Stock Market in Islamic Frame Work 

By Dr. M. Y. Khan

To be presented at 6th Annual Conference of Islamic Economics & Finance - Jakarta - 

Stock Market in Islamic Frame Work

( Dr. M. Y. Khan )

     This study has attempted to present an outline of stock market on the basis of Islamic standards in the following five sections. The paper has confined specially to equity market.  

Section I   :    Introduction to Equity Investment 

               Equity capital represents ownership capital. Equity shareholders collectively own the company, bear the risk and enjoy the reward of ownership. The potential rewards and ownership associated with equity shares make it an interesting financial asset unlike debt. Debt owners are sleeping partners with no active involvement in the business but with fixed income from debt. In Islamic finance, equity investment involves Mudarabah finance where capital owner and investment manager, distribute profit in accordance with agreed ratio. Financial loss is borne by the capital owner, the loss to the manager is the opportunity cost of his labour, skill and technique of management. The management however does not give guarantee of capital as well as profit. It may be noted that present Mudarabah participants can not consist of one or two capital provider and one or two managers who share profit. Today equity participation is through issue of equity shares to a very large number of investors by a corporate which is a legal entity. So only equity investors in capital, are the owners and management works as employees or hired professionals. Hence they do not share the profit but get salaries and other benefits which appear as cost to the

The Author is Former Economic Advisor to Securities and Exchange Board India (SEBI), Bombay. He was also Senior Director in Reserve Bank of India, Bombay and Visiting Officer to IMF. The Author has received good support from Prof. S.A.M. Hashmi, Principal of Akbar Peerbhoy College of Commerce & Economics, Bombay. Mr. Ansari Rehan, Executive Assistant from the same College. Special Thanks to Mrs. A.M.Y. Khan (Author’s wife) who went through the draft a number of times.

company. However one fact remains constant, the equity shareholders only are the partners. Crucial role of capital market was highlighted by Hicks. Hicks (1969) argued that industrial revolution was possible on an economic scale due to investments of  large  magnitude  made  in highly liquid  market. According to Hicks, it is the availability of liquid assets which is crucial and has been made possible by financial markets and development of liquid capital market. When we talk of capital market we mean the market where financial assets of long maturity like equity shares, other shares, bonds issued by corporates, securities issued by the Government and units of mutual funds are issued to mobilise financial resources from the savers (investors) by the primary deficit units. A number of intermediaries operate in the capital market to facilitate funds mobilisation and trading of them. These intermediaries in the primary market are merchant bankers, advisers to issue, registrars and underwriters. The secondary market includes stock exchanges, brokers, traders/dealers, depositories, clearing banks/clearing corporations. Since Islamic financial system prohibits interest bearing instruments, this paper would confine only to equity finance from capital market.

Why a firm should go for Equity? 

               Equity itself means fairness or the application of principles of justice. In capital market, stocks or shares not bearing interest have been defined as equity which confers ownership on investors and a right for dividend from a profit earning company. Every investor gets his reward according to size of his investment. Hence equity finance is crowned with fairness and justice. Equity partnership besides dividend, offers several benefits to investors as analysed below :  

i.        Equity market makes investment less risky; more profitable and more attractive by making it liquid. Liquid equity market improves the allocation of resources.

ii.                   Corporates with a large amount of debt have agency problem between creditors and managers. High profile management prefers to borrow for expansion of the company. When the debt equity-ratio rises, management has plenty of borrowed funds induced to commit “adverse selection” in identifying projects. Larger the firm’s debt, higher the risky investment and lower the profit due to non-performing assets. Hence debt owners hardly get repayment of debt and interest. If funds are raised by way of equity, owners of the company are more vigilant and accountable. As a matter of fact companies with high equity are better managed and management executives can be controlled by equity holders. So equity investment is superior to debt investment.

iii.      We now look from the agency cost point of view. Agency cost of debt is borne by the firms’ owners as a result of potential conflicts between debt holders and equity holders. The choice of capital structure can reduce the cost arising from such conflicts. Doherty (2000) highlights the agency cost arising from the fact that equity holders have limited liability while debt holders have fixed minimum return. In the event that company is successful, a maximum gain goes to equity holders. If the company is not successful, debt holders also bear the losses along with equity holders. Thus the lending is less safer than investment in equity stocks as equity holder can control the policies of the company. The value of firm rises with the increase of equity. So investor should invest more in equity. In a growing concern, the companies find it cheap to raise funds from equity market. Price discovery is of paramount importance as price is determined by the market forces in equity market. On the other hand, debt is some what illiquid asset and price determination is difficult as it is generally not traded.  

iv.               Modigliani and Miller showed that deductibility of interest payment from profit makes the firms rely more on debt. But there are evidences that companies with large borrowings and high debt become sick and insolvent. Their bad debt and interest liabilities exceed their net worth resulting in insolvency. This has generally happened when business faced demand recession for a few years or downward -business cycle persisted during this period or management turned to be dishonest and careless. However, equity dominated firms have withstood such crashing periods while debt dominated firms have collapsed. As a matter of fact high debt liability which sometimes can bulge for no fault of the company’s owners, can wipe out the entire net worth of the company.  

v.        Experts on industrial economics suggest that in industries where there are little concerns on how things should be managed, allocation of resources through stock market is desirable. This is because stock market provides a way of checking that firms are well run when there are divergences of opinion on how firms should be managed.

vi.      The debt and interest liabilities grow irrespective of the condition of the company. We have the experience, that debt liabilities of many developing countries made them insolvent due to servicing of external corporate debt. The outflow of capital on account of debt service has exceeded the fresh capital inflows. Large capital outflows put pressure on exchange rate and foreign exchange reserves of the domestic country.

vii.             In terms of international finance, foreign investors’ participation by way of foreign direct investment (equity) brings with it entrepreneurship, foreign technology, techniques and expertise.

viii.           Equity issues go through screening by the board of directors and executives before issue. A number of disclosure norms have to be satisfied and companies have to be rated by credit rating agencies. Consequently equity investment as well as funds raising by issuing equities is more objective oriented while management can borrow debt without facing any scrutiny which can be used for undesirable purposes.

ix.    Stock market functions as a scrutinizer of financial performance of corporates and serves as a guide to promote efficiency. It is known that a continuous valuation of companies is reflected in stocks prices and declaration of dividend. In the event, stocks prices start declining, possibility of takeover and merger emerges as a threat cautioning a company and its management to have financial discipline and efficient funds allocation. Another role of market prices is that they facilitate risk diversification through international integration, encourage a shift to higher return projects and help to promote growth. 

Section II :  Organising the Islamic Stock Market

Early Views on Stock Market

          The early authors of economics used the subject of stock market as an example in their discussions of competitive market conditions. Subsequently, the subject was expanded to the role of prices in the stock market in allocation of resources, providing incentives for accumulation and employment of capital. Although the development of stock market was discussed in neo-classical literature, the economic theory underlying the traditional form of the rational market view was developed during early 1990s. Recently, the efficient market hypothesis with the development of rational expectations has emerged as a point of discussion among the academicians in the area of economics and finance. The strong view that stock markets are efficient has invited a number of criticisms both as an observed empirical phenomenon and as an analytical concept.   

          Walras argued that stock market is perfectly competitive and equated it with a general equilibrium theory as attempted to generalize the particular form of fund in Paris Bourse. To him, the equilibrium prices are established through a process of an auctioneer calling out prices and Edgeworth-type recontracting so that no transactions are committed until market clearing price is called out. Walras cited that “stock market exchanges in a large investment centre like Paris or London” are an illustration of “how competition works in a well organised market” (in Elements of Pure Economics,1874).  

          Alfred Marshall agreed with Walras while indicating about stock exchanges. In his Principles of Economics, he gave illustrative real world examples of competitive markets. According to him stock exchanges are the pattern on which the markets have been and are being formed for dealing in many kinds of produce which can be easily and exactly described as portable and in general demand. He emphasized international securities which include Government Bonds and the Stocks and the bonds of Certain Great Corporations, for which there is a world market and a world price. However, there is little in Marshall’s Principles to connect stock exchanges with the function of capital accumulation and accommodation. 

          Stock market can be organized as an exchange or an over-the-counter (OTC) market. An exchange is a physical location where buyers and sellers come together physically or through electronic instructions to buy and sell securities. In contrast, over-the-counter market permits buyers and sellers to transact without meeting at one physical location or through computer linked network. Though many instruments like corporate bonds, debentures, Govt. securities, derivatives, commodities, etc. can be traded on stock exchanges, but this paper has been restricted to equities market.  

          Islamic stock exchange will have to be setup on the basis of Islamic Principles through equity participation. The stock exchange will not provide trading facilities for debt instruments, stocks of companies being financed by debt and companies manufacturing goods and services not compatible with Shariah Laws. Ownership of stock exchange will be with its shareholders. For achieving fair functioning of stock exchange, its shareholders will not be allowed to participate in trading and will not be permitted to be the partners of any other player in stock market. Distribution of dividend to shareholders of stock exchange will have to be linked to actual profits of the period under consideration and its shares will not be tradable. Dividend distribution has to be restricted to profits of the year so that accumulated reserves are not distributed. The shareholders could be institutions as well as individuals. The shareholders will have to observe all laws based on Shariah and will be subjected to corporate governance based on Islamic provisions or Islamic code.  

A Resemblance between Mudarabah Company and Modern Joint Stock Company : 

          Ownership of a company through equity shares in modern ownership concept, corresponds to partnership firm in Islamic Jurisprudence. Though Islamic scholars have specified a number of varieties of partnerships like Sharikatul-Amwal, Sharikatul-Sanai, Sharikatul Wajuh and Mudarabah. Except Mudarabah other varieties specified above would refer to proprietary and partnership companies with small scale of operations controlled by the owners themselves along with small partners in trade and commerce. This type of sectors today forms the unorganized segment of the business in any economy. Mudarabah financing today would involve promoting a company by the promoters by way of contributing capital and assigning the management of the same to professional managers. Though ownership and management policies may be framed by the promoters, execution remains with the executives and risk is to be borne by the promoters. Since medium and large companies seek billion dollars of resources, the number of shareholders also (partners) is very large, for the sake of accountability and recognised identity.  Such companies have to be registered with Government authorities, so that investors intending to become partners from long distances are sure of the personality of the company. Finally, the company is personified as a legal entity for functional purposes. You would see that present day joint stock companies are replica of Mudarabah companies and have to function according to mutual agreements and government regulations. We may explain one important point that most of the Shariah laws were given interpretations in early period of Islam when concept of industry involved only partnership firms and exchange mechanism was limited to geographical contiguity where number of economic agents personally knowing each other was small. Hence, there was physical contiguity among the partners. Today when a company has 50 thousand or 80 thousand shareholders scattered over the far flung areas, their personal relationship does not exist but the company has continuity of life because ownership of company is dispersed over million shareholders. Exit of few such partners does not lead to closure of a company. 

Identification of Islamic Joint Stock Company

           Islamic Joint Stock Company is that in which owners or contributors of financial resources invest their own savings on profit/loss basis. The company should not have any debt or any liability bearing interest rate in terms of money or in any non-monitory form. The company should not manufacture any product or service which is prohibited by Shariah. The company should not engage in exploitation of consumers, factors of production and natural resources given by God. The company should not indulge in over pricing and under pricing. The company should not obstruct free market forces. Corporate social responsibility is also the preamble of Islam. If the corporates do not develop moral and ethical standards and they are not accountable to them, their animal spirit to maximize their profits can lead to unfair business practices sacrificing externalities and social ethics. It is very well known that corporates with sufficient profits give money to finance public entertainment, or to local rehabilitation programmes or roads and parks development. Social responsibility has a wider meaning than conveyed by monetary donations and financing social events. Ethical behavior is an integral part of the responsibility, which every company/corporation owes toward that society in which it operates. Social responsibility is independent of the size of profit. To the extent any corporation abuses the society, it becomes threat to the society’s welfare and health. A company has to observe “ethical behavior” and “social responsibility”. That is why Shariah does not permit collusion which can result in cartel or monopoly of factors of production, of production itself and that of distribution of goods and services, and in exploitation of society. Such companies can not find place in capital market under Islamic frame work. 

Why company should go to stock market

           An advantage in going to stock market for trading is that company has to register on stock exchange and consequently gets national level recognition and creditability with its expected new owners, customers, employees and suppliers. Moreover, Stock exchange scrutinizes the character and sources of funds of company in all respects. According to Quran everybody must acquire resources rightfully in accordance with Islamic code, otherwise it would be a violation of Shariah conditions. Besides, stocks prices provide very valuable information. Everyday investors buy and sell shares making their judgment on prospects of a company. Moreover, exchange information leads to wider awareness among the investors. Firms may be able to obtain capital at more attractive terms from the market. An Islamic company will have to mobilise large resources for capital formation on this basis if it has to compete with large multinationals. Disclosure of character and motives of promoters, rating of company, disclosure of material information to investors, at the time of making issue by the company through stock exchange are mandatory. Shariah code of conduct verification would have to be certified before issue. Now we can understand that going to stock market is a proof that company is meeting all conditions of Shariah.  

Trading in Equity Stocks and Islamic view

          It may be said at the outset that Islam is for a fair and free market. The Holy Prophet (may peace be on him) discouraged any interference in the process of price determination by the state or individuals. Beside refusing to take any direct action, he prohibited the business practices which could lead to market imperfections. Consequently, stockholding, speculation, oligarchic collusion, concealment of vital information about the product and selling by false vows (misleading advertisement of the present day) were prohibited by Holy Prophet (may peace be on him). Thus the holy prophet (may peace be on him) nullified the influence of economic power on price mechanism. An equity share represents the net wealth of the company which can be traded. Islamic scholars are in agreement that stocks corresponding to Mudarabah partnership certificates can be exchanged or traded like real commodity which has a value in real terms. The investors have to purchase equity shares with real intention of investment and to hold them as a partner in the company. In other words equity shares have to be purchased to become partner and not for trading for profit making. This would be in Shariah, compatible to Mudarabah which is partnership in real sense. Of course, immediate sale of instrument can be made to meet unseen needs arising all of a sudden.  

          In this section it is proposed to define and explain some transaction activities in stock markets which are unlawful according to Quranic and Shariah injunctions. These activities are frauds and unfair practices in sales and purchase which are discussed below.  

Frauds in Trading 

Islamic Shariah has prohibited frauds in exchange of goods and services. The same is valid for transaction of shares which include an act of buying and  selling or subscribing to an issue of any security or equity shares or agreeing to buy and sell. In Islamic view fraud means any action, expression, omission or concealment committed whether in deceitful manner or by a person with his convenience or by his agent dealing in securities in order to induce another person or his agent to deal in securities, whether there is any wrongful gain or avoidance of any loss. Fraudulent action would also include misrepresentation of truth or concealment of material fact in such a way that opposite party acts to its own detriment, an incorrect suggestion knowingly given by one party to another party for purchase or sale, an active concealment of fact having knowledge of it, a promise made without any intension of performing it, any presentation made in reckless and careless manner, a false statement, giving out misinformation adversely affecting the market price of security, planting misleading news, predating or falsifying records, etc. Malpractice and manipulation is committed when buyer or seller of securities creates false or misleading appearance of trading not intending to effect transfer of beneficial ownership but only to inflate prices (Ghaban) or cause fluctuations (volatility) in price of securities for wrongful gains. 

Short Selling or Long Buying is Prohibited  

          A short sale is a sale of securities which the seller does not own at the time of affecting the sale or goods do not exist at the time of sale. This type of transaction is not permitted according to Sanani Ibn Qudama (WD) and Ibn Humam (1317H, 13/1P, 4/55, 6/36). Similarly if a purchaser of stocks buys long but does not have cash in hand or in bank or is likely to get his own money in due cause, is prohibited to do such deal because he adds fuel to price. As a matter of fact, a long position is one where trader buys the securities without the intension of having them or without the intention of accepting delivery.  

          Prophet, the honourable (may peace be upon him), did not approve sale of goods which seller does not own in his possession at the time of executing the sale. In financial market it is called short selling which has the potential of being misused for rigging the market prices. Moreover, short selling results either in extra profit making or defaults by the seller of securities. In capitalist frame work, short selling cools the stocks inflation expected to occur in the future by supplying the securities in the market. Short seller is trader in the stocks market. He sells equity shares to be delivered on a future date at a determined price in the expectation of fall in stock price before the settlement date and during this period he buys the stocks to make delivery at settlement date. Mostly there is no delivery and the trader gets arbitrage between the sale and purchase price. Short selling or long buying results in slump or shooting up of the market leading to crash of the stock prices or in major default blocking their payment and settlement culminating into bankruptcy and liquidation of financial system. Islam therefore has prohibited short selling in all types of trade. In the capital market short selling involves speculation. Similarly, long buying or using margin trading for long buying stimulate speculation resulting in stocks boom. The trader may pay margin on positions and can postpone settlement for next round. The long buying is financed by bank borrowing. In speculative market, turnover and velocity is very high because same quantity of shares/stocks change hands several times. This is false trading or false transaction activity because in terms of money value turnover rises but the quantity of stocks traded remains mostly the same. It does not add any real value to the company of which shares are overtraded. There is no additional capital formation in the economy. These activities add fuel to the market.          

          We may specify that speculative sales and purchase in short selling or otherwise generate “Gharar” or uncertainty in the outcome expected by the investors. The markets have experienced recurring volatility in stocks prices during booms leading to uncertainty and economic instability while short selling has ruined the investors. Economic instability results in distortion in investment planning of entrepreneurs.  

Process of Crisis in Short Selling

          Short selling could result in a loss if price of equity share rises instead of falling in the subsequent period. The losses in short selling shoot up because there is no limit on price rise. Many a times bulls generate price spiral artificially by cornering the floating stock. This occurs frequently whenever there is large scale short selling and bulls know that short sellers would need to make purchase to cover their short sales. A steep shortage of floating stocks arises due to cornering of supply of stocks by the bull and this act of bull pushes up the stock price artificially. Thereafter short sellers find it difficult to purchase or borrow same stock except by buying at a very high price from bull. On the other hand, there is an opposite case when bull gets overextended due to accumulated large positions financed by short term borrowing and the bears who would have come to know about bull buying spree, start heavy selling. They cause market price to sink and impose heavy losses on bull who is not able now to repay short term borrowings to lending bank. This manipulative game between bulls and bears can make even lending bank bankrupt and insolvent. Thus a default by a large trader can have a chain reaction percolating to insolvency of many banks resulting in defaults to million depositors. 

Insider Trading in Islamic View  

          Islam / Quran has focused on education, knowledge and correct information available to all concerned people. Transparency in information is equally important for all since lack of transparency can lead to misunderstanding of facts (Jahalat). According to Islamic view, an investor or any other entity associated with market activities should have knowledge of rules and regulations issued by the government authorities and Islamic law authority. They should also be competent in the knowledge of market mechanism before engaging in equity transaction (see Al-Ghazali, 1992, P-328).  Therefore, in any transaction, parties have to be very seriously accountable to facts, information and rules and regulations including ethics. In case of violation of these principles, a number of times, trading in shares results in insider trading. Insider trading involves a person (director of the company or any person associated with the company) who either on his behalf or on behalf of any person, deals in securities of a listed company on any stock exchange when in possession of unpublished price sensitive information not available to others. Insider trade also occurs when insiders communicate, counsel or procure directly or indirectly any unpublished price sensitive information to any person who can use this information to sell or purchase the stocks. Sensitive information could be defined as financial results, intended declaration of dividend, major expansion plans, expected mergers / acquisition and any other information likely to affect the profitability of the company. According to Shariah, all the information of the company should be known to dealers / brokers / investors in the market and should not be monopolised by insiders only. The information should be presented in understandable manner. 

Hiding of information and presenting it in a distorting manner by the insider or cornering the information is against teachings of Islam. It is totally illegal in Islamic view to trade on the basis of information which has not been yet made public. Insider trading as a matter of fact violates market efficiency and insiders can realize abnormally high return from trading by using the information they alone know. In capitalist economy which works without ethics, promoters of firm, directors on the board of the company, management executives produce false information and if unrestricted, can realize personal gains by selling shares short while jeopardizing the profitability of the firm and settle the trade by making purchase when prices have fallen. 

Market Efficiency and Securities Trading in Stocks Market 

          In modern capital market, market efficiency is an important and crucial feature of an ideal market in which transaction price should not differ from equilibrium value of stock. In reality transaction prices generally differ from equilibrium values that can be achieved only in frictionless market. It is generally hypothesized that market prices reflect all information. There is a view that prices at which stocks have been traded may reflect lagged adjustment transaction cost. Efficient Market Hypothesis stipulates three types of situations namely weak form efficiency, semi-strong efficiency and strong form efficiency. Let us have some more explanatory discussion on efficient market situations. 

Weak Form Efficiency focuses on informational content of the previous sequence of stock price movements. The current prices of stocks reflect all information found in the record of past prices. Thus there is no relationship between past and future price movement. According to Weak Form Efficiency price changes are not independent over time. How much information these movements contain for a market to be informationally efficient? If the market is frictionless, the answer is none. Alternatively speaking, in informationally efficient market abnormal returns cannot be earned by using trading rules based upon price movements. Many studies have been attempted to test whether lagged information work as input in current price formation. Findings have shown that prices adjust to news available before an event has occurred. Therefore profitable trading strategies can not be developed in relation to an event after it has occurred.  

Semi-Strong Form Efficiency is about the speed at which pieces of public information are reflected in stock prices. The stocks prices adjust rapidly to all publicly available information. The announcement of a piece of information  is considered an event which is utilised by investors within minutes and prices adjust completely to their previous level. Thus the traders in stocks will not be able to earn  superior return by using publicly available information. 

Strong Form Efficiency refers to hidden information which is extracted by the analyst. The hypothesis holds that all available information, public or private is reflected in price. This is superior input to earn huge profit. However better informed investors do not earn higher return because better information is costly. Informational efficiency requires that marginal return should equal the marginal cost of obtaining information.  

          However, markets are never perfect and frictionless. The efficient market hypothesis, is subject to a number of other variables besides information relating to company and its stocks. These variables are speedy settlement of trade, quick delivery and payment system, safe transaction of funds and financial instrument, no fraud and no manipulation in the market. According to Islamic view, information based price discovery is a partial solution of the problem of pricing. Islam focuses more on quality of information. The data reflecting information needs proper coverage, definition and correct analysis so that rumour based trading is stopped and investors can do transaction in securities on the basis of their rational results estimated quantitatively by using fundamentals of the company including all material information.  

          Market efficiency according to Islamic Jurists differs from capitalistic view of efficiency which has given emphasis only on trading efficiency based on information system. Equilibrium price is determined by the forces of investment maximization and related utility maximization objectives and not by demand and supply of stocks only. High profitability or excessive profitability due to hike in price caused by various market imperfections is not supported by the Shariah. Hence profit should occur on the basis of genuine demand and supply in competitive and perfect market without using drawbacks of the stock market as discussed in this paper. In perfect market only normal profit occurs otherwise demand and supply factors come into motion to wipe out excess profits. As such profit should not be generated by artificial demand or supply of stocks. Islam permits profit on account of price but on the basis of genuine demand with the intention of investment. According to Anas records, during the lifetime of Prophet (may peace be upon him) price level went up. People requested him “Messenger of Allah (may peace be upon him)! Fix the price for us.” On this, prophet (may peace be upon him) said “Prices are fixed by Allah. He contracts and expands the sources of livelihood. And I hope to meet my sustainer (God) in a state that no one raise a claim of injustice against me in respect of blood or money.” 

So Islam does not interfere in the price mechanism and recommends that demand or supply of goods or assets should not be distorted by any manipulation and friction.  

In Islamic frame work, price of stocks should reflect intrinsic value of stock backed by the networth of the company. We can define it as economic value or book-value of stock.          V    =     E + R + S .

                                             N           

V = Price of stock, E stands for equity paid up capital, R for Reserves and N for Number of shares, S stands for Surplus. 

          Financial accountants evaluate the value of financial assets on the basis of discounted future cash flow from the asset. The discounted sum works out to Present Value (PV) of the future cash flows as given below :

PV   =         C1               +             C2             +             C3              -  -             Cn    .

                (1+r)¹                      (1+r)²                        (1+r)³                          (1+r)^T 

C = Cash flows,  r = Discount rate  

The above relationship depicts future cash flows. The discount rate contains a risk adjustment factor and is related to systematic risk. The assumption is that unsystematic  risk would be taken care of, if the income of firm has been diversified. The condition of equilibrium would be arrived when market price of a stock is equal to Present Value of future flows of dividend from the investment. It is possible at this stage that present value may exceed the economic value of stock. In this situation an investor would be earning some capital gains at market price. Islamic market should oscillate between economic value and present value of share.  

Shariah Position on Risk Management

          The owners of a firm hold partnership through holding shares of the company which is listed on stock exchange providing the opportunity of selling and purchasing the stocks on the basis of demand and supply. As such the investors main concern is the value of their shares. It is worthwhile to state that investors are risk averse because risk reduces the value of shares. Therefore any reduction in risk by using risk management strategies will protect the value of shares. Since Shariah also recommends maintenance and protection of wealth, an investor has to protect his investment value from risk otherwise he violates the Islamic teachings. If we do not protect our assets from risk, we are involved in squandering of wealth. It is prohibited by Quran. Again we are trustee of wealth appointed by God so we have to protect it by all fair means.

          Islamic market shows concern for excessive profiteering. Market efficiency does not guide the price to reverse back to original point but helps to settle it above original and below boom point and that way equilibrium price goes on shifting upward. If you look at any price index for last 15 years, you will see this trend. It happens that stock prices by and large have no link with fundamentals of the company during short term and trading in stock market and stocks prices are determined in short term only. 

          The very objective of the Shariah is to promote welfare of the people which lies in safe guarding their faith, their life, their intellect, their prosperity and their wealth whatever insures the safe guarding of the firm, serves public interest and it is desirable - Al-Ghazali. Hence, risk which can inflict damage to human beings is socially not desirable. We must take all legal measures to avoid risk. 

          If risk is not mitigated, it can lead to financial disaster and economic instability ;  Risk management has to be adopted at investors’ level as well as on stock market level since equity stocks are under consideration as financial assets. According to Islamic provisions, “Severe damage (darar) has to be reduced and can be substituted by lighter damage” and damage (Darar) has to be avoided as far as possible. Thus risk has to be mitigated. As such risk containment measures have to be used as recommended by Shariah. Risk in financial assets is broken into two components namely systematic risk and unsystematic risk. Systematic risk associated with equity shares is systematically related to market. This risk originates from the market events and it is not specific to a stock of the company. On the other hand unsystematic risk is generated in the company to which the stock is related. This risk can be eliminated by diversifying the investment (portfolio approach). As unsystematic risk is not relevant to risk management, it is systematic risk which has to be managed. This risk arises from market due to over trading, very large exposures, manipulations, frauds, short-selling and long-buying, insider-trading,  informational inefficiencies, inefficient clearing and payment system and lack of transparency in the market. Thus it is the imperfection in the market which can create systematic risk for investors. Of course, there could be natural factors like macro economic fundamentals which can also effect the market in positive or negative sense. 

Section III   :   Stocks Market Today in Capitalistic System 

          Stock market today occupies an important position in the economies of many countries like United States, UK, Germany, France, Japan, India, Malaysia and many other countries. Stocks markets in the world have gone through a number of reforms and substantial growth. Every stock exchange is supposed to set goals of investor’s protection, safe and efficient market with efficient allocation of domestic savings and trading mechanism, low cost of transactions. Markets have to follow stringent disclosure norms, credit rating norms, free pricing and book building for price discovery in the primary market where companies enter to issue equity stocks. Even intermediaries institutions that assist primary market, are regulated by the Regulatory Authority. Merchant Bankers, underwriters, registrars, custodians, brokers, etc. have to meet capital adequacy norms and other codes of conduct prescribed by the domestic government and regulatory authority. They are subjected to inspection and investigations by Regulatory Authority regularly. 

          The trading in stocks is automated and screen based and the settlement period has been shortened. Today almost all stock exchanges work on T+2 settlement period basis. Moreover today trading is done in rolling settlement. There are no settlement defaults as trade is cleared by the Clearing Corporations set up by stock exchanges. Trading is paperless as shares in dematerialized form are kept in investors’ accounts with depositors. Almost all tradeable securities are transacted without delay, transit loss and forgery in transparent manner with all information contents. An important feature of today’s exchange market is that clients through computers, brokers, stock exchange with automation screen based trading, clearing corporation, depositories and clearing banks are having interconnectivity. This network has resulted in reduction in frauds and delay in settlement. Stock exchanges have transparent trading and have achieved reduction in cost of transaction. 

          The companies listed on stock exchange for trading have to sign listing agreement and have to observe conditions specified in the agreement. The listed company has to file quarterly financial statements of its operations and all material and sensitive information with stock exchange regularly. Stocks markets work according to guidelines and mandatory instructions of Regulatory body set up under Government Act. Regulatory Authority generally regulates functioning of stock exchanges, mutual funds, collective investment schemes, pension funds, etc. as all of them operate in the market. Among the other intermediaries being regulated are brokers, depositories, foreign financial institutions and other institutions investing in securities. Among them, brokers are closely regulated. Brokers are registered with Regulatory authority and have to follow all disclosure norms, Capital Adequacy norms and risk containment measures. In many countries like India, Government is encouraging corporatisaton of brokers to make them more methodological and financially strong. There are stringent laws and punishment for brokers, traders and other intermediaries associated with capital market for economic offences like frauds, manipulations, violation of regulatory norms, insider trading and violation of laws relating to volatility in the market.

Traders in stocks markets have a tendency to have exceedingly huge exposure and indulge in short selling, long buying and carry forward transaction. Such activities result in default and huge losses. To avoid such events, authorities impose margins on overall gross exposure of the broker member of stock exchange or their exposure in specific securities. Then there are volatility margins on movement of prices of equity shares, an exchange can use even circuit breakers. Authorities can halt the trading if market is going out of hand, in order to cool down the market. Mark to market margins and Value at Risk based margins are used to safeguard the settlement. Every stock exchange has to set up trade guarantee fund to provide safe settlement and to avoid defaults and Investors Protection Fund to protect investors. 

          Despite all precautions, measures and mandatory steps, transparency norms, disclosure norms on entry of firms, markets have shown adverse disruptions. For instance more than 2000 companies in India raised capital from the primary market during 1992-93 - 1994-95 and disappeared from the market. Millions of investors suffered a loss of more than Rs.2,000 crore resulting in confidence crisis and erosion of household investors base. Though there are stringent penalties available which could have been imposed but because of non-ethical approach of authorities, nothing could be done. This is the weakness of legal system in capital market. As regards trading of securities, the market has experienced many crippling events in many countries in the world and recently in East Asia. In India about 10 thousand companies are listed for trading of which only 30 per cent are traded but 60 per cent of them account for 80 per cent of turnover. Turnover has risen from Rs.400 bn. in 1992 to Rs.10233 bn. in 2004 but number of companies has almost remained constant. Since in capitalistic mode of securities trading, market does not investigate the quality of demand and nature of supply, stock prices reflect large scale of speculation; due to squaring up facility in the settlement system and low margin requirement exist unabated. In India, a trader can do any amount of short selling or can accumulate a long position and can square up trade before the end of settlement. The speculative trading in India resulted in crash of market. In 1992 end, BSE sensex dropped to Rs.2222 bn. from Rs.4467 bn. resulting in a loss of Rs.2245 bn. for investors. A large number of households suffered heavy losses. Many banks which financed speculative trade became insolvent leading to their merger with strong banks. Even a few foreign banks came in problems. Again, in 2000-2001 market capitalization at BSE suffered a fall of Rs.3412 bn. from Rs.9128  bn. in 1999-2000 to Rs.5716 bn. in 2000-01. Investors again lost Rs.4003 bn. in 2002-03. Investors suffer either loss or gains of the order of billion of rupees on alternative days. Such market cannot be considered a fair market. In order to show market vagaries, Table 1 was prepared to record absolute increase/decrease or gains or losses in the Indian stocks market.  

TABLE 1   :    INDIAN   STOCK  MARKET

                         BSE SENSEX FOR THE MONTH OF JANUARY 2005.

Date	Total Market Capitalisation Rs. (crore)	Absolute Increase	SENSEX Full Mkt. Value (Rs. Crs.)	Absolute Increase Decrease (-)	SENSEX Turnover (Rs. Crs.)
12/31/04	383002.34		735528.13		621.02
1/3/05	387440.38	4438.04	746152.72	10624.59	631.87
1/4/05	385805.27	-1635.11	742448.69	-3704.03	705.29
1/5/05	374657.95	-11147.32	718048.14	-24400.55	1179.21
1/6/05	369353.56	-5304.39	707976.57	-10071.57	1080.04
1/7/05	372431.64	3078.08	713778.77	5802.20	913.62
1/10/05	366307.42	-6124.22	701891.66	-11887.11	651.60
1/11/05	361332.96	-4974.46	693576.65	-8315.01	798.36
1/12/05	354357.78	-6975.18	680948.36	-12628.29	1166.77
1/13/05	361228.03	6870.25	694472.68	13524.32	902.11
1/14/05	358484.99	-2743.04	688601.45	-5871.23	834.90
1/17/05	359660.66	1175.67	690611.29	2009.84	885.56
1/18/05	359561.04	-99.62	690404.17	-207.12	1038.63
1/19/05	358455.94	-1105.10	688119.96	-2284.21	775.35
1/20/05	359031.85	575.91	688008.02	-111.94	1246.23
1/24/05	354571.86	-4459.99	680057.73	-7950.29	861.06
1/25/05	357855.40	3283.54	686599.80	6542.07	1036.14
1/27/05	362294.56	4439.16	696154.07	9554.27	1003.21
1/28/05	372726.58	10432.02	715500.35	19346.28	1150.32
1/31/05	380672.75	7946.17	731784.91	16284.56	1111.59

 Table 2 contains company wise figure of paid-up capital and their market capitalization. It would be seen that market value of paid-up capital has shown more than 1000 per cent rise on account of manipulation.

Table 2 : Paid-up share value and market capitalization of selected stocks traded on Bombay Stock Exchange at end of December 2004.

 (Figures are in Rs. crore)

Sr. No.	Name of Stock	Issued and Paid-up Capital	Market Capitalisation	Column3 as a percentage of Column 2	Volatility In per cent
	(1)	(2)	(3)	(4)	(5)
1	ABB	42	4116	9800	1.93
2	ACC	178	6036	3391	2.19
3	Bajaj Auto	101	11446	11333	1.87
4	Bharati	1853	40098	2164	3.25
5	BHEL	245	18769	7661	3.03
6	BPCL	300	13778	4593	2.88
7	CIPLA	60	9530	15884	2.13
8	Colgate	136	2436	1791	1.72
9	DABUR	29	2681	9245	2.74
10	DRREDDY	38	6622	17426	2.36
11	GAIL	846	1953	231	3.79
12	GLAXO	87	6724	7729	1.82
13	GRASIM	92	12125	13179	2.27
14	GUJMBCEM	179	7230	4039	2.26
15	HCL TECH	60	10235	17058	2.52
16	HDFC	248	19050	7682	2.35
17	HDFC Bank	287	14910	5195	2.60
18	Hero Honda	40	11429	2853	2.41
19	Hindal Co.	92	13156	14300	2.27
20	Hind Liver	220	31566	14348	2.01
21	Hind Petro	339	13626	4019	2.60
22	ICICI Bank	736	27313	3711	2.47
23	INDHOTEL	45	2429	5398	1.90
24	Infosystem	134	56028	41812	2.09
25	Reliance37	1396	74525	5338	2.20
26	Sail 39	4130	25898	6127	2.49
27	VSNl 48	285	6615	2321	3.13
28	Wipro 49	140	52408	37434	2.84
29	Zee Tele.	41	7077	17261	3.19
30	TISCO	530	21314	3854	2.82

 Since stock markets represent the capitalistic society, maximization of profit and wealth is the primary goal. Even the corporate governance has been designed for maximizing shareholders wealth without considering the ethical part of it. Similarly, in stock markets number of developments have been made to boom the market in the name of liquidity. I may clarify that stock market concept is an ideal one but it has been sacrificed on the alter of liquidity. Liquidity does not mean the turnover rise of the same number of shares in the market capitalisation due to overtrading. Turnover increase means rise in quantity of real-shares traded and liquidity means easiness to sell without loss of capital and without delay at minimum transaction cost. Some of the reasons for damaging the Indian stocks market and other stock markets are given below:   

I.                Brokers / traders are allowed to do total (gross) trade equal to many times of their capital or funds with clearing corporation. This empowers brokers to indulge in overtrading.

II.                Banks are permitted to provide finance to brokers for financing trade in securities.

III.                Since only margin money is required at the time of making order for buying the stocks, such money can be borrowed from banks or other brokers. As such purchasing the shares when an investor does not have finance, is undesirable and leads to increase in stocks’ prices.

IV.                Short selling and long buying generates volatility and uncertainty in the market.

V.                Trading in the market is done to reap high profits and not with the intention of investment. In India more than 60 per cent of trading is speculative and about 40 per cent is done on delivery basis.

VI.                Margining system is very liberal and margins are not kept in cash. Keeping securities as margin gives leverage to the traders.

VII.                Taxation system is faulty as capital gains are exempted from tax. This fiscal incentive motivates traders to speculate and earn abnormal profits.

           We have given the adequate idea of weaknesses of capitalistic mode of functioning of stock markets. The following section is devoted to operational frame work of Islamic stock markets which is expected to eliminate shortcomings of capitalistic mode of stock trading.

 Section IV : Operational Frame Work of Islamic Stock Market

Primary Market  

Theoretical aspects of Islamic stock market were discussed in the second section (II) and therefore in this section we attempt to discuss some operational features. We covered all provisions relating to issue of stocks in primary market. Investors in stocks in Islamic view should have intention of real ownership rather than trading. Shariah Regulatory Authority will have to impose lock-in-period of 4 to 5 years so that only real investors purchase the shares. Of course the company should offer buy-back facility in order to provide liquidity for investors in need. 

Islamic company should issue stocks on the basis of fixed price method calculated by appraising agency which should have free access to all available information from the issuing company. An issuer company before issue should obtain clearance from Shariah Regulatory Authority that there is no activity based on Riba and gharar in issue process. Mutual funds and other financial institutions intending to invest in Islamic instruments should submit quarterly Shariah Compliance Statement.

Pricing of shares can also be based on Present Value (PV) of future cash flows or on the basis of net worth of the company as discussed in section II. A company should not charge premium on issue without having any relationship with net worth and reputation or goodwill. Actually price of issued share should reflect its economic value. Allocation of stocks should be done on pro-rata basis when demand is more than stocks issued or there is an over subscription. A company can announce issue on stock exchange screen also to have wider awareness among the investors. Modern system of capitalistic process of offering securities through Book building process in which bids at various prices from investors or syndicate members are received and demand for stocks is determined on the basis of these bids and thereafter it’s price is discovered based on the basis of average price estimated by the merchant bankers and advisers to issue. In India book building has two options namely 75 per cent book building route and 100 per cent book building. A more than 60 per cent of offer is allocated to institutional buyers and rest to non-institutional and small investors. Since average price is fixed on the basis of book building route in which investors buy 60 per cent, average price is worked on the basis of higher prices in their bids. The remaining 40 per cent is also allocated on the average price and not on the price which small investors have quoted. However, Islamic stock markets should not adopt book building method because many times it involves over pricing by institutions due to their mutual understanding with the promoters. Fixed price issue method should be followed by Islamic market. An issuer will be always conservative in pricing the issue so that issue is fully subscribed. Hence price is always on the lower side. But book building price is aggressive and harms the investors. Moreover book building method does not offer enough opportunity to individual investors. 

1)      Secondary Market in operation 

          The most important organ of secondary market is stock exchange which provides facility of purchase and sale of stocks. The stock exchange can be organised either as a voluntary or non-profit making association or public limited company owned by shareholders or company limited by guarantee. The stock exchange as a public limited company owned by equity holders would be compatible with Shariah provided governing board members do not practice borrowing and lending operations and have no transaction activities on stock exchange. Moreover, executives of stock exchange should not be trader/broker on the stock exchange otherwise there will be no guarantee that stock exchange will function in fair manner. Stock exchanges have to be supervised and regulated by Shariah Regulatory authority on the basis of Shariah principles. Stock exchanges will supervise listed companies whether they follow Islamic provisions and listing agreement and stock exchange should work as a trustee to protect the interest of investors and particularly small investors.

 2)      Instrument to be traded

           Besides equity shares and preference shares right shares also can form the part of Islamic instruments to be traded. Mutual funds should promote equity linked schemes to mobilise funds to invest in equity shares and other Islamic instruments. Such units of mutual funds can be transacted on stock exchange. The listed companies can also list their bonds and debentures which should not be interest based instruments but dividend based instruments. Bonds can be traded in the market but holders of bonds cannot be owner of the company and also they can not participate in the management of company. Islamic bonds can be similar to fixed deposits of Islamic banks but tradeable. There will be one advantage to bondholders, they can be the first claimant in case company is liquidated. Islamic certificates of deposits also can be issued by Islamic companies and traded in the market. Islamic capital market in Malaysia offers many Islamic instruments. These include Islamic equity funds, balanced money market and bonds funds. These instruments are component of Shariah based Unit Trust funds. Islamic global Sukur Ijarah and Islamic derivatives are also instruments which can be listed on stocks exchange. Derivatives should be primarily used for hedging risk and can be traded with capital gains around the price + premium paid by the buyer of a derivative.

 3)      Principles of Trading

           We have already analysed certain transaction activities which Islam does not permit. These include overtrading, short selling, frauds, insider trading, cornering information, lack of transparency and absence of fairness in trade. These all hinder the competitive market functioning. High booms and crash in the securities market is a sign of imperfection. Even after all paraphernalia attached to stocks market trading of stocks does not result in real value addition. Competition result in high productivity, efficiency and gains for economy and society. Competition is healthy and productive if it can increase quality, efficiency and equity rather than cut throat competition by using unscrupulous and unethical tactics. Traders in market develop animal spirit and generate uncertainty and risk. To control such environment, trading needs to be restrained by putting cap on gross transaction of broker which should not exceed level of capital adequacy of broker. Broker should pay penalty if gross trade exceeds his capital deposits with the clearing corporation. Even stock-wise exposure should be subjected to a limit. If trader is found in manipulation activities, there should be severe cash penalty and cancellation of registration of broker. Banks and financial institutions should not be permitted to lend for financing the trading in securities. Islamic trading system should be 100 per cent delivery based and dematerialized. Only equity based company can participate in stock market and should observe Shariah in absolute sense. Islamic stock market will require all paraphernalia of modern exchange. Automated trading with all efficient mechanism is must for Islamic market.

 T+0 Rolling Settlement and Clearing of Trade

           Islamic stock exchange is supposed to discourage and prohibit short selling and long buying, manipulation in sales and purchase of stocks and frauds in transaction. In order to achieve these targets, execution and settlement of transaction should be as rapid as possible so that no one gets the chance to distort the market. As soon as the orders to buy or sell are routed through automated trading system, they should be matched to sell or buy orders of the counterparty. All orders have to be matched on a time / price priority basis. Islamic stock exchange will have to adopt rolling settlement system on T+0 basis. It means trade executed today has to be settled tomorrow by actual delivery of shares and cash payment. In such a mechanism, there is no possibility of manipulations. In almost all advanced stock exchanges, settlement of trade is done through clearing corporation which works as opposite party to seller as well as buyer and pay in and pay out is routed through it. Clearing corporation should be a guarantor of safe trade. Clearing corporation will have to be setup as an independent subsidiary of Islamic stock exchange. As such trading in stocks should have three phases, viz. trading, clearing and settlement. White stock exchange provides platform for trading, the Islamic clearing corporation determines the funds and securities obligations of the trading members and ensures that the trade is settled through exchange. Thus T+O eliminates fraud and manipulation in the system.

           Islamic stock market warrant availability of highly skilled investors. This needs professional education of high standard. Accounting standards to be practiced by all participants in the market and market sophistication require specialized training institutes. It is necessary to caution that Islamic stock exchange is a very costly affair. Stocks market have been facing traders in many forms like brokers on their accounts, individual households, non-banks finance companies, mutual funds, equity firms, foreign financial institutions, domestic financial institutions, pension funds and provident funds. Among them foreign financial institutions, should not be permitted to invest in Islamic stocks as they are simply traders. Other institutions and individual investors can be discouraged from overtrading in the market. All institutions like foreign institutions, mutual funds should not be permitted to sell or buy the stocks of a company beyond a limit. Heavy buying and selling should not impact the price of stock even to a decimal extent in order to minimise impact cost.

          Islamic stocks market should work as a trustee for investors and have to watch performance of listed companies. As soon as the stocks of a listed company record large fluctuations, stocks market should display SWAT analysis of the company on screen. The Islamic stock exchange statutorily should impose ban on rumours, incorrect estimates of results of company and misinformation. The Islamic stock exchange can announce divergence between stocks prices and real fundamentals of the economy as well as those of company of which stock is under reference.

          Muslim community has been lagging behind in the technical knowledge relating to investment and financial markets. There is a need to expand financial literacy among the Muslims. We can have Islamic Financial Management institutions and investment experts to impart education and working knowledge of Islamic investment principles. Awareness is also very important. We will have to develop the sense of accountability in the community as well as in the market players. Ethical values have to be matured and strengthened.

S ection V : Conclusions of the paper   

          Islamic stock market can play a crucial role in promoting equity investment and creating liquidity in the market and simultaneously avoid frauds, manipulations, inside trading, short selling and long buying. The capitalistic model of Indian stock market inspite of all facilities, disclosure standards and accounting standards failed to protect the investors and has crippled the confidence of investors. Many a times even a whole nation has to face adverse financial insolvency. Since financial markets are getting globalised and capital inflows are playing a game of free rider in other economies Islamic market would have emerged with stringent Shariah discipline and with most upto date technology and education in financial literacy. Stock market efficiency will have to be judged on the basis of growth of investment and capital formation. Minimum volatility, minimum divergence of market price of stock from its intrinsic value, severe punishment for violating the law and high level of financial literacy in Islamic world, should be the prime goal of Islamic stock exchange.