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.



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

146 Shahnaz Naughton and Tony Naughton



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

Religion, Ethics and Stock Trading 147



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




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




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




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




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




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,




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,




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.




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




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.




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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Religion, Ethics and Stock trading

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