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Islamic Stock Market and Shariah

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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:

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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.