IS AN ISLAMIC STOCK MARKET VIABLE?
TONY NAUGHTON
Islamic banking, based on the prohibition of interest, is well-established throughout the Muslim world. Attention has now turned towards applying Islamic principles to stock markets. Common stocks are a legitimate instrument in Islam, but many of the practices associated with stock trading are not.
The instruments traded and the structure and practices of stock markets are examined from an Islamic perspective. Speculation is not acceptable in Islam and measures would have to be taken to control speculative trading. In addition, short selling and margin trading are severely restricted.
The use of a stock index and equity futures and options are also unlikely to be acceptable within an Islamic market. Regulatory authorities in Muslim countries will therefore find a vast array of problems in attempting to structure a trading system that will be acceptable.
A separate stock market, based strictly on Islamic principles, is still very much at an early stage of evolution.
Many Muslim countries, or those with a majority Muslim population, have well-established stock markets, e.g., Egypt, Indonesia, Malaysia and Pakistan, which are basically Western-style markets tolerating practices that may not strictly adhere to Islamic principles.
However, in Malaysia, Islamic stockbrokers and Islamic-managed funds operate, and a separate “Islamic Index” has been established, comprising 179 permissible stocks on the KLSE.
As a first step towards an Islamic stock market, it is desirable that the financial system be free of Riba, or interest.
Riba has a much wider definition than simply referring to interest. It encompasses all forms of exploitation and excessive charges in business dealings. Stock market trading lends itself to practices that can be construed as Riba, e.g.:
• Asymmetric information,
• Insider trading,
• Manipulation of stock prices,
• Qimar, or gambling, which covers speculation.
Related to speculation is the creation of excessive uncertainty, or gharar. Entering into a contract, in this case a purchase or sale of stocks, with another party when there is excessive risk associated with the transaction, is unacceptable. This may apply in a very volatile market.
Another issue is whether certain transactions could be construed as ikrah. This relates to imposing a contract on an unwilling party, or imposing conditions that are unacceptable to them. This could occur in derivatives written on stocks where one party to an option, or futures contract, may require
completion of a contract at a time that is unacceptable to the other party.
The issue of derivatives leads us to consider one final area – hedging, or insurance. The question to be considered is whether this practice is acceptable. Derivative markets also have an element of speculation, because a well-functioning derivatives market depends on the interaction of speculators and hedgers.
Market Efficiency
Efficiency is a difficult concept to define in the context of stock markets.
In connection with Islamic stock markets, a broader view of efficiency is appropriate, similar to the concept of social efficiency. This is the notion that financial markets in general, and stock markets in particular, should be efficient in the sense that they support social justice, equity and the well-being of society.
Stock markets may actually create social inefficiency by encouraging unequal distribution of wealth.
Rash speculation also creates systemic risk and can have a destabilising effect on the economy, e.g.:
• The Wall Street crash of the 1920s
• The Stock Market crash of 1987
• The collapse of the Kuwait Souk Al Manaqh in 1982.
Stock markets also provide opportunities for dishonest activity, such as insider trading. These can have an adverse effect on moral standards and business ethics.
Information asymmetry is also relevant here. Firms seek to keep confidential certain aspects of their activities while market analysts seek to elicit these through painstaking research to profit from it by trading in advance of the rest of the market. The existence of institutional investors with highly skilled analysts leads to a form of information asymmetry – ‘informed’ and ‘uninformed’ investors.
Acceptable Securities
Many modern financial institutions, such as security and derivative markets, or instruments such as shares, bonds, futures, options, swaps and the like, create problems in an Islamic economy. The reason stems from a lack of clear Sharia guidance on their acceptability.
The approach used in Islam to examine the acceptability of anything that is unclear is to break the issues into their components and consider each within available Sharia guidance.
Common Stock
Common stocks (ordinary shares) are basically Mudaraba, or profit and loss sharing certificates. Robertson (1933) traces their origin to medieval Muslim traders. The acceptability of common stock rests on:
• ownership,
• a right to share profits,
• a right to elect the directors and to vote at meetings of stockholders,
• residual risk taking.
It is difficult to fault common stocks as an Islamic instrument.
What is more likely to be at fault is the market in which they are traded, particularly relating to the capital gain from stocks. Wlhen a capital gain results from speculative actions, or price manipulation, it is extremely difficult to justify this return as legitimate.
Debt Securities (Bonds)
Traditional Western-style corporate bonds are likely to fail any test of acceptability. They are interest-based and pay a fixed return attributable to the period of the debt with penalties in the event of default.
However, Islamic enterprises will need varying amounts of short- and medium-term debt capital and diversified sources of funds.
Bond markets enable companies to access large-scale long-term finance at predetermined rates.
The corporate sector, within an Islamic economy, will require the facility of debt financing in the form of transferable securities. How then are they to be structured?
A ‘free’ loan in the form of a Qard-al-Hasana (benevolent loan) is one possibility and is already in use in Islamic finance. However, some may argue that its use in a commercial situation is against the spirit of the original concept of Qard-al-Hasana. It is also unlikely to be an adequate framework for the ongoing provision of large-scale commercial finance.
As a token, detachable warrants were also issued to subscribers. The warrants entitle holders to subscribe for shares in Petronas Dagangan Berhad at a fixed price at a future date.
The warrants do not form a part of the underlying IDS, because a predetermined return cannot be negotiated in a Qard-al-Hasana facility. Both the IDS and warrants are tradable securities. Subscribers to the IDS can trade the detachable warrants or hold them to maturity and subscribe for shares.
The answer to debt instrument financing is likely to lie in transforming traditional interest-bearing bonds into a facility that is transaction-based, e.g., Murabaha, or Bai’ Bithaman ajil.
The debt instrument is tied to a particular transaction or a series of transactions packaged together. Bond investors would initially buy the asset(s) and resell to the borrower at a price above the original cost. Repayment over a stipulated period of time would be structured in a similar way to a conventional bond-servicing schedule.
The emerging consensus is that transaction-based contracts providing a return to the lender are acceptable, irrespective of whether the return is fixed or not. Where the return on a transaction is a fair reward, it is permissible, even if that reward is related to the period over which repayment is to be made.
Preferred Stock
Preferred stocks are not a significant form of finance for companies today.
Preferred stockholders forego voting rights and participation in management, but rank above common stockholders in sharing the profits and receive a fixed dividend.
The surrender of voting rights and management participation is not a valid reason for receiving a fixed return from finance invested in a company. Hence traditional Western style preferred stocks are not acceptable.
Restructuring of preferred stocks to make them ‘participating’ is likely to be acceptable where the participation is not a fixed return on the original amount invested.
Alternatively, it may be possible to structure preferred stock issues as relating to transactions, along similar lines to that proposed above for bonds issues.
Listing on an Islamic Stock Exchange
What type of firm can list on an Islamic stock exchange? The answer appears simple – Muslim companies operating in permissible areas of business activity. Haram activities would be disqualified from listing.
But what of activities that could be considered Makruh, discouraged but not forbidden? Environmental degradation, e.g., the destruction of forests for logging without adequate replanting, may fall within this category.
It is unclear to what extent an Islamic stock market would also be a social arbitrator Perhaps it would remain with individual investors and ethical investment funds to filter out those stocks deemed not to match their particular perspective on these issues.
What about ownership? Would a firm where the major stockholders are not Muslims, but conduct their affairs in a way that does not contravene any of the principles of Islam, be permitted to list?
Also, should a firm having dealings with interest-based banks and financial institutions be allowed to list?
It does not appear unreasonable to impose a listing requirement that firms do not take part in any interest-based financial activities. But the modern large-scale business organisation is often a complex structure of subsidiary and associated companies. Partly owned associated companies may not be fully within the control of the holding company and may be involved in interest-based, or other unacceptable, activities.
Stockbroking Firms
A traditional stock exchange comprises members of firms that act as brokers for investors, market-makers and traders on their own account. Membership is usually restricted in accordance with strict entry requirements.
Such a structure does not seem to be unreasonable for an Islamic stock exchange, provided the rules for membership do not unduly restrict competition and adversely affect investors.
The ideal member will be an Islamic securities business that conducts its affairs in accordance with Islamic requirements. This will include the absence of Riba in its financial dealing and avoidance of speculation and other unacceptable activities.
Again, the question arises as to whether non-Muslim firms would be allowed, or even firms that interact with interest-based banks and institutions, or deal with traditional stock market trading.
Who can invest in Islamic Stocks?
Should non-Muslim institutions and individuals be permitted access?
Islamic banks generally deal with both Muslims and non-Muslim clients. Why then might we wish to restrict access to Islamic securities?
A major risk is margin trading financed by interest-based loans. Controlling unacceptable dealings would be extremely difficult, particularly when investors are foreigners.
The advantage of open access lies in the greater variety and liquidity that would be provided to the market.
Perhaps the answer is to build into the regulatory system trading rules aimed at eliminating unacceptable practices, with a strong regulatory body monitoring trading to ensure that the ethical standards of all investors are maintained.
Speculation and Price Manipulation
Speculation takes a number of forms, but underlying the practice is the fact that speculators are not concerned with the underlying commodity or security in which they trade.
A speculator will buy stock in anticipation of prices rising and hope to sell at the higher price before taking delivery. Such purchases are often financed on margins or other forms of borrowing. A speculator will sell in anticipation of prices falling. A short sale will involve the speculator selling the stock and subsequently buying it at a lower price, thereby completing the deal.
Related to speculation is the practice of arbitrage. An arbitrageur is a particular type of speculator who seeks to obtain a risk-free return by taking advantage of discrepancies in security prices.
It is clear from the writings of Islamic economists and scholars that speculation is unacceptable because of its association with gambling and excessive risk-taking.
In addition, speculation creates volatility. This undermines the orderly functioning of the stock market, while the profits of speculators are achieved at the expense of other investors.
Margin Trading
Margin trading is the purchase of stocks on credit using a margin account at a stockbroking firm – buying stock by paying part of the price in cash and borrowing the remainder from the broker at the margin interest rate.
The appeal of margin trading is the ability to magnify any gains on a transaction, but at the same time it magnifies any losses.
From an Islamic perspective, margin trading, as outlined above, is clearly unacceptable.
However, it is possible to construct non-interest-bearing financial contracts to achieve the same thing, e.g., Bank Islam Malaysia Berhad offers share financing through Mudaraba profit-sharing contracts.
However, this is a controversial field, as some Islamic writers argue for a complete ban on any form of margin trading.
Short selling
A short sale is simply the sale of a stock not owned by the vendor to take advantage of an expected decline in the price of the stock. When the price declines, the stock is purchased and the short position closed. To facilitate these transactions, the vendor’s broker will cover the sale by lending stock.
Generally, the Sharia does not permit the sale of any commodity the owner does not possess, but with certain exceptions, such as salam contracts.
Under a salam contract, a clearly identifiable commodity can be sold for future delivery provided the vendor has paid in full for the commodity in advance.
A short sale resembles a salam contract, but only involves part payment though a margin account. The vendor hopes to buy the stock at a future date at an amount below the selling price. The purchase price is not yet known and cannot be paid in full.
Insider Trading
The danger here is that insiders may trade on privileged information to the detriment of other investors.
The interests of small and vulnerable investors must be protected from unscrupulous activity by more powerful, and better-informed investors.
But it is also unfair to prevent directors and others from trading in a company’s stock. The point at issue is whether they use privileged information to make profits at the expense of other investors.
For an Islamic market, it may be appropriate to follow the USA. Insiders are free to trade in their company’s stock at any time. Because of the difficulty in proving whether an insider used confidential information to make a gain, all short-term profits are forfeited. Full and prompt public disclosure of insiders’ dealings is also required.
It has to be recognised that, even in highly developed stock markets, no matter how sophisticated the monitoring system, unscrupulous insiders will still attempt to make illegal profits.
Stock Index Futures
A potential problem of stock index futures in an Islamic context is that they do not have a clearly defined underlying asset, but are a dollar multiple of the stock market index. In addition, futures permit hedgers to shift price risks to speculators and hence futures depend on speculation, an unacceptable practice in Islam.
Stock index futures are a good hedging device for diversified stock market investors as futures prices are typically highly correlated with the underlying market. Without hedging devices, investors are forced to accept that the market will move.
Speculators buy and sell futures to make a profit without necessarily having any involvement in the cash market. They assume the risk of price fluctuation that hedgers are trying to avoid and contribute to liquidity.
However, speculation alone does not rule out the use of futures. Trading in common stocks may be for speculative reasons, but that does not invalidate stocks as an Islamic financial instrument. However, if we eliminate speculation from stock index futures in an Islamic stock market, the result is a contract that hedgers would find difficult to use.
Is hedging a legitimate form of activity in Islam? There are two dimensions:
• Hedging is a form of insurance. However, insurance as a concept is not totally forbidden in Islam. The motive for hedging is the protection of an underlying investment. Hedging is just one of the risk minimisation techniques used by investors.
• Hedgers do not intend to take delivery of the commodity on which the futures contract is based but typically close out before maturity. In the case of stock index futures, it is debatable whether there is even an underlying commodity. An index cannot be physically delivered, the end result is an exchange of money being the difference between the opening price and closing price on the day of maturity.
The 7th Council of the Islamic Fiqh Academy ruled that ‘trading in the futures, market where the contract concludes on a converse contract sale resulting in a settlement based on the difference in price is not permissible’.
Islam does not forbid an agreement to sell a commodity in the future although there are restrictions on how it is to be done. For example, the contract of Istisna provides for an agreement to manufacture a commodity where both delivery and payment will be in the future.
Options on Stocks
Stock options (also known as equity options) provide the right to buy or sell the stock of a particular company at a specified price over a particular period of time. The holder of an option has the right, but not the obligation, to buy, or sell, the stock whereas the seller of an option must sell, or buy, if the holder decides to exercise.
A simple strategy is to buy a call option on a company’s shares. The cost is the premium – substantially less than the cost of buying the stock. The buyer anticipates the stock will rise in price providing a profit on the option.
However, if the stock price remains unchanged, or falls, the maximum loss is known in advance, i.e., the premium paid. It is clear from this example that a call buyer anticipates the stock price will rise while the seller of the call expects the price to remain unchanged or to fall.
However, if the writer of the call option holds the underlying stock a simple hedging strategy is being followed. The premium received provides some protection against a drop in price of the stock, but without further hedging, rising prices expose the seller to unlimited losses.
Similar arguments can be made for put options.
Warrants are a particular type of call option issued by corporations, giving holders the right to subscribe for new shares in the issuer. Underlying a warrant is the potential for the holder to become an equity investor in the issuing company at some future date. Investors therefore have the potential to participate in the growth of the company without actually being a shareholder.
Even though options have uses as a hedging tool, it is difficult to justify their use in an Islamic context. The problem is essentially the same as with stock index futures, where settlement is by exchange of cash. Stock options do provide for the delivery of shares at the exercise date, but in practice this is rarely done.
Under strict conditions it may be possible to consider stock options as acceptable. For example, all call sellers and put buyers must be investors in the stock and only European-style options be permitted.
Under strict conditions it may be possible to consider stock options as acceptable. For example, all call sellers and put buyers must be investors in the stock and only Europeanstyle options be permitted.
Regulation of the Stock Market
It is usual to find two regulatory bodies: the ruling body of the exchange itself, and an independent supervisory body such as the Securities and Exchange Commission (SEC).
An Islamic stock market may also need a Sharia Council that can rule on the Sharia acceptability of financial instruments and dealings.
Consideration needs to be given to how this body is to be structured. Whether the Sharia council is part of the stock exchange, or part of the regulatory body, or even a second independent body, is a matter yet to be determined.
A major task of the regulatory bodies will be the control of speculation and other undesirable activity.
One commonly used technique, particularly in Asian markets, is the use of price limits on daily movement of stock prices. Price limits are used in the stock markets of Japan, Korea, Malaysia, Taiwan and Thailand. The objective is to limit the ability of speculators or manipulators to push the price too much in either direction in a short period.
In the New York Stock Exchange, a system of ‘circuit-breakers’, or trading halts, serve a similar purpose. When an imbalance is detected in trading, or where significant news is about to be released concerning a stock, the exchange can initiate a temporary halt in trading.
The evidence on the effectiveness of these forms of control is, however, not good.
Other areas deserving attention include the regulation of mergers and acquisitions and the pricing of initial public offerings of stock (IPOs).
We have reviewed a wide range of issues relating to the potential for a separate Islamic securities exchange. Many difficulties are envisaged, particularly relating to speculation, or contracts that have potential for speculative trading.
There are also a number of technical problems relating to contracts that do not unequivocally involve the purchase and sale of a commodity at a clearly defined price.
Many of the issues discussed imply that an Islamic stock exchange is likely to be a very different institution when compared with modern stock markets.
The absence of speculation, or at least strict regulations to contain it, is probably the main distinction. However, it is likely that any developments towards a separate market will be gradual.
The modern Islamic bank is little different to a conventional commercial bank in terms of the range of facilities and services offered to depositors and borrowers.
What distinguishes an Islamic bank from a conventional bank is the strict legal interpretation of the underlying contracts. Such an approach seems appropriate for Islamic stock trading, broking and the operation of the stock market.
While we must accept that speculation and related activity has to be contained, it is not inconceivable that futures and option contracts can be restructured to overcome the technical problems that at present inhibit their use. Developments in countries such as Malaysia indicate that considerable progress has already been made in this direction.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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