Features and Characteristics of Islamic Capital Market

SUMMARY

This group report is about the differences features between Islamic capital market and conventional capital market. There are four features that we have mentioned in this report. The features are prohibition of riba, risk management practices, basic activities of finance and the last is product. The first feature is prohibition of riba which is one of the prohibited elements in Islamic capital market. In Islamic capital market, there are two categories of riba which are riba al-qard and riba buyu’. Islamic capital markets introduce market instruments such as bay al salam to promote a free-riba from all the  transactions. The second features of the Islamic capital market are risk management practices.  Risks exist in Islamic capital market transactions, just as in conventional markets. For example, risk management is becoming an important aspect of the Sukuk structure. The capacity to handle Sukuk risks. Sukuk is a capital market instrument whose structure and attributes distinguish it from other products such as common bonds or shares. The third feature  that can be different between Islamic capital market and conventional capital market is the basic activity of finance. The Islamic capital market is only permitted to offer investment instruments for projects that are beneficial to society, but they  are not allowed by any means to offer investment instruments in prohibited places such as casinos, alcohol products, products related to pork, pornography, conventional financial services, and conventional insurance. The last feature of the Islamic capital market is the product. Islamic financial products are governed by Islamic commercial law, which forbids riba and gharar (legal ambiguity or undue risk) in transactions. The most common types of contracts utilized in practice are sale, lease, partnership, and agency. Two stages of screening are applied to the universe of all stocks to identify Shariah compatible stocks.

INTRODUCTION

Malaysia has been at the forefront of global initiatives and efforts for the past three decades to establish a viable, sustainable, and feasible Islamic Capital Market that meets the needs of Muslims while also ensuring that its products and services appeal to all investors and issuers, regardless of religion. Islamic financial markets, like their conventional counterparts, play an important role in the country's economic growth and prosperity. Although Islamic financial markets operate in a similar manner to conventional capital markets, their activities are conducted in accordance with Shari'ah principles. To put it another way, the Islamic capital market should be free of activities prohibited by Islam, as well as aspects such as usury (riba), gambling (maysir), and excessive ambiguity (gharar). These restrictions are primarily intended to promote justice and level the playing field in order to protect the interests and avoid harms of all parties involved in market transactions, as stated in Shari'ah's (maqasid al Shari'ah) aims.

The Securities Commission of Malaysia recently allowed short-selling transactions under tight securities borrowing and lending (SBL) laws in an effort to improve the efficiency and competitiveness of the Malaysian capital market. At its 69th meeting on April 18, 2006, the Securities Commission's Shari'ah Advisory Council (SAC) decided that regulated short-selling (RSS) is in compliance with Shari'ah because the inclusion of SBL principles in RSS eliminates the element of gharar. The primary goal of this report is to investigate how Islamic capital market differs from the conventional market. The prohibition of riba will be the first characteristic. The risk management practice is the second characteristic. The third is about the fundamental activity of finance, and the fourth is about profitability.

The features that we brought this time are;

• Prohibition of Riba
• Risk Management
• Activity of Finance
• Product

PROHIBITION OF RIBA

As we understand, the first difference characteristic between islamic capital market and the conventional capital market is prohibition of riba. It is widely known that there is a specific rule in islamic law of commerce which is known as fiqh al-muamalat. Islamic capital market apply this rule in their business transactions in order to protect the customers as Islam aims to promote charity and helping others through kindness. In business, islamic capital market will take care of every aspect of the customer’s life which are considering social justice, equitability, and fairness, as well as the practicality of financial transactions. Thus, this is why riba is prohibited in islamic capital market. 

Riba is described as an increase that accrues to the lender in a loan transaction or in the exchange of a commodity without providing an equivalent counter value or recompense to the other party. In islamic capital market, there are two categories of riba which are riba al-qard and riba buyu’. In the context of current financial operations, riba al-qard occurs in the form of loans where riba al-qard is a prohibition on any set of predetermined rate of return aligned with the maturity and amount of capital. While, riba al-Buyu' is focused more on trade negotiations. A transaction in which a commodity is traded for a similar commodity but in uneven quantities, or for the same product in equal quantities but with a delay in delivery. Riba buyu’ usually occurs through the sale and purchase of six riba’s commodities which are gold, silver, dates, wheat, barley and salt. There are three common rules about riba’ al buyu: 

• When trading commodities of the same group and kind, such as gold for gold or dates for dates, two conditions must be met which are that both items must be identical and delivery must be timely.
• When trading commodities of the same group but different sorts, such as gold for silver or wheat for barley, there is only one condition which is promptness in delivery is not a condition.
• When trading commodities of various types and groupings, such as gold for wheat or silver for barley, no conditions are enforced, and free trading can take place regardless of equality, inequality, promptness, or delay.

This is why islamic capital markets introduce market instruments such as bay al salam to promote a free-riba transaction. Bay al salam a sale of an item that will be delivered at a future date but is not available at the time of the sale's conclusion. Bay al salam often happens to agricultural products as it takes some time to deliver them to the customers. It is necessary that the quality of the commodity to be purchased must be completely described, with no ambiguity that could lead to a dispute in the future. Bai salam encompasses practically everything that can be accurately stated in terms of quality, quantity, and workmanship. This product is perfect for agriculture financing for Islamic banks, but it can also be utilized to finance the working capital needs of corporate customers. As for now, bay al salam it is one of the most widely used Islamic financing modes in Islamic countries to encourage riba-free transactions.

While for conventional capital market, the business transactions are hugely depend on interest which is opposite to what islamic capital market apply in their business transactions. It is because the main goal of the conventional market is to gain profit. One of the conventional market examples is bonds. Bonds, often known as fixed-income instruments, are one of the most well-known asset types among individual investors, along with stocks. The bond market encompasses the buying and selling of a wide range of financial securities issued by diverse businesses. Bonds are issued by corporations and governments to raise debt cash to fund operations or pursue expansion possibilities. And in return, they promise to repay the original investment amount, plus interest. This is unacceptable in Islam as it involved an interest which is against Islam principle. 

RISK MANAGEMENT

The second features of the Islamic capital market are risk management practices. Risks exist in Islamic capital market transactions, just as in conventional markets. Furthermore, due to their participatory nature and their higher governance and liquidity requirements, Islamic capital market transactions confront particular Shari'ah risks. Uncertainty or exposure to unfavorable consequences is the most common cause of risk. For example, in any investment facility, the investor bears both the risk of loss and the responsibility of gain.

In the current context, where the conventional financial system dominates, risk management is exceedingly sophisticated and challenging within the Shariah confines. These regulations and principles control risk management in the Islamic capital market. Any transaction or instrument employed in risk management must be backed by a real, recognized economic asset or service. According to the terms and conditions of the contract, ownership must remain with the fund provider or lender, and he must bear risks in a true sense up to the asset or service's falling value. For example, risk management is becoming an important aspect of the Sukuk structure. The capacity to handle Sukuk risks has become a major factor in the market's success or failure. According to Haral (2010), risks should be reduced to the most practicable. In recent years, the fast rise of the Sukuk has demonstrated the Islamic financial system's authenticity and ability to address current business needs and problems. However, maintaining this position and expansion is impossible without effective risk management of the Sukuk structure. Understanding it is even more vital now, given the present financial crisis. (Mehmood, 2010).

Sukuk is a capital market instrument whose structure and attributes distinguish it from other products such as common bonds or shares. Traditional bonds, for example, do not have to comply with Shariah and hence do not pose a Shariah compliance risk, whereas Sukuk does. (Razaq, 2010).

The first and most important step toward better risk management is identifying the risks connected with the Sukuk. It is hard to think about hedging or managing risks unless one can correctly identify them (Haral, 2010). There are numerous dangers associated with Sukuk, including the risk of weak Sukuk mechanism regulation, the fact that Sukuk is not regularly traded in the secondary market, posing a liquidity risk, and, of course, the risk of Shariah compliance (Mehmood, Razaq & Haral 2010).

Sukuk structures are governed by Shariah and based on Islamic finance principles. Every Sukuk structure, from issue to maturity, should be Shariah-compliant at all times. Many Sukuk in practice, according to Taqi Usmani, chairman of the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI), are not in compliance with Shariah and are more closely related to interest-based instruments like bonds, which are prohibited in Islam (Kokab, 2010). Due to differences of opinion among Shariah experts and the fact that no good and licensed institute has been established globally that is accepted and adaptable, Shariah compliance risk remains a major concern.

To manage this risk, every Islamic financial institution in Sukuks has a Shariah compliance board or committee, similar to an internal audit committee. It is made up of notable, credible, and best-available Islamic scholars who oversee and direct the issuing of Sukuk. The Shariah compliance board issues a certificate of compliance for each Sukuk product and business. This is done at the institutional level, and each financial institution required to issue Sukuk has its own Shariah compliance board. This board makes decisions on each product and operation separately and independently, and the Sukuk product or transaction is examined once the compliance certificate is issued. Malaysia has formed a national Shariah council and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in Bahrain to standardize Shariah boards that have the same rules and regulations for the same product within a country.

Risk management is a Shari'ah-compliant concept that the Islamic finance industry has adopted. Indeed, as the Islamic capital market's offers have become more sophisticated over time, the necessity to develop adequate risk management systems that adhere to Shari'ah standards has grown in importance. One of the Islamic capital market requirements is that market participants have access to risk management, hedging, and derivatives tools. The distinctive nature of financial and investment activities and their variety have risk characteristics that affect both sides of the balance sheet of Islamic financial institutions. To control such risks, Islamic financial institutions should consider the risks in their transactions so that the capital can absorb the risks effectively.

ACTIVITY OF FINANCE

The third feature  that can be different between islamic capital market and conventional capital market is the basic activity of finance. The Islamic capital market is only permitted to offer investment instruments for projects that are beneficial to society and add value. But they are not allowed by any means to offer investment instruments in prohibited places such as casinos, alcohol products, products related to pork, pornography, conventional financial services, and conventional insurance. Shariah provides guidelines for a company's business nature, with a focus on religious value and social well-being. First things first, the main business of the company must be accepted (halal) according to Islamic principles. In al-Quran Surah al-Maidah verse 62 Allah said :  And you see many of them hastening into sin and aggression and the devouring of [what is] unlawful. How wretched is what they have been doing."

Meanwhile, conventional capital markets provide investment opportunities for every successful initiative, whether or not it is beneficial to society and the only thing that matters are how profitable and dangerous it is.  As a result, a gambling and casino can provide its bond in order to expand its gaming operation. A pornographic magazine or a nudist film production company are both good customers of a conventional capital market. As a result, conventional finance is unrestricted. 

According to Shariah Advisory Council (SAC) of the Securities Commission Malaysia, mixed types of companies are permitted by shariah on the following conditions:

• The core activities of companies must be follow the shariah which is  halal and the haram elements must be small compared to core activities
• Public perception of the company and  background of the companies must be good and free from any issue
• The core activities of the companies should have important benefit to the society (nation) and the country, and the haram elements - including umum balwa (common plight and difficult to avoid), urf (customs and rights of the non-Muslim community) - which are accepted by Islam must be very small.

In a broader perspective, previously in 2007 , Shariah Advisory Council (SAC) of Securities Commission Malaysia (2007) set few benchmarks to determine permissible and non-permissible activities such as:

• The five-percent (5%) benchmark: This benchmark is used to measure the level of mixed contributions from the activities that are clearly prohibited like interest-based companies such as conventional banks, insurances, financing and leasing companies and others, gambling, liquor, pork, pornography and so on.
• The ten-percent (10%) benchmark: This benchmark is used to measure the level of mixed contributions from the activities that involve the prohibited elements affecting most people and are difficult to avoid). For example, interest income from fixed deposit in conventional banks, revenue generated from tobacco-related activities as a tiny part of an overall shariah-compliant business.
• The twenty-percent (20%) benchmark: This benchmark is used to evaluate the level of contribution from mixed rental payment from shariah non-compliant activities, such as rental payment from the premise that is involved in gambling, sale of liquor and others.
• The twenty-five percent (25%) benchmark: This benchmark is used to evaluate the level of mixed contribution from the activities that are generally acceptable according to shariah and also have an element of maslahah (public interest) to society, but there are other elements that may affect the shariah status of these activities. For example, hotel and resort operations, share trading, stock brokerage houses, airplane companies, and others, as these activities may involve other relevant activities that are deemed unlawful by the Shariah.

Moreover, the Shariah Advisory Council (SAC) of Securities Commission Malaysia (2012) revised its benchmark criteria in 2012 and reduced the business activity benchmarks from four benchmarks to only two benchmarks:

• The five percent (5%) benchmark: The contributions from these activities to the group turnover and profit before taxation should not exceed 5% conventional banking, conventional insurance, gambling, liquor and liquor-related activities, pork and pork related activities, non-halal food and beverages, shariah non-compliant entertainment, interest income from conventional accounts and instruments including dividends from investment in shariah non-compliant instruments and interest income awarded arising from a judgment by a court or arbitrator, tobacco and tobacco-related activities, and other activities deemed non-compliant according to Shariah.
• The twenty percent (20%) benchmark: The contributions from these activities to the group turnover and profit before taxation should not exceed 20%: hotel and resort operations, share trading, stock broking business, rental received from shariah non compliant activities, and other activities deemed non-compliant according to shariah.

Other than business and financial criteria, some jurisdictions are known to also apply a cleansing mechanism to purify investments that are ruined by unlawful activities. The cleansing process of the income is normally performed by the individual investors, although in some cases, the Islamic funds would perform the task on behalf of their investors. For example, if some part of the income from interest-bearing accounts (prohibited by Shariah) is included in the income of the company, the portion of such income in the dividend paid to the shareholder must be given to society as a charity and must not be retained by the shareholder. This is called purification or dividend cleansing.

PRODUCT

The last characteristic of Islamic capital market will be about the product. Islamic financial products are governed by Islamic commercial law, which forbids riba and gharar (legal ambiguity or undue risk) in transactions. Islamic capital has been surging demand for Islamic products as investors have realised that the Islamic Capital Market strictly abides by Islam's religious values, principles and laws. Through constant innovation and the development of several Islamic products, such as Sukuk, Islamic REIT, Islamic Unit Trusts, and Islamic ETFs Islamic products are being well received globally. While riba is commonly interpreted as interest, it also has broader meanings, such as the prohibition of debt sale. Conventional markets such as REIT, Unit Trust, ETF, and modern derivatives such as forwards, futures, swaps, and options  are also prohibited since they contain aspects of both riba and gharar. Because interest is prohibited, Islamic finance structures financial goods using a variety of other permissible arrangements. The most common types of contracts utilized in practice are sale, lease, partnership, and agency. Two stages of screening are applied to the universe of all stocks to identify Shariah compatible stocks. The first screening is a qualitative business activity screening that weeds out businesses that are engaging in illegal items and services. Tobacco, alcohol, pornography, weapons, casino games, pork-related items, traditional banking institutions, and so on are the examples as stated on the third features. Companies that pass the qualitative screening are then subjected to a quantitative financial screening. Financial screenings determine the acceptable criteria for excluding enterprises with unsatisfactory levels of traditional debt, liquidity, interest-based investment, and/or impure income (Khatkhatay & Nisar, 2006; Derigs & Marzban, 2008). Shariah compatible equities are those that pass both qualitative and quantitative screening. 

For the first product, Sukuk are financial instruments that reflect equity, real estate, usufruct, money, debt, or any combination of these. Sukuk holders are the owners of the rights and bear the risks associated with these instruments. Sukuks can have fixed or variable returns and can be traded, depending on the contractual basis. Sukuk that represent debt or money are not negotiable and can only be traded for their face value. Thus, along with equity shares, instruments can be securitised and traded at negotiable prices if these represent real physical assets or usufruct. The types of instruments examined in capital markets will determine the linkages between the Islamic and conventional divisions. 

Furthermore, a group of professional fund managers manages a unit trust fund, which invests the pooled money in a portfolio of securities. This type of diversified portfolio allows investors to spread their assets out, minimizing portfolio risk in the event that some investments lose value while also increasing the chances of finding good stocks at good prices. As a result, mutual funds have become major investment vehicles for small and individual investors. It is also a vital conduit for capital transfer from households to productive sectors. As a result of its strategic implications for investment position, the topic of unit trust performance has gotten a lot of attention from practitioners and academics. As for Shariah-compliant unit trust funds, it is the investment funds that adhere to the criteria of Shariah law and Islamic principles. Islamic unit trust funds are a collective investment scheme that offers investors the opportunity to invest in a diversified portfolio of Shariah-compliant securities, fixed income securities and money market instruments. The investment management of the Islamic funds is not only based on capital market regulation but also on the Shariah principles, whereas the conventional funds are only restricted by the capital market regulation. Investments in non-Shariah compliance enterprises, such as items or services relating to traditional banking, insurance, and financial services, gambling, alcoholic beverages, and non-halal food products, will be excluded from a Shariah compliant unit trust fund. A Shariah-compliant unit trust fund must follow a number of rules, including investing solely in Shariah-compliant enterprises, forming a Shariah Board, conducting an annual Shariah audit, and donating to charity some sources of revenue prohibited by Shariah law, such as interest.

Next, unlike a conventional Exchange Trade Fund that has the liberty to track any benchmark index regardless of the Shariah status of the component stocks, an Islamic ETF tracks only benchmark index where the index constituents are Shariah-compliant companies. Apart from that, the management of i-ETF has to strictly observe the Shariah principles and Islamic investment guidelines. The operation of i-ETF is also overseen by a Shariah board, committee or advisor who would conduct Shariah-compliant audits and reviews from time to time.  An Islamic ETF and a conventional ETF share common characteristics. The main difference between a conventional ETF and Islamic ETF is the benchmark index that the Islamic ETF tracks. An Islamic ETF only tracks an Islamic benchmark index where the index constituents comprise companies which are Shariah compliant. An Islamic ETF is also required to appoint a Shariah adviser or committee to provide expertise and guidance to ensure that its structure, investments and all matters related to the funds' activities comply with the Shariah.

Lastly, Islamic real estate investment trusts or I-REITs are collective investment vehicles (typically in the form of trust funds) that pool money from investors and use the pooled capital to buy, manage and sell real estate. I-REITs provide an investment opportunity for those who wish to invest in real estate through Shariah-compliant capital market instruments with some guidelines and principles of Islamic Shariah by investors. Real estate investment trust (REIT) is a collective investment scheme in real estate that combines the best features of real estate and trust fund. i-REIT is the Shariah version of the conventional REIT. In November 2005, The Malaysian Government, through Securities Commission Malaysia (SC) issued Guidelines for Islamic Real Estate Investment Trusts, setting a new global benchmark for the development of this instrument and making Malaysia the first jurisdiction to introduce such guidelines in the industry (Muhammad, 2016). These guidelines provide guidance to market players on Shariah compliance in developing and managing an i-REIT. These guidelines also serve to complement the existing Guidelines on Real Estate Investment Trusts. Al-‘Aqar Healthcare REIT, Axis REIT, KLCC REIT and Al-Salam REIT are those Islamic ETF that are listed in Bursa Malaysia.

CONCLUSION

In conclusion, the capital market, both Islamic and conventional, represents a significant component of the overall financial system, fulfilling such as the facilitation of long-term financing for government and private sector businesses and the provision of much -needed liquidity through a well-functioning secondary market. The differences between the conventional and Islamic capital markets, however, lies in the necessity of the latter's compliances with shariah. The Securities Commission (SC) in Malaysia is responsible for developing screening rules that are used by all publicly traded firms in order to determine their halal status. It is critical to ensure that the business does not contain any forbidden elements. Prohibited activities in Islam, as well as elements such as usury (riba), gambling (maysir), and too much ambiguity, should be avoided in the Islamic capital market (gharar). The Islamic Capital Market contributes significantly to the country's economic prosperity and operates in parallel to the regular capital market, providing individuals and organizations with a variety of investment and financing options. It has grown in numerous ways, including its product and service offerings.

The growth of Islamic capital markets is linked to the development of capital markets in general. The Islamic financial system benefits from capital markets since Islam prohibits interest and encourages trading. The development of Islamic capital markets is a broad subject. It can cover a wide variety of subjects, such as the current condition of the regulatory system and possible improvements, market structure and practices, product range and development, market actors' nature and preferences, and the identification and development of support institutions. Conventional products such as equities, derivatives and bonds convert it  to Islamic products such as sukuk, Islamic traded fund (ETF), real estate investment trust (REIT) and many more.

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