Islamic Capital Market Instruments

 

The emergence of a distinct Islamic capital market, where investment and financing activities and products are structured in accordance with Shariah principles, is thus the result of a natural progression in the growth of the Islamic financial services industry. There is now a diverse range of Islamic capital market products and services available to meet the needs of those seeking to invest in accordance with Shariah principles. The Islamic capital market is divided into three sections: Islamic equity, Islamic bonds (Sukuk), and Islamic-compliant derivatives. The diagram below provides an overview of the Islamic capital market:

 ISLAMIC EQUITY

Islamic equity, like conventional equity, is a partnership in which both loss and return are shared. As a result, if profits are made and the issuing organisation decides to distribute a portion of them, the equity holder can benefit from dividends.

Corporate stocks can be classified as Shariah-compliant only if their business activities are not related to prohibited activities as defined by Shariah scholars. Alcohol, gambling, porkrelated products, pornography, conventional financial services, and conventional insurance are all prohibited business activities. Other activities or businesses may be prohibited in this context, such as tobacco, weapons, hotels, or entertainment, depending on the methodology or interpretation used by Shariah scholars in different jurisdictions. According to IOSCO “Report of the Islamic Capital Market Task Force of the International Organization of Securities Commissions” (2004), some jurisdictions are also known to use a cleansing mechanism to purify investments tainted by illegal activities. Individual investors typically perform the cleansing process; however, in some cases, Islamic funds will perform the task on behalf of their investors. For example, if some income from interest-bearing accounts (which Shariah prohibits) is included in the company's income, the proportion of such income in the dividend paid to the shareholder must be given to charity and cannot be retained by the shareholder. This is referred to as purification or dividend cleansing. In Malaysia, for example, a centralised body is in charge of screening listed stocks for Shariah compliance. The Securities Commission's Shariah Advisory Council (SAC) is in charge of reviewing and identifying stocks that are Shariah-compliant. The Securities and Exchange Commission then compiles the SAC's decisions and publishes a list of Shariah-compliant stocks twice a year.

Over time, the equity market expanded to include various types of Islamic funds, such as Islamic unit trusts, Islamic real estate investment trusts (Islamic REITs), commodity funds, Islamic exchange-traded funds (Islamic ETFs), Islamic private equity and venture capital funds, and various types of Islamic indices and index products, in addition to Shariahcompliant stocks (Islamic Capital Markets: Principles & Practices, 2015).

• Islamic Shares/Stocks/Equities: Investment in shares gives investors a share in the company and the potential for profit based on the company's future performance. Islamic equities are stock shares in companies that engage in Shariah-compliant activities. Through a process known as Islamic stock screening, these shares are approved and reviewed on a regular basis by a board of Shariah scholars. This procedure was created to determine whether company shares meet Shariah requirements. It assists investors in avoiding investments in prohibited sectors.
  
  
•  Islamic Unit Trusts: While investing in specific companies' stock carries significant risks, investors seek to diversify their portfolios by investing in investment funds. Unit trusts, also known as mutual funds or collective investment schemes, pool the funds of a group of investors and use them to invest in a variety of assets, commodities, and securities. Islamic funds professionally manage and invest funds in Shariah-compliant portfolios on behalf of institutional and retail investors. These funds are regulated and typically pool funds from the general public for investment in a diverse portfolio of securities. Shariah boards are typically engaged by Islamic unit trusts to advise and ensure that investment operations and portfolios are managed in accordance with Shariah principles.
  
  
• Islamic real estate investment trusts (Islamic REITs): The fund owns and manages investments in a diverse pool of properties such as residential, commercial, and retail properties, storage facilities, warehouses, and car parks in Islamic REITs. It then uses the revenue generated by these properties (for example, rentals) to pay out returns to unit holders. Islamic REITs offer investors a new investment opportunity that, unlike physical property investments, is more liquid because the units of publicly traded REITs can be easily converted to cash through stock exchange trading.
  
  
•  Islamic commodity funds: Islamic commodity funds invest in commodities that are permissible under Shariah law. Metals such as aluminium, copper, nickel, palladium, and platinum are among the most popular commodities.
  
  
• Islamic exchange-traded funds (Islamic ETFs): An ETF is a type of investment fund that holds assets such as stocks, bonds, commodities, and funds and whose shares are listed and traded on the stock exchange in the same way that company shares are traded. Its stock exchange trading implies that its shares can be bought and sold at any time. An Islamic ETF operates similarly to a conventional ETF, with the exception that Shariah compliance is its prerogative
  
  
• Islamic private equity and venture capital: Islamic private equity and venture capital funds invest in Shariah-compliant companies that are either new or small but have high growth potential. These rapidly expanding businesses are not generally listed on stock exchanges. The goals of such investments are to improve portfolio company performance and to sell or exit investments in such companies for a higher return once the growth target has been met. This type of investment has a high risk-return profile. During the growth phase, the risks are shared by the investors and the investee companies, and capital gains are realised at the time of exit

SUKUK

Sukuk is another important component of the Islamic capital market. In terms of terminology, 'Sukuk' is a traditional Arabic term that is the plural of 'Sakk.' The term 'Sakk' refers to a legal instrument, deed, or check. Sukuk is a type of Islamic financial instrument or security that represents ownership of an asset. Sukuk are asset-backed bonds (ABS). It is an Islamic investment certificate with claims not only on the cash flows or revenue generated by the asset, but also on the asset itself. Instead of receiving a fixed ratio of capital invested, the holder of a sukuk shares the business's profits and risks (Islamic Capital Markets: Principles & Practices, 2015).

Sukuk, unlike conventional bonds, are usually backed or secured by some underlying assets. Such assets provide built-in security to investments. As a result, in the event of a sukuk issuer's default, the sukuk generally reasonably assures sukuk holders, i.e. investors, of the ability to recover their investments, whether in full or in part, from the liquidation of the assets.

 The diagram below explains the general structure of sukuk:


 

The SPV is formed as a trust in the name of the sukuk holders. By providing a feasibility report, corporations fund users ask the SPV for the assets/investments they require for business purposes. The SPV evaluates the feasibility report and agrees on the mode of financing/type of sukuk to be used/issued. SPV now issues sukuk certificates and collects funds from sukuk holders. These funds are now being used to purchase/build/acquire assets as specified by the corporations. Profits/rents are now transferred to the SPV in accordance with the terms and conditions agreed upon. The SPV then distributes the funds to the sukuk holders in accordance with their investment ratio. At the final specified date, the corporations purchase the asset from the SPV at an agreed-upon price, which is typically equal to the face value of the sukuk outstanding. In exchange for the redemption of sukuk certificates, the SPV pays the settlement or selling price as well as any profits/rents to the sukuk holders (Haider & Muhammad Azhar, 2010).

In the sukuk market, various Shari'ah-compliant products are structured in accordance with Islamic financial contracts. Sukuk al-Ijarah, Sukuk al-Salam, Sukuk al-Murabahah, Sukuk al-Istisna, Sukuk al-Musharakah, and Sukuk al-Mudharabah are examples (Haider & Muhammad Azhar, 2010).

• Sukuk al-Mudharabah: The sukuk holders in Mudharabah sukuk provide the capital for the Shariah-compliant investment activity undertaken by the investment agent. The investment agent is paid a fee based on the profits generated by the business activity. There is a risk of losing equity if the investment project fails, but if the investment is pro table, the contributor is entitled to a fee for services rendered. The contributor is not entitled to a fee if the investment is not pro table. This type of Sukuk structure is currently being used to improve the public partnerships in capital-intensive projects such as the development of airports, seaports, dams, and power generation facilities. 
  
  
•  Sukuk al-Musharakah: The Musharakah agreement is a type of joint venture agreement between the issuer and the originator to engage in Shariah-compliant investment activity in accordance with the Musharakah agreement's business plan. Profits from the Musharakah arrangements are split evenly between the issuer and the originator. The profit share is predetermined, and the losses apportioned to each investor are limited to the amount invested. Corporations are currently using this type of sukuk structure to develop new projects or to expand on existing ones. It is also used to fund any other business activity on a Musharakah basis. 
  
•  Sukuk al-Ijarah: These are sukuk that represent ownership of equal shares in a rented property or the usufruct of the property. These Sukuk give their owners the right to own real estate, collect rent, and dispose of their sukuk in a way that does not jeopardise the lessee's rights, i.e. they are tradable. The holders of such sukuk are responsible for all maintenance and damage to the real estate. Ijarah is a legal structure in which the owner transfers the right of use or any benefit from a specific property or other assets/service to another person in exchange for a monetary consideration, such as rent. It is a different option than traditional leasing. It is a leasing agreement in which the contributor of equity (generally the bank) purchases property on behalf of its client and the client pays rent over an agreed period. Ijarah structure is currently involved in sale and lease back transactions. It raises funds from investors by using real estate/building as an asset.
  
•  Sukuk al-Murabahah: Transaction that allows the client (the investor) to purchase property without having to take out an interest-bearing loan. The holder of Murabahah sukuk or the capital provider acquires a specific asset/commodity from a third party and then sells it to the buyer or capital users at cost plus profit. The capital users then pay the asset/price of the commodity in instalments. The Murabahah structure of sukuk is used to finance a specific commodity or asset for resale to the borrower.
•   Sukuk Salam: Salam sukuk are issued in order to raise Salam capital. The holder of Salam sukuk is the purchaser of the commodity from the sukuk's issuer, the seller, at an agreed-upon spot price for the consideration of the commodity whose delivery will take place at an agreed-upon future date. Salam is a way to replace conventional future/forward contracts by taking Islamic laws and basic principles into account. The Salam structure is used to carry out a forward commodity contract in order to obtain funds against a commodity that is to be delivered at some future date.
•  Sukuk al-Istisna: The financing of property production through an advance payment for future delivery or a future payment for future delivery. Istisna sukuk certificates are issued to raise funds for the manufacture of a specific asset. Holders are the owners of an asset that will be produced or manufactured in the future. Sukuk holders are entitled to the proceeds of the sale of the certificate or asset manufactured. This sukuk structure is used to finance large and complex capital-intensive products or assets. For example, the production of aeroplanes and ships, as well as the development of large infrastructure projects. It is appropriate for use in BOT (buy, operate, and transfer) agreements.

Sukuk aided the development of the Islamic capital market sector and has remained the market's lifeblood to this day. Sukuk has grown in volume, issuer diversity, and instrument diversity over the years. It commands one of the strongest preferences among investors in both domestic and international markets, with demand for outweighing supply and many investors adopting a buy-to-hold strategy due to the lack of other Shariah-compliant instruments.

ISLAMIC-COMPLIANT DERIVATIVES

Aside from sukuk and equity, the ICM has also explored Islamic alternatives to derivatives. For example, the need for Shariah-compliant risk management tools prompted Islamic finance practitioners and researchers to investigate the features of conventional derivative products such as forwards, futures, options, and swaps and to employ Shariah-approved principles and contracts. These instruments are only used for hedging and not for speculation, as is common in conventional markets.

Islamic derivatives are any agreement made in accordance with Shariah, including an option, a swap, futures or forward contract, whose market price, value, delivery or payment obligations are derived from, referred to, or based on, but not limited to, Islamic securities, commodities, assets, rates, or indices. Structured products include derivatives such as credit default swaps, credit spread options, and collateralised debt obligations, which are used to efficiently hedge any profitable economic activity outside of the scope of conventional forms of on-balance-sheet securities in order to reduce the cost of capital and agency costs associated with market impediments to liquidity. Islamic concepts with derivative-like characteristics, such as Salam, Istisna, Arbun, Istijrar, Khiyar al-Shart, Wa'd, and Jialah, have been examined and proposed as alternatives for the development of Islamic hedging instruments (Islamic Capital Markets: Principles & Practices, 2015). 

Lastly, Summary and Conclusion.