Malaysia’s Importance to the Sukuk Market:

March 2007 Report

By Abdulkader Thomas

Introduction: In closing 2007, the sukuk markets closed the year as the opened with
another record setting issuance by a Dubai issuer – Nakheel’s $3.52 billion sukuk al ijara.
As a result of the strong finish, 2006 issuances were 2.36 times greater than the 2005 new
issuance volume. And, the gross market size doubled from $25.9 billion to $52.6. billion.
Assuming that the Arabian Gulf region is not subjected to any new conflicts, one may
expect that the sukuk market will enjoy another record year in 2007.

The Nakheel transaction is a tribute, albeit unintentionally to the role played by Malaysia
in pioneering the sukuk market. Albeit an adaptation of the ijara concept, Nakheel
harkens back to the landmark Guthrie and Malaysian sovereign issues of 2002, both of
which applied the basic ijara contract as the underlying Islamic means to achieve a profit.
The application of the forward lease is an innovation developed elsewhere, but made
possible in the sukuk space thanks to Malaysia’s progressive steps to define the broad
sukuk space, and grow it with new concepts. In this report, we will examine the
important regulatory and legislative philosophies and steps that have caused Malaysia to
achieve its importance in the definition of the Islamic capital market.

Prior to focusing on Malaysia, AJIF reports on the main trends in the market which are
largely unchanged from the prior quarter:

1. The awakening of more GCC underwriters and issuers to the sukuk opportunity,
and with this awakening, the fact that the GCC may now overtake Malaysia in
terms of issuance volume during the coming years.
2. Continuing market experimentation in the absence of both firm regulation in some
markets and the specific adoption of AAOIFI and IFSB standards by underwriters
and issuers.
Sukuk Markets as of December 31, 2006

2000 2001 2002 2003 2004 2005 2006

GCC Standard $ - $ 100.00 $ 200.00 $1,180.00 $ 1,893.08 $ 2,305.79 $14,787.41
Malaysian
Standard $ 336.30 $ 530.00 $ 719.40 $4,576.50 $ 5,054.30 $ 9,002.65 $11,910.51
Total $ 336.30 $ 630.00 $ 919.40 $5,756.50 $ 6,947.38 $11,308.44 $26,697.92
Aggregate $ 336.30 $ 966.30 $1,885.70 $7,642.20 $14,589.58 $25,898.02 $52,595.94

Aggregate GCC $ - $ 100.00 $ 300.00 $1,480.00 $ 3,373.08 $ 5,678.87 $20,466.28

Aggregate MS $ 336.30 $ 866.30 $1,585.70 $6,162.20 $11,216.50 $20,219.15 $32,129.66

disaggregated from Islamic Finance Information Service at www.securities.com

How Much and Where: In the end, the mega Nakheel deal put the GCC ahead of
Malaysian standard instruments instead of the two forms achieving parity. Please note

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that we indicate standards due to prevailing trends in the GCC in Malaysia and the
discomfort with some Malaysian instruments by many in the GCC. These points of
difference will be discussed below.

Malaysia will maintain a steady pace of production in 2007 because the engine is in place
and well oiled: rules, regulations, underwriters and market makers are defined, tested, and
capable of meeting new demand with ease. The UAE, less well oiled, is also promising a
strong 2007. But, following the establishment of new rules and clear regulation, Qatar
and Bahrain should provide strong competition to Dubai for new issuances. The
important markets that require specific regulatory adaptation for sukuk are Saudi Arabia
and Kuwait. As sukuk friendly regulation takes root in the GCC, it is sure to expand in
the other Arabian countries, just as Malaysia is influencing these countries as well as the
ASEAN region.

Sukuk Market Sizing through December 31, 2006

$60,000.00

$50,000.00

$40,000.00

$30,000.00

$20,000.00

$10,000.00
Total
$-
GCC Standard
2000 2001 2002
2003 2004 2005
2006

GCC Standard Malaysian Standard Total Aggregate

This data is dis-aggregated from Islamic Finance Information Service at www.securities.com and is based
on the author’s best efforts to clearly segregate concept origin. Future reports will show issuances from
2006 onwards. AJIF looks at the data in the above bar chart. The front row in bright green represents new
GCC issuances for the period; the light green second row represents the new Malaysian issuances; and the
third row, in dark green is the total GCC and Malaysian new issuances for the period. The back row in blue
is gross production of sukuk since the advent of the current sukuk market. The only element that the
available data does not facilitate tracking is the retirement or redemption of issues. There is also limited
public data on defaults or failures of sukuk issuances. Although no GCC issues are known to have failed,
some Malaysian issues are rumored to have defaulted or otherwise struggled.

Perhaps the single most significant fact that is not captured in current data sets is the
assertion that up to forty percent of the GCC issuances are sold to non-Islamic investors
in Europe; and a similar percent is sold from Malaysia to North Asian institutional
investors. In both cases, Islamic banks are not necessarily the main investors in any

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specific sukuk issuance. As we have noted in our prior reports, Basle II compliance
should drive a greater role for Islamic banks as buyers and issuers of sukuk.

2006 Sukuk Type

6.5% 11.8% 0.2% 18.29%

0.7% 0.3%

23% 24.95%

8.6% 0.8%
4.87%

Ijara Salam Musharaka E Ijara & Istisna'a

Mudaraba Mixed Assets Musyaraka D Istisna'a
BBA Murabaha Wakala

Experimentation with form: The fourth quarter of 2006 showed no end to

experimentation in the sukuk markets. But, the mega Nakheel ijara deal and the
continued application, directly and indirectly of the bai al dayn and BBA securities in
Malaysia have maintained the basic market balance as seen in the third quarter. below,
the elements on the left are predominately Malaysian Standard, and the elements on the
right are predominately GCC Standard.

Although there is an apparent decline in Malaysian style BBA or bai bi thamin al ajil
bonds from 6.5% at year end, up from 4.63% as of the quarter ending September 30,
2006. Musyaraka D bonds 23% were down from 28.17% of the third quarter figures.
Murabaha bonds 11.8% down from 15.6%. The proportion of debt sales based securities
has decreased by the end of the year, but this is a fact that is influenced by Nakheel.

At the end of the third quarter, ijara sukuk were only 7.5% of gross issuances: Thanks
mostly to Nakheel, ijara issuances were up to 18.29% for the 2007 issuances.

Musharaka E bonds, a collection of experimental forms being tested in the GCC, dropped
from 35.22% as of the end of 3Q06 to 24.95% of the total issuances in 2007. This
method will be subjected to more innovative concept testing, and should continue to form
an important part of the market. Curiously, there may be more attempts to solve the same
problems with mudaraba and wakala sukuk. Watch this space in 2007.

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Sukuk and the Malaysian Approach1: Since the start in the early 1980’s, Malaysia has
constructed a detailed plan to take Islamic banking from an idea to a full fledged parallel
system by 2020. The Islamic Banking Act of 1983 was based on an acknowledgement of
the aspirations of Muslims to have riba-free banking and investment services as well as
the government’s goal of establishing a modern financial system in every aspect to
Malaysia’s socio-economic goals for the 21st century economy. On a continuous basis,
the Malaysian government has been revising and adapting its Interest Free Banking
Scheme and securities programs to meet market and economic changes. The progressive
changes included three main primary pillars which were brought into place progressively
during the early 1990’s: Islamic Inter-Bank Money Market (“IIMM”), Mudaraba Inter-
Bank Investment (“MII”), and Islamic Inter-Bank Checque Clearing System (“IICCS”)2.
The most recent developments and the establishment of the Malaysian International
Islamic Financial Centre (“MIFC”).

MIFC changes to existing regulations and procedures were announced in August 2006
and these break down prior onshore/offshore distinctions; allows greater mobility of
capital. The reforms include Bank Negara allowing the operation of foreign currency
business through establishment of an international currency unit / business). In addition,
the Securities Commission and Bank Negara have introduced frameworks to allow the
issuance on non-Ringgit sukuk in Malaysia with an incentive exempting foreign investors
from withholding tax). The MIFC reforms must be seen in tandem with the endeavor of
Malaysia to build its Islamic finance educational infrastructure in the Bank Negara
funded International Center for Education in Islamic Finance (“INCEIF”) program.

In the Malaysian approach, the Malaysian scholars have applied the concept of bai al-
dayn or the sale of debts. The formal definition is:

“…the sale of debt as a type of contract in which the creditor sells his payable
right upon the debtor either to the debtor either to the debtor… or to a third party.
This sale [sic] contract between two parties may be either on the spot or forward
basis. It may also be either at a discount price or at the cost price.”3

Although controversial elsewhere, this approach has allowed the stepped transition to
Islamic principles from traditional banking. In the first step, the move is from a renting
of money or sale of credit, to the sale of a non-monetary asset as a means to create credit.
For inclusion in the Islamic debt scheme, the underlying debts must arise from a
permissible Islamic contract of sale, which could be murabaha or istisna’a. The sale of
debt allows the issuance of an Islamic promissory note affirming the payment obligation
under the original sale, and itself a negotiable or tradable instrument. As of this writing,

1
This section draws, partially, upon material previously published in Adam, Nathif and Abdulkader
Thomas, Islamic Bonds (London: Euromoney, 2004). The content is significantly changed and updated,
reflecting the latest developments in the market.
2
In addition to Bank Negara Malaysia materials which are available, a helpful summary of the Malaysian
Islamic markets scheme may be found at www.islamic-world.net/islamic-
state/malay_islamoneymakret.htm.
3
Moustapha, Dr. Sano Koutoub, The Sale of Debt: As Implemented by Islamic Financial Institutions in
Malaysia accessed on December 9, 2003 at www.drsan.net/papers/malaysia.htm.

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 the three tangible asset contracts of BBA (medium and long term sales debts), Murabaha
Note Issuance Facilities (short term sales contracts structure for working capital), Bai Al
Inah (sale and buy back between the same parties) and Bai al Dayn constitute 80% of
Malaysian Islamic debt market according to Aseambankers.4

When one considers the Malaysian space, it is worth comparing the trading profiles of
Malaysian instruments to the AAOIFI Investment Sukuk Standard:

Type AAOIFI Feature Tradable?

5
Murabaha Sakk represents assets purchased and Such sukuk are only tradable under Malaysian
intended for sale. Once the sale is made, the rules.
sakk represents a debt. In Malaysia, this is a
short term debt security.
Ijara Sakk must lay title claim to asset. The claim Such sukuk are universally tradable.
may be direct or beneficial.
Musharaka Sakk must lay title claim to asset, but this Depending upon the underlying asset, these sukuk
may include participation in business are tradable. In Malaysia, the underlying asset
ownership or operations. Frequently an may be a permissible debt form like a murabaha
“undertaking” is added to make a musharaka receivable.
operation more debt like.
Mudaraba Sakk must lay title claim to asset, but this Depending upon the underlying asset, these sukuk
may include participation in business are tradable. In Malaysia, the underlying asset
ownership or operations. Frequently an may be a permissible debt form like a murabaha
“undertaking” is added to make a musharaka receivable.
operation more debt like.
Declining Balance Sakk must lay title claim to asset, but this Depending upon the underlying asset, these sukuk
Partnership may include participation in business are tradable. In Malaysia, the underlying asset
ownership or operations. In this musharaka may be a permissible debt form like a murabaha
operation one partner promises to buy out receivable.
the other.
Wakala In this operation, the sukuk holders appoint Depending upon the underlying asset, these sukuk
the beneficiary of funds as their agent to are tradable. In Malaysia, the underlying asset
perform certain business operations. may be a permissible debt form like a murabaha
receivable.
Istisna’a Sakk must lay title claim to asset. This operation is a hybrid between an asset (not
yet completed) and a debt (the obligation to deliver
the completed asset). Therefore, the accepted view
is that trading is restricted. In Malaysia, these
sukuk are freely tradable.
Bai Bithamin Al Sakk represents assets purchased and Such sukuk are only tradable under Malaysian
Ajil intended for sale. Once the sale is made, the rules.
sakk represents a debt. In Malaysia, this is a
long term debt security.
Salam Sakk represents a claim on an asset. This operation is a hybrid between an asset (not
yet existing) and a debt (the obligation to deliver
the asset). Therefore, the accepted view is that
trading is not permitted.

4
Aseambankers, Malaysia – The Center of Islamic Product Innovation and Global Recognition in Malaysia
– the International Islamic Financial Centre, Report 2006, Kuala Lumpur, Malaysia.
5
Both Murabaha and Bai Bithamin Al Ajil operations in Malaysia may result from bai al ‘inah (a sale of the same
object between two parties and its repurchase at a different price by one of them), an both may result in a debt “dayn”
that is traded under rules called bai al dayn rules.

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Further milestones in 2006 include new products like regulated short selling with no
gharar, redeemable preference shares on basis of musharaka mutanaqisa, and restrictive
futures for stocks and palm oil. Perhaps each may prove controversial or subject to
further debate among scholars and market participants outside of Malaysia. Yet, each
demonstrates the capacity of Malaysian scholars and regulators to probe the frontiers of
product development in order to solve the commercial challenges of their public with an
answer framed by Sharia’a.

The importance of government intervention: tax incentives, required ratings and how
these policies help issuers and underwriters to enter the market, improve client and
underwriter confidence. One of the important sets of tax incentives in Malaysia is
comprised of stamp duty waivers for Islamic securities, bonds and financings. These
waivers put the Islamic “debt” sector on an equal footing with the traditional debt sector,
and may even create a marginal advantage.

An additional regulation in Malaysia that is supportive of the growth and integrity of the
market is that all new securities are issued with a rating from an approved rating agency.
The independence of the rating agencies are meant to promote public confidence and to
assist in defining the suitability of a security for investors. Even if rating agencies are not
perfect, there is no doubt that they shift the public’s reliance from assertions made by the
underwriter to more provable, independent assessments. This appears to be playing out
in Malaysia and helping to create a level playing field for issuers, investors and
underwriters.

Let’s summarize the Malaysian market space. A broad based coordination of

government policies has resulted in a comprehensive public policy that supports growth
and innovation in the Islamic financial market serving the Malaysian and international
public. Within the investment and securities markets, there is a clear and separate
universe of Securities Commission guidelines for Islamic instruments. These are
supported and governed by the Securities Commission Shariah Advisory Council which
was established in 1996. This Shariah Advisory Council works in parallel with the
central bank’s, Bank Negara Malaysia, Shariah Council.

The formalized outcome is the routinely updated series of master plan. For instance,
since 2001, the country has a Capital Market Master Plan that has allowed expansion to
Islamic asset backed securities and Islamic REITs (2005). The updated master plan has
allowed a transformation of Islamic securities issuances. Prior to 2004, Islamic securities
were issued under the rules relating to debentures (making BBA or long term Islamic
debt certificates an easy fit). In July 2004, SC issued Islamic Securities Guidelines,
which have created more opportunities for product innovation across Islamic contract and
concept types.

There is nothing new in these recent developments. They are consistent with the pattern
of benign market intervention that build on the Islamic Banking Act with the Takaful Act
of 1984; the periodic amendments to the laws governing banking and financial

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institutions, such as the opening of Islamic windows in 1993 with amendments to the
Banking and Financial Institutions of 1989; the formal regulation of appointed Sharia’a
advisors; and the coordination of GAAP for Sharia’a instruments with Malaysian
Accounting Standards Board.

So where has this dynamic regulatory environment gotten Malaysian Islamic Capital
Markets? Since 2005 the majority of new Malaysian bond issues are Islamic. The size of
the domestic sukuk outstanding is MYR 105.2 billion (approximately US$30 billion).
This is 47.75% of total outstanding bond issues. New sukuk approved by SC were
71.41% of the bond market in 2005 and 55.41% in 2006. In other areas of the capital
market, the 2006 Sharia’a compliant unit trust universe represented about 7.5% of unit
trust industry and 86% of listed equities are deemed Sharia’a compliant (up from 2005)
representing 64.26% of market capitalization.6

This capital markets element integrates well into the basic banking market. For instance,
CAGAMAS secondary market for Islamic mortgages was established in March 1994.
Although it has relied on the BBA and bai al dayn forms with recourse to originators, the
process has allowed Malaysian banks to securitize Islamic mortgages. The universe of
underlying Islamic mortgage assets were 21.6% of Islamic banking credit extended in the
first half of 2006, and 12.3% of total mortgage lending as of 6/2006. The issuance of
Islamic mortgage backed securities by CAGAMAS supports the Bank Negara goal of
building total Islamic banking assets to 20% of total banking assets by 2010.

And, the benignly dynamic market intervention is not expected to end. In 2007, new tax
incentives have expected in order to attract Sharia’a compliant managers to base
themselves in Malaysia. Currency liberalization has been introduced to allow LOFSA
based offshore operations to participate in on shore transactions. And, now international
ratings agencies will be allowed to opine on the creditworthiness of domestic Malaysian
transactions.7 The 2007 next steps build on the already robust achievements of the past.

A final feature of the Malaysian approach should be understood as the increasingly

holistic view taken by Malaysian regulators and legislators with respect to the Islamic
finance industry. Not only have they accommodated inbound investment along with the
relevant structures from the GCC, but the Malaysian regulatory framework plays well
with others. An important element of this is witnessed in various bilateral agreements
between Malaysia and their international peers including the Central Bank of Bahrain, the
Dubai International Financial Centre, as well as pan Islamic bodies including the IFSB,
AAOIFI and the Islamic Development Bank.

Conclusions: The sukuk markets finished 2006 strongly, to some degree mimicking the
traditional bond market with its pressure to close deals before the end of the year. Hence,
the landmark Nakheel deal closing in December 2006. Impressive growth should be

6
Quarterly Bulletin of the Malaysian Islamic Capital Market by the Securities Commission, March 2007,
vol. 2, No. 1
7
Quarterly Bulletin of the Malaysian Islamic Capital Market by the Securities Commission, November
2006, Vol. 1, No. 3.

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expected as both the GCC becomes more active, and as Islamic banks become even more
important investors in sukuk.

With gross issuances of US$52.6 billion through 2006 of which $20.4 billion complied
with GCC standards and $32.1 billion met Malaysian standards, the volume of sukuk
issuances is approximately equal to 10% of the gross assets of the Islamic banks. But,
non-Islamic investors in Asia and Europe may represent up to 40% of the buyers
according to diverse sources in the market. If true, then Islamic banks, already seeking to
replace their short term metals murabaha placements with sukuk and truly negotiable
instruments will become even more active buyers of sukuk. This will further sustain the
market at current levels, if not higher.

Up until now, Malaysian regulators and ministries have developed a robust Islamic
financial regulation framework that is meant to serve the broad public interest. These
along with a centralized Sharia’a governance and research function have allowed the
Malaysian Islamic securities market to be a leader. Now, new liberalizations in Malaysia
are meant to create new opportunities, and enhance the leadership role already enjoyed by
Malaysia. As noted by Nik Ramlah Mahmood of the Securities Commission at
Euromoney’s 2nd Annual Asian Islamic Banking and Finance Summit, the focus of the
Malaysian regulators is now to shift from policy driven initiatives to market driven
initiatives. The regulators’ job is to fine tune the framework, and the global industry is
now to drive the process of market evolution. The evidence, based on prior success,
indicates that Malaysia will continue its leadership role, informing the global sukuk
markets as to innovation and opportunities.

In our next report we will examine the challenge of musharaka and declining balance
partnership sukuk, equity or not?

Appendix: Web Resources for the Malaysian Market

Bank Negara Malaysia (Malaysian Central Bank) at http://www.bnm.gov.my

Islamic Financial Services Board at http://www.ifsb.org/

Association of Islamic Banks in Malaysia at http://www.aibim.com.my

Securities Commission http://www.seccom.com.my/

Labuan Offshore Financial Services Authority http://www.lofsa.gov.my

Bursa Malaysia http://www.bursamalaysia.com

Malaysian Accounting Standards Board www.masb.org.my

International Centre for Education in Islamic Finance www.inceif.org

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