Principles of Islamic banking and finance/PIBF203/Investment in stocks/Overview

Overview

The idea of investment in a jointly owned fund is quite old and a brief historical background will be given in next page. Mushrakah, the most desirable mode of finance from Islamic perspective, is a pre-Islamic concept and was in use in Makkah, an important center of commerce and trade in the sixth century. It was a mechanism of pooling investable resources for commercial use and sharing profit and losses proportionately. In most likelihood, there was no practice of trading of individually invested amounts. The prohibition of riba or usury made musharakah as well as mudarabah much more desirable modes of finance from shari'ah perspective.

Through a survey of literature, Alam et.al. (2017) note that although Muslims are considered pioneers of profit-and-loss-sharing investments in businesses through contractual agreements, which predate the concept of stock markets, the current form of stock market restricts the devout among them from seeking economic bounties from it because of several unsatisfying provisions from the viewpoint of the Islamic law or Shariah. Therefore, despite religious encouragement for Muslims to seek economic opportunities, they cannot engage wholeheartedly in the trading of conventional stock markets. Moreover, stock markets that follow the Islamic principles are still in the early stages of development. Furthermore, most stock exchanges in Muslim countries are Western-style markets, which tolerate many practices that do not comply with Islamic principles.

Due to limited focus on the Islamic finance, limited literature is available on the roles and principles of Islam-compliant stock markets. Moreover, only a handful of stock markets across the globe – such as Khartoum Stock Exchange (KSE) in Sudan, Kuala Lumpur Stock Exchange (KLSE) in Malaysia and Tehran Stock Exchange (TSE) in Iran – accommodate the Islamic laws of trading in the stock market. The conventional stock markets under the capitalistic system failed to protect the interests of ordinary investors time and again due to repeated stock market crashes across the globe, resulting in chronic financial crises and economic depressions.

The conventional theory of efficient market hypothesis (EMH) indicates that no one can get abnormal profits from the market by using any type of historical, private or public information. Nevertheless, many studies have shown that the EMT does not hold for many markets Therefore, investors and market regulatory bodies are looking for an alternative form of capital market where investors’ rights and interests will be best protected. As the world has been able to observe the advantages and benefits of value-based Islamic banking, the same principles and value-based system can be suggested as alternative of the conventional capital market system.

As shares of a company represents fractional ownership, trading in shares of joint stock companies should be a non-controversial issue in shari'ah. However, there are several things that made trading of shares problematic from Islamic perspective.

First of all the trading of shares cannot be allowed for companies that produce prohibited goods and services. This would not only include products that use pork meat or casinos where betting games are played but also conventional banks and insurance companies that earn most of their incomes from interest based investments.

Second, almost all companies raise their funds at least partially through debt based instruments which is not allowed in shari'ah. Thus trading of shares of those companies is tantamount to involving oneself in questionable activities.

Third, there is a general impression among ordinary Muslims as well religious scholars that the level of speculation in share trading is excessive although the selling of something that someone owns is non-problematic.

Fourth, at an earlier stage, even the issue of companies being legal entities was also a problem for some scholars. This is, however, not a significant matter of contention.

In a frequently quoted article, Khatkhatay and Nisar note that:

"..... in case of investment in equities traded on the stock exchanges, the investor needs to consider further issues of the company itself being involved in Shari[ah non-compliant financing and structuring. Due to this, initially Shari[ah scholars tended to completely rule out investment in listed equities. Over time however, realization has seeped in that a more balanced view needs to be taken.

For one, the general prevalence of conventional banking operations makes it inevitable that but for a miniscule percentage, all businesses have to transact with banks in some way or other and, to some extent at least, rely on interest-based finance. Secondly, portfolio investment in equities on the stock markets is a convenient and often the main investment avenue open to ordinary Muslim investors and it is also close to the ideal Islamic profit and loss sharing paradigm for financing.

Hence, the consensus is now veering towards accepting a degree of compromise in the definition of Shari[ah-compliant business. The Shari[ah boards of various organizations such as investment and banking organizations, official regulators and market intelligence providers have put forth various criteria to define the maximum degree of compromise which could be considered acceptable under Shari'ah, given the current business environment."

In this session we will first have a brief look at the history of trading in shares and stock markets and then discuss how the same are treated in Islamic finance.