The Relationship between Sukuk and SPV - Assignment Example

Running Header: Sukuk Student’s Name: Instructor’s Name: Course Name & Code: Date of Submission: Contents Contents 2 What is SPV 3 The Relationship between Sukuk and SPV 5 Abd, Rahman, ‘Sukuk, SPV and borrowing backed by collateral’, Islamic Law of Finance, 6 < http://islamiclawoffinance.blogspot.com/2011_01_01_archive.html>, 2011, (accessed 2 July 2011). 6 Emergency of Special Purpose Vehicle 7 Use of SPV and Structures 9 Benefits of SPV 11 Motivations for the Use of SPV 12 Rahman, A. ‘Sukuk, SPV and borrowing backed by collateral’, Islamic Law of Finance, 15 < http://islamiclawoffinance.blogspot.com/2011_01_01_archive.html>, 2011, (accessed 2 July 2011). 15 What is SPV A special purpose (SPV) or SPE (special purpose entity) is a legal entity established by a firm (regarded as the originator or sponsor) by transferring assets to the special purpose vehicle, to execute some particular prescribed activity or purpose, or a number of such transactions. The major aim of SPV is merely to execute the transactions, for which they were developed, and they do not make substantive decisions; the rules guiding them are established in prior and keenly define their activities. In fact, there is no single person working at an SPV and it doesn’t have location that is physical. In short, SPVs are actually robot organizations that don’t have workers, establishing no economic decision, cannot go bankrupt, and it has no physical location. An SPV can either be a company or a Trust. It can also be either offshore or on shore. Special purpose corporates are utilized for many legitimate objects such as solutions to structured risk management. An SPE as a legal outfit, it is developed with orientation of sponsoring firm (that might be regarded as an administration, seller, originator, or sponsor)1. Basically, the sponsor takes the form of huge finance firm, bank, insurance company, or investment company. An SPV is an entity whose operations are actually restricted to financing and acquisition of particular liabilities or assets. In this respect, a differentiation should be made clear between liability securitizations and asset securitizations. Asset securitizations are mostly carried out by finance firms and banks, and basically include giving bonds that are supported by cash flows of assets generating income (ranging from residential mortgage loans to credit card receivables). Liability securitizations are mostly carried out by insurance firms, and actually includes offering of bonds that replaces the risk of a possible insurance liability (ranging from an unexpected claim level on a particular type of product to a catastrophic natural occurrence). In securitizations, SPV accommodates the risk of asset either via the purchase of the assets or in form that is synthetic. The assets are later utilized as collateral for notes given by the SPV. It is clear that SPVs do not hold ability or right to be involved in any activities other than those rights outlined in legal documents establishing and regulating the transactions of securitization and the SPV. The moment SPV is created, it should operate as an absolute independent entity2. Special purpose vehicles are strong structured financial tools. Both the investing community and the banking community have gained as SPVs facilities management of bank balance sheet and oversee the establishment of new classes of investment. Responses to recent financial scandals endangered to eliminate some of the beneficial and legitimate uses of SPV, due to fail to address the root cause of the problem. Due to their normally off-balance, private nature, and bankruptcy remote, special purpose vehicle can be utilized to for both illegitimate and legitimate objectives. There has been reaction to recent financial scandals resulted to proposal on changes on accounting for special purpose vehicles. Argument: The SPV is a vital entity in both Islamic financial systems and secular traditional financial systems. The Relationship between Sukuk and SPV Markets of debts are main part of the financial sector and efficiently supplement the funds offered by the banking quarters. In growing economies, these markets are still at initial stages of their development. Sharia (Islamic Law) restricts the paying and charging of interest3. Hence, in countries where population of Muslim makes a vital part of the society, tradition markets of debts cannot grow. This has resulted to high need and demand for establishment of alternatives to regular debt markets that can be accommodated to Law of Islam. This has resulted to high growth of a market of multi-billion dollar in sharia complaint sovereign and corporate Islamic established financial tools referred to as sukuk. In capital markets that are Islamic inclined, interest rate changes and other traditional forms of derivative tools like detachable options and credit derivates are not acceptable since they are prohibited in sharia4. In area of securities and bonds, the utilization of Islamic securities or Sukuk have become more popular, both as a means of firms to obtain fund via the offer of corporate sukuk, and a way of obtaining government finance via sovereign issues. The importance of Sukuk is to offer instruments that are shariah compliant for investment that do not entail interest and extreme uncertainty (Gharar). Sukuk are entitlement to rights in specific assets inclusive of certain degree of asset ownership. The sukuk are majorily based on Murabaha, Musharaka, Mudaraba, Salam, Ijarah, and Istisna mode of finance and on the foundation of pooled portfolios. The AAOIFI (the accounting and auditing organization for Islamic financial institutions) that offers standards on Sharia, ethical, governance, auditing, and accounting standards has established 14 different sukuk types. The sukuk structure depend on the creation of special purpose vehicle (SPV) where it responsibility is to give out certificates that represent for instance entitlement to debt, the asset ownership, accumulation of returns from different sukuk or entitlement to rental income. In sukuk issuance or securitization world, special purpose vehicle is actually developed on basis of the common law difference between equitable and legal ownership/right where the SPV (trustee) is seen to take legal ownership of the subject asset utilized in securitization or sukuk for the gain of beneficiary5. It is argued that obtaining beneficial interest in the subject asset is not enough to offer the actual holders of sukuk an absolute ownership right as outlined under the Sharia since every right is exercisable only via the SPV or trustee. The objective to have structure inclusive of structures including SPEs is to attain bankruptcy remoteness implying that whatever happens to the originator will not cause the asset in legal ownership of the SPE susceptible to any undertaking by possible action of recovery by other originator potential creditors. The SPV actually have a very limited staff and share capital where its only instrument is to enable the issuance or transfer of the sukuk or bond. SPV is not allowed to carry out any activity of real business or trading for the profit of the bond or sukuk6. Emergency of Special Purpose Vehicle SPV are legal entities that are developed to carry out specific undertaking and are utilized in structuring many products of capital market in the world. The emergency of SPVs is a vital component of the securitization. A process whereby securities are developed whose payments are backed up by cash flow obtained by a financial assets pool is referred to as securitization7. This procedure offers funding to the market, hence aiding to making sure that consumers can acquire credit they need. The effectiveness gotten from market via securitization is passed on to customers in lower interest rate credit forms. Securitization SPVs are legal entities like partnerships, trusts or corporations developed for a particular and limited objective or purpose. An SPV actually takes a role of depository for a given group of assets in a securitization, and in turn, issues securities to the marketplace for purchase by investors. The process of securitization would not happen without the capability to put in place SPEs. Investors do not desire to carry on any risk related to the seller. They are only willing to carry on a particular degree of risk related to the particular pool securitized assets in which they are investing. This means that the emergency of SPV is to shield investors from the adverse credit event or bankruptcy affecting the financial institution that sells and establishes assets to the SPE. The SPVs for securitization are viewed as bankruptcy remote because they are separated from the financial institutions that sold and or created assets to them, and are prevented from carrying out new financial obligations and activities. In other words, securitization is the issuance and creation of debt bonds or securities, whose payments of interest and principal derived from cash flows obtained by separate assets pools8. The process has emerged from a non-existent sector in 1970s to 6.6 $ trillion at the 2nd quarter of year 2003. This practice of securitization is carried out by businesses and financial institutions of all type in order to realize the amount of cash flow produced by assets. These are mostly financial assets like loans, but also can be leases or trade receivables. Mostly, the originator of asset expects a regular payment streams. The stream of payment can be utilized to back principle and interest payments on securities of debt by pooling the assets together. Mortgages that are securitized are referred MBS (mortgage-backed securities) while assets that are securitized are referred to as ABS (asset-backed securities). In dialect of securitization, SPV must be first created in order to initiate a securitization. Use of SPV and Structures Special purposes vehicles are used in structured finance and mostly categorized as either paythrough or passthrough structures9. The sukuk structures depend on the creation of special purpose vehicle which has a role of issuing certificates. Various SPVs are used in different types of Sukuk, hence it is used for sukuk categorization. The sukuk organization basically includes the structuring or packaging of pools of sharia compliant assets without or with credit enhancement into securities. The structure is founded on a particular contract of exchange that can be established via the purchase and sale of an asset based on leasing of particular assets, deferred payment or participation in a joint-venture business. The sukuk issuance needs an exchange of an underlying asset that is sharia complaint for financial consideration via the application of different sharia principles like Murabaha, Istisna, Salam and Ijara among others. Sukuk al-Ijara is one type of structure where Ijara (lease) is a contract according to what a party leases out or purchases equipment needed by the client for a rental charge10. The period of the rental and charge are agreed in advance and asset ownership is retained by the lesser. There are steps involved in this structure. Firstly, the obligator sells particular assets to the SPV at an agreed predetermined price of purchase. The SPV provide financing by issuing sukuk certificates in an amount similar to the price of purchase where this is then passed on to the seller (obligator). Then, a lease agreement is signed between the obligator and SPV for a fixed time frame, where the obligator leases back the assets as lessee. This is followed by SPV receiving periodic rentals from the obligator where there are distributed between sukuk holders (investors). On a dissolution event or at maturity, the SPV sells assets back to the seller at a price that is pre-determined. The value of price is supposed to be equal to nay amount still owed under the terms of the Ijara Sukuk. Another type of structure is Sukuk al-Salam where salam is the sale of particular goods, finely defined in its quantity and quality which will be passed to the person purchasing on a fixed date in the future against an advanced entire price payment on the spot. Sukuk-al-Salam are certificates of same value offered for the aim of mobilizing capital of salam in order goods to be delivered on the basis of salam come to the certificate holders ownership. SPV create and sells Salam-based securities under which the funds mobilized from investors are paid in advance the firm SPV in return for promise to offer a good at a future date. The difference between the sale and purchase price is the gain to the SPV and hence to the Sukuk holders11. Sukuk al-Murabaha is another type of structure where Murabaha means the sale of commodities at a comprising the purchasing price and a margin of profit accepted by both parties involved12. In this type of sukuk, the initial step is an ultimate agreement signed between the borrower and the SPV. Secondly, SPV gives sukuk to the investing individuals and receive proceeds of sukuk. Then, SPV buys good on the spot basis from the supplier of good. This is followed by SPV selling good to the borrower at the spot profit margin and price, paid on installments spread over an agreed duration. Finally, the borrower sells the good to the buyer of good on the spot basis and the investors get the final profits and sale price. Additionally, SPV is used in transaction structure of all other sukuk types like Istisna among others. Benefits of SPV One of the benefits associated with SPV is that it enables securitizations that would not be possible without it13. This is because investor do not want to carry on any risk related with the seller. They slightly willing to bear a certain level of risk related to the specific securitized assets pool in which they are investing. This implies that SPV safeguard the investors from the bankruptcy or other uncertainties affecting financial firms that develops and or sells commodities to the SPV. The SPV that are securitized are regarded as bankruptcy remote due to their nature of being isolated from the financial firms that sold or and created commodities to them and are blocked from carrying out a new financial obligations and new activities. Another major advantage of SPV is that it aids in freeing up the capital and separating the risk. The sponsoring company and SPV are shielded from risks like insolvency that might occur during the period of operation. Additionally, SPV enables securitization of assets without interfering with relationship of management. Any income that predictable and generated by secure assets can be securitized under the arrangement. From estimations, the global securitization market has raised to 544 billion us$ in 2003 from 1.2 us$ billion in 198514. Actually, firm can utilize prospect earnings to raise money. Motivations for the Use of SPV The securitization transactions and SPVs are seen as a way of lowering risks of the underlying pool of exposures held by the SPE and redirecting these risks to those entities most willing to handle them15. This is a motivating aspect for both investors and originators. Sponsoring or originating institutions can utilize SPVs for purposes of risk management, like transferring interest rate, credit, market, event, or insurance risks to other parties. Originators might utilize SPVs to obtain additional liquidity and resources, or to lower costs of funding. Medium companies might use SPV structures to pool exposures and hence gaining more and more cost-effective access to the market of capital16. Investors may be motivated to buy securities offered by SPV to acquire exposure to new class of assets or likely to avert internal limits and regulations, such as those associated with credit quality and name concentration. In the situation of synthetic transactions, investor might view it beneficial that they would not have to cater credit exposures at the outset. Regulatory capital also acts as a vital factor of motivation for entering into transactions with SPVs. Specifically, differences between various regulatory capital frameworks offer varying incentives to enter into certain transaction. These variations present themselves along 2 dimensions. One is the varying treatment of retained exposures in transactions that are securitized, and second one is variation in treatment for on-balance loans. Due to the insulation from bankruptcy, SPVs are able to get better ratings of credit compared to their sponsor institutions and hence can give securities at low interest compared to how sponsor would have to pay if it offered securities on its own. By utilizing SPVs, the sponsoring institution thus funds its operations at reduced rates compared to how it would on its own. References Brunnermeier, C. Dominance of the Islamic Financial System, 2008, pp. 2-19. Dar Al Istithmar, ‘An introduction to the underlying principles and structure’, Sukuk, 2006, pp. 1-35. Gorton, G & Souleles, N. ‘Special Purpose Vehicles and securitization’, The Risks of Financial Institutions, vol. 2, issue 6, 2007, pp. 549-604. Kabir H & Michael, M. Islamic and capital markets, Wiley Publishers, Canada, 2007. Khalid, H. ‘ The Future of Sukuk: Substance over Form? Understanding Islamic securitization, Asset-Backed and AAOIFI principles’, Moody’s Investors Service, 2009. Kothari, V. ‘What is securitization’, Journal of Banking and Finance, vol. 4, issue 2, 2007, pp. 241-274. Mahmoud, E. Islamic Finance: Law, Economics and Practice, Cambridge University Press, Cambridge, 2006. Miguel, W. Fixing Global Finance, Yale University Press; Expanded and updated ed edition, USA, 2010. Muhammad, H. ‘Structuring the Islamic finance industry’, International Journal of Islamic and Middle Eastern Finance and Management, vol. 3 issue 2, 2010, pp. 15-28. Muhammad,T & Usman, M. An introduction to Islamic finance, Brill publishers, 2002. Rahman, A. ‘Sukuk, SPV and borrowing backed by collateral’, Islamic Law of Finance, < http://islamiclawoffinance.blogspot.com/2011_01_01_archive.html>, 2011, (accessed 2 July 2011). Tavakoli, J. ‘Structured finance: uses (and abuses) of special purpose entities’, Journal of Tavakoli Structured Finance, vol. 2, issue 5, 2003, pp. 49-75. The Bond Market Association, Special Purpose Entities (SPEs) and the Securitization Markets, 2002, PP. 1-10. The Financial Express, What is a Special Purpose Vehicle?, , 2005, (accessed 2 July 2011). The Joint Forum, ‘Report on Special Purpose Entities’, Bank for International Settlements, vol. 3, issue 2, 2009, pp. 5-107. Read More