ROLE & REGULATION OF STOCK EXCHANGE IN AN ISLAMIC ECONOMY

ROLE & REGULATION OF STOCK EXCHANGE IN AN ISLAMIC

ECONOMY

Presenter: Mohammed Obaidullah, Economist, IRTI October 21, 2008

8th Distance Learning Course8th Distance Learning Course An Intermediate Course in Islamic

Economics

Part I: Common Stock in Islamic Finance

Part II: Ethics & Efficiency in Islamic Stock Market

Part III: Issues & Trends in Regulation

PLAN OF PRESENTATION

Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

Part I: Common Stock in Islamic Finance


Common Stock in Islamic Finance

• Common Stock and Mudaraba: Issue of Limited Liability

• Common Stock and Musharaka: Issue of Managerial Participation

• Common Stock and Sukuk


Conditions for Permissibility and Negotiability

• The main business of the company is not in violation of Shariah.

• If the company invests/ lends/ deposits its surplus funds in interest-bearing assets or borrows money on interest, it must not be “significant”

• If some income from interest-bearing accounts is included in the income of the company, the proportion of such income in the dividend must be given in charity.

• Stocks of a company are negotiable only if the company owns some non-liquid assets.


Common Stock in Islamic FinanceShariah Screens: Example: I (DJIM)

• Industry Type: Excluded are companies that represent the following lines of business: alcohol, tobacco, pork-related products, financial services, defense/weapons and entertainment.

• Financial Ratios: Excluded are companies whose:• Total debt divided by trailing 12-month average market

capitalization is 33% or more; Cash plus interest-bearing securities divided by trailing 12-month average market capitalization is 33% or more; Accounts receivables divided by 12-month average market capitalization is 33% or more.


FINANCIAL SCREEN

Subject to continuous change in the light of new insights ; Not to be taken as “divine” rules of Shariah compliance.

Example: One-third rule:• The Prophet PBUH advised Abu Bakr RAA not to

donate more than One-Third of his wealth, and commented that "One Third is too much (Al Thuluth Katheer)".

• Critics of the one-third rule assert that it involves an out-of-context use of the above hadith


Common Stock in Islamic FinanceShariah Screens: Example: II (S&P)

Sector-Based Screens• Business activities related to the following are

excluded: Pork; Alcohol; Gambling; Financials; Advertising and Media (newspapers are allowed, sub-industries are analyzed individually); Pornography; Tobacco; Trading of gold and silver as cash on deferred basis


Accounting-Based Screens•Debt / Market Value of Equity (12 Month average) < 33 %;•Accounts Receivables / Market value of Equity (12 Month average) < 49 %;•(Cash + Interest Bearing Securities) / Market value of Equity (12 Month average) <33%;•Non-Permissible Income other than Interest Income / Revenue < 5%•Dividend Purification Ratio: Dividends * (Non Permissible Revenue / Total Revenue)

Common Stock in Islamic FinanceShariah Screens: Example: II (S&P)


Part II: Ethics & Efficiency in Islamic Stock Market


• Allocational Efficiency• Pricing Efficiency• Informational Efficiency• Operational Efficiency

Ethics & Efficiency in Islamic Stock Market

Forms of Efficiency


•Freedom from Coercion •Freedom from Misrepresentation •Right to Equal Information •Right to Equal Information Processing Power•Freedom from Impulse •Right to Trade at Efficient Prices •Right to Equal Bargaining Power


Norms of Secular Ethics


• Freedom to Contract• Freedom from Al Riba

• Freedom from Al Gharar (Excessive Uncertainty)• Freedom from Al-Qimar (Gambling) and Al-

Maysir (Unearned Income)• Freedom from Price Control and Manipulation

• Entitlement to Transact at Fair Prices• Entitlement to Equal, Adequate and Accurate

Information• Freedom from Darar (Detriment)• Mutual Cooperation and Solidarity• Maslahah Mursalah (Unrestricted Public Interest)


Norms of Islamic Finance


• Merit Regulations Vs. Mandatory Disclosures• Price Fixation Vs. Free Pricing• Role of Intermediaries in Offer and Sale• Tender Method (Bai Muzayadah)

Genuine Bids Only (Prohibition of saum `ala saum akhihi)

• Underwriting Wholesale Purchase Followed by RetailBest Efforts UnderwritingRisk Transfer

Islamic Stock Market: Nature and Regulation of Primary

Market


Islamic Stock Market: Nature and Regulation of Secondary

Market


Speculation on Stock Markets:Co-operative or Zero-sum GamesThe Issue of Liquidity and Transaction Costs

Day TradingMargin Trading: Riba-based BorrowingStock Lending and Short SellingSettlement SystemInsider TradingTrading Halts

Allocational Vs. Operational Efficiency

Part III: Issues & Trends in Regulation


International organization of securities commissions (IOSCO)

Objectives And Principles of Securities Regulation For Islamic Securities Products 1.To ensure that markets are fair, efficient and transparent; 2.To protect investors; and 3.To reduce systemic risk These objectives are supported by the 30 core principles

“There is no need to formulate separate regulatory principles [as] IOSCO‟s objectives and principles of securities regulation can be applied to Islamic capital markets.”

Issues & Trends in Regulation


•Co-operation and information sharing between regulators • Accounting disclosures based on internationally acceptable standards (such as IFRS) in coordination with AAOIFI•Regulatory classification of Islamic securities products and their treatment in a fair, transparent and consistent manner•individual regulators to consider defining their position on Shariah compliance•Subject of PSIAs – an ideal area of further research in IF

IOSCO Recommendations


Other Standard Setting Bodies

Islamic Financial Services Board (IFSB) Covers banking, insurance and securities

regulationwide range of initiatives it has undertaken,

for example developing corporate governance standards for Islamic collective investment schemes, and capital adequacy requirements for Sukuk securitisations

Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)

Standards on accounting, auditing, ethics, Shariah and governance.


Key Issues in Islamic Stock Market Regulation

• How to maintain a linkage between financial and real sectors of the economy

• How to balance between concerns about allocational and operational efficiency


Thank You


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ROLE & REGULATION OF STOCK EXCHANGE IN AN ISLAMIC ECONOMY

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