Islamic Banking & Finance Page 21-02-2020

Islamic Capital Market

Islamic financial or Capital market is the market where the financial instruments are traded in ways that do not conflict with the Shari’ah principles; it plays an important role in generating economic growth and complimenting and broadening the Islamic banking. Islamic financial market transactions are required to be carried out in ways that do not conflict with the Shari’ah so that the market is free from activities prohibited by Islam such as excess encompassing Riba, Maysir and Gharar. Therefore, 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.

The objectives of the Islamic financial market are to ensure the equitable allocation of capital to sectors which would yield the best of returns to the owners of capital and to ensure that there exists sufficient investments opportunities to attract surplus funds in accordance with the owners’ preferences in terms of the extent of risk involvement, rate of return as well as the period of investment.

Equity-based securities that don’t guarantee any return and don’t include forbidden businesses can constitute investments in line with Islamic financial law. Whereas debt-based securities that carry a fixed return until maturity, such as debentures, bonds, preferred stocks and commercial paper, are inconsistent with Islamic principles and it would therefore be necessary for new instruments to be designed to replace them. Preferred stocks can match within the Islamic framework by turning them into redeemable equities with an element of participation in both earnings and the proceeds of liquidation.

However, debt and preferred stocks would be replaced by Islamic instruments. In fact, Islamic financial instruments have particular characteristics to comply with the Shari’ah rules, they should represent share in equity, real assets, usufruct or a combination of some or all of these, they should not earn money on debt and their holders must be the owners of whatever rights these instruments represent and bearers of all related risks. The tradability of an instrument related to a debt must in accordance with Shari’ah rules and it should not be allowed to earn any return. In addition, at the Issuance of Islamic financial instruments based on Mudarabah or Musharakah, the issuers should keep separate accounts for each specific project, 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 the profit and loss accounts must be declared at the date mentioned in the prospectus and balance sheets; the Principle and expected return on investment cannot be guaranteed. An example of fixed-return contract approved by the Shari’ah is Ijarah and it is possible to raise funds by this mean through the Stock Market and other financial markets like interbank.

Lease-stocks gives ownership to the stockholders of the leased equipment, from which they receive a known flow of rent. This is allowed in Shari’ah since they will have to borne the risk of the eventual value being much lower than what was estimated.

Stock market is one of the most important sources for companies to raise money. It is simply a central place where people come together to buy and sell stocks. 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. The companies involved must be publicly held companies; which mean that they have to be companies that sell stocks to public investors on an open market. In addition to acting as a market place for stock trading, stock markets also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller. This eliminates the risk to an individual buyer or seller that the counterparty could default on the transaction. In addition, stock markets provide an effective tool for controlling private sector performance, particularly that of public companies, and offers the facility for the exchange of information about investment opportunities to help improving investors’ decisions

The major activity in the Stock Market is the buying and selling of equity-based securities, that are, shares in businesses. These investments do not guarantee any return and the investor has an even chance of loss. Therefore, this activity is in line with Islamic financial law. But the true Islamic spirit demands two other conditions for an investment: first, the business invested in must not be one that is forbidden, and second, the entire capital structure of the firm must conform to Islamic financial principles. Debt-based securities such as debentures, bonds, preferred stocks and commercial paper also constitute an important proportion of the capital market. These types of securities carry a fixed return until maturity and are inconsistent with Islamic principles; it is then necessary for new instruments to be designed to replace them.

Arbitrage, hedging, speculation and options are not allowed in Islamic Capital Market. In case they are a mix of equity and debt than more than some % (as approved by Sharia Scholars of a particular Jurisdiction) are not allowed to be traded in the capital Market. Some have said that the interest-bearing debt-to-market capitalization ratio has to be less than 30% while others have said it must be less than 33.3%. Of course, the reason for this difference of opinion is that neither of these numbers (30% and 33.3%) has any real basis in either the Quran or Sunnah. Commonly used financial instrument and practices that are often considered haram are:  short selling or buying, use of derivatives like forwards, futures, options: swaps.

Dow Jones Islamic Market Index (DJIM), launched in 1999 in Bahrain, was the first index created for investors seeking investments in compliance with Muslim Sharia law.

In Pakistan Karachi Meezan Index (KMI-30) was introduced in 2009 and the base period for this Islamic index is 30 June 2008. It was created as a joint effort by the Karachi Stock Exchange (now known as Pakistan Stock Exchange) and Al-Meezan Investment Bank (now known as Meezan Bank Limited.

Some other notable other Islamic Stock Market indices are S&P 500 Sharia Index  FTSE ( Shariah Global Equity Index) MSCI Islamic Index Series: (Morgan Stanely Capital International) etc.

The MSCI World Islamic Index reflects Sharia investment principles and is designed to measure the performance of the large and mid cap segments of the 23 Developed Markets (DM) countries that are relevant for Islamic investors.