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Islamic capital market, an overview


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Islamic Capital Market (ICM) is the result of growing need for Islamic finance. This paper discussed various topics related to capital market and their Islamic appraisal. The sukuk market have been discussed in more detail. A global scenario have been highlighted and Islamic finance in Bangladesh have been discussed with problems and prospects.

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Islamic capital market, an overview

  1. 1. ISLAMIC CAPITAL MARKET A Complete Overview ABSTRACT Islamic Capital Market (ICM) is the result of growing need for Islamic finance. This paper discussed various topics related to capital market and their Islamic appraisal. The sukuk market have been discussed in more detail. A global scenario have been highlighted and Islamic finance in Bangladesh have been discussed with problems and prospects. Mohammad Shiblu
  2. 2. Executive Summary Islamic Finance is a growing industry. Islamic Capital Market (ICM) is the result of worldwide Islamic finance growth. ICM can be called as a capital market according to Islamic Shari’ah. However, as a new industry, it has some limitations, problems that should be overcome. In the first part of this report, conventional capital market is viewed from risk and return perspective. Functions of a conventional capital market are discussed. Also, the main two items of capital market i.e. stock and bonds are discussed in very brief before going into discussion about ICM. In the second part of the report, Justification for establishing a ICM is given and why we need a Islamic Capital Market have been discussed. Also, the risk and return from Islamic perspective have been discussed in brief. In the third part, Islamic equity market is discussed. The contractual form between the firm and shareholders are discussed with the concept of limited liability from Islamic perspective. Different screening criteria are discussed that are being implemented throughout the word. Also, the permissibility or prohibition about short selling is discussed in some detail with the topic of speculation. In the fourth part, the most important part of Islamic capital market, the sukuk market are discussed. The types of sukuk with some innovative model like GDP-Linked sukuk, Commodity-Linked sukuk have been discussed. These model have solved some problem with present sukuk structures. Also, the tradability of different sukuk and a practical example of ADIB sukuk issuances are given. Some shari’ah concerns about present sukuk practices are also discussed. A snapshot of current global sukuk market have been given, it have been seen that sukuk market is growing very fast though some setback occurred in 2008 in the time of global economic crisis. Sukuk market have crossed USD 100 billion milestone. In part 5, derivatives market instruments like options, futures, forwards, swap etc have been discussed from Islamic perspectives. The Islamic alternatives like bai al arbun, bai al salam have some features of derivatives. In 6th part, the paper is concluded by discussing some problems and prospects of Islamic finance industry in Bangladesh.
  3. 3. Contents Contents Pages 1.Overview of the capital market 2 1.1 Functions of capital market 2 1.2 Risk & Return 3 1.3 Bond 3 1.4 Stocks 4 2. Overview of Islamic capital market 6 2.1 Justification of ICM 7 2.2 Risk & Return 7 3. Overview of Islamic equity market 9 3.1 Contract form 9 3.2 Stock Screening 10 3.2.1 Issues in screening process 12 3.3 Short selling 12 3.3.1 Eligibility of stocks to be a subject matter of a loan contract 13 3.3.2 Bai al-mad’um (selling what the seller doesn’t own) 13 3.3.3 Issues of benefitting from a loan contract 14 3.4 Speculation 15 4. Overview of the Sukuk Market 17 4.1 Types of Sukuk 17 4.1.1 Mudarabah Sukuk 17 4.1.2 Musharaka Sukuk 17 4.1.3 Wakala Sukuk 17 4.1.4 Muzara’a (Sharecropping) Sukuk 18 4.1.5 Musaqa (irrigation) Sukuk 18 4.1.6 Mugharasha (Agricultural) Sukuk 18
  4. 4. 4.1.7 Ijarah Sukuk 18 4.1.8 Istisna Sukuk 18 4.1.9 Murabaha Sukuk 18 4.1.10 Salam Sukuk 19 4.2 Innovative Sukuk 20 4.2.1 GDP-Linked Sukuk (GLS) Model 20 4.2.2 Commodity Linked Sukuk (CLS) Model 20 4.4 Secondary Market of Sukuk (Tradability) 22 4.5 Global Sukuk Market – A Snapshot 22 4.5.1 Distribution of Sukuk Issuance by Issuer States 23 4.5.2 Distribution of Sukuk Issuances by Structure 25 4.5.3 Distribution of Sukuk Issuances by Region 27 4.6 A Case Study – Abu Dhabi Islamic Bank (ADIB) Example 27 4.6.1 Abstract 27 4.6.2 ADIB Sukuk Explanation 28 4.7 Sharia’h Concerns in Sukuk 29 5. Overview of the Derivative Instruments 31 5.1 Forward & Futures 31 5.1.1 Islamic appraisal 31 5.2 Options 32 5.2.1 Islamic Appraisal 32 5.3 SWAP 32 5.3.1 Islamic Appraisal 32 5.4 Islamic Alternatives 33 5.4.1 Bai al Salam 33 5.4.2 Bai al Arbun 33 6. Problems & Prospects of Islamic Finance in Bangladesh 35 6.1 Problems of Islamic Finance 35 6.1.1 Absence of Islamic Money Market 35 6.1.2 Absence of Suitable Long-term Assets 35 6.1.3 Shortage of Supportive and Link Institutions 35
  5. 5. 6.1.4 Organizing Relationship with Foreign Banks 36 6.1.5 Long-term Financing 36 6.2 The Future of Islamic Finance in Bangladesh 36 6.2.1. New banking philosophy for the Islamic Banks 36 6.2.2. Banking Policies and practices should be modernized 36 6.2.3. Policy and Strategy should be formulated 36 6.2.4. Stepping for Distributional Efficiency 37 6.2.5. Allocating Efficiency should be promoted 37 6.2.6. Government and Central bank's Responsibilities 37 6.2.7. Inter-Islamic Bank Co-operation and Perspective Plan 37 Bibliography 38
  6. 6. P a g e 1 | 39 01. Capital Market (CM) 1. Overview of capital market 1.1 Functions of the capital market 1.2 Risk & Return 1.3 Bond 1.4 Stocks
  7. 7. P a g e 2 | 39 1. Overview of the capital market The Collection of markets, institutions, laws, regulations and techniques through which various forms of financial instruments / assets are traded and financial service offered by financial intermediaries constitute a financial system. In a financial markets, the surplus units of the society and deficit units of the society meets. Financial markets help to flow cash from surplus to deficit units. Almost All kinds of financial market do this task. Financial markets can connect directly the surplus and deficit units i.e. capital market or indirectly i.e. bank and insurance. This is shown in the below diagram. Kinds of Financial Markets 1 Financial assets are traded in financial markets like stock, bonds etc. Financial assets are the claims on future cash flow. Financial assets that have longer maturity generally more than one year are traded in capital market. Capital market can be divided into two types, when the securities are offered for the first time, it is called primary market, all the subsequent trading are occurred in the secondary market. 1.1 Functions of capital market Capital market play very important functions in the financial system that listed below.  Increasing liquidity  Construction of diversified portfolios is possible Financial markets Direct market Capital market Debt market Equity market Derivative market Indirect market Commercial Banks Insurance Unit trust Merchant Banks Deficit units Surplus units
  8. 8. P a g e 3 | 39  Mobilizing the capital  Provides risk management tools  Reduce transaction costs (through efficient pricing)  Measuring economic performance  Management evaluation 1.2 Risk & Return Risk is the possibility of incurring a loss in financial transaction. Risk is measured through variance or standard deviation. Risk are two types, one can be minimized called diversifiable risk or unique risk and another is market risk that affects all the stocks in the market measured by beta. [1] Risk can be diversified through creating portfolio of negatively correlated securities. The optimal portfolio can be selected from efficient set of portfolios. The objective here is to minimize risk and maximize return. Risk and return goes hand in hand, the higher the risk, the higher the return. 1.3 Bond A bond is a debt instrument in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. [2] The short term government debt instrument is called Treasury bill and corporate debt instrument is called commercial paper. Bond is valued by below formula. C = Coupon payment r = Discount rate F = Face value t = remaining time to maturity 1 Beta is the Sensitivity of a stock’s return to the return on the market portfolio. 2 [Accessed on 8th may, 2016].
  9. 9. P a g e 4 | 39 1.4 Stocks A stock is a type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings. [3] Stock can be common stock or preferred stock. Preferred stock have similarity with both equity instrument and debt instrument. Stock can be valued by discounting future dividends, by using dividend discount model. If the dividends growth rate is constant, dividends can be measured through below formula. 𝑃 = 𝐷1 𝑟 − 𝑔 D1 = Forward dividend r = Discount rate g = Growth rate 3 [Accessed on 8th may,2016]
  10. 10. P a g e 5 | 39 02. Islamic Capital Market (ICM) 2. Overview of the Islamic Capital Market 2.1 Justification of ICM 2.2 Risk & Return
  11. 11. P a g e 6 | 39 2. Overview of Islamic capital market ICM refers to a market where the transactions and other activities are carried out in a way that comply with Shariah principles. Allah says in the Qur’an, “Then We pun you, [O Muhammad], on an ordained way (Shariah) concerning the matter [of religion]; so follow it and do not follow the inclinations of those who do not know.” [Al Qur’an 45:18]. Shariah has a say on every matter relating to human life. The components of shariah are depicted below. In the matters of Ibadah, Shariah gives detailed rulings, However in case of Muamalah (i.e. transactions) shariah provides general rulings. [4] So, a basic system of Islamic legal system is that an activity or a commodity that is not prohibited through the shari’ah texts is permissible. Thus, man has to observe the prohibition only. [5] However, the law is not end itself, shari’ah has the objectives (Maqasid) behind the law. For example, in the Qur’an after giving ruling concerning properties abandoned by enemy without a war effort, Allah states, “ that it will not be a perpetual distribution among the rich from among you..” [Al Qur’an 59:7]. So, one of the maqasid in islamic economy is redistribution 4 Dr. Bilal Philips, The Evolution of Fiqh p.34 5 Muhammad Ayub, Understanding Islamic Finance, p.38
  12. 12. P a g e 7 | 39 of wealth and equity or distributive justice, so that wealth is not circulated among the riches. To maintain this equity and promote justice, all tools of injustice is made haram in Islamic commercial law depicted below. Islamic Commercial Law 1 2.1 Justification of ICM ICM plays the same role as capital market in conventional framework i.e. mobilizing capital. However, the method and objectives must differ because of two different worldviews. 2.2 Risk & Return Business transactions have inherent risk in it that can’t be avoided is acceptable in Islam. The characteristics of this type of risk is it is unintentional, unavoidable and insignificant. Two legal maxims worth mentioning here are ‘with profit comes liability’ and ‘no profit without risk’. However, risk associated with eating others wealth is gambling, business is not a zero sum game, however, gambling is a zero sum game, one party wins and another party loses. General Principles of Islamic Commercial law Freedom of contract Avoid Ribah Gharar Maysir illicit goods i.e. pork Mutual consent
  13. 13. P a g e 8 | 39 03. Islamic Equity Market 3. Overview of the Islamic equity market 3.1 Contract form 3.2 Stock screening 3.2.1 Issues in stock screening 3.3 Short Selling 3.3.1 Eligibility of stocks to be a subject matter of a loan 3.3.2 Selling what the seller doesn’t own 3.3.3 Issue of Benefitting from a loan contract 3.4 Speculation
  14. 14. P a g e 9 | 39 3. Overview of Islamic equity market Islamic capital market is the natural outcome of the growing Islamic finance industry. The very initial entrants in the field of Islamic finance were Islamic savings and investment companies at small level. Mit Ghimar Bank (1961) in Egypt is earliest example of this. A very early review and identification of shari’ah compliant stocks was undertaken in 1983 by Bank Malaysia Berhad., which lead to introduction of a centralized process of such identification of Securities Commission of Malaysia in june 1997. The first equity Index was first launched in Malaysia by RHB Unit Trust Management Berhad. in May 1996. It was followed by Dow Jones Islamic Market Index (DJIMI) in February 1999, Kuala Lumpur Shariah Index (KLSI) in April 1999 and Financial Times Stock Exchange Global Islamic Index (FTSE-GII). The next was DJMI Turkey Index in 2004 and many countries have introduced shariah index. [6] Investment in stocks of shari’ah compatible business always deemed fit in Muslim societies. If a firm conducting halal business, sharing in it through stock is perfectly legitimate. [7] The main shariah issues pertaining to trade in stocks are given below.  The business of the company whose stock are to be traded  The form of stock/share contract  Shari’ah compatibility of trading practices pertaining to stocks. 3.1 Contract form The modern corporation is a legal entity, management is separate from ownership. The shareholders are the real owners of the corporation who provides capital and elect board of directors. Board of directors select management bodies who operate the business. The relationship between shareholders can be considered as a partnership or musharaka contract and the relationship between board of directors and management or shareholders can be seen as wakala [8] or ijarah [9] contract. However, the issue is about limited liability. Islamic norms is that the debtor will be liable to the creditor for his debt and have to pay the full amount. OIC Fiqh Academy has 6 Salman Syed Ali, Islamic Capital Market Products: Developments and Challenges, p. 18 7 Salman Syed Ali, Islamic Capital Market Products: Developments and Challenges, p. 15 8 Agency contract 9 Lease contract
  15. 15. P a g e 10 | 39 approved investing in stock whose business is licit and accepted the two terms limited liability and legal entity provided that the parties dealing with these companies limited capacity to liability and presumably consent to it. 3.2 Stock Screening Islamic prohibition to maintain justice and equity and prohibition against illicit activities demand stock screening to find out the shar’ah compliant stocks. The business of the company mustn‘t be involved in Ribah, Gharar, Maysir and illicit goods and services. The majority of the assets should be in illiquid form for trading in secondary market because of restrictions of trading in debt and money. The illicit income should be below the certain level. There is no international single standards on screening process. The conditions listed by Usmani (1999) may be guiding principles listed below. 1. The main business of the company doesn’t break the shari’ah rules. 2. If the main business of the company is licit, like automobiles, textile, etc. but they deposit their surplus amounts in an interest-bearing account or borrow money on interest, the shareholder must express his disapproval against such dealings, preferably by raising his voice against such activities in the annual general meeting of the company. 3. If some income from interest-bearing accounts is included in the income of the company, the proportion of such income in the dividend paid to the shareholder must be given in charity. 4. The shares of a company are freely negotiable only if the company owns some illiquid assets. These are the general criteria, each stock exchange have adopted different criteria for sharia screening. Some stock exchange adopts both income statement and balance sheet screening but stock exchange in Malaysia only adopts income statement screening. The screening process can be divided into two steps. 1. The core screening: Here a stock is declared permissible when the issuing company produces output that are free from elements prohibited by Shari’ah. 2. The financial screening: Computation of a set of financial ratios & compare them against specified benchmarks.
  16. 16. P a g e 11 | 39 The comparisons of various stock selection criteria are given below. The first table compares core screening and second table compares financial screening.10 Core Screening 1 Financial Screening 1
  17. 17. P a g e 12 | 39 Once shari’ah compliant securities may be declared non sharia compliant because of leverage ratio or other ratio. The exchanges declare the lists of shari’ah compliant stocks from time to time. If the stock is declared non shari’ah compliant which was shari’ah compliant before, the fund managers and stock holders should immediately liquidate the stock if the price is greater than investment price and wait until price increasing if the price is below investment price. However, if the shareholder keep the share and sell it later date the price increase between announcement date and selling date must channel to charity. The fund managers must separate the non-permissible income portion from the portfolio income and channel them to charity before distributing dividend, this is called income purification. 3.2.1 Issues in screening process Two issues are concerned in screening process. First is that some non-permissible activity is tolerated i.e. interest income up to 5% to promote screening process, however, this should be seen as a transitory process. Second is that there is no international standard or criteria. Shari’ah compliant today doesn’t necessarily imply presence of good business ethics. This criteria should be added to screening process. 3.3 Short selling [11] One of the most popular and commonly used financial instruments in conventional capital market is short selling. Many finance literature assert that short-selling provides liquidity, drives down overpriced stocks and generally increases efficiency of the markets, facilitates hedging. The demerits are that the possible loss from short selling is theoretically infinite and the unrestrained short selling pressure could lead to collapse in the share prices. Besides the debate of the merit and demerits of short selling, shari’ah compliancy criteria is also included in Islamic finance. The issues concerning short selling can be divided in three. 1. Eligibility of stocks to be a subject matter of a loan contract 2. Bai al-mad’um (selling what the seller doesn’t own) 10 Salman Syed Ali, Islamic Capital Market Products: Developments and Challenges, p. 18-22 11 Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is motivated by the belief that a security's price will decline, enabling it to be bought back at a lower price to make a profit.
  18. 18. P a g e 13 | 39 3. Issue of Benefitting from a loan contract [12] 3.3.1 Eligibility of stocks to be a subject matter of a loan contract With the exception of Hanafi jurists, most jurists (the Malikis, Shafi`is and Hanbalis) ruled that loans are permissible for all goods eligible for forward sale (salam). This includes fungible goods (mithli) and non-fungible goods (qimi). This view is supported by the below hadith. "It was narrated by Rafi` that the Prophet (pbuh) borrowed a young camel, and then received a charity of camels and ordered Rafi` to repay the man another young camel, Rafi` said that the closest he could find was a six year old camel (which is more valuable). Then the Prophet (pbuh) ordered him to give it to the man, and added “the best among you is the one who is the best in repaying his debts” [13] The Hanafies, on the other hand, argue that homogeneous (mithli) properties are the only proper object for the loan contract. They argue that a loan contract cannot validly be concluded with regard to non-homogeneous (qimi) properties at it is almost impossible to find an equivalent good to repay the loan. [14] Based on the above, according to all jurists including the Hanfis, since stocks satisfy the homogeneous (mithli) properties, they are qualified to become the subject matter of a loan contract. 3.3.2 Bai al-mad’um (selling what the seller doesn’t own) According to Imam ibn Taymiyya [15] and his student ibn Qayyum16, what was narrated in the Hadith is the prohibition of sales with excessive risk and uncertainty (gharar), where the object may be undeliverable, whether it exists or not (e.g. a runaway horse or camel). They assert that the emphasis of the Hadith is on the seller’s inability to deliver, which entails excessive risk and uncertainty. 12 Dusuki and Abozaid , Fiqh Issues in Short Selling as Implemented in the Islamic Capital Market in Malaysia, p. 65 13 Sahih Muslim, Abu Dawud, Tirmidhi, Nasa’I, Ibn Majah. 14 Dusuki and Abozaid , Fiqh Issues in Short Selling as Implemented in the Islamic Capital Market in Malaysia, p. 15 Ibn Taymiyya was a prominent scholar, died in 1328 CE. 16 Ibn Qayyum was the student of Ibn Taymiyya, died in 1350 CE.
  19. 19. P a g e 14 | 39 In general, selling what the seller does not own at the time of sale in a non-salam contract is valid only according to Ibn Taymiyah and Ibn Qayyim, while it is invalid according to the majority of jurists. The majority scholars of Islamic jurisprudence assert the rationale (`illah) of prohibiting sale prior taking possession (qabd) was mainly due to the presence of gharar (excessive risk and uncertainty), which may lead to dispute amongst the transacting parties. This was because of the concern that the goods might not be delivered due to damage or other factors. Thus Islam prohibits any transactions involving bay` ma`dum since the delivery of the subject matter cannot be effected and this brings about the prohibited element of gharar.17 According to Shariah Advisory Council of Malaysia’s view, the issue of gharar can be overcome and hence eliminated in Regulated Short Selling (RSS) with the inclusion of Securities Borrowing and Lending (SBL) principles. In other words, the introduction of SBL can increase the probability that the shares sold will be delivered. When the probability of delivery is high, then the element of gharar will no longer be significant. Consequently, when an obstacle that hinders the recognition of a certain activity as Shari`ah compliant is overcome, then that transaction or activity can be classified as Shari`ah compliant. [18] 3.3.3 Issues of benefitting from a loan contract In short selling, the lender gets certain percentage of return as a profit from lending. For example: in Malaysia, this is 2%. However, this is clearly ribah, any stipulated excess from the loan constitute ribah. Finally, there is a debate about whether short selling is permitted or not. Opponents argues based on the literal meaning of the hadith, ‘don’t sell what you do not possess’. 17 Dusuki and Abozaid , Fiqh Issues in Short Selling as Implemented in the Islamic Capital Market in Malaysia, p. 72 18 Their arguments are based on a well-known fiqh maxim: “When an issue that impedes (the permissibility) is removed, then the activity which was initially forbidden becomes permissible”.
  20. 20. P a g e 15 | 39 3.4 Speculation Much of the issues about short selling is about speculation. Some of the arguments about speculation is given below. The proponent’s argument are-  Speculation reduces price fluctuations  Speculation activates the market as it encourages the circulation of large amounts of stocks or goods, increases liquidity.  The speculator seeks to obtain a personal profit and there is nothing wrong with that. The opponent’s argument are-  Speculation aggravates price fluctuations as it originally relies on such fluctuations and it finds no room if the prices stayed stable  The brokers and the well-informed speculators are the ones who benefit from the intense heat produced by speculation  Speculation does not differ from gambling but rather it is one of its modern forms (it does not encourage production…)  More losers than gainers (the experienced ones)  Speculation is zero sum game.
  21. 21. P a g e 16 | 39 04. Sukuk Market 4. Overview of the Sukuk Market 4.1 Types of Sukuk 4.2 Innovative Sukuk 4.2.1 Commodity Linked Sukuk (SLS) Model 4.2.2 GDP Linked Sukuk (GLS) Model 4.3 Sukuk Al- Istithmar vs Conventional Instruments 4.4 Secondary Market of Sukuk (Tradability) 4.5 Global Sukuk Market - A Snapshot 4.6 A Case Study- ADIB example 4.7 Shari’ah Concerns in Sukuk
  22. 22. P a g e 17 | 39 4. Overview of the Sukuk Market The early Muslims have used the word Assakk, which means certificate or order of payment. And the plural of this ‘Arabic term is Sukuk. They used Sukuk in those early days as a form of papers representing financial obligations originating from trade or any other commercial activities. However, in the modern day Islamic financial system, Sukuk are known as instruments of the Islamic capital Market and it is one of the best financial instruments and mechanisms that are commensurate with the needs of issuers/originators and investors. [19] According to AAOIFI “Investment Sukuk (Sukuk al Istithmar) are certificates of equal value representing undivided shares in ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity”. [20] 4.1 Types of Sukuk AAOIFI identified fourteen types of sukuk. Each of these sukuk is formed according to known Islamic transaction contracts such as wakala, mudarabah, ijarah etc. Some of them are described here. 4.1.1 Mudarabah Sukuk These are certificates that represent project or activities managed on the basis of Mudarabah by appointing one of the partners or another person as the mudarib for the management of the operation. 4.1.2 Musharakah Sukuk These are certificates representing projects or activities managed on the basis of Musharaka by appointing one of the partners or another person to manage the operation. 4.1.3 Wakalah Sukuk These are certificates that represent projects or activities managed on the basis of an investment agency by appointing an agent to manage the operation on behalf of the certificate holders. 19 IIFM Sukuk Report (3rd edition) : A Comprehensive Study of the Global Sukuk Market, p. 3 20 IIFM Sukuk Report (3rd edition) : A Comprehensive Study of the Global Sukuk Market, p. 4
  23. 23. P a g e 18 | 39 4.1.4 Muzara’a (Sharecropping) Sukuk These are certificates of equal value issued for the purpose of using the funds mobilised through subscription for financing a project on the basis of Muzara’a so that the certificate holders become entitled to a share in the crop according to the terms of the agreement. 4.1.5 Musaqa (irrigation) Sukuk These are certificates of equal value issued for the purpose of employing the funds mobilized through subscription for the irrigation of fruit bearing trees, spending on them and caring for them on the basis of a Musaqa contract so that the certificate holders become entitled to a share in the crop as per agreement. 4.1.6 Mugharasha (Agricultural) Sukuk These are certificates of equal value issued on the basis of a Mugharasa contract for the purpose of employing the funds for planting trees and undertaking the work and expenses required by such plantation so that the certificate holders become entitled to a share in the land and the plantation. 4.1.7 Ijarah Sukuk These are certificates of equal value issued either by the owner of a leased asset or a tangible asset to be leased by promise, or they are issued by a financial intermediary acting on behalf of the owner with the aim of selling the asset and recovering its value through subscription so that the holders of the certificates become owners of the assets. 4.1.8 Istisna Sukuk These are certificates of equal value issued with the aim of mobilizing funds to be employed for the production of goods so that the goods produced come to be owned by the certificate holders. 4.1.9 Murabaha Sukuk These are certificates that represent equal value issued for the purpose of financing the purchase of Murabahah commodity and therefore, the certificate holders become the owners of the purchased commodity. In this transaction, the issuer of these certificates is the seller of the Murabahah commodity, the subscribers are the buyers of that commodity and mobilized funds are
  24. 24. P a g e 19 | 39 the purchasing cost of the commodity. The certificate holders own the Murabahah commodity and are entitled to its sale price. 4.1.10 Salam Sukuk These are certificates of equal value issued for the aim of mobilizing Salam capital so that the goods to be delivered on the basis of Salam contract are owned by the certificate holders. In this transaction the issuer of these certificates is the seller of the Salam goods, the subscribers are the buyers of the goods and the mobilized funds are the purchase price of the commodity, which is the Salam capital. Thus, the certificate holders are the owners of Salam goods and they are also entitled to the sale price of the certificate or the sale price of the Salam goods sold through a parallel Salam, if any. Types of Sukuk 1
  25. 25. P a g e 20 | 39 4.2 Innovative Sukuk In this section, some innovative sukuk models are provided that solve the present shari’ah problem of the sukuk practice around the world. 4.2.1 GDP-Linked Sukuk (GLS) Model This model is based on forward ijarah where return is linked to the GDP of the issuing country. It is a model for sovereign [21] sukuk where actual economic indicator is used to calculate return on non-income generating government assets or projects. Here, Return is linked to GDP that measures the actual performance of a economy, so it matches the payment obligation to payment ability. The investors share the economic performance risk of the issuers. The return is calculated through below formula. 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑥 𝑘 % = 𝐼 𝑘 × 𝑋0 % 𝐼 𝑘 = 𝐺 𝑘 𝐺0 Xk = The rate of return at kth year, after issuance Gk = is the growth rate of GDP at year k G0 = is the growth rate of GDP agreed upon by contracting parties. 4.2.2 Commodity Linked Sukuk (CLS) Model This model is also based on forward ijarah. Government can raise funds for non-income generating projects where return is linked to price index of a basket of issuing countries export commodities. The model also matches the payment obligation to payment ability. The investors share the risk arising from the volatility of the commodity market. This model constitute a hedging components. 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑥 𝑘 % = 𝐼 𝑘 × 𝑋0 % 𝐼 𝑘 = 𝑃 𝑘 𝑃0 21 Sovereign sukuk are Sukuk issued by a national government. The term usually refers to Sukuk issued in foreign currencies, while Sukuk issued by national governments in the country’s own currency are referred to as government Sukuk.
  26. 26. P a g e 21 | 39 Ik = Basket Price Index Pk = The price of the commodity in the basket, in the year k xk% = Annual Profit Rate in the Year k 4.3 Sukuk Al- Istithmar vs Conventional Instruments Sukuk Al-Istithmar is characterized with many features that distinguish them from the non Shari ‘ah complaint bonds. These features include: (a) Sukuk Al-Istithmar are certificates of equal value issued in the name of investor therefore, a legitimate claim of its owner/investor over the financial rights and obligations represented by the certificate can be established. (b) It represents a common share in the ownership of the tangible assets earmarked for investment, usufructs, services etc. and hence, it does not represent debt as in the case of non Shari ‘ah compliant bonds. (c) It is issued on the basis of known and acceptable Shari ‘ah investment contracts and in accordance with Shari ‘ah principles which governing its issuance as well as its trading. (d) Investors in Sukuk Al-Istithmar share the profit according to the agreement set forth in the prospectus and also bear the losses if any, based on the percentage/proportion owned by each investor. The fundamental difference between bonds and sukuk is that while bonds are fixed- income securities, sukuk Al-Istithmar are not fixed – income securities, because they do not represent debts between the issuer and the investors. Rather, the investors share Sukuk returns and proceeds according to percentages stated in the prospectus, and bear losses in proportion to the number of the Sukuk certificates held by them. Sukuk have very similarity with conventional securitization process. However, the Shariah compliance condition for the transaction requires the presence of Shariah advisory board in the process. Furthermore, the prohibitive stance of the majority of Muslim scholars towards the sale of debt makes it inoperative to securitize a pool of asset composed of a majority of receivables.
  27. 27. P a g e 22 | 39 4.4 Secondary Market of Sukuk (Tradability) Some sukuk can be traded where some can not. The deciding factor here what the sukuk represents. If sukuk represent the ownership in the underlying assets, it can be traded. However, if it represent the debt obligations, it can not be traded as debt can not be traded without the face value what is called Hawala. [22] The tradability of various sukuk is given below. Tradability of Sukuk 1 4.5 Global Sukuk Market – A Snapshot Sukuk market is in an expansionary phase. New market have been emerging from different side of the world. The deeper market was created in Malaysia and Bahrain, the hub of Islamic finance. The other GCC23 countries and new countries from Europe and 22 Hawalah means transferring debt obligation by making another responsible for it. 23 Gulf Cooperation Council (GCC), political and economic alliance of six Middle Eastern countries—Saudi Arabia, Kuwait, the United Arab Emirates, Qatar, Bahrain, and Oman.
  28. 28. P a g e 23 | 39 Africa have issued sukuk. The entry from Turky in global sukuk market is also appealing. The global sukuk market have crossed USD 100 billion milestone. [24] Source-IIFM Sukuk Report (4th Edition) 1 4.5.1 Distribution of Sukuk Issuance by Issuer States The financial crisis of 2008 had some negative impact in sukuk market. Though before 2008, corporate issuances comprised larger part of global sukuk issuance, after 2008 sovereign and quasi-sovereign [25] comprised the larger part of global sukuk issuances. After 2013, the corporate [26] issuances are increasing and sukuk market is emerging as a new sector in Islamic capital market and in Islamic financial system. 24 IIFM Sukuk Report (4th edition), p.4 25 Quasi sovereign sukuk are Sukuk issued by a public sector entity that is like sovereign Sukuk. It may carry explicit or implicit government guarantee. 26 Corporate sukuk is a Sukuk issued by a corporation as opposed to those issued by the government. It is a major way for companies to raise funds in order to expand its business or for a specific project. 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Grand Total Series 1 1172 1371 7057 9465 13698 33837 50041 24264 37904 52978 92403 137499 138170 599861 0 100000 200000 300000 400000 500000 600000 700000 Total Global Sukuk Issuance (2001-2013) Series 1
  29. 29. P a g e 24 | 39 Source: IIFM Sukuk Report (4th Edition) 1 15% 12% 73% International Sukuk Issuance (2001-2008) Sovereign Quasi Sovereign Corporate 33% 26% 41% International Sukuk Issuance (2009-July 2014 Sovereign Quasi-Sovereign Corporate
  30. 30. P a g e 25 | 39 4.5.2 Distribution of Sukuk Issuances by Structure Sukuk Al Ijarah is the most popular and widely used structure for International Sukuk issuances while at domestic level Sukuk Al Murabahah continues to be the most used 30% 1% 69% Domestic Sukuk Issuance (2001-2008) Sovereign Quasi-Sovereign Corporate 71% 7% 22% Domestic Sukuk Issuance (2009-July 2014) Sovereign Quasi-Sovereign Corporate
  31. 31. P a g e 26 | 39 structure both in terms of value and volume and the reason for this is due to issuance by certain larger market share countries. Sukuk Al-Wakala is becoming popular in international sukuk issuances day by day though it was not popular in time 2001-2008. In the case of domestic issuances, Sukuk Al-Musharaka was popular in the past phase (2001-2008), but later Murabaha Sukuk became very popular in domestic market. International Sukuk Issuance (2001-July 2014) Salam Sukuk Musharaka Sukuk Murabaha Sukuk Wakalah Sukuk Ijaraha Sukuk Bai Bithaman Ajil Hybrid Sukuk Islamic Exchangeable Sukuk Mudarabah Sukuk Istisna Sukuk Domestic Sukuk Issuance (2001-July 2014) Salam Sukuk Musharaka Sukuk Murabaha Sukuk Wakalah Sukuk Ijaraha Sukuk Bai Bithaman Ajil Hybrid Sukuk Islamic Exchangeable Sukuk Mudarabah Sukuk Istisna Sukuk
  32. 32. P a g e 27 | 39 4.5.3 Distribution of Sukuk Issuances by Region Asia is dominant in issuing sukuk because of the deeper market in Malaysia and Indonesia. GCC countries specially Bahrain, Saudi Arabia, Qatar is becoming active. Turky is the new country in issuing sukuk. 4.6 A Case Study – Abu Dhabi Islamic Bank (ADIB) Example 4.6.1 Abstract This case study intends to highlight on the successful issuance of the Shirkat-ul-Milk structure based Sukuk worth US $ 500 million issued in November 2011 by Abu Dhabi Islamic Bank (ADIB) a top tier Islamic financial services group in the United Arab Emirates (UAE). The issuance of this Sukuk has been a successful step towards diversifying and lengthening funding sources for Islamic financial institution. Sukuk Summary SPV ADIB Sukuk Company Ltd. Structure type Al Ijara Issue size USD 500,000,000 22% 2% 3% 73% Global Sukuk Issuances-Regional Break-up (2001-July2014) GCC & Middle East Europe & Others Africa Asia & Far East
  33. 33. P a g e 28 | 39 Issue Date 30-Nov-11 Maturity date 11/30/16 Return 3.78% Fix or Variable Fixed Return frequency Semi Annual Pricing =Spread (over mid-swaps) 245bp Book Runners HSBC, Citigroup, NBAD, Standard Chartered Bank, Nomura Securities Listing London S.E. ISIN RegS XS0711035286 4.6.2 ADIB Sukuk Explanation ADIB Sukuk Diagram
  34. 34. P a g e 29 | 39 1. On the Issue Date, the certificate holders will pay the issue price to ADIB Sukuk Company (as Issuer/Trustee). 2. The proceeds will be used by ADIB Sukuk Company to purchase a co-ownership interest in a portfolio of Ijarah assets from ADIB (as Seller) under a Purchase Agreement. 3. ADIB (as Managing Agent) agrees to maintain the co-owned Ijarah assets through a Management Agreement. 4. ADIB will pay to the Issuer an amount representing its share of profit in respect of the co-ownership as sets on each Periodic Distribution Date. If the profit returns are insufficient to fund the periodic distribution payment, ADIB will make up for the shortfall by providing Shari‘ah compliant funding to ADIB Sukuk Company. However, if profit returns are more than the amount needed to pay the relevant periodic distribution, the excess will be paid to ADIB as an incentive fee. 5. The Issuer will sell its co-ownership interest in the co-ownership assets to ADIB (as Purchaser) on the Maturity Date, pursuant to a Purchase Undertaking. 6. The Exercise Price paid by ADIB is intended to fund the dissolution amount payable by the Issuer under the Trust Certificates. 4.7 Sharia’h Concerns in Sukuk The sukuk issuances so far raises some shari’ah concerns that need to be addressed and solved. The guarantee in annual payment to investors make sukuk almost like conventional debt. It is difficult to find some neutral third party who guarantee the payment to the investors. Another issue is about purchasing the sukuk at face value or pre-agreed price that is almost like Bai-al inah. The combination of different contracts to make a sukuk issuance is also cumbersome and sometimes the investor doesn’t understand the mechanisms. Scholars should look on this topic to solve the problem and make a shari’ah complient sukuk market.
  35. 35. P a g e 30 | 39 05. Derivative Market 5. Overview of the Derivatives Instruments 5.1 Forward & Futures 5.2 Options 5.3 SWAP 5.4 Islamic Derivative Instruments 5.4.1 Bai Salam 5.4.2 Bai al-Arbun
  36. 36. P a g e 31 | 39 5. Overview of the Derivative Instruments Most popular derivative instruments are forward, futures, options and recently swap contracts. These instruments have different versions also. These are called derivatives because they derive their value from underlying assets. Derivative instruments are used for hedging [27] against price risk, exchange risk, interest rate risk etc, for arbitraging [28] and for speculating [29]. In this section we will appraise all these instruments from Islamic perspectives with the probable Islamic alternatives like salam and arbun contracts. 5.1 Forward & Futures A Forward contract is a customized arrangement between two parties to carry out a transaction at a future date but at a price determined today. Forward contracts have some limitations like multiple coincidence of needs, potential for price squeeze, counterparty or default risk etc. that leads to the emergence of futures that solved the problem. Future contract are organized and exchange traded forward contracts. 5.1.1 Islamic appraisal Forwards and futures are rejected by many shari’ah scholars including Mufti Taqi Usmani on the basis of gharar, maysir etc. The reasons are given below.  The issue of non-existence of the subject matter (bay' al ma'dum) at the time of the conclusion of the contract.  The issue of selling debt for debt which means both the price and goods are deferred. Imam Ahmad Ibn Hanbal reported a consensus on its prohibition.  Derivatives markets are mostly used for speculative transaction, so it is a zero sum game.  The underlying assets may not be halal. However some scholars like Hashim Kamali accepts forwards and futures with the assumptions that underlying assets are halal. There arguments are given below.  The essential element of a sale is delivery of the thing sold, and if the seller is unable to deliver, this becomes garar. 27 Hedgers are the players whose objective is risk reduction by taking long or short position. 28 Arbitraging are the players whose objective is to profit from pricing differentials/mispricing. 29 Speculators are the players who establish positions based on their expectations of future price movements.
  37. 37. P a g e 32 | 39  The hadith reporting selling debt for debt is weak according to some jurists.  Futures and forwards are halal if underlying assets are halal based on maslahah (public welfare) and darurah (needs). 5.2 Options Options give the holders the right to buy and sell the assets at exercise price in future date. However, options doesn’t create obligation, it give options to exercise. 5.2.1 Islamic Appraisal When viewed solely as a promise to buy or sell an asset at a predetermined price within a stipulated period, shari’ah scholars find nothing objectionable with options. It is in the trading of these promises and the charging of premiums that objections are raised. And based on this two issues, some scholars disapproved options. Conventional options have some similarities with two concepts in the Islamic commercial law, namely: al-Khiyar[30] and al-urbun. 5.3 SWAP Swaps are customized bilateral transactions in which the parties agree to exchange cash flows at fixed periodic intervals, based on an underlying asset. 5.3.1 Islamic Appraisal It is one of the principles of the Shariah that two financial transactions cannot be tied together in the sense that entering into one transaction is made a precondition to entering into the second. In interest rate swap, one party pays the difference to another for nothing. In foreign exchange swap, parties involved want to change currency in future with rate that is fixed by today and contract sealed today. This doesn’t fulfill the sale of Currency (bay` al sarf) condition, that is, it should be exchanged by using spot rate. 30 The concept of al-khiyar arises in exchange contracts. These options may provide the contracting parties a right, either to confirm or to cancel the contract within a stipulated time period [e.g. option as a condition or stipulation (khiyar al-shart); option for defect (khiyar alayb); option of determination or choice (khiyar altayeen); option of inspection (khiyar al-ruyat); and option of acceptance (khiyar al-majlis)].
  38. 38. P a g e 33 | 39 5.4 Islamic Alternatives Two contracts in Islamic finance have derivatives features. These are bai al salam and bai al arbun. These two are described below. 5.4.1 Bai al Salam Bai al Salam is a contract where one party (buyer) pays in advance where the commodity is deferred to a future date. Bai salam is almost like conventional forward contract, the big difference between the two is that in bai salam price is paid in advance, commodity is deferred, where in forward both are deferred. Bai salam have also default risk, the seller may not provide the commodity in time. The buyer can take security to minimize the risk. 5.4.2 Bai al Arbun Bai al-’urbun refers to a sale in which the buyer deposits earnest money with the seller as part of part payment of the price in advance, but agrees that if he fails to ratify the contract, he will forfeit the deposit money, which the seller can keep. While the three schools of law (Hanafi, Maliki, and Shafii), consider al-urbun as an invalid contract, the Hanbali school held that it is a legal contract.
  39. 39. P a g e 34 | 39 06. Islamic Finance in Bangladesh Problems & Prospects
  40. 40. P a g e 35 | 39 6. Problems & Prospects of Islamic Finance in Bangladesh 6.1 Problems of Islamic Finance 6.1.1 Absence of Islamic Money Market In the absence of Islamic money market in Bangladesh, the Islamic banks cannot invest their surplus fund i.e., temporary excess liquidity to earn any income rather than keeping it idle. Because all the Government Treasury Bills, approved securities and Bangladesh Bank Bills in Bangladesh are interest bearing. Naturally, the Islamic banks cannot invest the permissible part of their Security Liquidity Reserve and liquid surplus in those securities. As a result, they deposit their whole reserve in cash with Bangladesh Bank. Similarly, the liquid surplus also remains uninvested. On the contrary, the conventional banks of the country do not suffer from this sort of limitations. As such, the profitability of the Islamic banks in Bangladesh is adversely affected. 6.1.2 Absence of Suitable Long-term Assets The absence of suitable long term assets available to Islamic banks is mirrored by lack of short term tradable financial instruments. At present there is no equivalent of an inter- bank market in Bangladesh where banks could place, say, over-night funds, or where they could borrow to satisfy temporary liquidity needs. Trading of financial instruments is also difficult to arrange when rates of return are not known until maturity. Furthermore, it is not clear whether Islamic banks in Bangladesh can utilize more exotic instruments, such as derivatives, that are becoming increasingly popular with conventional banks. Obviously, these factors place Islamic banking in Bangladesh at a distinct disadvantage compared to its conventional banking counterpart. 6.1.3 Shortage of Supportive and Link Institutions Any system, however well integrated it may be, cannot thrive exclusively on its built-in elements. It has to depend on a number of link institutions and so is the case with Islamic banking. For identifying suitable projects, Islamic banking can profitably draw the services of economists, lawyers, insurance companies, management consultants, auditors and so on. They also need research and training forums in order to prompting entrepreneurship amongst their clients. Such support services properly oriented towards Islamic banking are yet to be developed in Bangladesh.
  41. 41. P a g e 36 | 39 6.1.4 Organizing Relationship with Foreign Banks Another important issue facing Islamic banks in Bangladesh is how to organize their relationships with foreign banks, and more generally, how to conduct international operations. This is, of course, an issue closely related to the creation of financial instruments, which would be simultaneously consistent with Islamic principles and acceptable to interest-based banks, including foreign banks. 6.1.5 Long-term Financing Islamic Banks stick very closely to the pricing policies of the government. They cannot benefit from hidden costs and inputs, which elevate the level of prices by certain entrepreneurs without any justification. On the other hand, Islamic banks as financial institutions are even more directly affected by the failure of the projects they finance. This is because the built in security for getting back their funds, together with their profits, is in the success of the project. Islamically, it is not lawful to obtain security from the partner against dishonesty or negligence, both of which are very difficult if not impossible to prove. 6.2 The Future of Islamic Finance in Bangladesh 6.2.1. New banking philosophy for the Islamic Banks There seems to be a gap between the ideals and actual practice of Islamic banks in Bangladesh. In their reports, booklets, bulletins and posters their banks express their commitment to striving for establishing a just society free from exploitation. Study shows that a little progress has been achieved so far in that direction. 6.2.2. Banking Policies and practices should be modernized Islamic banks, with a view to facing the growing competition either fellow-Islamic banks or the conventional banks which have launched Islamic banking practices, will have to adapt their functioning in line with modern business practices. 6.2.3. Policy and Strategy should be formulated The first action that deserves immediate attention is the promotion of the image of Islamic banks as PLS banks. Strategies have to be carefully devised so that the image of Islamic character and solvency as a bank is simultaneously promoted.
  42. 42. P a g e 37 | 39 6.2.4. Stepping for Distributional Efficiency The task is more challenging for Islamic banks, as they have to promote their distributional efficiency from all dimensions together with profitability, Islamic banks, step by step, have to be converted into profit loss-sharing banks by increasing their percentage share of investment financing though PLS modes. 6.2.5. Allocating Efficiency should be promoted The Islamic banks can improve their Allocative efficiency by satisfying social welfare conditions in the following manner. First, they should allocate a reasonable portion of their investible funds in social priority sectors such as agriculture (including poultry and fishery), small and cottage industries and export-led industries like garment, shrimp cultivation. Secondly, when the percentage shares of allocation of investible funds are determined among the sectors of investment financing, profitability of projects should be the criterion for allocating investment funds. The criterion would be best satisfied if more and more projects were financed under PLS modes. 6.2.6. Government and Central bank's Responsibilities Government should think actively for the promotion of Islamic banking in Bangladesh considering its pre-development role. Bangladesh Bank should develop some Islamic Monetary and saving instruments and create separate window for transactions with the Islamic banks and a full-fledged Islamic banking Department for analyzing, supervising, monitoring and guiding purpose, thereby facilitating Islamic banks for their smooth development in Bangladesh. 6.2.7. Inter-Islamic Bank Co-operation and Perspective Plan All Islamic banks should come forward to help each other’s and adopt a perspective plan say for 27 years for Islamization of the banking system of Bangladesh. To actualize this mission, they should set-up immediately an Apex Research Academy and Training Institute designed with modern tools.
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