ROLE & REGULATION OF STOCK EXCHANGE IN AN ISLAMIC ECONOMY

1. ROLE & REGULATION OF STOCK EXCHANGE IN AN ISLAMIC ECONOMY 8th Distance Learning CourseAn Intermediate Course in Islamic Economics Presenter: Mohammed Obaidullah, Economist, IRTI October 21, 2008

2. PLAN OF PRESENTATION Part I: Common Stock in Islamic Finance Part II: Ethics & Efficiency in Islamic Stock Market Part III: Issues & Trends in Regulation Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

3. Part I: Common Stock in Islamic Finance Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

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

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

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

7. 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 ThuluthKatheer)". •  Critics of the one-third rule assert that it involves an out-of-context use of the above hadith Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

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

9. Common Stock in Islamic FinanceShariah Screens: Example: II (S&P) • 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) Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

10. Part II: Ethics & Efficiency in Islamic Stock Market Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

11. Ethics & Efficiency in Islamic Stock Market Forms of Efficiency • Allocational Efficiency • Pricing Efficiency • Informational Efficiency • Operational Efficiency Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

12. Ethics & Efficiency in Islamic Stock Market Norms of Secular Ethics • 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 Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

13. Ethics & Efficiency in Islamic Stock Market Norms of Islamic Finance • 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 • MaslahahMursalah (Unrestricted Public Interest) Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

14. Islamic Stock Market: Nature and Regulation of Primary Market • Merit Regulations Vs. Mandatory Disclosures • Price Fixation Vs. Free Pricing • Role of Intermediaries in Offer and Sale • Tender Method (BaiMuzayadah) Genuine Bids Only (Prohibition of saum `ala saumakhihi) • Underwriting Wholesale Purchase Followed by Retail Best Efforts Underwriting Risk Transfer Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

15. Islamic Stock Market: Nature and Regulation of Secondary Market Speculation on Stock Markets: Co-operative or Zero-sum Games The Issue of Liquidity and Transaction Costs • Day Trading • Margin Trading: Riba-based Borrowing • Stock Lending and Short Selling • Settlement System • Insider Trading • Trading Halts • Allocational Vs. Operational Efficiency Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

16. Part III: Issues & Trends in Regulation Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

17. Issues & Trends in Regulation International organization of securities commissions (IOSCO) Objectives And Principles of Securities Regulation For Islamic Securities Products To ensure that markets are fair, efficient and transparent; To protect investors; and 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.” Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

18. IOSCO Recommendations • 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 Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

19. Other Standard Setting Bodies • Islamic Financial Services Board (IFSB) • Covers banking, insurance and securities regulation • wide range of initiatives it has undertaken, for example developing corporate governance standards for Islamic collective investment schemes, and capital adequacy requirements for Sukuksecuritisations • Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)Standards on accounting, auditing, ethics, Shariah and governance. Eighth Distance Learning Program on Intermediate Course in Islamic Economics, October 21, 2008

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

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