174 AN INTRODUCTION TO ISLAMIC FINANCE
markets are at a comparatively early stage of development. Conventional cap-
ital markets have two main streams: the securities markets for debt trading
and the stock markets for equity trading. As we have seen, Muslims cannot
participate in debt markets of any kind. The concept of stock markets is in
consonance with the Shari’ah’s principles of profi t/loss sharing, but not every
business listed on the stock market is fully compatible with the Shari’ah. These
issues present challenges for the development of Islamic capital markets.
The need for capital markets was realized at the early stages of devel-
opment of the Islamic fi nancial industry, but not much progress was made.
During the 1980s and 1990s, Islamic fi nancial institutions (IFIs) mobilized
funds successfully through growing deposits, which were invested in a few
fi nancial instruments, mostly dominated by commodities or trade fi nancing.
However, limited investment opportunities, a lack of liquid assets and other
constraints meant that the IFIs’ asset composition remained fairly static and
heavily focused on short - term instruments. With continuing demand for
Shari’ah - compliant fi nancing, there was a pressing need to develop capital
markets to facilitate long - term fi nancing for businesses and to create port-
folio diversifi cation opportunities for investors and fi nancial intermediaries.
By the late 1990s, Islamic fi nancial markets had realized that the devel-
opment of capital markets was essential for their survival and growth.
Meanwhile, the wave of deregulation and liberalization of capital markets
in several countries led to close cooperation between IFIs and conventional
fi nancial institutions to fi nd solutions for liquidity and portfolio manage-
ment. Since then, several efforts have been made in this respect, particularly
in the development of asset - backed securities and of Islamic funds com-
prising portfolios of securities such as, but not limited to, equity stocks or
commodities. IFIs kept demanding a security that could behave like the con-
ventional fi xed-income debt security at a low level of risk but also complied
with the Shari’ah. In addition, they wanted to extend the maturity structure
of their assets to go beyond the typical short - term maturity given by trade -
fi nance instruments. This led to experimentation with the sukuk, which has
risk/return characteristics similar to a conventional debt security.
STOCK MARKETS AND ISLAMIC FUNDS
As discussed in Chapter 6, equities and stocks are the core capital markets in
the Islamic fi nancial system as they promote risk sharing and profi t/loss shar-
ing. With the exception of Malaysia, stock markets in Muslim countries are
developing only gradually, forcing Islamic investors to invest in the stock mar-
kets of developed economies. However, there are certain rules which need to
be followed in selecting stocks. Though there are growing numbers of Islamic
funds becoming available that are Shari’ah - compliant, there is a need to develop
stock markets in countries that are serious about developing Islamic fi nance.
The concept of a market to trade equities is fully compatible with the Shari’ah
but the operations and trading rules and practices should also be compliant.