Incentive-Compatible Ṣukūk Mushārakah for Private Sector Funding

Abstract

Despite the huge potential on both the demand and supply sides of the ṣukūk market, the current ṣukūk structures fall short of adequately meeting the market’s needs as the Sharīʿah compliance of many of them and/or their economic efficiency are questionable. Even though partnership-based ṣukūk are claimed to reflect the true spirit of Islamic finance, their underuse as a financing instrument is a notable fact. Such a situation, if not addressed, will impede the development of the ṣukūk market in the future. This paper proposes an innovative ṣukūk mushārakah model for consideration by companies and revenue generating infrastructure projects. The model has an incentive-compatible feature by making the share of the issuing entity in the profit positively related to its performance in addition to a convertibility clause. The sector Return on Equity (ROE), adjusted with the firm beta, is considered a benchmark for measuring the performance of the firm. The paper examines the design of the model, its risk return profile as well as its pricing for secondary market trading. The theoretical properties of the model are empirically validated through two types of simulations: Monte Carlo Simulation and backtesting. The proposed model constitutes a new class of financial security with respect to the residual nature of the claim and its limited tenor. It, thus, presents an opportunity for diversification. The model implies higher risk for the investor, as neither the profit nor the capital is guaranteed–like common stock– but the return is expected to be higher. The model would entail higher financial cost for companies–as compared to debt instruments–but it would imply at the same time lower probability of bankruptcy, since the ṣukūk are equity-based instruments.