Principles of the Islamic Capital Market: Opportunities and Challenges

INTRODUCTION

A study shows that the Islamic capital market is growing at 12%-15% annually. It comprises 25% of the global capital market. The Islamic Capital Market (ICM) operates in most of the world''s continents, including non-Muslim countries. Shariah-compliant capital market products are trading on leading world exchanges, including Dubai NASDAQ, Malaysia stock exchange, London stock exchange, Luxembourg stock exchange and Saudi Arabia stock exchange.

This article would highlight the growing potential of ICM by analyzing some of the leading Islamic indexes, including the Dow Jones Islamic Index (DJIM) and the FTSE Global Equity Index. This paper would also explore the opportunities and the challenges towards various contenders of the Islamic capital market.

1. Islamic Capital Market

ICM is in tandem with Shariah laws: principles and guidelines derived from the hHoly Quran and Hadith. ICM is a vital component of the Islamic finance industry after the money market allows global distribution and growth of Islamic finance assets. According to the Islamic financial services industry stability report 2020, the Islamic money market comprises a significant share of Islamic finance assets fully supported by equity, fixed income and commodity and other classification of assets. Below is the most recent distribution of Islamic financial instruments and investments worldwide:

Islamic equity, Sukuk and Shariah-compliant derivatives are driving sectors of ICM. Mainly, Sukuk has shown robust growth in the last five years. According to the Securities Commission Malaysia, this investment instrument has reached the value of RM76.98 billion by 2020.

2. Shariah Global index

Unlike its conventional counterpart, the ICM adopts Shariah screening methods. This screening criterion configures qualitative and quantitative filters. Businesses must pass specific standards pertaining to the business activities, including debt level and maintain an income and expenses threshold. Many stock index providers have adopted these standards so investors can take advantage of opportunities offered through Shariah-compliant funds.

2.1 Dow Jones Islamic Market Index

The pedigree of DJIM started in 2000, the first Shariah-compliant benchmark. This index variant includes thousands of constituents based on a float-adjusted market capitalization weightage scheme (FMC). FMC, also known as free-float, provides more accurate movement of the stocks where the company''s market cap is calculated by multiplying the number of outstanding shares with the share price. DJIM indices are broad market, blue-chip, strategy and thematic indexes. Those entire indexes are subject to Shariah, a criterion formed by the Standard & Poor (S&P) Shariah advisory board.

2.1.1 Shariah-compliant Screening

To access whether a stock compliant with Sharia requirements, two methods are adopted:

• Sector-Based Screening: The business earnings should not include the prohibited activities according to Islamic laws. That included Selling and buying alcohol, pork, tobacco and conventional financial services. However, non-compliance business activities are tolerated and shouldn''t exceed 5% of the business''s total earnings.
• Accounting Based Screening: As per Dow Jones accounting-based screening threshold of 33% is applied to various financial ratios. The purpose of this level is to discourage companies from an unacceptable level of debt and impure earnings. Below earnings must be less than 33%
  • Total debt divided by 24-month average market capitalization
  • Total company''s cash and interest income by two years average market capitalization
  • Net accounts receivable divided by average market capitalization.

2.1.2 Performance Indicators: DJIM

Under the market ticker of DJIM, the strongest constituent or stock has a market value of 2.8 million, where this index has continued to show an up-ward trend in the last five years. The stocks under this index paid a net total return of 19.67% in 2021. According to S&P fundamentals, the projected price-to-earnings ratio (P/E) is estimated to be 24.92. The index weightage dominates by the technology sector holds 37.7% of the total value.

Source: Dow Jones Islamic Market Index

2.2 FTSE Global Equity Shariah Index Series

FTSE is a subsidiary of the London stock exchange that has established a series of Shariah-compliant indices under the FTSE global equity Shariah series benchmark, the companies'' inclusion on the All-cap index series. With no restriction of market capitalization, the Shariah index series has allowed trading of thousands of companies ranging from the small, mid and large-cap. GIIS (Global Islamic Index Series), a subset of the All-world index group, constitutes 13 different indices broadly classified on a regional and country basis.

2.2.1 Shariah Screening Criteria

FTSE Shariah index series adopts Shariah eligibility criteria for stocks. The constituents screened quarterly to access their financial and non-financial position

• Non-financial Criteria: Similar to Dow Jones, FTSE has the same criteria. The business activity should not base on illegal activities with an acceptable level of less than 5%
• Financial Criteria: FTSE eligibility for financial screening has the following requirements:
  • Debt/ total asset ratio less than 33%
  • Cash and Interest bearing security / total asset less than 33%
  • Account receivable /total asset less than 50%
  • Dividend Purification ration less than 5%

2.2.2 Performance Indicators-FTSE Developed Shariah Index (SWD)

One of the regular performers from the family of GIIS, the index has shown steady performance in the last five-year with a continuous upward trajectory. In the previous year, the index price has increased by 10%, which has been strongest compared to other indexes in the basket of GIIS.

Source: Financial Times

3. Opportunities

ICM ensures the protection of the investors through transparency and avoiding systematic risks. This market is showing robust growth in the last decade due to the interest of Muslim and non-Muslim individual and institutional investors. Some opportunities can seize grip and size of Islamic capital products and services.

• Adopting alternative product solutions can improve liquidity management and attract more investors. For example, margin trading allows traders to borrow funds in the conventional market. Due to Shariah restrictions, margin trading can replace using qard structure to facilitate the growth of Shariah-compliant hedging and the stock market.
• Enhance industry strength through digitalization. The world is shifting towards non-brick institutional trading strategies. For example in Indonesia, there is a Shariah online trading system for stock transactions. There are already 13 exchange members in Indonesia with such application transaction systems like Shariah IPOT, HOTS Shariah, e-smart Shariah, etc.
• Institutional investors manage massive funds and can contribute high liquidity, especially in the equity market. If governments continue to corporate investors with legal and regulatory framework support, ICM can grow substantially. Taking the example of Malaysia, Islamic Financial Services Board (IFSB) appreciated the role of the Malaysian government in promoting institutional investors in the ICM. According to a report by Thomson Reuters, Malaysia is the top-ranking country in quantitative Islamic finance development and projects to be a key player in the growth of Islamic fund assets by 2023.

4. Challenges

ICM plays a vital role in contributing to liquidity management of the Islamic finance industry through various investment instruments. However, this sector is subject to different operational, financial and governance challenges.

• Conventional capital market assures principle and fixed return to its investors. ICM to deal with industry competition ensures principle return to its investors through a third-party guarantee. This results in higher transaction costs and reduced convergence.
• There is a lack of harmonized framework and sharia regulations due to the difference of Shariah framework in the potential countries.
• Lack of specialized financial institutions, third-party services and ICM platforms don''t allow exploring the potential lies in middle-income countries.
• Lack of trained and skilled personnel can deal with product structuring and policy mechanisms like Islamic muamalah, digitalisation, issues about money trading (bay-al-dyan), benchmarking issues like LIBOR and others. /li>

5. Conclusion

The ICM is still nascent and competing with the already developed conventional market. However, various Shariah-compliant international indices are catering to the investment needs. Thus, there is a need to explore the potential of this market through innovative structural and regulatory reforms.