Islamic Finance Market

Islamic Finance Market www.ziaahmed.org Islamic Finance Market By: - Zia Ahmed zia@ziaahmed.org www.hhrdevelopment.com www.hhrdevelopment.com zia@ziaahmed.org Page 1 of 31 Islamic Finance Market www.ziaahmed.org INDEX 1. Definition of Financial Market................................................................. 3 1.1. Financial Market Instruments ........................................................... 4 Capital Markets.................................................................................... 4 Financial Instruments ........................................................................... 4 Negotiability of Financial Instruments ..................................................... 5 Role of the Primary Market .................................................................... 5 The Role of the Secondary Market .......................................................... 6 2. Islamic Approach for the Financial Market................................................ 7 2.1. Objectives of Islamic Financial Market ............................................... 9 2.2. Limiting the Liability ..................................................................... 10 3. Capital and the Stock Market ............................................................... 11 3.1. Islamic Finance and the Stock Market.............................................. 12 3.2. Equity-Based Securities ................................................................. 12 3.3. Debt-based Securities ................................................................... 12 3.4. Preferred Stocks........................................................................... 12 3.5. Potential Problem Areas ................................................................ 13 Speculation ....................................................................................... 13 Information Disclosure Standards......................................................... 14 The Regulatory Environment ............................................................... 14 Market Stabilization Fund .................................................................... 15 4. Screening Criteria of Islamic Investments.............................................. 16 4.1. Pecuniary Screening ..................................................................... 16 5. Commodities and Foreign Exchange Markets.......................................... 20 6. Derivatives Market ............................................................................. 24 6.1. Arbitrage, Hedging, Speculation, Options, Repos Trading ................... 25 6.2. Arbitrage..................................................................................... 26 6.3. Hedging ...................................................................................... 27 6.4. Speculation ................................................................................. 27 6.5. Options ....................................................................................... 28 6.6. Repos Trading.............................................................................. 29 6.7. Acceptable Risk ............................................................................ 29 www.hhrdevelopment.com zia@ziaahmed.org Page 2 of 31 Islamic Finance Market www.ziaahmed.org 1. 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 longterm 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. The financial markets can be divided into different subtypes: • Capital markets which consist of: o Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. o Bond markets, which provide financing through the issuance of Bonds, and enable the subsequent trading thereof. • Commodity markets, which facilitate the trading of commodities. • Money markets, which provide short term debt financing and investment. • Derivatives markets, which provide instruments for the management of financial risk. o Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market. • Insurance markets, which facilitate the redistribution of various risks. • Foreign exchange markets, which facilitate the trading of foreign exchange. www.hhrdevelopment.com zia@ziaahmed.org Page 3 of 31 Islamic Finance Market www.ziaahmed.org Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages. 1.1. 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. Financial Instruments The capital market provides both overnight and long term funds and uses financial instruments with long maturity periods. The following financial instruments are traded in this market: • Equity instruments • Credit market instruments • Derivative instruments • Foreign exchange instruments • Hybrid instruments www.hhrdevelopment.com zia@ziaahmed.org Page 4 of 31 Islamic Finance Market www.ziaahmed.org • Insurance instruments In today's financial marketplace, financial instruments can be classified generally as equity based, representing ownership of the asset, or debt based, representing a loan made by an investor to the owner of the asset. Foreign exchange instruments comprise a third, unique type of instrument. Different subcategories of each instrument type exist, such as preferred share equity and common share equity, for example. Negotiability of Financial Instruments As the financial markets function with the help of financial instruments through which financial resources are mobilized and invested, these instruments require to be negotiable. The negotiability means that these instruments can be bought and sold and ownership of instruments transferred from one person to another through the act of buying and selling between a party who wishes to invest surplus funds and the holder who is willing to dispose of a particular instrument. The examples of negotiable instruments are cheques, certificates of deposits, promissory notes, banker acceptances, bonds, etc. Role of the Primary Market In the primary market, securities are issued on an exchange basis. The underwriters, that is, the investment banks, play an important role in this market: they set the initial price range for a particular share and then supervise the selling of that share. Investors can obtain news of upcoming shares only on the primary market. The issuing firm collects money, which is then used to finance its operations or expand business, by selling its shares. Before selling a security on the primary market, the firm must fulfill all the requirements regarding the exchange. After trading in the primary market the security will then enter the secondary market, where numerous trades happen every day. The primary market accelerates the process of capital formation in a country's economy. www.hhrdevelopment.com zia@ziaahmed.org Page 5 of 31 Islamic Finance Market www.ziaahmed.org The primary market categorically excludes several other new long-term finance sources, such as loans from financial institutions. Many companies have entered the primary market to earn profit by converting its capital, which is basically a private capital, into a public one, releasing securities to the public. This phenomena is known as "public issue" or "going public." There are three methods though which securities can be issued on the primary market: rights issue, Initial Public Offer (IPO), and preferential issue. A company's new offering is placed on the primary market through an initial public offer. The Role of the Secondary Market The secondary market is a market for used goods where one investor can buy a security from other investors instead of the issuer. All the securities are first created in the primary market and then, they enter into the secondary market. Banking thrives on the existence of secondary financial markets. The commercial banks invest in very short-term financial assets, which they can convert into cash very quickly at negligible conversion cost. There are several ingredients of a secondary financial market: financial papers, dealers, and financial institutions. Various kinds of financial assets such as securities, bonds, shares, debentures, commercial papers are the financial instruments. Merchant banks, investment banks, mutual funds, investment funds etc. are the financial institutions. Then, there are a large number of buyers and sellers who deal in these financial papers. The establishment of an efficient secondary market will be crucial to the smooth functioning of PLS investment. There are two main reasons for this. 1. It is difficult to value the underlying assets and their earning potential, particularly for small periods or during the gestation period. No such problem arises in the case of debt contract, since the earnings and time schedule are agreed at the beginning of the project. www.hhrdevelopment.com zia@ziaahmed.org Page 6 of 31 Islamic Finance Market www.ziaahmed.org 2. Long-term PLS financing outside the Stock Market may also be illiquid, which discourages investors. This is not peculiar to PLS, but, together with item I above, it can cause further difficulties. The secondary market can provide the valuation method and, by making trading possible, solves the liquidity problem. Contracts made by financial intermediaries can be listed on the Stock Market and traded just like primary securities and their value will be available at all times. Thus the existence of the secondary market solves both the problems mentioned above. The elimination of a known cost of capital is replaced by a mechanism which continuously updates the value of capital and gives adequate opportunities for risk transfer through the trading of ownership. 2. 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 www.hhrdevelopment.com zia@ziaahmed.org Page 7 of 31 Islamic Finance Market www.ziaahmed.org 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. 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, www.hhrdevelopment.com zia@ziaahmed.org Page 8 of 31 Islamic Finance Market www.ziaahmed.org 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. 2.1. 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. www.hhrdevelopment.com zia@ziaahmed.org Page 9 of 31 Islamic Finance Market www.ziaahmed.org 2.2. 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. Limited companies are of two types, namely, private or public. In a private limited company, the number of shareholders is usually small. In many countries, the law makes it obligatory for a limited company to invite the general public to subscribe to the company’s capital if the number of shareholders reaches a certain point, say, 50 shareholders. Then it becomes a public limited company. Whether its shares will be quoted on the Stock Exchange(s) or not is the company’s decision, subject to approval by the Stock Exchange authorities, if the share is to be quoted on Stock Exchange. www.hhrdevelopment.com zia@ziaahmed.org Page 10 of 31 Islamic Finance Market www.ziaahmed.org 3. 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 acts as a platform for companies to raise money for their business and investors to invest in securities. When both the buyers and sellers in stock markets are institutions, rather than individuals, the stock market principle is more institutionalized. The emergence of this institutional investor concept has brought some improvements to stock market operations around the world. 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 www.hhrdevelopment.com zia@ziaahmed.org Page 11 of 31 Islamic Finance Market www.ziaahmed.org 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. 3.1. 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. 3.2. 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. 3.3. 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. 3.4. 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, www.hhrdevelopment.com zia@ziaahmed.org Page 12 of 31 Islamic Finance Market www.ziaahmed.org 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. 3.5. 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 www.hhrdevelopment.com zia@ziaahmed.org Page 13 of 31 Islamic Finance Market www.ziaahmed.org 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. www.hhrdevelopment.com zia@ziaahmed.org Page 14 of 31 Islamic Finance Market www.ziaahmed.org 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 www.hhrdevelopment.com zia@ziaahmed.org Page 15 of 31 Islamic Finance Market www.ziaahmed.org right to purchase a certain percentage of public equity in all companies and its main purpose will be to stabilise the market. 4. 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 the implication is that each company should be examined on its own merits. Companies that are classified as being in acceptable industry groups may also be excluded if they have a significant ownership stake in, or derive revenue from, haram (nonpermissible) activities. 4.1. 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-toequity 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 www.hhrdevelopment.com zia@ziaahmed.org Page 16 of 31 Islamic Finance Market www.ziaahmed.org 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 interestfree, 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 www.hhrdevelopment.com zia@ziaahmed.org Page 17 of 31 Islamic Finance Market www.ziaahmed.org 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 www.hhrdevelopment.com zia@ziaahmed.org Page 18 of 31 Islamic Finance Market www.ziaahmed.org 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, nonoperating 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 www.hhrdevelopment.com zia@ziaahmed.org Page 19 of 31 Islamic Finance Market www.ziaahmed.org 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.” 5. Commodities and Foreign Exchange Markets The commodities market is an exchange for buying and selling commodities for immediate delivery or future delivery. The trading of commodities consists of direct physical trading and derivatives trading on the basis of spot, futures and forward In order to minimise the risk of uncertainty of prices in the future: (1) Spot trading is any transaction where delivery either takes place immediately, or if there is a minimum lag, due to technical constraints, between the trade and delivery. Commodities constitute the only spot markets which have existed nearly throughout the history of humankind. In a spot transaction, both the commodities (in conventional market, currency is also considered a commodity) and its price should be exchanged simultaneously. Spot sales are most common in the Islamic, as well as the international, markets. (2) A forward contract is an agreement between two parties to exchange at some fixed future date a given quantity of a commodity for a price defined today. The fixed price today is known as the forward price. In a Forwards market the currency or commodity is sold for a future date and the delivery of the article, as well as payment of the price, are deferred. However, the specifications of the article, time and place of delivery, as well as the currency and amount, are all settled at present. So the seller is hedged against any fall in price of the article, and the buyer is assured of the supply on time, as well as covered against a possible increase in price by the time he needs the article. Islamic Forward Contracts are made with the express intention of delivering the currency on the specified future date. In common practice it is called a ‘sale’, but in Islamic law it is only a promise to sell rather than an actual sale Forward dealing transaction has always been a difficult proposition for Islamic banking as most of the attributes in dealing in future dates contradicts the www.hhrdevelopment.com zia@ziaahmed.org Page 20 of 31 Islamic Finance Market www.ziaahmed.org Shari’ah rules of certainty and transparency, as well as any contracts that deals with speculation or uncertainty (gharar) and gambling (maysir), are deemed as “prohibited. While there are contracts that caters for future transactions such as the Bai Salam and Bai Istisna’a, but those never really took off in a big way due to the restrictive conditions imposed for such contracts. In a conventional forward contract where both payment and delivery is made at a future date is deemed un-Islamic, as the transaction is agreed and binding whereas both payment and delivery remains uncertain. The conventional “deferred contract” therefore carries the potential losses to one party. Generally, the forward purchase is not considered to be permissible as it contravenes the general rule ‘do not sell what you do not own’, an established principle of Islamic jurisprudence. Therefore the normal contract for shorting shares is not permissible under Shari’ah rules. However, Forwards as such are common to human economic activities, so they are not new. Tradable forwards were known since the time of Imam Malik (179H, circa 800G) in Madinah, where Salam (forwards) contracts where allowed by the Maliki School to be traded in a secondary market (e.g. al-Dharir [12]). However, forwards involving essential food commodities (wheat, barely, dates and salt) were not allowed to be traded in a secondary market, following the instruction of the Prophet that food cannot be sold without being possessed in advance. In other words, tradable forwards in principle were known and established more than 1200 years ago. But these futures differ from contemporary futures in two fundamental aspects: advanced payment and delivery. In all Salam contracts, the full price must be paid in advance. Further, the underlying commodity must be delivered at maturity, and there are several restrictions on subsequent canceling and settling of the contract without delivery. These two sets of conditions prevented the contract from being used for pure speculative purposes, whereby it ends up in exchanging money for money, a result that Muslim scholars unanimously consider to be void and null. www.hhrdevelopment.com zia@ziaahmed.org Page 21 of 31 Islamic Finance Market www.ziaahmed.org Prophet Muhammad provided the price, quality, quantity and period of delivery are specified at the time of transaction. Based on this principle, it is lawful to perform forward sales which are exactly what one does in the Commodity Market. However, one often does not take delivery of the commodity purchased. This raises the doubt whether subsequent transactions are allowed or not. Commodity markets are widely used for a transaction called Tawarruq. This is the purchase of a commodity on credit and the sale to a third party at spot for a lower price – two sales contracts replicating exactly a conventional loan. Treasuries of Islamic financial institutions in particular rely on this method to manage their assets and liabilities. The approach is highly disliked among academics and practitioners but Islamic finance still lacks an elegant solution to meet this necessity. There are several contracts that create deferred obligations that are permissible in Islamic Banking. The ones that are commonly used are: • Murabaha (cost plus mark-up). • Bai Muajjal - Deferred payment of goods which are delivered upfront. • Bai Salam - Payment upfront or in advance for delivery of goods in future for which a regular market exists and involves short-term positions • Bai Istisna’a - Payment upfront or in stages for manufacture and/or delivery of goods in future involving long-term positions. • Arbun - A non-refundable down-payment for right to buy and sell an asset in a certain time in future. • Wa’ad (promise) (3) A futures contract has the same general features as a forward contract but is transacted through a futures exchange. Commodity and Futures contracts are based on what’s termed "Forward" Contracts. Early on these "forward" contracts (agreements to buy now, pay and deliver later) were used as a way of getting products from producer to the consumer. These typically were only for food and agricultural products. Just like the price of bananas at the grocery store, the prices of buyer of the futures contract makes money, because he gets the www.hhrdevelopment.com zia@ziaahmed.org Page 22 of 31 Islamic Finance Market www.ziaahmed.org product at the lower, agreed-upon price and can now sell it at the higher, market price. If the price goes down, the seller makes money, because he can buy the commodity at the lower market price, and sell it to the buyer at the higher, agreed-upon price. If commodities traders had to actually deliver the product, very few would do it. Instead, they can fulfil the contract by delivering proof that the product is held at a location or at a warehouse, by paying the cash difference, or by providing another contract at the market price. Forward contracts have evolved and have been standardised into what we know today as futures contracts. In the Futures market also the commodity or currency sold is agreed to be delivered/paid at a future date like in a forward sale, but there is a difference between the two. In a Forwards market, the article is actually delivered and the price is actually paid on the agreed future date, but in a Futures market, actual delivery or payment is very rare; only the difference in market price of the Item on the agreed future date and the contracted price is paid or received by the seller. The primary purpose of futures trading is not to receive or deliver the contracted goods but to minimise risks. Organised futures, where most contracts end up in settling price differences, are relatively recent phenomenon. The buyer of a Futures contract does not have to put up the full price of the contract at the time of purchase. As the delivery/payment never takes place, only the price difference is settled. One party gains, the other loses, and there is no benefit for the country’s real economy. A stronger party can also easily exploit small new investors. So the Shari’ah does not permit ‘Futures’ trading. While the Syariah Advisory Council (SAC) of Securities Commission Malaysia considers that Futures trading of commodities is approved as long as underlying asset is halal (permissible), Ustaz Ahmad Allam of the Islamic Fiqh Academy (14/5/1992) ruling is that “SIF trading is HARAM, since some of the underlying stocks are not halal. Until and unless the underlying asset or basket of securities in the SIF is all Halal; SIF trading is not approved.” Further, the prominent senior www.hhrdevelopment.com zia@ziaahmed.org Page 23 of 31 Islamic Finance Market www.ziaahmed.org Shari’ah scholar, Mufti Taqi Usmani, considers that “Futures transactions not permissible. For two reasons; i. According to Shari’ah, sale or purchase cannot be affected for a future date. ii. In most futures transactions delivery or possession is not intended. 6. Derivatives Market The derivatives markets are the financial markets for derivatives. In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk. These involve arbitrage, hedging, speculation and options. Theoretically, derivatives are supposed to distribute risk among market participants in accordance with their ability to assume them. If such distribution is achieved, each party would be better off, thus improving efficiency and productivity. Derivatives are thus the main instruments used conventionally to hedge various types of risk. But they are also the main instruments for speculation. How to balance the two functions is a major challenge to economists and Shari’ah scholars alike. M. Allais (1993) describes derivatives markets as “casinos where gigantic games of poker are played” (p. 35). One of the best know investor Warren Buffet also described that derivative is a ‘’time bomb, both for the parties and that deal in them and the whole economics system.’’ Derivatives are generally zero-sum exchanges between two parties. According to former Federal Reserve Chairman, Alan Greenspan (1999): “Overall, derivatives are mainly a zero-sum game: one counterparty’s market loss is the other counterparty’ smarket gain” (see also Group of Thirty, 1994, p. 64). Options and futures are examples of zero-sum games, since for every party who gains the counter-party loses (Investopedia.com; 12.2005). As such, derivatives are not “real” transactions since no transfer of ownership takes place. Only money changes hands at the end of the contract. Delivery of underlying assets is very rare; in futures, for example, 99% of all contracts are www.hhrdevelopment.com zia@ziaahmed.org Page 24 of 31 Islamic Finance Market www.ziaahmed.org settled before maturity (Pilbeam, 2005). For this reason, the Financial Services Authority of the UK defines derivatives as “contract for differences” (Swan, 2000, p. 11). 6.1. Arbitrage, Hedging, Speculation, Options, Repos Trading Risk is a challenge in both Islamic as well as conventional finance. On one hand experts and specialists agree that no economic growth can take place without taking risks. “Nothing ventured nothing gained” is the first principle of investment. Further, total absence of risk distorts incentives and hence deteriorates economic efficiency. Thus, risk is inevitable for economic progress. On the other hand, excessive risk will hurdle investment and deter growth. The question then becomes: How to reach a balance between these two ends? Islamic finance provides a general approach for reaching the answer to this crucial question. When it comes to for-profit transactions, risk cannot be separated from ownership of real goods and services. This is not because risk as such is desirable; in fact, it is exactly the opposite. An effective strategy to minimise and control risk is to have it integrated and embedded in real activities. In this manner, risk becomes naturally controlled by real economy. Arbitrage, hedging and speculation are also practised in the commodity and foreign exchange markets and must be compatible with the Shari’ah and the general principles of the trading in Shari’ah: a) The market in the Islamic economy works on the free will of buyers and sellers. The prices are determined by the free flow of supply and demand. Manipulation of prices is prohibited. b) Short sales i.e. sales before having legal ownership of the article in question, are not allowed. c) The quantity, specifications, price, time and place of delivery etc. of the article have to be specified. www.hhrdevelopment.com zia@ziaahmed.org Page 25 of 31 Islamic Finance Market www.ziaahmed.org d) Since trading is based on available information about the company, providing inaccurate Information is forbidden. Protecting public interest is supreme. e) Buying stock by paying part of the price in cash and borrowing the remaining amount from the broker at interest, called Margin Trading, is not allowed. As the increasing number of businesses is trading internationally, therefore, there is genuine need for them to hedge their positions against unexpected changes in market prices and exchange rates which may erode their profitability or make their purchases very expenses from other countries. To do so, Wa’ad (promise), Murabaha (cost plus mark-up) or Salam (advance payment) product structures could be used to hedge against these risks; however, these products are still in the age of infancy and not used widely because of the objections from many Shari’ah scholars. “Whenever taking risk is praised it is because of the added value and wealth creation that follows, not that risk as such is desirable. This represents a vital difference between legitimate and undesirable risk: Risk is legitimate when it is necessary for value creating. But when no value is added, it is a form of gambling. Risk falls into two categories: commercial risk, where one would buy a commodity in order to sell it for profit, and rely on Allah for that. This risk is necessary for merchants, and although one might occasionally lose, but this is the nature of commerce. The other type of risk is that of gambling, which implies eating wealth for nothing. This is what Allah and his Messenger (peace be upon him) have prohibited”. (Hedging in Islamic Finance by Sami Al-Suwailem; Occasional Paper No. 10, p 55, IRTI, Jeddah, KSA 2006) 6.2. Arbitrage The simultaneous purchase and sale of a currency in different markets, the one who is doing arbitrage makes money out of the very temporary difference in prices at two markets, and thus plays an economic role by stabilising the prices in different markets, as the difference in prices just cannot stay for more than a www.hhrdevelopment.com zia@ziaahmed.org Page 26 of 31 Islamic Finance Market www.ziaahmed.org few seconds in the highly sophisticated international markets. The Islamic law allows arbitrage if delivery is actually involved. 6.3. Hedging Hedging was a common (and sometimes necessary) practice of farming cooperatives that insured against a poor harvest by purchasing futures contracts in the same commodity. If the cooperative has significantly less of its product to sell due to weather or insects, it makes up for that loss with a profit on the markets, since the overall supply of the crop is short everywhere that suffered the same conditions. “Hedging is used generally to denote neutralising and minimising risk. In this respect, it naturally belongs to Islamic economic objectives. As such, this is not an issue and should not raise any concerns. The issue, however, is how to reach this goal, and what means is used to meat this end. If the means involves pure speculation and gambling-like activities, it would be illegitimate, even if the objective is. Ends do not justify means and thus noble ends necessitate noble means. Obaidullah (2005) rightly notes, “The provision of hedging facility is hardly an adequate rationale for tolerating qimar and maysir. The Shari’ah does not disapprove of hedging, since it brings in some maslaha. It is the zero-sum nature of the game that the Shari’ah finds objectionable, as in it lie the roots of social disharmony and discord.” (Hedging in Islamic Finance by Sami Al-Suwailem; Occasional Paper No. 10, p 175, IRTI, Jeddah, KSA 2006). To achieve legitimate hedging without maysir therefore is a challenge for Islamic finance in facing. 6.4. Speculation In everyday life a businessman watches the trend of events in the political, financial and economic field and makes a judgement about the level of prices in the near future. His purchases/sales are guided by the result of this mental exercise. This is called speculation. In Islam, genuine speculation is allowed, but professional speculation, where the speculator is not a genuine investor, is not allowed. His intention is just to exploit the situation. www.hhrdevelopment.com zia@ziaahmed.org Page 27 of 31 Islamic Finance Market www.ziaahmed.org Many mainstream economists and investors express concerns about the behavior of financial markets in general, which extends naturally to derivatives, as the most important tools for speculation. Keynes (1936) was among early economists who expressed dissatisfaction with gambling-like financial market: “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done”. (Hedging in Islamic Finance by Sami Al-Suwailem; Occassional Paper No. 10, p 159, IRTI, Jeddah, KSA 2006) 6.5. Options In its basic form, the idea of a stipulated sale with penalty is quite old. Arbun was one such contract, where the buyer would pay a down-payment with the condition that, if he cancels the contract, he would lose his down-payment. It was known since the time of the second Caliph Omar ibn al-Khat_ tab (22H, circa 700G) (al-Dharir [12]). Options are of three types, viz. ‘Call’, ‘Put’ and ‘Put and Call’. In a Call option the buyer has the option of buying at any time during the Call period at today’s price by paying a small premium called ‘Call Money’ to the other party (writer). If, during the Call period, the price goes above today’s price plus the premium paid, the option will be worth exercising. In a Put option the buyer has the option of selling at any time during the Put period at today’s price, by paying a small premium called ‘Put money’ to the writer. A Put and Call option gives the right to sell or buy. The majority of scholars do not allow options trading as both the delivery as well as the full price are deferred, and it can be very speculative, but some allow it as it involves a right for purchase/sale. The Islamic Fiqh Academy, Jeddah, has not approved options, as they do not come under any of the Shari’ah-nominated contracts. The Shar’iah also does not allow any premium for the option, as it is not an actual sale or purchase; it is only a right, which is an abstract object. www.hhrdevelopment.com zia@ziaahmed.org Page 28 of 31 Islamic Finance Market www.ziaahmed.org In Islamic banking, the closest to an option is the khiyar al-shart, or stipulated option contract. This also concerns itself with the temporality of an object, being a sale agreement in which one or both parties has 'the right to rescind an otherwise binding contract' (Vogel and Hayes 1998: 155) within a specified period of time from its commencement. The khiyar al-shart contract provides an analogical basis for other sorts of options contracts, and is a point of great debate within IBF circles. There is general agreement, however, that khiyar al-shart contracts are valid if and only if they remain linked to the object that is at issue in the proposed sale. In other words, the contract itself cannot be bought or sold. Given the conception of property as always containing within it a temporal quality, this view of the khiyar al-shart option makes sense. 6.6. Repos Trading The stock-holder sells his shares to a conventional bank for a certain price, along with a promise to the bank to buy back the shares after a specified period at a price which is higher than the price he received, the difference of the two amounts representing interest for the intervening period. In the Shari’ah, if the buy back is made a precondition for the original sale transaction, it is not valid. But if the buy back is not a condition in the contract, and the excess payment is voluntary, the transaction is valid. 6.7. Acceptable Risk Shari’ah scholars have discussed the conditions under which risk can be tolerated, and those under which it is not. Generally, they point that risk is tolerable if it satisfies the following conditions: 1. It is inevitable. 2. It is insignificant. 3. It is involuntary. The first condition implies that the same level of added value of the concerned activity cannot be achieved without assuming risk of loss or failure. www.hhrdevelopment.com zia@ziaahmed.org Page 29 of 31 Islamic Finance Market www.ziaahmed.org The second condition concerns the degree of this risk. It states that likelihood of failure shall be sufficiently small. Scholars were clear that likelihood of failure should be less than that of success in order for involved risk to be acceptable (alDharir, op.cit.). We shall see later how this condition distinguishes the Islamic approach from conventional, Neo-classical approach. The third condition follows from the first two. The objective of a normal economic activity is the value it creates, not the risk it necessitates. This risk therefore cannot be the intended part of the transaction. www.hhrdevelopment.com zia@ziaahmed.org Page 30 of 31 Islamic Finance Market www.ziaahmed.org We are click away zia@ziaahmed.org Development of Private Placement Memorandum Fund Document Shariah Compliant Fund Structure’s Sharial Compliant Acquisition Feasibility Studies All Your Corporate Finance Needs www.hhrdevelopment.com zia@ziaahmed.org Page 31 of 31