The disparities between regulatory ideals and financial realities are coming home to roost in the US. But in the Gulf there are still areas for financial optimism - albeit more measured in tone. Islamic finance is one such area. As a whole the industry continues to grow, but demand for its once rising star, the sukuk, is waning.

Issuances of sukuk fell by 50 per cent since January compared with the same period last year. Undoubtedly one reason is the global erosion in credit confidence. Another is the concern voiced early this year by the industry body, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).

The chairman of the organisation, Shaikh Mohammad Taqi Usmani, criticised a common form of sukuk that apparently violates the Sharia-compliant principles surrounding risk and profit-sharing.

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The type of sukuk in question is sold with a repurchase undertaking: a guarantee that the borrower will repay the face value at maturity, or in the case of default - thus allowing investors' capital to be reimbursed. Critics categorise this form of sukuk as merely a form of corporate credit. Usmani estimated that as many as 85 per cent of sukuk are raised with such buyback clauses.

The controversy sent ripples through the industry, but perhaps unsurprisingly in a sector posting significant growth, players have been quick to develop new Sharia-compliant financial vehicles. In a move seen by many as a panacea, Abu Dhabi-based Sorouh Real Estate concluded the world's largest Sharia-compliant securitisation in September. The deal is fully asset-backed non-recourse financing, which will please the AAOIFI in that it meets the criterion in terms of risk and profit sharing.

A clutch of innovations have allowed the Islamic financial services industry to appeal to a wider clientele. However, as has been highlighted by the issues surrounding Sharia-compliance and the sukuk market, the perennial challenge remains - attracting new clients while staying true to Islamic principles.

Predecessor

Although the Sorouh deal has set a precedent, it has a predecessor in the shape of the Middle East's first true-sale Islamic securitisation. Last year Tamweel, the largest real estate finance provider in the UAE, raised the bar significantly. But, as is the case with many market vehicles, structures change and need updating. The Tamweel and Sorouh transactions are indicative of the evolutionary characteristics of Islamic finance. As situations necessitate, deals can be re-engineered to meet new requirements, while still adhering to Islamic beliefs.

Sorouh's deal was the first to securitise instalment sales, the receivables from the sale of land. And regionally it is the highest non-sovereign rated issuance, while also being the first asset-backed securitisation in Abu Dhabi.

Naturally, breakthroughs such as these are met with growing expectations and heralded as the solution. But just how practical a solution is this? The intricacy behind such deals could actually be one of their drawbacks; only sophisticated investors are likely to understand the complexity of the assets underlying securitisations. This may leave many to opt for more straightforward options, especially considering the current financial turbulence.

The important question now is whether the AAOIFI ruling has done intractable damage to the future appetite for sukuk. Firstly, it is worth remembering that the Islamic bond in question is an evolving structure and other types, such as ijara, which operates on lease finance basis and at maturity passes ownership to the borrowers, have no such controversy attached to it.

However, the overall picture for Islamic finance appears bright. According to the 2008 Notable Trends in Global Islamic Finance report by Moody's Investors Service, the coming five years will bring unprecedented growth for the sector. They estimate that the value of Islamic finance will grow to $4 trillion from the $700 billion today. Over the past few years the industry has grown at a healthy clip, on average 15-20 per cent annually.