A Note on Sukuk and their role in Islamic Finance

        [LSE/HIFP Seminar,7 February 2008]




This note argues that distancing sukuk from debt is necessary to make them free of riba and elements of maysir (gambling). This can be done by making sukuk based on real assets to the exclusion of murabaha receivables. It also requires doing away with the commitment to redeeming sukuk at their original price on expiry of their term. These steps may save Islamic finance from contributing to the trend towards inequity and instability germane to conventional debt based financial system.  Oil rich Muslim countries issuing sukuk should especially avoid financial products likely to further worsen the distribution of income and add to popular discontent.


Nature and Role of Sukuk


The introduction of sukuk in Islamic finance has been a great help. Many a project in private and public sectors have been facilitated by recourse to sukuk. Sukuk have great potential for promoting risk sharing thereby increasing savings mobilization and investment, spurring growth leading to enhanced welfare. The purpose of this note is to explore possible ways of keeping sukuk away from being debt instruments based on risk shifting that increase inequality and cause instability, thereby decreasing welfare.  We start from the position that trade in debt instruments (obviously at prices different from their face values) is riba. There is a sizable literature on riba being unfair, leading to inequity, instability and inefficiency, so we need not repeat all those arguments[1]. Distancing sukuk from debts is required in order to make Islamic finance serve its purposes in enhancing prosperity with justice and equity.


What makes some of the sukuk debt instruments is inclusion of murabaha receivables into the package of assets against which sukuk are issued and the commitment to redeem them at their face value at some future date, regular periodical returns being paid in between. There is no difference, in effect, between this and a sum of money lent for an interval being serviced by periodical payment covering the interval.


What happens if murabaha receivables are treated as not saleable (except at their face value)? Most probably it will have a negative effect on the practice of murabaha, as well as cause a decrease in the total demand for sukuk. What happens if there is no commitment to buy back a leased asset (against which sukuk were issued) at their original price? Most probably there will be a decrease in the demand for sukuk as people not willing to take any risk regarding the sale value of the asset shy away. Since Islamic finance does not offer the opportunity of lending at interest many prefer non-Islamic finance. So purging Islamic finance from incipient debt-structures only restores the original position: Those who have no problem with interest bearing transactions may not stick to Islamic finance. Whether this will cause some loss of market share in countries like Bahrain and Malaysia is difficult to predict  off hand. Much will depend on innovation and on what other alternatives are made available. It will also matter if the rationale of these reforms is fully explained to the market participants, to the people in general and to the policy makers.


It is argued that it is not wise to deprive people of an option they prefer. Investors’ sovereignty seems to be a natural corollary of consumers’ sovereignty. But it is not a rational argument, as individual choices that are aggregated to arrive at the relevant totals may not always serve the social weal. The society has a right, rather a duty to protect itself (and all its members) from possible bad choices of some of its members. This is empirically established in case of drug use and investment in drugs trade. Islamic economists have argued that riba leads to a bad distribution of income and wealth. Riba also leads to instability[2]. Using riba to mobilize resources does not increase welfare.


As it stands now people have an option to quit the Islamic financial market and go to the conventional financial market, consequent upon blocking the debt based sukuk structures. It has yet to be established empirically that they will in fact abandon sukuk in favor of conventional bonds after the above-mentioned reforms. Insofar as it is Islamic legitimacy that influences their choices, people may still prefer clean sukuk to debts. They may do so due to a conviction that that debt proliferation is bad for the economy.


Debt Proliferation and Welfare


It is argued that debt proliferation is no cause of concern as long as debt servicing can be sustained. The argument could carry some weight if debt was always to be serviced out of the new wealth created by the productive use of the resources mobilized through debt. But there can be no such guaranty as the returns payable are in no way dependent upon or linked to the productivity of the funds mobilized through debt or debt based sukuk. Should debt be serviced out of existing wealth of the society but fail to generate an equal amount of wealth through its productive use, it would amount to a redistribution of social wealth in favor of suppliers of loans. There is no economic or moral justification for such redistribution. It is immoral as well as inefficient to assure increased wealth to fund owners who refuse to expose their funds to any of the risks that invariably attend upon wealth creation. On the other hand, by insisting on all sukuk issues being clean, free of riba, Muslim countries would be taking a step towards a more just and humane financial arrangement than prevails in much of the world. Many individual fund owners, Muslim as well as non-Muslim, prefer earning additional wealth the clean way. The claim that purging sukuk from elements of riba would make the sukuk market shrink cannot be accepted without proper empirical evidence. The Islamic finance industry owes it to itself to educate people into the bad effects of debt financing and the expected good effects of riba-free Islamic financing. As of now the industry has failed to do so. Instead of devoting any resources to R&D it invested in “conventionalizing” the industry thereby undermining the very reason for its existence.


Rich Muslim countries should better opt for clean, riba-free sukuk as this will prevent an already inequitable distribution from worsening further. Their undemocratic political systems are more vulnerable to popular discontent than their western counterparts. A further descent into inequity and a financial system prone to instability could be fatal.


It may be argued that distancing sukuk from debts will render them akin to stocks and shares. Why should a company desirous of funds not issue new shares instead of launching sukuk, it is asked. The answer is: sukuk can be project specific which is a  great advantage. The proclivity to mimic debt instruments prevalent in conventional finance has in fact hindered the process of innovation in structuring sukuk that are free of riba yet cater to different classes of investors, classification being based on their attitudes towards risk. The prohibition of money now for more money later is accompanied, in Islamic finance, by the permission of leasing out real estate or capital goods at fixed rents and rentals, or of charging a higher price when selling on credit. Any legitimate economic purpose that a money loan on interest serves (like reducing monitoring and transaction costs in certain circumstances) can often be served by these two permissions taken together.


Interest bearing debts and its burgeoning trade, takes the economy onto the path of instability by creating an inverted pyramid of debt securities. The market for debt is vulnerable to gambling like speculation because of the slender base of real assets on which it stands.  On the other hand ijarah and murabaha are activities belonging to the real economy. Trade in papers based on them would not have the ill effects of conventional finance as long as they do not involve trading debts. Just as trading in real goods and services differ widely as regards the risk attached to them, so would the sukuk based on them differ in their risk profile. But there is an objective basis underlying the market for sukuk based on ijarah and murabaha (provided their exchange takes place within the well known Shariah constraints, i.e. no discounting of debts and no redemption at par values).



Ijarah sukuk with pre-announced periodical incomes are the nearest to conventional bonds that Islamic finance can offer. Even these would carry some risk as redemption would be possible only at market price. A commitment to redeem them at their original price amounts to selling a debt, whereas the whole rationale of sukuk is to avoid doing that. Market value of Ijarah sukuk at the time of redemption may be higher than, equal to or lower than their original price. In other words, Ijarah sukuk are vulnerable to capital gains or losses. This is the same risk that attends upon the purchase and sale of the real assets on which Ijarah sukuk are based. These sukuk have the advantage of being available in small denominations. Fund owners who cannot afford to buy the underlying assets can buy parts of them by buying sukuk. They are saved the trouble of managing real assets as these are taken care of by the financial intermediaries issuing sukuk. Sukuk can be marketed globally while the property on which they are based sits in a particular country, given the public institutions that enforce contracts and protect property rights.


Risk Shifting Versus Risk Sharing


Prohibition of riba implies that fund owners who do not want to take any risk at all, neither risk of capital gain or loss nor the risk attaching to periodic returns, cannot enter the investment market. Their money cannot earn them more money. No economist has claimed that this will cause havoc to the economy of man. On the contrary paying a price for “liquidity preference”, without any reference to the marginal efficiency of capital, is rightly seen as problematic.


The world has more wealth today than anytime before. Much of this wealth is in the hands of people who have lots to spare. Add to this the financial institutions entrusted with money by the rich, the not so rich and even by the masses, in order to earn more money for them. Much of the prosperity the world enjoys today depends on the productive employment of this liquidity. Sukuk are very convenient vehicles of transferring some of this liquidity to people capable of employing it into productive projects. A diverse spectrum of investment vehicles serves persons with different perceptions of risks and returns. Debt-based financing, some of the sukuk included, shifts the risks involved in wealth creation on to the user of funds. Inside the same country this method of financing tends to make the rich richer and the poor poorer, relatively speaking. At the international level, debt financing has been ruinous for many developing countries in Asia and Africa. The Islamic way of risk sharing, on which genuinely Islamic sukuk should be based, would make the additional wealth created with the use of the existing wealth to be shared between fund users and fund owners while both bear the risks involved and the resulting loss. 

With increasing wealth must go equitable distribution of additional wealth so that the society retains its balance and people live in peace and harmony. Widespread poverty, great disparities in standards of living, conspicuous consumption and great display of affluence ……cause envy, resentment and a tendency towards violence, especially when there are few opportunities for the have-nots to improve their lot and when there is no effective supply of public services like education, health care and transportation. As of now, most countries of the world evidence these characteristics. It is yet to be recognized universally that this phenomenon owes itself, largely, to a policy of risk shifting rather than risk sharing. A movement to make sukuk instruments for risk sharing rather than risk shifting is long overdue.


In case additional wealth creation is accompanied by more unequal distribution, a greater proportion of additional wealth going to the rich, and when the share of the poor goes on decreasing in the relative sense, people get frustrated, lose hope and succumb to despair providing a breeding ground for violent ideologies. Unfortunately this has been going on in recent decades, mostly as a result of debt financing which transfers a given percentage of wealth to fund owners irrespective of the fund’s actual contribution to wealth creation. The institution of interest---paying for money capital irrespective of its contribution to wealth creation----has been one of the factors responsible for a fall in the relative share of wages in national income in most countries, especially the United States of America. In much of the un-developed world large sections of population must go without any income because of “unemployment”. But thanks to the institution of interest, money capital never goes without income!


Even though absolute poverty may have somewhat decreased, the increasing gap between the rich and the poor has been causing frustration and anger. This is as true of citizens of any single nation as of the community of nations as a whole. Rejection of riba, i.e. refusal of entitlement to an increase in wealth for those who would insist on a guaranty that their existing wealth does not share the risks attending additional wealth creation, will go part of the way in rectifying the situation.


As a necessary step towards a just and equitable society, discounting of debt should also be disallowed. To prevent a thriving market for debt it is necessary to prohibit exchange of debt with cash at a discount in line with the well known Shariah prohibition of exchanging unequal quantities of the same money or unequal quantities of debts. Shifting the risk of default is a transaction accompanied by excessive uncertainty (gharar). Transactions focused on risk shifting imply gambling like speculation as they rely on difference in tastes for risk and nothing more. On the other hand risk sharing arrangements are essentially cooperative ways to meet life’s contingencies. Risk sharing is a way of facing risk. The reward of facing the risk involved is uncertain. The burden, in case of loss may be too much. So two or more parties come together. The terms of sharing the rewards are freely agreed upon. Differences in the participants’ perception of the risks involved will be decisive in the resulting bargain. Even though the motivation may be making a profit, it is very different from a game of chance. There are real gains to be reaped, real wealth to be created in case of successfully meeting the risks involved. The bargain focuses on sharing these gains. The bargain does not create the risks involved, as these risks have an objective existence independent of the participants in the bargain. This nature of risk sharing remains intact despite unbundling different kinds of risks                 and repackaging them to suit different types of customers. It is an entirely different story with risk shifting. Neither the seller nor the buyer of a risk may have any stake in the wealth creation that may or may not depend on facing that risk. The only thing necessary for a deal to be possible is that the parties to the bargain view the outcome differently. The reward/loss of either party to the bargain does not depend on what happens in the production sector, whether additional wealth is created or not. It depends on whose guess comes true. If it is a deal between two parties, only one of them stands to gain, not both. It is different in case of risk sharing in which each one of the two parties to a deal stands to gain or lose, i.e either both lose or both gain. Facing risk is a means of wealth creation. It deserves a reward when wealth creation actually does take place. But why should anyone get a compensation for shifting risks? Like all gambling, risk shifting is a zero sum game. It does not add to social wealth. The society is better off without it.


Gambling in the debt market (i.e., buying and selling risk) does not create additional wealth, yet the gamblers are seen to become wealthier! The secret lies in the way money is created and managed in a debt based economy like ours. The system is so designed that the supply of money expands in response to the demand for debt. But a very large part of the additional paper wealth goes to the players in the financial markets, giving them an undeserved handle over the real markets. This further reinforces the perversion in conventional finance: Instead of the financial sector serving the real sector, the real sector gets subservient to the whims of the financial elite.


I do not dispute the empirical fact that sale and purchase of debts at discount (sometimes very big discounts) has greatly contributed to the expansion of the debt market. Also true is the claim that an expansion of the debt market enables more developmental projects to be undertaken. But has it contributed to welfare? It has certainly not contributed to equity. Furthermore, the phenomenon of junk bonds has increased the vulnerability of the financial markets to speculation and further weakened the nexus between the real and financial markets.


The lender has a right to write off whole or part of the debt. He can accept a less than full payment from the debtor. In other words a debt instrument can be “exchanged ” for less than equal amount in cash from the debtor. To argue from this in favor of allowing discounting of debts is not correct as discounting in the debt market does not alter the debtors’ obligation to pay the full amount when the time comes. As a matter of fact those who buy debts at a discount do so in order to make a profit by getting par value when the debt matures.


Towards a Humane Economy


There is a basic dissonance between the tendency to mimic conventional financial practices and products and promoting Islamic finance. The former tendency assumes that conventional financial products and practices respond to genuine social needs. It ignores their ill effects in terms of injustice, inequity and instability. But the entire rationale of Islamic finance is quest of prosperity with justice and equity. Insofar as a debt market obstructs equitable distribution of wealth and income, it must be constrained. Distancing sukuk from debts should be considered in this context.


As hinted above, distancing sukuk from debt is also necessary for strengthening the link between the real and financial markets. It is better for the economy to keep the financial sector follow the real sector rather than the other way around. Finance is a facilitator for production, exchange and consumption of real goods and services that are our natural objects of desire. When financial growth itself becomes an object of desire, and production and exchange of real goods and services becomes a means to that end, a great perversion takes place. Even though this kind of attitude towards finance is not universal, being confined to a section of the population who has the means to play the money game, the ruinous effects spread throughout the society affecting everybody. This tendency cannot be rooted out unless financial papers are restored to their natural status: representatives of real assets. Only then will the demand and supply of real goods and services, reflecting people’s tastes and capabilities, decide allocation of resources and, consequently, distribution of income. As it stands now, under the aegis of debt-based, speculative finance, allocation of resources and distribution of income are vulnerable to manipulation of oligopolies and financial power centers. Financial papers often serve like gambling chips, once their link with the real economy is loosened.


A financial product’s claim of being Shariah compliant cannot be accepted unless it is shown to be in consonance with the objectives of Shariah, the maqasid. In the presence of evidence that debt financing vitiates the higher purposes of Shariah , equitable distribution and relative stability, debt-like sukuk cannot be regarded to be Shariah compliant. It is naïve to assume that replicating conventional financial products demonstrates the viability of Shariah in modern age. The distinctive feature of Shariah is its welfare-enhancing role. Mimicking un-transparently collateralized debt instruments without any regard for their tendency to reduce welfare is no service to Shariah.




Sukuk are there to stay. That they are recognized as genuine Islamic financial products and do not languish into the gray area of conventional clones requires further restructuring that would distance them from being debts. People have to be convinced of the long run advantages of risk sharing at the society level so that they resist the temptation to reap transient benefits of risk shifting at the personal level. The assurance sought through guaranteed redemption at original price can be partly supplied by strengthening public institutions that monitor financial transactions and enforce contracts and by raising the level of trust in the society.

[1] For a summary of literature and detailed references, see this author’s Riba Bank Interest and the Rationale of its Prohibition (2004) Jeddah, Islamic Research and Training Institute, Chapter 4.Also,Abbas Mirakhor (2007)  ‘Islamic Finance and Globalization : A Convergence? ’ London. Euro-money Conference, June.

[2] For an empirical Study and references to earlier empirical studies, see Hassan, M Kabir and M Imtiaz Ahmed Mazumdar (2002) Islamic Finance and Economic Stability: An Econometric Analysis ’.Proceedings of the Fourth Harvard University Forum on Islamic Finance,Cambridge,Mass., Harvard University,pp13-25. For theoretical arguments, Mohsin S Khan(1995) ‘ Islamic Interest Free Banking: A Theoretical Analysis,’ Encyclopedia of Islamic Banking and Insurance, London, Institute of Islamic Banking and Insurance,pp.50-66.