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7/30/2019 Religion, Ethics and Stock trading
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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 Islamicprinciples, is still very much at an early stage
of evolution. This development is part of anon-going program on Islamisation of the finan-
cial system in the Muslim world (Naughtonand Tahir, 1988). Many Muslim countries, or
those with a majority Muslim population, havewell established stock markets, for example,
Bangladesh, Egypt, Indonesia, Malaysia andPakistan. These stock exchanges are basically
Western style markets tolerating practices thatmay not strictly adhere to Islamic principles (El-
Din, 1405/1985). However, countries such asMalaysia 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 aseparate “Islamic Index” has been established
comprising 179 permissible stocks on the KualaLumpur Stock Exchange (New Horizon, 1996).
This paper is an introduction to the issues asso-
ciated with the formation of a separate Islamicstock market. The paper will draw on interpre-tations of Shari’ah, which is the name given tothe sources of the sacred law of Islam, governing
all aspects of a Muslim’s life. The principalsources of Islamic law are Al-Qur’an, theimmutable collection of revelations received by
the prophet Muhammad and Sunnah, which iscustom 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, onlyPakistan comes closest to having a financial
system totally free of interest. Riba has a muchwider definition than simply referring to interest.
It encompasses all forms of exploitation andexcessive charges in business dealings. Stock
market trading lends itself to practices that canbe 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 thedisadvantage 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
Religion, Ethics and Stock
Trading: The Case of an Shahnaz NaughtonIslamic Equities Market Tony Naughton
Journal of Business Ethics 23: 145–159, 2000.© 2000 Kluwer Academic Publishers. Printed in the Netherlands.
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activity. Manipulation of stock prices, for instance
through creating a false market in a stock, is alsotypically illegal in Western countries and is
another aspect of exploitation that would beregarded as riba in Islam.
One of the most difficult aspects of designingan Islamic stock market is the issue of Qimar , or
gambling. This concept covers speculation in the
stock market, that is, trading in securities purelyfor short-term gains resulting from uncertainty
in the market. In Western markets, moderatelevels of speculation are regarded as quite accept-
able. Speculators keep the market more watchfulof 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 tospeculation 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 applyin a very volatile market. Both a buyer and a
seller should not transact business when theoutcome of the deal is highly uncertain (Kazmi,
1994). However, stocks are risky and marketparticipants are attracted to them because the
higher the risk of a stock, the higher theexpected return. Stock market regulators in an
Islam market would have to consider whether itis 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 construedas Ikrah. This relates to imposing a contract onan unwilling party, or imposing conditions that
are unacceptable to them (Kazmi, 1994). Froma Western perspective it is difficult to see any
problem in this regard. Market participantschoose to buy and sell stocks and take positions
in derivative markets. Parties willingly enter intosuch 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 twowilling parties. However, in the case of options
written on stocks, the very nature of the contractimplies that option buyers will exercise the
contract only when it is beneficial to them, whilebeing potentially loss making for sellers. Even
though both the buyer and seller of an optionenter in the contract willingly, the very fact that
the buyer can impose a loss on the seller maymake 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, usingderivatives, is a form of insurance. Investors may
seek to protect their underlying investments bybuying and selling der ivatives 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 wellfunctioning 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 issuesare extremely complex and are subject to the
interpretation provided by scholars from the mainschools 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 stockmarket. It is important that the issues are widely
understood and debated. The area of Islamicbanking is one in which vigorous debate con-
tinues as to the most appropriate methods to usefor the provision of finance to bank customers.
It is likely that a healthy and vigorous debate willcontinue for a long time in this area as well.
Market efficiency
A strong feature of Western financial marketstoday is deregulation. Markets are allowed to
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function without undue government interfer-
ence. In the case of stock markets, this approachcannot mean a total absence of regulation
because of the need to protect investors frominsider traders, price manipulators, excessive r isk-
taking and other aspects of moral hazard (GhonRhee, 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. Thereare 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 – theoptimal allocation of resources in the primarymarket. In the secondary market we tradition-
ally consider operational efficiency and informa-tional efficiency. An operationally efficient
market is one in which the lowest possibletransaction prices prevail in the secondary
market. This requires a well-developed stock-broking industry with healthy competition
between brokers. It also implies a well-developedtrading 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 intosecurity prices in the secondary market. Financial
economics places greater emphasis on informa-
tion efficiency because, if prices fully reflect allinformation about firms, resources will be
“properly” allocated. Therefore an information-ally efficient market is also, by definition,
allocationally efficient (Martin, Cox andMacMinn, 1988). While these concepts of effi-
ciency appear highly relevant from an Islamic
perspective, it is likely that a broader conceptionof 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 inparticular, should be efficient in the sense that
they support social justice, fairness and the wellbeing of society (Samuels and Yacout, 1981).
This is not a strong feature of traditional Western
views of efficiency. Some would argue that stockmarkets actually create social inefficiency by
encouraging unequal distribution of wealth. Rashspeculation also creates systemic risk and can have
a destabilising effect on the economy. The Wall
Street crash of the 1920s and to a lesser extentthe 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 dangersfaced by Muslim countries when uncontrolled
speculation is permitted. In addition to specula-tion, stock markets provide opportunities for
dishonest activity such as insider trading. Thesecan 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. Fama’s concept of strong form efficiency
assumes there is no confidential information. Asmight be expected, this form of efficiency is
not supported by the literature. Firms seek tokeep confidential certain aspects of their activi-
ties while market analysts seek to elicit thisthrough 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 whichRock (1986) simplifies as a division of the
market between “informed” and “uninformed”investors. As discussed above, asymmetric infor-
mation is a potential obstacle when consideringacceptable contracts in Islam.
Securities
Modern financial institutions, such as security
and derivative markets, or instruments such asshares, bonds, futures, options, and swaps create
problems when they are utilised in an Islamiceconomy. The reason stems from a lack of clear
Shari’ah guidance on their acceptability. Of theseinstitutions and instruments, stock markets and
common stocks are perhaps the simplest, yet
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there appears to have been little in the way of
comprehensive examination of their acceptabilityin modern Islamic society. As mentioned previ-
ously, stock markets are permitted in Muslimcountries. That in itself does not mean that the
instruments and trading practices of the marketsare in accordance with Shari’ah. Interest-based
banks are permitted in the majority of Muslimcountries, yet there is general acceptance that
interest is forbidden in Islam. The approach usedin 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 bediscussed in subsequent sections of the paper.
Common stock
In an Islamic context we may refer to common
stock as Mudarabah, or profit and loss sharingcertificates. The idea of dividing capital into small
portions in the form of stocks may appear to haveits 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 anownership claim on a company and stockholders
are owners of the business. As such they areentitled 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 withownership. In the event of the winding up of a
company, all third party claims must first be metbefore stockholders become entitled to any
return of capital.Islamic economists and scholars agree that
these features make common stocks acceptablesecurities 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 theIslamic 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 IslamicConference. The CIFA has commenced a series
of meetings to consider a range of unresolved
issues of Islamic jurisprudence. The Council is arespected advisory body that offers guidance tothe international Muslim community. Stocks
closely adhere to the profit and loss sharingprinciple 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 toMuslim investors through the stock market. A
traditional Western style corporate bond is likelyto fail any test of acceptability. To begin with
they are interest based, paying a fixed returnattributable 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 andprincipal. Such penalties are deemed to be
unIslamic as they are close to usury, the principlereason for the prohibition of interest in Islam
(Siddiqi, 1403/1983).
However, Islamic enterprises will need varyingamounts of short- and medium-term debt capital.
It can be argued that Islamic banks and financialinstitutions can provide this finance through
various Islamic financial contracts. These con-tracts fall into four categories with many
variations. The most radical, from a Westernpoint of view, are profit and loss shar ing contacts
whereby banks are effectively limited-term equityinvestors in the borrower organisation. Examples
of such contracts are Mudarabah, mentionedabove, and Musharika. The second category arecontracts based on transactions, whereby a bank
buys assets required by customers and sells themto the customer at a profit, with deferred
payment. Examples include the contracts of
Murabahah and Bai’ Bithamin Ajil . A thirdcategory are contracts that resemble Western style
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leasing with the contract of Al-Ijarah 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 Islamicfinancing 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 accessingshort- and medium-term finance from banks and
financial institutions as well as issuing bonds andother debt instruments in financial markets. Bond
markets enable companies to access longer-term
finance at predetermined rates, whereas bankfinance 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 totalamount 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 debtfinancing in the form of transferable securities.
How then are they to be structured? Clearly aninterest-bearing bond is not acceptable. One
possibility is to utilise “free” loans in the formof a Qard-ul-Hasan (benevolent loan) facility.
This is already in use in Islamic finance, althoughsome argue that its use in a commercial situa-
tion is against the spirit of the original conceptof Qard-ul-Hasan. The instrument is designed as
a benevolent facility to the needy. While thereare circumstances where a firm may qualify for
such a facility, it is questionable whether it shouldbe 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 bankscannot 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 isclearly an inadequate framework for the ongoing
provision of large-scale commercial finance inbanking or in the form of a Qard-ul-Hasan bond
facility.
However, there have been several attempts toutilise Qard-ul-Hasan in bond issues. An inter-
esting example was the 1994 issue of M$300million of Islamic Debt Securities (IDS) in the
form of a Qard-ul-Hasan facility by Petronas, the
national oil company of Malaysia. At maturityrepayment 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 thewarrants entitled holders to subscribe for shares
in Petronas Dagangan Berhad at a fixed price ata future date. The warrants did not form a part
of the underlying IDS, because a predeterminedreturn cannot be negotiated in a Qard-ul-Hasan
facility. Both the IDS and warrants are tradable
securities. Subscribers to the IDS can trade thedetachable warrants or hold them to maturity andsubscribe for shares.
The solution to the problem of Islamic debtsecurities is likely to lie in transforming tradi-
tional interest bearing bonds into a facility thatis transaction based. Equity based debt contracts
are unlikely to provide the balance of financingrequired 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 debtinstruments tied to a particular transaction, for
example the purchase of a particular asset by afirm, or a series of transactions packaged
together. Subscribers to a bond issue wouldinitially buy the asset(s), resell to the borrower
at a price above the original cost and receivepayment for the sale over a stipulated period of
time in a similar manner to a conventional bondservicing schedule. The transaction is effectively
a collateralised bond, whereby bondholders retaina claim on title until maturity.
Such forms of debt and bonds raises thequestion 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 thereturn will be larger the longer the period of
repayment stipulated in the contract. This hasfrequently been challenged on the grounds that
it has similarities to interest and hence riba [seefor example Siddiqi (1403/1983, p. 138)]. The
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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 whichrepayment is to be made (Husain, 1994). A
straight loan made to a borrower that is nottied to any particular transaction, and which
bears a return in the form of interest, is notacceptable. 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 theemergence 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 beutilised in an Islamic system. Preferred stock-
holders forego voting rights and participation inmanagement 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 theoriginal 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 whilethe return to bondholders is called interest.
Mohsin (1403/1983) argues that, in an Islamiccontext, the surrender of voting rights and
management participation is not a valid reasonfor receiving a fixed return from finance invested
in a company. Hence traditional Western stylepreferred stocks are not acceptable. Mohsin con-
siders that the restructuring of preferred stocksto give them more equity like features is likely
to be acceptable, provided the return to investorsis not a fixed return on the original amount
invested. Alternatively, it may be possible tostructure preferred stock issues as transaction
specific, along similar lines to that proposedabove 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 marketwould be developed for companies operating in
permissible areas of business activity. Clearly theprovision of gambling services, pork products or
alcohol would be unacceptable. These areproducts 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 fallwithin this category. It is unclear to what extent
an Islamic stock market would also be a socialarbitrator in these matters. Clearly Haram
activities cannot be permitted. However, thereis a tradition in Islam that it remains with the
individual to determine whether to engage inMakruh 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 outthose stocks deemed to be engaged in Makruh
activities that do not match investors views onthese issues. The application of this form of
scrutiny by investors is not new, given thepopularity of ethical investment funds in coun-
tries such as the U.S.A. (Knoll, 1994).
It can therefore be expected that the listingrequirements 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 principlesof 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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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 thatact as brokers for investors, market makers and
traders on their own account. Member firmstypically dominate the controlling body or
council of the exchange. The controlling bodyof 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 stockexchange is usually restricted and new firms
would either buy an existing seat, or make anapplication in accordance with strict entry
requirements.Such a structure does not seem to be unrea-
sonable for an Islamic stock exchange, providedthe 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 Islamicrequirements. 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-Muslimfirms 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 pragmaticsolutions in the case of Islamic banking. AsIslamic 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 maynot be acceptable to strict Muslims it is officially
tolerated, at least as a transitional measure. Asimilar approach may be appropriate in stock
trading. Traditional stockbroking firms could deal
through windows offering services to Muslims
investors in an Islamic stock exchange, whileretaining investment services to others in a
traditional market. These issues illustrate themany institutional problems that need to be
confronted before progress is made on thedevelopment of a fully fledged Islamic market.
Speculation
Speculation is one of the most important issues
to be dealt with when planning an Islamic stockexchange. Speculation takes a number of forms,
but underlying the practice is the fact thatspeculators 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 theeconomic aspects of being a long term investor,
but because of a desire to make a quick gain frombuying and selling. A speculator will buy stock
in anticipation of prices rising usually with ashort-term horizon. The danger of this, as
observed by Brailsford and Heaney (1998), is thatwhat is initially planned as a short-term position,
with a sale to be completed before takingdelivery of the stock, may well result in a longer
term position when the stock does not performas expected. Such purchases are often financed
on margins or other forms of borrowing. Aspeculator will sell in anticipation of prices
falling. This strategy may involve a short salewhereby the speculator borrows stock from a
broker with a view to subsequently buying it ata lower price, thereby completing the deal. The
Islamic acceptability of margin financing andshort 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 returnwith 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 withmodern communications and computerised
trading, as price discrepancies in differentdomestic markets are quickly eliminated from the
system. For the purposes of this paper arbitrage
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will be regarded as one aspect of speculation. The
use of the term speculation will apply to anypractice that aims at short term gain without an
intention to participate as an equity investor inthe company concerned.
It is clear from the writings of Islamic econ-omists and scholars that speculation, as described
above, is unacceptable because of its associationwith 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 theprofits 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 anyactivity 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 anIslamic market. Metwally (1404/1984) developed
a controversial set of recommended operatingrules 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 ManagementCommittee of the stock exchange would meet at
three monthly intervals to set the maximum pricefor 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 theannouncement of the maximum price.
Transactions would not be permitted at pricesabove the maximum set by the committee.
Investors would be free to trade shares at any
price below the maximum. New issues of stockwould also only be permitted during the tradingperiod, with the issue price being the already
determined maximum. The aim is to preventexcess returns to subscribers. While these strict
trading rules are likely to have a major deterrenteffect on speculation, they do have many flaws.
Chapra (1405/1985b) considered the rulesunworkable. 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 acompany’s stock. Second is the matter of equity.
Being restricted to a short period in which they
can trade their stocks would disadvantage smallinvestors. Those who need to liquidate their investment may be forced to accept lower prices.
A more workable solution to the controlof speculation is therefore necessary. One
commonly used technique, particularly in futuresmarkets and in certain Asian stock markets, is the
use of price limits on daily movement of stockprices. 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 thana 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 isto limit the ability of speculators or manipulators
to push the price too much in either directionin a short period.
Trading halts are another technique used inmarkets such as the Australian Stock Exchange
and the New York Stock Exchange to control
trading in individual stocks. Examples of whenthe exchange may initiate a trading halt include
a serious order imbalance in a stock and whenprice sensitive news is about to be released
concerning a stock. The trading halt is aimed atproviding a cooling off period where market
participants are given time to reassess the stockin a less pressurised environment. The New York
Stock Exchange also operates an exchange-widesystem 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 needsto be carefully considered. The evidence on the
effectiveness of trading halts and price limits isnot good. Lee, Ready and Seguin (1994) found
that trading halts in New York actually increasedvolatility 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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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 marginaccount at a stockbroking firm. The opening of
an account enables the client to commencemargin trading, that is buying stock by paying
part of the price in cash and borrowing theremainder from the broker at an interest rate
called the margin interest rate. Formalised margintrading is well established in most stock markets
and regulatory authorities attempt to use margincalls and margin interest rates as devices for
controlling speculative activity. Non-formalisedmargin trading through personal borrowing,
without notification to the broker concerned, ismore difficult to control. The appeal of margin
trading is the ability to magnify any gains on atransaction, 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 hasbeen reinforced by the Council of the Islamic
Fiqh Academy (CIFA) which considered margintrading at its 1993 meeting. The CIFA ruled that
it is not permissible to borrow money withinterest 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 constructnon-interest bearing financial contracts to achieve
the same thing. For example, in Malaysia, BankIslam 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 thatmargin purchases bring about unnecessary
changes in trading volume and contribute toprice 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 saleof 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 thesetransactions 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 salesare 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 inshort sales further suggests that short selling is
unacceptable. From a more technical viewpoint
we can examine the structure of the contract tosee 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 providedthe vendor has paid in full for the
commodity in advance. It may be possible toview a short sale as resembling a salam contract,
but it would fail a test of being permissiblebecause short sales involve part payment though
a margin account. The vendor hopes to buy thestock at a future date at an amount below the
selling price. The purchase price is not yetknown and cannot be paid in full. The balance
of evidence to date suggests that short sellingwould 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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officer or stockholder of a company that has
access to privileged information not available toother stockholders, or potential investors in the
firm. There are two main issues to do withinsider trading. The first is trading in the firm’s
stock by insiders. It is not unreasonable thatinsiders have a right to trade the firm’s stock. The
danger is that insiders may trade on materialinside information to the detriment of other
investors. That is the second and crucial issue todo 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 manycountries 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. Theinterests of small and vulnerable investors must
be protected from unscrupulous activity by morepowerful, and better informed, shareholders.
While there is no clear Shari’ah guidance on theissue 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 sametime a balance has to be maintained. It is also
unfair to prevent directors and others fromtrading in a company’s stock. The approach
adopted in the U.S.A. by the Securities andExchange Commission (SEC) is to require
directors, officers and major shareholders to
report all transactions in their firm’s stock. Thisinformation is made public by the SEC to enable
the investing community to be aware of theimplicit vote of confidence, or lack of confi-
dence, by insiders. In addition, because of thedifficulty in proving whether an insider used
confidential information to make a gain, all short
term profits are forfeited and penalties imposedin some instances. A similar system of regulationwould be appropriate in an Islamic market to
maintain a balance between permitting insidersto 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 themonitoring 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 therisk-return profile of their portfolios. While
commodity futures have a long history, the useof financial futures, such as stock index futures,
have only become common in financial marketssince 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 frommarket fluctuations. Stock index futures are agood hedging device for diversified stock market
investors as futures prices are typically highlycorrelated with the underlying market (Jones,
1996, p. 700). To hedge risk, investors must takea 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 forbidan agreement to sell a commodity in the future,
although there are restrictions on how it is tobe done. For example the contract of Istisnaprovides for an agreement to manufacture a com-
modity where both delivery and payment will bein the future. It is a requirement that a clearly
defined commodity be specified in the contract.
It is unlikely that a stock index future wouldmeet these requirements because a dollar value
of an index is unlikely to be regarded as a clearly
defined commodity. Without a clearly definedcommodity the ability to physically deliver anything is in doubt. The end result of a modern
stock index future is an exchange of cashrepresenting 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 heargues they typically do not result in an exchange
of title of the underlying commodity. However,
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a typical commodity future does allow for
exchange of title. His argument is based on thefact that users of futures may choose to close out
their positions prior to maturity. The questionthen arises whether the fact that hedgers do not
wish to take delivery of a commodity, invalidatesthe use of futures. The clearest guidance we have
is from the CIFA which ruled that “trading inthe 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 theopinions of the CIFA are not binding, even in
the Sunni branch of Islam, their deliberations areinterpreted as having been carefully considered
from a Shari’ah perspective.
An additional problem with regard to stockindex futures is the ability of hedgers to shiftprice 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 thecash 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 involvementin the cash market. Speculators are regarded as
essential in modern futures markets because theyassume the risk of price fluctuation that hedgers
are trying to avoid. They also contribute to theliquidity of the futures market and over time their
involvement reduces the volatility of the market.
However, speculation alone does not rule out theuse of futures. For example, trading in common
stocks may be for speculative reasons, but thatdoes not invalidate stocks as an Islamic financial
instrument. What is necessary is to eliminatespeculation. However, if we eliminate specula-
tion from stock index futures in an Islamic stock
market, the result is a contract that hedgerswould 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 activityin 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 arenot as clearly defined as those of the insurer (New Horizon, November 1994). Hedging in an Islamic
stock market may be acceptable provided boththe buyer and seller of the stock index future are
fully aware of the position they are in and are notattempting 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 associatedwith holding single stocks or undiversified port-
folios.
In summary the argument for the use of stockindex futures rests on their legitimate use as a
hedging techniques. The fact that the contractis capable of being used by speculators does not
invalidate its use. The biggest stumbling block isthe technical nature of the settlement process.
Commodity futures, where an exchange of titleto 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 acceptableinstruments 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 somewhatcumbersome process, it is not impossible to
create such a contract. Early examples of stockindex futures such as the TOPIX 50 traded on
the Osaka Stock Exchange involved physicaldelivery 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 developedfinancial markets a wide variety of exchange
traded and over-the-counter (OTC) options areavailable to investors. Exchange traded options
are standardised contracts traded on a derivativesexchange, while OTC options are individual
contracts negotiated with financial institutions.
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In this section we will deal only with exchange
traded equity options as the terms of OTCoptions are flexible. Exchange traded options are
relatively straight forward contracts and aresufficient 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 theobligation, 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 equityoptions with the objective of determining
whether their use is justified in an Islamic stock
market. A simple strategy is to buy a call optionon a company’s shares. The investor in a calloption can control a claim on the underlying
stock for the life of the option. The cost will bethe 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 priceremains unchanged, or falls, the maximum loss is
known in advance, i.e. the loss is the premiumpaid. It is clear from this example that a call buyer
anticipates the stock price will rise while theseller of the call expects the price to remain
unchanged or to fall. Such a simple call optionstrategy 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 wr iter of the call option holds
the underlying stock a simple hedging strategy
is being followed. The premium receivedprovides some protection against a drop in priceof the stock. The writer would of course have
to be very confident that the price would notrise because unlimited losses could arise. There
are, however, a variety of more complex hedgingstrategies 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 opposingview. Again the transaction appears as pure
speculation, particularly if both parties have noinvolvement in the underlying stock. However,
the purchaser of a put may be a hedger if the
underlying stock is held in his/her por tfolio. Theinvestor buys the stock and simultaneously buysa put written on the stock. The strategy provides
a form of insurance against a drop in the priceas 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 rightto 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 thanequity options. Underlying a warrant is the
potential for the holder to become an equityinvestor in the issuing company at some future
date. Warrants are not normally issued as aseparate exercise, but are offered as part of a
larger financing package. Investors therefore havethe 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. Institutionalinvestors 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, makingavailable risk-return combinations that would not
otherwise be available. Stock index optionsprovide 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 Islamiccontext. The problem is essentially the same as
with stock index futures where settlement is byexchange of cash. Stock options do provide for
the delivery of shares at the exercise date, but inpractice this is rarely done. The 7th Council of
the Islamic Fiqh Academy considered tradedoptions as part of the review of new financial
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instruments. Options appear to have created
many problems of interpretation and it is notclear from the reports of the Council whether
they are regarded as permissible (JIBF, 1994). Theweakness 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 byan options exchange to provide investors with
the means by which they can speculate and hedgeprice movements in the underlying stock.
However, Elgari (1994) defends stock options inIslam provided the seller of a call, and the buyer
of a put, holds the underlying stock. He alsorecommends 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 newshares 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 thecase of the Petronas warrants, the underlying
transaction was an Islamic finance contract. Thisprovides 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 exchangewhich acts as a self regulatory mechanism, as well
as an independent governmental supervisory
body such as the SEC. The professional dealingsof member firms may best be served by self
regulation through a council of the stock
exchange. Protection of investors and the publicis also probably best served by a regulatory bodyindependent of the members of the stock
exchange. However, in an Islamic stock marketthere remains the question of a body that can
rule on the Shari’ah acceptability of financialinstruments and dealings. The need for a third
regulatory body arises in countries where anIslamic institution operates, but the legal system
is not based on Shari’ah. In Indonesia and
Malaysia, for example, Islamic banks have beensubject to a form of Islamic supervision in the
absence of a Shari’ah based legal system. Thestructure and powers of such a body is of utmost
importance as Shari’ah acceptability should be an
overriding requirement of the operation of anIslamic 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 arecontrolled 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. TheCouncil includes respected Islamic scholars
recruited from the community. While thisarrangement is essentially a form of self regula-
tion, with the requirement to set up a Shari’ahcouncil enshrined in the Malaysian Islamic
Banking Act 1983.The precedent set in Islamic banking is likely
to drive any initiatives in setting up Islamic stocktrading activities in countries without a Shari’ah
based legal system. The growth in financialderivatives 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. Thedominant 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 investmentfirm operating with its own Shari’ah council to
guide its operations. This form of self regulationis direct towards the activities of individual firms.
Broader market-wide issues are also likely to needoverall guidance and supervision in a consistent
manner. A further regulatory body would createa profusion of regulatory bodies. Hence the inde-
pendent regulatory body of the stock exchangecould take on this role as part of its overall super-
vision of the market.
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Conclusion
In this paper we have reviewed a range of issues
relating to the potential for a separate Islamicsecurities exchange. Many difficulties are envis-
aged, particularly relating to speculation, or contracts that have potential for speculative
trading. There are also a number of technicalproblems relating to contracts that do not
unequivocally involve the purchase and sale of acommodity at a clearly defined price. Many of
the issues discussed imply that an Islamic stockexchange 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 involvea gradual introduction of Islamic contracts and
practices that in many respects imitate Westernoperations. There are similarities with the intro-
duction of Islamic banking. A modern Islamicbank 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 conventionalbank is the strict legal interpretation of the
underlying contracts. Such an approach seemsappropriate for Islamic stock trading, broking and
the operation of the stock market. While wemust accept that speculation and related activity
has to be contained, it is not inconceivable thatfutures and option contracts can be restructured
to overcome the technical problems that atpresent inhibit their use. Developments in coun-
tries such as Malaysia indicate that considerableprogress has already been made in this direction.
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Shahnaz NaughtonSchool of Marketing & Management
Tony NaughtonSchool of Accounting & Finance,
Griffith University,Gold Coast, QLD 9726,
Australia,E-Mail: [email protected].
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