Economics and Business

The Operation of the Modern Financial Markets for Stocks and Bonds and its Relevance to an Islamic Economy

The purpose of this paper is to analyze the structure and the operation of both the primary and the secondary markets for stocks and bonds, including the use of options, warrants, and rights in the securities market of a modem economy, such as the United States, with a view to ascertain which of these securities might be permissible to invest in under an IsIamic economic system. Section I starts with a brief description of the nature and operation of the primary and the secondary markets for securities. It then describes the nature and scope of each type of security in terms of risks and returns to the issuer and the investor. Section 11 starts with an interpretation of the Islamic injunctions with respect to trade and investment. It then proceeds to examine the extent and conditions under which investment in particular securities may be permissible under an Islamic Economic System. Section 111 summarizes the results of the study and concludes with some tentative suggestions.

INVESTING IN SECURITIES
  • PRIMARY AND SECONDARY MARKETS FOR SECURITIES
  • The primary market is the market where securities are first issued by corporations (or joint stock companies) and/or by governments. In the United States, as well as in other countries, the issuer of the security announces through the news media its intention to issue the security at a future date. Such an announcement includes information about the purpose of the new issue (i.e., it often provides some detailed information about how the newly raised funds are to be used, in what operations, and what are likely to be the results of such an investment), the face value or par value of each security, the total number of securities that will be offered for sale, and where and from whom (or which institution or institutions) the investing public can acquire such a security.

    The placement of securities in the primary market may take any of the following forms: _first, the securities may be directly placed (direct placement) by the issuer-i.e., the sellers of the stocks, bonds or options can directly sell their securities to the investors (i.e., the buyers of securities) at negotiated prices. Usually stocks are sold at a premium over their face or par value.

    Bonds, on the other hand, are sold at a discount. Direct placement is the cheapest way to issue securities because the issuer does not have to pay any middleman or intermediary to bring in the customers (i.e., the investors). It is  also the cheapest way of buying securities on the part of the investors because they do not have to pay any commission or fee to the intermediary.

    However, direct placement often is not feasible because the issuers of securities may not be  knowing the investors who may be interested in buying their securities. This brings us to the second way of placement of securities, which we can term as underwriting of securities. Underwriting means selling of securities to the intermediary or the underwriter at a discount and/or for a commission or fees. When a group of underwriters buy securities to resell them to the final investors at a profit, this group is called the underwriting syndicate. In the U.S. and in Europe, among other countries, the underwriters are usually investment banks. A group of such banks join together to place large issues. Placement through the underwriter or underwriting syndicate is more expensive than direct placement because the issuer has to sell them at a discount and, at times, has to pay additional amounts in the form of fees or commissions. The final investors also receive less for their money because they have to buy the securities at higher prices and, in addition, have to pay commission and fees to the underwriter or underwriting syndicate. Investment bankers do not always underwrite the issues of new Securities. This brings us to our third method of placement of securities. When investment bankers do not buy the securities from the issuers to resell to the ultimate investors, but merely bring the issuers and the investors together for fees or commissions, it is known as the use of best efforts. Whether or not the use of best efforts is more or less expensive than issuing of securities through underwriters depends upon the reputation and economic strength of the issuing company or the government. If the issuer is a well known party and is known for its successful exploits, it costs less to use best efforts. However, if the issuer is a new party or a party which is known to have financial problems, it is costlier for it to use best efforts. There is a fourth method of security placement. It is known as standby underwriting. Standby underwriting simply means that the issuer first tries to place his securities directly, but not being sure about his complete success in his attempt he signs a contract with underwriter or an underwriting syndicate for the remaining issues he would not be able to place himself. In other words, the underwriter and the issuer agree on a price of the remaining securities, which is usually lower than the price the issuer can get for his securities under direct placement. Standby underwriting is a little bit less expensive than underwriting of the entire issue.

    The funds, net of placement costs, that are raised by the issuers and bought by the final investors are used to purchase real economic assets (e.g., plants, equipment, raw materials, labor, etc.). It is these funds which ultimately determine the size of and the rate of growth in the real Gross National Product (GNP) of a country. Not every purchase of stocks, bonds, options or rights contributes directly to the expansion of economic activities. Such securities bought only in the primary market (i.e., first issue) contributes to real economic expansion because the receivers of these funds (i.e., the issuers of securities) are the ultimate producers of goods and services and they use funds for those purposes. However, the bulk of the transactions in securities take place in the secondary market where the buyers and the sellers are both investors in financial assets-they exchange one form of financial asset, say a security, for another form, like money. The buyers and the sellers of securities in the secondary market may both profit or lose from their transactions, but such transactions have little or no direct impact on the original issuer of the securities (i.e., the corporations, companies, establishments, and governments that originally raised funds by issuing them).

    DMC Firewall is a Joomla Security extension!