The Sukuk market has grown significantly because of the increasing demand for Shari’ah-compliant products and the global rise of Islamic banking. However, it still lacks effective Shari’ah-compliant risk management tools to address Sukuk default risks, making Sukuk investments riskier compared to conventional bonds that offer multiple hedging instruments. This study, therefore, aims to develop a Shari’ah-compliant credit default swap (CDS) model as a hedging mechanism for Sukuk investors and enhances credit risk management in the Sukuk market while adhering to Islamic legal and ethical principles.
This study adopts a conceptual and analytical approach, drawing upon classical Islamic jurisprudence (fiqh) and modern financial engineering techniques. The proposed SCDS model, grounded in a Waʿad (unilateral promise) and an Ijārah (lease) contract, seeks to replicate the risk-mitigation function of conventional CDS and is subsequently evaluated from a Shari’ah perspective to insure not engaging in riba (interest), gharar (excessive uncertainty) or maisir (speculation).
The outcomes of conceptual analysis revealed that the Shari’ah-compliant CDS model offers an ethical solution for managing Sukuk default risk, based on real asset-backed ownership, a binding Waʿad (unilateral promise) and Ijārah (lease contracts). The protection seller commits to buying the Sukuk at face value upon default, ensuring investors recovery without speculation. Payments are tied to rental income, avoiding gharar and maysir. This structure enhances liquidity, encourages Sukuk trading and aligns with global standards like the IIFM/ISDA Tahawwut Master Agreement supporting a more stable, ethical and tradable Islamic finance market.
The proposed Shari’ah-compliant CDS model provides Islamic financial institutions, regulators and Sukuk investors with a practical mechanism for credit risk management that adheres to Shari’ah principles. By linking protection to real assets, the model aims to enhance market liquidity, mitigate the impact of Sukuk defaults and reduce the potential for systemic financial instability.
This paper offers one of the first comprehensive frameworks for a Shari’ah-compliant credit default swap tailored to the Sukuk market. This study bridges a critical gap between the need for effective risk management and the constraints of Shari’ah law, providing a foundation for future innovation in Islamic financial derivatives.
