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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

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Part I: Common Stock in Islamic Finance

Part II: Ethics & Efficiency in Islamic Stock Market

Part III: Issues & Trends in Regulation

PLAN OF PRESENTATION

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Part I: Common Stock in Islamic Finance

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Common Stock in Islamic Finance

� Common Stock and Mudaraba: Issue of LimitedLiability

� Common Stock and Musharaka: Issue ofManagerial Participation

� Common Stock and Sukuk 

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Conditions for Permissibility andNegotiability

� The main business of the company is not in violation ofShariah.

� If the company invests/ lends/ deposits its surplus funds in

interest-bearing assets or borrows money on interest, it mustnot be ´significantµ

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

� Stocks of a company are negotiable only if the company ownssome non-liquid assets.

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

� Industry Type: Excluded are companies that represent thefollowing lines of business: alcohol, tobacco, pork-relatedproducts, financial services, defense/weapons and

entertainment.

� Financial Ratios: Excluded are companies whose:

� Total debt divided by trailing 12-month average marketcapitalization is 33% or more; Cash plus interest-bearing

securities divided by trailing 12-month average marketcapitalization is 33% or more; Accounts receivables dividedby 12-month average market capitalization is 33% or more.

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FINANCIAL SCREEN

Subject to continuous change in the light of new insights ; Not tobe taken as ´divineµ rules of Shariah compliance.

Example: One-third rule:

� The Prophet PBUH advised Abu Bakr RAA not to donate morethan One-Third of his wealth, and commented that "One Thirdis too much (Al Thuluth Katheer)".

� Critics of the one-third rule assert that it involves an out-of-

context use of the above hadith

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Common Stock in Islamic Finance

Shariah Screens: Example: II (S&P)

Sector-Based Screens

� Business activities related to the following areexcluded: Pork; Alcohol; Gambling; Financials;

 Advertising and Media (newspapers are allowed,sub-industries are analyzed individually);

Pornography; Tobacco; Trading of gold and silver ascash on deferred basis

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 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 (12Month average) <33%;�Non-Permissible Income other than Interest Income / Revenue <

5%�Dividend Purification Ratio: Dividends * (Non Permissible Revenue /Total Revenue)

Common Stock in Islamic Finance

Shariah Screens: Example: II (S&P)

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Part II: Ethics & Efficiency in Islamic Stock 

Market

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� Allocational Efficiency

� Pricing Efficiency� Informational Efficiency

� Operational Efficiency

Ethics & Efficiency in Islamic Stock Market

Forms of Efficiency

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�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

Ethics & Efficiency in Islamic Stock Market

Norms of Secular Ethics

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� 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)

Ethics & Efficiency in Islamic Stock Market

Norms of Islamic Finance

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� 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)

� UnderwritingWholesale Purchase Followed by Retail

Best Efforts Underwriting

Risk Transfer

Islamic Stock Market:

Nature and Regulation of Primary Market

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Islamic Stock Market:

Nature and Regulation of Secondary Market

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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

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Part III: Issues & Trends in Regulation

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International organization of securities commissions (IOSCO)

Objectives And Principles of Securities Regulation For Islamic

Securities Products1. To ensure that markets are fair, efficient and transparent;2. To protect investors; and3. To reduce systemic risk These objectives are supported by the 30 core principles

´There is no need to formulate separate regulatory principles[as] IOSCOs objectives and principles of securities regulationcan be applied to Islamic capital markets.µ

Issues & Trends in Regulation

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�Co-operation and information sharing between regulators� Accounting disclosures based on internationallyacceptable standards (such as IFRS) in coordination with

 AAOIFI�Regulatory classification of Islamic securities productsand their treatment in a fair, transparent and consistentmanner�individual regulators to consider defining their position onShariah compliance�Subject of PSIAs ² an ideal area of further research in IF

IOSCO Recommendations

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Other Standard Setting Bodies

Islamic Financial Services Board (IFSB)Covers banking, insurance and securities regulation wide range of initiatives it has undertaken, for exampledeveloping corporate governance standards for Islamiccollective investment schemes, and capital adequacyrequirements for Sukuk securitisations

 Accounting and Auditing Organisation for Islamic

Financial Institutions (AAOIFI)Standards on accounting, auditing, ethics, Shariah andgovernance.

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Key Issues in Islamic Stock MarketRegulation

� How to maintain a linkage between financial

and real sectors of the economy

� How to balance between concerns aboutallocational and operational efficiency

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Thank You

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