CHAPTER 2

Institutions and Markets

2.1 Islamic Approach to the Implementation of Islamic Financial System

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.

2.4 Structures of Financial Markets

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.

Based on the Instrument

The financial market structure that is based on instruments can be divided into debt
markets and equity markets. In other wards, there are two ways for firms or
government agencies to raise funds in a financial market: by issuing debt securities
(bonds) or equity securities (stocks). Issuing a debt instrument is the most common
method of raising funds. This debt instrument represents a contractual agreement
whereby the borrower is obliged to pay the holder of the instrument a certain fixed
amount of money at agreed intervals. The return to investors is in the form of interest
income (coupon payments). Upon maturity, the principal amount will be paid to the
investors. Depending on the maturity, a debt instrument can be a short term
instrument if its maturity is less than a year, intermeduate term instrument if its
maturity is between one and 10 years, or long term instrument if its maturity is 10
years or longer. Long term debt instruments tend to bear more risk and are expected
to yield a higher expected return than short term instruments.
Essentially, the interest or coupon payments embedded in debt instruments like bond
clearly violate the Shariah principles. Under Shariah, loan contracts must always be
interest free. Any additional benefit to the lender in a loan contract either monetary or
in kind is deemed a form of riba, which is prohibited in Shariah. This prohibition is
evidenced in many verses of the Quran and the sayings of the Prophet (p.b.u.h.).

Alternatively, debt securities in Islamic debt market is structured based on Islamic

debt certificates like Sukuk which actually resembles the features of conventional
bonds representing debt or borrowed funds by the issuer. However, unlike bonds
which are merely based on loan contracts that generate interest through coupon,
sukuk rarely use loan contracts because there is no value-added return to investors
from the contract due to the Shariah prohibition of riba in loan transactions. Instead,
sukuk is structured based on a variety of Shariah compliant contracts to create the
asset and financial obligations that are to be represented by sukuk. For example, the
asset or financial obligations between the issuers and subscribers (investors) can be
created via Shariah permissible contracts of sales, leasing, equity partnership and
joint partnership. The return on investment is derived from the profits generated from
these sales or leasing contracts as well as the profit sharing mechanism in the
partnership contracts.

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.

Based on the Issuance of Securities

People or firms in financial markets can sell new securities and resell old securities
issued by them or others. A primary market is a market where new issues of
securities such as bonds and stocks are sold by the initial issuer, such as firms or the
government selling to the first buyer or creditor who wishes to buy. However, primary
markets are not as well known as secondary markets, and in fact most trades are not
done in primary markets. Why? This is because most of the trades in primary
markets are done behind closed doors. Investment banks are the main players in
primary markets through underwriting securities, by which the bank guarantees a
price for a firms securities and then sells the securities to the public.

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.

Methods Used in Secondary Markets

There are two methods in which secondary markets are conducted exchange
markets and over-the-counter (OTC) markets. An OTC is a decentralized market of
securities not listed on an exchange where market participants trade over the
telephone, facsimile machines, or electronic networks instead of on a physical
trading floor. There is no central exchange or meeting place for this market. In the
OTC market, trading occurs via a network of middlemen called dealers, who carry
inventories of securities to facilitate the buy and sell orders of investors, rather than
providing the order matchmaking service seen in specialist exchanges such as the
KLSE.

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.

Based on the Maturity

The last method in structuring the financial market is based on the basis of maturity
of the securities traded in each market. The money market is a segment of the
financial market in which financial instruments with high liquidity and very short
maturities are traded. The money market is used by partipants as a means for
borrowing and lending in the short term, from several days to just under a year.
Money market securities consist of negotiable certificates of deposit (CDs) or Islamic
negotiable instruments of deposits (INIDs), bank acceptances, Treasury bills, or
Islamic accepted bills, commercial papers, municipal notes, repurchase agreements
(repos) and short term sukuk. The money market is used by a wide array of
participants, from a company raising money by selling commercial paper into the
market to an investor purchasing CDs as a safe place to park money in the short
term. The money market is typically seen as a safe place to put money due to the
highly liquid nature of the securities and short maturities, but there are risks in the
market that any investor needs to be aware of, including the risk of default on
securities such as commercial paper. The capital market, on the other hand, is the
market in which longer term debt (one year or more) and equity instruments are
traded.

2.5 Classification of Financial Markets

In todays financial world, one of the renowned classifications of financial markets is

the money market and capital market. As mentioned in the previous section, this
classification is based on the maturity of the securities traded in a financial market.

The Islamic Money Market

The money market is an approach for channelling short-term funds with maturities
typically varying from overnight to those not exceeding 12 months. It provides a
ready source of funds for market participants facing temporary shortfalls in funds. At
the same time, it also provides short-term investment opportunities and outlets for
those with temporary surplus funds. An efficient money market is an intermediary not
only for financial institutions but also for firms and non-bank investors to invest their
surplus funds. Because the transaction does not take place in building, it is being
settled through phone call and electronically so the money market usually have an
active secondary market. The instruments differ in terms of their rates and liquidity.
Money market operations comprise two broad categories: placement of short-term
funds, and purchase and sale of short-term money market instruments (such as
bankers acceptances, negotiable instruments of deposit, Treasury bills, Cagamas
notes, etc.). The interbank players in the money market are the commercial banks
and investment banks.

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.

Money Market Participants

The main participants in the money markets are banks, nonbank financial institutions
such as takaful and insurance companies, business corporations, the government
treasury, and the Central Bank. Banks use the money market for liquidity purposes,
especially to adjust the mismatch of assets and liability in their balance sheet. They
will use the money market to obtain liquidity or to place their surplus funds for a
limited period. They could also buy money market instruments such as Malaysian
Islamic Treasury bills and NIDCs to invest surplus funds, or sell their holdings of
these instruments to raise funds.

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. .

The ultimate objective of Islamic financial system in Malaysia is to operate in parallel

with the conventional financial system. This system is bound to specific legal
frameworks, such as the Islamic Banking Act, Takaful Acts, and rules governing the
Islamic Interbank Money Market (IIMM). The Islamic financial system comprises of
Islamic banking Institutions, Islamic money and capital markets, the Takaful industry,
and non-banking institutions.

Components of the Malaysian Islamic Money Market

The Islamic Money Market is known in Malaysia as the Islamic Interbank Money
Market (IIMM). Prior to the establishment of IIMM in January 1994, the Government
Investment Certificate (GIC) was the only available Shariah-compliant short term
instrument available to Islamic banks for liquidity management. The problem
experienced using this instrument was that the secondary market for the instrument
was not available, as the instrument was issued under the principle of qard al-hasan
(benevolent loan), which made it non-tradable.

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.

Mudarabah Interbank Investment

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

Also known as Tawarruq, this is a liquidity management program originally

introduced by BNM in March 2007, as an avenue for Islamic banks to invest their
excess funds with the Central Bank. Now it is being used as in terbank investment
among the Islamic money market participants. In Malaysia, Bursa Suq Al-Sila has
been established to provide a platform for commodity murabahah transactions. The
underlying asset used in this exchange is Crude Palm Oil (CPO) although otherv
assets such as aluminium have also been used in the GCC countries. Under this
arrangement, an investing bank purchases an underlying asset, say CPO, from a
broker and sells it to the investee bank at cost plus with an agreement that it pays
the investing bank on a deferred payment basis. The investee bank may then
appoint the investing bank as its agent to sell the commodity to another broker on a
spot basis or may sell the commodity on its own to another broker. The reverse of
this transaction is also known as reverse tawarruq, and can be done if a bank is in
need of short term funds. In contrast to MII where the rate of return is determined
upon the maturity of the investment, the rate of return of commodity murabahah is
fixed upfront and known to the investing bank.

Wakalah Investment

Wakalah investment is an agency concept whereby the muwakkil (investing bank)

appoints the investee bank (wakil) as its agent to invest in Shariah-compliant
transactions on behalf of the muwakkil. The investee bank will notify the investing
bank of the profits expected to be generated upon placement of funds. Any profits
exceeding the quoted expected profits will be retained as an incentive to the investee
bank. The investee bank is also entitled to draw an agency fee from the incentive
obtained. The investing bank as principal will bear all risks associated with the
transactions except for those risks resulting from the investee banks willful act or
gross negligence. The formula to calculate the profit payable to the investing bank
under Wakalah inverstment is the same as commodity murabahah investment.
Trading of Islamic Money Market Instruments
Trading in the Islamic money market instruments represents the second component
of the Islamic money market. It is aimed at facilitating placement among the money
market players just like the interbank investment, but through the issuance or
purchase of financial instruments. The money market instrument is more flexible
compared to the interbank investment in the sense that the instruments can easily be
traded in the secondary market. This therefore makes it easy for banks that
purchase money market instruments to sell or liquidate them whenever they want
without waiting until the maturity of the instruments. An active secondary market is
therefore bnecessary to facilitate the trading of money market instruments before
maturity, thereby reducing liquidity risk and enhancing the efficiency in the market.

Unlike interbank investment that is mainly restricted to aspproved interbank

institutions, participants in this market constitute both financial and non-financial
institutions. The instruments offered in the market are different from one another in
terms of risk profile, yield, tenor, marketability and liquidity. It should also be noted
that the term money market instruments refers to short term investment papers,
including long term instruments, such as government securities that have almost
reached their maturity date.

Government Investment Issue (GII)

Formerly known as Government Investment Certificates (GIC), GIIs were first

introduceds in July 1983 in conjunction with the establishment of Malaysias first
Islamic Bank, BIMB. BNM, on behalf of the Malaysian government issued for the first
time non-interest bearing GII to meet the special needs of the bank and other
corporations which are interested in these securities. The government Investment
Act 1983 undetr which certificates are issued, provides certificates with maturities of
one year or more to be issued and for dividends, instead of interest, to be paid on
the certificates. The original GIC was issued under the principle of qard al hasan
(benevolent loan), which restricts its trading in the secondaery market. Financial
institutions needing liquidity will have to surrender or their GICs back to BNM, after
which dividends will be paid. The determination of the dividend is not ex-ante but
rasther ex post.
The above constraints led BNM to replace GIC with GII in 2001. GII is structured on
the contract of bay al-inah (sale and buyback). For example, BNM will identify a
Shariah compliant asset and then invites tenders from Islamic financial institutions
for the asset. The IFI which offers the most competitive price will be selected to be
the buyer cum investor and gets to buy the asset on spot sale. The investing bank in
turn will resell the asset back to BNM on the principle of bay bithaman ajil (deferred
sale) if the coupon is to be paid periodically, or murabahah (cost plus) if the GII is a
zero coupon instrument. The debt incurred by BNM through the deferred buyback is
securitized in the form of GII. Thus, the spot price paid by the investing bank will be
at face value if the GII is issued on the principle of BBA or discounted value if the GII
is issued under murabahah. The investing bank can either hold the GII until maturity
or sell it in the secondary market. At maturit, BNM redeems the security by paying
the full purchase price of the assets (or face value of GII) to GII holders.

Malaysian Islamic Treasury Bills (MITB)

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.

Bank Negara Monetary Notes (BNMN)

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.

Sukuk Bank Negara Malaysia Ijarah (SBNMI)

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.

Islamic Negotiable Instruments (INI)

This is a Shariah compliant instrument equivalent to the conventional

Certificate of Deposits (CDs). INI may be issued based on the BBA or Mudarabah.
The instrument based on BBA is called the Negotiable Islamic Debt Certificate
(NIDC), while the one based on mudarabah is called the Islamic Negotiable
Instruments of Deposit (INID).

Negotiable Islamic Debt Certificate (NIDC)

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.

Islamic Negotiable Instruments of Deposit (INID)

INID is a certificate representing a sum of money deposited by an investor with an

issuing bank, which is repayable to the bearer on a specified future date at the
nominal value of the instrument plus profit. It is issued based on the mudarabah
(profit sharing) principle. The investor is the rabbul mal while the mudarib is the
issuing bank. Just like NIDC, INIDs are bearer instruments and are traded on the
basis of price, which means that the principal value is quoted in terms of price per
RM100 nominal value.

Islamic Accepted Bill (IAB)

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.

Sell and Buy Back Agreement (SBBA)

This is similar to the conventional Repurchase Agreement (Repo) but structured in

Shariah compliant way. Repo in conventional banking is an agreement under which
a seller of securities sells the securities to a buyer at an agreed price and
repurchases the securities from a buyer at a specified price on a future date. The
difference between the repurchase price and the original sale price is the interest
earned by the buyer who is also a lender. Under the Sell and Buy Back Agreement
(SBBA), the transacting parties enter into two separate agreements. The first
agreement is between the seller (owner) of the securities and the buyer (investor)
who buys the securities at a specified price agreed upon by both parties. The second
agreement is a forward purchase agreement whereby the buyer (investor) promises
to sell back the securities to the original owner and the latter promises to buy it back
at a specified price on a specified future date. The first contract is an outright sale
and thus the securities will cease to be part of the sellers investment portfolio. BNM
requires that at least one of the parties to an SBBA transaction must be an Islamic
banking institution, while the tenor for a SBBA transaction must not exceed 1 year
and the minimum value must be at least RM50,000.

Cagamas Sukuk

Cagamas Berhad, the National Mortgage corporation, was established as a special

vehicle to mobilize low cost funds to support the national home ownership policy and
to spearhead the development of the private debt securities in Malaysia. To that end,
Cagamas issued a number of Islamic fixed income securities that are traded in the
money market. The securities are Sanadat Mudarabah Cagamas and Sanadat
Cagamas.

Sanadat Mudarabah Cagamas (SMC)

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

Sanadat Cagamas, also known as Cagamas BAIS, is another type of Islamic

security issued by Cagamas to finance the purchase of Islamic housing finance
debts and Islamic hire / purchase debts. This sanadat however is issued under the
principle of BBA, in which the cost of the assets purchased is equivalent to the par
value of the sanadat and the profit earned is equivalent to the coupon of the sanadat.
Coupons are paid semiannually while the par value is redeemable upon maturity.
The tenor of the sanadat can be 10 years. The pricing formula for this snadat is
similar to the fixed rate GII if the sanadats tenor is more than 1 year, while if the
tenor is less than 1 year, the pricing formula will be based on NIDC, which has a
tenor of more than a year.

Islamic Corporate Sukuk

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.

Functions of the Islamic Money Market

The functions of an Islamic Money Market can be divided into three main categories.
The first function is liquidity management. The money market serves as an avenue
for IFIs to source daily funding or to invest short term. Access to the money market
enables IFIs to maintain optimal liquidity, thereby allowing them to meet the
demands of their customers at any time. This therefore allows the IFIs to cope with
short term pressures that may arise. It gives flexibility to the IFIs to face every
liquidity situation that might arise due to different timing of cash inflows and outflows.
Non-financial institutions use the money market to manage the fluctuations in their
working capital needs, by obtaining either short term funding or placement.
Consequently, they will be able to enjoy low cost funding or investment returns with
low risk.

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.

2.5 The Islamic Capital Market

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).

Shariah Compliant Securities

The Islamic equity sector comprises products such as Shariah-compliant securities
listed on Bursa Malaysia and Islamic mutual funds or Islamic unit trust funds.
Currently, Shariah-compliant securities represent more than 85 percent of the total
securities listed on Bursa Malaysia.

The Shariah Advisory Councils list of Shariah-compliant securities is updated and

released in May and november every year. The list is an essential reference for
Muslim investors in identifying Shariah-compliant securities, and gives them greater
confidence to invest in the stock market.

Islamic Equity Indices

The availability of Shariah-compliant securities led to the introduction of the Islamic
equity index, known as the Kuala Lumpur Shariah Index in 1999, to meet the
demands of local and foreign investors who seek to invest in securities which are
consistent with Shariah principles. Bursa Malaysia Bhd collaborated with FTSE to
launch two Islamic equity indices, namely FTSE Bursa Malaysia Emas Shariah Index
(benchmark index) and FTSE Bursa Malaysia Hijrah Shariah Index (the countrys
first Shariah radeable index) to provide a broad benchmark or reference for
Shariah-compliant equity investment in Malaysia. These indices are for investors,
both local and foreign, who wish to invest in stocks that are compliant with Shariah
principles. Bursa Malaysia (BM) is the only exchange with three comprehensive and
transparent Shariah screening processes: FTSE Group, Yassar Ltd, and the SCs
Shariah Advisory Council (SAC). Therefore, the second role of BM toward the
development of ICM is to perform the regulatory plus the risk management duties.
(BMs role is to create the Islamic market as the exchange market. BM now odders
a complete range of innovative Islamic market products from derivatives, equities,
and commodities across all sectors and industries. So the first role of BM is to
encourage companies to list their stocks on a Shariah-compliant stock list to meet
the investors desire). FTSE-Bursa Malaysia Emas Shariah Index replaced the Kuala
Lumpur Shariah Index as a broad reference for Shariah-com[pliant equity
investment in Malaysia.

Islamic Collective Investments

Islamic collective investments or Islamic mutual funds is a type of investment
scheme that involves collecting money from different investors and then combining
all the money collected to fund the investment, which is in compliance with Shariah
principles. Islamic collective investment funds offer investors the opportunity to
invest in a diversified portfolio of Shariah-compliant securities, managed by
professional managers in accordance with Shariah principles.

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.

The Malaysian sukuk market continued to experience unprecedented growth. In

2007, over 76 percent of all bonds approved by the SC were sukuk with a total
value of RM121.3 billion. These were largely innovative structures based on widely-
accepted principles, such as musyarakah, ijarah, and istisna. Malaysias ICM
continued to strengthen its reputation as a center of innovation in 2007 with
landmark issuances, such as the largest sukuk and conventional bond funding
program of RM60 billion by Cagamas Bhd, the sukuk issuance of RM15.4 billion by
Binariang GSM Sdn Bhd, the largest exchangeable sukuk of US$850 million by
Khazanah Nasional Bhd and the RM3 billion TM Islamic Stapled Income Securities
by Telekom Malaysia and Hijrah Pertama Bhd.

The SC introduced a facilitative framework for the issuance of foreign currency

dominated sukuk to promote Malaysia as an international sukuk center. Qualified
issuers, such as multilateral development banks, multilateral financial institutions,
sovereigns and quasi-sovereigns, and multinationals which issue a non-ringgit sukuk
rated at least a single A, will be deemed approved and can also be offered to
sophisticated investors onshore. The new framework allows international
documentation based on UK or US laws and accepts ratings by international credit
rating agencies to reduce issuance costs for international issuers.
2.6 Development of Equity Markets

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.

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 musyarakah contracts. Musyarakah Mulk giving the partner
ownership rights to a specific real asset and Musyarakah 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
Musyarakah 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 Musyarakah Aqed,
then it it 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 Musyarakah which is neither a
Musyarakah Mulk or Musyarakah 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 Musyarakah Mulk renders most transactions
in a stock market illegal from the Shariahs 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
markers. 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 back-door, 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.

2.7 Shariah Screening of Shares

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.

10 % Umum balwa (prohibited element

affecting most people and difficult to
avoid), for example, interest income from
fixed deposits in conventional banks,
tobacco-related activities
20 % Used to assess the level of mixed
contributions from rental income derived
from activities that are not Shariah
compliant, for example, rental income
received from premises selling liquor.
25 % Maslahah to the public, for example,
hotel and resort operations, stockbroking.

compliant:

Table 1: Shariah Non-compliant

 (i) Entertainment deemed non-permissible (this would include adult
entertainment, cinemas, the music industry and hotels).
(ii) Weapons and defense
In some cases, the company in question operates in a permissible sector but
receives revenue from non-permissible activities (originating from a minor
division, subsidiary or associate company).

In some Shariah jurisdictions, most notably Malaysia, these so-called mixed

companies are considered Shariah compliant provided they fulfill certain additional
criteria. More specifically a ceiling benchmark or threshold of non-permissible
revenue is applied to determine Shariah compliance. The benchmarks are applied to
both revenue and profit before tax.

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.

Table 2: Measuring the quantum of interest-based financing

Ratio 1: Total interest-based debt Trailing 24-month average market

capitalization

Ratio 2: Sum of cash and interest bearing securities Trailing 24-month

average market capitalization

Ratio 3: Interest bearing accounts receivable Trailing 24-month average

market capitalization
For a stock to be considered Shariah compliant, the above three ratios must not
exceed 33 per cent. Market capitalization, or sometimes referred to as market cap
is the total dollar market value of all of a companys outstanding shares. Market
capitalization is calculated by multiplying a companys outstanding shares by the
current market price of one share. The investment community uses this figure to
determine a companys size, as opposed to sales or total asset figures. The FTSE
Islamic Index also stipulates that interest income must not exceed 5 % of total
income.

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.

A cursory look at current practices on dividend purification reveals that a common

method is simply to purge a portion of dividend paid. This has been argued as
representing an incomplete form of purging, and appears to be mere window
dressing to sooth the conscience of Shariah compliant investors. The AAOIFI
advocates the following method for dividend purification. First, divide total prohibited
income by the number of issued shares of the company. Then, multiply this with the
number of shares owned by the investor. The burden of purging is on the
shareholder on the last day of the companys financial year. It can be argued that this
would constitute an unfair treatment. Although shares may have exchanged hands
numerous times during a year, it is the shareholder on that last day of the financial
year who carries the onus of dividend purification. Furthermore, such a stipulation
may encourage sell- down just prior to financial year end, thus creating unnecessary
and unwarranted share price volatility. One suggestion is to pro-rate the puging
quantum by the portion of time that the share is owned.

2.8 International Infrastructure Institutions

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).

Accounting and Auditing Organization for Islamic Financial Institutions

(AAOIFI)
The AAOIFI is an Islamic international autonomous non-profit corporate body that
prepares accounting, auditing, governance, ethics and Shariah standards for IFIs
and the industry. The AAOIFI is responsible for examining the specific requirements
of Islamic financial transactions and recommending standards to resolve issues of
Shariah compliance and identify gaps in applying conventional reporting to IFIs. The
AAOIFI has so far issued 26 accounting standards, five auditing standards, seven
governance standards, two codes of ethics and 41 Shariah Standards.

International Islamic Financial Market (IIFM)

The IIFM is the global standardization body for the Islamic capital market and money
market segment of the Islamic finance services industry. Its primary focus lies in the
standardization of Islamic products, documentation and related processes. The
major objectives of IIFM are to enhance cooperation among the regulatory
authorities of Islamic financial institutions, address the liquidity problem by expanding
the maturity structure of instruments, and look into asset backed securities.

General Council for Islamic Banks and Financial Institutions (CIBAFI)

CIBAFI was established in 2001 in Bahrain as an international non-profit
organization which supports and promotes the Islamic financial services industry
through information, media, research and development, consultancy, and human
resources development.

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.

Islamic Financial Services Board (IFSB)

IFSB, which is based in Kuala Lumpur, serves as an international standard-setting
body of regulatory and supervisory agencies that have vested interest in ensuring
the soundness and stability of the Islamic financial services industry. In advancing
this mission, IFSB promotes the development of a prudent and transparent Islamic
financial services industry through the introduction of new standards, or adapting
existing international standards consistent with Shariah principles, and recommend
them for adoption. Two important projects undertaken by IFSB were, firstly, the
preparation of a report describing the role of Islamic finance in contributing to global
financial stability and secondly, to formulate an innovative mechanism to enable
cross-border liquidity management that would deepen and broaden the global
Islamic finance industry.

Islamic International Rating Agency (IIRA)

The IIRA started operations in July 2005 to facilitate development of the regional and
national financial markets by delineating relative investment or credit risk, providing
an assessment of the risk profile of entities and instruments. IIRA is the sole rating
agency established to provide capital markets and the banking sector in
predominantly Islamic countries. While the traditional rating agencies have a very
important role to play in the analysis of conventional institutions and the instruments
they issue, the IIRA serves in carrying on the business of rating, evaluating and
appraising both institutions and instruments within the Islamic finance space.

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.

IIRA is structured in a way to preserve its independence. It has a board of directors

and a completely independent rating committee. Its Shariah board comprises experts
in the field.
Existing Rating Agencies in Malaysia
Rating Agency Malaysia Bhd (RAM) is set up in early 1990 to help spur the
development of the Private Debt Securities (PDS) market through introducing the
rating service. The shareholders are commercial banks, merchant banks and finance
companies. It is a long-term bonds rating scale that starts from AAA which is the best
credit risk down to C which is the poorest credit risk and D as default and uses P1 at
the top end down to NP that means non prime, the highest investment risk for short-
term bonds. The type ratings are corporate debt, financial institutions, Islamic debt,
claims-paying ability, asset-backed securities and credit portfolio rating.

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.

International Islamic Liquidity Management Corporation (IILM)

In order to enhance the ability of IFIs to manage liquidity, an entity was established
to address this need. The IILM is an international entity established to issue short
term Shariah compliant financial instruments to facilitate more efficient liquidity
management for institutions offering Islamic financial services and to support the
increasing cross border transactions between those institutions. Its membership is
opened to central banks, monetary authorities, financial regulatory authorities,
government ministries or agencies that have regulatory oversight on finance or trade
and commerce; and multi-lateral organizations which will hold shares of the IILM.
The IILM was established on 25 October 2010 with 14 founding shareholders
(consisting of 12 central banks or monetary authorities from Indonesia, Iran, Kuwait,
Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Saudi Arabia, Sudan, Turkey and
the UAE) and two multi-lateral institutions (the Islamic Development Bank and the
Islamic Corporation for the Development of the Private Sector). Its head office is
located in Kuala Lumpur.
Islamic Banking and Finance Institute, Malaysia (IBFIM)
Formerly known as BIMB institute of Research & Training Sdn Bhd (BIRT), the
Islamic Banking and Finance Institute Malaysia Sdn. Bhd (IBFIM) was officially
launched in 19th February 2001 by the Finance Minister at the time, Tun Daim
Zainuddin.

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:

Public Awareness Programmes

o Seminar, workshop, conference, talk, colloqium on Islamic
banking and finance (both locally and abroad).
Skilled-based Training Programmes
o Comprise series of programmes in Islamic banking, takaful and
capital market.
Certification Programmes
o Islamic Certified Credit Professional (CCP-i)
For credit officers to practice Islamic Financing
o Islamic Financial Planner (IFP)
For individuals to market/promote Islamic Financial
Planning services
o Shariah Scholars Induction Programme (SiSIP)
Specialised to equip Shariah scholars with necessary
knowledge on the operational aspect of Islamic finance
In-house Training Programmes
o Customised training program in Islamic banking, takaful, and
capital market upon request by the institutions.

2.9 Securities Commission (SC)

The Securities Commission is a statutory body set up under the Securities

Commission Act 1993 (SCA), reporting directly to the Minister of Finance. It is the
sole regulatory body for the regulation and development of the capital market in
Malaysia. The Securities Commissions Acts establishes the SC, which is the body
that regulates the securities industry as a whole. It sets out the powers and functions
of the SC, a body corporate that is entrusted with regulating the securities industry.
The Act also contains provisions for Take Over and Mergers. The SC has wide
enforcement and investigation powers ensuring the smooth running of a fair and
orderly market. Two main roles of SC under the Securities Commission Act 1993 are
to act as a single regulatory body to promote the development of capital markets and
to take responsibility for streamlining the regulations of the securities market, and for
speeding up the processing and approval of corporate transactions. SC mission is to
promote and maintain fair, efficient, secure and transparent securities and futures
markets and to facilitate the orderly development of an innovative and competitive
capital market in Malaysia. Among regulatory functions of SC are registering the
prospectuses for all securities except those issued by unlisted recreational club,
regulating all matters relating to securities and futures contracts, regulating the take-
over and mergers of companies, regulating all matters relating to unit trust schemes,
licensing and supervising all licensed persons, supervising exchanges, clearing
houses and central depositories and encouraging self-regulation and ensuring
proper conduct of market institutions and licensed persons.

2.10 The Shariah Advisory Council of Bank Negara Malaysia

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.

3. Shariah advisors must equip themselves with various knowledge pertaining to

modern finance and banking. The ability to communicate in English is also
indispensable in examining legal documents that are usually written in
English. Failure to improve themselves will weaken and delay the fatwa
process.

4. Shariah advisors should not be distracted by titles or worldly rewards.

Perform their duties diligently, and be capable of producing precise fatwas. If
these matters are not done with care, it will sully the names of Shariah
scholars before the eyes of financial industry executives.

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.

6. Shariah advisors must be honest with bank representatives if they do

understand a concept or product. They should not feel embarrassed to admit
their lack of understanding. They cannot approve a product with the
assumption that there are other people who understand it better. The advisors
are responsible for each consent and approval without relying on someone
elses consent.

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.

2.12 Takaful Industry

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.

There are a number of significant differences between takaful and conventional

insurance companies. Takaful companies not only follow the principles of Shariah,
but also have distinctive features compared to conventional companies.

The following is a comparison between takaful and conventional insurance

companies:

Table 3: Takaful vs Conventional Insurance

Takaful Companies Conventional Insurance Companies

Takaful is based on mutual cooperation. Conventional insurance is based solely on

commercial factors.

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.

There is a full segregation between the Premium paid by the policyholder is

participants Takaful Fund account and the considered as income to the company,
shareholders accounts. belonging to the shareholders.

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.

Takaful companies have re-insurance with Conventional insurance companies do not

Re-Takaful companies or with conventional necessarily have re-insurance with re-
re-insurance companies that adhere to insurance companies that abide by Shariah
certain conditions of Shariah. principles.

2.13 Other Islamic Financial Institutions

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.

Islamic Development Bank (IDB)

IDB is an international financial institution established in pursuance of the
Declaration of intent issued by the Conference of Finance Ministers of Muslim
Countries held in Jeddah in Dhul Qadah 1393H, corresponding to December 1973.
The Inaugural Meeting of the Board of Governors took place in Rajab 1395H,
corresponding to July 1975, and the Bank was formally opened on 15 Shawwal
1395H corresponding to October 1975.
The functions of the Bank are to participate in equity capital and grant loans for
productive projects and enterprise besides providing financial assistance to member
countries in other forms for economic and social development. The Bank is also
required to establish and operate special funds for specific purposes including a fund
for assistance to Muslim communities in non-member countries, in addition to setting
up trust funds. The Bank is authorized to accept deposits and to mobilize financial
resources through Shari'ah compatible modes. It is also charged with the
responsibility of assisting in the promotion of foreign trade especially in capital
goods, among member countries; providing technical assistance to member
countries; and extending training facilities for personnel engaged in development
activities in Muslim countries to conform to the Shari'ah. Example of its
responsibilities are to participate in equity and grant loans for productive projects, to
provide financial assistance to member countries for economic and social
development also to provide technical assistance to member countries.

Venture Capital Companies

Venture capital is a type of private equity capital typically provided to immature, high-
potential and growth companies. Venture capital investments are generally made as
cash in exchange for shares in the invested company. VC typically comes from
institutional investors and high net worth individuals and is pooled together by
dedicated investment firms. In the Islamic Financial Industry, the investment made
by the VC companies must be limited to business activities that are Shariah-
complaint. Some examples of VC companies are BIMB Venture Capital Sdn. Bhd,
FIRSTFLOOR Capital Sdn. Bhd, MIDF AMANAH Venture Sdn. Bhd and others.

Development Financial Institutions & Cooperatives Banks

Development financial institutions (DFIs) are specialized financial institutions
established by the Government as part of an overall strategy to develop and promote
specific strategic sectors, such as agriculture, small and medium enterprise (SMEs),
infrastructure development, shipping and etc. Development Financial Institutions Act
2002 (DFIA) came effective on 15th February 2002. The DFIA aims to ensure
effective and dynamic supervision of DFIs, and provides the appointment of Bank
Negara Malaysia as the central regulatory and supervisory body for the DFIs.
Examples of DFIs are Bank Pembangunan Malaysia Berhad, Export-Import Bank Of
Malaysia Berhad, Bank Simpanan Nasional, Lembaga Tabung Haji, Bank Pertanian
Malaysia Berhad (Agrobank) and etc.

2.14 New Directions for Islamic Financial System

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.

Questions to Check Your Understanding of this Chapter:

1. Is ICM in Malaysia complete in terms of realizing the Maqasid aspect? Relate
your answer to the two elements that Islamic financial institutions must have in
its implementation.

2. If you look at the Islamic institutions (financial and non-financial) in the

financial system of Malaysia, with regards to their mushrooming, have quantity
 downplay quality? Relate your answer to supporting mechanisms like
government intervention, legislation and so on.

3. Why have Sukuk been introduced as instruments in both Islamic money and
capital markets?

4. Are there similarity between Takaful and Conventional Insurance Companies?

5. In what way exchange traded funds (ETFs) are similar to investing in stocks?

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