Every number used to govern money eventually risks drifting away from what it was designed to measure. Not because anyone breaks the rules, but because once a rule has a number attached to it, people naturally learn to satisfy the number rather than the intention behind it.

This isn’t necessarily cynicism or misconduct. It is closer to a structural feature of incentives. Attach consequences to a measurement, and the measurement starts adapting to the pressure around it - often quietly, legally, and with everyone acting rationally. Economists call this Goodhart’s Law. And few areas show it more clearly - or more expensively - than corporate debt covenants and executive compensation KPIs.

This piece starts from first principles: what Goodhart’s Law actually means, how it appears in debt and compensation contracts, why even intelligent and well-intentioned people can fall into the trap, and what can be done to keep a metric meaningful when everyone has an incentive to improve it.

Part 1: A Rule Too Simple to Ignore

In 1975, British economist Charles Goodhart was examining why the Bank of England’s monetary targets kept losing their effectiveness. Whenever policymakers selected a measure of money supply and began managing the economy toward it, the relationship between that measure and the broader economic objective started to weaken.

The observation, later popularized by anthropologist Marilyn Strathern, is usually summarized as:

“When a measure becomes a target, it ceases to be a good measure.”

The mechanism is straightforward. A metric is initially chosen because it correlates with something we actually care about - a healthy company, a well-managed fund, or a creditworthy borrower. That relationship generally holds as long as nobody is specifically optimizing for the metric.

Once real consequences - a bonus, covenant breach, or credit downgrade - are tied to that number, the relationship can begin to break. There are now two ways to improve the score: improve the underlying business, or improve the number. The second is often faster and cheaper, so the incentive to take that route grows.

Finance is an especially good laboratory for this because so much of it is built around contracts tied to specific numbers. Two of the clearest examples are debt covenants and executive compensation. To understand how Goodhart’s Law operates in practice, it helps to build each one up from first principles.

Part 2: Covenant EBITDA - When the Target Redefines the Company

Start with the basics. When a company borrows money, the lender doesn’t simply hand over cash and hope for the best. The loan agreement includes covenants - financial tests the borrower must continue to meet throughout the life of the loan.

A common example is a leverage covenant, typically measured as Debt/EBITDA. A company might agree to keep Debt/EBITDA below 4.0x. Breach that limit, and the lender may be able to declare a default, demand repayment, or renegotiate the loan.

EBITDA was originally a useful shorthand for operating performance, stripping out financing structure, taxes, depreciation, amortization, and other non-cash items to make companies easier to compare. But EBITDA is a constructed measure, not a single fixed number. Loan agreements often give borrowers flexibility over what can be included or excluded for covenant purposes.

That is where “covenant EBITDA” can begin to diverge from the EBITDA an independent analyst would calculate.

The add-backs total $16.0mm - a 28% uplift over reported EBITDA. Against $280mm of net debt, that swings leverage from 4.83x on a reported basis to 3.78x on a covenant basis: the difference between a business that is close to breach and one comfortably inside its terms.

Leverage(reported) = 280 / 58.0 = 4.83x vs Leverage(covenant) = 280 / 74.0 = 3.78x

None of this is necessarily fraudulent. Each add-back can usually be justified on its own, and lawyers on both sides negotiate the definitions carefully before the loan closes. But when enough individually defensible add-backs are stacked together, the covenant ratio can look comfortably healthy even as the company’s underlying cash generation deteriorates.

The result is that the lender’s early-warning system - the very reason the covenant exists - can quietly stop working just when the warning matters most.

Part 3: The Denominator Game - EPS and ROE

The same pattern appears in executive compensation, often in an even more mechanical way. Two common metrics used in executive bonuses and long-term incentive plans are earnings per share (EPS) growth and return on equity (ROE). Both are ratios, which means they can improve in two ways: increase the numerator or reduce the denominator.

1. EPS accretion from buybacks alone

EPS = Net Income / Shares Outstanding

Suppose net income is $120mm and the company has 100mm shares. EPS is $1.20. If it buys back 10mm shares using existing cash or new debt, EPS rises to $1.33 ($120mm / 90mm) - an 11% increase with no improvement in operating performance.

If the buyback is debt-funded, higher interest expense will reduce net income. But if borrowing costs are low enough, the benefit from the lower share count can still outweigh the added interest, creating EPS accretion even when enterprise value is unchanged or has deteriorated.

2. ROE decomposition (DuPont)

ROE = (Net Income / Revenue) × (Revenue / Assets) × (Assets / Equity)

These three components are net margin, asset turnover, and leverage. Management can improve ROE through genuine operational improvements in the first two, or simply increase leverage and reduce the equity base.

For example, increasing the equity multiplier from 8x to 10x raises ROE by 25%, even if profitability and asset efficiency remain unchanged. That is why credit analysts use DuPont analysis before treating higher ROE as evidence of stronger business quality - the same ROE can reflect either a more profitable business or a more leveraged and fragile one.

In both cases, the metric rises and the bonus may vest, but the underlying question - has the business actually become more valuable or resilient? - remains unanswered. The headline number can improve while the underlying business moves in the opposite direction.

Part 4: Why This Happens Without Misconduct

It’s tempting to see this as a story about managers deliberately gaming the system. A more useful explanation is psychological - and it doesn’t require anyone to be dishonest.

Once a target becomes important and tied to rewards, attention naturally shifts toward whatever moves the measured number. Steven Kerr described this decades ago as “the folly of rewarding A while hoping for B”: organizations often reward one behavior while actually wanting another, then act surprised when people optimize for what is on the scoreboard.

Negotiated definitions make this effect even stronger. When people debate what counts as a one-time cost or a reasonable leverage add-back, it is natural for each side to argue for the interpretation that benefits them. No one needs to be acting in bad faith.

The result is gradual, collectively reasonable drift: each adjustment may be defensible on its own, yet over time, the final number can move far from what it was originally meant to represent.

Part 5: Keeping the Measure Honest

This is where the focus should shift from diagnosis to design. Metrics can never be made completely ungameable, but they can be structured so that gaming them requires either genuine operational change or enough effort to become visible. Five mechanisms do most of the work.

1. Cap and Sunset the Add-Back Schedule

Instead of allowing an open-ended list of adjustments, credit agreements can cap total add-backs at a fixed percentage of reported EBITDA - often 15–20% - and require a “non-recurring” item to lose that treatment if it appears again within the following four quarters.

This turns a subjective question - “Is this really one-time?”- into a simple, auditable test: did it occur in the previous four quarters? No fresh negotiation is needed at every measurement date.

2. Force Multi-Metric Consistency

A single ratio can be gamed in isolation. Two or three related metrics that should move together are much harder to manipulate without genuine improvement.

For example, pair EPS growth with free cash flow per share, or ROIC with WACC. Pair ROE with a minimum equity or capital-adequacy floor. If EPS rises mainly because of buybacks while net income and FCF remain flat, the divergence becomes the warning signal.

This is similar to how auditors compare covenant EBITDA with statutory EBITDA over time: the gap between related measures can reveal more than either number alone.

3. Replace Cliff-Edge Tests with Trends and Relative Benchmarks

A binary threshold - breach 4.0x and trigger a default, or miss the EPS target and lose the bonus - creates a strong incentive to manage the number around the measurement date.

Two alternatives help. First, use trailing-twelve-month or multi-quarter averages instead of a single-period snapshot, reducing the impact of one-off actions. Second, benchmark performance against peers or the wider sector, such as relative TSR or ROIC, rather than relying only on absolute targets. This makes it harder to manage the metric without considering the broader market.

4. Track the Gap, Not Just the Number

Lenders and auditors can independently calculate a metric using a stricter definition - for example, statutory EBITDA instead of covenant EBITDA, or unlevered ROE instead of reported ROE - and track the gap between the two over time.

A small, stable gap is usually unremarkable. But a gap that keeps widening quarter after quarter can signal weakening underlying performance, often before the headline ratio breaches the covenant. That is precisely the early-warning function the covenant was supposed to provide.

5. Use Equity Cures and Clawbacks as Pressure Valves, Not Loopholes

Well-designed agreements can combine strict definitions with controlled ways to deal with breaches. Equity cure rights can allow sponsors to inject capital to fix a covenant breach, but only a limited number of times over the life of the loan. Clawback provisions can allow boards to recover bonuses if the underlying results are later restated.

Both reduce the incentive to manipulate the metric. A genuine breach can be fixed properly rather than hidden, while an inflated bonus can be recovered later. Gaming the number becomes less attractive because it is no longer a one-way win.

Part 6: Closing

Goodhart’s Law isn’t a flaw in financial contracts. It is an unavoidable consequence of reducing something as complex as “Is this business healthy?” to one negotiable number. That number will naturally be influenced by whoever has the most at stake in how it looks, and that influence often won’t appear as misconduct while it is happening.

The answer isn’t to find a metric that can never be gamed - no such metric exists. It is to design contracts with that reality in mind: limit adjustments, make multiple metrics corroborate each other, measure trends rather than snapshots, and track the gap between the reported number and a stricter version underneath it.

Done consistently, a covenant or compensation plan stops being a number management simply needs to hit and returns to its original purpose:

an early-warning system, not a target.

Picture a university where students hire their own examiners, pay them directly, and get to pick a new examiner if the first one grades too harshly. You'd assume the grades coming out of that system are, at best, generous. At worst, meaningless.

That, in essence, is how the global credit rating industry has worked for the last fifty years. And despite a financial crisis that was substantially caused by this exact arrangement, it's still how the industry works today.

Part 1: START WITH THE BASICS: WHAT A CREDIT RATING ACTUALLY IS

Strip away the jargon and a credit rating is a simple thing: a letter grade - AAA down to D - that estimates how likely a borrower is to pay back what it owes. Governments get rated. Corporations get rated. So do the complex bundles of loans that banks package and sell to investors.

These letters matter enormously, for a reason most people outside finance don't fully appreciate. A rating isn't just a helpful guide for investors doing their own homework - it's often a legal gatekeeper. Many pension funds, insurance companies, and money-market funds are only permitted, by their own charters or by regulation, to hold debt above a certain rating threshold. A single downgrade - say, from BBB- to BB+ - can force forced selling by every institutional investor no longer allowed to hold the paper. That one notch can move billions of dollars, not because anything about the underlying company changed overnight, but because the label attached to it did.

So who hands out these labels? Three companies, essentially. Moody's and S&P Global each control something like 40% of the global ratings market, and Fitch holds most of the rest - together the "Big Three" account for roughly 90-95% of credit ratings issued worldwide. This is not a crowded, competitive marketplace. It's closer to a regulated oligopoly wearing the costume of a market.

That oligopoly exists partly by regulatory design. In the US, an agency needs to be designated a Nationally Recognized Statistical Rating Organization (NRSRO) by the SEC before its ratings can be used to satisfy the regulatory requirements described above - and under global bank capital rules like Basel III, the rating on a bond determines how much capital a bank has to hold against it. A AAA bond eats up almost no regulatory capital; a junk bond eats up a lot. This is the detail that turns credit ratings from "useful opinion" into "regulatory input" - a distinction that matters a great deal for everything that follows.

Part 2: THE TWIST NOBODY BUDGETS FOR: WHO ACTUALLY PAYS

Here's where it gets interesting, and where most primers on credit ratings stop short of the uncomfortable part.

You'd reasonably assume that if a rating exists to protect investors, investors would be the ones paying for it - the way you pay a home inspector before you buy a house, not the seller. That was, in fact, how the industry worked for most of the 20th century. Investors paid for subscriptions to rating reports, and rating agencies had every incentive to be right, because their entire business was selling accurate information.

That changed in the 1970s. Photocopiers had made it trivially easy for a single subscriber to duplicate a rating report and pass it around for free, which quietly gutted the investor-pays subscription business. Around the same time, regulators began requiring public debt to carry a rating from a recognized agency, which meant every issuer suddenly needed one, guaranteed customer. The industry pivoted to a new model almost overnight: issuers would now pay for their own ratings.

Think about what that flips. The rating agency's paying customer is no longer the party trying to find safe, honest information - it's the party trying to borrow money as cheaply as possible. The examiner is now paid by the student. And once you see this shift, entire chapters of financial history start to read differently.

Part 3: THE STRESS TEST THE SYSTEM FAILED

The clearest evidence of what this conflict produces arrived in 2007 and 2008. In the run-up to the crisis, somewhere around 80-95% of a typical subprime mortgage-backed security was carved into slices carrying the highest possible AAA grade - the same grade assigned to the safest government debt on earth. Investment banks paid handsomely for these gold-star ratings because AAA-labeled paper could be sold to pension funds, insurers, and conservative money managers who were contractually barred from touching anything riskier.

Then reality caught up. By the time the dust settled, more than 90% of the AAA ratings handed out on mortgage-backed securities issued in 2006 and 2007 had been downgraded to junk. Some deals were wiped out completely - one subprime issuer saw every single one of its 75 AAA-rated securities from 2006 eventually collapse to junk status. The U.S. Financial Crisis Inquiry Commission, tasked with the official autopsy, put it about as bluntly as a government report ever does: the crisis, in its words, could not have happened without the rating agencies.

This wasn't primarily a case of agencies being duped by clever bankers, though that happened too. It was, in large part, a business model working exactly as its incentives suggested it would. The agencies were being paid by the very banks assembling these mortgage bonds, and there was always another rating agency willing to be more generous if one got too cautious - a dynamic known in the industry as rating shopping.

An issuer could quietly solicit a preliminary opinion from two or three agencies, see which one produced the friendliest grade, and only pay for (and publish) that one. The agency that said no simply never got hired again. In a market with only three real players, that's not a subtle disincentive - it's existential.

It also helps to understand "why" AAA was so achievable in the first place. Mortgage bonds aren't rated as one lump sum - they're sliced into layers called tranches, arranged in a "waterfall" where the top tranche gets paid first and absorbs losses last, while the bottom tranche absorbs losses first and gets paid last, if at all. This is called subordination, and it's the mechanism banks used to manufacture AAA ratings out of distinctly non-AAA mortgages: pile enough risky loans together, carve out a thin top slice protected by all the losses below it, and the rating models said that top slice was nearly bulletproof. The models were right about the mechanics of subordination in normal times and catastrophically wrong about how correlated mortgage defaults would become when a nationwide housing bust hit every tranche at once. Add the fact that the agencies bore essentially no legal liability for getting a rating wrong, and you have a textbook case of moral hazard - the incentive to take on more risk when someone else, or something else, absorbs the downside. 

Part 4: THE REFORM THAT WASN'T

Here's the part of the story that should bother you more than 2008 itself: this is still how it works.

Dodd-Frank, the sprawling 2010 reform law written explicitly in response to the crisis, took direct aim at the ratings industry. It created a dedicated SEC Office of Credit Ratings. It mandated formal studies into alternatives to the issuer-pays model - including a genuinely interesting proposal where a neutral board would randomly assign which agency rated which deal, removing the issuer's ability to shop for a friendly grade. Congress even gave the SEC explicit authority to implement that random-assignment system by rule, without needing to come back for further legislation.

The SEC studied it. The GAO studied it. Regulators held a public roundtable in 2013 to debate the merits. And then, by the SEC's own later admission, the agency simply never acted. No business model was ever recommended. The random-assignment system was never implemented. More than a decade on, issuer-pays remains the dominant compensation structure across the industry, largely unchanged in its basic architecture from the model blamed for the worst financial crisis in eighty years.

Why did reform stall? Partly because the alternatives have real flaws of their own - the SEC's own analysis found that even random assignment might not fully kill rating shopping, since issuers could still hire additional agencies for supplementary opinions. Partly because the Big Three, having survived the crisis with their market position essentially intact, had every incentive to lobby quietly and wait the reform momentum out. And partly because - this is the uncomfortable structural point - regulators themselves have leaned on credit ratings for decades to set capital requirements and eligible-investment rules. The system is now load-bearing. Ripping out issuer-pays without a workable replacement risks a bigger mess than leaving a flawed thing standing.

Part 5: WHY THIS ISN'T JUST A 2008 STORY

It's tempting to file this under "historical curiosity" - a scandal that got its punishment in the form of collapsed banks and a decade of regulatory hand-wringing. But the same structural conflict is quietly present every time you read a headline about a country's sovereign rating being cut, or a corporation issuing a fresh bond.

Sovereign ratings are a particularly sharp version of the same tension. Rating agencies assess government creditworthiness while simultaneously courting relationships with those same governments' debt offices, their central banks, and the investment banks that structure sovereign bond sales. A downgrade can genuinely move a country's borrowing costs and, by extension, its fiscal room to maneuver - which means the agency doing the grading is never fully insulated from the politics of the grade it hands out.

And at the level of ordinary corporate debt, the same quiet incentive persists on every single issuance: the agency wants the repeat business, the issuer wants the friendliest defensible grade, and the investor relying on that letter to make a decision is not the one writing the check.

Part 6: SO WHAT WOULD ACTUALLY FIX THIS?

None of this means credit ratings are useless - they aggregate real analytical work, and most of the time issuer-pays ratings are directionally accurate. The problem isn't that the system fails constantly; it's that it fails predictably at the worst possible moments, precisely when the incentive to be lenient is strongest - during a boom, when issuance volume (and fee revenue) is highest and everyone least wants to hear "no."

The GAO, tasked by Dodd-Frank with actually cataloguing the alternatives, came back with a shortlist. It's worth walking through each one properly, because they fail and succeed in genuinely different ways - this is where the interesting trade-offs live.

a. Random assignment model. A neutral body - not the issuer - decides which NRSRO rates a given deal. This is the model Dodd-Frank explicitly authorized the SEC to implement without further legislation, and it kills rating shopping in its purest form. But the SEC's own 2012 study found the flaw baked in: an issuer can still privately commission an unofficial second opinion from a non-assigned agency and use it as leverage even if it never becomes the official rating.

b. Investor - pays model. Flips the money flow back to the pre-1970s structure - the institutions relying on the rating fund it directly. This already exists: Egan-Jones Ratings, an NRSRO since 2007, runs largely on subscriber fees. But a 2023 academic study found the opposite conflict re-emerging - more optimistic ratings and slower downgrades for bonds more heavily held by its own paying subscribers. Flip the direction of the money and the conflict doesn't disappear; it relocates.

c. Designation model. The agency is still picked and paid the way it is today, but securities holders - not the issuer - designate which agency receives the fee. It keeps issuer-side funding while giving investors the power to reward or punish a track record, though it requires dispersed bondholders to coordinate, something they're historically poor at.

d. Platform or utility-style ratings. The most structurally radical option: a non-profit or public utility issues a baseline rating funded by industry-wide fees, similar to how an exchange or clearinghouse operates as shared infrastructure rather than a for-profit gatekeeper. It most cleanly removes the profit motive - but nobody has built one at scale to find out what new problems that creates.

Notice the pattern across all four: every fix solves the "specific" conflict it targets and introduces a "different" one somewhere else. That's not an argument for inaction - the issuer-pays model's failure mode is the best-documented and most catastrophic of the bunch, which is exactly why it's the one Congress singled out. But it explains, more honestly than "regulatory capture" alone, why a fifteen-year-old mandate to fix this has produced studies, roundtables, and no rule.

What would move the needle without waiting for Washington to pick a single model: mandatory dual ratings from differently-compensated agencies on structured products, pairing one issuer-paid rating with one subscriber-paid or platform rating so the two conflicts at least point in opposite directions rather than the same one; hard liability for rating agencies when a rating is later shown to have ignored known, documented deterioration, closing the "just an opinion" legal shield that has historically protected agencies from lawsuits; and regulators gradually stripping ratings out of hard-coded capital rules - something Dodd-Frank also mandated and only partially delivered - so a single letter grade stops being the sole gatekeeper for how much capital an institution must hold.

None of these needs a single perfect model to be chosen. They need the two-decade-old political will to actually legislate a functioning fix, rather than fund a well-documented shelf of studies about one.

The next time a headline tells you a company or a country just got upgraded or downgraded, it's worth asking the same question you'd ask of any grade: not just what the score is, but who's paying the person holding the red pen - and whether the fix on the table quietly hands the pen to someone with a different, but equally real, reason to be generous.

Every so often, finance produces an instrument that forces you to ask what a familiar word actually means. Sukuk are one of those instruments. They are routinely described in the financial press as “Islamic bonds,” a phrase that is both the most useful shorthand available and, on closer inspection, almost a contradiction in terms. Islamic finance does not permit bonds - not in the conventional sense - because it does not permit interest. And yet the global sukuk market has grown into a trillion-dollar asset class that investors buy, price, and trade in ways that look, from a distance, remarkably like the bond market it was built to avoid.

This is not a piece about whether Islamic finance is legitimate, or whether sukuk are a clever workaround or a genuine innovation. It is a piece about a more interesting question sitting underneath that debate: when you change the legal form of a financial instrument but leave its economic substance intact, have you actually changed anything at all? To answer that, we need to start from first principles - with what debt actually is, and why anyone issues it in the first place.

Part 1: What Debt Financing Actually Is

Strip away the jargon, and a bond is a simple arrangement: an investor lends money today in exchange for a promise of more money later. A government or company that needs capital - to build a highway, fund a budget deficit, or expand a factory - issues a bond instead of, say, going to a single bank for a loan. The bond is simply that loan cut into thousands of tradable pieces, sold to many investors at once.

The mechanics are consistent nearly everywhere in the world. A company issues a bond with a face value of $1,000, a coupon rate of 5%, and a 10-year maturity. The investor hands over $1,000 today. In exchange, the issuer pays $50 a year - the coupon - for ten years, and returns the original $1,000 at the end. The investor's return is contractual and largely disconnected from how the underlying business actually performs. If the company has a spectacular year, the bondholder still just gets their $50. If the company has a terrible year, the bondholder still expects their $50 - and if they don't get it, that is a default, with real legal consequences.

This is precisely why debt is so useful, and why it dominates global capital markets. It lets a company raise money without giving up ownership. It gives investors a predictable, senior claim that sits ahead of equity holders if things go wrong. And it lets governments finance deficits, wars, and infrastructure without printing money outright. The entire architecture of modern finance - corporate treasuries, sovereign budgets, pension funds seeking steady income - is built around this one instrument: a fixed, time-bound promise to pay, regardless of outcome.

That last phrase - regardless of outcome - is the hinge on which this entire article turns.

Part 2: The Principles of Islamic Finance

Islamic finance is built on a small number of principles derived from Shariah, and nearly every distinctive feature of sukuk traces back to one of them.

The prohibition of riba

Riba is usually translated as “interest,” though the concept is broader: any predetermined, guaranteed increment charged simply for the use of money over time, detached from any real economic activity or risk. The underlying objection is not to profit itself, but to profit that is earned without exposure to risk or productive effort - money simply generating more money by the passage of time alone.

The prohibition of gharar

Gharar refers to excessive uncertainty or ambiguity in a contract - selling something you don't clearly own, or entering an agreement where the terms are so vague that one party is essentially gambling. Islamic contracts are expected to specify, in concrete terms, what is being exchanged, by whom, and under what conditions.

The requirement of an underlying asset or venture

Perhaps the most important principle for our purposes: financial returns should be tied to real economic activity - a tangible asset, a trade, a lease, a partnership in a venture - rather than to money lent against money. This is the principle that pushes Islamic finance away from a direct loan-and-interest structure and toward instruments built around ownership, leasing, and trade.

Risk-sharing over risk transfer

Conventional debt transfers nearly all the operating risk to the borrower while the lender's return stays fixed. Islamic finance, in its idealized form, prefers structures where the financier shares in the genuine performance of an asset or venture - profit and loss both - rather than simply extracting a guaranteed spread.

Put these four principles together, and you get a financial system that looks very different from conventional debt. But governments, companies, and large infrastructure projects in Muslim-majority markets still needed to raise huge amounts of money from many investors while offering them predictable payments. Sukuk were developed to meet this need - providing a way to raise large-scale funding while following Islamic finance principles.

Part 3: What Sukuk actually is

The word sukuk is the plural of sakk, an Arabic term for a certificate or deed - the linguistic root, incidentally, of the English word “cheque.” A sukuk is not a debt certificate. Structurally, it is a certificate of undivided beneficial ownership in a specific asset, a pool of assets, or a business venture. The investor is not lending money to the issuer. The investor, at least in form, is buying a proportional ownership stake in something real - a building, an aircraft, a toll road, a trade transaction - and their return comes from the income that asset generates, whether that's rental income, trading profit, or the proceeds of a lease.

That is the theory. The mechanics of how it is actually built are where things get interesting - and where the resemblance to a bond starts to sharpen.

The cast of characters

● Originator / Obligor - the entity that actually needs the money (a government, bank, or corporation).

● Special Purpose Vehicle (SPV) - a separate legal entity created solely to hold the underlying asset and issue the sukuk certificates. This separation is what makes the certificates a claim on an asset rather than a direct claim on the originator's balance sheet.

● Investors / Sukuk holders - who buy the certificates and, in form, become co-owners of the underlying asset via the SPV.

● The underlying asset - real estate, equipment, a commodity, and so on, which must exist and be identifiable for the structure to be Shariah-compliant.

A worked example: an ijara sukuk

The most common structure is the ijara (lease-based) sukuk, and a simplified example makes the mechanics concrete. Suppose a government wants to raise $500 million for ten years.

● The government sells a specific asset - say, a portfolio of government buildings - to a newly created SPV for $500 million.

● The SPV raises that $500 million by issuing sukuk certificates to investors, who now hold beneficial ownership of the buildings through the SPV.

● The SPV immediately leases the buildings back to the government under an ijara (lease) agreement, in exchange for periodic rental payments.

● Those rental payments - say, 5% of the asset value annually, or $25 million a year - are passed through to sukuk holders as their periodic distribution.

● At maturity, the government (via a separate purchase undertaking) buys the buildings back from the SPV for the original $500 million, and that amount is returned to investors as their principal.

Look at the cash flows an investor actually receives: $25 million a year for ten years, then $500 million back at the end. That is, cash-flow for cash-flow, identical to a conventional 10-year bond with a 5% coupon. The difference is not in what money moves and how it moves. A bondholder is being paid interest on a loan. A sukuk holder is being paid rent on a leased asset, and then repaid for the sale of that asset back to the government.

Part 4: Same Cash Flows, Different Structure

In practice, for the vast majority of sukuk issued globally, the rental rate is pre-agreed, the repurchase price is fixed in advance regardless of what the asset is actually worth at maturity, and the entire arrangement is wrapped in a purchase undertaking that guarantees the investor gets their capital back on schedule. The asset ownership is real in a legal sense, but the economic exposure to that asset's actual performance has been engineered away.

Part 5: The Paradox

Here is the uncomfortable question this structure raises: if a sukuk delivers a fixed periodic payment, on a fixed schedule, with principal returned in full at a fixed date regardless of how the underlying asset actually performed -how is that economically different from interest on a loan?

This is not just a observation. It has been debated openly within Islamic finance scholarship for decades, and it has a name: the asset-backed versus asset-based distinction, which is the fault line running through almost every serious critique of the modern sukuk market.

Asset-backed sukuk

In a genuinely asset-backed structure, investors have real recourse to the underlying asset if the originator defaults. The SPV's ownership is not merely nominal - if the government or company can't pay, sukuk holders can, in principle, claim the actual asset, sell it, and recover value from it. Their return is genuinely linked to the asset's performance and value, not just its existence on a term sheet. This is closer to the risk-sharing spirit of Islamic finance's founding principles.

Asset-based sukuk

The overwhelming majority of sukuk issued in global markets today are asset-based, not asset-backed. The underlying asset exists mostly to satisfy the Shariah requirement that a real asset underpins the transaction - but investors have little or no real recourse to that asset if things go wrong. Instead, they rely on a purchase undertaking: a separate contractual promise from the originator to buy back the asset at a fixed price on a fixed date, no matter what that asset is actually worth. Strip away the language, and that purchase undertaking is functioning exactly like a repayment guarantee on a loan.

In simpler terms, the paradox is this:

Riba was prohibited because it gives the lender a guaranteed return without taking on real economic risk. But in some sukuk structures, the investor may still be promised a fixed return and repayment on a specific date, regardless of how well the underlying asset actually performs.

So, although the legal structure looks different from a conventional interest-bearing loan, the economic outcome can sometimes look very similar.

In other words:

The paperwork has changed, but the underlying risk may not have changed as much.

The key question is: Who is actually taking the risk, and who is guaranteed to get their money back?

That is the heart of the sukuk paradox.

Part 6: Financial Engineering, or Genuine Innovation?

It would be too simple to say that sukuk are simply conventional bonds in disguise. There are important differences. Sukuk investors face Shariah-compliance risk, which bondholders do not, and the requirement for an underlying asset or transaction creates a link to real economic activity that pure debt does not.

Some structures, particularly genuinely asset-backed sukuk and certain mudaraba or musharaka arrangements, also expose investors to real performance risk and can behave very differently from conventional bonds.

A fairer way to view sukuk is as a spectrum. Some structures closely resemble conventional debt in their economic outcome, while others genuinely reflect Islamic finance's principle of risk-sharing. The difference often comes down to the fine print: the purchase undertaking, recourse provisions, and what happens when the issuer defaults.

This debate also exists within the Islamic finance industry itself. Some scholars have criticized certain sukuk for focusing more on the form of a transaction than its substance - technically avoiding riba while recreating a similar economic outcome through complex contracts.

That is the heart of the sukuk paradox: has the transaction genuinely changed how risk and reward are shared, or has the same economic result simply been achieved through a different legal structure?

Part 7: What this says about debt, more broadly?

Step back from sukuk, and the deeper pattern is not unique to Islamic finance. Modern finance is full of instruments designed to deliver the economic benefits of one thing while legally being classified as something else - preferred stock that behaves like debt, leases structured to stay off balance sheets, or derivatives packaged as bonds.

Sukuk are a particularly clear example because the constraint they were designed to address - a religious prohibition - is so clearly defined. This makes the tension between legal form and economic substance easier to see.

That is what makes the sukuk paradox relevant even to those with no connection to Islamic finance. It highlights a broader truth: financial instruments are legal structures built around economic realities, and the two do not always move together. Changing the label, contract, or legal structure can change how an instrument is treated for tax, regulatory, or religious purposes - without necessarily changing who bears the risk, who is guaranteed to be paid, or who ultimately suffers when things go wrong.

Part 8: Conclusion

Return, then, to the question this article opened with. A conventional bond represents a claim on the issuer's promise to repay. A sukuk, in its ideal form, represents an ownership interest in, or entitlement to returns from, an underlying asset, usufruct, or business activity. But when that underlying structure is combined with a purchase undertaking that fixes the repurchase price, returns benchmarked to conventional rates, and contractual mechanisms designed to deliver investors a predictable amount at maturity regardless of the underlying asset's performance, the economic distinction between the two can begin to blur.

Perhaps this is less a failure of Islamic finance than a reflection of how difficult it is to separate financial engineering from economic reality. Islamic finance has developed different contractual structures, ownership arrangements, and legal mechanisms for raising capital. But in some sukuk structures, the economic exposure can still closely resemble that of conventional debt.

This leaves us with a broader question: if two financial instruments produce similar cash flows, allocate risk in similar ways, and lead to similar outcomes in default, how much does the legal label really matter? Are they genuinely different financial instruments - or simply two different legal structures built around a similar economic reality?