Innovating in Sukuk Capital Markets July 2019 Market Analysis

Market Analysis

Contents

Introduction...... 1 Sukuk al-Ijara...... 2 The Wethaq Platform...... 4 Streamlining the Sukuk Product Lifecycle..... 5 Wethaq Template Generation...... 7 Wethaq’s Smart Clauses in Generated Templates...... 8 Corda: A Modern Financial Market Infrastructure...... 9 Benefits and Implications...... 10 Interoperability with ‘CorDapps’, and Other Trading and Settlement Platforms...... 11 Benefiting from Cash Settlement Innovations...... 12 Cost Efficiency and Transparency...... 13 Shariah Compliance...... 14 Conclusion...... 15 Appendix...... 17 About the Authors...... 18 Introduction Distributed ledgers and ‘smart clauses’ S&P Global Ratings believes that particularly can allow standardization of legal documents and for complex modelling Shariah interpretation, and financial technology of financial transactions (fintech) could help accelerate the Sukuk between counterparties market growth in the short to medium term. in a manner that allows Today, we are still in a situation where all relevant participants the process of issuance of Sukuk is more to more effectively cumbersome and lengthy compared with maintain an up-to- the process of issuing a conventional bond. date record of pertinent The involvement of several parties with, transaction details, even sometimes, opposite perspectives on how as those details evolve. a Sukuk should be structured and sold does Capital markets have become not help either. To reach its full potential, the increasingly global in the last process of issuance of Sukuk and the process ten years and a vast network of issuance of a conventional bond have to of issuers and investors have come together across a growing be equivalent in terms of time, effort and cost portfolio of products. Islamic deployed to be able to tap the market. That finance products, such as the requires inclusive standardization of legal popular Sukuk instruments, have documentation and Shariah interpretation. We contributed to this growth, but can be uniquely complex to call it inclusive as, in our view, the requirements document and structure. The of all the stakeholders have to be taken into reliance of many such products consideration when coming up with the on regional conventions and standard legal documentation or with Shariah historic infrastructure also interpretation. Fintech and particularly the use impacts the efficiency of the issuance process. of blockchain and smart contract protocols, on the other hand, could be another accelerator Blockchain technology, especially if it helps make the process smoother distributed ledgers and ‘smart and clarify responsibilities under different clauses’ (as described in this paper) can help to optimize the scenarios of Sukuk issuance or resolution. value chain of Sukuk instruments from origination and structuring Dr. Mohamed Damak, Global Head of Islamic Finance, to issuance, administration S&P Global Ratings and trading.1 However, in order to capitalize on such potential,

1 All blockchains are distributed ledgers, but not all distributed ledgers “batch” information together into a chain of blocks. For simplicity the term blockchains and distributed ledgers are used interchangeably in this paper.

© 2019 R3. All Rights Reserved 1 next-generation capital market As per a widely recognised infrastructure must be flexibly definition: designed to account for the nuances and requirements “[t]he term “Ijara” is broadly IIFM’s Shariah- of these instruments. This understood to mean the ‘transfer compliant financial paper sets-out the conceptual of the usufruct of an asset to documentation another person in exchange for a framework for this infrastructure and product as well as design steps already rent claimed from him’ or, more literally, a “lease”…The Ijara is underway in anticipation of pilot confirmation particularly useful in this respect issuances to follow. standards are as it can be used in a manner that provides for regular payments playing an This paper specifically examines throughout the life of a financing important role in Sukuk al-Ijara, a common Islamic arrangement, together with the 2 the harmonization finance instrument that allows flexibility to tailor the payment capital raisers and capital profile - and method of calculation and creation of providers access to Shariah- - in order to generate a profit. In efficiency, trust 3 compliant products certified by addition, the use of a purchase and transparency Shariah boards.4 Conventional undertaking (to repurchase the in the industry. (i.e., non-Islamic) bond structures assets and repay investors at maturity) is widely accepted in the The digitization are not considered to be 6 Shariah-compliant as they context of Sukuk al-Ijara...” of standard involve the payment and receipt In a traditional Sukuk al-Ijara documentation of interest. Sukuk securities, by and introduction contrast, comply with Shariah structure, proceeds from the principles through passing on Sukuk issuance are used to fund of smart contracts the returns from an underlying the purchase of specific assets to facilitate the by the Sukuk issuer (the “Sukuk asset or through a contractual operational aspects assets”). The Sukuk assets are in arrangement with respect to that of these standards asset.5 turn leased back to the originator of the assets. The Sukuk assets are is much needed held on trust by the issuer for the and will provide a Sukuk al-Ijara Sukuk-holders as beneficiaries. further boost to the Lease payments paid by the Sukuk al-Ijara presents a Sukuk originator to the Sukuk growth of the Sukuk strong foundational product to issuer are paid to the Sukuk- markets. analyze, due to its popularity, holders as profit distribution for relative simplicity and general their Sukuk holding. At maturity, International Islamic acceptance by most Shariah Sukuk assets are repurchased by Financial Market scholars as a classic Sukuk the Sukuk originator, the trust is structure. dissolved and the principal is thus repaid to Sukuk-holders.

2 Common structures include: (i) Sukuk al-ijara (lease-backed financing), (ii) Sukuk al-Mudaraba (financing based on a partnership where Sukuk-holders bear capital risk and partner with an entrepreneur contributing their project expertise), (iii) Sukuk al-Wakala (financing based on an agency agreement whereby the principal appoints an agent to invest funds in a pool of investments or assets that are purchased by the agent on behalf of the Sukuk-holders). (iv) Sukuk al-Murabaha (financing based on the principles of a commodity sale in consideration for deferred payment at a profit mark-up). Less common is the Sukuk al-Istisna (financing in a project context where the underlying project/deliverable can be identified with a high degree of specificity). 3 ‘The Shariah’ is a religious canonical law forming within the Islamic tradition. 4 Or, in some jurisdictions, a centralised Shariah Authority. 5 Whilst noting that, fundamentally, holders of senior unsecured Sukuk rely on the creditworthiness of the obligor. 6 Definition and chart from Dubai International Financial Centre – Clifford Chance Sukuk Guidebook UAE, 2009 – copy here.

ORIGINATOR as Oblogor under ORIGINATOR ORIGINATOR Purchase Undertaking ORIGINATOR as Seller as Lessee as Servicing Agent and under Sale Undertaking

Sale Price 4 (Consideration Sales of Assets 8 9 Exercise Price of Sale)

Lease of Assets Rentals Appointment as 11 5 6 Servicing Agent

ISSUER SPV as Issuer and as Trustee 3 12

Sale of Assets Sukuk 1 7 Periodic (Trust Certificates) Distribution Amounts Reimbursements Cash Dissolution 2 10 of Servicing Costs Amount (set-off against Supplemental Rental)

Source: DIFC – Clifford Chance Sukuk Guidebook INVESTORS

Under the traditional set up, the Sukuk issuer releases these lease, service agency agreement the Sukuk-holders will, upon funds (as per the terms and and purchase/substitution subscribing for the Sukuk, receive conditions of the Sukuk) through undertakings cover the a beneficial ownership interest in the paying agent to accounts arrangement between the Sukuk the Sukuk assets. Sukuk-holders nominated by the Sukuk-holders. originator and the Sukuk issuer are the registered owners of in respect of the Sukuk assets. Sukuk certificates that represent Principal traditional transaction An agency agreement covers beneficial ownership in the documentation required to be the appointment of the registrar, trust. The Sukuk certificates are negotiated includes a declaration paying agent, calculation agent initially represented by a global of trust over the trust assets, the and transfer agent to perform certificate, held by a custodian creation of a global certificate to the relevant functions on behalf and cleared through the relevant represent ownership in beneficial of the Sukuk issuer in respect central securities depository interests in the trust and offering of ownership of the Sukuk (“CSD”).7 As funds are paid by the documentation to investors. A certificates and payments of Sukuk originator under the lease, sale and purchase agreement, amounts due thereunder.

7 Such as Euroclear / Clearstream / Wethaq itself as CSD – see Appendix.

© 2019 R3. All Rights Reserved 3 The efforts to entirely decentralise Through the platform and in an The Wethaq capital markets (i.e. for functions automated fashion, Wethaq Platform such as custody to be operated undertakes the functions of by a protocol between network registrar (and also CSD, where Introduction participants rather than housed desired), trustee-delegate, within one regulated entity) paying agent, calculation agent have faced some regulatory and transfer agent. These In the second half of 2018, the challenges.9 Additionally, given functions range from maintaining Wethaq team worked on a proof the complexities of complete the definitive registry of Sukuk of concept (“PoC”) intended to architectural or political certificate holdings, undertaking apply new technologies to Sukuk decentralization, even public certain duties on behalf of Sukuk- markets for institutional investors. blockchains do not in practice holders and in relation to trust Wethaq sought to validate its fully decentralize operations assets in certain circumstances core assumptions of what the or governance. Wethaq is (as ‘delegate’ of the ‘issuer- issuance of Sukuk al-Ijara using pragmatically designed to trustee’), making calculations distributed ledger technology comply with existing regulations and payments as agent in and ‘smart clauses’ would entail. through its combination of relation to other obligations of The PoC aimed to: (i) have the (i) contractual relationships the issuer/fundraiser. In pursuit ledger operate as a registry and with, and duties towards, the of automation, Wethaq elects to central securities depository; fundraiser and other parties, (ii) code and deploy ‘smart clauses’ (ii) ‘inter-operate’ with other regulatory permissions, such as to assist its performance of these settlement infrastructures and the innovation testing license functions in a deterministic and payment gateways; (iii) function recently granted to Wethaq programmable way. While the within the existing regulatory by the Dubai Financial Service first commands to be automated framework; and (iv) have market Authority, and (iii) use of a are the various functions participants, service providers ‘permissioned’ distributed ledger (trustee-delegate, registrar, and governance stakeholders for the facilitation of the Sukuk paying agent etc), cashflows interact with each other within issuance and administration and (bookbuilding commitments the platform. the efficient exercise by Wethaq and coupon payments) and of its responsibilities. As such, the management of the These PoC objectives would serve Wethaq will remain responsible Sukuk certificates (issuance, Wethaq’s aspiration to become to perform its various functions allocation and registration), the “the innovative, end-to- 8 under the contracts and exercise the programming will continue end ecosystem orchestrator” its duties from a regulated with subtler ‘legal states’11 (such through the programming of the perspective.10 as events of default and their business and legal logic of Sukuk transactions on the Wethaq Platform.

8 This being identified by McKinsey as one of the four strategic options for banks (and, we would add, financial institutions such as Wethaq) in a changing financial landscape. From Banks in the Changing World of Financial Intermediation, 2018 here. 9 In this respect, we find this recent statement from the Monetary Authority of Singapore to be an appropriate assessment of distributed ledger technology’s (DLT) potential in financial services: “Although the “D” in DLT stands for Distributed, it should not be mistaken for a decentralised system. The fact is that every aspect of DLT – including contracts, standards, protocols, databases, and algorithms – are all centric implementations. While in some cases, blockchain allows for disintermediation, in others, it allows the efficient and effective process automation that creates new value for customers and businesses.” From Delivery versus Payment on Distributed Ledger Technologies - Project Ubin by MAS here. 10 The Appendix to this paper sets out further information regarding the regulatory set up of Wethaq in the Dubai International Financial Centre (DIFC) and intended regulatory treatment and engagement for issuances through the platform. 11 For example, the activation of the purchase undertaking to achieve repayment of principal.

© 2019 R3. All Rights Reserved 4 consequences12) and governance of certificates representing services of structuring and principles.13 the beneficiaries of the trust distribution can be unbundled established by the declaration from each other and, then, be In the environment of of trust over the Sukuk-assets. As automated to the extent possible. the Wethaq Platform, the such, the only parties involved changes to traditional Sukuk in this implementation (other The Wethaq objectives are to documentation described above than nominated advisers such streamline overall coordination, would be minimal with the as lawyers, Shariah board and standardise processes and same substantive obligations placement agents) will be the automate these financial undertaken to Sukuk-holders. fundraiser and, possibly, its services of a more administrative For example, rather than using advisory bank14, an issuer special nature. In practical terms, upon a global certificate registered purpose vehicle (SPV) and completion of the ‘smart term- and mobilized in traditional CSDs, Wethaq. sheet’ and its submission (for Sukuk-holdings will be recorded instance, by the fundraiser’s on Corda with Wethaq acting as Streamlining the Sukuk CFO at the ‘click of a button’), registrar to update such records Product Lifecycle the terms are ‘negotiated’ and as a CSD alternative to with potential investors and, Euroclear/Clearstream and other eventually, ‘fed into’ the Wethaq Under current industry practice, incumbent depositories. Templates with the entire suite the Sukuk issuance is exclusively of documents being generated15 led by banks and fundraisers, Where required to comply and, to the extent required, with the bank typically bringing with local legal requirements, tailored by service providers its structuring and distribution a global certificate may be to the specific needs of the expertise to bear. For this, the issued and held by Wethaq as issuance.16 Upon finalization, the bank relies on its own private depository in the usual form. offering memorandum and other and proprietary processes Under the Sukuk documentation, transaction documents (with within a ‘closed’ ecosystem. We the Sukuk-holders will receive their embedded smart clauses) believe that the objectives of interests in the Sukuk assets may be deployed on the ledger standardisation and automation held on trust by the trustee per and offered to potential investors. are better served in a more open the traditional structure. The ecosystem where the financial Sukuk-holders will still be holders

12 Wethaq will invite industry participants in a research and development group to devise legal markup language to convey precisely the business and legal logic behind the Sukuk transactions. More intuitively: the Sukuk markup language (‘SML’) will be used to parametrize (“tag”) the ‘smart fields’ in a transaction and make them readable by the smart clauses. Upon its development, Wethaq plans to release, to an extent, the SML as “open sourced” software and promote its adoption as an industry standard. 13 In an effort to code and automate more than the usual parameters, Wethaq will seek to develop a ‘Corda State’ permitting the creation of states on Corda to represent legal rights and states when these arise (i.e. when they “crystallise”) according to the legal prose. Potential benefits would be: (a) these “crystallised” rights and their consequences are created and managed as standardised instructions and code at the ledger level; (b) Wethaq maintains a registry of these crystallised states; for example a registry of options, events of default and corporate actions; (c) while Wethaq will send notification alerts to the party and the party can exercise the rights on the web browser, an audit trail of these exchanges is recorded on the ledger. We expect at some point that such innovation may dispense with the need for separate notices (for example, notice of termination) given by paper or digitally as they can be served at ledger level; and (d) it would allow the creation of certificates that aggregate legal rights before they can be exercised. 14 The Wethaq Platform will also be available to investment banks and boutique advisors that wish to continue advising their client fundraisers in relation to pure advisory mandates that do not extend to the mechanics of debt capital markets issuance: here, this constituency can avail itself of Wethaq as a Sukuk/debt capital markets ‘implementation tool’ or ‘Sukuk manufacturing factory’ and so benefit from the ‘bolt-on’ functionality of Wethaq which includes its inherent cost and operational efficiencies and the access to broker dealers and, optionally, exchanges. 15 The legal documentation generated may then be edited online by the law firm appointed by the fundraiser. While these are lengthy documents, the mechanical aspects of terms are fairly standard in large areas, and the law firm would be able to collaborate and finalise them within a reasonable time. 16 Wethaq is able to draw on various sources of market data (being relevant ‘oracle’ feeds into the Wethaq ecosystem) such as an ‘indicative rating/scoring’ tool from a reputable rating agency so as to be able to suggest to the fundraiser a profit rate fit for the transaction they have in mind before the fundraiser invites feedback from the pool of potential investors and finalises the commercial terms.

© 2019 R3. All Rights Reserved 5 Crucially, the service providers To promote an open ecosystem nor does it propose to charge are engaged by the fundraiser and cost transparency, Wethaq a mark-up to such service directly and their billing is will not provide these services providers’ own fees. managed through a dashboard.17 (legal, Shariah, rating, etc.)

Figure 2: The Issuer & Investor Journeys

STRUCTURE Issuer Journey Term Sheet Term Sheet Generation Issuer Approval Announcements LAUNCH ADMINISTER Profit Rate Syndication Bookbuilding Soft-Sounding Payment Pre-Auction Closes Bookbuilding Opens Corporate Actions Certificate Allocation Legal Exchange Activity Documentation Legal Review Confirm Receipt Events of Default Legal Opinion of Funds Scheduled Finalise Issue Certificates Conditions Precident Redemption Sharia Approval SPV Incorporation SPV Bank Setup Preview and Approve Investment Memoradum Investor Journey

SYNDICATION SUBSCRIPTION View Terms Subscription Terms

Soft-Sounding Allocation

ISSUANCE ALERT Pre-Auction Generation of CERTIFICATE STATUS Commitment Bookbuilding Finalise Finalise

Source: Wethaq

With the deployment of transaction and its associated in the issuance, allocations the offering memorandum, issuance after reviewing the and, ultimately, issuance and the various smart clauses terms. This subscription has its settlement of certificates in return are activated starting with intended legal consequences for the transfer of funds using a market standard bookbuilding and activates, in sequence, the payment gateway. Benefitting mechanics. These are based smart clauses that conduct from Corda Settler (as explained on widely recognized market the bookbuilding process. below), the Wethaq Platform will practices18 as may be refined The platform hosts an order not need to hold a client money for any issuance-specific management system which account for the purposes of the idiosyncrasies. From the investors’ is automated with pricing and bookbuilding and settlement perspective, each investor allocation algorithms supported process relying instead on may access a dashboard by smart clauses to regulate transmitting SWIFT gpi payment where it can subscribe to a any indications of interest instructions and recording the

17 In parallel to this ‘self-service’ issuance, Wethaq also enables the advisors to the fundraiser and even underwriters to ‘plug-in’ to the platform and make use of its standardisation and automation benefits. 18 See, for example, ICMA Group 2010 Explanatory Note on Pre-sounding, Bookbuilding and Allocations here.

© 2019 R3. All Rights Reserved 6 successful payments on delivery The output of the process is Trust asset-specific terms and versus payment (“DvP”) terms on the creation of an offering analysis on Shariah compliance the ledger. memorandum and suite of in respect of the transfer of Sukuk issuance documentation Sukuk-assets into the trust will be Wethaq can also facilitate in digital form tailored to a conducted by external advisors on the distribution side: by particular deal.19 The auto- through the Wethaq Platform. sourcing funds from investors generation of documentation with notifications of new in this way is expected to save There are therefore three issuances to its registered users extensive time and cost in processes envisaged for the and, importantly, the ability to creating a “substantially ready” contractual documentation/ onboard broker-dealers who set of terms for “vanilla” deals for terms: may participate in the distribution external advisors to take forward aspects of bookbuilding by in an expedited manner. One • template set of terms offering a ‘Wethaq issuance’ to example of this process would generated upon launch of their own pool of investors. be “selling restrictions”, being the a Sukuk issuance by the standard disclaimers applied fundraiser on the platform; Wethaq Template in offering documentation to • terms specific to each deal will Generation identify which type of investors be added by the fundraiser and may have access and to set its external advisors which will out where (and where not) the Once on-boarded to the amend or expand the template certificates are being offered/ terms (e.g. risk factors, selling platform, the fundraiser (or its regulated/listed (as applicable) restrictions and commercial advisory bank) would provide in the relevant jurisdictions. parameters); and the deal specific information Wethaq intends to maintain a in a standardized term-sheet • sub-category of each type of database of selling restrictions and then, further to feedback term will be coded to become for the relevant forms of offer/ on indicative terms from a smart clauses. marketing in the relevant pool of potential investors, jurisdictions where investors may All terms would sit in a automatically generate the entire access the platform. A fundraiser generated and, once agreed, Sukuk documentation on the would include its preferred digitally authenticated original basis of that term-sheet. These jurisdictions, in a tick-box agreement tagged on Corda. ‘Wethaq Templates’ would be format, and the relevant selling As explained below, certain market standard legal templates restrictions would be generated.20 smart clauses will be embedded developed with a leading law in these digital agreements firm with relevant practice area There will of course be a large to conduct, in an automated expertise. External advisers will number of provisions specific fashion, certain of the agency then be appointed to customize to each deal which require functions undertaken by Wethaq. the documentation to the extent individual negotiation with required for the specific issuance. support from external advisers.

19 The entire suite of documentation can extend to hundreds of pages and extensive time and legal costs can be saved by them being prepared in this way. 20 As Wethaq is not providing legal advice, it would be up to the fundraiser to obtain its own advice on any required changes to these specific to a transaction/marketing process.

© 2019 R3. All Rights Reserved 7 Wethaq’s Smart Clauses by removing the requirement third party to benchmark the for several “trusted” financial relevant reference rate (for in Generated Templates institutions to manually conduct instance, whichever interbank the relevant functions (whether offer rate this may be), enabling Though there have been through their own electronic dynamic performance based on ‘data-driven’ 21 clauses used in systems or otherwise). Second, real-world data. finance for decades, the ‘smart there is certainty that the code clauses’ are their evolution in a will perform the obligations In the present case, while crucial aspect: performance of delegated to it as intended by Wethaq is responsible for the obligations is automated using the parties and beyond anyone’s programming of the smart strict and formal programming unilateral control. Lastly, smart clauses (and ‘wraps’ them with language which is deployed on clauses can be programmed legal prose, in the form of the a distributed ledger beyond the to ‘self-execute’ during the term information memorandum, control of any single party to that of an agreement upon receipt to ensure their validity), upon ledger. of pre-defined data from a their deployment on Corda, third-party source, known as an Wethaq may no longer alter This automation creates several ‘oracle’. For example, a smart their logic or output without the efficiencies. First, the execution of clause could be constructed to consent of the related parties. In contractual terms recorded on a connect to a data feed from a technical terms, these clauses distributed ledger reduces costs

Figure 3: Digital Legal Template with “Smart Clause” Embedded

Agency Agreement

SUKUK AL-IJARA Agency Agreement SUKUK AL-IJARA Template Agency Agreement Paremeters DIGITAL LEGAL TEMPLATE This agreement binds PAYING AGENT to check the REGISTER ISSUER SPV ALICE LTD OF SUKUK CERTIFICATES on a CERTIFICATE HOLDER BOB LTD PERIOD basis and instruct the PAYING AGENT WETHAQ (Smart Clause) ISSUER SPV to make a direct REGISTRY WETHAQ (Smart Clause) SWIFT gpi payment of the PERIOD QUARTERLY COUPON PAYMENT to each COUPON PAYMENT $10 SMART CLAUSE CERTIFICATE HOLDER with a PAYMENT INSTRUCTIONS CORDA SETTLER copy to the PAYING AGENT for PAYMENT GATEWAY SWIFT gpi recording it on the REGISTER

Source: Wethaq

CORDA PROTOCOL

21 For example, options contracts that are automatically exercised upon their strike price being reached or credit default swaps automatically triggered upon a credit event occurring.

© 2019 R3. All Rights Reserved 8 are deployed on Corda where the representations of value on in transactions, and even then, consensus (validation) of their them such as cryptocurrencies) the only data shared is whatever logic and output can only be are a unique innovation in the was agreed to in the design of achieved through the appointed history of finance, given their the CorDapp. This is typically the ‘notary’ nodes before they are operational decentralization, minimal amount of data needed permanently recorded on the settlement times, and global to reflect the evolution of a distributed ledger. liquidity access. However, within transaction. regulated wholesale capital Corda was developed with the markets, distributed ledger Further, a well-developed identity explicit purpose of recording architectures must meet the layer in Corda enables firms and enforcing legal agreements functional and non-functional to transact compliantly and between commercial parties. requirements of network ensure they are transacting In order to do so, Corda builds participants. Public distributed with appropriate counterparties. upon the concept of “Ricardian ledger architectures weren’t Additionally, settlement finality Contracts”22. Ricardian Contracts originally built to be used for enables the real-world issuer to complement the textual form of business transactions. demonstrate compliance with ‘natural language contracting’ finality regulations as well as by placing the defining elements Corda was built from the eliminate risks from ‘blockchain of a legal agreement in a ground-up through an intensive forks’ that occur with public format that is both readable by requirement-gathering process (‘permissionless’) blockchains.23 humans as well as machines. alongside the teams from 40+ Distributed ledgers that use Further, Corda was built with of the largest global banks. As a probabilistic settlement such as the understanding that there result, Corda differentiates itself ‘proof of work’ or ‘proof of stake’ is a need for natural language from other distributed ledger are inappropriate for wholesale contracts which explain what technologies due to its data capital market transactions happens in the event that the privacy, well-defined identity involving regulated entities. code fails to operate as the ‘spirit layer, settlement finality, and of the contract’ intended. regulatory compliance. While the Regulatory flexibility is highlighted open-sourced platform is now specifically around the data Corda: A Modern being used across many diverse sharing requirements pertaining Financial Market sectors including healthcare, to who can see what data. A energy, and supply chains, the financial regulator on the Wethaq Infrastructure core ‘flows’ and ‘states’ on Corda Platform, for example, would are well-suited for regulated be able to supervise directly Corda differentiates itself capital markets transactions. and in real time the issuance from other distributed ledger and trading activity through a technologies due to its data Corda is unique as a distributed ‘supervisory node’.24 Further, a privacy, well-defined identity ledger in that its ‘nodes’ do not regulator could access a copy layer, settlement finality, and broadcast data to all other of the ledger-based register regulatory compliance. nodes in the network. Corda of Sukuk-holders to oversee application (“CorDapp”) users certain lifecycle stress events Public (‘permissionless’) share data only among the (for instance, a default by the distributed ledgers (together with participants specifically involved fundraiser) or to oversee business

22 For a detailed explanation, see the seminal article ‘Smart Contract Templates: foundations, design landscape and research directions’ by Clack, Bakshi & Braine 2016, available here. 23 This settlement finality was identified in Project Jasper by the Bank of Canada, R3 and others as one of the key Principles for Financial Markets Infrastructure (PFMIs) in the regulatory assessment of distributed ledger technologies. 24 The innovation here is that the governance stakeholder does not need to request Wethaq to provide an activity report or access to Corda but, instead, has itself live and direct access to Corda on a ‘need to know’ basis.

© 2019 R3. All Rights Reserved 9 continuity in respect of Wethaq.25 Further, Wethaq can inter-operate As for Shariah compliance, Benefits and with the global Corda ecosystem, the third party Shariah board Implications and take advantage of new may issue the relevant fatwa developments with cash (fiat) (i.e., certificate of Shariah The value proposition of settlement functionality within a compliance) over the platform on the Wethaq Platform is the distributed ledger environment. request of the issuer/originator streamlining of processes, and then, through an assigned reduction of intermediaries, We envision the Sukuk markets node, monitor continuously or and automated performance of becoming more integrated and be automatically notified of any contractual obligations through distributed with more visibility for irregularities arising during the life the use of smart-clauses on each participant as shown in the 26 of the Sukuk. a distributed ledger-based chart below. platform.

Figure 4: Wethaq Ecosystem

DIGITAL ASSET PAYMENT EXCHANGE & INSTRUCTIONS SETTLEMENT/ DISTRIBUTION Payments directly between DEPOSITORY ALTERNATIVE NETWORK Payer and Payee with a copy SERVICES TRADING SYSTEMS Nominee Banks & sent to Corda Setter Euroclear/Clearstream etc. NASDAQ Dubai, KSA Tadawul, Broker-Dealers etc. SIX Digital Exchange, US (E.g., Investor and (Option A) Templum Markets etc. (Option A) Coupon Payments) (Option A)

SWIFT for Market Infrastructures API API Settlement/Depository Services Corda Node for ‘native’ Supervisory Node: DLT settlement (Wethaq CSD) Financial Regulator(s) (Option B) SWIFT gpi Digital Asset Exchange & Alternative Trading Systems Supervisory Node: Corda Node for ‘native’ Sharia Board DLT settlement (Option B)

Distribution Network Oracle Node: Supervisory Node: Oracle Node: Corda Node for ‘native’ Settlement R3 Notarisation Corda Settler DLT settlement Services Service (Option B)

WETHAQ/CORDA Network Wethaq CorDapp & Database

Law Firms Proxy Source: Wethaq Sharia Boards Other Service Providers using Wethaq Developer Tools Rating Agencies and Data Services

Corporate Service Providers

25 The regulator could also obtain a copy of the register and oversee Sukuk-holder protection in a transition to a traditional structure outside of the platform, if required. 26 We expect regulators will appreciate this access to useful data on over-the-counter (OTC) trading of Sukuk on the secondary market to be able to achieve better transparency of OTC markets, assess changes in these markets, monitor trends in trading, and respond accordingly. Currently, most fixed income securities are traded through decentralised, dealer-intermediated, OTC markets, however, as with MiFID II in the European Union, we observe a strong trend in the direction of better market transparency for regulators; Wethaq can operate to enable and support this trend.

© 2019 R3. All Rights Reserved 10 Interoperability with ecosystem on a distributed have successfully tested the ledger by building required use of distributed ledgers ‘CorDapps’, and Other infrastructure and other integral (including R3’s Corda platform) Trading and Settlement elements such as standards and for ‘tokenized assets’ settlement. Platforms software development kits. Within The trial was conducted in the Wethaq Platform itself, third partnership with U.S. stock market R3 has designed Corda to be the parties may use open-sourced Nasdaq and Deloitte. In another platform that bridges seamlessly Corda Developer Tools and, for jurisdiction, a recent report from from legacy infrastructure to their specific Sukuk needs, the the US DTCC validates the choice ‘digital-first’. Wethaq Developer Tools to ‘plug of Corda for these projects, in’ and offer their services and claiming that Corda has high The Wethaq Platform is not an products on the platform. enough performance to handle ‘island’ but benefits from the peak trading volumes in the US openness and functionalities of Interoperability with other equity markets. the Corda ecosystem. CorDapps will also have the potential to enable new, digital- Wethaq will seek to enable, Many of the world’s largest first markets. Incumbents are gradually and following their financial institutions are currently developing their own respective requirements, listing deploying production-quality CorDapps, which may provide of the securities issued on its Corda nodes; R3 has designed a means for new platforms platform with traditional and Corda to be the platform that like Wethaq to interact with digital exchanges in the Middle bridges seamlessly from legacy digital exchanges globally.30 East (e.g. Nasdaq Dubai, KSA infrastructure to ‘digital-first’. R3 For example, leading Swiss Tadawul), Europe (e.g. SIX Digital considers that a great advantage stock exchange SIX recently Exchange) and South East of Corda is its integration with proclaimed they expected digital Asia.31 Wethaq aims to allow ‘off-ledger’ infrastructures27: exchanges on distributed ledgers Sukuk-holders to trade their ranging from third-party sources to completely replace traditional Sukuk securities and settle their of data28 (that are used as input ones within ten years. SIX is trades on incumbent settlement to the smart clauses) to payment building its own digital exchange, infrastructures outside the gateways; and settlement SDX, that will be completely Wethaq Platform (Euroclear/ systems29 for the settlement of overseen and regulated by Clearstream etc) through the the Sukuk securities by a global the Swiss government and assignment of an International community of investors and the country’s financial market Securities Identification Number traders. regulator, FINMA, and will facilitate (ISIN) to each security.32 trading in stocks, bonds and Financial institutions, financial exchange-traded funds. In In this case, the trade may be market infrastructures and addition, Singapore Exchange concluded between market corporations are supporting the (SGX), along with the Monetary participants that do not have development of an increasingly Authority of Singapore (MAS), to register with the Wethaq global capital markets Platform. Rather, they may use

27 While at the same time is ready to carry out the relevant functions (settlement and payment) ‘natively’ on the ledger for when the regulators and capital markets participants are ready to do so. 28 Also known as ‘oracles’ connected through an API, such as Thomson Reuters BloqOne IQ. 29 Such as SWIFT gpi integration currently in R3/SWIFT prototype stage; recent announcement here. We explain in detail below the integration of payment gateway and the interaction with settlement infrastructures. 30 Significant benefits of such interaction would be that settlement and payments can happen ‘natively’ on the ledger without reliance on off-ledger incumbent infrastructures and payment gateways. 31 Listing and admission of trading details will highlight that the certificates may be listed on a relevant digital exchange or traditional securities exchange with relevant connectivity to the distributed ledger-based recording system for transfer of ownership. However, it will be clear to investors that there may be no such platform available for the certificate at the time of issue or for a long period after issuance (depending on the facts of the relevant issue). 32 By Nasdaq Dubai acting as National Numbering Agency in the case of the Dubai International Financial Centre (DIFC).

© 2019 R3. All Rights Reserved 11 their existing accounts on those the transaction, marking it purposes of settlement.34 As incumbent infrastructures and/ settled on the Corda Protocol indicated in the image below, or their nominee banks. As if, and only if, all conditions are the Wethaq Corda Settler ‘node’ Wethaq remains the registrar and satisfied and the corresponding operates to ‘interact’ with SWIFT depository updating the definitive settling payment is successful. in general, meaning it ‘listens distributed ledger-based register Settlement can be achieved in on’ (i.e. checks/can receive of the securities, the third-party with an on-ledger transfer of a copy of) relevant ‘message settlement infrastructure will settlement assets, or off-ledger types’ from the SWIFT library; eventually have to communicate with a payment initiation and and, in this way, Wethaq can the data of the DvP-settled trade confirmation on a non-Corda track external investors (as well through an API for the Wethaq payment gateway. In a typical as the fundraiser) in relation to Platform to then automatically scenario, the payer is notified, their available funds and the update its definitive register through the Corda Settler, that movement of funds as between accordingly. settlement has been requested them. and that it must instruct a We expect the digital exchanges, payment to the required address In the words of the International in particular, to consider favourably (bank account, digital wallet Swaps and Derivates Association this access to a new source of or other) before the specified (ISDA)35 a “light ledger” (such as compliant and digital-first Sukuk deadline. Once an ‘oracle service’ Wethaq) is “a distributed ledger, securities while, at the same time, (such as the payment gateway which is akin to a sophisticated the fundraisers to welcome the or the recipient bank) confirms messaging system that enables access to new sources of liquidity to the Corda Settler through an communications between beyond the traditional centers of API that the payment has been participants but where payments GCC and SE Asia. made, then the Corda Settler, settle off-chain via existing in turn, automatically updates payment systems like SWIFT.” Benefiting from Cash the Corda Protocol that the transaction has, indeed, been As more innovations with Settlement Innovations 33 settled. distributed ledger-based settlement evolve, Wethaq The Wethaq Platform will aim to The recent initiative announced aims to be uniquely placed to capitalize on several different by SWIFT and R3 to enhance take advantage of these new types of cash settlement Corda Settler through the settlement protocols. These options using distributed ledger integration of ‘SWIFT gpi’ (global may involve central-bank issued technology as they mature. payments innovation) as a digital currencies (such as Most recently, R3 has released payment gateway has wide- “Aber”, currently in pilot stage Corda Settler, an open-sourced reaching potential for efficient between the central banks of KSA CorDapp that allows payment payments between market and UAE), or perhaps private- obligations arising on the Corda participants; this initiative would sector led initiatives (such as Protocol to be settled via any enable transaction flows to be ‘stablecoins’). traditional rail capable of providing tracked in real-time allowing, cryptographic proof of settlement, an appropriately permissioned whether ‘on-’ or ‘off-ledger’. Cost Efficiency and agent (Wethaq in our case) to Transparency observe, follow and audit the Corda Settler allows two Sukuk issuer/SPV’s funds without transacting parties to agree Sukuk markets have less cost Wethaq itself needing to hold to the method and conditions efficiency and transparency than a client money account for the of settlement, then execute conventional debt markets due

33 In the next phase of development, the Corda Settler will support domestic deferred net settlement and real-time gross settlement payments. 34 With the obvious regulatory and operational benefits these direct payments have compared to funds passing through an intermediate for settlement purposes. 35 Recent paper here

Beneficiary Company A Payer Company B Face Value 260 EUR Due By 2018-12-04 Settlement Oracle Exchange Rate Oracle Settlement Method [address: ra6mzL1xy9aN5..., Payment Network oracle: Settlement Oracle] Status Unsettled Payments Other Corda Other Network [txID: 2E91FF59F1D725..., amount: Network 260 EUR, status: SENT] ID b567bf99-98ce-4414-96ao... Company A Notary Cluster Company B

to relatively higher structural, any distribution intermediary. As compliance and document it does not reserve for itself any complexity. As an alternative to ‘deal-making’ or advisory role Wethaq would this, Wethaq would be the entity (acting, in financial terms, as a accountable for performing ‘pass-through’ platform), Wethaq be the entity functions that would otherwise be does not seek to calibrate its fee accountable performed by a number of banks, as a function of the credit risk of for performing clearing and trustee entities all the fundraiser. incurring separate fees and other functions that engagement costs. As for certain other third parties, would otherwise they would be engaged directly be performed Wethaq expects to charge a by the fundraiser and issue their single fee to the fundraiser invoices through the Wethaq by a number (or to its advisory bank) on Platform without any ‘mark- of banks, account of structuring, order up’ applied by Wethaq.36 For management, registrar (and example, the relevant third clearing and CSD), trustee-delegate, paying party Shariah board could have trustee entities agent, settlement and other reviewed and familiarised itself all incurring administration related services; with the basic default Wethaq the fee charged to the fundraiser Templates at the time of its separate fees (or its advisor bank) will be on-boarding onto the platform. and other benchmarked against market Then, at the time of each Sukuk rates and/or charged as a issuance, this external Shariah engagement commission levied from the board would not need to review costs. issuance proceeds charged by these default templates in detail the issuer’s advisory firm and/or again, but only any amendments

36 Third party costs include: SWIFT payment distribution cost (competitive in comparison to banking fees); SPV establishment/corporate service providers; Shariah board review; rating agency (initial review, rating and ‘scoring’); legal advisory and any listing fees.

© 2019 R3. All Rights Reserved 13 specific to a particular issuance, perspective) and with fewer in order to issue the relevant operational hurdles. In practice, fatwa (certificate of Shariah this should enable efficient The distributed compliance) required by the institutional private placements relevant investors. Other time and, in particular, a greater ledger facilitates sensitive costs, such as legal number of ‘smaller fundraisers’ cash flow record fees for drafting and negotiation to access the capital markets. keeping in a are also reduced through the Investors can also avail of template generation approach more ‘choice’ in Islamic finance transparent described above. products and advisers have more and easily ‘benchmark data’ in this area. reconcilable An important variable cost is 39 expected to be that charged Shariah Compliance way… The by broker-dealers acting as employability of distributors37 as a mark-up (or Wethaq’s objective to improve ‘smart clauses’ ‘re-offer’ spread) for successful transparency in the Sukuk placement of primary issuance markets is aligned with Shariah gives Shariah to their own clients. This fee will principles. boards the depend on the overall interest in the issuance and the profile of The distributed ledger opportunity to the fundraiser but we expect also facilitates cashflow record ensure Shariah that the platform will attract and keeping in a transparent and compliance by encourage open competition easily reconcilable way that amongst such marketing and demonstrates the source and building and distribution entities and, as a timing of payments. In the mapping real result, competitive fee outcomes Sukuk context this can support world Shariah benefitting fundraisers. transparency in the issuance and payment process and in requirements Wethaq’s operational framework tracking the underlying assets or within the and regulatory accountability cashflows generated. presents, for routine global structure itself. 38 fundraisers , an alternative The employability of ‘smart ecosystem to global and regional clauses’ gives Shariah boards the Shariyah Review Bureau banks. At the same time, and for opportunity to ensure Shariah the same reasons, the platform compliance by building and can be expected to appeal mapping real world Shariah to fundraisers that, although requirements within the structure creditworthy and appealing to itself. This can be done by taking investors in general, may be salient Shariah guidelines of under-banked by incumbents, the underlying transaction and or wish to access the capital embedding them in the digital markets with a more competitive contract thereby ensuring fee arrangement (from a that the transaction is ‘only’ structuring and administration executed when those Shariah

37 Bank treasuries, asset managers and other capital entities, among others (and within the relevant regulatory constraints of an ‘exempt offering’), may buy to hold and trade as principal for their own trading books. 38 Including sovereigns, supranationals, agencies, well known financial institutions and corporates globally, often household names. 39 Observations provided by the Shariyah Review Bureau (https://shariyah.com) specifically in relation to the Wethaq Platform.

© 2019 R3. All Rights Reserved 14 conditions are met. These self-executing clauses have Conclusion These self- the potential to eliminate the need for human intervention Corda integrates with existing executing thereby automatically reducing (off-ledger) systems, providing clauses have the potential of non-Shariah a path for the existing financial compliant transactions. system to participate. the potential to eliminate the Furthermore, Shariah audit Fintech and distributed ledger need for human processes can be engineered technology, in particular, are and automated using Wethaq’s driving an unprecedented intervention smart clauses and through this period of innovation across thereby help build efficiency into the capital markets. As the pace Shariah supervisory system. For of innovation increases, these automatically example, the Shariah auditors or technologies begin integrating reducing the scholars can, where necessary, with each other and shifting more potential of access the information about segments of the capital markets the transfer for Shariah purposes ecosystem towards shared non-Shariah of the trust assets via these platforms. The landscape is likely compliant smart clauses thereby making to look unrecognizable to its transactions. the Shariah verification process current form, with current assets easier. fully digitized and new types of digital assets being traded in All information (including markets and alternative trading ownership of the trust assets, systems that may not even exist when they were purchased, the today or are only now starting to date on which ownership was emerge. transferred) is integral to Shariah compliance and can be viewed In this changing market in real-time. Moreover, as soon landscape, enterprise- as such data is recorded onto distributed ledgers like Corda the Wethaq Platform, it cannot be are designed to address the changed or deleted. All this helps complicated challenges of provide an efficient, secure, and enabling settlement finality, permanent Shariah audit trail. regulatory compliance and

© 2019 R3. All Rights Reserved 15 investor protection. Possibly Platform will benefit from the most importantly, Corda modernisation of workflows, integrates with existing (off- the automated performance of ledger) systems, providing a several regulated functions in path for the existing financial one ecosystem, the application system to participate. New digital of legal technology (document assets, with legal underpinnings generation and smart clauses) and support from real-world and the streamlined integration custodians and asset issuers, with third party market will enable 24/7 transactions, infrastructures. settlement with finality and full regulatory compliance, unlocking Wethaq expects to obtain valuable liquidity and delivering regulatory support in key efficiencies for issuers and jurisdictions (GCC and SE investors across the globe. Asia) and be ready to issue its inaugural Sukuk products later The rapid development of this year. We invite the Sukuk enterprise-distributed ledgers markets community and the will inevitably disrupt Sukuk Corda ecosystem to engage with markets too. Benefitting from the us in our plan to ease access ‘permissioned’ architecture of to capital markets for eligible Corda and interoperability with fundraisers, source new products both incumbent as well as newer for investors internationally, market infrastructures, Wethaq is introduce operational efficiencies well placed to lead an evolution for the various service providers of the securities ‘value chain’ and, in general, closely integrate in these markets within existing Sukuk markets with their global regulatory frameworks. counterparts.

The fundraisers and their advisor banks that will use the Wethaq

© 2019 R3. All Rights Reserved 16 Appendix: Licensing Approach Having reviewed relevant regulations and discussed specifics with regional regulators, the Wethaq Platform is expected to be appropriately permissioned to cover its varying roles (as delegate, registrar (CSD) and agent functions) in its proposed jurisdictions of operation, principally in the DIFC.

In April 2019, Wethaq was granted, in principle, an innovation testing license (ITL) from the Dubai Financial Services Authority (the “DFSA”) which covers the scope of activities which Wethaq will undertake in connection with its operations described in this case study: (i) ‘Arranging Deals in Investments’, (ii) ‘Providing Trust Services’ and (iii) ‘Providing Custody’, with an endorsement for ‘Holding or Controlling Client Money Assets’. Wethaq will therefore be regulated, on the basis of the ITL, to act as Delegate, Registrar, Paying Agent, Calculation Agent, Transfer Agent and, if required, CSD.

Wethaq will be conducting its activities in “testing” mode, for a limited period whilst operating under the ITL40, with informed parties and targeting institutional investors (DFSA “Professional Clients”) only. Following the ITL period, upon approval from the DFSA following successful testing and application, Wethaq would be upgraded to full license by the DFSA. Wethaq will then be fully regulated, with the required capital and systems and controls, to conduct its functions in and from the DIFC.

40 The ITL is intended to provide the ability to test live products and services as a regulated firm with various rule modifications for a limited period, with the expectation of graduation to a full license by further application at the end of the testing period.

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About Wethaq

Wethaq (Capital Markets) is a regulated fintech entity in the sukuk capital markets operating out of the Dubai International Financial Centre with presence in Riyadh and London. For more information about its platform and the sukuk issuances scheduled, please contact the contributors to this paper: Dimitrios Vourakis (Chief Product Officer) and Ron Akram (Markets & Regulatory Structuring) at [email protected]

About this publication

This publication is intended for informational and educational purposes only and does not replace independent professional judgment or advice. No information contained in this publication is to be construed as legal advice. R3 does not assume any responsibility for the content, accuracy or completeness of the information presented or for any loss resulting from any action taken or reliance made on any information included in this publication.

About R3

R3 is an enterprise blockchain software firm working with a broad ecosystem of more than 300 participants across multiple industries from both the private and public sectors to develop on Continue the conversation Corda, its open-source blockchain platform, and r3.com Corda Enterprise, a commercial version of Corda for enterprise usage. @inside_r3

The Corda platform is already being used in medium.com/inside-r3 industries from financial services to healthcare, shipping, insurance and more. It records, manages and executes institutions’ financial agreements in perfect synchrony with their peers, creating a world of frictionless commerce. Learn more at r3.com.