One of the key rules of Islamic law is the prohibition on charging interest (riba) on money that is lent. Traditional capital market instruments, such as bonds, commercial paper and medium-term notes all have a fundamental interest-and-principal component. This may appear to make Islamic capital market instruments a contradiction in terms but, thanks to the concept of the ijara sukuk, it is possible to overcome the problems associated with the prohibition on charging interest. The ijara sukuk has become more common as a result of recent discussions by shariah scholars on the compliance of other sukuk structures with the shariah. However, this approach does not suit all and there is still the need for other innovative structures to allow greater freedom for issuers and investors looking towards the market. Such innovative structures will have to meet the requirements of the shariah in order to have success in the market.

The ijara solution

Ijara (which is a word derived from rental in Arabic) is a structure that utilises an asset's rental stream to produce a return to the owner of the asset. A classic example would be if two parties, A and B, wished to enter into a financing of an asset. For example, A would like to buy a car but does not have the purchase price. A can approach B (who does have money) and ask B to purchase the car and lease it to A and eventually sell it to A. A and B can structure the arrangement between them so that periodic payments by A to B include both the lease component and the purchase price for the car, which will be fully paid up at the end of the term.

This arrangement works and operates like an amortising loan in many respects. However, Islamic scholars have become comfortable with the arrangement being a sale and lease of an asset as opposed to a loan under which principal and interest are payable. The traditional ijara structure was in use for some time before Islamic capital market instruments started to appear.

How can the ijara structure be used and adopted for an issue of instruments that have similar cash-flow qualities to standard capital market instruments? What if the party seeking the finance does not wish to own an asset but needs financing for other purposes?

Using ijara for fixed income instruments

It is perfectly possible to use a form of the ijara structure in a capital markets context. For example, a special purpose company can be incorporated to issue sukuks (a form of Islamic capital market instrument) to investors. The sukuks can be listed on a stock exchange. The company then uses the funds raised from investors to purchase land or tangible assets that it then leases to a third party. At the expiry of the term of the lease, the third party has agreed to purchase the land from the company at a price equal to the face value of the initial issue amount of the sukuks. Pursuant to a declaration of trust, the land or asset is held by the company in favour of the sukuk-holders. All returns made on the land are conveyed to the sukuk-holders (including lease payments and the final repurchase proceeds to be paid by the purchaser). The cash flow produced is similar to any bond cash flow. The lease payments (that are determined based on a spread over Libor) are like coupons and the repurchase proceeds paid at the end of the term are like the principal component of a bond. Islamic scholars are comfortable with the use of Libor as a lease pricing reference mechanism and not as a means of calculating interest. A floating lease price has been considered acceptable by Islamic scholars as landlords and tenants (in the traditional sense) can agree on raising or lowering lease payments on land over the period of a tenancy.

As trading in debt above or below par would obviously breach the Islamic finance principle of not charging interest and the ability to trade freely in capital market instruments is critical to investors, there is a potential further problem. However, since the ijara sukuks represent an interest in the underlying assets and not debts, they can be traded above or below par freely without breaching any Islamic principles. At the end of the term of the sukuk, the land or asset is purchased by a party under a purchase undertaking. The purchase price received by the company under the purchase undertaking is then distributed to the holders of the sukuk at the end of the term (economically similar to a payment of principal under a conventional bond). Such purchase undertakings are still considered acceptable by shariah scholars for ijara sukuk structures but are not necessarily acceptable for other types of sukuk structures (such as musharaka sukuk or mudaraba sukuk) due to recent discussions between scholars on the issue.

Structural disadvantages of sukuk al ijara

Islamic scholars have broadly accepted the ijara structure. Despite its simplicity and its broad acceptance, however, it suffers from some potential commercial disadvantages for the issuer, namely:

• not all potential issuers have access to the necessary underlying asset for such a transaction;
• the asset is tied up for the term of the transaction, the owner of the asset cannot divest it freely and there could be negative pledge implications in putting the asset into the transaction;
• even if a potential issuer does have access to an appropriate underlying asset, depending on the jurisdiction where the asset is located, stamp duty and taxation costs associated with introducing the asset into the structure could make such a transaction unviable; and
• there could be continuing shariah audits in connection with the asset: these can be time-consuming and costly for the issuer.

Moving forward

To overcome the limitations of the ijara sukuk structure, more innovative structures can be used. Pooling of investor funds on a mudaraba basis (an Islamic financing term referring to participation financing) in order for the funds to be invested in various shariah-compliant transactions that meet set criteria is an option. The return to the investors will be linked to the underlying shariah-compliant transactions and their performance.

However, this structure is not viable for many potential issuers that do not have the required shariah-compliant transaction portfolio for the funds to be invested in. Furthermore, because of the need for some genuine risk participation, the return cannot give investors the certainty of being fixed or floating.

On the other hand, while the return on such a structure is based on the performance of the issuer and the underlying transactions, making the return calculation very different to standard capital market instruments, these products can be structured to give a return that is very similar to an ordinary bond. However, as mentioned above, a purchase undertaking for such structures has recently been questioned from a shariah perspective (making structuring such transactions more challenging).

Alternative structures are being contemplated based upon other well-known Islamic financing methods and innovative proposals. The biggest challenge that these potential structures face is producing an instrument that can be traded freely in the secondary market without breaching the fundamental Islamic principle of not trading in debt above or below par and meeting shariah standards as now accepted. The ijara structure gets around this problem cleanly by producing instruments that represent an interest in an underlying asset that can be traded. To overcome this problem, some of the structures being contemplated are extremely complex and document-intensive. However, there seems to be a strong will to come up with a structure that will open the Islamic capital markets to issuers that cannot or do not necessarily want to provide assets to their borrowing structures. The structural challenges will no doubt be resolved in a way that will be acceptable to shariah scholars in the very near future.