December 2013

Stock Exchange – Maqasidi view

Contents• First Part• Definition & Characteristics of SE• Functions of SE• Importance of SE• Second Part• Main Types of Stocks:

– Shares– Bonds– Options

• Third Part• Trading Mechanisms:

– Speculation– Short Selling– Margin Trading

• Conclusion

Definition and Characteristics• Is the venue or the means in or through which securities

trading takes place. Securities are issued by companies and governments and can take the form of shares (equity), bonds (debt) and other investment instruments such as, derivatives, ETFs…etc.

• Securities Markets are, in fact, free markets depend on forces of supply/demand to determine prices, and are operating under the supervision of official Regulators, which are primarily responsible for investors protection through ensuring fairness, transparency and integrity of the markets, and that they are free of cheating, fraud, ambiguity, rumors and gambling, and where the price is determined transparently by the forces of supply and demand.

Functions• It is the venue where companies and governments can

constantly acquire long-term finance, in contrast to banks which provide only short-term finance.

• It facilitates the price discovery process i.e. investors can know the prices of financial assets through the market.

• It spreads risk amongst large number of investors, and therefore, it adds to the stability of the financial system.

• It enhances corporate governance and financial disclosure standards.

• It is a good source of liquidity, thus play an important role in reducing liquidity risk.

• It represents an exit window, as it gives investors the discretionary right to sell their securities at any time, which helps to reduce liquidity risk.

Importance• Encouragement of savings, investments and mobilization of funds. A

Securities market play an important role in mobilizing national savings and direct them in the investment channels to support the national economy, and increase the rates of growth and prosperity which will eventually benefit the society as a whole.

• Source of Long-Term Funds. Securities markets (through both its primary and secondary components) are considered to be one of the most important source of funds for companies to obtain the necessary funding for the establishment and expansion of businesses.

• Price discovery. The stock exchange plays an important role in determining the equilibrium prices (or fair prices) for securities listed therein.

• Risk management. stock exchanges help to reduce the risk within the economy by spreading the risk among a big number of risk takers.

Stock Exchange – Public Interest (Maslaha Mursala)

• Maslaha Mursala: Public interest that has no textual authority on its validity or otherwise.

• Conditions: – Not in conflict with Sharia’h– Genuine– General– Doesn’t involve Hardships

Can we consider Stock Exchange Maslaha Mursala?

Main Types of Securities• Shares (Equity) The capital of a stock-company is distributed

into shares. Each share represents a part of ownership and is offered for sale in order to raise capital for the company.

• Shares can be classified according to Sharia’h permissibility into 3 categories:– Shares of companies which are involved in totally permissible

activities – In this case owning those shares is permissible from Sharia’h standing. What about Shares of Islamic Banks where receivables 75%?

– Shares of companies which are involved in totally impermissible activities – In this case owning those shares is prohibited by Sharia’h.

– Shares of companies for which their core business is permissible but they have some impermissible activities such as financing core business (which is permissible) through conventional debt.

3rd Category• The jurists’ opinions regarding the third category still

controversial, at one end some, including OIC Fiqh Academy, advocate that it is impermissible to invest in those stocks, based on a number of sources such as, the various Qura’n verses which prohibits Riba, Prophet’s PBUH Sayings (Ahadeeth) and some Fiqh maxims like the one which stipulates “If the lawful (Halal) mixed with the unlawful (Harram), then the unlawful dominates”.

• At the other end of the spectrum, some advocate that it is permissible to own those companies but under some conditions. In fact, the promoters of permissibility have referred to a number of sources also, such as, the Fiqh maxim that says “That which is independently impermissible becomes permissible when done in conjunction with the permissible” and the other Maxim which says “What is Inescapable is Tolerable”.

Islamic Index – QE Alrayan Index

Types of Securities – Cont’d• Bonds (RIBA) Bonds are the second major security listed

in Stock Exchanges. A bond can be defined as certificates of equal value issued by companies and/or countries, and represents a short or long term loan/financial claim on the issuing entity to repay its face value as well as fixed accrued interest in specific dates.

• Options (Gharar/Gambling) Option is a contract between two parties whereby one party (writer/seller) has an obligation to fulfill the contract and the counterparty (holder/buyer) has the right (not the obligation) to exercise the option at a pre-agreed price over a certain period of time. ZERO Sum Game

Trading Mechanisms - Speculation• Speculation is the investment activity whereby an investor is

willing to tolerate a high risk with regard to high-frequency trading in the stock exchange.

• The speculator is the investor who owns a relatively large capital outlay and has a diverse portfolio of securities and trades securities on a high frequency basis over the short term, which does not exceed hours or few days maximum.

• This type of investment involves a high level of risk and uncertainty about the profits or losses in the short term, but usually speculators have sufficient market experience as well as reasonable knowledge of how to read and analyze financial statements of listed companies, in addition to applying technical analysis and charting to shares prices and indexes.

Speculation Paradox• On one hand, some blame speculators for price manipulations, spreading

rumors, increase prices volatility and ending up having price bubbles in stock markets. (Excessive Ghaban)

• On the other hand, it is argued that speculative trading as an activity in itself does not constitute damage to the stock markets, but on the contrary, this activity provides the liquidity needed by those markets, since the speculator is always ready to buy or sell securities at any time during the trading session from the rest of the transacting parties in the market. (Slight Ghaban)

• Opinion: Legitimate speculation helps, very often, to restore the balance between supply and demand, and reduces price fluctuations in the securities markets as well as playing an important role in determining the equilibrium price (fair price) of the listed securities. Also, speculation makes stock markets liquid and enable them to act as Exit windows to investors, consequently, this will encourage savings and investments through the primary and secondary segments of the capital market. (Slight Ghaban can be tolerated)

Trading Mechanisms – Short Selling

• Short-selling is the sale of a security by a seller who doesn’t own such security and borrows it on the anticipation that its price will decline and he/she will buy it after a period of time at the lower price to make profit.

• From definition, we can deduce that short-selling involves two issues i.e. (i) selling what is not owned (Gharar) and (ii) securities lending and borrowing (Riba).

Trading Mechanisms – Short Selling• From reviewing Fiqh literature we can deduce that selling an

object by a seller who doesn’t own it is prohibited mainly due to “Gharar” and its implication of potential disputes that may arise between the buyer and seller in this case. But, since in today’s market this transaction is regulated by the market authorities and clearing houses (CCP) to always guarantee the delivery of securities from seller to buyer, regardless, then we can deduce that this issue has become irrelevant in present markets.

• The second issue of borrowing the securities is the real issue in short-selling transactions. Securities are considered as fungible and homogenous assets as money, thus, they are subject to Riba rulings, and since securities lending and borrowing contracts are executed based on a paid fee/interest to the lender, then it should be prohibited in Islamic securities market.

Trading Mechanisms – Margin Trading• Securities can be bought on credit offered by brokerage

companies to their clients. In this case, the buyer contributes part of the purchase amount, let’s say 40% (initial margin) .The Brokerage Company finances the other 60% for an interest and takes the bought securities as a collateral.

• If prices of the bought securities decline the brokerage company asks the buyer to replenish their account, this is referred to as a margin call, if the buyer doesn’t pay the required amount the broker has the right to sell the collateralized securities to cover the unpaid part of the account.

• Obviously, this transaction is impermissible from Sharia’h perspective as it involves interest (Riba).

Conclusion• Stock markets, in general, have genuine importance for countries’ economies.

They facilitate funds mobilization from surplus units to deficit units. They help in spreading risks amongst a big number of risk takers. And, they provide a place and means for assets’ price discovery. Definitely, Islamic stock markets are no different and Muslim countries should encourage the establishment of such Sharia’h compliant markets for the benefit of their people.

• Islamic stock markets should have built-in regulations to guarantee that listed securities and trading mechanisms are Sharia’h compliant.

• In principle, the investment in company’s common shares is permissible unless companies are dealing in non-sharia’h compliant businesses, or their screenings don’t comply with the well-known Sharia’h Indexes criteria.

• Bonds as a debt security cannot be listed in Islamic stock markets and can be replaced by Sukuk.

• Reasonable ‘legitimate’ speculations are accepted and needed for the success of Islamic stock markets. (Slight Ghaban can be tolerated)

• Short-selling cannot be facilitated by Islamic stock markets, not because Gharar but because the SBL mechanism which is based on interest/Riba

• Margin-trading cannot be facilitated by Islamic stock markets as they involve interest-based loans.

Thank You

Q & A