This literature review demonstrates the notion, span and principles of Islamic Capital Market(ICM) around the world. Fueled by increasing income streams from Gulf countries, a rise in Islamic faithfulness and an ever increasing concern to use Islamic financial products which are becoming more accessible to people, this segment of the financial services market is expected to continue to have a rampant growth. A quantitative and empirical assessment of the achievement, opportunities and challenges of ICM is made.
2.2 Introduction to Islamic Capital Market
Whether it is in Malaysia, London or even United States, Islamic financial instruments are experiencing unprecedented global demand. But while Shariah compliant mortgage schemes (isharaka), insurance (takaful), leasing (ijarah) and some retail products have been available for a number of years, it is the growth of ICMs, and particularly of Islamic debt instruments that have taken many by surprise, both inside and outside the Arab and Muslim world. A good estimate is that the Islamic financial sector has assets somewhere between $US750 billion and $US1 trillion (Hawser 2008: 39-41). A little over $US500 billion of this is held by self-identifying Islamic financial institutions (Timewell and Divanna 2007). To put things in perspective, this is less than 1% of the global financial sector and in the forthcoming five years, it would be a $US2 trillion industry ( Source: AMEinfo,2010)
The ICM refers to the market where activities are carried out in ways which does not conflict with the principles of Islam. It represents an assertion of religious law in capital market transactions where the market is free from prohibited activities and elements such as riba (usury), maysir (gambling) and gharar (ambiguity). An ICM is to provide long term fundraising and investment as well as to enhance depth and liquidity of Islamic financial system. ICM products and services may be illustrated as follows:
Figure 2.1: ICM Products and Services
Source: Adapted from Securities Commission Malaysia
A capital market is essential for any economy to progress and succeed. Capital markets provide long-term capital through a series of short-term contracts. These securities may be derivatives, equity based or debt-based. Warde (2000: 175-176) enumerated the panoply of advantages that are gained, which are the followings:
They provide liquidity in the market as they offer lowest transaction price.
They enlarge the options of investors and attract foreign investments as well as national savings.
There is resource mobilization and hence an efficient capital allocation.
They reduce the level of risks by offering opportunities of geographical and sectoral diversification.
Efficient capital markets provide transparency and thus asset pricing by determining price of risk.
The rising consciousness and demand for investing in agreement to Islamic principles on an international scale has created a prosperous Islamic capital market. The ICM functions as an equivalent market to the conventional capital market for capital seekers and providers and offers financiers with an alternative investment attitude that is rapidly gaining acceptance. The fact that the Islamic financial market does not forbid participation from non-Muslims creates unlimited upside to the depth and breadth of this market.
2.3 Basic instruments of Islamic finance
Paying or receiving interest which is forbidden under the Islamic law does not mean that making money is condemned and thus do not participate in any investing and financing activities. There exist a plethora of techniques and instruments applied by Islamic institutions. The following figure illustrates the most applied instruments and contracts:
Figure 2.2: Financing instruments and methods
Source: Tamer (2003: 100)
As noted from the above chart, murabaha also known as cost-plus sale or mark-up trade finance is the mostly used financing technique. It implies that the bank purchases an asset by buying it on behalf of its client. Subsequently, the client purchases the asset on a deferred payment and against a profit margin, which has been agreed upon by both parties. It is also interesting to note that the bank assumes the liability of the asset. As a matter of fact, this creates a fixed, predetermined and secure indebtedness, thus making murabaha attractive for Islamic financial institutions as a substitute to interest-based transactions.
Mudaraba also known as silent partnership based on profit and loss sharing is a type of contract where the financial institution grants the entire capital for a certain project whilst the entrepreneur which is the client offers his labour and expertise. The profits are shared by both parties at a certain fixed ratio while the losses are borne exclusively by the bank.
Musharaka also known a joint venture and based on profit and loss sharing is a type of financing where the financial institution is not the unique provider of capital to finance a project. According to Ahmad (1993), one or several entrepreneurs may approach an Islamic bank for financing a project. Consequently, the whole financing is mutually provided by the entrepreneurs and the bank and each individual has right to management. The entrepreneurs become partners (musharik) and the profit and losses are shared in relation to the respective capital contribution.
Another well known financing method is ijarah which can be compared to the traditional method of leasing. As explained by Iqbal and Miakhor (2006: 84-85), in this situation an Islamic financial institution leases the asset to a client on lease payments for a specified time period and there's no option of ownership for the client. The insurance and maintenance of the lease asset is the financial institution's liability. However, at the end of the ijarah contract there is the possibility for the tenure customer to purchase the asset under a separate sale agreement called ijarah wa iqtina at a token price.
There are other important financing methods based on murabaha which are important for ICM. Warde (2000: 133) enlightened some of them which are istisna also known as commissioned manufacture, salam and bay muajil also known as credit sale respectively. Under the istisna contract, the purchaser buys a commodity while the seller carries out the manufacturing of the commodity at an agreed price and as per specified descriptions. On the other hand, salam is the sale of goods or commodities where the price is paid in advance whereas a bay muajil contact is where the commodity is delivered immediately but the price is given in the future.
2.4 Islamic Funds
2.4.1 Equity Funds
Stock markets and equity markets are important elements of capital markets. Equity trading involves speculation, but under ICM the speculation cannot be considered as pure speculation, as it is backed by economical analysis. Conversely, this is not the only criteria that an investor needs to obey as there a series of restrictions relative to the company that needs to be respected as well. For example, it is prohibited to invest in companies whose core business activities are not Shariah compliant. To have a better understanding of what is being explained, we can have a look at the Dow Jones Islamic Market Indexes (DJIMI), which includes 2343 Shariah compliant stocks from 69 countries and whose market capitalisation was US $ 16.33 trillion as at February 26, 2010. (Source: Dow Jones & Company Inc., 2010) The screening guideline established by the DJIMI Shariah Supervisory Board, firstly excludes all businesses whose stocks and equities are backed by conventional financial services, pork-related products and so on. Secondly, it is concerned with financial ratios of companies, i.e. all companies having excessive rate of debt and impure interest income have to be removed.
Another matter of stock screening is purification. It is an important process as it gives the opportunity to fund managers to boost diversification, thus reducing the risk of their portfolios. If a shareholder is willing to change the prohibited activities, he must purify the income received from impure activities by donating this to charity and the impure income should not exceed 5%of the gross income. (Source: DeLorenzo, 2000: 4)
Some other well known indices are the Karachi Stock Exchange (KSE), Standard & Poor's 500 index, Kuala Lumpur Shariah Index (KLSI), and the Financial Times Stock Exchange Global Islamic Index (FTSE-GII). However, it is to be noted that the screening process might differ from each indices.
2.4.2 Non-Conventional Funds
Private equity fund based on musharaka is one among the number of choices that exist to Islamic investors. Wilson (2007: 4-5) posits that private equity funds in Islam offers a possibility for development. He even gave the example of Unicorn Bahrain, whose Global Equity fund covers a wide market including USA, South East Asia, the Gulf region and some Mediterranean countries such an Turkey.
Real-estate and property funds are another examples of Islamic funds. Real-estate funds are acceptable on condition that they are Shariah compliant, e.g. there must not be casinos as they are involved in gambling. These funds can be managed by conglomerates that own real estate such as residential and commercial properties, hotels, health-care facilities and so on. The funds can be based on ijarah as well and the gains are to be distributed among the investors of the funds.
Commodity fund is another popular type of Islamic fund. It can be based on murabaha contract. As compared to conventional commodity fund, here there are strict conditions that need to be followed because of Shariah compliance and it is worthwhile noting that even risk is minimal capital is not guaranteed.
We have the impression that hedge funds in Islamic context is not possible. However, there have been modernism and there has been the introduction of hedge funds which was launched using another approach without violating the Islamic law. As a result, this encourages and allows investors to contract investment strategies that were previously denied to them. It also includes option trading and short selling. Salam and Arbun are instruments that are alternatives to conventional futures and options. According to Butcher(2003), hedge fund has the advantage that it is backed and approved by esteemed Islamic scholars such as Sheik Yusuf DeLorenzo and Sheik Nizam Yacuby.
2.4.3 Growth and Performance of Islamic Funds
As compared to the conventional fund industry, the range and size of the Islamic fund industry is small. There was a school of thought that the Shariah principles might not offer enough choice of funds for diversification and moreover the impact of these principles could adversely influence the performance of Islamic funds. Nonetheless, looking at the figures, the Islamic fund industry is rapidly expanding and form the year 2000 and early 2010 equity assets have more than tripled.
Figure 2.3: Size and Growth of Islamic Equity Funds
Source: Adapted from KPMG International (2006: 9)
The expansion of the Islamic fund industry is largely by the introduction of non-conventional funds and the future is bright but taking into consideration conventional funds as well that are indicating remarkable growth potential which had slowed due to the recent crisis. Also, we shall not exclude the large financial assets in Gulf countries, especially in countries where there are the privatisation process, e.g. Dubai. The following chart illustrates the development of funds between 1996 and 2006.
Figure 2.4: Number of Shariah compliant funds
Source: ifinance(2009)
To dissipate the apprehension that Shariah principles and restrictions might limit the performance of funds, many authors namely Hakim and Rashidian (2002), Girard and Hassan (2005), Elfakhani and Hassan (2005), and Hussein (2005) had conducted studies and the findings of all of them had the same conclusion, i.e. the restrictions and conditions of Islam do not negatively affect performance. Therefore, this gives more confidence to Islamic investors. But it is to be noted that the industry needs not be overconfident and there are challenges, for example,it has to draw lessons from the past where a number of Islamic funds closed down.
2.5 Characteristics and legitimacy of Sukuk
Sukuk should not be confused with conventional shares or bonds. Shares are issued by a stock company that has been granted independent juristic personality. In the case of bonds, the bond holder enters into a debtor-lender relationship with the bond issuer. In contrast, the design of the sukuk is derived from the conventional securitisation process in which a special purpose vehicle is set-up to acquire assets and to issue financial claims on the asset. The issuer of a sukuk sells to an investor group the certificate, who then rents it back to the issuer for a predetermined rental fee. The issuer also makes a contractual promise to buy back the sukuks at a future date at par value. Sukuk is Shariah compliant as long as the returns are from the performance of a real asset rather than interest from debt obligations.
Sukuk Issuance (US$ million)
Year
2000
2001
2002
2003
2004
2005
2006
Corporate Sukuk
336.3
530
179.9
4537.06
5731.19
11358.89
24526.32
Sovereign Sukuk
0
250
800
1180
1479.35
706.5
2271.6
Total Sukuk issuance
336.3
780
979.9
5717.06
7210.54
12065.39
26797.92
Percentage Growth
131.94
25.63
483.43
26.12
67.33
122.11
Table 2.1: Sukuk issuance
Source: Nissar (2007)
In 2000 total size of sukuk was only US$ 336 million with no sovereign sukuk in the market. We can see from the above table that the size of total sukuk issued in 2001 was only US$ 336 million and in a short span of just six year the total size of sukuk has crossed US$ 27 billion. The growth achieved in 2003 has been most impressive at 483%. In 2006 also total growth achieved by sukuk is 122%.
The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has played an key role by having developed Shariah standards in relation to sukuk. As a result, this contributes to the success of sukuk in terms of versatility. Also, its enhanceability can allow different sukuk structures for credit enhancements. The variety of sukuk structures defined in the AAOIFI standards allow for structuring across legal and fiscal domains, fixed and variable income options, etc. The fact that sukuk is a liquid asset and traded in secondary markets same as in conventional markets makes it easily tradable, and as it conforms to global bond regulations gives the opportunity to invest internationally. Another advantage is that it can be analysed and rated by international rating agencies, thus contributing to its tradability and distribution. The following table as discussed by Adam and Thomas (2004) illustrates between sukuk, conventional bonds and shares.
Sukuk
Bonds
Shares
Nature
Not a debt of issuer but undivided ownership share in specific assets/projects/services
Debt of issuer
Ownership share in corporation
Asset backed
A minimum of 51% tangible assets
Generally not required
Not required
Claims
Ownership claims on the specific underlying asset
Creditors claims on the borrowing entity and in some cases liens on assets
Ownership on the company
Security
Security by ownership rights in the underlying assets
Generally unsecured debentures
Unsecured
Principal and returns
Not guaranteed by issuer
Guaranteed by issuer
Not guaranteed by company
Purpose
Only by Shariah compliant purposes
Can be issued for any purposes
Can be offered for any purposes
Trading of security
Sale of an ownership participation in a specific asset
Sale of a debt instrument
Sale of shares in a company
Responsibility of holders
Responsibility for defined duties to the underlying asset limited to the extent of participation in the issue
Bondholders have no right for the circumstances of the issuer
Responsibility for the affairs of the company limited to the extent of holding in the company
Table 2.2: Differences between sukuk, conventional bonds and company shares
Source: Adam and Thomas (2004: 53)
The legitimacy of sukuk structures in the Shariah lie in the fact that they do not take advantage of interest rate movements. It is derived from Hadith but is neither clearly prohibited nor approved. Adam and Thomas (2004) argues that Islamic scholars have the opinion that everything is allowable as long as it is in line with the primary sources of the Islamic jurisprudence.
2.6 Challenges facing Islamic Capital Markets
The challenges facing ICM can be classified into 4 different categories.
Figure 2.5: Challenges facing ICM
Source: Author
2.6.1 Religious Challenges
Lack of uniformity between Islamic scholars is one of the main challenges that need to be tackled. There have been conflicting views that were expressed on the interpretation of the Shariah compliance of financial products and services. As a result, this creates confusion in the mind of investors about their permissibility. The reason behind these controversies is that some scholars are more liberal while others are more conservative. To come to a solution there needs to be an independent and international supervisory authority that could monitor Shariah compliance of financial institutions. As a result, this will put an end to numerous criticisms saying that there are only several dozen scholars globally who have the necessary training in Islamic law, conventional law as well as business experience to advise the companies. Abraham (2008: 43) argued "they are also criticised to sit on numerous boards, earning multi-million dollar salaries, wielding a great deal of power (Kahf 2004; Ram 2008) and have been called "rock star Shariah scholars" by Forbes (Morais 2007)".
Speculation is the other point of controversy as some believe that speculation attempts to predict the future outcome of an event, but it has to be distinguished as to whether the speculative operations are backed by sophisticated collection and analysis of information to minimise risks or whether they are pure gambling. Hence, they believe that it does not violate any Shariah rules and also reflects more the speculative element of the capital markets. There is the probability that scholars might be forced to accept a slight degree of speculation by deregulating certain rules and conditions.
2.6.2 Challenges of the Sukuk market
Ali (2005) explained the problem that can result when most sukuks are associated to a real asset. This may cause problems to small institutions in raising capital because compared to large institutions they do not have large pools of real assets. Hence, it be can assumed that this may pose problems to new comers like Mauritius in the ICM which would most probably launch sukuks in the future.
It is argued that there's sound secondary market yet for the tradability of sukuk. As a consequence, there is the need to make it more efficient in order to improve liquidity, lessen transaction costs and so on.
So far the sukuk market is expanding, thus with its further growth and development there need to be more indices so as to provide better monitoring and better performance measures.
2.6.3 Challenges of the Islamic Funds
As discussed before, because the capital market is still young there are no track records for sophisticated performance measures and risk/return behavior for the Islamic fund industry as well. So there is the need for the implementation of an appropriate and sophisticated risk management and diversification framework and there need to be higher screening efforts where fund managers can have in depth information about companies.
Another aspect is about the stability of screening criteria because the criteria varies from country to country. El-Gamal (2006: 126) advocates that screens are easier to define in the abstract but more difficult to implement. For example, it is easy to say that businesses that serve alcoholic drinks should be excluded (possibly excluding certain hotel chains, airlines, restaurant chains, etc.) Hence, some scholars believed that leasing airplanes to airlines that are known to serve alcoholic drinks is permitted. Their reasoning was that the primary business of the airline is transportation of passengers, rather than serving or transportation of alcoholic beverages.
2.6.4 Challenges in the regulatory framework
Prudential supervision is just as necessary in Islamic finance as well in order to reduce risks to the soundness of the financial system. It is a fact that insolvency risks cannot be ruled out altogether, most notably in cases where operations are carried out according to a two-tier mudarabah arrangement, i.e. , when the assets and liabilities sides of a financial institution balance sheet are fully integrated.
An appropriate regulatory framework for an Islamic financial system should aim at reinforcing the operating environment of financial institutions, as well as their internal governance, and market discipline. To help develop such a regulatory framework, standards and best practices established are useful and provide a valuable reference. However, these standards cannot always be applied to ICM in the same way that they are in the conventional capital market.
Furthermore, a weak financial system is likely to prevent the economy from benefiting from the ongoing process of globalisation and the liberalisation of capital markets, particularly in developing and emerging market countries (which are often the ones where Islamic financial principles are followed) where banks are the major players in domestic financial markets.
2.7 Conclusion
This chapter has reviewed in depth the literature underpinnings pertaining to development and challenges of ICM. In order to ensure all the components of an ICM have been enlightened, vital issues that could not included in this chapter are dealt in the appendices.
