It is important to recognize that Islam means to submit oneself to God (Allah), the
Creator, completely. This means that the purpose of life in this world is to serve God
and to declare that worshipping and praying as well as life and death are only for
God. Therefore it becomes mandatory for every Muslim to believe, to express in
words, worship and continue to work to uphold and spread the teachings and
injunctions of Allah. In other words, three Islamic concepts are involved when
fulfilling or carrying out Islamic injunctions in all aspects, including the muamalah
injunctions in the financial system. They are Tawhid (belief in one God), Iman (having
faith in God) and Aqidah (belief in the teachings and injunctions of God). All these
are for perfecting a Muslim by acquiring Taqwa (fear in God) and Taabbud (to submit
oneself to God). Therefore, it will not be in line with Taqwa and Taabbud if initially
we have our own ideas of structuring the Islamic financial system, and realizing
those ideas with only the Islamic injunctions that conform to our ideas. This means
rejecting other relevant injunctions that can slow down the progress of our working
model. Finally, it is important for a Muslim to recognize that the Islamic financial
system must have two elements. First, it must be a system that is carried out in the
spirit of Islam, not according to the Islamic label. Secondly, the system must have the
characteristics of sophistication, progressive and competitive. This implies that in
developing the mechanism and products in the Islamic financial system, the aspects
that need to be emphasized are the spiritual aspect and Islamic values. What this
means is that it is not just about making sure that the form that the product is in
contains no riba elements, or just limiting our scope to only the financial instruments
that existed in the Arab world about 1400 years ago.
2.2 The Malaysian Financial System
An understanding of the financial system and what are included within it are
important to be recognized. A financial system is a collection of markets, institutions,
laws, regulations, and techniques that operate in channelling investable funds the
surplus side or savers to the deficit side or borrowers. The system seeks for efficient
allocation of resources between those savers and borrowers. The households are
basically the principal lenders through financial intermediary institutions, but
sometimes business enterprises, local as well as federal government, foreigners,
and foreign governments experience excess funds and therefore lend them out
tthrough financial markets. The borrowers also come from households, for example,
homeowners; from governments, to build a road or a bridge, or to finance the annual
budget; and from business enterprises, to finance their production activities.
Financial markets (sukuk, bond, and stock markets) and financial intermediary
institutions (Islamic banks (commercial and investment banks), takaful companies
(Islamic alternative to insurance), mutual funds and other Islamic finance companies)
facilitate the flow of funds from savers to borrowers by developing instruments,
techniques and products that not only meet the needs of depositors and customers,
but more importantly comply with the Shariah. This means the behavior and
operation of financial institutions and markets operating under the Islamic financial
system need to comply with the rules and principles of Shariah.
Funds flow from lenders to borrowers via two routes. First, in direct or market-based
finance, debtors borrow funds directly from lenders in financial markets by selling
them financial instruments, also called securitries (such as debt securities and
shares), which are claims on the borrowers future income or assets. If financial
intermediaries play an additional role in the channeling of funds, one refers to this as
indirect finance. Financial intermediaries can be classified as credit institutions, other
monetary financial institutions, and other financial intermediaries. Financial markets
and financial intermediaries are not separate entities but are strongly inter-linked.
2.3 The Roles and Functions of Financial Markets
Apart from the general function of financial markets and institutions, there are also
specific functions of financial markets and institutions.
1. Savings
Financial markets provide an avenue for the publics savings. Bonds, stocks, and
other financial claims sold in the money and capital markets provide accesible liquid
investments, a relatively low risk outlet for public savings, which flow through the
financial markets into investments, so that more goods and services can be
produced (productivity increases).
2. Wealth
The capital market provides an excellent avenue to store wealth (preserve the value
of assets we hold) until funds are needed for spending. This use of funds is more
productive than storing wealth in the form of tangible assets, such as automobiles or
items that are subject to depreciation and often carry a great risk of loss. Moreover,
bonds, stocks, and other financial instruments do not wear out over time and usually
generate income.
3. Liquidity
The capital market provides a means of converting financial instruments into cash,
with little risk of loss. The capital market provides liquidity (immediately spendable
cash) for savers who hold financial instruments, but are in need of cash.
4. Credit
In addition to providing liquidity and facilitating the flow of savings into investments to
build wealth, the financial market furnishes credit to finance consumption and
investment spending. In this regard, individuals can borrow money to buy properties
or a company can get financing to expand their businesses.
5. Payments
The financial markets also provide a mechanism for making payments for the
purchase of goods and services. Certain financial assets, including currency, non-
interest bearing checking accounts (demand deposits), and interest-bearing
checking accounts serve as a popular medium of exchange in makiung payments all
over the globe.
6. Risk protection
Financial markets offer businesses, consumers, and government protection against
life, health, property, and income risks. This is accomplished by allowing participants
to engage in both risk sharing and risk reduction approaches. Risk sharing occurs
when an individual or an institution tranfers their risk exposure to someone willing to
accept that risk (such as an insurance company), while risk reduction usually takes
place when we diversify our wealth across a wide variety of different assets, so that
our overall losses are likely to be limited.
7. Policy
Goverments, particularly the Central Bank, use financial markets as one of the tools
to manage monetary stability of the country. Through financial markets, governments
could manage some economic parameters, such as money supply, inflation,
exchange rate, and other relevant factors of the economy.
Financial markets are divided into four types based on the instrument, the issues of
the security, the trading methods in secondary markets, and the maturity.
The other way of raising funds for firms and government agencies is through the
equity market by issuing equity securities (stocks). Equity securities differ from debt
securities in that the former represent partial ownership in the issuing entity while the
latter have no such right. Furthermore, equity securities tend to be riskier than most
long term debt instruments, but they also tend to have a higher expected return as
well. Holding equity securities of any corporation has its own advantage and
disadvantage. As the corporation grows and its value increases, holders of its stocks
can earn a return in the form of periodic dividends and a capital gain if they sell
stocks. Holders of its stocks, however, can experience a negative return as well if the
corporation performs poorly and if the stock price declines over time. Equity markets
are for raising long-term funds. While bonds, sukuk, or other debt instruments have
maturity dates, equities do not and therefore are considered long term securities.
People or firms who are holding common stock, as an example of equity instrument,
obtain their shares from the net income and assets of a business. Therefore,
shareholders are sometimes called residual claimants, which means that they can
only get their shares after the stock-issuer company pays all its debts and taxes.
From the perspective of a company that wants to acquire funds, debt and equity
instruments are the two ways of getting those funds. It is said that the company
acquires debt funds when it takes a loan or sells bonds, while equity funds are raised
when the company issues shares to the public, whom are keen on the companys
progress and growth rather than on earning interest on debt.
The development of the equity market benefits society because it provides a greater
variety of channels for borrowing, particularly for medium and long-term financing.
The equity market provides an opportunity for corporations to raise funds by issuing
stocks and shares to be listed on the Main or Second Board of Bursa Malaysia
Berhad. The primary market is used to raise new capital for enterprises while the
secondary market provides the requisite liquidity for investors to meet their individual
needs. Secondary market trading in stocks and shares is conducted through
stockbrokers. Besides the Main and Second Boards, there is also the Malaysian
Exchange of Securities Dealing and Automated Quotation (MESDAQ). MESDAQ is a
separate exchange established in 1997 for small, high-growth potential and high-
technology companies.
After those securities are traded in a primary market, the current owner may want to
sell it again due to liquidity problems or to make profits. He or she can now sell those
securities in a secondary market. Therefore, a secondary market is a market where
securities are traded after they are initially offered in the primary market. Although
the person who has sold the security in a secondary market receives money in
exchange for the security, the company that issued the security acquires no new
funds. The company receives funds only when the security is first sold in the primary
market. Transactions in capital market instruments are either exchange-traded or
OTC. In many countries, transactions in the primary and secondary money market
are over-the-counter (OTC) via electronic telecommunications, but some are done in
an exchange such as the Bursa Suq Al-Sila in Malaysia.
Brokers and dealers are very important for the functioning of the secondary market.
Brokers are agents of investors who match buyers with sellers of securities, while
dealers link buyers and sellers by buying and selling securities at a stated price. The
Kuala Lumpur Stock Exchange (KLSE) of Bursa Malaysia is the best known example
of a secondary market. It also includes futures markets and options markets.
An exchanges market, on the other hand, is where buyers and sellers of securities or
their agents meet in one central location to conduct trades either physically or
through an electronic trading platform. The quoted prices of the various securities
listed on the exchange represent the only prices that are available to investors
seeking to buy or sell the specific assets. A good example of this is the New York
Stock Exchange, and Bursa Malaysia is an example for exchanges market where
trades are conducted via an electronic trading platform. The New York Stock
Exchange is considered a centralized market because orders are routed to the
exchange and then are matched with an offsetting order. However, the foreign
exchange market is not deemed to be centralized because there is no one location
where currencies are traded and it is possible for traders to find competing rates
from various dealers from around the world.
Banks as financial institutions are regulated by the Central Bank to put aside
deposits in the form of reserves. Theoretically banks should not have any problems
to provide the sufficient reserve, but in practical due to their lending activities, the
banks may have deficits in their deposits. Therefore, to fulfill the policy they need to
borrow from businesses or any financial institutions (lenders) that have surplus cash
money. Lenders in the money market usually do not aim for high returns on their
money market funds. They actually do not want to hold the idle surplus chash
because cash money alone can earn no income; idle cash is the opportunity cost in
terms of lost interest income (dividend). However, they do not want to invest in the
capital market either because perhaps in the short time they need to use the funds
and it will be difficult if they liquidate in the capital market.
The persons involved in the money market can be either the lender or the borrower.
They can be the government, businesses, banks, investment companies (brokerage
firms), finance companies (commercial leasing companies), insurance companies
(property and casualty insurance companies), or pension funds provider. Because of
the high amount of funds needed during the transactions in the money market, the
individual investors are difficult to interfere.
Business corporations as well as government agencies also use the money market
for short term investments. Likewise, large business corporations, by virtue of their
high credit ratings, source short term funds by issuing commercial papers. The
Central Bank, being the regulator and whose role is to promote market stability, uses
the money market to transmit its monetary policy. One such example is the use of
open-market operations as a means of influencing the liquidity level and short term
interest rates in the domestic financial system. Changes to the liquidity and short
term interest rates will affect long term rates in the financial system. Finally, the
government, another important player in the money market, uses the market as a
source of short term funding via the issuance of securities. .
Today, the Malaysian Islamic money market comprises two components: Islamic
interbank market, and trading of Islamic money market instruments.
Islamic Interbank Market
Generally, the Islamic interbank market is considered the largest component of any
Islamic money market, particularly the overnight sub-component. Ac active interbank
market is essential to provide signals to the Central Bank to determine the volume of
open market operations.
The overnight market is where Islamic financial institutions (IFIs) trade among
themselves their reserve balances to meet their day-to-day liquidity requirements.
For instance, banks with surplus liquidity can place their excess funds at other banks
overnight. The overnight rate adjusts to balance the supply of and demand for bank
reserves. A short market rate, in particular, the interbank overnight rate may be used
to serve as an operational guide for monetary operations of the Central Bank. In
2009, the overnight market comprises 83 percent of the total interbank market. The
Shariah contracts currently used in the Malaysian Islamic interbank market are
mudarabah, murabahah and wakalah.
The first Islamic interbank investment started in Malaysia in early 1994 with the
establishment of Mudarabah Interbank Investment (MII). In this arrangement, a
surplus bank as rabbul mal or fund provider will place its excess funds for a limited
period with a deficit bank or mudarib (manager of fund) on a pre-agreed profit
sharing ratio. In line with mudarabah principles, any losses will be borne by the
surplus bank.
Under the current BNM rules, the minimum amount of investment is RM 50,000,
while the tenor can be anywhere from overnight to 12 months. When MII was first
introduced, the rate of return paid by the deficit bank was based on its gross profit
rate on a one year investment. However, this method was not transparent, as some
banks underdeclared their return by excluding certain types of income. Following
this, in 1995, BNM came up with a new rule by introducing a benchmark rate that is
equivalent to the prevailing rate of the Government Investment Issue (GII) plus a
spread of 0.5 percent. Hence, the minimum rate of return payable to the surplus
bank is the prevailing rate of return from GII plus 0.5 percent. This rate of return
computation methodology was used until 2004 when BNM replaced it with a more
comprehensive framework, where it sets out the calculation of distributable profits
and the derivation of rates of return to deppositors.
Commodity Murabahah
Wakalah Investment
MITB are short term securities issued by the government as an alternative to the
conventional Treasury bills. Unlike GII which are issued to finance the development
expenditure of the government, MITB are issued to finance the governments
operating expenditure. The MITB are structured based on the bay al-inah principle
where BNM on behalf of the government will sell the identified governments assets
on a competitive tender basis, to form the underlying transaction of the deal.
Allotment is based on highest price tendered (or lowest yield). Price is determined
after the profit element is imputed (discounting factor). The successful bidders will
then pay cash to the government.
The bidders will subsequently sell back the assets to the government at par based
on credit terms. The government will issue MITB to bidders to represent the debt
created. MITB are usually issued weekly with original maturities of one year and are
priced on a discounted basis. Both conventional and Islamic institutions can buy and
trade on MITB.
These are short term money market instruments issued by BNM to replace the Bank
Negara Negotiable Notes (BNNN). The underlying contract used to be bay al inah
but now has been replaced with murabahah. The issuance of BNMN is based on
commodity Murabahah, as explained earlier. The issuance is normally made through
publication in FAST and the tenor for this instrument ranges from 1 to 12 months,
although now it has been extended to three years. The debt created from the
commodity Murabahah is tadable in the secondary market under the concept of bay
al-dayn. New issuance may be based on discount or coupon bearing. Discount-
based BNMN is traded using a convention similar to the existing BNNN and
Malaysian Islamic Treasury Bill (MITB), while profit-based BNMN is traded using the
market convention of Government Investment Issue.
This is an Islamic money market instrument that is issued under the Ijarah (lease)
principle. To facilitate the issuance of SBNMI, BNM established a special purpose
vehicle named as BNM Sukuk Berhad (BNMSB). The first stage of the sukuk
issuance involves BNM selling the identified assets to BNMSB and BNMSB paying
BNM for the assets from the proceeds of the sukuk issuance. The assets will then be
leased to BNM for rental payment consideration, which is distributed to investors as
a return on a semiannual basis. Upon maturity of the sukuk ijarah, which will coincide
with the end of the lease tenure, BNMSB will then sell the assets back to BNM at a
predetermined price. One advantage of using ijarah principle is that the rental can be
set as fixed or variable, thus mimicking a floating rate bond.
NIDC is a document issued by an IFI to evidence that a sum of money has been
deposited with the issuer for a specific period. The NIDC stipulates that the issuer
has the obligation to pay the bearer the amount deposited together with profit at a
specified future date. This document is issued based on BBA. The issuing bank will
first identify an asset whose value is based on the amount to be deposited and sells
this asset to the investor at an agreed-on cash price. Subsequently, the investor
agrees to resell the same asset back to the issuing bank at the original sale price
plus mark up, which is payable on a deferred basis. To evidence the indebtedness
from the deferred sale, the issuing bank issues NIDC to the investor. Upon maturity,
the investor or bearer presents the NIDC to the issuing bank against payment for its
nominal value plus the profit portion.
NIDC are bearer instruments and are initially issued to the investee bank. They can
be resold at discount before maturity. NIDCs are traded on a price basis, which
means that the principal value is quoted in terms of price per RM100 nominal value.
IAB is the Shariah equivalent of the conventional Bankers Acceptance. IAB is a bill
of exchange drawn on or drawn by a bank, payable at a specific date in the future, to
evidence the debt that arises out of a trade transaction.
This bills may be used as part of the trade finance facility by importers to finance
their imports or purchases or exporters to finance their exports or sales. Among the
conditions set by BNM for the issuance of IAB are as follows. The financing facility
must be for a genuine trade, the good involved must be tangible and Shariah
compliant, it must not involve the selling or purchasing of services, and the parties
involved must bot be a single entity. Under the current BNM rules, the minimum
denomination for an IAB is RM 50,000 and in multiples of RM1,000.
Import and Local Purchases
In import IAB, the Islamic bank will first appoint the customer as its agent to
purchase the required asset from the exporter or seller on behalf of the bank. The
asset is consequently resold to the customer on a murabahah basis at a mark-up
price with the agreement to repay based on dereffred payment, which can be up to
365 days. Upon maturity, the customer pays to the bank the cost of the goods and
the banks profit margin. The sale of goods by the bank to its customer on a deferred
basis represents debt, which is securitized in the form of a bill of exchange that is
drawn by the bank on, and accepted by the customer for, the full amount of the
selling price that will be paid on maturity. The Islamic bank as the drawer of IAB can
hold the IAB until maturity, when it will receive the full selling price, or alternatively
sell the IAB prior to its maturity at a discount to any investors using the principle of
bay al-dayn.
Export/Local Trade
After an exporter has obtained approval of his bank for export trade finance facility,
and fulfilled the export documentations required under the export pr sales contract,
the documents are sent to the importers bank. The exporter later draws on his bank
a new bill of exchange as a substitution bill that represents the IAB. The acceptance
by the bank indicates a promise that it will pay the full value of the bill to the bearer
upon maturity. The bank then purchases the the IAB from the exporter at a discount
under the principle of bay al-dayn. The bank can hold the IAB until maturity and
receive the full selling price or it can sell the bill before maturity to a third party at
discount.
Cagamas Sukuk
This is an asset based sukuk issued by Cagamas Berhad under the concept of
mudarabah. The main objective of this instrument is to finance the purchase of
Islamic housing debts issued under the principle of BBA and the purchase of Islamic
hire purchase debts issued undewr the principle of ijarah thumma al-bay. Based on
the Mudarabah concept, the sukuk holder bears any loss that results in a reduction
of the value of the sukuk while profit is shared between the sukuk holders and
Cagamas according to the agreed-on profit sharing ratio. Coupon is paid
semiannually on coupon day. The sanadats are redeemable at par on the maturity
date unless there is principal diminution. The maturity of sanadat can run up to 10
years.
Sanadat Cagamas
These are Shariah compliant bonds or sukuk first introduced in malaysia in 1990 by
Sarawak Shell. They can be structured based on a number of Islamic finance
contracts, such as BBA, murabahah, salam, istisna, ijarah, mudarabah, musyarakah
and wakalah. These sukuks can be issued on either a discounted basis or profit or
rental basis. Hence the pricing formula will also be based on the type of sukuks
issued.
The money market also serves as the avenue for secondary trading of money
market instruments. Money market participants, depending on their view of rates of
return, will either buy or sell money market instruments in anticipation of obtaining
investment returns. The instruments available in the money market provide investors
with different levels of risks, returns, and maturity.
Finally, the money market is used as a channel for the central bank to conduct its
monetary policies. The central bank will use open market operations by undertaking
repos and reverse repos, purchasing and selling eligible securities, and providing
short term financing directly to banks that are in a deficit sittuation. In this way, the
central bank is able to manage liquidity and influence benchmark rates in the money
market. Changes in the liquidity and benchmark rates in the money market will
thereby influence liquidity and rates of return in other markets. As such, the effect of
a monetary policy change is first reflected in the money market, and that will
ultimately lead to adjustments in other markets such as sukuk and bond, equity, and
banking systems.
Whether it is conventional money market or Islamic money market, they have the
same characteristics, purposes and aims. What makes them differ are the
instruments allowed in the Islamic money market that are restricted to certain
circumstances. The Islamic money market refers to the market where the activities
are carried out in ways that do not contradict with the conscience of Muslims and the
religion of Islam.
The Islamic money market started in Malaysia during the introduction of Islamic
banking in the early 1980s. Due to this establishment, the Islamic banking system is
regulated to to have the following three main components: large number of Islamic
financial institutions offering Islamic products, large number of Islamic financial
institutions providing Islamic facilitries, and the Islamic Interbank Money Market.
Malaysia has a strong Islamic banking industry, with a strong Islamic interbank
money market at work. The Central Bank of Malaysia established the Islamic money
market in 1994 to cater to the needs of the Islamic banks by managing their excess
and deficit funds in short term investments. Mudharabah Interbank Investment (MII)
was the first instrument introduced. The number of instruments developed increased
from year to year to include a single or multiple Islamic contracts from mudharabah
(profit and loss sharing), murabahah (mark up cost), bay bithaman ajil (deferred
payment sale), bay al-dayn (sale of debt), and bay al inah. An increase in the
number of money market instruments in the Islamic money market increased the
Islamic banks exposure to a wide range of risks such as credit, operational, profit
and liquidity risks. The money market where medium and short term instruments are
being traded is different from the debt and capital market, which dealt with long term
investments. An attempt will be made to explain the present structure of the Islamic
money market system at the national level and the possible Islamic contracts used in
the sale and purchase of securities in the primary and secondary interbank money
markets.
Since the inception of Islamic finance in the 1960s, Malaysia is among the countries
that have provided a wide range of Islamic financial products and activities and
therefore has become the main player of Islamic finance in the world today,
particularly in the Islamic Capital Market (ICM) area. These achievements cannot be
separated from the role of the Malaysian government through its bodies / institutions,
such as Bank Negara Malaysia (BNM), Securities Commission (SC), and Bursa
Malaysia (BM).
The capital markets in Malaysia consist of conventional and Islamic markets for
medium- and long-term investment.
Just as capital markets play a critical role in the conventional financial system, their
role in the Islamic financial system is also equally important. Conventional capital
markets have two main streams the securities markets for debt trading and the
stock markets for equity trading. Raising capital through debt is not possible in the
Islamic system due to the prohibition of interest. Although borrowing and lending on
the basis of debt is a common practice in modern conventional markets, Muslims
cannot participate in any debt markets. The concept of stock markets is similar to the
Shariah principles of profit and loss sharing, but not every business listed on the
stock market is fully compatible with the Shariah. These issues pose challenges for
the development of Islamic capital markets.
Several efforts have been made, especially in two areas. The first is the development
of a debt-like security in the forms of an asset-backed security, and the second is the
development of Islamic funds comprising of portfolios of securities such as, but not
limited to, equity stocks or commodities. Islamic equity funds become popular with
investors who had a risk appetite for equity investment. IFIs kept demanding a fixed-
income like security, which could behave like the conventional fixed-income debt
security at a low level of risk but which also complied with the Shariah. In addition,
IFIs wanted to extend the maturity structure of their assets to go beyond the typical
short-term maturity given by trade finance instruments. This led to experimentation
with creating Shariah-compliant, asset-backed securities, namely the Sukuk, which
have risk/return characteristics similar to a conventional debt security.
Therefore, the Islamic capital market in Malaysia can be divided into two main
sectors, the Islamic equity and the sukuk sector. Hence, Malaysia, through Bursa
Malaysia, also provides the market for Islamic Real Estate Trusts (Islamic REITs)
and sukuk (Islamic bonds).
The Islamic unit trust industry has evolved and experienced significant growth in the
past decade. The inception was launched by the Arab-Malaysian Bank when it
established the Tabung al-Ittikal in 1991, followed by Tabung Amanah Bakti by Asia
Unit Trust Berhad in 1993. BIMB and the states of Sarawak, Selangor, and Kedah
established a unit trust fund in the following year, 1994. The total number of Islamic
unit trust funds increased from 144 in
September 2009 to 160 in June 2011, out of 580 unit trust funds in the industry.
Next is Exchange Traded Funds (ETFs). These funds are relatively new in the world
of capital market. The equity market started wiith the trading of stocks. Retail
investors sometimes do not have time to pick up the stocks. To solve this problem, a
collection of stock was created to mitigate the risk and these are called mutual funds.
In this mutual fund, a manager manages the stocks for a pool of investors. Although
this fund is relatively diversified, it still could not beat the market return. For that
reason, an index fund was created. This is the fund that tracks the index. However,
both of these funds (mutual funds and index funds) are not traded; hence ETFs was
created. ETFs are essentially unit trust funds that are listed and traded on a stock
exchange. The difference between ETFs and unit trust funds is in the manner their
units are bought and sold. Since ETFs are listed, their units can be bought and sold
anytime during stock exchange trading hours. Investors buy and sell ETF units
through their stockbroker rather than through unit trust agents. In addition, while unit
trusts are actively managed with fund managers picking up stocks that will generate
a higher return than the market, most ETFs follow an index fund investment strategy
of passive management. In this passive management, managers do not pick stocks
based on fundamental analysis. Instead an ETF manager aims to track the
performance of a benchmark index. He does not have to pick his own set of stocks
but simply follows the constituents of the index that he is tracking because the aim is
to provide investors with the same returns as that of the market.
The primary advantages of ETFs over regular unit trust or mutual funds are quite
appealing. They are passively managed funds and they incur lower fees. This is
despite the fact that they can be transacted in smaller quantities. An ETF enjoys the
benefit of diversification since it tracks the performance of an index that is made of
several different companies so that an investor can spread the risk in a single
transaction and at a lower cost compared to a managed fund.
Islamic Real Estate Investment Trust (REIT) is another scheme: a trust fund that has
gained acceptance among international Islamic investors. It is a collective investment
vehicle that pools money from investors and uses these funds to buy, manage, and
sell real estate. The Malaysian government is very concerned about this
development, and through SC, Malaysia was the first to introduce Islamic REITs
guidelines in 2005, which provided Shariah guidance on the investment and
business activities of the Islamic REIT. The Islamic REITs Guidelines also facilitates
the creation of a new asset class for investors, and allows fund managers to further
diversify their investment sources and portfolios.
Following the issuance of Islamic REITs Guidelines, KPJ Healthcare Bhd became
the first Malaysian company to establish and launch Islamic REITs. Known as
Al-Aqar KPJ REIT, the I-REIT was the first listed Islamic REITs under the Islamic
REITs Guidelines and the first Islamic healthcare REIT in the world. KPJ Healthcare
Bhd identified seven hospitals within the group as its main asset class for the
establishment of the Islamic REITs. In February 2007, Al-Hadharah Boustead REIT
became the second Islamic REITs listed on Bursa Malaysia. Under the structure, Al-
Hadharah Boustead REIT acquired plantation assets from the Boustead Group
consisting of oil palm estates and palm oil mills. Being the first Islamic plantation
REIT, Al-Hadharah Boustead REIT also provides an opportunity for investors to
participate in plantation ownership. Therefore, Malaysia owns the worlds first
hospital REITs and plantation REITs.
Sukuk Market
The sukuk market has been the driver of growth of the Malaysian ICM. Many world-
first issues with sizeable amounts and innovative structures were originated in the
past years. Among them were: first sukuk issue of RM125 million by shell MDS; first
global sovereign sukuk of US$600 million by the Malaysian Government; first sukuk
musyarakah of RM2.5 billion by Musharakah One Capital Bhd; first rated Islamic
residential mortgage-backed securities of RM2.05 billion by cagamas MBS Bhd; and
first exchangeable sukuk musyarakah of US$750 million by Khazanah Nasional Bhd.
A formal model for a stock market according to principles of Islam has yet to be
formulated, but there have been a few attempts to identify issues distinguishing an
Islamic stock market from a conventional stock market. There are at least three
major structural issues that need to be resolved.
Limited Liability
First is the question of what is the best contractual agreement representing a share
in a joint stock company with limited liability. Limited liability raises the issue of how
to deal with a legal entity such as a corporation, which has a legal personality and
needs to be treated as a juridical person. Some argue that limited liability conflicts
with a basic Islamic moral and legal principle, that obligations are, as it were,
indestructible without agreed release of forgiveness from the creditor. In this respect,
Islamic Fiqh scholars need to address several critical issues such as the acceptance
of a corporation as a partnership (on basis of Musyarakah) or some other similar
contract. In addition, what happens to the liability in case of the insolvency of the
judicial person (i.e., company)? Some Shariah scholars are of the view that there
are certain precedents where from the basic concept of a juridical person may be
derived by inference in Islamic Fiqh.
In general, investment and trading in modern day equities are permissible. However,
not all shares of companies are Shariah compliant assets. Thus to ensure Shariah
compliant investing, two types of screening are typically applied, namely business
activity or sector screening, and financial screening.
Sector Screening
The purpose of sector screening is to exclude, from the universe of investable stock,
companies that operate businesses that violate Shariah injunctions. In almost all
cases, shares of firms whose primary business activities are in the following sectors
would be deemed as Shariah non-compliant assets:
(i) Conventional or interest-based finance (riba)
(ii) Gambling, gaming, casino operations and number forecasting (maysir)
(iii) Prohibited goods and services such as pork, non-halal meat, alcohol and
prostitution
(iv) Conventional insurance (gharar)
(v) Tobacco manufacturing or sale
(vi) Stockbroking or trading in non-Shariah approved securities
In addition, there are some Shariah jurisdictions which also consider the following
sectors Benchmark Application as
Shariah non-
5% Mixed contributions from clearly
prohibited activities such as conventional
banking (riba), gambling, liquor, pork and
non-halal food production.
compliant:
Financial Screening
Upon passing the sector screening, stocks are then subjected to financial screening
to evaluate the extent of interest-based financing and interest-based income. It has
been reasoned that some portion of riba-based financing and revenue should be
tolerated. This is because, imposing a strict stipulation that Shariah compliant
companies must not have any form of interest-based financing nor have any interest-
bearing investments or deposits, would, at present time, severely constrict the
investment universe of investable stocks available to Muslim investors. The use of
financial ratios to measure the quantum of interest-based financing and income
varies from one index (or Shariah authority) to another. For illustrative purposes, we
look at the following which is employed by the Dow Jones Islamic Indices.
Dividend Purification
In addition to sector and financial screening, some Shariah jurisdictions stipulate that
the Shariah non-compliant portion of revenues received by Shariah compliant stocks
need to be cleansed. The impure dividends (profit distribution) should be
chanelled to charities or avenues of public benefit. Here, there are marked variations
in practice as well as issues that arise. First, one could ask, should purification be
done only on dividends paid out? What about capital gains on sale of shares, as that
would constitute a form of return to investors and implicitly contain some portions of
tainted income from the company. In some equity markets, dividend payout ratios
are typically very low. The bulk of returns to shareholders come in the form of capital
gains resulting from appreciation in share prices. Also, some stocks, usually the so-
called growth stocks, reinvest their earnings as part of their managements strategy.
Secondly, there is the question of how to capture the purification of interest-based
financing. Thirdly, do we interpret interest received as revenue (abd hence, allowing
some deductions before we arrive at the amount that requires cleansing), or do we
consider interest received as profit? The fourth issue is the debate of deduct versus
inform. Who should be responsible for the purification, the company itself, the fund
manager (in the case of mutual funds or unit trusts) or the individual investor?
Making the necessary purification before distribution to investors is probably more
cost effective but it makes certain assumptions about the religious convictions of
investors, and not to forget, taking into account the interests of non-Muslim
shareholders. The fifth issue concerns the debate of purification versus screening.
Some would contend that we can do away with screening altogether why not just
purify any and all tainted income, regardless of its quantum? At this juncture, it would
suffice to say that controversies are still present, and that it is hoped that as Islamic
equity markets develop, these unresolved issues would find amicable solutions.
The Islamic financial services industry has seen a number of Islamic financial
infrastructure institutions being established to support its global development. These
include the Islamic Financial Services Board (IFSB), the Accounting and Auditing
Organization for Islamic Financial Institutions (AAOIFI), International Islamic
Financial Market (IIFM), General Council for Islamic Banks and Financial Institutions
(CIBAFI), ad well as other ancillary institutions such as the International Islamic
Rating Agency (IIRA), the Liquidity Management Center (LMC) and the International
Islamic Liquidity Management Corporation (IILM).
CIBAFI aims to settle financial and commercial disputes between concerned parties
that have chosen to comply with Shariah to settle disputes. CIBAFI also contributed
in establishing a department for Islamic banking in the US Treasury Department in
2002, building a database containing historical administrative, financial and statistical
information about IFIs, and launching the Quality Certificate Project for Islamic
finance products.
IIRA offers sovereign ratings, credit ratings, Shariah quality ratings and corporate
governance ratings. Sovereign and credit ratings assess the likelihood that an entity
will repay its debt obligations in a timely manner. Shariah quality ratings evaluate the
level of compliance with the Shariah principles while the corporate governance
ratings consider the practices of an entity to assess the demarcation of stakeholders
rights and responsibilities as well as compliance with the existing decision making
rules and procedures.
IIRA publishes professional analytical research for its multiple constituencies. The
research will set a high standard for the market, enhancing the level of
understanding of the value of fundamental analysis in assessing default or
investment risk. In view of the nature of its activities, the presence of a rating agency
should increase transparency in the market through its promotion of disclosure and
knowledge of standards in other markets. It will enhance the investment decision
process by educating investors in the use of ratings criteria and methodology utilized
elsewhere.
Malaysia Rating Corporation Bhd (MARC) opened its doors in June 1996 as an
alternative choice for issuers. Comprise life and general insurance companies, stock
broking companies and discount houses. Long-term rating symbols also range from
AAA to D, while its short-term rating symbols range from MARC-1 to MARC-4.
Conduct under relevant laws and regulation in particular Companies Act 1965,
MARC MOA&AOA, Employment Act 1955, Industrial Relation Act 1967, and
Occupational Safety and Health 1994.
Globally known for its role in training, business advisory and Shariah advisory the
Islamic banking industry, Takaful, and Islamic capital market. IBFIM is an industry-
owned institute dedicated to producing well-trained, high competent personnel and
executives with the required talent in the Islamic finance industry.
Some of the programmes or activities the IBFIM offers to the Islamic Finance
Industry:
The Shariah Advisory Council (SAC) was established in May 1996, it is to advise the
Commission on Shariah matters pertaining to the ICM and to provide Shariah
guidance on ICM transaction and activities, aimed at standardising and harmonising
applications. Members of the SAC are qualified individuals who can present Shariah
opinions and have vast experience in the application of Shariah law, particularly in
the areas of Islamic economics and finance. Since the establishment of the SAC,
several capital market instruments have been evaluated and approved that are
ordinary shares, warrants, call warrants, non-cumulative preference share,
redeemable preference shares, crude palm oil futures contracts, crude palm kernel
oil futures contracts, khazanah zero-coupon bonds, single Stock Futures and Islamic
asset securitisation/Islamic debt securitization.
Duties of Shariah Advisory Council
1. The Shariah advisor should focus more on the field of Fiqh Muamalat, Usul
fiqh and Maqasid Shariah. Frequent readings and discussions must be
conducted with bank officials. This is important to ensure that they understand
the process, concept, and application of a transaction perfectly. Views backed
by expertise will be taken seriously and executed well by the financial
institution administration. Financial institutions are not interested in theoretical
suggestions that are of no help.
2. The public is fully dependent on the Islamic bank or Islamic banking and
takaful stamp. Thus, it is vital to ensure that these stamps are by proper
authorization of the Shariah Advisory Council. This is to establish the Islam
logo and name in financial institutions, similar to the JAKIM stamp for the food
industry. Therefore, all Shariah advisors of financial institutions will be aware
that have a responsibility before Allah s.w.t. to ensure every transaction they
manage must be in accordance to the Shariah. If they have truly performed
ijtihad, working and thinking seriously in deriving a fatwa, it is indeed sufficient
for them. Therefore, it is hoped that Shariah advisors are able to fulfill their
duty to the best of their capability and with trustworthiness, as they will be held
accountable in front of Allah s.w.t. later.
5. Shariah advisors should be proactive and show great concern regarding any
product or transaction produced by the financial institution under their
administration. There are Shariah advisors who deny any knowledge of a
product or operation by the financial institution that they administer. We refuse
to hear any statements of denial such as I dont know anything and am not
responsible, or It was not discussed with us. It cannot be denied that these
matters occur due to the weaknesses of the financial institution itself.
However, it is hoped that Shariah advisors will be more proactive so financial
institutions will take Shariah approval seriously.
Shariah scholars who uphold the amanah as Shariah advisor, whether inside
or outside a financial institution, should strive to increase their knowledge
before rushing forward to accept the position. Lest, various negative
ramifications will arise. It is undeniable that many who accept this position with
the intent of learning and eventually becoming an expert. This is highly
encouraged but determination must also be present.
The word takaful is derived from an Arabic word which means joint guarantee,
whereby a group of participants agree to jointly guarantee among themselves
against a defined loss. Takaful is a Shariah-compliant form of insurance. The takaful
operator is the administrator of the fund and manages the fund in trust on behalf of
the participants, and the contract between participants and the operator is governed
under the contract of Mudarabah or Wakalah. Mudarabah gives the right to the
contracting parties to share profit, while liability for loses is borne by the participants;
and under the Wakalah model, the takaful operators earn a fee for services rendered
while liability for losses is borne by participants. The fee may vary based on the
performance of the takaful operator. It can be a fixed amount or based on an agreed
ratio of investments profit or surplus of the takaful funds.
Mudharabah Model
Under the mudarabah contract, the takaful operator acts as the mudarib
(entrepreneur) and the participants as rabbul mal (capital providers). The contract
specifies how the surplus from the takaful operations is to be shared between the
takaful operator and the participants. Losses are borne by the participants or capital
providers.
Wakalah Model
The wakalah concept is essentially an agent-principal relationship, where the takaful
operator acts as an agent on behalf of the participants and earns a fee for services
rendered. The fee can be a fixed amount or based on an agreed ratio of investment
profit or surplus of the takaful funds.
Takaful is free from interest (riba), gambling Conventional insurance includes elements of
(maysir) and uncertainty (gharar). interest, gambling and uncertainty.
All or part of the contribution paid by the The premium is paid to conventional
participant is a donation to the Takaful Fund, insurance companies and is owned by them
which helps other participants by providing in exchange for bearing all expected risks.
protection against potential risks.
Takaful companies are subject to the Conventional companies are only subject to
governing law as well as a Shariah the governing laws.
Supervisory Board.
Any surplus in the Takaful Fund is shared All surpluses and profits belong to the
among participants only, and the investment shareholders only.
profits are distributed among participants and
shareholders on the basis of Mudarabah or
Wakalah models.
In case of the deficit of a participants Takaful In case of deficit, the conventional insurance
Fund, the takaful operator (wakeel) provides company covers the risks.
free interest loan (qard hasan) to the
participants.
The plan owners and shareholders capital is The capital of the premium is invested in
invested in investment funds that are Shariah funds and investment channels that are not
compliant. necessarily Shariah compliant.
Other than the Islamic banking institutions presently available in Malaysia, there are
other non-bank Islamic financial institutions which contributes to the development of
the Islamic Financial System in Malaysia.
So far, the Islamic financial system has been concentrated on debt financing,
neglecting equity financing which is more appealing for the development of the
Islamic financial system as the conventional banks may be unwilling or unable to
undertake this type of financing. Equity financing is best represented by both
mudarabah and musyarakah contracts of partnership. The reluctance of the modern
Islamic financial system is likely caused by a few reasons which are interrelated and
subsequently render the Islamic financing based on equity financing less popular.
The first reason undoubtedly is due to the high risk which both mudarabah and
musyarakah are exposed to.
Although both the conventional and Islamic financial system runs alongside each
other, serving the needs of their customers. However, their concept in the financial
world is transparently different as most of the conventional menthods in the financial
world goes against the Islamic teachings such as the practicing of riba, and the
involvement of gharar, while the Islamic financial system serve to follow the Shariah
law and thus, using the Islamic teachings, do not practice riba or gharar. This
difference between the two financial systems would act as a guideline for customers
to pick the financial system which will be best for them, in practicality and spirituality.
Though both financial systems are universal, making them available for everyone
regardless of their religion, the Muslims would surely opt for the Islamic financial
system in the hope to follow the Shariah law as best as they can while the Non-
Muslims may choose either depending on the rate of return they may get from either
the two financial systems or which industry theyd like to invest in.
Undeniably, the Islamic Financial Services Board (IFSB) has helped create
awareness amongst consumers in the significance of Islamic Finance and the issues
that may have an impact on the Islamic financial services industry. This has helped
to encourage more investments in the Islamic financial system by investors and build
consumers trust in the system.
The role of the Islamic Banking and Finance Institutions situated in Malaysia,
abbreviated as IBFIM, should also be noted as its continous effort in producing well-
trained, high competent personnel and executives with the required talent in the
Islamic finance industry has helped shaped the development of the Islamic Financial
System and also its future.
3. Why have Sukuk been introduced as instruments in both Islamic money and
capital markets?
5. In what way exchange traded funds (ETFs) are similar to investing in stocks?
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