Principles of Islamic banking and finance/PIBF203/Hedging and derivatives/Why derivatives are controversial in Islamic finance

Why are conventional derivatives controversial in Islamic finance

Besides riba and commercial activities in prohibited goods and services, shari’ah also prohibits

• betting and gambling (maisir) as sinful behavior in contracts with a remote probability of positive payoffs to the investor (“game of chance”), as well as

•preventable contractual uncertainty and/or contingency risk of performance (gharar), including all financial derivative instruments and agreements aimed at speculative trade (rather than genuine hedging and/or equitable risk sharing) that result in payments without an underlying asset transfer.

These overarching requirements for a valid sale under Islamic contract law distill a number of more specific conditions, which pertain to shari’ah compliant derivatives:

Price certainty and balance between borrowers and lenders without manipulation of risk

While the fair value of an asset and the return from investment are inherently uncertain, the shari’ah prohibition of maisir stipulates that transactions are tantamount to gambling or speculation if they generate returns from money as a store of value (rather than a medium of exchange to execute trade or shared investment) and have the manipulation of risk as their primary or sole purpose.

While commercial risk-taking is deemed permissible, the (probability of a certain) price to be paid for an asset is definite (although potentially adjustable to the fair value in case of material changes) and must be known to both parties ex ante. Uncertain returns or payment obligations that are incalculable ex ante and divorced from (required) asset performance and/or the rendering of a service can amount to speculation. However, contracts that are premised on the reduction of risk to facilitate trade (and quite possibly enhance productivity) could be considered acceptable under the religious maxims of shari’ah.

Identifiable characteristics and certainty about delivery results in terms of quantity and quality

In order to avoid gharar and jahl (ignorance), sales must be immediate and absolute, which requires that the object of a bona fide trade or exchange must exist (or come into existence based on demonstrated real capital input) and its characteristics clearly identifiable before the transfer of title takes place. Exchanges involving asymmetric information between contracting agents imply the risk of delusion or deception, especially if payment obligations and delivery results differ from rational expectations. Such contractual uncertainty could lead to exploitation if they generate unilateral (or zero-sum) gains from state- or time-contingent prices, resulting in divergent impacts on different agents. Agreements that attribute sales to future dates, sales contingent on future events, or promises of future sales are not considered enforceable contracts. The exceptions are forward contracts on agricultural commodities (salam) or manufactured goods (istisnaa) with delayed delivery and payment respectively, whose premise of creating commercial value overrides the prohibition of term contingencies until fulfillment of the contract; and

Asset ownership and prohibition of leverage (underfunding)

Shari’ah principles align financial claims with investments in real assets, which marginalizes the possibility of underfunding through leverage while fostering equity ownership (in lieu of financial leverage from debt creation without underlying asset values). Thus, any reference asset is required to be in the (constructive) ownership and possession of the creditor (or, in the context of risk management, the protection seller) at the inception of a transaction in order to ensure the asset-backing of financial obligations (which also “collateralizes” the performance of contractual obligations) and the risk and reward sharing that follows from it.

Derivatives under shari’ah law

Since the object of a transaction may not exist at the time a contract is signed, Islamic scholars argue that derivatives could lead to excessive uncertainty, unnecessary risks (gharar) or speculation that verges on gambling (maisir) due to state-contingent pricing and the absence of predetermined object characteristics and—points 1.1 & 1.2 above. In particular, there is concern about the fact that absence of an absolute reference value could result in zero-sum payoffs of both sides of the bargain and possible exploitation of the ignorant. That being said, standardized contract specifications, advanced market conduct, and supervisory controls may render the latter argument invalid. That leaves only the question of how the ex-ante protection against downside risk via premium payments can be reconciled with the potential for unlimited upside potential in contracts that may pay off at a pre-determined time in the future, such as options.

Another key argument presented against derivatives in Islamic finance pertains to the counterparty risk (and associated potential of avertable uncertainty) from the sale of a nonexistent asset or an asset not in the possession of the seller (qabd) (i.e., taking possession of the item prior to resale, which negates the hadith “sell not what is not with you”). Derivatives supplement cash markets as alternatives to trading underlying assets by providing hedging and low-cost arbitrage opportunities. However, many derivatives contracts are used for speculation (and are deficient of actual hedging need), which belies equal risk sharing (sharik) in actual ownership of the reference asset(s) by all contractual parties subject to religious restrictions governing lending and profit-taking.

A majority of scholars continue to reject futures and options as unconcluded contracts, because unfunded or partially funded transactions do not imply legal ownership (and possession) of the reference asset, which would guarantee the delivery of the contractual asset with certainty at a future date. For some, it can be conceded, that even in the contemporary form of futures trading “some of the underlying basic concepts as well as some of the conditions for such trading are exactly the same as [the ones] laid down by the Prophet for forward trading. However, it is also pointed out that, one should be cautions about the potential of unnecessary risks arising from speculation, exploitation (given that payment obligations are contingent on the intertemporal valuation), and the perceived lack of a physical asset ownership, which render conventional futures non-permissible under shari’ah law.

Other criticism that has been raised by a number of Islamic scholars relates to the deferment of both actual asset delivery and final payment in conventional derivatives contracts, such as futures. Futures are generally priced marked-to-market, which requires interim payments (“margin calls”), by the party whose contingent claim has lost value (“out-of-the money”). In addition, parties to the transaction tend to cash settle the price difference upon closeout or maturity. While such arrangements typically help mitigate contingency risk of asset delivery and ensure definite performance by means of cash settlement (if physical delivery fails or one party defaults), they have been deemed noncompliant with Islamic law, given that same object of exchange cannot be bought and sold between two parties at different prices and with time delay of payment, delivery or both (due to the use of the object over the contract period) (bay al’ inah). Scholars find that the interim cash payments due to margin requirements and cash settlement (rather than physical delivery of underlying assets) do not meet the shari’ah principles of underlying asset transfer and certainty about final payment obligations. Intertemporal (re-)pricing turns the contract into a debt sale without the element of a genuine transfer of asset ownership. Similarly, offsetting a contractual obligation via cash settlement (contingent on a particular economic outcome) would portend to a pure cash exchange without asset ownership and/or the creation of real assets, which violates shari’ah principles, and, thus, would be without proper cause (illah).

However, futures-like instruments do exist in Islamic finance. For instance, the exchange of currencies or means of payment in a sarf contract requires the transaction to take place at spot before the contracting parties disperse. In addition, future delivery of commodities is permissible (as in salam and istisna), but payment must be immediate, which rules out MTM pricing.

For similar reasons, several scholars also consider options in violation of Islamic law. Options redress the contingency risk of definite asset delivery (and the associated exposure to discretionary nonperformance) in forward and futures in return for the payment of an upfront, nonrefundable premium. Holders of a call (put) option (“promisees”) acquire from the seller (“promissor”) the right (but not the obligation) to acquire (sell) the underlying asset at a predetermined price during a specific period of time. Therefore, options do not only serve to hedge adverse price movements and take advantage of favorable price movements at low transaction cost, but they also cater for contingencies regarding the delivery or receipt of the asset. Usmani, a prominent Islamic scholar, observes that “according to the principle of the shari’ah, an option is a promise to sell or purchase a thing on a specific price within a specified period. Such a promise in itself is permissible and is normally binding on the promisor [like a wa’ad contract]. However [,] this promise cannot be the subject matter of a sale or purchase. Therefore, the promisor cannot charge the promisee a fee for making such a promise.”

Nonetheless, it seems that the question of whether there is scope for options under Islamic law has not been answered conclusively so far. In many instances, arbun (down payment) and wa’ad (unilateral promise) have been used to design shari’ah-compliant instruments that resemble call options. Given that the intrinsic value of an option is determined by changes in the fair value of the reference asset with zero-sum payoffs, however, only the time value of an option (independent of the realization of unilateral gains) appears permissible. The inherent leverage in options and their detachment from the reference asset(s) remain controversial. Nonetheless, Bacha suggests that disqualifying options on the grounds of gharar and maisir presumes that they are primarily transacted for speculative gains and not genuine hedging – a claim that may not be accurate in most cases.

In summary, insufficient (or absent) asset-linkage and the potential of unilateral gains in many derivatives seem to supplant the concept of equitable risk sharing and contractual certainty, which define the perimeter of religiously acceptable risk management behavior under Islamic law. Although the avoidance of counterparty risk of periodic payments and contingency risk of definite performance is essential to establishing possible shari’ah compliance of derivatives, conventional remedies to these contractual uncertainties (using futures or options) seem to controvert Islamic principles. For instance, the assurance of both payment and delivery through state-contingent (periodic) cash settlement (in the case of futures) and provisions for unilateral deferment (in the case of options) imply a zero-sum proposition ex ante and intertemporal debt creation without underlying asset transfer.

In addition, some controversial features of conventional derivatives, might have been more relevant in the past, when simple, unsupervised, and unorganized capital markets implied considerable counterparty and contingency risk. This could make conditions of mutual gain, value creation and asset ownershipwhich are motivated by the same stability-enhancing rationale but implemented differentlyless binding on shari’ah-compliant risk management strategies if the underlying intent of Islamic principles were revisited under current market conditions. In today’s more developed financial markets, where transactions are easier to document and enforce, a more flexible interpretation of some of these principles that preserves the main moral tenets of Islam might be warranted.