QUESTION 1: The idea of having one single procedure for the Shariah screening process that applies to all exchanges is easier said than done. Please do compare the screening procedures that have been outlined by regulator, exchange, and even advisory corporations. What makes those screening processes differ from others?
INTRODUCTION
The screening procedure is intended to discover aspects that contravene Shariah law, which derives from the Quran and the teachings of Prophet Muhammad. The Shariah bans aspects including usury (riba), gambling (maysir), and uncertainty (gharar). These components are found in a variety of typical financial transactions. This signifies indirect participation in prohibited acts, which is a major sin for Muslims. In today's world, it would be difficult and uncommon to locate fully Shariah-compliant equities, as the majority of nations have conventional financial institutions, leaving them vulnerable to riba-related activities. Consequently, the current circumstance does permit the presence of prohibited elements throughout the screening procedure. According to a famous saying by scholars, "there must be no intentional interest income," hence companies are accountable for ensuring they do not engage in prohibited activities. In order to address this issue, Shariah scholars have agreed on an appropriate level of involvement in such practices by businesses and outlined the processes for purifying immoral earnings.
Islamic institutions have introduced Shariah-based products alongside the introduction of Islamic banking. Before releasing a new product that complies with Shariah law, individuals working in the banking industry have conducted extensive research. As the years pass, a number of Shariah-compliant products and services have been developed to serve prospective customers and clients in Islamic banking and finance. Before the Shariah advisory board can certify a product as Shariah-compliant, it must pass through a series of screening procedures. This committee will guarantee that the given product adheres to the Shariah. In recent years, established products such as murabaha, musyaraka, and ijarah have garnered their own audience. The banking industry is in competition to provide a variety of products. The modern corporate environment necessitates more comprehensive offerings, such as e-commerce, online banking, and others.
Shariah screening is performed to eliminate equities deemed inappropriate for investing because they contain prohibited aspects such as alcohol, gambling, and riba. This is due to the fact that there are currently joint ventures or partnerships (shirkah) in the Islamic commercial sector involving Muslim partners and their non-Muslim partners in a variety of business operations. Therefore, before proceeding with such joint ventures, the Muslim partners must confirm that the ventures comply with Shariah principles. The development of the screening process was primarily motivated by a growing knowledge among Muslim investors regarding favorable conditions in foreign stock markets. High involvement in conventional interest-based banking has deterred Muslim investors from the stock market. A few academics view this as a significant loss for Muslims, given the stock market promises a high profit. Therefore, in 1987, Muslim scholars gathered and established criteria allowing Muslims to earn halal income through stock market investment (Noor Latiffah Adam & Nordin Abu Bakar, 2013).
SHARIAH METHODOLOGY
The screening process typically focuses on two areas: business screening and financial screening. The purpose of the business screening is to determine the type of main business. In the meantime, a financial analysis is being conducted to ascertain if the company's revenue is free from unlawful income or if it is involved in it, but within the acceptable ratio approved by the Shariah scholar.
There are numerous Shariah screening procedures throughout the world, including the AAOIFI screening, Securities Commission Malaysia screening, Dow Jones Islamic screening, MSCI screening, FTSE screening, and Russel-Jadwa screening methodology, and others.
For instance, in classifying securities listed in Bursa Malaysia as to whether Shariah-compliant or not, there are two stages of screening applied by the SAC of SC of Malaysia in the previous Shariah screening methodology. In the first stage of screening, based on the data gathered by the SC, the SAC will be focusing on the activities of the company that issues the securities. As long as the activities of those companies are not contrary to the Shariah principles, their securities will be classified as Shariah compliant securities. However, their securities will be classified as Shariah non-compliant securities if they are involved in any of the following core activities:
Business Activity Benchmark
Business activity benchmarks are the first level of quantitative evaluation in the updated Shariah screening approach. The business activity benchmark, which was formerly comprised of four benchmarks, has been reduced to only two benchmarks under the updated approach. According to the new Shariah screening methodology, the following is how the contribution of Shariah non-compliant operations to the company's income and profit before tax will be measured and compared to the applicable business activity benchmarks.
(i) The five-percent benchmark
The 5% benchmark applies to the following businesses/activities:
- traditional banking and lending
- traditional insurance
- gambling
- liquor and liquor-related activities
- pork and pork-related activities
- non-halal food and beverages
- Shariah non-compliant entertainment
- tobacco and tobacco-related activities
- interest income from conventional accounts and instruments (including interest income awarded arising from a court judgment or arbitrator)
(ii) The 20-per cent benchmark
The 20-per cent benchmark is applicable to the following businesses/activities:
- share trading
- stockbroking business
- rental received from Shariah non-compliant activities
- other activities deemed non-compliant according to Shariah principles as determined by the SAC.
Financial Ratio Benchmark
While the second is addressed under "Quantitative or Financial Examination," the first is covered under "Sector and Activity-Based Filtration." There are primarily two methods used in quantitative or financial checks. The first step is to make sure that the company's primary assets are not mostly cash or cash-related. Stock trading is identical to cash-for-cash trade with discounts or premiums if the company's primary asset is cash. Because Shariah currency laws must be followed while exchanging money, this will result in the issuing of riba' (interest).
Insiders and outsiders alike can benefit from financial measures and benchmarks. Management may utilize this data to aid in decision-making and goal-setting, as well as to compare their company's performance to that of similar organizations. Lenders and other creditors can analyze credit risk using the same data. Ratios can aid management in identifying symptoms of core company problems and focusing its attention where it is most required. Objective metrics also reduce the chance of a choice being made only on the basis of intuition or emotion. The SAC considers the following factors when determining financial ratio benchmarks:
(i) Cash over total assets
The cash put in traditional accounts and instruments is the only cash that must be included in the calculation. A company's cash should be removed from the computation if it is kept in an Islamic account.
(ii) Debt over total assets
Interest-bearing obligations are the only ones that must be factored into the equation. Sukuk should be omitted from the computation if the firm uses Islamic finance. To achieve these valuation standards, each ratio must be less than 33%, and Shariah-compliant securities will only be issued by corporations that meet the requirements in all values. The SAC considers the qualitative component of public perception or image of the company's actions from the perspective of Islamic teaching in addition to the two-tier quantitative criteria mentioned above.
It should be highlighted that the first method takes into account all debt and currency, whether or not it complies with Shariah. The firm will be categorized as a cash- or debt-based corporation if cash or debt reaches or surpasses a specific level. Trading its shares at a discount or a premium will thus result in usury problems.
Furthermore, below are the screening procedures by AAOIFI screening, Securities Commission Malaysia screening, Dow Jones Islamic screening, MSCI screening, FTSE screening, and Russel-Jadwa screening methodology.
AAOIFI
AAOIFI was founded in 1990 with the goal of providing Islamic financial institutions with accounting, auditing, governance, ethics, and other Shariah requirements. It helps to harmonize and standardize the theoretical basis and practices of Islamic financial institutions all around the world. AAOIFI is a significant worldwide non-profit organization located in Bahrain that is primarily responsible for the creation and production of standards for the global Islamic finance sector. For worldwide Islamic finance, it has produced a total of 100 standards in the areas of Shariah, accounting, auditing, ethics, and governance. It has more than 45 institutional members from throughout the world, including central banks and regulatory bodies, financial institutions, accounting and auditing organizations, and legal firms. Its criteria are currently adopted by all major Islamic financial institutions throughout the world, and they have helped to bring international Islamic financial practices closer together.
The aims of AAOIFI are to improve accounting, auditing, governance, and ethical thinking connected to the activities of Islamic financial institutions, taking into consideration worldwide standards and practices that accord with Islamic Shariah. Following that, it aims to disseminate accounting, auditing, governance, and ethical thinking related to the activities of Islamic financial institutions and their application through training seminars, periodic newsletters, report preparation, research, and other methods. The latter aims to simplify Islamic financial institutions' accounting policies and procedures by preparing and issuing similar accounting standards and interpretations to those institutions. AAOIFI recognizes Shariah-compliant businesses by ensuring that they are not primarily engaged in unauthorized business activities such as usury or interest/usury-based activities (such as conventional banking), trade-in uncertainty/risk (gharar) (such as insurance companies), gambling/games opportunities (maysir) (such as casinos), or unauthorized manufacturers or dealers of products or services (such as casinos) (such as liquor, pork and prostitution). Meanwhile, AAOIFI focuses on the following financial ratios for financial ratio screening:
- Interest-bearing deposits of less than 30% of total equity market capitalization
- Debts carrying interest of less than 30% of total equity market capitalization
- Total market value of illiquid assets is greater than 30% of total market value of assets.
SC MALAYSIA
According to the Securities Commission Act of 1993, the Securities Commission Malaysia (SC) was created on March 1st, 1993. (SCA). With the adoption of four activity-based screening benchmarks in 1995, the SAC devised this Shariah screening methodology to carry out Shariah screening procedure for firms listed on Bursa Malaysia (previously known as Kuala Lumpur) Stock Exchange (KLSE). Two types of assessments are used in the methodology: quantitative and qualitative evaluations. The SC submits a report to the Minister of Finance based on the SCA, and our financial statements are presented to Parliament each year. In 1997, Malaysia's Securities Commission (SC) established the Kuala Lumpur shares Shariah index exchange as a key tool for accelerating the development of Islamic capital markets. The Islamic capital market is a market where operations are carried out in a way that does not, by nature, clash with the conscience of Muslims and Islam.
To put it another way, the Islamic capital market symbolizes the application of religious law to capital market transactions, ensuring that the market is devoid of banned behaviors such as riba (riba), gambling (maisir), and ambiguity (gharar). SACSC is responsible for certifying and updating the list of Shariah-compliant securities. The SC's 17-year-old screening review technique went into effect in 2013 as part of the SC's attempts to improve Shariah compliance for equities and investment management. The new technique employs a two-stage quantitative approach that employs company activity benchmarks as well as newly established financial ratio benchmarks. Previous qualitative evaluations were kept. SAC SC begins its screening process by analyzing companies based on two broad categories: business activities (Haram, mixed, or Halal) and company finance (basically, how much interest-based loans the company has in its capital structure and how much interest-based income it earns). The SC gathers information on the firm from a variety of sources, including annual reports, survey responses, and corporate management responses to inquiries.
DJIMI
The Dow Jones Index is a pioneer in the development of new indexes for both established and developing markets. On February 9, 1999, the Dow Jones Islamic Market Index (DJIM) was introduced in Bahrain. DJIMI is formed by removing stock that violates Islamic restrictions on specific advantages and types of operation (Shamsuddin, 2014). It is the world's first Islamic market. The Dow Jones Shariah Board Fatwa, which was issued in 1998, was used to create the index. The Dow Jones Islamic Market Index tracks the performance of equities in a variety of markets that are Shariah-compliant and fulfil other criteria that vary per index or market, as explained below. Unless otherwise mentioned in the Eligibility Criteria and Index Construction, the index utilizes a floating adjusted market capitalization (FMC) weighted methodology. The index family contains broad market indices, blue chips, strategies, and thematic indices that have passed the Shariah compliance rules-based screen. Stocks are checked to see if they fit the criteria for inclusion in the index before being added.
To be Shariah-compliant, businesses must fulfil specific criteria, including Shariah-compliant products, commercial operations, debt levels, and interest income and costs. The Dow Jones Index has signed a deal with Intelligence Ratings (RI) Partners to deliver a Shariah screen and stock filters based on it. Ratings Intelligence Partners is a London/Kuwait-based consultancy organization that specializes in Islamic investment market solutions. His forces are made up of qualified Islamic researchers who work closely with the Shariah Supervisory Board, which is a group of Islamic academics tasked with interpreting business concerns and making business-related decisions for the index. Shariah Supervision at DJIMI To create The Dow Jones Islamic Market Index, the Board used a two-stage equities screening method (Dow Jones, 2013). A qualitative screening is undertaken in the first step to rule out sectors whose fundamental commercial operations are regarded to be incompatible with Islamic teachings. The DJIMI Shariah Supervisory Board specifically identified six sectors as illegal (haram):
- alcohol
- pork-related products
- conventional financial services (interest-based banking, conventional insurance, etc. )
- entertainment services (hotels, casinos/gambling, cinemas, pornography, music, etc.)
- tobacco
- weapons and defense
MSCI Global Islamic Indices
The MSCI Islamic Indices Series adheres to Shariah investment tenets. Based on an MSCI Equity Index, an Islamic Index excludes all non-compliant equities in accordance with the MSCI Islamic Index Series Methodology. The Islamic Indexes exclude non-Shariah-compliant assets by screening for business activities and financial ratios. There are two varieties of the index that employ comparable business screening criteria but use separate methodologies for financial screening in terms of ratio calculation. The MSCI Islamic Index Series denominator is Total Assets, whereas the MSCI Islamic M-Series Index denominator is Average Market Capitalization. The Islamic Index Methodology has been deemed Shariah-compliant by MSCI's Shariah advisors' council of Shariah scholars (Islamic Indexes, 2022).
The MSCI Islamic Index methodology was evaluated and deemed Shariah-compliant by an independent Shariah advisory council comprised of Islamic scholars. Moreover, when computing ratios, it identifies Shariah-compliant debt and derivatives. MSCI was also among the first index providers to factor dividend purification into their indexes' total return calculations. In the meantime, the financial ratio screening uses buffer rules to reduce turnover, and indexes can be tailored to customer requirements, including screenings, ESG, Climate, and Factors.
SiRMuhammadi et al. Stated that Shariah investment principles prohibit investments in companies that engage in the following activities or get more than 5% of their revenue from them. As for business screening, the activities that being prohibited are alcohol: distillers, vintners, and producers of alcoholic beverages, including producers of beer and malt liquors, owners and operators of bars and pubs, pork-related products, tobacco: cigarettes and other tobacco product’s manufacturers and retailers, conventional financial services, defense/weapons, gambling/casinos, music, hotels and cinemas, and adult entertainment. Meanwhile, for financial screening, Shariah investment guidelines prohibit investments in firms that derive a disproportionate amount of income from interest and firms with excessive debt. MSCI employs the three financial ratios listed below to screen for these companies:
- Total debt divided by total assets should be less than 33.33%
- Cash and interest-bearing securities divided by total assets should be less than 33.33%
- Account receivables and cash divided by total assets should be less than 33.33%
FTSE
The FTSE Bursa Malaysia Index Series is a broad variety of indexes encompassing all qualifying businesses listed on the Bursa Malaysia Main and ACE Markets. This index series was launched in 2006 in conjunction with Bursa Malaysia. The indexes are intended to assess the performance of the various capital segments of the Malaysian market, classifying them as large cap, mid cap, small cap, emerging, and Shariah-compliant. The indexes allow market participants to measure, invest, and develop goods for these unique Malaysian market groups. The agreement also introduces FTSE Russell's FTSE4Good index methodology to the Malaysian market via the FTSE4Good Bursa Malaysia Index, which is aimed to identify Malaysian companies with recognized corporate responsibility standards (Malaysian Sustainable Finance Initiative, 2020).
Next, the FTSE Bursa Malaysia Index's primary eligibility criteria are free float and liquidity. First is free float, where each organization is mandated to have a minimum of 15 percent free float. The free float eliminates restricted shareholdings, such as cross holdings, major long-term ownership by founders, their families, or directors, restricted employee share plans, government holdings, and portfolio investments subject to a lock-in condition for the duration of the clause. The market capitalization of each firm is multiplied by a free float factor in accordance with the banding stated in the FTSE Bursa Malaysia Ground Rules. This element is used to determine how the company's market activities are attributed to the index. Second, consider liquidity. The liquidity screen is implemented to ensure that the company's shares are sufficiently liquid for trading. Companies are required to ensure that at least 10 percent of their free float-adjusted shares in issue are traded in the twelve months preceding the annual index review in December. It covers 30 firms from the primary market and lists between 900 and 1000 companies. The index began with a value of 100 on January 2, 1977.
In addition, FTSE uses Bursa Malaysia's real-time and closing prices to generate the FTSE Bursa Malaysia KLCI. The calculation relies on a value-weighted formula and a free-floating component. Every 15 seconds, the FTSE Bursa Malaysia KLCI values are calculated and broadcast in real-time. The FTSE Bursa Malaysia Index Advisory Committee reviews the FTSE Bursa Malaysia KLCI twice a year, in June and December. For the review, complete market capitalization data as of the final trading day of May and November are utilized. Any changes to constituents will be effected after business hours on the third Friday of June and December.
FTSE stated that companies engaged in any of the following activities shall be excluded as non-Shariah compliant. Under the business screening, the total interest and non-compliant income should not exceed 5% of the total revenue of the following:
- Conventional finance (non-Islamic banking, finance and insurance)
- Alcohol
- Pork-related products and non-halal production
- Entertainment including casinos and gambling
- Tobacco
- Weapons, arms, and defense manufacturing
Meanwhile, the remaining businesses are next subjected to a financial screening. Companies must meet the following financial ratios to be considered Shariah-compliant:
- Debt is less than 33% of total assets.
- The sum of the company’s cash and interest-bearing securities over total assets should not be more than 33.33%.
- Accounts receivable and cash are less than 50% of total assets.
Russell Jadwa
Russell Jadwa Shariah Based Funds PLC - The Emerging Markets Equity is an Ireland-based UCITS-certified open-end investment. The objective is long-term investment returns. Next, the Fund invests in equities listed or traded in emerging market nations or that derive the majority of their overall revenue from such countries (Bloomberg - Are You a Robot?, 2022). In 2009, Russell Investments and Jadwa Investment have reached an agreement to establish the Russell-Jadwa Shariah Index family, a new Shariah-compliant product. HRH Prince Faisal bin Salman, chairman of Jadwa, Andrew Doman, president and CEO of Russell, and senior managers from both organizations were present at the signing event on June 24.
Screened from the pool of 10,000 equities comprising the Russell Global Index, the Russell-Jadwa Index included over 2,700 securities from over 60 nations. The new index family will be divisible by location, country, mature and emerging markets, capitalization size, sector, industry, and style in order to offer fully modular benchmarks that capture the complete opportunity set within each segment. Furthermore, Islamic finance and Shariah-compliant funds have seen phenomenal growth during the past decade. The indexes that have been constructed by Russel with Jadwa include equities from 62 nations, providing investors with the most comprehensive country coverage available. In addition, Russell-Jadwa feels that their screening delivers the greatest standard and strictest of Shariah compliance. Regarding their business screening, the revenue earned by illegal activities and interest income must account for less than 5% of their entire income. These illegal activities include:
- Financial institutions
- Alcohol, tobacco, or weapons
- Production and distribution of meat not slaughtered according to shariah rules.
- Production and distribution of pork
- Gambling, managing casinos and adult entertainment
- Production and distribution of magazines, advertising, TV, cinema and video games
- Restaurants, hotels and places of entertainment that provide prohibited services
- Trading of gold and silver as cash on a deferred basis
- Stem cells/human embryos and genetic cloning
- Manufacturing and distributing weapons
Lastly, financial screening eliminates companies with excessive exposure to interest and other sources of unlawful income, as well as investments that are forbidden. Businesses are excluded if;
- Total cash, deposit, and receivables divided by the immediately preceding 12-month average total market capitalization exceeds 70%
- Interest-bearing debt divided by the immediately preceding 12-month average total market capitalization exceeds 33%
- Total cash, deposits and interest-bearing securities divided by the immediately preceding 12-month average total market capitalization exceeds 33%.
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CONCLUSION
In short, according to scholars, stock markets including secondary market trading and stock ownership are lawful. Due to its financial structure, a substantial portion of a market's equities may not be Shariah-compliant. According to the Islamic legal principle of darurah, equity investments are permitted. In this regard, some screens have been created to accept shares with a minority income from Shariah non-compliant stocks.
Major Shariah concerns include non-halal goods and services, such as gambling, alcohol, adult entertainment, pork products, and offensive weapons. Companies cannot invest in them if they represent their primary business lines. Companies that offer both Shariah-compliant and non-compliant items must surpass a particular revenue threshold in order to be considered Shariah-compliant in their non-compliant income generating. Hence, these restrictions will be lifted once the Islamic banking and financial industry has grown substantially, and not to forget that haram-derived income must be purified.
INFOGRAPHIC
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