets is distinct to conventional bonds in many ways. The main distinctive feature is that Quar'anic laws prohibits the practice of usury or "Riba" (i.e. the charging and paying of interest), which is in fact a fundamental aspect of conventional debt financing. Some of the core prohibitions of Shari'ah are outline below:

• transactions in unethical goods and services (e.g. transactions involving tobacco, alcohol, etc);
• earning returns or interests from loan contracts (Riba);
• excessive uncertainty in trade contracts (Gharar);
• gambling and chance-based games (Qimar); and
• trading in debt contracts at discount (i.e. amounting to an indirect form of Riba).

The charging of Riba in financial contracts is not considered to be fair under the religious tenets of Islam, since money is meant to be simply a medium of exchange and not a commodity per se. When money is used for the exchange of commodities, it should reflect the real value of those commodities. On this basis, the charging of any surplus value or interest (in excess of the actual cost of a particular asset) is forbidden, as this will give rise to unjust enrichment.

Whilst on the one hand, Quar'anic laws prohibit Riba, on the other hand, it permits commerce and tolerates the earning of any just and legitimate commercial benefits such as profits, rent, and income. For example if the rent value of a building amounts to €1000 and the rent charged by its landlord is €1000, this is acceptable, as there is no Riba and no unjust enrichment of the landlord at the expense of his tenant. Contrariwise, if the landlord claims an additional €200 interest on top of the rent charge, this is not permissible and will amount to Riba, as it is an unjust claim exceeding the real value of the property.

Thus, in a traditional Islamic mortgage transaction, if a lender lends a sum of money to a borrower, for instance to buy a car, the lender would certainly not be able to recover any sum more than the amount lent to the borrower (i.e. the purchase price of the car). The only way for the lender to earn a legitimate and just benefit without acting in contravention of he principles of Shari'ah is, instead of offering to the buyer a loan to purchase the car, the lender might buy the car itself from the seller, and resell it at a profit to the buyer (who will in turn pay back the seller by lease installments). This basic sale and leaseback mechanism is known as Ijarah and is one of the techniques often used in Islamic banking and finance to replicate the concept of interest.

Against this background, Islamist bankers and lawyers have developed a range of financial arrangements to render Islamic debt financing instruments Shari'ah-compliant. These include:

• Safekeeping ("Wadiah");
• Joint ventures- partnership contracts ("Musharakah");
• Profit sharing- partnership contracts ("Mudharabah");
• Cost plus exchange contracts ("Murabahah"); and
• Leasing exchange contracts ("Ijarah").

The concept of Sukuk goes back to the classical period of Islam, in the middle ages. In its original simplest form, Sukuk is an Arabic term that refers to any document representing a contract or transfer of rights, obligations or monies in conformity with the principles of Shari'ah. But more recently, neo-Islamic scholars and jurists have developed new and modern forms of Sukuk instruments that can be used in structured finance, without being in breach of Quar'anic laws. The modern Sukuk incorporates the above-mentioned Islamic principles of Wadiah, Mudharabah; Musharaka, Murabahah and Ijarah in the field of securitisation and capital markets and ensure that Islamic structured products are compliant with the tenets of Islam.

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), an Islamic international organisation responsible for preparing accounting, governance, ethics and Shari'ah standards for Islamic financial institutions, have identified a variety of fourteen types of Shari'ah-compliant Sukuk; among these, Sukuk al-musharaka and Sukuk al-ijarah are the most common structures used in the field of Islamic securitisation and are examined below.

Sukuk al-musharaka is a form of asset-backed security (which is more in the nature of an equity-type instrument) and which is based on the principle of Musharakah. It is in the nature of a multilateral partnership involving an asset-originator ("Musharik"), an SPV, and a committee representing the body of bond subscribers ("Musharaka-holders"). The SPV will issue Sukuk al-musharaka certificates to Musharaka-holders, giving them direct ownership in the underlying assets held by the SPV, and right to share together with the Musharik, and the SPV, all the profit and loss of the business venture, as opposed to the sharing of any other proscribed returns or interests, which could constitute Riba.

The Sukuk al-ijarah structure is quite similar to conventional repurchase agreements, repos and leaseback arrangements, entered between lenders and borrowers for the purpose of acquiring assets, but are subject to the principle of Ijarah. The typical scenario in a Sukuk al-Ijarah will usually involve a securitisation arrangement whereby a borrower (seller/ cash receiver) will sell an asset to a lender (buyer/cash provider), subject to the agreement that the borrower will repurchase the asset at an agreed profitable price to the lender at the maturity date. The lender (usually an SPV) will in turn raise finance for the facility agreement by issuing Sukuk al-ijarah certificates.

The application of credit derivatives and synthetic structures for the purpose of hedging Sukuk structured products has also posed some jurisprudential difficulties to Islamic jurists. Since derivatives (including options, futures, total return swaps, credit default swaps, FX forward, etc.) are of speculative nature, Shari'ah will not allow their usage if they were to amount to Gharar (excessive uncertainty in trade contracts) and/or Qimar (gambling and chance-based games) (as discussed above).

To ensure compliance with Quar'anic laws, some lawyers have referred to the concept of "Maslahah" or "public benefit" (which provides that if something is overwhelmingly in the public good, it may be transacted) for justifying the use of derivatives for hedging and managing financial risks. Other jurists have invoked, by analogy to conventional option, the Islamic concept of "Bay al-urboon", which provides that in situations where a buyer of a good makes a deposit to buy a particular commodity in future, then if circumstances dictate that he will not buy the product anymore, then the seller is entitled to keep the deposit.

A significant development in that area is that the International Swaps and Derivatives Association (ISDA) is currently working in conjunction with the Bahrain-based International Islamic Financial Market (IIFM) on the development of a Shari'ah-compliant Master Agreement based on the 2002 ISDA Master Agreement. The whole idea is to give to over-the-counter Islamic derivatives similar impetus that the publication of the original 1992 ISDA Master Agreement gave to the conventional derivatives market.

The recent innovations in the Sukuk market have dramatically changed the dynamics of the Islamic finance industry. The Sukuk success story only began modestly some six years ago in Malaysia, which pioneered the international Islamic finance market by the issuance of the first global sovereign Sukuk, along with a series of corporate Sukuk issuances. Ever since, the global Sukuk market has expanded rapidly and broadened its horizon to attract a number of prominent sovereign and corporate issuers in the Arabian Gulf (notably in Dubai, Bahrain, Qatar and Kuwait) and in many other countries in Asia and the rest of the world.

The issuance of the first European Sukuk by the German federal state of Saxony-Anhalt, amounting to US$100 million, through a Netherlands-based SPV in July 2004, was a significant episode in Islamic finance. The economic motivation behind this deal appeared to have been part of Saxony-Anhalt's strategy for promoting inward investment in its region by accessing the huge and growing Islamic liquidity pool, in addition to the conventional investor base.

Following the landmark Saxony-Anhalt transaction and the continuous expansion of Islamic finance, Sukuk has become increasingly popular. The level of global interest in Islamic finance is huge, both within and outside the Muslim world. The government of Japan, Thailand, and Hong Kong have all recently announced their intentions of issuing sovereign Sukuk; and the UK Government in its 2008 budget, has taken major steps towards the issuance of a first UK sovereign Islamic bond and announced some significant tax measures to promote the UK competitiveness in the increasingly attractive Islamic finance sector.

The potential for Ireland to tap the myriad of opportunities in the fast-expanding Islamic financial market is huge. Dublin has already earned a solid reputation as being a major centre for specialist securitisation and is recognised globally as an investment hub for hedge funds and asset-backed securities. The listing of NICBM Sukuk on the ISE has not only enhanced Ireland's profile in the global Islamic finance industry, but is a perfect illustration of the flexibility of the Irish capital market towards Shari'ah-compliant products. Ireland is without any doubt well positioned to emerge as a premier location and a prime hub for Islamic financial transactions in Europe and the occidental world.

September 2008.

For further information please contact Joe Gavin.