Islam prohibits interest and encourages trade. To start a business, one needs to raise capital. One way to do so is by issuing shares to the public. These shares can be traded in the Share Markets or Stock Exchanges. We need to know the way these markets work to decide the permissibility of their practice in Islam. Let us try and study them from an Islamic perspective.
THE PRIMARY MARKET
Stock Exchanges, also called capital markets, have two basic functions. First is to raise capital for the company from the public by selling shares. This is called the Primary market.
Why does a company go to the stock market? Won’t it get a loan from an Investment Bank? Yes, it would but then the company will have to shell out interest payment depending on the risk of the project it seeks to finance. A better alternative would be to go for equity finance rather than debt finance. In equity finance, those who loan you the money become your partners or shareholders. They thus share both profits and losses, unlike banks that demand their fixed return on investment irrespective of how the company fares. Most shareholders will be looking to get a regular return on their investment in the form of a dividend. A dividend is the proportion of the profits made by the company each year that is returned to the shareholders.
The role of a Stock Exchange in the primary market is to liaise with investment banks and businesses that are looking to raise capital by selling shares. This process involves the business being ‘listed’ or ‘floated’ on the Stock Exchange. In this case, the business will effectively get its capital through the initial sale of its shares or securities by creating an I.P.O (Initial Public Offering)
THE SECONDARY MARKET
The second job of the Stock Exchange is to act as an intermediary to bring together those who wish to sell their shares with those who wish to buy. This is called the Secondary market.
People buy shares for a variety of reasons: to secure dividends or to sell them after the price of the shares increases. If people wish to sell shares then it would be very inconvenient for the business itself to take the shares back and then sell them on to someone else. Such a process would be extremely disruptive and impractical. The Stock Exchange, therefore, acts as a market that puts those wanting to sell shares in touch with those seeking to buy. To facilitate this process the market has two main ‘players’ – stock brokers and market makers.
A stockbroker plays in what can be called the retail part of the market. Stockbrokers buy and sell shares on behalf of their clients and generally belong to the firms that are members of the Stock Exchange. They earn their money from charging a commission on each transaction. They might also advise clients on the shares that the client might be thinking of trading. These are known as Full service brokers.
Some stockbrokers may act as ‘execution only’. This means they merely buy and sell shares at low commission rates but do not offer any advice.These are known as Discount brokerages.
Market makers do not earn a commission from their activities. They simply buy and sell shares on their own account but make their money on the difference between the price they pay for buying shares and what they sell them for. This difference is called the ‘spread’. If a market maker bought 400,000 shares in Reliance for Rs 290 each and later in the day sold them for Rs 292, it would have made Rs 800,000. Market makers are usually the big investment and multinational banks and finance companies.
BULLS AND BEARS
Thus the secondary market is the place where all the action takes place. The prices of shares being traded go up and down. Prices fluctuate because the buyers and the sellers have different expectations about the company performance. There are other reasons too that contribute to the shaky share prices like market sentiment, external major events and fluctuating interest rates. When prices of shares keep on increasing, the market is set to be bullish. When the prices of share keep going down, the market is called bearish.
INSTRUMENTS OR PRODUCTS IN SECONDARY MARKET
Rights Issue / Rights Shares
Government securities (G-Secs
FUTURES AND OPTIONS
The Secondary Market is complimented by the Derivatives Market.
is a standardised contract traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price.
A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract at his discretion but a futures contract obligates both parties of a “futures contract” to fulfil the contract on the settlement date.
ISLAMIC POSITION ON SHARES AND STOCKS
The most common position adopted by scholars is as follows. Islam prohibits any fixed return on investment. The idea being as a partner you have to share both profit and loss.
So as an investor in stocks you can grab shares from I.P.Os and let them appreciate in value over a period of time. You can then sell them off for a profit and all this is perfectly lawful as long as the company is not in any haram business like interest-based Banks and financial institutions or liquor and entertainment companies.
Similarly, trading in shares in the secondary market also seems quite legitimate as long as the companies are dealing in halal products and services.
However, Bonds and Gsecs are not permissible as you are getting a guaranteed return on your investment. Futures and Options are also ruled out as you are hedging yourself against any price fluctuation and trying to get a fixed return at a fixed time.
There are some scholars who say that since shares make you partners in the business, it is not halal, as one can hardly find any company in which ‘interest’ does not form part of its financial income. (We now have a DOW Jones Islamic Fund that invests in Shari’ah compliant companies). They further argue that the volatile trading of shares in the secondary market is akin to gambling and the value of stock has no relation to the market fundamentals of the company.
Both positions have proofs and arguments to sell. Whose shares to buy? You decide!
are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security. For example, buying a ‘call option’ provides the right to buy a specified amount of shares at a fixed price at some time on or before expiration, while buying a ‘put option’ provides the right to sell. Upon the option holder’s choice to exercise the option, the party that sold, or wrote, the option must fulfil the terms of the contractis a financial instrument that derives its value from the the value of underlying stocks, bonds, currencies, commodoties. Examples of the financial instruments used in derivative markets are Futures and Options.is a bond that is normally secured / charged against the asset of the company in favour of debenture holder. An unsecured certificate of debt generally issued by a company, municipality or government agency. A bond investor lends money to the issuer and in exchange, the issuer promises to repay the loan amount on a specified maturity date.): These are sovereign (credit risk-free) instruments issued by the Central Bank on behalf of the Government. They are available in wide range of maturity dates, from short term (less than one year) to long term (up to 20 years).: Owners of these are entitled to extra dividend other than the normal dividend obtained through regular Equity shares: Issued free of cost to existing shareholders from the accumulated profits of previous years.: Those issued to existing shareholders proportionate to the number they already hold.: Those entitle its holders to become fractional partners in business with voting rights.