Islamic Stock Market and Shariah

Islam

Islamic Finance

 

Islamic Finance Market   

o                  Definition of Financial Market

A financial market may be defined simply as a market for the exchange of capital and credit in the economy. Money markets concentrate on short-term debt instruments; capital markets trade in long-term debt and equity instruments. The purpose of these markets is to channel savings and surplus liquidity into long-term productive investments.

In economics, a financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient market hypothesis. Financial markets have evolved significantly over several hundred years and are undergoing constant innovation to improve liquidity.

o       Financial Market Instruments

Financial Market instrument are defined as long-term financial instruments generally with maturity exceeding one year.

Capital Markets

The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities. A capital market is a market where both government and companies raise long term funds to trade securities on the bond and the stock market. It consists of both the primary market where new issues are distributed among investors, and the secondary markets where already existent securities are traded.

In the capital market, mortgages, bonds, equities and other such investment funds are traded. The capital market also facilitates the procedure whereby investors with excess funds can channel them to investors in deficit.

o                  Islamic Approach for the Financial Market

Like conventional markets, Islamic financial markets have two components: capital and money markets. The Islamic Financial Market (IFM) refers to the market where the financial instruments are traded in ways that do not conflict with the Shari’ah principles. In other words, the IFM represents an assertion of religious law in the financial market transactions where the market should be free from the involvement of prohibited activities by the Shari’ah.

Most of the financial instruments used in contemporary financial markets are based on interest, which is clearly prohibited in Islam. Hence, development of financial instruments whose provisions, terms and conditions do not violate Shari 'ah principles, is the first and foremost requirement towards the evolution of Islamic capital markets. Secondly, most of the practices of capital markets, in handling financial instruments may also be repugnant to both Islamic law as well as Islamic norms of morality. There is a need to review the present practices prevailing in the financial market to identify which of these practices needed to be reformed from an

Islamic point of view and which of them may be acceptable. Thirdly, institutions, which may be conducive to functioning of Islamic financial markets, need to be established.

Islam is not averse to the idea of financial intermediation. It is a fact, that whatever be the form of economic organisation, a society, may have surplus and deficit households in terms of possession of financial resources. Hence, efficient use of financial resources of the society would necessitate some form of cooperation between the surplus and deficit units.

o       Key features of Islamic capital market instruments

a) Instrument should represent share in equity, real assets, usufruct or a combination of some or all of these and should not earn money on debt.

1) Instrument representing real physical assets and usufruct are negotiable market price.

2) Instrument representing debts in their negotiability are subject to rules of hawalah.

3) Instrument representing a combination of different categories are subject to rules relating to the dominating.

• If debt are relatively larger the portfolio’s negotiability will be subject to hawalah-al-dayn

• If currency component is larger to sarf and

• If real / physical assets and usufructs are overwhelming, to selling at market prices.

b) The Issuance of Islamic Financial Instruments based on mudarabah or musharakah is subject to following conditions:

i) The Principle and expected return on investment cannot be guaranteed

ii) If the financial instrument were issued for specific purposes or projects, the prospectus should include full disclosure of the nature of the activities, contractual relationships and obligations between the parties involved and ratio of profit sharing; and

iii) The issuers of financial instruments should keep separate accounts for each project and must declare its profit and loss accounts at the date mentioned in the prospectus and balance sheets.

c) Holder of Islamic financial instruments are the owners of whatever rights these instruments represent and bearers of all related risks, and

d) An Instrument the object of which is debt should not be allowed to earn any return and that its negotiability/tradability must be in accordance with the shari’ah rules.

o       Objectives of Islamic Financial Market

In principle, the objectives of the Islamic financial market are again based on the Shari’ah, which in essence should be treated as an important and necessary vehicle to transfer funds from surplus to deficit units. This is to ensure the equitable allocation of capital to sectors which would yield the best of returns to the owners of capital and hence contribute towards the overall growth and expansion of the economy.

It is also the objective of the Islamic financial market to ensure that there exists a means of attracting surplus funds for worthwhile investments in accordance with the owners' preferences in terms of the extent of risk involvement, rate of return as well as the period of investment preferred. Without the financial market, the fund owners could not find sufficient opportunities to invest for either short term or long term. Most investments have gestation lags and of long term in character. Emergency needs may arise from time to time which cannot be easily met. It is also un-Islamic to hoard wealth. It is therefore necessary for wealth owners to invest their funds in order not to allow their funds to be unnecessarily eroded by the obligatory zakat.

o       Limiting the Liability

There is no objection in Shari’ah to setting up a company whose liability is limited to its capital and the company clientele knows this fact since awareness on their part precludes deception. Nor is there any objection in Shari’ah to the fact that the liability of some shareholders is unlimited without compensation for such a commitment. A shareholder is responsible for the liability incurred by the company only to the extent of his share.

Limited companies issue shares to their subscribers, whose liability is limited to the extent of the shares held by them. This is the basic difference between a limited company and an unlimited company shareholder. In the latter, the shareholders liability to the creditors of the company is unlimited. Shareholders of the company can be physical persons, or legal persons or both. Shares of joint stock companies can be a major area for Islamic banks’ investments. The Company is deemed to have a separate entity distinct from its members. Therefore, the company has legal rights and bears liabilities. It can sue for its rights and can be sued for failing to discharge its commitments.

o                  Capital and the Stock Market

A stock market typically refers to a financial market that handles the buying and selling of company stocks, derivatives and other securities. Stock markets trade company securities that are listed in the stock exchange. Investors and security issuers both participate in stock markets. Different sized entities participate in stock market activities, ranging from small investors to the governments, corporations, large hedge fund traders, and banks. Corporations, governments, and companies issue securities on the stock market to collect funds.

The stock market, in which long-term securities are traded, forms a major component of the capital market. Equity based securities such as shares of public limited companies (also debt-based securities, in which Islamic banks do not deal) are bought and sold in the Stock Exchange.

The Stock Market performs a number of useful functions in the economy:

a) Intermediation,

b) The Valuation of Businesses,

c) The Separation of Ownership from Management; and

d) The Trading of External Financial Claims.

a) Intermediation

The most important function of the Stock Market is intermediation. It channels money from savers to investors, thus providing long-term capital to business through equity or debt. It also provides flexibility in the mobilising of funds, giving diversity of risk. The primary market serves to help firms to raise new resources, while the secondary market facilitates liquidity of investments through the trading of shares.

b) The Valuation of Businesses

The value of a firm is determined by pricing its securities on the basis of the present value of the expected stream of cash flow generated over the life of the firm. There are two sets of factors that influence the market value of firms.

o       Islamic Finance and the Stock Market

In order to discuss what should be the role of stock market within an Islamic framework, we have to identify which of its existing forms and practices are acceptable to Islam and which will have to be modified to make them consistent with Islamic principles.

o       Equity-Based Securities

An equity based securities or fund is simply an investment vehicle that allows investors to take advantage of investing in a diversified group of stocks which manages risk and exposure to one or a few stocks. It also offers the opportunity to participate in the long-term performance of the stock market. There are many ways to structure a fund which are entirely driven by what investors demand.

o       Debt-based Securities

A large proportion of the capital market consists of debt-based securities, such as debentures, bonds, preferred stocks and commercial paper. All these types of securities carry a fixed return until maturity and are convertible and negotiable.

Clearly, such characteristics are inconsistent with Islamic financial law and it would therefore be necessary for new instruments to be designed to replace them.

o       Preferred Stocks

Preferred stock combines the features of pure debt and common stock. If the business goes bankrupt, preference stockholders have priority in getting their money back over ordinary share holders. They sometimes, though not often, have a feature whereby, after a certain amount of dividend has been paid to them, the holders share in the profits with common holders.

The provision for paying dividends and the proceeds of liquidation are contrary to the principles of Islamic financing, though the other features mentioned above are less so and could be easily modified to fit the principles of profit and loss sharing (PLS).

There is complete agreement among all schools of Islamic jurisprudence that in a participative arrangement no fixed return can be paid to any of the parties. This is a strong Shari’ah requirement and any priority in the matter of dividends or assets is completely unacceptable to Islam.

o       Potential Problem Areas

The Stock Market will play a pivotal role in the Islamic financial system, but, in order to provide a continuous pricing mechanism, will have to be insulated from major shocks and crashes. A major shock would have more effect on the Islamic system, because its entire capital resources, both short-term and long-term, are equity-based and not debt-based.

Thus an operational framework to insulate the market from major shocks is vital if the

Islamic financial system is to be brought into being. For this purpose, there are three key areas of the market that need to be constantly reviewed.

1. Speculation,

2. Information disclosure standards; and

3. The regulations guiding operations and trading practices

Speculation

Those who trade ownership in fixed assets tend to have expectations about business performance that are entirely different from those of managers. This is because they often try to predict the psychological behaviour of the market in complete disregard of the underlying economic value of assets. This can cause misallocation of resources as firms which are overvalued attract more investment than those which are undervalued and this, in turn, results in losses and gains entirely unrelated to real economic effects, such as greater output. Such results are like the results of gambling, involving transfer of resources among the participants but adding nothing to the initial stock of resources.

Speculation can cause wild swings in the market and was largely responsible for the crashes of 1929 and 1987. The actual value of the business assets of the whole of corporate America could not really be supposed to have decreased overnight by 30% at those times.

Information Disclosure Standards

The nature of any financial arrangement is determined by the volume and quality of information available, and this is so especially where a number of partners enter into an agreement. The Stock Market is no exception to this rule and needs a continuous flow of information if it is to operate smoothly. It may reasonably be assumed that the information requirements of PLS financing are much more stringent that those of debt-financing.

There are three things that help to ensure an adequate flow of public information.

1. All companies that are listed on the Stock Exchange must register with a regulatory agency and are required to disclose a good deal of information which would help investors to make informed decisions about buying their shares.

2. This information is audited by independent auditors

3. Any significant changes in share holding are brought to the notice of the regulatory agency. This protects small investors by ensuring that significant changes in shareholding are not the result of some people having inside information not available to the public.

The Regulatory Environment

The regulations guiding operations and trading practices require two types of restrictions which must be imposed on the market if it is to operate safely.

1. Those which ensure an adequate flow of information about the business whose securities are being traded.

2. Those which control the trading practices in the market. These define the role of brokers and dealers, set margin limits and control fees and commissions.

The most important regulation is the margin requirement, that is, the extent to which credit can be used to finance stock purchases, for excessive use of credit can have a bad effect on the market.

There is also a set of regulations which sets limits to issue prices of new stocks, determines the role of underwriters and describes the procedure for allocating new securities among prospective shareholders (ballots, rights issues, etc.)

Islam enjoins its followers to honour their contracts and prohibits them from gaining from coercion or deceit. The Qur’an describes those who are successful, both in this world and the next, as “those who faithfully observe their pledges and covenants” (23:8). A number of verses in The Qur’an command Muslims, and indeed all mankind, to refrain from coercion and deceit:

And eat not up your property among yourselves in vanity, nor seek by it to gain the hearing of judges that you may knowingly devour a portion of the property of others wrongfully” (2:188). “Lo! those who devour the wealth of orphans wrongfully do but swallow fire into their bellies and they will soon be enduring burning flame” (4:10).

Market Stabilization Fund

Market crashes are not always caused by speculative trading or deterioration in economic conditions. Purely psychological factors can be responsible. Even after appropriate safeguards to discourage speculation and to reform the regulatory environment are introduced, disruptions will still be able to occur.

In the Islamic financial system, to eliminate these wild swings in stock values and speculations, the Stock Market will have to be protected by a market stabilization fund. It will be non-profit-making and will draw its funds partly from the government and partly from the stockholders. This fund will have a pre-emptive right to purchase a certain percentage of public equity in all companies and its main purpose will be to stabilise the market.

o                  Screening Criteria of Islamic Investments

To ensure that the companies selected for investment are acceptable from the perspective of Shari’ah, a screening process is carried out to exclude stocks deemed unacceptable for investments, including alcoholic beverages and tobacco, gambling activities, pork, and arms manufacturing for other than defensive purposes. In addition to government and corporate bonds, Islamic funds also avoid high-geared stocks which pay excess interest on debts. As with ethical investment selection both positive and negative criteria can be used. Investment in conventional interest-based financial institutions may also be regarded as haram (non-permissible).  Rather theimplication is that each company should be examined on its own merits. Companiesthat are classified as being in acceptable industry groups may also be excluded ifthey have a significant ownership stake in, or derive revenue from, haram (nonpermissible)activities.

o       Pecuniary Screening

Most Islamic financiers accept that modern corporate capital structure inevitably includes some debt on the balance sheet and fixed-income liabilities. Portfolio investments in companies with low-interest income, and below-average debt-to-equity ratio have been declared acceptable by various Shari’ah advisory boards, providing profits are purified. This purification of investment obliges fund managers to determine what percentage of a company's profit is derived from interest-bearing accounts, and then giving it in Zakat, a religious "tax" paid to charities, or to other charitable organisations. But Islamic scholars differ in defining acceptable debt-to-capital ratio.

The criteria for selection outlined earlier are essentially qualitative in the sense that they involve judgment rather than precise measurement. However, quantitative criteria are also used when screening equities to ensure that they are Shari’ah compliant. These involve calculation of ratios, such as the proportion of interest bearing debt to assets or the ratio of total debt to the average market capitalization of a company over a period of 12 months.

In practice, fund management groups seeking to comply with the Shari’ah adopt several criteria, and there is disagreement and debate about what approach is most appropriate. First they examine the extent to which a company’s income is derived from interest, any proportion in excess of 15 per cent being unacceptable. The second criterion is to consider the extent of debt-to-equity finance, a proportion in excess of one-third being unacceptable Dow Jones of DJIM Indexes advocated tighter criteria in the I990s, with a limit of 25 per cent for the debt-to-capitalization ratio, but there was no consensus on this.

The FTSE Islamic Index adopts only one financial screen, excluding companies that have interest-bearing debt divided by total assets equal to or greater than one-third or 33.33 per cent. DJIM Indexes has three financial screens to exclude companies:

1. No Islamic investment if total debt divided by the trailing 12-month average market capitalisation is greater than or equal to 33 per cent.

2. Omit companies if the sum of cash and interest-bearing securities divided by the trailing 12-month average market capitalisation is greater than or equal to 33 per cent of revenues.

3. Exclude companies if the accounts receivable divided by the trailing 12-month average market capitalisation equal to or exceed 33 per cent.

Shari’ah neither allows short sales because the seller does not own the sold shares, nor purchase on margin, since the full price of the purchased shares is not paid. It does, however, allow the purchase of shares of companies whose primary function is not lending or borrowing on Interest like a conventional bank, or which do not deal in a prohibited item like alcohol, provided the full price is paid and the shares are actually delivered. The transaction should be interest-free, made without any coercion on either party, and there should be no uncertainty about the price, date and place of delivery. If the Stock Exchange is allowed to work freely without manipulation, which is the trait of an Islamic Stock Exchange, the price of the stock will reflect the true intrinsic worth of the company.

According to International Shari’ah scholar, Sheikh Yusuf Talal DeLorenzo, “four important points need to be kept in mind. Firstly, that the screens developed by our scholars are interim tolerance parameters or preliminary attempts to deal with issues of interest as these effect corporations and should in no way be considered the final word on any of these matters. Secondly, that these apply only to non- Muslim owned/operated companies. Thirdly, that this is not to be understood as an endorsement of these corporate practices. And, fourthly, that all impermissible income must be calculated and cleansed.”

On the acceptable debt-to-capital ratios, Sheikh Yusuf Talal DeLorenzo view is that these should in no way be understood as the final word on the matter. “This is because these ratios are the results of ijtihad or effort expended by qualified scholars of fiqh in disciplined academic research. As you know, recourse may be had to

ijtihad when there are no texts of direct relevance from the Qur’an or the Sunnah to indicate a Shari`ah ruling on a particular issue. Under such circumstances, it was the instruction of the Prophet, upon him be peace, to "exercise your learned opinion," or use ijtihad to arrive at a ruling. The rules governing the practice of ijtihad, the qualifications for practicing it, and the methodologies to be applied were developed by the jurists of the classical period. Then, within the limits of those rules, contemporary Islamic jurists have practiced ijtihad and arrived at the guidelines or screens for Shari`ah compliance of equities.” “In order to place a limit on the amount of interest that maybe tolerated in an Islamically-acceptable investment, scholars turned to ijtihad because there are no clear guidelines on the subject in the Qur’an or the Sunnah. Rather, they combed the texts of these revelational sources for something that might be considered of relevance, even if that something was mentioned in a different context. This is for there as on that evidence derived from the Qur’an or the Sunnah is stronger than the evidence of reason alone. This is a well-established legal principle; and this is why certain jurists, Abu Hanifah for example, held evidence from even a weak hadith to be more valid than the evidence of reason (qiyas) alone.”

 “Another of the screens prescribed by our scholars is that interest-based, non-operating income must be less than five percent of revenues. Now, it should be understood that the income of which we speak here is incidental income, or income separate of the income derived from the primary business of the company. The way this income comes about is that when companies receive payments for goods and services, they may not always be able to spend all of the money, and a cash reserve will begin to accumulate. Then, whether these reserves sit in bank accounts, or whether they are invested, short term, in interest-earning instruments like CDs, they will earn interest. It is this interest that we are concerned with. If it amounts to less than 5% of the company’s revenues, this too may be considered negligible. But, it must be calculated and cleansed. Fortunately, this sort of income is easily traces do in the balance sheets of corporations, and the matter of cleansing is relatively simple.”

“Finally, in regard to the screen on accounts receivable, the Shari`ah allows investing in shares of companies in which the primary business activity is deemed lawful if the accounts receivable do not represent the majority (more than 50%) of the total assets. Thus, if the primary business of the company is halal (permissible) and the sale methodology for obtaining corporate revenue is through installment payments, which may be deemed incidental or subordinate if the accounts receivable do not exceed 45% percent of the total assets, then investment in such a company will be permissible. It should be noted in this regard that if the receivables total more than fifty percent, the majority of the company’s dealings will actually be in money, and not in goods, services, and assets. “

“This position is consistent with the established and recognized Islamic juristic rule stating that what is not permitted independently may be permitted subordinately, cited in many contemporary fatwas (Shari’ah rulings). Therefore, if the accounts receivable do not exceed 45% of the total assets, consistent with the rule of majority determining ultimate judgment, an Islamic investor will not be prohibited from purchasing shares in such a company.”

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Comments 14 comments

rehanrehan 2 years ago

In depth analysis Business setup in can be an enriching experience. While much has been written on its influence on contemporary living, it is yet to receive proper recognition for laying the foundations of democracy. It still has the power to shock so called 'babies', whom I can say no more about due to legal restrictions.


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ZIa Ahmed khan 3 years ago from Kuwait Author

@irfan Muhammad - Thanks a lot


Irfan Muhammad 3 years ago

thanks very help ful


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ZIa Ahmed khan 4 years ago from Kuwait Author

@Cheetah - Thanks, yes modern currency which was de-linked from in 1992 is real problem of crisis and poverty. These are really printed papers which has no value just a commitment on behalf of printer of of the paper called currency, Islam does not accept the currency as it is in present forms, it has very clearly defined values equivalent in gold and silver. This is the only way to make system sustainable.In Just 40 years this system of fiat currency i.e.1972 onward is being questioned and responsible is financial crisis and poverty.


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cheetah786 4 years ago

Islamic financial system is very simple and our simple practices can eliminate the interest factor at all.

Islamic financial system is simple system and it should acceptable regardless of religion.

Roots of evil is the currency system of world that further make us to face the trouble of inflation, that in turn give rise to interest rates.

Modern Currency is the fake commodity, while we are taught in school that take money as real commodity.. we need some real solutions as alternates for the present currency system and banking systems..


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ZIa Ahmed khan 5 years ago from Kuwait Author

Thanks for your comments and support.


Bbudoyono profile image

Bbudoyono 5 years ago

Great hub, very informative. Thanks a lot for writing it.


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zishan 5 years ago

Great informative articles, nice efforts, zia khan sahib..


Rose Anderson 6 years ago

Hi,

As I see in your post there is lots of good information available on Islamic finance. Islamic finance has change a lot in the recent few years. Rest of the world specially American and European countries want to get advantage of these change in there own interest. Innovation of sukuk also one of the big reason that non Islamic countries look on the Islamic finance market.

Sukuk is an alternate way of investment where the investor get the benefits of investment and its treated as rent on investment, to avoid the interest on investment which is strictly prohibited in Islam.I have also some site and blog ,I have write on same topic check my post : http://portfolioanalyst.blogspot.com/2010/09/islam... http://portfolioanalyst.blogspot.com/2010/09/sukuk...

I want to write one guest post for your blog .If you agree than contact me at roseanderson26@gmail.com


islamic finance courses  6 years ago

There is no doubt that the Islamic market needs big bang which has grown considerably over the mainstream market does. If he wins the apparently tense relationship between the secular side of the business, ensuring Shariah compliance is a critical factor in the coming months.


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businessfinance 6 years ago

Very informative,so many new ideas has been opened here. Great post.


projectfinances profile image

projectfinances 6 years ago

Great hub...full of new ideas and information...


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ForexCashBack 6 years ago from Corvallis, Oregon

Thank you for publishing this hub! It is very informative and I found it enlightening. I have always been curious how Islamic Markets work considering that most western countries financial systems are based on charging interest rates to put more money in circulation and I have always wondered how a no interest rate financial system would work.

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