Financial Markets and Securities

Islamic approach to capital market requires adherence to Shari’ah principles. Most of the financial instruments in conventional markets involve interest, unfruitful speculation (Gharar) or even wagering (Maysir), which are prohibited in Islam. Thus, the first requirement of development of Islamic financial products is to assure that these do not violate Shari’ah. The activities of Islamic Financial Markets also need to be reviewed to check if they do not contravene Shari’ah principles. Finally, new institutions should evolve that are conducive to trading of Islamic financial products.

All economies have individuals and organizations which are either capital rich or deficient. Financial institutions provide the crucial role of intermediation and bring the two entities together for efficient flow of capital. Islam is supportive of this activity. The Islamic market must ensure that the capital flows efficiently, providing ample opportunity for investments with optimum returns based on risk preference of the investors. Primary instruments should be equity based which do not guarantee a return and are used for business activities not prohibited in Islam. Traditional debt instruments such as bonds, preferred stocks, commercial papers and others which carry a predetermined rate of return should be replaced with new Shari’ah compliant instruments.

The securities or instruments should be based on equity, real estate, usufruct or a combination. These instruments should be negotiable at market price with no earnings on debt. If debt is made negotiable it should be based on Hawalah principles. Shari’ah scholars do not allow the sale of debt for profit but permit its transfer at face value. In case of mixed portfolio, the rules for the dominant component would prevail. If securities are based on Mudarabah or Musharakah, the security of principle or expected return should not be guaranteed. If the instrument is for a specific purpose, the documents must be transparent in terms of nature of the project, participants, and profit ratios. In case of multiple projects, the earnings or losses for each project must be declared separately. The investors in Islamic instruments become owners and enjoy the rights and risks pertaining to the assets.

The Islamic financial markets also require a pricing mechanism to prevent major shocks and crises such as what happened in the Western markets in 1929, 1987, and early 2000s. For this purpose the regulators need to review speculation, information disclosure standards, and trading practices. Uncontrolled speculation can cause wild swings in the market without benefiting the economy. This is very similar to gambling where one set of players lose while others gain with no gain for the economy. The information disclosures safeguard against insider trading to make sure certain people are not benefiting at the expense of investing public. The review of trading practices define roles of brokers and dealers, and set margins, fees, and commissions to make it a level playing field.

The conventional stock market would require certain changes to conform to Islamic principles. We can begin by looking at the current practices in the light of Shari’ah and see what, if any changes are required for each.

Equity Based Securities constitute shares in one company or fund consisting of a diverse groups of companies based on a risk and earnings profile. There is no guarantee of return and even the entire capital is at risk of loss. This securities are in line with Islamic principles as long as the businesses invested in are not involved in prohibited activities and the capital source of the company or companies is not interest based.

Debt-based Securities include debentures, bonds, and commercial paper. These are convertible and negotiable instruments which carry a predetermined interest rate to maturity. Due to the involvement of interest , these are against Islamic principles and new instruments would be needed to replace these.

Preferred Stock is a combination of debt and equity. In case of business failure, preferred stock owners get priority of claim over ordinary stock holders. Sometimes, they also get priority over dividends. Both of these features are contrary to Shari’ah. Other arrangements will have to be sought for distribution of dividends and proceeds of liquidation to bring preferred stocks into the fold of Shari’ah.

Since most of the securities in Islamic financial system would be based on profit and loss sharing, there is more of need to protect against speculation and market crashes. A major financial crises could be detrimental to well being of the Islamic system since most capital is equity based. Three key areas are cited for protecting against market crashes: speculation, information disclosure standards, and operating and trading practices.

Speculation arises from expectations of the market players which is not necessarily tied to the economic well being of the company. Overvalued companies attract more investment thus increasing the market cap. It has been observed that high tech companies such as Apple or Cisco will sometimes exceed in market cap over ExxonMobil or General Motors even though the intrinsic value of high tech company is much lower than the assets of an established company. Speculation cannot be eliminated as long as there is market to trade securities. Unregulated speculation could cause market crashes. But, controlling speculation would negatively impact the market efficiency.

The information disclosures safeguard against insider trading to make sure certain people are not benefiting at the expense of investing public. Equity investors require public information about a company to make informed decisions. This also includes any large movement of shares of the company. However, all information cannot be provided to the public which results in some people having privileged information.

The market requires regulations for trading practices to define roles of brokers and dealers, and set margins, fees, and commissions to make it level playing field. Unregulated margin trading on credit can have a profound effect on share prices. Rules are also required for issue of new stocks, underwriting, and allocation of new stocks.

Equity based Islamic financial products would require a balance of regulations for stability against efficiency of trading. The pricing and commissions should be left to the market to promote efficiency. Besides the controls available in the developed world, some other mechanisms may be required. These include review of market makers, large trading houses, program trading houses, and also availability of a market stabilization fund. However, it has been proven in the recent past, as in 2008 crisis, that equity based Islamic financial products are more robust than debt based instruments.