120 AN INTRODUCTION TO ISLAMIC FINANCE
dominate the conventional capital markets and debt is considered the major
source of external funding for the corporate and public sectors. As the result
of fi nancial innovations and the application of fi nancial engineering, large
numbers of fi nancial products have been developed for resource mobiliza-
tion. Most of these innovations are variations on plain vanilla debt or equity
security, with added options or customization.
In comparison, future Islamic capital markets will have two major cat-
egories; (i) stock market; and (ii) securitized “asset - linked” securities. Due
to the prohibition of interest, the fi nancial system will be free of any debt
market and there will be clear preference for risk-sharing securities such
as an exchange - traded stock market. After the stock market, a market for
securitized securities issued against pool of assets which carry risk–return
characteristics of underlying assets will be the major source of capital.
Stock market With the prohibition on interest and the preference for part-
nerships to share profi ts and losses, equity markets hold a signifi cant place.
Therefore, Islamic scholars have pointed out the necessity, desirability and
permissibility of the existence of a stock market in the fi nancial system of
Islam in which transactions in primary capital instruments such as corporate
stocks can take place. The conditions of the operations of these markets, in
accordance with the rules of the Shari’ah, are much like those that prevail
in markets for goods and services. For example, in such markets the rules
are intended to remove all factors inimical to justice in exchange and to
yield prices that are considered fair and just. Prices are just or equitable not
on any independent criterion of justice, but because they are the result of
bargaining between equal, informed, free and responsible economic agents.
To ensure justice in exchange, the Shari’ah has provided a network of ethical
and moral rules of behavior for all participants in the market and requires
that these norms and rules be internalized and adhered to by all. Given that
a proper securities underwriting function is performed by some institutions
in the system (the banks, for example), the fi rms could then raise the neces-
sary funds for their investment projects directly within the stock market,
which would provide them a second source of funding other than the banks.
A stock market operating strictly in accordance with Islamic rules
is envisioned to be one in which the disposal of investible funds is based
on the profi t prospects of the enterprises, in which relative profi t rates refl ect
the effi ciencies between fi rms, and in which profi t rates (as signals coming
from the goods market) are not distorted by market imperfections. Such a
market might be expected to allocate investible funds strictly in accordance
with expected investment yields; that is, resources would be allocated in
order to fi nance higher - return projects. Stock markets would also be capa-
ble of improving allocation of savings by accumulating and disseminating
vital information in order to facilitate comparisons between all available
opportunities, thus refl ecting the general effi ciency in resource allocation
expected from a system that operates primarily on the basis of productivity
of investment.