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Supporters of Islamic finance saw an opportunity when the international financial crisis exposed the flaws in the western model of finance. Events, however, have shown that the much-heralded "ethical" sukuk bonds too are vulnerable to default.

The near-collapse of Dubai World, one of the emirate's three main state-owned business groups, toward the end of last year and the default on sukuk bonds issued by Nakheel, one of its property developer subsidiaries, badly shook investor confidence. This was further harmed when three other sukuk issuers defaulted. Sales of Islamic bonds were down 22% in the first half of this year.

These problems have prompted investors in the $130bn Islamic bond market to push for stronger rights of ownership of assets to protect against such defaults. Until now, there was some confusion by investors about what risks they were taking on. A sukuk bond is structured to comply with Sharia law by not paying interest to investors but giving them a share of the revenues from certain assets that are placed in a special-purpose vehicle (SPV). However, this doesn't mean the bond was asset backed, ie. the investor can claim a share of the assets in the SPV upon default, but was merely asset based and so relies on the issuer agreeing to sell assets if they can't make interest payments on time.

"When some originators have found themselves in financial trouble or, worse, have become insolvent, sukuk investors have found themselves unexpectedly competing with the general body of creditors, rather than simply enforcing against or taking possession of the assets supporting their sukuk," says Neale Downes, regional head of banking and finance for law firm Trowers & Hamlins in the Middle East.

The obvious answer is to make more sukuk bonds asset backed than the just 4% that are currently rated by Moody's Investors Service. However, analysts point out that the legal environment in many countries is not supportive of asset-backed structures, meaning that such bonds will remain a minority of total issuance. This does, of course, open up opportunities for countries like Kazakhstan where such asset-backed structures are possible.