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STOCK MARKET

IN ISLAMIC RFAMEWORK

Dr. M. Y. Khan

Introduction

Equity capital represents ownership capital. Equity shareholders collectively

own the company, bear the risk and enjoy the reward of ownership. The

potential rewards and ownership associated with equity shares make it an

interesting financial asset unlike debt. Debt owners are sleeping partners with

no active involvement in the business but with fixed income from debt. In

Islamic finance, equity investment involves Mudarabah finance where capital

owners distribute profit in accordance with agreed ratio. Financial loss also is

borne by them jointly. It may be noted that present Mudarabah participants do

not consist of one or two capital provider and one or two managers or

employees. Today equity participation is through issue of equity shares to a

very large number of investors by a corporate which is a legal entity. So a large

number of equity investors are the owners and management works as employees

or hired professionals. Hence they do not share the profit but get salaries and

other benefits which appear as cost to the company. However one fact remains

constant that capital mobilization is a corner-stone of Islamic finance and as

such capital market occupies prime place in Islamic financial structure. The

crucial role of capital market was highlighted by Hicks. Hicks (1969) argued

that industrial revolution was possible on an economic scale due to investments

of large magnitude made in highly liquid market. According to Hicks, it is the

availability of liquid assets which is crucial and this was made possible by

financial markets and development of liquid capital market. When we talk of

capital market we mean the market where financial assets of long maturity like

equity shares, other shares, bonds issued by corporate, securities issued by the

O you who believe! Fulfill your

obligations (Holy Quraan)


Government and units of mutual funds are issued to mobilize financial

resources from the savers (investors) by the primary deficit units. A number of

intermediaries operate in the capital market to facilitate funds mobilisation and

trading of them. These intermediaries in the primary market are merchant

bankers, advisers to issue, registrars and underwriters. The secondary market

includes stock exchanges, brokers, traders/dealers, depositories, clearing

banks/clearing corporations. Since Islamic financial system prohibits interest

bearing instruments, this paper would confine only to equity finance from

capital market.

Why a Firm Should Go for Equity?

Equity itself means fairness or the application of principles of justice. In capital

market, stocks and shares not bearing interest have been defined as equity which

confers ownership on investors and a right for dividend from a profit earning

company. Every investor gets his reward according to size of his investment.

Hence equity finance is crowned with fairness and justice. Equity partnership

besides dividend offers several benefits to investors as analysed below:

1. Equity market makes investment less risky; more profitable and more

attractive by making it liquid. Liquid equity market improves the allocation

of resources from one company to another and enhances the return efficiency

for investors.

2. Corporate with a large amount of debt have agency problem between

creditors and managers. High profile management prefers to borrow for

expansion of the company. When the debt equity-ratio rises, management

has plenty of borrowed funds induced to commit “adverse selection” in

identifying projects. Larger the firm’s debt due to borrowings and higher the

risky investment as management becomes careless, lower the profit rates due

to non-performing assets. Hence debt owners get little repayment and

interest and firm carries large borrowed liabilities. If funds are raised by way


of equity, owners of the company are more vigilant and stronger. As a matter

of fact companies with high equity are better managed and management

executives can be controlled by equity holders. So large equity investment is

superior to debt investment.

3. We now look from the agency cost point of view. Agency cost of debt is

borne by the firms’ owners as a result of potential conflicts between debt

holders and equity holders. The choice of capital structure can reduce the

cost arising from such conflicts. Jensen and Meckling (1976) highlight the

agency cost arising from the fact that equity holders have limited liability

while debt holders have fixed minimum return. In the event that company is

successful, a maximum gain goes to equity holders. If the company is not

successful, debt holders also bear the losses along with equity holders. Thus

for lender it is safer to invest in equity stocks and control the policies of the

company. It has also been witnessed that shareholders have an incentive to

introduce investment strategies which reduce the outstanding debt in order to

eliminate the influence of lending bank through its nominated director on the

governing board. The value of firm rises with the increase of equity. So

investor should invest more in equity. In a growing concern, the companies

find it cheap to rise funds from equity market Equity shares are more liquid

than any other assets or debt of any type. Marketability and liquidity means

that equity shares can be transacted quickly with lower transaction cost than

debt and with lower capital loss. Price discovery is of permanent importance

and equity price is determined by market forces. On the other hand, debt is

somewhat illiquid asset and price determination is difficult as it is generally

not traded.

4. Modigliani and Miller (1958 and 1963) showed that deductibility of interest

payment from profit makes the firm to rely more on debt. But there are

evidences that companies with large borrowings and high debt become sick

and insolvent. Their bad debt and interest liabilities exceeded their net worth


resulting in insolvency. This has generally happened when business faced

demand recession for a few years or downward -business cycle persisted

over a long period or management turned to be dishonest and careless.

However, equity dominated firms have withstood such crashing periods

while debt dominated firms have collapsed. As a matter of fact high debt

liability which sometimes can bulge for no fault of the company’s owners

can wipe out the entire net worth of the company.

5. Allen (1993) suggested that in industries where there are little concerns on

how things should be managed, allocation of resources through stock market

is desirable. This is because stock market provides a way of checking that

firms are well run when there are divergences of opinion on how firms

should be managed.

6. Equity shares can be described more easily than fixed income securities.

However, equity participation needs more highly skilled investors than

investors in debt. Equity investment requires superior knowledge of

associated risk dimension.

7. The debt and interest liabilities grow irrespective of condition of the

company. We have the experience, that debt liabilities of many developing

countries made them insolvent due to servicing of external corporate debt.

The outflow of capital on account of debt service has exceeded the fresh

capital inflows. Large capital outflows put pressure on exchange rate and

foreign exchange reserves of the domestic country.

8. In terms of international finance, foreign investors participation by way of

foreign direct investment (equity) brings with it entrepreneurship, foreign

technology and techniques and expertise.

9. Equity issues go through screening by the board of directors, executives and

regulator before issue. A number of disclosure norms have to be satisfied.

Consequently equity investment as well as funds raising by issuing equities


is more objective oriented while management can borrow debt without

facing any scrutiny and can be used for undesirable purposes.

10. Our experience shows that inflow of foreign equity brings in improved

accounting and reporting standards and exposes domestic companies to

advanced supervisory and managerial techniques. Equity investment through

foreign inflows avoids excessive reliance on foreign debt and saves firm

from recurring debt servicing burden in foreign exchange reserves. The

substitution of foreign debt by foreign equity makes firm less vulnerable to

external insolvency.

11. Stock markets functions as a scrutinizer of financial performance of

corporate and serves as a guide to promote efficiency. It is known that a

continuous valuation of companies is reflected in stocks prices and

expectations for dividend. In the event, stocks prices start declining,

possibility of takeover and merger emerge as a threat cautioning a company

and its management to have financial discipline and efficient funds

allocation. Another role of market prices is that they facilitate risk

diversification through international integration, encourage shift to higher

return projects and help to promote growth.

12. It would be seen that the above analysis revealed that financing by issuing

equity shares is more judicious and would not result in adverse selection of

low quality projects. Agency problem can be solved by providing incentives

to managers. These incentives can be linked to profitability and productivity

of the company.

Organising the Islamic Stocks Market

Equity stocks markets can be organized as an exchange or an over the counter

(OTC) market. An exchange is a physical location where buyers and sellers

come together physically or through electronic instructions to buy and sell

securities. In contrast over the counter, market permits buyers and sellers to


transact without meeting at one physical location through computer linked

network. Though many instruments like corporate bonds, debentures, Govt.

securities, derivatives, commodities, etc. can be traded on stock exchanges, but

this paper has been restricted to equities market because only equity shares

conform to Islamic principles of finance.

Islamic stock exchange will have to be setup on the basis of Islamic Principles

through equity participation. The stock exchange will not provide trading

facilities for debt instruments, derivatives, companies being financed by debt

and companies manufacturing goods and services not compatible with Shariah

Laws. Ownership of stocks exchange will be with shareholders in stock

exchange. For achieving fair functioning of stock exchanges, its shareholders

will not be allowed to participate in trading and will not be permitted to be the

partners of any other player in stock market. Distribution of dividend to

shareholders of stock exchange will have to cope and its shares will not be

tradable. These shareholders could be institutions as well as individuals. The

shareholders will have to observe all laws based on Shariah. The stock

exchange will be subjected to corporate governance based on Islamic provisions

or Islamic code.

Ownership of a company through equity shares in modern ownership concept,

correspondences to partnership firm in Islamic Jurisprudence. Though Islamic

scholars have specified a number of varieties of partnerships like Sharikatul-

Mufawadah, Sharikatul-Sanai, Sharikatul Wajuh and Mudarabah. Except

Mudarabah other varieties specified above would refer to proprietary and

partnership companies with small scale of operations controlled by the owners

themselves along with small managing group. This type of sector today forms

the unorganized segment of the business in any economy. Mudarabah financing

today would involve promoting a company by the promoters by way of


contributing capital and assigning the management of the same to professional

managers. Though ownership and management policies may be framed by the

promoters, execution remains with the executives and risk is born by the

promoters. Since medium and large companies seek billion dollars of resources,

the number of shareholders also (partners) is very large. For the sake of

accountability and recognised identity, such companies have to be registered

with Government authorities, so that investors intending to become partners

from long distances are sure of the personality of the company. Finally, the

company is personified as a legal entity for functional purposes. You would see

that present day joint stock companies are replica of Mudarabah companies and

have to function according to mutual agreements and government regulations.

We may explain one important point that most of the Shariah laws were given

interpretations in early period of Islam when concept of industry involves only

partnership firms and exchange mechanism was limited to geographical

contiguity and number of economic agents personally knowing each other.

Hence, there was physical contiguity among the partners. Today when a

company has 50 thousand or 80 thousand shareholders scattered over the far

flung areas, their personal relationship does not exist but the company has

continuity of life because ownership of company is dispersed over million

shareholders. Exit of few such partners does not lead to closure of a company.

Identification of an Islamic Joint Stock Company

Islamic Joint Stock Company is that in which owners or contributors of

financial resources invest their own savings on profit/loss basis. The company

should not have any debt or any liability bearing interest rate in terms of money

or in any non-monitory form. The company should not manufacture any product

or service which is prohibited by Shariah. The company should not engage in

exploitation of consumers, factors of production and natural resources given by

God. The company should not indulge in over pricing and under pricing. The


company should not obstruct free market forces. Corporate social responsibility

is also the preamble of Islam. If the corporate do not develop moral and ethical

standards and they are not accountable to them, their animal spirit to maximize

their profits can lead to unfair business practices sacrificing externalities and

leading to high social cost. It is very well known that corporate with sufficient

profits give money to public broadcasting efforts, or to local rehabilitation

programmes or donations. Social responsibility has a wider meaning than

conveyed by monetary donations and financing social events. Ethical behavior

is an integral part of the responsibility, which every company/corporation owes

toward that society in which it operates. Social responsibility is independent of

the size of profit. To the extent any corporation abuses the society; it becomes

threat to the society’s welfare and health. A company has to observe “ethical

behavior” and “social responsibility”. That is why Shariah does not permit

collusion which can result in cartel monopoly of factors of production,

production and distribution of goods and services and exploitation of society.

Such companies cannot find place in capital market under Islamic frame work.

Why Company Should go to Capital Market

The exchange monitors information of a firm on a wider scale among the

investors and an Islamic company will have to mobilize large resources for

capital formation on this basis if it has to compete with large multinationals.

Character and profits of promoters, rating of company, disclosure of material,

and information to investors at the time of issue of company should be

mandatory.

Trading in Equity Stocks and Islamic View

It may be said at the outset that Islam is for a fair and free market. The Holy

Prophet (may peace be on him) discourages any interference in the process of

price determination by the state or individuals. Besides refusing to take any


direct action, he prohibited these business practices which could lead to market

imperfections. Consequently, stockholding, speculation, oligarchic collusion,

concealment of vital information about the product and selling by false vows

(misleading advertisement of the present day) were prohibited by Holy Prophet

(may peace be on him). Thus the holy prophet (may peace be on him) nullified

the influence of economic power on price mechanism. An equity share

represents the net wealth of the company which can be traded. Islamic scholars

are in agreement that stocks corresponding to Mudarabah partnership

certificates can be exchanged or traded like real commodity which has a value

in real terms. The investors have to purchase equity shares with real intention of

investment and to hold them as a partner in the company. In other words equity

shares have to be purchased to become partner and not for trading for profit

making. This would be in Shariah compatible to Mudarabah which is

partnership in real sense. Of course, immediate sale of instrument can be made

to meet unseen needs arising all of a sudden.

In this section it is proposed to define and explain some transaction activities in

stock markets which are unlawful according to Quranic injunctions. These

activities are frauds and unfair practices in sales and purchase which are

discussed below.

Frauds in Trading

Islamic Shariah has prohibited frauds in exchange of goods and services. The

same is valid for transaction of shares which include an act of buying and

selling or subscribing to any issue of any security or equity or agreeing to buy

and sell. In Islamic view fraud means any action, expression, omission or

concealment committed whether in deceitful manner or by a person with his

convenience or by his agent dealing in securities in order to induce another

person or his agent to deal in securities, whether there is any wrongful gain or


avoidance of any loss. Fraudulent action would also include misrepresentation

of truth or concealment of material fact in such a way that opposite party acts to

its own detriment, an incorrect suggestion knowingly given by one party to

another party for purchase or sale, an active concealment of fact having

knowledge of it, a promise made without any intension of performing it, any

presentation made in reckless and careless manner, a false statement, an act of

issuer of securities, giving out misinformation adversely affecting the market

price of security, planting misleading news predating or falsifying records, etc.

Malpractice and manipulation is committed when buyer or seller of securities

creates false or misleading appearance of trading not intending to effect transfer

of beneficial ownership but only to inflate prices (Ghaban) or cause fluctuations

(volatility) in price of securities for wrongful gains.

Short Selling or Long Buying is Prohibited

A short sale is a sale of securities which the seller does not own at the time of

affecting the sale or goods do not exist at the time of sale. This type of

transaction is not permitted according to Sanani Ibn Qudama (WD) and Ibn

Humam (1317H, 13/1P, 4/55, 6/36). Similarly if a purchase of stocks contracts

to buy ion future and has does not have cash in hand or in bank or is likely to

get his own money in due cause is prohibited to do such deal because he adds

fuel to price. A long position is one where trader buys the securities without the

intension of having them or without the intention of accepting delivery.

Prophet, the honorable (peace be on him), did not approve sale of goods which

seller does not own in his possession at the time of executing the sale. In

financial market it is called short selling which has the potential of being

misused for rigging the market prices. Moreover, short selling results either in

extra profit making or defaults by the seller of securities. In capitalist frame

work, short selling cools the stocks inflation in future by supply securities in the


market. Short seller is trader in the stocks market. He sells equity shares to be

delivered on a future date at a determined price in the expectation of fall in

stock price influence before the settlement date and during this period he buys

the stocks to make delivery at settlement date. Mostly there is no delivery and

the trader gets arbitrage between the sale and purchase price. Short selling or

long buying results in slump or shooting up of the market leading to crash of the

stock prices or in major default blocking their payment and settlement

culminating into bankruptcy and liquidation of financial system. Islam therefore

has prohibited short selling in all types of trade. In the capital market short

selling involves speculation. Similarly, long buying or using margin trading for

long buying stimulate speculation resulting in stocks boom. The trader may pay

margin on positions and can postpone settlement for next round. The long

buying is financed by bank borrowing. In speculative market, turnover and

velocity is very high because same quantities of shares/stocks change hands

several times. This is false trading or false transaction activity because in terms

of money value turnover raises but the quantity of stocks traded remains mostly

the same. It does not add any real value to company of which shares are

overtraded. There is no additional capital formation in the economy. These

activities add fuel to the market.

We may specify that speculative sales and purchase in short selling or otherwise

generate “Gharar” or uncertainty in the outcome expected by the investors. The

markets have experienced recurring volatility in stocks prices during booms

leading to uncertainty and economic instability while short selling have ruined

the investors. Economic instability results in distortion in investment planning

of entrepreneurs.


Process of Crisis in Short Selling

Short selling could result in a loss if price of equity share rises instead of falling

in the subsequent period. The losses in short selling shoots up because there is

no limit on price rise. Many times bulls generate price spiral artificially by

cornering the floating stock. This occurs frequently whenever there is large

scale short selling and bulls know that short sellers would need to make

purchase to cover their short sales. A steep shortage of floating stocks arises due

to cornering of supply of stocks by the bulls that push up the stocks prices

artificially. Thereafter short sellers find it difficult to purchase or borrow same

stocks except by buying at very high price from bulls. On the other hand, there

is an opposite case when bulls get overextended due to accumulated large

positions financed by short term borrowing and the bears who would have come

to know about bull buying spree, start heavy selling and cause market price to

sink and imposes heavy losses on bull who is not able now to repay short term

borrowings to lending bank. This manipulative game between bulls and bears

can make even lending bank bankrupt and insolvent. Thus a default by a large

trader can have a chain reaction percolating to insolvency of many banks

resulting in defaults to million depositors.

Insider Trading in Islamic View

Islam / Quran has focused on education, knowledge and correct information

available to all concerned people. Transparency in information is equally

important for all since lack of transparency can lead to misunderstanding of

facts (Jahalat). According to Islamic view, an investor or any other entity

associated with market activities should have knowledge of rules and

regulations issued by the government authorities and Islamic law authority.

They should also be competent in the knowledge of market mechanism before

engaging in equity transaction (see Al-Ghazali, 1992, P-328). Therefore in any

transaction, parties have to be very seriously accountable to facts, information


and rules and regulation including ethics. In case of violation of these

principles, a number of times, trading in shares results in insider trading. Insider

trading involves a person (director of the company or any person associated

with the company) who either on his behalf or on behalf of any person deals in

securities of a listed company on any stock exchange when in possession of

unpublished price sensitive information. Insider trade also occurs when insiders

communicate, counsel or procure directly or indirectly any unpublished price

sensitive information to any person who can use this information to sell or

purchase the stocks. Sensitive information could be defined as financial results,

intended declaration of dividend, major expansion plans, expected mergers /

acquisition and any other information likely to affect the profitability of the

company. According to Shariah, all the information of the company should be

known to dealers / brokers / investors in the market and should not be

monopolised by insiders only. The information should be presented in

understandable manner.

Hiding of information and presenting it in distorting manner by the insider or

cornering information is against teachings of Islam. It is totally illegal in Islamic

view to trade on the basis of information which has not been yet made public.

Insider trading as a matter of fact violates market efficiency and an insider can

realize abnormally high return from trading by using the information they alone

know. Insiders have an advantage of information flow and can manipulate it. In

capitalist economy which works without ethics, promoters of firm, directors on

the board of the company, management executives produce false information

and if unrestricted, can realize personal gains by selling shares short while

jeopardizing the profitability of the firm and settle the trade by making purchase

when prices have fallen.


Shariah Position on Risk Management

The owners of a firm hold partnership through holding shares of the company

which is listed on stock exchange providing the opportunity of selling and

purchasing the stocks on the basis of demand and supply. As such the investors’

main concern is the value of their shares. It is worthwhile to state that investors

are risk averse because risk reduces the value of shares. Therefore any reduction

in risk by using risk management strategies will protect the value of shares.

Since Shariah also recommends maintenance of protection of wealth, an

investor has to protect his investment value from risk otherwise he violates the

Islamic teachings. If we do not protect our assets from risk, we are involved in

squandering of wealth. It is prohibited by Quran. Again we are trustee of wealth

appointed by God so we have to protect it by all fair means.

The very objective of the Shariah is to promote the welfare of the people which

lies in safe guarding their faith, their life, their intellect, their posterity and their

wealth whatever insures the safe guarding of these firm serves public interest

and is desirable - Al-Ghazali.

If risk is not mitigated, it can lead to financial disaster and economic instability;

Risk strategic management has to be adopted at investors’ level as well as on

stocks market level since equity stocks are under consideration. According to

Islamic provisions, “Severe damage (darar) is made to disappear by lighter

damage” (Ibid Av.1.2.6). “The smaller of two harms (darar) is chosen” (Ibid

Article28) “Damage (Darar) is to be avoided as far as possible” (Ibid Art.30).

As such risk containment measures have to be used as recommended by

Shariah. Risk in financial assets is broken into two components namely

systematic risk and unsystematic risk. Systematic risk associated with equity

shares is systematically related to market. This risk originates from the market

events and it is not specific to a stock of the company or characteristics of the


company. On the other hand unsystematic risk is generated in the company to

which the stock is related. This risk can be eliminated by diversifying the

investment (portfolio approach). As unsystematic risk is not relevant to risk

management, it is systematic risk which has to be management. This risk arises

from market due to manipulations, frauds, short-selling and long-buying,

insider-trading informational inefficiencies, inefficient clearing and payment

system and lack of transparency in the market. Thus it is the imperfection in the

market which can create systematic risk in the market.

Stocks Market Today

The trading in stocks is automated and screen based; the settlement period has

been shortened. Today almost all stocks exchanges work on T+2 settlement

period basis. Moreover today trading is done in rolling settlement basis. There is

no settlement default as trade is cleared by the Clearing Corporations set up by

stock exchanges. Trading is paperless as shares dematerialized are kept in

investors’ accounts with depositors. Almost all tradable securities are transacted

without delay, transit loss and forgery in transparent manner with all

information contents. An important feature of today’s exchange market is that

clients through computers brokers, stock exchange with automation screen

based trading, clearing corporation, depositories and clearing banks are having

interconnectivity. This network has resulted in reduction in funds, delay in

settlement, transparent trading and reduction in cost of transaction.

The companies listed on foreign exchanges for trading have to sign listing

agreement and have to observe conditions specified in the agreement. The listed

company has to file quarterly financial statements of its operations and all

material and sensitive information with stock exchange regularly. Stock markets

work according to guidelines and mandatory instructions of Regulatory body set

up under Government Act. Regulatory Authority generally regulates


functioning of stock exchanges, mutual funds, collective investment schemes,

Pension funds, etc. as all of them operate in the market. Among the

intermediaries being regulated are brokers, depositories, operations of foreign

institutions and other institutions investing in securities. Among them brokers

are closely regulated. Brokers are registered with Regulatory authority and have

to follow all disclosure norms, Capital Adequacy norms and risk containment

measures. In many countries like India, Government is encouraging

corporatisaton of brokers to make them more methodological and financially

strong. There are stringent laws and punishment for economic offences like

frauds, manipulations, violation of regulatory norms, insider trading laws and

laws relating to volatility in the market.

Risk Management

Traders in stocks markets have a tendency to have exceedingly huge exposures

and indulge in short selling, long buying and carry forward transaction. Such

activities result in default and huge losses. To avoid such events, authorities

impose margins on overall gross exposure of the member of stock exchange or

their exposure in specific securities. Then there are volatility margins on

movement of prices of equity shares, an exchange can use even circuit breakers.

Authorities can halt the trading if market is going out of band, in order to cool

down the market. Mark to market margins and at risk based margins are buy

used to safeguard the settlement. Every stock exchange has to set up trade

guarantee fund to provide safe settlement and to avoid defaults and Investors

Protection Fund to protect investors.

Mark to Market Margins and Value at Risk Based Margin

Since stock markets today represent the capitalistic society in which

maximization of profit and wealth is the primary goal. Even the corporate

Governance has been designed for maximizing shareholders wealth without


considering the ethical part of it. Similarly, in stock markets number of

development have been made to boom the market in the name of liquidity. I

may clarify that stock market concept is an ideal one but it has been distorted in

the name of liquidity. The liquidity means easiness to sale without loss of

capital and without delay at minimum transaction cost. Some of the reasons for

damaging the capital market are given below:

1. Brokers / traders are allowed to make total trade equal to many times of

their capital or funds with clearing corporation. This empowers brokers to

indulge in overtrading.

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

securities.

3. Since only margin money is required at the time making order for buying

the stocks, such money can be borrowed from banks or other brokers. As

such purchasing the shares when an investor does not have finance is

undesirable and leads to rise in stocks prices.

4. Short selling and long buying generates volatility and uncertainty in the

market.

5. Trading in the market is done to reap high profits and with intention of

investment. In India more than 70 per cent of trading is speculative and 36

per cent is done on delivery basis.

6. Margining system is very liberal and margins are not kept in cash. Keeping

securities as margin give leverage to the traders.

7. Taxation system is faulty as capital gains are exempted from tax. These

fiscal incentives motivate traders to speculate and earn abnormal profits.

Primary Market - Operational Frame Work of Islamic Stock Market

Theoretical aspects of Islamic stock market were discussed in the first section

and therefore in this section we attempt to discuss some operational features.

We covered all provisions relating to issue of stocks in primary market.


Investors in stocks in Islamic view should have intention of real ownership or

partnership feeling rather than trading in them. Islamic stocks Regulatory

authority will have to impose lock-in-period of 4 to 5 years so that only real

investors purchase the shares. Of course the company should offer buy-back

facility in order to provide liquidity for sellers in need.

There is a view that Islamic company should issue stocks on the basis of fixed

price method calculated by appraising agency which should have free access to

all available information from the issuing company.

Pricing of shares can also be based on real expected dividend or on the basis of

net worth of the company. Company should not charge premium on issue

without having any relationship with net worth and reputation or goodwill.

Actually price of issued share should reflect its economic value + or minus 5 per

cent. As this 5 per cent will be determined by the market forces. Allocation of

stocks should be done on pro-rata basis when demand is more than stocks

issued or there is an over subscription. A company can announce issue on stock

exchange screen also to have wider awareness among the investors. Modern

system of capitalistic process of offering securities in Book building in which

bids at various prices from investors or syndicate members are reduced and

demand for stocks is determined on the basis of these bids and thereafter its

price is discover based on judgment of merchant bankers and advisers to issue.

Book building has two options namely 75 per cent book building route and 100

per cent book building. A more than 60 per cent of offer is allocated to

institutional buyers and rest to small investors. However, Islamic stock markets

should not adopt this because many times it involves over pricing by institutions

due to their mutual understanding with the promoters.


Fixed price issue method should be followed by Islamic market. An issuer will

be always continuous and conservative in pricing the issue so that issue is fully

subscribed. Hence price is always on the lower side. But book building price is

aggressive and harms the investors.

Instrument to be Traded on Islamic Stock Exchange

Besides equity shares, preference shares and right shares can form the part of

Islamic Instrument to be traded. Mutual funds float equity linked scheme to

mobilize funds to invest in equity shares. Such units of mutual funds can be

transacted on stock exchange. The listed companies can also list their bonds and

debentures which are not based instruments but dividend based instruments.

Bonds can be traded in the market but holders cannot be owner of the company.

Islamic bonds can be similar to fixed deposits of Islamic banks but tradable.

Principles of Trading Activities

We have already analyzed certain transaction activities which Islam does not

permit. These include overtrading, short selling, frauds, insider trading,

cornering information, lack of transparency and fairness in trade. These all

binds the competitive market functioning. High booms and crash in the

securities market is a sign of imperfection. Even after all paraphernatra attached

to stocks market cornering of stocks and manipulative trading does not resulting

in real value addition. Competition result in high productivity, efficiency and

gains for economy and society. Competition is healthy and productive if it can

increase quality, efficiency and equity rather than cut throat competition by

using unscrupulousness and unethical tactics. Traders in market acquire animal

spirit generate uncertainty and risk. To control such environ trading needs to be

restrained by putting cape on gross margin which should not exceed capital

adequacy of trader. Trader should pay penalty if gross trade exceeds his capital

deposit with clearing corporation. Even stock-wise exposure should not be


copped. If trader is found in manipulation activities, there should be severe

penalty. Banks and financial institutions should not be permitted to lend for

financing the trading in securities. Islamic trading system should be 100 per

cent delivery based and dematerialized. Only equity based company can

participate in securities market and should be observe Shariah in absolute sense.

Islamic stock market will require all parapherantra of modern exchange.

Automate trading with all efficient mechanism is must for Islamic market.

Islamic stocks market warrants availability highly skilled investors. This needs

education of very standard. Accounting standard and market satisfaction require

specialized training institute. It is necessary to caution Islamic stocks is a very

costly affair stocks market have been facing traders in many forms like brokers

or on their accounts individuals, non-banks finance companies, mutual funds,

equity firms, foreign financial institutions, domestic financial institutions,

pension funds and provident funds. Among them foreign financial institutions,

mutual funds, financial companies should not be permitted to invest in Islamic

stocks as they simply traders but other institutions and investors can be

discourage from buying and selling the selling the same stock in the same or

next settlement as a matter of fact there needs to be a lock-in period of 6 months

in the secondary market.

Islamic stocks market should work as a trustee for investors and has to watch

performance of a listed company. As soon as the stocks of a listed company

recorded large fluctuations, stocks market should display SWAT analysis of the

company on screen. The stock exchanges statutorily should discount rumors and

incorrect and misinformation. The Islamic stock exchanges can announce

divergence between stocks prices and real fundamentals of the economy.


Muslim community has been lagging behind in the technical knowledge relating

to investment and financial markets. There is a need to expand financial trading

among the Muslim. We can have Islamic Financial Management institutions

and investment experts to impart education and working knowledge of Islamic

investment mechanism. We will have to develop the sense of accountability in

the community as well as in the market players. Ethical values have be matured

and strengthened.

T+0 Rolling Settlement and Clearing of Trade

Islamic stock exchange is supposed to discourage and prohibit short-selling and

long-buying, manipulation in sales and purchase of stocks and frauds in

transaction. In order to achieve these objectives, execution and settlement of

trade should be as rapid as possible so that no one gets the chance to distort the

market. As soon as the orders to buy and sell are rooted through automatic

trading system they should be matched and monitored for speedy settlement. All

orders have to be matched on real-time basis and stock price priority basis.

Islamic stock exchange will have to adopt settlement system on t+0 basis. It

means trade executed today has to be settled tomorrow by actual delivery of

shares and cash payment. There is no possibility of arbitrage in such system.

They will have to set up clearing corporation which will be guarantor of trade

settlement. The clearing corporation will have to be set up as an independent

subsidiary of Islamic stock exchange. Islamic clearing corporation will

determine the funds and securities (shares) obligations of a trading member and

ensure that trade is settled. Thus t+0 settlement can eliminate fraud and

manipulation.

Conclusions of the Paper

Islamic stock market can play a crucial role in promoting investment in equity

shares and can create liquidity in the market. It would reduce frauds,


manipulations, insider trading, short-selling and undue arbitrage. The

capitalistic model of stock market in spite of all facilities, disclosure standard

and accounting standard, risk mgmt to protect the investors, has crippled their

confidence. Many a times even a whole nation has to face adverse financial

insolvency like East-Asian countries in 1997. Since financial markets are

getting globalized and capital inflows are playing a game of free rider in other

economies, Islamic stock exchange with stringent Shariah discipline and most

up to date technology and education in finance can eliminate a number of short

comings of today’s stock exchanges. Stock market efficiency will have to be

judged on the basis of growth of investment or capital formation. Minimum

volatility, marginal divergence of market price of stock from its intrinsic value,

severe punishment for violating the law and high level financial literacy in

Islamic market should be the prime goal of Islamic stock exchange.

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