Religion, Ethics and Stock Trading: The Case of an Islamic Equities Market

Author(s): Shahnaz Naughton and Tony Naughton

Source: Journal of Business Ethics, Vol. 23, No. 2 (Jan., 2000), pp. 145-159
Published by: Springer
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Religion,
Ethics and Stock
Trading:
The Case of
an
Islamic
Equities
Market
Shahnaz
Naughton
Tony Naughton
ABSTRACT. Islamic
banking,
based on the
prohi
bition of
interest,
is well established
throughout
the
Muslim world. Attention has now turned towards
applying
Islamic
principles
in
equity
markets. The
search for alternatives to Western
style
markets has
been
given
added
impetus
in Muslim countries
by
the
turmoil in Asian financial markets in 1997. Common
stocks are a
legitimate
form of instrument in
Islam,
but
many
of the
practices
associated with stock
trading
are not. In this
paper
the instruments traded and the
structure and
practices
of stock markets are examined
from an Islamic
perspective. Speculation
is not
accept
able in Islam and measures would have to be taken
to control
speculative trading.
In addition short
selling
and
margin trading
are
severely
restricted. The use
of stock index and
equity
futures and
options
are also
unlikely
to be
acceptable
within an Islamic market.
Regulatory
authorities in Muslim countries will
therefore find a vast
array
of
problems
in
attempting
to structure a
trading system
that will be
acceptable.
Introduction
A
separate
stock
market,
based
strictly
on Islamic
principles,
is still
very
much at an
early stage
of evolution. This
development
is
part
of an
on-going program
on Islamisation of the finan
cial
system
in the Muslim world
(Naughton
and
Tahir,
1988). Many
Muslim
countries,
or
those with a
majority
Muslim
population,
have
well established stock
markets,
for
example,
Bangladesh, Egypt,
Indonesia,
Malaysia
and
Pakistan. These stock
exchanges
are
basically
Western
style
markets
tolerating practices
that
may
not
strictly
adhere to Islamic
principles (El
Din, 1405/1985). However,
countries such as
Malaysia
are
making
solid
progress
in
establishing
the
necessary
infrastructure to facilitate stock
trading
in accordance with Islam. Islamic
broking
houses and Islamic
managed
funds
operate
and a
separate
"Islamic Index" has been established
comprising
179
permissible
stocks on the Kuala
Lumpur
Stock
Exchange (New
Horizon,
1996).
This
paper
is an
introduction to the issues asso
ciated with the formation of a
separate
Islamic
stock market. The
paper
will draw on
interpre
tations of
Shari'ah,
which is the name
given
to
the sources of the sacred law of
Islam,
governing
all
aspects
of a Muslim's life. The
principal
sources of Islamic law are
Al-Qur'an,
the
immutable collection of revelations received
by
the
prophet
Muhammad and
Sunnah,
which is
custom sanctioned
by
tradition,
particularly
records of the actions of the
prophet.
As a
first
step
towards an Islamic stock market
it is desirable that the financial
system
be free of
riba,
or interest. For a
discussion on the
prohi
bition of interest in Islam and the
integration
of
religion
and
economics,
see
Gambling
and Karim
(1991).
From the above list of
countries,
only
Pakistan comes closest to
having
a financial
system totally
free of interest. Riba has a much
wider definition than
simply referring
to interest.
It
encompasses
all forms of
exploitation
and
excessive
charges
in business
dealings.
Stock
market
trading
lends itself to
practices
that can
be construed as riba. For
example,
the
problem
of
asymmetric information,
where one investor
has
superior
information to
another, may
create
situations where that information is used to the
disadvantage
of the other investor. Confiden
tiality
and the use of
superior
information for
gain
are
generally acceptable
in a
Western stock
market,
provided
it is not
privileged price
sensi
tive information
being
used
by
insiders. Western
markets
typically
treat insider
trading
as an
illegal
fc?. fournal of
Business Ethics 23:
145-159,
2000.
r
? 2000 Kluwer Academic Publishers. Printed in the Netherlands.
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All use subject to JSTOR Terms and Conditions
146 Shahnaz
Naughton
and
Tony Naughton
activity. Manipulation
of stock
prices,
for instance
through creating
a
false market in a
stock,
is also
typically illegal
in Western countries and is
another
aspect
of
exploitation
that would be
regarded
as riba in Islam.
One of the most difficult
aspects
of
designing
an Islamic stock market is the issue of
Qimar,
or
gambling.
This
concept
covers
speculation
in the
stock
market,
that
is,
trading
in securities
purely
for short-term
gains resulting
from
uncertainty
in the market. In Western
markets,
moderate
levels of
speculation
are
regarded
as
quite accept
able.
Speculators keep
the market more watchful
of what is
happening
and their
trading improves
liquidity (Figlewski, 1979).
The interaction of
rationale
investors,
those that trade on "true"
information
relating
to the
stock,
and
specula
tors,
who trade on
"noise",
help
to
keep
the
market efficient in a Western sense
(Black, 1986).
A wide
range
of issues to do with
speculation
will need to be resolved before we can contem
plate
a
fully functioning
Islamic stock market.
Another
unacceptable practice
related to
speculation
is the creation of excessive uncer
tainty,
or
Gharar.
Entering
into a
contract,
in this
case a
purchase
or sale of
stocks,
with another
party
when there is excessive risk associated with
the
transaction,
is not
acceptable.
This
may
apply
in a
very
volatile market. Both a
buyer
and a
seller should not transact business when the
outcome of the deal is
highly
uncertain
(Kazmi,
1994).
However,
stocks are
risky
and market
participants
are attracted to them because the
higher
the risk of a
stock,
the
higher
the
expected
return. Stock market
regulators
in an
Islam market would have to consider whether it
is
acceptable
to
permit trading
to continue in a
period
of
high price volatility.
Another issue related to stock
trading
is
whether certain transactions could be construed
as Ikrah. This relates to
imposing
a contract on
an
unwilling party,
or
imposing
conditions that
are
unacceptable
to them
(Kazmi, 1994).
From
a Western
perspective
it is difficult
to see
any
problem
in this
regard.
Market
participants
choose to
buy
and sell stocks and take
positions
in derivative markets. Parties
willingly
enter into
such contracts in the full
knowledge
of the terms
and
possible
outcomes. From an Islam
perspec
tive this would not be a
problem
in the case of
traditional stock
trading
as a trade involves two
willing parties.
However,
in the case of
options
written on
stocks,
the
very
nature of the contract
implies
that
option buyers
will exercise the
contract
only
when it is beneficial to
them,
while
being potentially
loss
making
for sellers. Even
though
both the
buyer
and seller of
an
option
enter in the contract
willingly,
the
very
fact that
the
buyer
can
impose
a loss on
the seller
may
make such
a contract
unacceptable
in Islam. In
addition the fact that the loss relates to a deriv
ative
position,
and not
directly
to a
clearly
identifiable transaction in
goods
or
services,
creates further difficulties. This will be discussed
in
greater depth
below.
The issue of derivatives leads us to consider
one further area,
the
question
of
hedging
or
insurance. Traditional Western
style
insurance is
severely
restricted in Islam and
hedging, using
derivatives,
is a form of insurance. Investors
may
seek to
protect
their
underlying
investments
by
buying
and
selling
derivatives such as
options
and
futures. The
question
to be considered is whether
this
practice
is
acceptable.
Derivative markets also
have an element of
speculation,
because a well
functioning
derivatives market
depends
on the
interaction of
speculators
and
hedgers.
At the end of this
paper
it is
unlikely
that we
will have resolved these issues.
Many
of the issues
are
extremely complex
and are
subject
to the
interpretation provided by
scholars from the main
schools of Islamic
jurisprudence.
The
objective
of this
paper
will therefore be to
provide
a better
understanding
of selected issues involved in
establishing
a
fully functioning
Islamic stock
market. It is
important
that the issues are
widely
understood and debated. The area of Islamic
banking
is one in which
vigorous
debate con
tinues as to the most
appropriate
methods to use
for the
provision
of finance to bank customers.
It is
likely
that a
healthy
and
vigorous
debate will
continue for a
long
time in this area as well.
Market
efficiency
A
strong
feature of Western financial markets
today
is
deregulation.
Markets are allowed to
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Religion,
Ethics and Stock
Trading
147
function without undue
government
interfer
ence. In the case of stock
markets,
this
approach
cannot mean a total absence of
regulation
because of the need to
protect
investors from
insider
traders,
price manipulators,
excessive risk
taking
and other
aspects
of moral hazard
(Ghon
Rhee, 1992).
The main
argument
in favour of
deregulation
is that it
permits
markets,
whether
they
are
financial
or
product
markets,
to be
more
efficient.
Efficiency
is of course a
difficult
concept
to
define in the context of stock markets. There
are
many
approaches
to
defining efficiency.
Efficiency depends
on whether we are consid
ering
the
primary
or
secondary
function of the
market. At the
primary
level of the market we
can talk about allocational
efficiency
-
the
optimal
allocation of resources in the
primary
market. In the
secondary
market we tradition
ally
consider
operational efficiency
and informa
tional
efficiency.
An
operationally
efficient
market is one in which the lowest
possible
transaction
prices prevail
in the
secondary
market. This
requires
a
well-developed
stock
broking industry
with
healthy competition
between brokers. It also
implies
a
well-developed
trading system
that
speedily
and
accurately
processes
transactions. An
informationally
effi
cient market is one in which
inputs
of informa
tion are
speedily
and
accurately incorporated
into
security prices
in the
secondary
market. Financial
economics
places greater emphasis
on informa
tion
efficiency
because,
if
prices fully
reflect all
information about
firms,
resources will be
"properly"
allocated. Therefore an information
ally
efficient market is
also,
by
definition,
allocationally
efficient
(Martin,
Cox and
MacMinn,
1988).
While these
concepts
of effi
ciency appear highly
relevant from an Islamic
perspective,
it is
likely
that a broader
conception
of
efficiency may
be
appropriate.
This broader Islamic view of efficient
security
markets is similar to the
concept
of social effi
ciency.
This is the broad based notion that
financial markets in
general,
and stock markets in
particular,
should be efficient in the sense that
they support
social
justice,
fairness and the well
being
of
society (Samuels
and
Yacout,
1981).
This is not a
strong
feature of traditional Western
views of
efficiency.
Some would
argue
that stock
markets
actually
create social
inefficiency by
encouraging unequal
distribution of wealth. Rash
speculation
also creates
systemic
risk and can have
a
destabilising
effect on the
economy.
The Wall
Street crash of the 1920s and to a lesser extent
the Stock Market crash of 1987 are
examples
of
the threat that stock markets
pose.
The
collapse
of the Kuwait Souk Al
Manaqh (stock exchange)
in
1982,
due to the failure of
major speculators
and their
financiers,
is an
example
of the
dangers
faced
by
Muslim countries when uncontrolled
speculation
is
permitted.
In addition to
specula
tion,
stock markets
provide opportunities
for
dishonest
activity
such as insider
trading.
These
can have an adverse effect
on
moral standards and
business ethics.
While social
efficiency
is difficult to
concep
tualise in an Islamic stock
market,
the lack of
strong
form information
efficiency (Fama, 1970)
in the
secondary
market
may
also create diffi
culties. Famas
concept
of
strong
form
efficiency
assumes there is no confidential information. As
might
be
expected,
this form of
efficiency
is
not
supported by
the literature. Firms seek to
keep
confidential certain
aspects
of their activi
ties while market
analysts
seek to elicit this
through painstaking
research. The aim is to
profit
from this information
by trading
in advance
of the rest of the market. The existence of insti
tutional investors with
highly
skilled
analysts
leads to a form of information
asymmetry
which
Rock
(1986) simplifies
as a division of the
market between "informed" and "uninformed"
investors. As discussed
above,
asymmetric
infor
mation is a
potential
obstacle when
considering
acceptable
contracts in Islam.
Securities
Modern financial
institutions,
such as
security
and derivative
markets,
or instruments such as
shares, bonds, futures,
options,
and
swaps
create
problems
when
they
are utilised in an
Islamic
economy.
The reason stems from a
lack of clear
Shari'ah
guidance
on their
acceptability.
Of these
institutions and
instruments,
stock markets and
common stocks are
perhaps
the
simplest, yet
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148 Shahnaz
Naughton
and
Tony Naughton
there
appears
to have been little in the
way
of
comprehensive
examination of their
acceptability
in modern Islamic
society.
As mentioned
previ
ously,
stock markets are
permitted
in Muslim
countries. That in itself does not mean that the
instruments and
trading practices
of the markets
are in accordance with Shari'ah. Interest-based
banks are
permitted
in the
majority
of Muslim
countries,
yet
there is
general acceptance
that
interest is forbidden in Islam. The
approach
used
in Islam to examine the
acceptability
of
anything
that is unclear is to break the issues into their
components
and consider each within available
Shari'ah
guidance.
Two
commonly
used securi
ties,
common
stocks and bonds and a third and
less
common
security, preferred
stocks are
reviewed below. Futures and
options
will be
discussed in
subsequent
sections of the
paper.
Common stock
In an Islamic context we
may
refer to common
stock
as
Mudarabah,
or
profit
and loss
sharing
certificates. The idea of
dividing capital
into small
portions
in the form of stocks
may appear
to have
its
origin
in the
early stages
of the
development
of Western economies.
However,
Robertson
(1933)
traces the
origin
of stocks to medieval
Muslim traders. Common stock
represents
an
ownership
claim on a
company
and stockholders
are owners of the business. As such
they
are
entitled to share in the rewards of
ownership
and
are entitled to the
profits
of the firm. Other
ownership rights
include the
right
to elect the
directors of a
company
and to vote on
impor
tant issues at
meetings
of stockholders.
However,
stockholders bear the residual risk associated with
ownership.
In the event of the
winding up
of a
company,
all third
party
claims must first be met
before stockholders become entitled to
any
return of
capital.
Islamic economists and scholars
agree
that
these features make common stocks
acceptable
securities within Islam. For a
comprehensive
coverage
of this debate
see
Mohsin
(1403/1983).
Common stocks have also been
approved
as an
instrument for investment
by
the Council of the
Islamic
Fiqh Academy (CIFA)
at its seventh
meeting
in 1993
(JIBF, 1994).
The CIFA is an
international
body
of Muslim
jurists sponsored
by
the
forty-six
nation
Organisation
of Islamic
Conference. The CIFA has commenced a series
of
meetings
to consider
a
range
of unresolved
issues of Islamic
jurisprudence.
The Council is a
respected advisory body
that offers
guidance
to
the international Muslim
community.
Stocks
closely
adhere to the
profit
and loss
sharing
principle
that is a
strong
feature of modern
Islamic
banking theory (Naughton
and
Tahir,
1988).
It is therefore difficult to fault
common
stock as an Islamic instrument.
Debt securities
(bonds)
Debt
securities,
such as
bonds, present problems
if utilised
by
Islamic firms and made available to
Muslim investors
through
the stock market. A
traditional Western
style corporate
bond is
likely
to fail
any
test of
acceptability.
To
begin
with
they
are interest
based,
paying
a fixed return
attributable to the
period
of the debt. Penalties
are
imposed
in the event of
default,
with bond
holders
typically
entitled to take action
against
the issuer to recover the
outstanding
interest and
principal.
Such
penalties
are deemed to be
unlslamic as
they
are close to
usury,
the
principle
reason for the
prohibition
of interest in Islam
(Siddiqi, 1403/1983).
However,
Islamic
enterprises
will need
varying
amounts of short- and medium-term debt
capital.
It can be
argued
that Islamic banks and financial
institutions can
provide
this finance
through
various Islamic financial contracts. These con
tracts fall into four
categories
with
many
variations. The most
radical,
from a Western
point
of
view,
are
profit
and loss
sharing
contacts
whereby
banks are
effectively
limited-term
equity
investors in the borrower
organisation. Examples
of such contracts are
Mudarabah,
mentioned
above,
and Musharika. The second
category
are
contracts based on
transactions,
whereby
a bank
buys
assets
required by
customers and sells them
to the customer at a
profit,
with deferred
payment. Examples
include the contracts of
Murabahah and Bai' Bithamin
Ajil.
A third
category
are contracts that resemble Western
style
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Religion,
Ethics and Stock
Trading
149
leasing
with the contract of
AUIjarah being
the
most
commonly
used. A final
category
is benev
olent loans that are
increasingly being
used to
solve
problems
where there is no suitable Islamic
financing
contract. A benevolent loan is referred
to as
Qard-ul-Hasan.
In a Western context the
corporate
sector will
diversify
their sources of
capital by accessing
short- and medium-term finance from banks and
financial institutions as well as
issuing
bonds and
other debt instruments in financial markets. Bond
markets enable
companies
to access
longer-term
finance at
predetermined
rates,
whereas bank
finance is
typically
at
floating
interest rates.
Very
large-scale
debt is
typically beyond
the
scope
of
any single
bank and the need to
syndicate
loans
brings
with it the need to issue debt as
transfer
able securities. The ultimate form of
syndication
is a
bond issue. With
a bond
issue,
the total
amount to be raised is divided into small
parcels
of debt that are
readily
transferable.
It can
be assumed that in an Islamic
economy
the
corporate
sector will also
require
debt
financing
in the form of transferable securities.
How then are
they
to be structured?
Clearly
an
interest-bearing
bond is not
acceptable.
One
possibility
is to utilise "free" loans in the form
of a
Qard-ul-Hasan (benevolent loan) facility.
This is
already
in use in Islamic
finance,
although
some
argue
that its use in a commercial situa
tion is
against
the
spirit
of the
original concept
of
Qard-ul-Hasan.
The instrument is
designed
as
a benevolent
facility
to the
needy.
While there
are circumstances where a firm
may qualify
for
such a
facility,
it is
questionable
whether it should
be a mainstream and
regular
form of
financing
Islamic
enterprises (Chapra,
1405/1985a, p. 255).
A
Qard-ul-Hasan
loan is free of
any
rate of
return,
although
the
recipient may
wish to
reward the
provider
with a return in excess of
the
original
amount borrowed. While banks
cannot enforce the
payment
of additional
amounts,
they provide
the
facility
on
the
expec
tation that
corporate
borrowers will return sums
in excess of the
original borrowing.
This is
clearly
an
inadequate
framework for the
ongoing
provision
of
large-scale
commercial finance in
banking
or in the form of a
Qard-ul-Hasan
bond
facility.
However,
there have been several
attempts
to
utilise
Qard-ul-Hasan
in bond issues. An inter
esting example
was the 1994 issue of
M$300
million of Islamic Debt Securities
(IDS)
in the
form of a
Qard-ul-Hasan facility by
Petronas,
the
national oil
company
of
Malaysia.
At
maturity
repayment
of the loan will be at
original
value.
As a
token,
detachable warrants were also issued
to subscribers. The use of warrants in an Islamic
context will be discussed below. In this case the
warrants entitled holders to subscribe for shares
in Petronas
Dagangan
Berhad at a fixed
price
at
a
future date. The warrants did not form
a
part
of the
underlying
IDS,
because a
predetermined
return cannot be
negotiated
in a
Qard-ul-Hasan
facility.
Both the IDS and warrants are tradable
securities. Subscribers to the IDS can trade the
detachable warrants or
hold them to
maturity
and
subscribe for shares.
The solution to the
problem
of Islamic debt
securities is
likely
to lie in
transforming
tradi
tional interest
bearing
bonds into a
facility
that
is transaction based.
Equity
based debt contracts
are
unlikely
to
provide
the balance of
financing
required by
modern business
enterprises,
or to
meet the
portfolio requirements
of investors.
Transaction based contracts such as
Murabahah,
or Bai' Bithamin
Ajil,
can be used to create debt
instruments tied to a
particular
transaction,
for
example
the
purchase
of a
particular
asset
by
a
firm,
or a series of transactions
packaged
together.
Subscribers to a
bond issue would
initially buy
the
asset(s),
resell to the borrower
at a
price
above the
original
cost and receive
payment
for the sale over a
stipulated period
of
time in a similar manner to a conventional bond
servicing
schedule. The transaction is
effectively
a collateralised
bond,
whereby
bondholders retain
a claim on title until
maturity.
Such forms of debt and bonds raises the
question
of a
fixed return. The resale of
an
asset,
at a
price
in excess
of its
original
cost,
repre
sents a
fixed return to the
provider
of finance.
Current
practice
in Islamic
banking
is that the
return will be
larger
the
longer
the
period
of
repayment stipulated
in the contract. This has
frequently
been
challenged
on the
grounds
that
it has similarities to interest and hence riba
[see
for
example Siddiqi (1403/1983, p. 138)].
The
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150 Shahnaz
Naughton
and
Tony Naughton
emerging
consensus is that transaction based
contracts are
acceptable irrespective
of whether
the return is fixed or
whether the
magnitude
of
return
depends
on
the
period
over which
repayment
is to be made
(Husain, 1994).
A
straight
loan made to a
borrower that is not
tied to
any
particular
transaction,
and which
bears a return in the form of
interest,
is not
acceptable.
This is so even if the
proceeds
of
the loan are
ultimately
used to
buy
a
particular
asset.
The outcome of this debate is
likely
to be the
emergence
of debt instruments or
bonds that take
the form of Islamic contracts related to under
lying
transactions. This is
already emerging
in
certain Muslim countries.
Preferred
stock
As
already
mentioned,
preferred
stocks are not a
significant
form of finance for
companies today.
However,
they
are
occasionally
used and we
therefore need to consider whether
they
can
be
utilised in an
Islamic
system.
Preferred stock
holders
forego voting rights
and
participation
in
management
and
as a
consequence
rank above
common
stockholders in
sharing
the
profits.
However,
their dividend is
fixed,
not as a share
of
profits,
but as a fixed return related to the
original
amount invested. Preferred stock
closely
resembles traditional debt
financing,
or bonds.
The main difference is
simply
the terms
used;
the
return to
preferred
stockholders is dividend while
the return to bondholders is called interest.
Mohsin
(1403/1983) argues that,
in an Islamic
context,
the surrender of
voting rights
and
management participation
is not a
valid reason
for
receiving
a fixed return from finance invested
in a
company.
Hence traditional Western
style
preferred
stocks are not
acceptable.
Mohsin con
siders that the
restructuring
of
preferred
stocks
to
give
them more
equity
like features is
likely
to be
acceptable, provided
the return to investors
is not a fixed return on the
original
amount
invested.
Alternatively,
it
may
be
possible
to
structure
preferred
stock issues as transaction
specific, along
similar lines to that
proposed
above for bond issues.
However,
the result in
both cases is a
hybrid security
the benefits of
which are unclear.
Listing
on an Islamic stock
exchange
The
question
of what
type
of firm can list on
an Islamic stock
exchange appears
to be a
straightforward
issue. An Islamic stock market
would be
developed
for
companies operating
in
permissible
areas of business
activity. Clearly
the
provision
of
gambling
services,
pork products
or
alcohol would be
unacceptable.
These are
products
that are
Haram,
expressly
forbidden,
in
Islam.
However,
there are a number of other
activities that firms
engage
in that could be
considered
Makruh,
discouraged
but not for
bidden. A whole
range
of issues
relating
to
environmental
degradation,
for
example,
may
fall
within this
category.
It is unclear to what extent
an
Islamic stock market would also be a social
arbitrator in these matters.
Clearly
Haram
activities cannot be
permitted.
However,
there
is a
tradition in Islam that it remains with the
individual to determine whether to
engage
in
Makruh activities
(Ruthven, 1984).
There is
merit in
avoiding
such activities but no
wrong
doing by
involvement. Islamic ethical investment
funds could take on
the role of
filtering
out
those stocks deemed to be
engaged
in Makruh
activities that do not match investors views on
these issues. The
application
of this form of
scrutiny by
investors is not
new,
given
the
popularity
of ethical investment funds in coun
tries such as the U.S.A.
(Knoll, 1994).
It can therefore be
expected
that the
listing
requirements
for an
Islamic stock market will
require scrutiny,
not
only
of the financial
per
formance and soundness of
firms,
but also of the
religious acceptability
of their business activities.
This
scrutiny may
also extend to the
question
of
ownership,
for
example,
where the
major
stock
holders are not
Muslims,
but conduct their affair
in a
way
that does not contravene
any principles
of Islam. Should these firms be allowed to list
on an Islamic stock
exchange?
There are
paral
lels in Islamic
banking
that
support
the
accep
tance of such firms. Bank Islam
Malaysia,
for
example,
conducts a
substantial amount of its
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Religion,
Ethics and Stock
Trading
151
financing
activities with firms that are owned
by
non-Muslims
(Naughton
and
Shanmugam,
1990).
Stockbroking
firms
A traditional stock
exchange
structure is one in
which the market
comprises
member firms that
act as
brokers for
investors,
market makers and
traders on their own account. Member firms
typically
dominate the
controlling body
or
council of the
exchange.
The
controlling body
of the
exchange
will act in the role of a
self
regulator
in tandem with some form of inde
pendent regulatory body
that oversees the
oper
ation of the market.
Membership
of the stock
exchange
is
usually
restricted and
new firms
would either
buy
an
existing
seat,
or make an
application
in accordance with strict
entry
requirements.
Such a structure does not seem to be unrea
sonable for
an
Islamic stock
exchange, provided
the rules for
membership
do not
unduly
restrict
competition
or
adversely
effect investors.
However,
the rules
may
restrict what
type
of firm
is admitted to
membership.
The ideal member
will be an Islamic securities business that
conducts its affairs in accordance with Islamic
requirements.
This will include the absence of
riba in its financial
dealing
and avoidance of
speculation
and other
unacceptable
activities.
This leads to the
question
whether non-Muslim
firms would be
allowed,
or even firms that
interact with interest-based banks and institu
tions,
or deal with traditional stock market
trading.
A
pragmatic
solution to these issues
may
be
acceptable during
the
period
of transition.
Malaysia already
has a
precedent
for
pragmatic
solutions in the case of Islamic
banking.
As
Islamic
banking
has been introduced into the
country,
banks have been
permitted
to offer
customers an
Islamic "window" in what is
otherwise interest-based banks. While this
may
not be
acceptable
to strict Muslims it is
officially
tolerated,
at least as a
transitional measure. A
similar
approach may
be
appropriate
in stock
trading.
Traditional
stockbroking
firms could deal
through
windows
offering
services to Muslims
investors in an
Islamic stock
exchange,
while
retaining
investment services to others in a
traditional market. These issues illustrate the
many
institutional
problems
that need to be
confronted before
progress
is made
on the
development
of a
fully fledged
Islamic market.
Speculation
Speculation
is one of the most
important
issues
to be dealt with when
planning
an
Islamic stock
exchange. Speculation
takes a number of
forms,
but
underlying
the
practice
is the fact that
speculators
are not concerned with the under
lying commodity
or
security
in which
they
trade.
A
speculator may
trade in
gold,
Swiss francs
or
IBM
stock,
not because of an interest in the
economic
aspects
of
being
a
long
term
investor,
but because of a desire to make
a
quick gain
from
buying
and
selling.
A
speculator
will
buy
stock
in
anticipation
of
prices rising usually
with a
short-term horizon. The
danger
of
this,
as
observed
by
Brailsford and
Heaney (1998),
is that
what is
initially planned
as a
short-term
position,
with a sale to be
completed
before
taking
delivery
of the
stock, may
well result in a
longer
term
position
when the stock does not
perform
as
expected.
Such
purchases
are often financed
on
margins
or other forms of
borrowing.
A
speculator
will sell in
anticipation
of
prices
falling.
This
strategy may
involve a
short sale
whereby
the
speculator
borrows stock from
a
broker with a view to
subsequently buying
it at
a lower
price, thereby completing
the deal. The
Islamic
acceptability
of
margin financing
and
short
selling
will be discussed below.
Related to
speculation
is the
practice
of
arbitrage.
An
arbitrageur
is a
particular type
of
speculator
who seeks to obtain a risk free return
with a zero investment. An
example
of a
poten
tial
arbitrage opportunity
is the existence of
identical assets at different
prices
in different
markets. Such
practices
are more difficult with
modern communications and
computerised
trading,
as
price discrepancies
in different
domestic markets are
quickly
eliminated from the
system.
For the
purposes
of this
paper arbitrage
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152 Shahnaz
Naughton
and
Tony Naughton
will be
regarded
as one
aspect
of
speculation.
The
use of the term
speculation
will
apply
to
any
practice
that aims at short term
gain
without an
intention to
participate
as an
equity
investor in
the
company
concerned.
It is clear from the
writings
of Islamic econ
omists and scholars that
speculation,
as described
above,
is
unacceptable
because of its association
with
gambling
and excessive risk
taking (see
for
example Chapra, 1405/1985a).
In
addition,
speculation
creates
volatility.
This undermines the
orderly functioning
of the stock market while the
profits
of
speculators
are achieved at the
expense
of other investors.
Any potential
benefits of
speculation,
for
example by injecting liquidity
into the market is not considered
by
Islamic
scholars to
outweigh
the
negative aspects.
If
any
activity
is deemed to be forbidden and
Haram,
that
activity
cannot be
acceptable
under
any
circumstance
(Ruthven, 1984).
Attention therefore needs to be directed
towards
operational
control of
speculation
in an
Islamic market.
Metwally (1404/1984) developed
a controversial set of recommended
operating
rules for an Islamic stock market aimed at
pre
venting
the
practice
of
speculation.
The thrust of
his
approach
is that share
prices
are not free to
find their own level. The
Management
Committee of the stock
exchange
would meet at
three
monthly
intervals to set the maximum
price
for the shares in all listed
companies.
This
price
would be based on the net worth of a
company
as
reported
in the
quarterly
balance sheet
pre
sented to the Committee.
Trading
in stocks could
only
take
place
for one week
following
the
announcement of the maximum
price.
Transactions would not be
permitted
at
prices
above the maximum set
by
the committee.
Investors would be free to trade shares at
any
price
below the maximum. New issues of stock
would also
only
be
permitted during
the
trading
period,
with the issue
price being
the
already
determined maximum. The aim is to
prevent
excess returns to subscribers. While these strict
trading
rules are
likely
to have a
major
deterrent
effect on
speculation, they
do have
many
flaws.
Chapra (1405/1985b)
considered the rules
unworkable. First is the
question
of
determining
a maximum
price
based on
accounting
data. A
balance sheet
prepared
in accordance with tradi
tional
accounting principles
is
unlikely
to
provide
a
good guide
to the true market value of a
company's
stock. Second is the matter of
equity.
Being
restricted to a short
period
in which
they
can trade their stocks would
disadvantage
small
investors. Those who need to
liquidate
their
investment
may
be forced to
accept
lower
prices.
A more workable solution to the control
of
speculation
is therefore
necessary.
One
commonly
used
technique, particularly
in futures
markets and in certain Asian stock
markets,
is the
use of
price
limits on
daily
movement of stock
prices.
Price limits are used in the stock markets
of
Japan,
Korea,
Malaysia,
Taiwan and Thailand.
In these markets the
price
of
any
stock is not
permitted
to move
up,
or
down,
by
more than
a
percentage
of the
opening price.
In
Taiwan,
for
example, prices
cannot exceed more than
plus
or
minus 7% of the
opening price.
When a
stock
reaches the
price
limit,
trading
does not halt.
Investors
may
continue to trade in the
stock,
but
only
at
prices
within the limit. The
objective
is
to limit the
ability
of
speculators
or
manipulators
to
push
the
price
too much in either direction
in a short
period.
Trading
halts are another
technique
used in
markets such as the Australian Stock
Exchange
and the New York Stock
Exchange
to control
trading
in individual stocks.
Examples
of when
the
exchange
may
initiate a
trading
halt include
a serious order imbalance in a stock and when
price
sensitive news is about to be released
concerning
a stock. The
trading
halt is aimed at
providing
a
cooling
off
period
where market
participants
are
given
time to reassess the stock
in a less
pressurised
environment. The New York
Stock
Exchange
also
operates
an
exchange-wide
system
of "circuit-breakers" that halt
exchange
trading
in the event of
large price
declines.
Any system
aimed at
controlling prices
or
trading activity
in an Islamic stock markets needs
to be
carefully
considered. The evidence on the
effectiveness of
trading
halts and
price
limits is
not
good.
Lee,
Ready
and
Seguin (1994)
found
that
trading
halts in New York
actually
increased
volatility
in the stock
price
and
brought
about an
increase in volume of trades. Wu and
Naughton
(1995)
found that when the Securities and
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Religion,
Ethics and Stock
Trading
153
Exchange
Commission of Taiwan reduced
price
limits from 5% to 3% to control the
market,
volatility
of stock
prices actually
increased.
Margin trading
As introduced
above,
margin trading
refers to the
purchase
of stocks on credit
using
a
margin
account at a
stockbroking
firm. The
opening
of
an account enables the client to commence
margin trading,
that is
buying
stock
by paying
part
of the
price
in cash and
borrowing
the
remainder from the broker at an interest rate
called the
margin
interest rate. Formalised
margin
trading
is well established in most stock markets
and
regulatory
authorities
attempt
to use
margin
calls and
margin
interest rates as devices for
controlling speculative activity.
Non-formalised
margin trading through personal borrowing,
without notification to the broker
concerned,
is
more difficult to control. The
appeal
of
margin
trading
is the
ability
to
magnify any gains
on a
transaction,
but at the same time it
magnifies any
losses as these are not shared with the broker.
From an Islamic
perspective margin trading,
as
outlined
above,
is
clearly unacceptable.
This has
been reinforced
by
the Council of the Islamic
Fiqh Academy (CIFA)
which considered
margin
trading
at its 1993
meeting.
The CIFA ruled that
it is not
permissible
to borrow
money
with
interest from a
stockbroker,
or other
party,
to
buy
shares and to
deposit
them as
security
for the loan
(JIBF, 1994).
However,
this does not outlaw the
practice entirely,
as it is
possible
to construct
non-interest
bearing
financial contracts to achieve
the same
thing.
For
example,
in
Malaysia,
Bank
Islam
Malaysia
Berhad offers share
financing
through
Mudarabah
profit sharing
contracts.
However,
writers such as
Chapra (1405/1985b)
go
so far as to recommend that
only
cash
pur
chases be allowed because of the
potential
harm
margin trading
can
have.
Chapra
argues
that
margin purchases bring
about
unnecessary
changes
in
trading
volume and contribute to
price volatility
without
any
underlying
economic
justification.
In
addition,
the
potential
for
regulatory
authorities to
change margin require
ments further adds to the
uncertainty
of the
market.
However,
this is an
evolving
field and
much has
yet
to be done to settle the issues.
Short
selling
Short
selling
is
again
an area of
activity
where
great
care is needed when
examining
the issues.
As outlined
above,
a short sale is
simply
the sale
of a stock not owned
by
the vendor. The
purpose
is to take
advantage
of an
expected price
decline.
When the
price
declines,
the stock is
purchased
and the short
position
closed. To facilitate these
transactions the vendor's broker will cover the
sale
by lending
stock.
Chapra (1405/1985b)
strongly
advocates the abolition of short
selling
in an
Islamic
market,
arguing
that such sales
are
speculative
and fail to
perform
any
useful
economic function. The
public
interest,
masalahah,
is better served
by prohibiting
short
sales. The element of
speculation
involved in
short sales further
suggests
that short
selling
is
unacceptable.
From a more technical
viewpoint
we can examine the structure of the contract to
see
whether
any component
is not
permissible.
Generally
Shari'ah does not
permit
the sale of
any
commodity
the owner
does not
possess,
but
with certain
exceptions
such as salam contracts.
Under
a
salam contract a
clearly
identifiable
com
modity
can be sold for future
delivery provided
the vendor has
paid
in full for the
commodity
in advance. It
may
be
possible
to
view a
short sale as
resembling
a salam
contract,
but it would fail a test of
being permissible
because short sales involve
part payment though
a
margin
account. The vendor
hopes
to
buy
the
stock at a future date at an amount below the
selling price.
The
purchase price
is not
yet
known and cannot be
paid
in full. The balance
of evidence to date
suggests
that short
selling
would not be an
acceptable practice
in an Islamic
stock market.
Insider
trading
Insider
dealing
is a
phenomenon subject
to
regulation
in
many
stock markets in the world.
An insider is
typically
defined as
any director,
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154 Shahnaz
Naughton
and
Tony Naughton
officer or
stockholder of a
company
that has
access to
privileged
information not available to
other
stockholders,
or
potential
investors in the
firm. There are two main issues to do with
insider
trading.
The first is
trading
in the firm's
stock
by
insiders. It is not unreasonable that
insiders have a
right
to trade the firm's stock. The
danger
is that insiders
may
trade on material
inside information to the detriment of other
investors. That is the second and crucial issue to
do with insider
trading. Generally, trading
on
inside information to the detriment of other
investors,
even if the trader is not an
insider,
is
interpreted
as an
unacceptable practice.
In
many
countries it is deemed to be
illegal.
In an
Islamic stock market insider
trading
presents basically
the same
problem
for
regula
tors as it does in a Western stock
exchange.
The
interests of small and vulnerable investors must
be
protected
from
unscrupulous activity by
more
powerful,
and better
informed,
shareholders.
While there is no clear Shari'ah
guidance
on the
issue of insider
trading,
the use of
privileged
information to make
profits
at the
expense
of
other investors is a form of riba that would be
deemed
unacceptable
behaviour. At the same
time a
balance has to be maintained. It is also
unfair to
prevent
directors and others from
trading
in a
company's
stock. The
approach
adopted
in the U.S.A.
by
the Securities and
Exchange
Commission
(SEC)
is to
require
directors,
officers and
major
shareholders to
report
all transactions in their firm's stock. This
information is made
public by
the SEC to enable
the
investing community
to be aware of the
implicit
vote of
confidence,
or lack of confi
dence,
by
insiders. In
addition,
because of the
difficulty
in
proving
whether an insider used
confidential information to make a
gain,
all short
term
profits
are forfeited and
penalties imposed
in some instances. A similar
system
of
regulation
would be
appropriate
in an Islamic market to
maintain a balance between
permitting
insiders
to trade and
prohibiting
the use of
privileged
information for
profit.
It has to be
recognised,
however, that,
even in
highly developed
stock
markets,
no matter how
sophisticated
the
monitoring system, unscrupulous
insiders will
still
attempt
to make
illegal profits.
Stock index futures
We turn our attention now to the
use of stock
index futures
by equity
investors to fine-tune the
risk-return
profile
of their
portfolios.
While
commodity
futures have a
long history,
the use
of financial
futures,
such as stock index
futures,
have
only
become common in financial markets
since the 1980s. Stock index futures
are now a
feature of all
major
stock markets in the world.
The contract
permits
investors to trade a dollar
value of the stock index for future
delivery.
For
practical
reasons settlement takes
place
in cash
rather than
physical delivery
of all stocks com
prising
the index.
Stock index futures
provide
investors with the
means
by
which
they
can
protect
themselves from
market fluctuations. Stock index futures are a
good hedging
device for diversified stock market
investors as futures
prices
are
typically highly
correlated with the
underlying
market
(Jones,
1996, p. 700).
To
hedge
risk,
investors must take
a
position
such that
profits
and losses in the stock
index futures offset
changes
in the value of their
underlying
stock
portfolio.
The
potential
to use stock index futures in an
Islamic stock market
depends
first on whether
the
concept
of future
delivery
of a
commodity
is an
acceptable practice.
Islam does not forbid
an
agreement
to sell a
commodity
in the
future,
although
there are restrictions on how it is to
be done. For
example
the contract of Istisna
provides
for an
agreement
to manufacture a com
modity
where both
delivery
and
payment
will be
in the future. It is a
requirement
that a
clearly
defined
commodity
be
specified
in the contract.
It is
unlikely
that
a stock index future would
meet these
requirements
because a dollar value
of an
index is
unlikely
to be
regarded
as a
clearly
defined
commodity.
Without
a
clearly
defined
commodity
the
ability
to
physically
deliver
anything
is in doubt. The end result of a modern
stock index future is an
exchange
of cash
representing
the difference between the
opening
and
closing price
of the contract on the
day
of
maturity. Chapra (1405/1985b)
dismisses all
forms of modern futures contracts because he
argues they typically
do not result in an
exchange
of title of the
underlying commodity.
However,
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Religion,
Ethics and Stock
Trading
155
a
typical commodity
future does allow for
exchange
of title. His
argument
is based on the
fact that users of futures
may
choose to close out
their
positions prior
to
maturity.
The
question
then arises whether the fact that
hedgers
do not
wish to take
delivery
of a
commodity,
invalidates
the
use
of futures. The clearest
guidance
we have
is from the CIFA which ruled that
"trading
in
the futures market where the contract concludes
on a converse contract sale
resulting
in a settle
ment based
on the difference in
price
is not
permissible" (JIBF,
1994,
p. 59).
While the
opinions
of the CIFA are not
binding,
even in
the Sunni branch of
Islam,
their deliberations are
interpreted
as
having
been
carefully
considered
from a Shari'ah
perspective.
An additional
problem
with
regard
to stock
index futures is the
ability
of
hedgers
to shift
price
risks to
speculators (Jones,
1996, p. 685).
This
implies
that futures
depend
on
speculation,
an
unacceptable practice
in Islam. While
hedging
with futures is done to
protect
a
position
in the
cash
market,
the
ability
to achieve this
depends
to some extent on
the involvement of
specula
tors.
Speculators buy
and sell futures to make a
profit
without
necessarily having any
involvement
in the cash market.
Speculators
are
regarded
as
essential in modern futures markets because
they
assume the risk of
price
fluctuation that
hedgers
are
trying
to avoid.
They
also contribute to the
liquidity
of the futures market and over time their
involvement reduces the
volatility
of the market.
However,
speculation
alone does
npt
rule out the
use of futures. For
example, trading
in common
stocks
may
be for
speculative
reasons,
but that
does not invalidate stocks as an Islamic financial
instrument. What is
necessary
is to eliminate
speculation.
However,
if we eliminate
specula
tion from stock index futures in an Islamic stock
market,
the result is a contract that
hedgers
would find difficult to use. The interaction of
speculators
and
hedgers
would be
missing
from
the market.
Let us now consider whether
hedging,
as
described
above,
is a
legitimate
form of
activity
in Islam. The
problem
has two dimensions. First
is the observation that
hedging
is a form of insur
ance. Islam
places
severe restrictions on
using
modern forms of life and
general
insurance. The
problem
with modern Western forms of insur
ance is that
they
contain elements of riba and
contractually
the
rights
of the insured
party
are
not as
clearly
defined as those of the insurer
(New
Horizon,
November
1994). Hedging
in an Islamic
stock market
may
be
acceptable provided
both
the
buyer
and seller of the stock index future
are
fully
aware of the
position they
are in and are not
attempting
to
speculate.
The motive for
hedging
is the
protection
of an
underlying
investment.
Hedging
is
just
one of the risk minimisation
techniques
used
by
investors. For
example,
investors hold diversified
portfolios
of stocks to
eliminate a
significant
element of risk associated
with
holding single
stocks or
undiversified
port
folios.
In
summary
the
argument
for the
use of stock
index futures rests on their
legitimate
use as a
hedging techniques.
The fact that the contract
is
capable
of
being
used
by speculators
does not
invalidate its use. The
biggest stumbling
block is
the technical nature of the settlement
process.
Commodity
futures,
where an
exchange
of title
to a
commodity
can take
place,
would not
present
a
problem
in this
respect.
However,
modern stock index futures
typically
involve cash
settlement and are
therefore not
acceptable
instruments in Islam.
Changing
the settlement
process
to involve the
delivery
of the basket of
stocks that
comprise
the index would conform
to Shari'ah. While this creates a
somewhat
cumbersome
process,
it is not
impossible
to
create such a contract.
Early examples
of stock
index futures such as the TOPIX 50 traded on
the Osaka Stock
Exchange
involved
physical
delivery
of stock.
Options
on
stocks
Options
on
stocks
(also
known as
equity options)
are
yet
another area of
complexity
when con
sidering
an Islamic stock
exchange.
In
developed
financial markets a
wide
variety
of
exchange
traded and over-the-counter
(OTC) options
are
available to investors.
Exchange
traded
options
are
standardised contracts traded on a
derivatives
exchange,
while OTC
options
are
individual
contracts
negotiated
with financial institutions.
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156 Shahnaz
Naughton
and
Tony Naughton
In this section we will deal
only
with
exchange
traded
equity options
as the terms of OTC
options
are flexible.
Exchange
traded
options
are
relatively straight
forward contracts and are
sufficient to
explore
the issues from an Islamic
perspective.
A stock
option provides
the
right
to
buy
or
sell the stock of a
particular company
at a
spec
ified
price
over a
particular period
of time. The
holder of an
option
has the
right,
but not the
obligation,
to
buy,
or
sell,
the stock whereas the
seller of an
option
must
sell,
or
buy,
if the holder
decides to exercise.
Let us now
explore why
investors use
equity
options
with the
objective
of
determining
whether their use is
justified
in an Islamic stock
market. A
simple strategy
is to
buy
a call
option
on a
company's
shares. The investor in a call
option
can control
a
claim on the
underlying
stock for the life of the
option.
The cost will be
the
premium paid
which is
substantially
less than
the cost of
buying
the stock. The
buyer
antici
pates
the stock will rise in
price providing
a
profit
on the
option.
However,
if the stock
price
remains
unchanged,
or
falls,
the maximum loss is
known in
advance,
i.e. the loss is the
premium
paid.
It is clear from this
example
that a
call
buyer
anticipates
the stock
price
will rise while the
seller of the call
expects
the
price
to remain
unchanged
or to fall. Such a
simple
call
option
strategy
is
extremely
difficult to
justify
from an
Islamic
perspective.
If both the
buyer
and writer
of the call do not hold the
underlying
stock,
nor
have
any
intention to hold
it,
their involvement
is
purely speculative. They
are
trading options
for
the
purposes
of
making
returns from
price
movements.
However,
if the writer of the call
option
holds
the
underlying
stock a
simple hedging strategy
is
being
followed. The
premium
received
provides
some
protection against
a
drop
in
price
of the stock. The writer would of course have
to be
very
confident that the
price
would not
rise because unlimited losses could arise. There
are, however,
a
variety
of more
complex hedging
strategies
that would
provide
the
hedger
with
better
protection.
The
buyer
of a
put
is
anticipating
a fall in the
stock
price resulting
in a
profit
on the transac
tion. The seller of a
put option
has an
opposing
view.
Again
the transaction
appears
as
pure
speculation, particularly
if both
parties
have no
involvement in the
underlying
stock.
However,
the
purchaser
of a
put may
be a
hedger
if the
underlying
stock is held in his/her
portfolio.
The
investor
buys
the stock and
simultaneously buys
a
put
written on the stock. The
strategy provides
a
form of insurance
against
a
drop
in the
price
as the investor is able to sell the stock at a
price
higher
than the market
price.
Warrants are a
particular type
of call
option
issued
by corporations giving
holders the
right
to subscribe for new shares in the issuer. While
warrants are
essentially
call
options,
the charac
teristics are
quite
distinct from
options
on stocks.
Warrants are
typically
much
longer
term than
equity options. Underlying
a warrant is the
potential
for the holder to become
an
equity
investor in the
issuing company
at some future
date. Warrants are not
normally
issued as a
separate
exercise,
but are offered
as
part
of a
larger financing package.
Investors therefore have
the
potential
to
participate
in the
growth
of the
company
without
actually being
a shareholder.
The attraction of warrants to
issuing companies
is that
they
are
able to issue other forms of
securities at a lower cost
by attaching
the
warrants as
part
of the
package.
While it is
accepted
that
speculators,
or
pro
fessional
option
traders,
play
a
major
role in
options
markets,
so also do
hedgers.
Institutional
investors make
particular
use of
hedging
and use
a
range
of
option strategies
to
protect
their
underlying
stock
portfolios.
The use of
options
changes
the
potential portfolio profile, making
available risk-return combinations that would not
otherwise be available. Stock index
options
provide
similar
opportunities
as do individual
stock
options,
but in a broader sense.
However,
even
though options
have uses as a
hedging
tool,
it is difficult to
justify
their
use in an
Islamic
context. The
problem
is
essentially
the same as
with stock index futures where settlement is
by
exchange
of cash. Stock
options
do
provide
for
the
delivery
of shares at the exercise
date,
but in
practice
this is
rarely
done. The 7th Council of
the Islamic
Fiqh Academy
considered traded
options
as
part
of the review of new financial
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Religion,
Ethics and Stock
Trading
157
instruments.
Options appear
to have created
many problems
of
interpretation
and it is not
clear from the
reports
of the Council whether
they
are
regarded
as
permissible (JIBF, 1994).
The
weakness of the case for stock
options
is that
they
are not issued as
part
of
any underlying
transac
tion,
or even as
part
of a
capital raising by
the
company
concerned. Instead
they
are issued
by
an
options exchange
to
provide
investors with
the means
by
which
they
can
speculate
and
hedge
price
movements in the
underlying
stock.
However,
Elgari (1994)
defends stock
options
in
Islam
provided
the seller of a
call,
and the
buyer
of a
put,
holds the
underlying
stock. He also
recommends standardised
European-style options
that can
only
be exercised at
expiration,
to
reduce
flexibility
and hence the
potential
for
speculation.
The case for warrants is
stronger.
We
already
have an
example
of the issue of warrants on new
shares in Petronas
Dagangan
Berhad as
part
of
an Islamic
financing package
as discussed above.
The
company
concerned
typically
issues warrants
as
part
of
an
underlying financing package.
In the
case of the Petronas
warrants,
the
underlying
transaction was an Islamic finance contract. This
provides
reassurance that the warrants are a
permissible
form of
security.
Regulation
of the stock market
In
existing
markets it is usual to find two
regu
latory
bodies: the
ruling body
of the
exchange
which acts as a self
regulatory
mechanism,
as well
as an
independent governmental supervisory
body
such as
the SEC. The
professional dealings
of member firms
may
best be served
by
self
regulation through
a council of the stock
exchange.
Protection of investors and the
public
is also
probably
best served
by
a
regulatory body
independent
of the members of the stock
exchange.
However,
in an Islamic stock market
there remains the
question
of a
body
that can
rule on the Shari'ah
acceptability
of financial
instruments and
dealings.
The need for a
third
regulatory body
arises in countries where
an
Islamic institution
operates,
but the
legal system
is not based on Shari'ah. In Indonesia and
Malaysia,
for
example,
Islamic banks have been
subject
to a form of Islamic
supervision
in the
absence of
a Shari'ah based
legal system.
The
structure and
powers
of such a
body
is of utmost
importance
as
Shari'ah
acceptability
should be an
overriding requirement
of the
operation
of an
Islamic financial institution.
In the case of Islamic
banks,
Shari'ah
super
vision is
typically
based
on a
system
of self
regulation
with each bank
operating
a
separate
Shari'ah committee. Bank Islam
Malaysia
Berhad,
for
example,
is
regulated, along
with other
banks,
by
Bank
Negara,
while
day-to-day operations
are
controlled
by
the Board of Directors. A
separate
committee of the
bank,
the Shari'ah
Council,
rules
on
any
matters where there is doubt as to
the Islamic
acceptability
of the transaction. The
Council includes
respected
Islamic scholars
recruited from the
community.
While this
arrangement
is
essentially
a form of self
regula
tion,
with the
requirement
to set
up
a Shari'ah
council enshrined in the
Malaysian
Islamic
Banking
Act 1983.
The
precedent
set in Islamic
banking
is
likely
to drive
any
initiatives in
setting up
Islamic stock
trading
activities in countries without
a Shari'ah
based
legal system.
The
growth
in financial
derivatives and other
complex
financial
arrange
ments are
likely
to create
many problems
of
Shari'ah
interpretation.
Consideration needs to
be
given
to how this is to be
accomplished.
The
dominant model used in Islamic
banking
is to
operate
a
Shari'ah council at the level of the
individual firm. This
suggests
that the interests of
the Islamic
investing community
are
appropri
ately
served
by
each
brokerage
and investment
firm
operating
with its own
Shari'ah council to
guide
its
operations.
This form of self
regulation
is direct towards the activities of individual firms.
Broader market-wide issues are also
likely
to need
overall
guidance
and
supervision
in a consistent
manner. A further
regulatory body
would create
a
profusion
of
regulatory
bodies. Hence the inde
pendent regulatory body
of the stock
exchange
could take
on this role as
part
of its overall
super
vision of the market.
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158 Shahnaz
Naughton
and
Tony Naughton
Conclusion
In this
paper
we have reviewed a
range
of issues
relating
to the
potential
for a
separate
Islamic
securities
exchange. Many
difficulties are envis
aged, particularly relating
to
speculation,
or
contracts that have
potential
for
speculative
trading.
There are also a number of technical
problems relating
to contracts that do not
unequivocally
involve the
purchase
and sale of a
commodity
at a
clearly
defined
price. Many
of
the issues discussed
imply
that an
Islamic stock
exchange
is
likely
to be a
very
different institu
tion when
compared
with modern stock markets.
The absence of
speculation,
or at least strict
regulations
to contain
it,
are
probably
the main
distinction.
However,
it is
likely
that
any
devel
opments
towards a
separate
market will involve
a
gradual
introduction of Islamic contracts and
practices
that in
many respects
imitate Western
operations.
There are similarities with the intro
duction of Islamic
banking.
A modern Islamic
bank is little different to a conventional com
mercial bank in terms of the
range
of facilities
and services offered to
depositors
and borrowers
(Naughton
and
Shanmugam, 1990).
What dis
tinguishes
an Islamic bank from a conventional
bank is the strict
legal interpretation
of the
underlying
contracts. Such
an
approach
seems
appropriate
for Islamic stock
trading, broking
and
the
operation
of the stock market. While we
must
accept
that
speculation
and related
activity
has to be
contained,
it is not inconceivable that
futures and
option
contracts can be restructured
to overcome the technical
problems
that at
present
inhibit their use.
Developments
in coun
tries such as
Malaysia
indicate that considerable
progress
has
already
been made in this direction.
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Advances in
Pacific
Basin Financial Markets
1(1),
157-166.
Shahnaz
Naughton
School
of Marketing
&
Management
Tony Naughton
School
of Accounting
&
Finance,
Griffith University,
Gold
Coast, QLD 9726,
Australia,
E-Mail:
t.naughton@bhm.gu.edu.au.
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