DLT and capital-raising in Islamic Finance

Introduction

Over the past few years, the implementation of new technologies has deeply transformed the financial sector. One of these technologies, arguably the most disruptive, is the Distributive Ledger Technology (‘DLT’), whose paradigm is blockchain. In brief, these are encrypted databases in which peer-to-peer transactions are recorded in a ledger ‘shared’ among all participants, called ‘nodes’ (Nakamoto 2008). Such nodes are, essentially, computers that run the software of a specific blockchain. New transactions are entered into by participants that hold an address, a public key and a private key, and validated by some of the nodes -called ‘miners' - through a consensus protocol. Once this occurs, the ledger is updated in all nodes accordingly. Thus, the database is distributed: the whole chain is kept in all nodes simultaneously, with no centralized register in which to store the information (European Securities and Markets Authority (‘ESMA’) 2017; European Union Agency for Network and Information Security (‘ENISA’) 2016; Oudin 2017; Wright & De Filippi 2015).

DLT has many applications in finance. This contribution analyzes its use in capital-raising through the issuance of S/zunn-compliant financial instruments registered in the blockchain, i.e. so-called cryptosecurities; specifically, I refer to their legal framework in Europe, although some conclusions may be extrapolated to other jurisdictions. This application of DLT has a number of benefits, which may prove to be particularly relevant in the context of Islamic Finance.

On the one hand, it reduces costs and facilitates regulatory compliance and risk management (ENISA 2016). In particular, DLT removes intermediary risk, i.e. the risk of default or insolvency of the intermediary, and custody-chain risk, given that it is an entirely disintermediated system (yet, intermediation may still exist outside the platform, e.g. exchanges). Additionally, for the reasons discussed below, the blockchain provides an environment beneficial for start-ups’ capitalraising, which may tap investors directly.

On the other hand, it enhances the access to investment by the public, especially for investors interested in early stage businesses (ESMA 2019). This is particularly interesting for Islamic communities which have been traditionally unbanked and with limited access to investment opportunities in many jurisdictions. In addition, where such instruments are negotiated in a secondary market, liquidity is higher and enhances the possibilities to build a diversified portfolio.

In this contribution, I take as a point of departure the current means in Sharia-compliant capital-raising in the capital markets, particularly by referring to sukuks. I briefly address sukuk’s features from the Sharia perspective and the applicable legal framework when sukuk issuances take place in Europe. In particular, the regulatory requirements for public offerings and admission to trading (prospectus rules) and securities registration requirements in order to access regulated markets (book-entry form).

Subsequently I discuss the possibility to apply DLT to register sukuks and explore its limitations from a legal standpoint and its advantages. In addition, I refer to the issuance of new SAc/m-compliant instruments by way of initial coin offerings (‘ICOs’). In particular, I analyze these new instiuments from a legal perspective to determine to what degree the same regulatory framework applies. Finally, I argue that the mainstream application of DLT depends on the reduction of current legal uncertainties, relating, for instance, to categorizing the extremely heterogeneous types of tokens issued. Ultimately, the goal is to avoid that such issuances remain unregulated, while ensuring that issuers may anticipate their obligations and liability arising from their breach.

Traditional capital-raising activity in financial markets

Sharia law perspective

Traditionally, 5/mrm-compliant capital-raising activity in the capital markets has taken place by way of the so-called sukuk, which have been defined as ‘certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and seivices or (in the ownership of) the assets of particular projects or special investment activities’ (Accounting and Auditing Organization for Islamic Financial Institutions -‘AAOIFT, standard n 17). As with any Sftarm-compliant product, there is a number of restrictions applicable to sukuk, including the prohibition of riba, gharar, gambling and certain assets and activities. In addition, the most specific feature of sukuk from the Sharia perspective is the fact that the sukuk holders have a share in the ownership of the underlying assets, i.e. the certificates represent property over certain assets, and the investors’ (sukuk holders’) reward are the profits generated by such assets. This shows the spirit of income being linked to risk-taking in Islamic Finance; there is no fixed remuneration but rather it is dependent on the capability of the assets to generate cash flows (profit and loss sharing value).

There are different ways to categorize sukuks. One classification distinguishes between sukuks ‘asset based’, in which the originator retains the relevant assets in its balance sheet and only transfers the beneficial ownership to the special purpose vehicle (‘SPV’) (the sukuk issuer), and ‘asset backed’, in which, conversely, the originator passes the legal title to the SPV. The latter can be understood as an Islamic asset securitization.

Although the former structure has traditionally been dominant in the market, scholars discuss whether it is S//o/7h-compliant or not (Al-Ali 2019). Of course, each sukuk issuance has a fatwa (legal pronouncement) by at least one Sharia board, certifying that such sukuk complies with Sharia law, but scholars take approaches that may vary largely. In 2008, the AAOIFI declared that asset-based sukuks are not SAarm-compliant (Abdullah 2018).

Other classifications are based on the structure underlying the issuance, e.g. mudaraba, musharaka or wakala. Currently, the most common structures are sukuk al-ijara, sukuk al-murabaha and sukuk al-mudaraba-wakala (Latham & Watkins 2017). There is a relatively large number of examples of sukuk issuances in European capital markets, among which the recent FAB Sukuk Company Limited $500,000,000 issuance on January 2020, structured as a wakala sukuk (First Abu Dhabi Bank PJSC being the agent) and admitted to trading on the London Stock Exchange (FAB n.d.). This will serve as an example to illustrate the explanation below.

Sukuk legal framework in Europe

The above description of sukuk practice focuses only on features relevant from the Sharia law perspective. As it is apparent, however, one also needs to consider sukuks from the perspective of the national applicable legislation. Indeed, one difficulty in the implementation of these strucmres is the necessary compliance with both concurrent bodies of law (McMillen 2008). In this contribution, I take mainly a European perspective, with a focus - whenever possible - on EU regulatory rules.

The first element to be considered from the regulatory perspective is whether sukuks qualify as ‘transferable securities’ or not. Under MIFID II, ‘transferable securities' are defined as ‘those classes of securities which are negotiable on the capital market, with the exception of instruments of payment’ (article 4( 1 )(44)).‘ The MIFID II definition is, of course, quite wide and has been transposed differently in the different Member States. It is complemented with a non-exhaustive list of examples of what should be considered securities, which include securitized debt. Generally, sukuks are freely tradable (they are very often admitted to trading on a secondary market, making the instrument more attractive to investors by enhancing liquidity, as shown by the FAB Sukuk Company Limited example, in which sukuks were admitted on the London Stock Exchange). In addition, the structure often resembles a conventional securitization. Therefore, they fall within the scope of the MIFID II transferable securities definition.

Precisely because they are considered transferable securities for MIFID II purposes, where such sukuks are offered to the public or admission to trading to an EU-regulated market is requested, disclosure requirements established by the European Prospectus Regulation apply: the issuer shall draw up a prospectus disclosing both financial information and the terms and conditions of the sukuks, highlighting associated risk factors, obtain the approval by the competent authority and publish it.2 In the FAB Sukuk Company Limited example, a base prospectus and final terms were approved by the Financial Conduct Authority (‘FCA’), the English competent authority. Note that in the UK, a relevant Islamic Finance hub, the EU regulatory framework still applies (Withdrawal Agreement 2020),3 even though the UK is no longer a Member State of the European Union. It remains to be seen whether, in the near future, other relevant Islamic financial centres, i.e. Luxembourg or Ireland, take over the role of the UK in the Islamic Finance activity in the EU.

In addition to the above, other requirements need to be met in order to access secondary markets in the EU. Notably, to obtain admission to trading on a regulated market or a multilateral trading facility, EU law establishes that transferable securities shall be registered in book-entry form within a central securities depositary (‘CSD’) (arts. 3.1 and 3.2 of the CSD Regulation).4

Furthermore, some jurisdictions mandate that transferable securities are initially registered in certificate form, e.g. in the form of a global certificate, with a subsequent dematerialization in a CSD in book-entry form. In the FAB Sukuk Company Limited case, the sukuks are registered in a global certificate deposited with a common depositary for Euroclear and Clearstream and then dematerialized in Euroclear/Clearstream, which are the corresponding CSDs. Sukuk holders hold their interest in the global certificate in book-entry form in Euroclear/Clearstream, where clearing and settlement of transactions takes place.

This approach to securities registration, very common in international markets, is reflected in the AAOIFI definition of sukuk which, as highlighted above, refers to the idea of‘certificates’. However, the existence of a certificate depends on the law applicable, as some jurisdictions do not require it but instead establish the registration of transferable securities directly in book-entry form. For example, under Spanish law, a sukuk to be admitted to trading on Spanish regulated markets (‘AIAF’) shall be dematerialized directly in book-entry form in Iberclear (the Spanish CSD). Therefore, unlike the practice in Anglo-Saxon markets and others (see the FAB Sukuk Company Limited example), there would be no (global) certificate (article 6.2 Spanish Securities Act).5

 
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