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Islamic capital market in Malaysia

CHAPTER 2

The dual capital market exists in Malaysia, the conventional capital markets operating parallel with the Islamic capital market. Islamic capital market in Malaysia can be divided into the Islamic equity, sukuk and also the Islamic mutual or unit trust fund market. The Islamic Capital Market (ICM) refers to the market where activities are carried out in ways which does not conflict with the principles of Islam. The ICM represents an assertion of religious law in capital market transactions where the market is free from prohibited activities and elements such as riba (usury), maisir (gambling) and gharar (ambiguity). The growing awareness of and demand for investing in accordance to Islamic principles on a global scale has created a flourishing Islamic capital market, more so today due to increasing wealth in the hands of Muslims worldwide who are actively involved in corporate and business activities.

Consider these statistics:

The Muslim population of the world today is estimated at about 1.5 billion, representing a sizeable 24% of total world population of 6.3 billion

Latent Islamic funds in global financial institutions is said to be at US$1.3 trillion while the Islamic financial market is estimated to be US$230 billion in size, with an annual growth rate of 12% to 15%

There are over 250 Islamic financial institutions currently operating in about 75 countries worldwide, with more than 100 Islamic equity funds managing assets in excess of US$5.0 billion. Indeed, the pace of development in the Islamic financial market has gathered momentum with the formation of various international Islamic organisations to study and promote this alternative market. These organisations include the Islamic Financial Services Board (IFSB), the International Islamic Financial Market (IIFM) and the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). Today, the Islamic financial market runs parallel to the conventional financial market and provides investors with an alternative investment philosophy that is rapidly gaining acceptance. The fact that the Islamic financial market does not prohibit participation from non-Muslims creates unlimited upside to the depth and breadth of this market.

MALAYSIA PIONEERING THE ICM

The ICM functions as a parallel market to the conventional capital market for capital seekers and providers. It has played a complementary role to the Islamic banking system in creating a comprehensive Islamic financial market in Malaysia. Malaysia has been recognized as the pioneer and at the forefront in Islamic finance. Presently, Malaysia far surpasses other Muslim countries in terms of market infrastructure with unflagging support by the Government providing the impetus for growth of the local ICM.

MILESTONES

Malaysia has pioneered many ‘firsts’ and the key milestones paving the way for Malaysia to be a leading ICM. Among them are:

The establishment of the first Islamic equity unit trust fund, Arab Malaysian Tabung Ittikal (1993).

The first full-fledged Islamic stockbroking company, BIMB Securities Sdn Bhd (1994).

The Securities Commission formed an Islamic Capital Market Unit which later evolved into a full-fledged department (1995). The Shariah Advisory Council (SAC) was later established (1996).

The Minister of Finance launched the Capital Market Masterplan of which 13 recommendations were formulated, establishing Malaysia as an international centre for Islamic capital market activities (2001).

Introduced the first global corporate Sukuk, The Guthrie Sukuk, this created a paradigm shift in the international Islamic financial market (2001)

Introduced the first global sovereign Sukuk, The Malaysian Government Sukuk, which was more than twice over subscribed (2002).

The Malaysian Government is actively promoting the Labuan International Offshore Financial Centre as a global centre for the ICM.

A comprehensive tax incentive package for Islamic securities similar to conventional securities was proposed under the Federal Budget 2004, and has since been implemented.

Dubai financial services authority (DFSA) signed a mutual recognition agreement with securities commission, the agreement open opportunity for distribution and marketing of Islamic fund between Malaysia and Dubai (2007).

Flolating of Asia’s first shariah compliant exchange traded fund (ETF) on Bursa Malaysia (2008)

Bursa Suq Al-Sila was launched in 2010. This is the first commodity trading platform to facilitate Islamic liquidity management and financing by Islamic banks.

FURTHER PROGRESS UNDER THE CURRENT LEADERSHIP

Advancement of the ICM under the current Government is greatly expected and anticipated especially with the introduction of the concept of Islam Hadhari. In addition, Malaysia bears the testimony of being recognized as a leader by other Islamic countries, testified by its appointment to the Chairmanship of the Organization of Islamic Conference (OIC) and Non-Aligned Movement (NAM). This reaffirms Malaysia’s leadership role in the developing world generally as well as the Islamic world specifically. As a global spokesperson, it is imperative that Malaysia leads by example. There has also been positive recent developments towards creating a more liberalized market, among these efforts include:

Liberalisation of foreign participants. These involve:

Issuance of 5 new licenses to foreign stockbrokers.

Issuance of up to 5 new licences to foreign fund managers.

Provision for 100% foreign ownership in futures broking industry.

No restrictions on the number of foreign dealer representatives.

Liberalisation of foreign exchange controls allowing Malaysians to now invest abroad.

SHARIAH STATUS AT PRE-LISTING

Previously, Shariah compliance reviews were only conducted on companies after they were listed on Bursa Malaysia. Since October 2004, however, companies applying to be listed can now request for the Shariah review process to be conducted simultaneously with the company’s application to list. This is in line with the Government’s aim of developing the ICM and it is encouraging to note that by the end of 2004, 3 companies had requested for this review.

THE ONSHORE ISLAMIC CAPITAL MARKET

Malaysia is the first Islamic country to have demutualised its exchange, Bursa Malaysia Berhad, and list on its own bourse. Bursa Malaysia Berhad listed on 18 March 2005, represents a single consolidated group comprising equities, derivatives and offshore markets. The equities market is then subdivided into the Main Board, Second Board and a high growth market called MESDAQ.

Bursa Malaysia has several market attractions which include:

A growing market in terms of market capitalisation and number of listed companies (The number of listed companies grew by 34% (253) to 989 as at end April 2005, compared to 736 in 1998. Market valuation touched RM689 billion (US$181 billion) as at end April 2005).

Improving liquidity via improved “free float” – the Government’s investment arm, Khazanah is divesting RM246 billion (US$65 billion) in equities and shares in 40 Government-linked companies which it owns, accounting for 35% of the total market capitalization.

There are 231 listed companies with market capitalisation above US$100 million, testifying to the growing depth of the market.

Active trading activity – total market transacted value is RM70 billion (US$18 billion) and total market transacted volume is 37 billion units.

Bursa Malaysia has in its “stable” almost 1000 listed companies which cuts across over 50 different economic activities.

There is diversity in investors’ demography. 20% of shares listed on Bursa Malaysia are foreign owned and foreign trades make up around 30% of overall trade value in daily trading.

Bursa Malaysia promotes only the best corporate governance practices. For example, there is a mandatory quarterly reporting requirements and 1/3 of the board of directors in a public listed company is required to consist of independent directors. Among the Malaysian firsts in corporate governance include:

First to have a comprehensive code for corporate governance in March 1999.

First to have mandatory training for directors of listed companies.

First in the region to set up an accounting standards board, the Malaysian Accounting Standards Board (MASB).

First to revamp listing requirements in the region.

First in the region to set up Minority Shareholders Watchdog Group.

The establishment of the Malaysian Institute of Integrity (IIM).

With the complexities of the capital market and the various instruments on offer today, clearly an authoritative body is required to define and provide guidance on what is and is not permissible under Islamic law. It is imperative that this body must possess adequate infrastructure to enable the system to operate and function efficiently and effectively. Towards this end, the Islamic Capital Market Unit within the Securities Commission’s Market Policy and Development Division has been mandated to research and develop products and activities pertaining to the ICM in Malaysia.

ROLE OF SHARIAH ADVISORY COUNCIL (SAC)

The main thrust of ICM products is compliance to Islamic principles. To this end, the Shariah Advisory Council was established in 1996 primarily:

To advise the Securities Commission on Shariah-related matters.

To provide Shariah guidance on ICM transaction and activities, aimed at standardising and harmonising applications.

Primary sources of research and reference are the Quran and Sunnah, while secondary sources include Ijmak, Qiyas and Maslahah. Product origination and innovation are based on various Islamic concepts such as Ujrah, Bai’ Dayn, Ijarah, Istisna’, Mudharabah, Murabahah, Qardhul Hasan and Musharakah. The determination whether a particular stock is Islamic or not are based on the sources of income received by the corporation. There are 4 ratios called benchmark ratios of 5%, 10%,20% and 25% which determines the Shariah status of the corporate body and hence its securities and shares.

SELECTION PROCESS

The SAC of the Securities Commission established under section 18 of the Securities Commission Act 1993, was given the mandate to ensure that the running of the Islamic capital market complies with Shariah principles. Its scope of jurisdiction is to advise on all matters related to the comprehensive development of the Islamic capital market, and functions as a reference centre for issues related to the Islamic capital market. The members of the SAC consist of Islamic scholars/jurists and Islamic finance experts. The list of securities approved by the SAC is updated annually in April and October. The approved securities include ordinary shares, warrants and transferable subscription rights (TSRs). This means that warrants and TSRs are also classified as approved securities from the Shariah perspective, provided the underlying shares Shariah compliant. On the other hand, loan stocks and bonds are only Shariah compliant if they are issued based on Shariah principles. Two phases of compliance review process are qualitative parameters and quantitative parameters.

THE PARAMETERS:

QUALITATIVE PARAMETERS

The general criteria in evaluating the status of Shariah-approved securities are that the companies are not involved in the following core activities:

Financial services based on riba (interest).

Gambling.

Manufacture or sale of non-halal products or related products.

Conventional insurance.

Entertainment activities those are non-permissible according to Shariah.

Manufacture or sale of tobacco-based products or related products.

Stockbroking or share trading in non-Shariah approved securities.

Other activities deemed non-permissible according to Shariah.

The SAC also takes into account the level of contribution of interest income received by the company from conventional fixed deposits or other interest-bearing financial instruments. In addition, dividends received from investments in non-Shariah approved securities are also considered in the analysis carried out by the SAC. For companies with activities comprising both permissible and non-permissible elements, the SAC considers 2 additional criteria:

The public perception or image of the company, which must be exemplary.

The core activities of the company must be considered maslahah (in the public interest) to the Muslim ummah and the country, and the non-permissible elements present must be minimal and involves matters such as `umum balwa (common plight and difficult to avoid) and `uruf (custom).

QUANTITATIVE PARAMETERS

To determine the tolerable level of mixed contributions from permissible and non-permissible activities towards revenue and profit before tax of a company, the SAC has established several benchmarks based on ijtihad (reasoning from the source of Shariah by qualified Shariah scholars). If the contributions from non-permissible activities exceed the benchmark, the securities of the company will not be classified as Shariah approved. SAC uses the following benchmarks (Securities Commission, 2009):

The 5% benchmark

This benchmark is used to assess the level of mixed contributions from the activities that are clearly prohibited such as riba (interest-based companies like conventional banks), gambling, and activities derived from liquor and pork which are deemed haram (prohibited).

The 10% benchmark

This benchmark is used to assess the level of mixed contributions from the activities that involve the element of umum balwa (a prohibited element affecting most people and difficult to avoid). An example of such a contribution is the interest income from fixed deposits placed in conventional banks. This benchmark is also used for tobacco-related activities.

The 20% benchmark

This benchmark is to assess the level of contribution from mixed rental payment from shariah non compliant activities such as the rental payment from the premise that involved in gambling, sale of liquor and etc.

The 25% benchmark

This benchmark is used to assess the level of mixed contributions from the activities that are generally permissible according to Shariah and have an element of maslahah (public interest), although there may be other elements that could affect the Shariah status of these activities. Among the activities that belong to this benchmark are hotel and resort operations, share trading, stockbroking, as these activities may also involve other related activities that are deemed non-permissible according to Shariah rules. In a bid to promote understanding of Shariah approved securities.

BURSA MALAYSIA’S SHARIAH MARKET

As at 31 May 2010 there are 847 stocks which are Shariah compliant. These stocks then represent the components of Bursa Malaysia’s Shariah Index, amounting to 88% of the total listed companies or 63.0% of the market capitalisation. These Shariah compliant stocks are derived from all 3 sub-markets within Bursa, namely the Main Board, Second Board and the MESDAQ market..

SHARIAH INDEX

The Shariah Index was launched in April 1999 to meet the demands from local and foreign investors who seek to invest in securities which are consistent with the Islamic principles of Shariah. Investors seeking to make investments based on Shariah principles now have a benchmark towards making better informed decisions. The Shariah Index is a weighted-average index with components comprising the securities from the Main Board which have been approved by the SAC. The index tracks the performance of these Shariah approved securities and is regularly updated to reflect changes in the SAC’s Shariah approved list of companies.

ISLAMIC INVESTMENT AND SERVICES

Malaysia offers a holistic set of ICM infrastructure ranging from products, stockbrokers, trust funds and debt securities (bonds). Presently, there is one full-fledged Islamic stockbroking company with 3 other conventional stockbroking companies that provide Islamic windows in the ICM. In fulfilling the need of specific needs of private investors, there are also asset management companies that manage funds in accordance to the Shariah principles. Although this activity is fairly new compared to Islamic unit trusts, the interest among high networth Muslim investors to engage professional managers to invest their funds has been increasing of late. Another significant development in the ICM intermediation activities and services is the role of independent Shariah advisers for the purpose of facilitating the issuance of Islamic corporate bonds. In 2004 alone, there were 16 new Shariah based unit trust funds introduced to the ICM, statistically, 24.4% of all unit trust funds approved in the industry are Shariah compliant.

ISLAMIC PRIVATE DEBT SECURITIES

SELECTION PROCESS

Islamic financial instruments to be listed on the LFX will require endorsement by the Shariah Council of their country of origin or from any internationally accepted Shariah Council.

PARAMETERS

The respective issuance for listing should not be less than US$100 million for debt securities.

DEVELOPMENTS OF ISLAMIC INSTRUMENTS ON LFX

The development of the international Islamic capital market augurs towards the development of Islamic instruments on LFX. Currently, there are 5 listed instruments that are deemed Islamic with a total market capitalisation of US$2 billion representing 18% of the total market capitalisation.

The instruments are:

i. US$150 million Serial Islamic Lease Sukuk by First Global Sukuk Inc

The US$150 million Islamic Lease Sukuk is part of a US$395 million Serial Islamic Sukuk issuance that Bank Islam (Labuan) Limited has been mandated to arrange by Kumpulan Guthrie Berhad (Guthrie). In December 2000, Guthrie was granted a RM1.5 billion (US$400 million) Al-Ijarah Al-Muntahiyah Bit-Tamik by a consortium of banks.

The original facility was raised to re-finance Guthrie’s acquisition of a palm oil plantation in the Republic of Indonesia. The consortium was then invited to participate as the underwriter/primary subscriber of the Sukuk Transaction.

ii. US$600 million Sukuk Al-Ijarah Trust Certificates by Malaysian Global Sukuk Inc

Malaysia Global Sukuk Inc. was incorporated in Labuan under the Offshore Companies Act, 1990 on 3 June 2002. The authorised share capital of the issuer is US$12,000, of which 2 ordinary shares are owned by The Ministry of Finance Inc., a body corporate established under the Minister of Finance (Incorporation) Act 1957.

The purpose of the transaction was to enable the Government of Malaysia to raise financing in accordance with Shariah principles. All payment obligations raised under the transaction documents rank “pari passu” with its senior, unsecured foreign currency debt obligations.

iii. US$700 million Sukuk Trust Certificate by Qatar Global Sukuk QSC

The transaction involves Qatar Global Sukuk QSC (QGS) issuing rated trust certificates (Sukuk), the proceeds of which will ultimately be used for general funding purposes by the Government of the State of Qatar. The rationale for this transaction is to allow the Government of the State of Qatar to raise shariah compliant funds.

QGS will purchase a certain land parcel from the Government of the State of Qatar. The land parcel will be leased by QGS to the Government of the State of Qatar for a 7-year period corresponding to the duration of the trust certificates. The land parcel excludes all buildings and all other fixtures, thus, construction and completion costs for the building and fixtures are paid for by the government.

QGS declared that it will hold these assets in trust for the holders of the trust certificates. The lease rental payment from the Government of the State of Qatar to QGS will exactly match the periodic distribution payments payable on the trust certificates. The lease rental payment is calculated based on -month U.S. dollar LIBOR plus a margin.

iv. US$250 million Sukuk Trust Certificate by BMA International Sukuk Company

The Kingdom of Bahrain, acting through the Ministry of Finance and National Economy (in such capacity, the Head Lessor), will lease by way of head lease for a term of 100 years a certain land parcel to the Issuer pursuant to the Al-Ijarah Head Lease Agreement.

The Kingdom of Bahrain, acting through the Ministry of Finance and National Economy, (in such capacity, the Sub-Lessee), will lease by way of sub-lease from the Issuer the Land Parcel on the terms set out in the Al-Ijarah Sub-Lease Agreement for a period of 5 years commencing on the Closing Date and terminating on the Periodic Distribution Date falling in June 2009. The sub-lease is subject to earlier termination if the trust is dissolved early.

v. US$350 million Sukuk Trust Certificates by Sarawak Corporate Sukuk Inc. (SCSI)

Sarawak Economic Development Corporation (SEDC) raised financing amounting to US$350 million by way of issuance of series of trust certificates issued on the principle of Sukuk Al-Ijarah. For purposes of the proposed Sukuk, SCSI was incorporated on 23 November 2004 as a special purpose company, under the Offshore Companies Act (OCA), 1990 in Labuan.

The certificates were issued with a maturity of 5 years and under the proposed structure, the proceeds will be used by the issuer to purchase certain assets from 1st Silicon (Malaysia) Sdn Bhd. Therafter, the Issuer will lease assets procured from 1st Silicon to SEDC for an agreed rental price for an agreed lease period of 5 years. The rental payable by SEDC will be supported by the State Government of Sarawak via a letter of support.

MARKET CAPITALISATION OF ISLAMIC INSTRUMENTS LISTED ON LFX

To further enhance its global reach, LFX has established a Memorandum of Understanding with the International Islamic Financial Market (IIFM) and Bahrain Stock Exchange in Bahrain. The MOU would provide greater co-operation and pave the way for both organisations to develop the International Islamic capital market by developing channels of communications and exchange of information specifically for activities involving primary listings and the promotion of a secondary Islamic financial instruments market. LFX will continue to increase its efforts to further develop in tandem with the development of the Islamic capital market internationally.

EQUITY-BASED ICM PRODUCTS

In the early stages of the development of the Islamic financial system in Malaysia, the capital market played a relatively minor role as the Islamic banking system, which was first introduced in the early 1980s, had provided for most of the financing need for Islamic economic activities. Nevertheless, Islamic investment activities can be traced back to the mid-1960s when Lembaga Tabung Haji (then known as Lembaga Urusan & Tabung Haji) began to manage funds belonging to Muslims planning to perform pilgrimage in Mekah, in accordance to Islamic principles. The significant development in the Islamic capital market (ICM), however, is more apparent in the 1990s when more companies and other entities began to source for funds from the capital market to finance their economic activities. Concurrently, with the introduction of Syariah-approved securities on the Kuala Lumpur Stock Exchange (KLSE), investors started to invest in these securities through market intermediaries that operate in accordance to Syariah principles. Since then, the ICM has been increasingly accepted as an alternative market for capital seekers and providers. Indeed the development of the ICM has further broadened and deepened the Islamic financial markets in Malaysia.

Participation in the ICM was minimal in the 1970s and 1980s as there was insufficient clear guidance on the securities that can be invested and traded by Muslim investors. Although investments in equities are generally permissible, the lack of clear guidance and authoritative view made it difficult for Muslim investors to identify securities that were deemed permissible from the Syariah point of view. Companies that issue securities to investors are involved in various kinds of business activities and some of these activities were not deemed permissible for Muslims to invest as the returns in the form of dividends or capital gains could contain non-permissible elements.

This, to a large extent, had left the Muslims behind in this economic activity that had, since the early 1980s undergone rapid growth and transformation from a simple to a much more sophisticated market. In responding to the need for such investment guidelines, Bank Islam Malaysia Berhad took the early initiative to review and identify companies considered to be permissible for Muslims to invest. This was a watershed. Bank Islam had provided the investors with the list of Syariah permissible shares ("halal counters") by excluding shares of companies that were involved in activities containing non-permissible elements such as riba, gambling and gaming, non-halal food and liquours activities.

The effort was given a further boost with the introduction of the Syariah approved securities list in June 1997 by the Securities Commission's Syariah Advisory Council (SAC). In the process of determining the Syariah status of the listed securities, the SAC had developed several basic Syariah criteria as a guidance. The criteria were structured based on the Quran and the Sunnah as well as the general principles of Syara'. In this process, the SAC focused on the core activities of the companies such as goods and services that were offered to their customers. T he Syariah approved securities list is updated regularly by reviewing the companies' annual financial reports, responses to a survey aimed at obtaining detailed information and through specific inquiries made with the respective company's management. The updated list is officially released to the public in the month of April and October of every year. The release of this list has, to large extent, given investors the necessary guidance, opportunities and also confidence in choosing and investing in listed securities that comply with Syariah principles.

For Muslim investors who prefer their investments to be managed professionally, they could do so by investing in Islamic unit trusts. Just like conventional unit trusts, Islamic unit trusts are regulated under the Guidelines on Unit Trust Funds. For Islamic funds, additional provisions are provided under certain chapters of the Guidelines which requires the establishment of a Syariah committee whose members are subject to the approval of the Commission. A management company of an Islamic fund together with their Syariah committee will generally subscribe to the Commission's list of Syariah approved securities for investment guidance. Since the early 1990s, the number of Islamic unit trust funds grew steadily. As at end of December 1993, there were 2 Islamic unit trust funds, but this has increased to 44 funds as at 31 December 2002 with the total net asset value (NAV) and total units in circulation amounted to RM3.21 billion and 5.76 billion units respectively.

The availability of a clear guidance for investment in the Syariah-approved securities has also facilitated the innovation of an Islamic stock market benchmark to measure the Islamic equity performance. There are currently two Islamic indices available for market participants. The first Islamic index, the RHB Islamic Index (RHBII) was introduced on 10 May 1996 by RHB Unit Trust Management Bhd. The second index, which is the KLSE Syariah Index (KLSI) was introduced on 17 April 1999. The KLSI is a broad-based price-weighted average index, constructed from the list of the Commission's Syariah-approved securities that are listed on the KLSE's Main Board. The existence of KLSI has opened up the opportunity to the unit trusts industry to innovate and offer an index-based fund. This was clearly the case when the first Islamic index fund called MBf Syariah Index fund was launched in January 2002.

DEBT BASED ICM PRODUCTS

Congruent to the increased interest in the further application of Islamic products, Islamic bond market has been identified as an alternative instrument for financing and investment. The growing interest to use Islamic bonds can be traced back in the early 1990s when major corporations such as Shell MDS and Petronas Dagangan raised a significant amount of fund through the application of Islamic bonds. Since then, a number of Islamic bonds have been issued by both the private and public sectors to finance their long term funding needs. The Islamic bonds are usually structured along the basic Islamic concepts and principles of Murabahah, Bai' Bithaman Ajil, Qardhul Hasan, Istisna', Ijarah and Mudarabah. One of the earliest Islamic bond is the Government Investment Issue or Gil (formally known as the Government Investment Certificate or GIC) which is issued by the Government to provide liquidity and to facilitate the management of assets in the Islamic banking system. The issuance of Gil is based on the Islamic concept of Qardhul Hasan. The first issue was made in 1983 upon the inception of Bank Islam and the demand for these Islamic instruments increased significantly since March 1993 following the establishment of Islamic windows and interest-free banking schemes by conventional banking institutions. In a more recent development, we have seen the issuance of Malaysian Savings Bond by Bank Negara Malaysia for the retirees who wish to invest in fixed income instrument, in the Islamic way. In this case, the instrument is structured along the principles of Bai' Inah.

Being an investment arm of the Government, Khazanah Nasional Bhd took the initiative to support the promotion of ICM products with the issuance of a series of zero-coupon bonds aimed at facilitating the price discovery process in both the primary and secondary bond markets. These Khazanah bonds were structured based on the principles of Murabahah and Bai' Dayn. In facilitating the issuance of the Khazanah bonds, the Commission's SAC was involved in providing their Syariah views on the features of the bonds to ensure that they complied with the acceptable Syariah principles and concepts. The first series of Khazanah bonds was issued in September 1997 and as at 31 December 2002 the outstanding amount stood at RM 10 billion.

Applying the principles of Bai' Dayn and Mudarabah, Cagamas Berhad (National Mortgage Corporation) introduced the Cagamas Mudarabah Bonds in May 1993. They were the first Islamic mortgage-based securities in the world to be issued under the structure of Islamic securitisation and based on the Syariah principle of Mudarabah. It was structured in such a way to facilitate the financing for the purchase of Islamic housing loans from Islamic banking systems.

In response to the demand for Islamic products, Cagamas also issued new Cagamas Mudarabah Bonds to purchase Islamic hire purchase receivables (AITAB) from Islamic banks. The success of Cagamas in issuing Islamic bonds has encouraged many corporations to raise funds through the issuance of bonds under Islamic principles. The issuance of Islamic corporate bonds, including short-term Islamic commercial papers, are normally structured based on the Islamic financing principles of Bai Bithaman Ajil, Murabahah, Ijarah and Istisna'. Similar to conventional corporate bonds, Islamic corporate bonds must be rated by rating agencies. Since July 2000, the issuance of conventional corporate bonds and Islamic corporate bonds must comply with the Guidelines on the Offering of Private Debt Securities (PDS Guidelines) and other related SC's guidelines. In 2002, Islamic corporate bonds have exceeded more than half of the total funds raised in the corporate bond market in Malaysia.

ICM INTERMEDIARIES & SERVICES

Taking cognisance of the need of Muslim investors to trade and invest in the stock market, Islamic stockbroking services began to emerge in 1994 with the setting up of a full-fledged Islamic stockbroking company by the first Islamic bank in the country. In 1998 a second full-fledged Islamic stockbroking company was established. In addition to these two stockbroking companies, other conventional stockbrokers have indicated their interest in this specialised business. As of today, three Islamic windows are operating side-by-side with their conventional stockbroking services. In fulfilling the specific needs of private investors, there are also asset management companies that manage funds in accordance to Syariah principles. Although this activity is fairly new compared to Islamic unit trusts, the interest among high net worth Muslim investors to engage professional managers to invest their funds has been increasing gradually. This is evident with the existence of few asset managers that are managing individual funds in accordance to Syariah principles.

Another significant development in the ICM intermediation activities and services is the role of independent Syariah advisers for the purpose of Islamic corporate bonds issues. Paragraphs 30 to 33 of the PDS Guidelines provide the requirement for the Syariah adviser to advise on all aspects of Islamic corporate bonds including documentation, structuring and investment. As at 31 December 2002, there were five independent Syariah advisers approved by the Commission for the purpose of providing advice on Islamic corporate bond issues. In addition, the existing Syariah committees of an Islamic bank or a licensed institution approved by Bank Negara to carry out Islamic Banking Scheme can also be engaged by the issuer for the same purpose.

In achieving this, the Commission had established an informal group called the Islamic Instruments Study Group (IISG) in 1994 to facilitate the process of reviewing and appraising research findings undertaken by the ICMU, and to provide a means for the ulama' to understand the capital market from a regulatory and developmental perspective. The IISG was subsequently replaced by the SAC in May 1996 as part of the broader objective to streamline policy-related Syariah compliance issues and to act as a centre of reference for any unresolved Syariah issues.

To attract more participants into the ICM, a wide range of commercially viable and acceptable instruments must be made available to cater for the various needs and demands of market participants. The ICM products must also be at least equal to if not better than the conventional products in terms of its risk-return profile and cost competitiveness. In addressing this issue, the Commission has adopted a two-pronged approach. The first strategy is to identify existing conventional capital market instruments that are acceptable to Islam and can be adopted by the ICM. This strategy is adopted on the premise that irrespective of their origin, conventional financial instruments that do not contain prohibited elements such as riba, maisir and gharar, and found suitable with the teaching of Islam should be adopted and utilised by the industry players. Recognising the rich heritage of Islamic contracts and the richness of Islamic fiqh, the development and innovation of new ICM instruments are essential to support the first strategy. Compared to conventional market, the ICM has relatively fewer acceptable instruments.

Nevertheless, the process of developing and innovating new Islamic instruments are more demanding and challenging as they require the ability to structure products which are consistent with Syariah principles and also consistent with the commercial legal system of the country. Another important aspect in developing the ICM is the provision of training and education to ensure that investors and market participants posses strong appreciation and understanding on the ICM operations. Through the Commission's education arm, the Securities Industry Development Centre (SIDC), various programmes have been organised for this purpose. In 1996, 1997 and 2002, three international ICM conferences were organised to discuss issues on the Islamic capital market. Several workshops were also held for specific group of industry players such as market intermediaries, remisiers, academicians, students and the public. Such efforts to educate and to create greater awareness among investors and to enhance the skills and expertise of market participants will be done continuously and extensively to promote and strengthen the ICM in Malaysia.

Critical for the development of ICM, that is: establishing the necessary infrastructure support, increasing the scope of ICM instruments, and enhancing awareness, knowledge and skills among industry participants. While these would not necessarily guarantee the success of the ICM, they would to a large extent support the progress towards that direction. In addition, co-ordinated efforts should also be made by both the private and public sectors, and Syariah scholars as well, to ensure that the ICM would continuously be supported, and possesses the relevant infrastructure, expertise and acceptable products needed to attract Muslim investors, both local and foreign, to the ICM.

The role of capital markets in promoting an efficient financial system cannot be overemphasized. Given that a developed financial system can make positive contributions to economic development, the existence of vibrant capital markets becomes a necessity for any economy. Capital markets facilitate long-term financing for businesses and entrepreneurs by attracting savings from a large pool of investors. These markets provide long-term capital to entrepreneurs through a series of short-term contracts (securities) with investors who may enter and exit the market at will. An efficient capital market is expected to perform the following functions:

To provide a resource mobilization mechanism leading to an efficient allocation of financial resources in the economy.

To provide liquidity in the market at the cheapest price, i.e., the lowest transaction cost or low bid-ask spread on the securities being traded in the market.

To ensure transparency in the pricing of securities by determining the price of the risk premia, reflecting the riskiness of the security.

To provide opportunities for constructing well-diversified portfolios and to reduce the level of risk through diversification across geographic regions and across time.

Capital markets consist of primary and secondary markets. Whereas primary markets are important to raise new capital and depend on the supply of funds, secondary markets make a significant contribution by facilitating the trading of existing securities. In some ways, secondary markets play an equally critical role by ensuring liquidity and fair pricing in the market and by giving valuable signals about the security. In other words, secondary markets not only provide liquidity and low transaction costs, they also determine the prices of the securities and their associated risk on a continuous basis, incorporating relevant new information as it arrives.

Just as capital markets play a critical role in the conventional financial system, their role in the Islamic financial system is also equally important. Whereas conventional capital markets have an established and long-running track record, Islamic capital markets are at a rather early stage of development. Conventional capital markets have two main streams: the securities markets for debt trading and the stock markets for equity trading. As we have already discussed, 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 in consonance with the Shariah's 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.

The need for capital markets was realized at the early stages of development of the Islamic financial industry, but not much progress was made. During the 1980s and 1990s, IFIs mobilized funds successfully through growing deposits, which were invested in a few financial instruments, mostly dominated by commodities or trade-financing. Due to the limited investment opportunities, lack of liquid assets and other constraints, the composition of IFIs' assets side remained fairly static and heavily focused on short-term instruments. The main areas of concern were the lack of portfolio and risk management tools and the absence of derivative instruments. With continuing demand for shariah-compliant financing, there was a pressing need to develop capital markets to facilitate long-term, shariah-compliant financing for businesses and to create portfolio diversification opportunities for investors and financial intermediaries.

By the late 1990s, Islamic financial markets had realized that the development of capital markets was essential for their survival and further growth. Meanwhile, the wave of deregulation and liberalization of capital markets in several countries led to close cooperation between IFIs and conventional financial institutions to find solutions for liquidity and portfolio management. Since then, several efforts have been made in this respect, especially in two areas. The first is the development of a debt-like security in the form 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 became 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 ot 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.

DEVELOPMENT OF EQUITY MARKETS

The Islamic economic system relies upon vibrant markets for equity-based securities. 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 and the foremost 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 Musiwmkali) 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 wherefrom the basic concept of a juridical person may be derived by inference in Islamic Fiqh.

CONTRACTUAL STRUCTURE OF AN EQUITY STOCK

The second issue is related to the type of contract most appropriate to represent a common share as a partnership in a joint stock company. The Shariah identifies two broad categories of musharakah contracts, Musharakah Mulk giving the partner ownership rights to a specific real asset and Musharakah Aqed, granting the partner ownership rights to the value of assets without any specific linkage to any real asset. It is important to understand this distinction. For example, if a stock is represented as Musharakah Mulk, then buying and selling of stock will be equivalent to buying and selling an identifiable real asset and hence becomes subject to the rules applicable for bay' (trade/sale). On the other hand, if a stock is treated as Musharakah Aqed, then it is not subject to bay' rules but this raises other issues such as trading, valuation, and possession. A review of current rulings indicates that the joint stock company has been treated as a new form of Musharakah which is neither a Musharakah Mulk or Musharakah Aqed, but a combination of the two, in that the rulings regarding buying and selling stocks are largely treated under the former, while shareholder rights and basic investment operations are treated under the latter. This adds to the confusion surrounding the issue. Shabsigh (2002) argues that classifying the joint stock company as Musharakah Mulk renders most transactions in a stock market illegal from the Sharialis point of view.

NEGOTIABILITY AND TRADABILITY

The third structural issue to be resolved is the most critical of all and is related to the negotiability, transferability and tradability of stocks in primary and secondary markets. While Islamic law encourages trading and markets in all tangible goods and properties, it restrains, if not prohibits, the trading of financial interests under the suspicion of trading leading, through a back­door, to the prohibited element of Riba. The law blocks trading in monetary obligations (such as Dayn (debt), currency, or equivalents of currency), obligations demarcated in generic goods (e.g., so many bushels of a particular grade of wheat), and even contingent or future rights generally. For example, the Shariah ruling being followed at present is that the stocks of a company are negotiable only if the company owns some non-liquid assets. If all the assets of a company are in liquid form, i.e., in the form of money, then the stock cannot be purchased or sold, except at par value, because it is argued that in this case the stock represents money only and money cannot be traded except at par. With the changing economic structure where there are a large number of economic entities engaging in providing services and holding illiquid assets, this poses serious problems. Consequently, a financial intermediary cannot exist in the form of a public company. In addition to these structural issues requiring serious analysis and debate, there are several operational aspects of conventional stock markets which are in direct conflict with the principles of Islamic markets. The following three operational differences are noteworthy.

ISLAMIC BONDS — SUKUKS

Efforts to develop and launch a shariah-compatible bond-like security were made as early as in 1978 in Jordan where the government allowed the Jordan Islamic Bank to issue Islamic bonds known as Muqaradah bonds. This was followed by the introduction of the Muqaradah Bond Act of 1981. Similar efforts were made in Pakistan where a special law called the Mudarahah Companies and Mudarahah Flotation and Control Ordinance of 1980 w7as introduced. Neither of these efforts resulted in any noteworthy activity, because of the lack of proper infrastructure and transparency in the market. The first successful introduction of Islamic bonds was by the Malaysian Government in 1983 with the issuance of the Government Investment Issues (Gil) — formerly known as the Government Investment Certificates (GIC). The pace of innovation was very slow and IFIs were unable to develop an active market for such securities. Meanwhile, the success of securitization of assets in the conventional markets provided a framework which could work for Islamic assets as well.

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