Capital Markets 201
higher levels of legal and documentation expenses as well as distribu-
tion costs; and involves examining structural robustness in addition to
evaluating the credit quality of the obligor. Standardization of contracts
will reduce this problem.■ (^) Floating - rate sukuk are often linked to a conventional interest rate
benchmark such as the London Inter Bank Offer Rate (LIBOR). When
it comes to pricing, sukuk compete directly with the conventional bonds
in the level of relative spreads. From the conventional borrowers’ point
of view, there is no inherent cost advantage to be gained from tapping
into sukuk markets, since the terms available are mostly derived from
competitive pricing levels in the more liquid and cheaper conventional
bond market. Borrowers, therefore, need to formulate a comprehen-
sive, long - term and strategic view on how to reduce the overall funding
cost by tapping into Islamic markets, rather than focusing on a single
transaction.
■ (^) In principle, sukuk - based funding should be cheaper, since it is based on
collateralized cash fl ows, but in reality this is not the case. It is expected
that as the market matures and investors are more comfortable with the
instrument, costs will decrease and the market will become more effi cient.
■ (^) Due to the shortage of good quality bond issues in the sukuk market,
subscribers, which include institutional investors, central banks, and
private-sector Islamic banks, tend to hold the sukuk till maturity. As
a result, the level of activity in the secondary market is low, which, in
turn, reduces liquidity and also increases transaction costs by the way of
high bid - ask spreads. This problem can be overcome by increasing the
supply of sukuk and by developing a market for retail investors.
■ (^) There may be intermediation costs involved in issuing sukuk when
more than one layer of investment banks is involved. Conventional
banks often co - lead an issue with the Islamic banks and may be taking
a larger share of fees. Also, a conventional investment bank may not
be willing to invest time and effort to develop small - scale sukuk in the
local market. This gap should be fi lled by a more active involvement of
Islamic investment banks.
■ (^) It should also be noted that with sukuk the need for monitoring costs
has not been eliminated entirely. In order to obtain a contract on favo-
rable terms, borrowers may be tempted to exaggerate their competence,
ability, or willingness to provide what the principal requires. In such
cases, the principal, in order to protect its interests, often requires that
borrowers provide evidence that they can indeed perform the task in the
manner required. In order to protect themselves from adverse selection,
principals (investors) may enter into contracts with entrepreneurs who
have the necessary credentials, with the assurance that these agents are
competent and trustworthy. Investment banks can play a critical role in
reducing the potential for making a wrong choice by conducting due
diligence and providing a transparent execution of the deal.