Islamic Capital Market

Key Components: Islamic Capital Market

• Shariah Compliant Stocks

• Islamic Funds

• Sukuk / Islamic Investment certificates- Fixed, quasi fixed and Variable return securities

Shariah Compliant StocksShariah Guide lines:Shariah based principle of equity

participation is Shirkah.

Stocks are classified as Shariah compliant if their business activities do not fall in the prohibited list prescribed by Shariah Scholars.

Certain financial ratios are also applied for screening.

Shariah Compliant Stocks

Prohibited activities:• Alcohol

• Gambling

• Pork related products

• Pornography

• Conventional financial services

• Conventional insurance

• Tobacco,

• Indecent Entertainment

Financial Ratios:• Main ratios applied are

– Debt to equity ratio– Cash and interest bearing

securities to equity ratio– Cash to asset ratio

• In Malaysia, the screening of listed stocks is undertaken by a centralised body- Shariah Advisory Council of SEC

• In other jurisdictions, screening services are performed by individual institutions

Shariah Related Issues in Stocks Trading

• Not permitted to purchase shares by raising interest bearing loans through a broker or someone else.

• Not permitted to pledge the shares for the interest bearing loan.

• It is not permitted to sell the shares that the seller does not own which is called short sale. The promise by the broker to lend these shares at the time of delivery is of no consequence.

Issues in Stocks Trading (Contd)

• Not permitted to conclude futures contract for shares because according to Shariah only one thing either payment or delivery can be deferred.

• The contract of Salam is not permissible in shares – identified items.

Types of Funds• Equity Funds

• Mudaraba Funds

• Commodity Funds

• Property Funds

• Ijarah Funds

Investment & Murabaha Funds:Involve purchase of commodities from third

parties (through a bank as an agent of the fund) and reselling the same to the bank on deferred basis

Profit between the bank and the fund is comparable to returns from money market instruments.

Mixed Funds:The subscription amounts of which are employed in

different types of investments like equities, leasing, commodities, etc. For trading of Mixed Funds the tangible assets should be more than 51% while the liquid assets and debts less than 50 percent.

Islamic Capital Market - Issues

• Regulatory Framework

• Shariah' compliance and convergence

• Product development

• Cost efficiency

• Development of market professionals

• Investor education

• Knowledge sharing

Securitization

SecuritizationInvolves:• Evaluating specific risks• Isolating and efficiently allocating risks• Evaluating the taxation, accounting and

legal implications within the regulatory framework

• Designing appropriate credit enhancement structures e.g. over collateral, cash collateral, subordination etc.

• Pricing the residual risk.

Securitization: Unbundling of roles

Traditional business model revolves around originating an asset and holding it till maturity.

Through securitization, it is possible to Disaggregate, repackage and distribute

assets to different parties – able and willing to accept them

Realize benefits from specialization and economies of scale

• Securitization transforms originator’s role from being an accumulator to that of a distributor.

Benefits to financial sector Securitization creates incentives for originator

for Developing transparent credit approval process Efficient collection procedures and strong

mechanisms to control this process Public availability of information about pool performance

adds to confidence in securitized paper New forms of securities – market completion Assist development of capital markets Attracts conservative buyers Draws international capital Facilitates efficient allocation of risks

Securitization mitigates the Risks

Originator’s Perspective

• Mitigates liquidity risk of an illiquid asset

• Reduced cost of funding

• Takes assets off balance sheet, without loss of use

• Reduced cost of finance if the investment is serving multiple originators by pooling assets

Investors’ Perspective• Foreign exchange risk is

reduced if underlying asset is denominated in multiple currencies

• Pooling of diversified assets with heterogeneous risk

• Mitigates earnings risk

• Undivided ownership of the asset is an added protection

SECURITIZATION

SHARI’AH PERSPECTIVE

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What is Securitization?

• Issuing certificates of

ownership against an

investment pool or business

enterprise.

Securitization

• Securitization is a structured finance process that distributes risk by aggregating debt instruments in a pool, then issues new securities backed by the pool.

• The term "Securitisation" is derived from the fact that the form of financial instruments used to obtain funds from the investors are securities.

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Types of Securitization

• Securitization of Musharakah

• Securitization of Murabahah

• Securitization of Ijarah

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Securitization of Musharakah

• Musharakah is a mode of financing which can be securitized easily.

• Especially in case of big projects where huge amounts are required.

• KLSE main board

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Securitization of Musharakah

Musharakah certificate

• Every subscriber can be given a Musharakah certificate, which represents his proportionate ownership in the assets of the Musharakah.

• After the project is started, these Musharakah certificates can be treated as negotiable instruments.

• Can be bought and sold in the secondary market.

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Securitization of Musharakah

Some Essential Conditions

• All the assets of the Musharakah should not be in liquid form.

• Portfolio of Musharakah should consist of non-liquid assets valuing more than 50% of its total worth.

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Securitization of Musharakah

• However, if Hanafi view is adopted, trading will be allowed even if the non-liquid assets are less than 50% but the size of the non-liquid assets should not be negligible.

• Whenever there is a combination of liquid and non-liquid assets, it can be sold and purchased for an amount greater than the amount of liquid assets in combination.

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Difference Between Musharakah Certificates and a Conventional Bond

Musharakah Certificates• Represents the direct

pro rata ownership of the holder in the assets of the project.

• If all the assets of the

joint project are in liquid form, the certificate will represent a certain proportion of money owned by the project.

Conventional Bond• Has nothing to do

with the actual business undertaken with the borrowed money.

• The bond stands for a loan repayable to the holder in any case, and mostly with interest.

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Securitization of Murabahah • Murabahah is a transaction, which cannot

be securitized for creating a negotiable instrument to be sold and purchased in secondary market.

• However, if the Murabahah paper is transferred, it must be at par value; not more, not less.

• A mixed portfolio consisting of a number of transactions including Murabahah, may issue negotiable certificates subject to certain conditions.

• The reason is obvious. If the purchaser/client in a murabahah transaction signs a paper to evidence his indebtedness towards the seller/financier, the paper will represent a monetary debt receivable from him.

• In other words, it represents money payable by him.

• Therefore transfer of this paper to a third party will mean transfer of money.

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Securitization of Murabahah

• It has already been explained that where money is exchanged for money (in the same currency) the transfer must be at par value.

• It cannot be sold or purchased at a lower or a higher price.

• Therefore, the paper representing a monetary obligation arising out of a murabahah transaction cannot create a negotiable instrument.

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Securitization of Murabahah

• If the paper is transferred, it must be at par value.

• However, if there is a mixed portfolio consisting of a number of transactions like musharakah, leasing and murabahah, then this portfolio may issue negotiable certificates subject to certain conditions.

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Securitization of Murabahah

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Securitization of Ijarah

• It is possible to create a secondary market instrument for the financiers on the basis of Ijarah.

• The lessor (owner) can sell the leased asset wholly or partly either to one party or to a number of individuals to recover his cost of purchase of the asset with a profit thereon.

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Securitization of Ijarah

• This purchase of a proportion of the asset by each individual may be evidenced by a certificate, which may be called 'Ijarah certificate'.

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Securitization of Ijarah

Ijarah certificate• Represents the holder's proportionate

ownership in the leased asset.

• The holder will assume the rights and obligations of the owner/lessor to that extent.

• The holder will have the right to enjoy a part of the rent according to his proportion of ownership in the asset.

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Securitization of Ijarah

• In the case of total destruction of the asset, he will suffer the loss to the extent of his ownership.

• These certificates can be negotiated and traded freely in the market and can serve as an instrument easily convertible into cash.

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Securitization of Ijarah

Essential Condition

“It is essential that the Ijarah certificates are designed to represent real ownership of the leased assets, and not only a right to receive rent.”

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SECURITIZATION OF

GOVERNMENT ASSETSPorts

Airports

Railways

Roads and Bridges

Hospitals

Schools

Buildings

Dams

Land – mainly owned by the Provincial Government

State owned Enterprises

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MODE

Sale and Lease back

Sale and Lease-to-Purchase (Diminishing

Musharakah)

VEHICLE

Central Bank

Primary Dealers

Secondary market

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INSTRUMENTS

Treasury Bills

Government Sukuk

USES

Liquidity Management of Islamic and non-

Islamic Banks.

Money Market Operation

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Federal

Provincial

District and Municipal

Semi Government

Zakat Fund

Non-Tax Resource general for all levels of

Government