In this second part of a three part series of articles introducing our audience to Islamic Finance, we will specifically discuss the role of the Islamic Capital Markets.
Similar to Conventional Capital Markets, Islamic Capital Markets help mobilise funds from savers and deposit holders by assigning them to intermediaries which possess managerial talents and investment opportunities. In more simple terms, Capital Markets, which consist of both primary and secondary markets, provide a platform for those who require capital and those who hold capital. The underlying assets could be Equity Shares, Bonds, Commodities or Structured Products.
What is important to note is that the Islamic Capital Market offers products and services similar to conventional products and services however, these products are structured in a way that is acceptable and in accordance with Shari’ah principles and requirements.
The Equity Market in Islamic Finance
Firstly, let’s take a look at the Islamic Equity Market. Similar to the conventional Equity Market, the Islamic Equity Market provides an environment for investors to invest in the Shares of Companies and/or facilitate collective investments through funds. The main difference here is that, given the shareholders are Equity providers who support the “activities” of the Company, these “underlying activities” of the Company are required to be in accordance with Shari’ah principles. In order to avoid non-compliant companies, a stock screening process is fundamental so that non-compliant stocks/companies are filtered out. This can take place over a two stage screening process.
Stage 1 Screening: Investors should not be investing in a company whose activities are non-compliant. Non-compliant activities could include selling or producing alcohol, pork or gambling.
Stage 2 Screening: Investors should not be investing in a company which is non-compliant with acceptable Financial Ratios. The screening of Financial Ratios exposes the company’s level of borrowing, cash and interest-bearing accounts. This is to prevent investors from investing in companies which are debt dependent. In other words, companies which may be subject to high levels of interest bearing activities are also non-compliant with Shari’ah principles.
Note: this very screening process is one of the factors fuelling the debate on whether the principles embedded in Islamic Finance could be used as the backdrop to a more stable financial system.
The Fixed-Income or Sukuk Market
The Islamic Fixed Income Market is somewhat different to the Conventional Fixed Income Market. This is mainly driven by the high dependency on interest (not acceptable in Islamic Finance) payments and receivables in the Conventional Market.
The Islamic equivalent of a Conventional Bond is called a Sukuk. A Sukuk is essentially an asset-based investment which grants the Sukuk holder an undivided interest in the “underlying asset” in proportion to his or her investment. The Sukuk Certificate is evidence of the ownership component. Hence, the funds raised on the back of an issue of Sukuk notes will be used to invest in the “underlying assets”. The Sukuk holder is therefore entitled to share a proportion of the returns generated by the “underlying assets”. The difference here is that the Islamic investor has an ownership interest in a real “underlying asset” and not just a debt instrument.
The Derivatives & Structured Products Market in Islamic Finance
Islamic Structured Products hold an equally important role within Islamic Capital Markets, given that they are vital in managing and hedging Risk for the Islamic investor. Unlike the Conventional Derivatives Market, which places a strong focus on Credit Risk, Islamic Structured Products attempt to manage Market, Operational, Rate of Return & Equity Investment Risk.
Although this is a heavy topic, we can summarise by sharing the main Products used in the Islamic Structured Products sphere.
Given that we have only touched on the three main drivers of the Islamic Capital Market, we hope it highlights the relative infancy (just the last 40 years) of the Islamic Finance Market compared to that of Conventional Finance. In our third and last part of the series we will attempt to answer the question How Big, is the potential for the Islamic Finance industry?
Ibrahim Schneidawind® is a Swiss based Financial Intermediary offering Independent Investment Management Services, Core-Plus Real Estate and Private Equity Investing. We offer Independent Investment & Wealth Management solutions in both Conventional and Islamic Finance. Ibrahim Schneidawind®, based in the City of Zurich, Switzerland, is a member of the Self-Regulatory body, PolyReg, and is therefore entitled to act as a Finance Intermediary according to Art 2, Para 3 of the Anti Money Laundering Law.
For more information about our Wealth & Investment Management Services in both Conventional & Islamic Finance, please contact us at firstname.lastname@example.org.