Islamic Capital Markets

The development of Shari’ah compliant financial products dates back to the early 1970s with the emergence of the first Islamic banks and has been growing dramatically especially in the last decades. Although the components of the Islamic capital market and the conventional capital market are similar, the properties of the products that constitute each component are different (Alam et al., 2017). The Islamic capital market can be defined as the securities markets where all kinds of transactions are carried out in accordance with Islamic principles. The main purpose of the Islamic capital market is the same as conventional capital markets. However, the main difference is the transactions that must be made in accordance with the Islamic rulings such as prohibition of interest, uncertainty and gambling. In this context, in Islamic equity market, it is not possible to invest in the stocks of companies that involve; interest-based activities, activities related to the entertainment sector such as gambling and nightclubs, organizations dealing with the production and sale of haram products such as alcoholic beverages, activities based on uncertainty, and stocks of companies that involve activities related to the weapon and defense industry.

Islamic capital markets consist of Islamic equity markets, Islamic bond market (Sukuk) and Islamic derivatives market. The equity market, also known as stock market, can be defined as the market where the shares of joint stock companies are traded. Within the framework of Islamic equity market, the crucial point is the activities of the issuer companies. Namely, in Islamic equity market, it is important to examine whether the company's activities are carried out according to Shari’ah principles or not. Alam et al.

(2017) defines the Islamic equity market and related products based on Islamic funds and Islamic equity funds as follows:

Public listed companies: A platform for deficit units to raise money through equity financing and for investors to invest in companies' stocks.

Unit Trusts and Mutual Funds: An investment plan in which a fund manager collects money from investors with similar investment objectives to invest in a portfolio of assets such as stocks and bonds.

Islamic Private Equity Funds: The equity of companies that are not listed on a public stock exchange. The principle difference that separates Islamic and traditional private equity funds is the suitability of the investee companies with respect to the Shari’ah board.

Islamic Specialized Funds: Funds that invest neither in listed nor non-listed companies.

Although the Islamic investment funds, which are the funds managed in accordance with Islamic criteria, emerged in the early 1990s, they have grown rapidly among Islamic financial products. Moreover, they can be restricted to a particular class of assets such as real estate, leasing and commodities and also hybrid of equities and commodities.

Derivatives, on the other hand, can be defined as the financial contracts that are arranged between two parties to buy and sell from today, depending on the future value of assets whose qualifications are predetermined. Derivative markets are the markets in which derivatives are traded. In other words, derivative markets are the markets where any goods or financial instruments are purchased and sold today for delivery or cash settlement at a later date (Ersoy, 2011). As in conventional finance, risk management is critical and crucial in Islamic finance. Within this context, as Iqbal and Mirakhor (2007) explain, derivative markets carries out three main functions as risk reduction and redistribution, price discovery, stabilization and completeness of markets. Accordingly, the main purpose of the derivative markets is facilitating the risk transfer among the economic agents. In Islamic finance, the derivatives market is comprised of Islamic forward forex, Islamic options, Islamic forwards and futures and swap contracts.

However, while Islamic banks must first examine the derivatives that they use risks, such as foreign exchange, market, credit, and liquidity risks, they must first examine the compliance of these instruments with Islamic principles. Furthermore, the existence of forward and future markets increases the information flow while leading price discovery

function to the sector. In addition, derivatives market customizes and monetizes payoffs with considerable transaction costs (Iqbal and Mirakhor, 2007).

Sukuk is the second largest component of the Islamic finance sector after Islamic banking.

According to The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) sukuk is defined as the “certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects or special investment activity” (AAOIFI, 2017, p. 468). Sukuk is also referred as Islamic bonds and it is an interest-free investment instrument that provides ownership right on a real asset and enables to earn income from the relevant asset.

The most commonly used sukuk certificates can be given as follows:

• Sukuk al-Ijarah: A leasing contract. The usufruct of the asset subject to the certificate passes from the asset owner to the contract renter.

• Sukuk al-Mudharaba: A partnership contract realized on the basis of profit-loss partnership where one party provides capital (money) and the other party provides labor, knowledge, experience or management.

• Sukuk al-Murabahah: A sale and purchase contract with predetermined cost and profit

• Sukuk al-Musharakah: A type of partnership where two or more parties come together to trade and make profit on the basis of profit and loss sharing principle.

• Sukuk al-Salam: Forward based certificates issued to raise funds for the purchase of the Salam based goods subject to transaction.

• Sukuk al-Istisna’: A type of sukuk that has been developed to fund manufacturers or contractors, mostly in real estate development, large equipment and equipment construction, and financing of large infrastructure projects that are produced in the future.

Sukuk is different from bonds and stocks in many aspects. These differences are given in Table 4 (ISRA, 2017, p. 31-31):

Table 4: Comparison Between Bonds, Sukuk and Shares

Bonds Sukuk Shares

Nature

Represent an IOU or interest-bearing debt obligation of the issuer.

Represent proportionate ownership in Shari'ah compliant assets, usufructs, services, intangible assets, commodities or profit-sharing venture or financial asset or any combination thereof through a mixed portfolio of various assets.

Represent proportionate

ownership in the corporation as a whole.

Issuer

Issuer of conventional is not limited in the business activities.

Any issuer who is engaged in business activities which are permissible under Shari'ah.

Any issuer.

Investors Only non-Islamic investors

Islamic and non-Islamic investors.

Islamic and non-Islamic investors.

Relationship Established

between Issuer and

Investor

Lending relationship giving investors the status of creditors.

Relationship is based on Shari'ah contracts used for structuring the sukuk.

The investor is conferred ownership rights in the corporation issuing the shares.

Underlying Assets

No assets required for unsecured bonds i.e.

there is no need for collateral backing the bond issue. For secure bonds, underlying assets backing bonds may include non-Shari'ah compliant assets.

Underlying assets must comply with Shari'ah requirements.

Underlying assets can represent both debt and non-debt assets.

Not required

Asset-Relates Expenses

Bond holders are not affected by asset-related expenses.

Sukuk holders may be affected by asset-related expenses. None

Status

Generally, represent unsecured creditors, except if bonds are backed by specific assets.

Sukuk holders in asset backed sukuk have recourse to the assets in the event of default or if the issuer faces difficulty to pay.

They are ranked senior to unsecured creditors. Sukuk holders in asset based sukuk are generally ranked pari passu with other unsecured creditors and have no recourse to the assets.

Shareholders represent the most junior in rank to other classes of securities with full or preferred voting rights.

Equity shares can also be in the form of preference shares which have near-senior claims to dividends and capital.

Return on Investors

Coupon payment in the form of interest representing a percentage of the capital. They correspond to fixed interest, connoted to riba.

Periodic payments represent a percentage of actual profits and rentals.

Shareholders receive dividend payments.

These are not guaranteed by the corporation.

Bonds Sukuk Shares

Principal Repayment

by Issuer

Return of principal at maturity is an irrevocable obligation, irrespective of whether the project funded was profitable.

In principle, there i s no ex-ante fixed obligation of capital repayment for partnership based sukuk structures However, in sale based and lease-based structures, the return of principal is guaranteed.

None, as the shares represent perpetual instruments.

Utilization of Proceeds

No specific

requirements. Bonds can be issued for meeting any financing needs that are legal in the jurisdiction of the issuer.

Proceeds must be used to finance Shari'ah compliant activities.

Equity can be issued for meeting any financing needs of the corporation.

Tradability in Secondary

Market

Selling bonds represents sle of debt.

Selling sukuk is basically the sale of a share of an asset or in a project. Shari'ah standards at the global level only allow the sale of tangible assets, some intangible assets and interest in ventures.

Represent a sale of shares in the company.

Pricing

Bond pricing is based on credit rating of the issuer and terms and conditions, usually a spread over a reference interest rate.

Sukuk pricing depends on the structure of the sukuk. For non-recourse asset-backed sukuk, pricing is based on the asset backing the sukuk. For sukuk structured based on fixed income and debt-creating contracts, their pricing is typically similar to bond pricing, but may be affected by factors including market depth, liquidity, complexity etc.

Pricing is tied to performance of the corporation.