Principles of Islamic banking and finance/PIBF203/Hedging and derivatives/Derivatives and Islamic finace

Derivatives and Islamic finance
“Mention the word derivative to any Islamic Financial practitioner, or student for that matter, and there are two very likely responses that are very opposite. To many, derivatives are, as warren buffet put it, financial weapons of mass destruction. The evidence of it is that derivatives were, what many claim, to be largely the cause of the 2008 Global Financial Crisis. Others are more indifferent and perhaps would like to consider other factors before deciding if derivatives are the harbinger of the next financial apocalypse or perhaps an opportunity for managing risks.”

But what exactly is this thing called a derivative. A derivative is essentially a security, the price of which is dependent upon one or more underlining assets. Hence the name derivative because it literally derives its value from another thing, whatever that thing may be. The most popular of these derivatives are forwards, futures, options and swaps. Without going into too much detail a forward contract is an agreement between a buyer and a seller where the buyer agrees to buy an underlining asset form another party, while the delivery is differed the price is determined on the spot. A futures contract is a standardized forward contract making it more tradable. An option contract can be either a put option or call option. A put option gives the buyer the right but not the obligation to sell a predetermined price and a call option gives the buyer the right but not the obligation to buy. A swap offers the opportunity for 2 counter parties to exchange the object of the swap; it could be a cash flow, bond maturities, currency and etc.

So what is the problem with these exotic financial instruments one might ask? A common allegation against derivatives is that they are prone to use of speculation. This may be so as evidence by Gorge Soros making billions from shot selling by speculating that the price of a currency would go down. Another common allegation against derivatives is that they are prone to abuse. This was shown in the Global Financial Crisis of 2008 where mortgages bundled into a collateralized debt obligation where it was cut up into different tranches and sold. It then became increasingly popular for the junior tranche (worst of the mortgages) to be re-securitized and sold again in what has been termed ?synthetic securitization? where the credit risk is sold to another party, essentially a credit default swap where the seller of the credit default swap would guarantee the tranche sold against default from the original asset. The problem was that the re-securitization was done again and again with no one knowing the barer of the final risk. The moment the mortgage owners began to default on their payments it triggered panic within the financial system as many were left with worthless assets.

It is interesting to note that while the two allegations may be true they indeed remain examples of gross abuse of derivatives and not necessarily the nature of derivatives themselves. To draw an analogy; a knife could either be used to kill or for many other beneficial purposes but it is dependent on the person who uses it. So when it comes to derivatives is it fair to say that a derivative itself is an abomination or does it depend on the nature of the derivative structure and what its intended purpose is.

With that in mind are derivatives even acceptable in Islamic Finance if so under what conditions? Also, what benefit could Islamic Finance obtain from such an instrument? Many scholars are suspicious of derivatives and rightly so as the complexity of such instruments should be met with great scrutiny. Some are of the opinion that futures contracts are halal as long as the underlining commodities are halal. It could also be argued that there is a need for hedging and futures contracts provide an avenue for risk management which would be a need for the ummah. Others such as Mufti Taqi Usmani find that futures contracts are not permissible due to the assertion that a sale or a purchase cannot be affected at a future date and the fact that in most futures transactions delivery or possession is not intended and therefore the niah of the contracting parties is questionable.

Option contracts too garner mixed views. Some scholars such as Hashim Kamali liken options to urbun (a type of security deposit where the payer of urbun reserves the right to buy a thing) and therefore allow it. Many others on the other hand find it unacceptable, as there is a possibility that one gains at the loss of another and therefore is an injustice. Other reasons include that the option contract is detached form the asset and the element of maysir (gambling) that is apparent. Mufti Taqi Usmani argues that the price of an option is similar to a premium and the charging of a premium is unacceptable. Also a promise cannot be the subject matter of sale therefore the Mufti finds that since the prevalent options transactions in the options market are based on charging fees on these promises, they are not valid according to Shariah and this applies to all options be it call or put.

It seems that there is much difference in opinion amongst the scholars, however it may be beneficial to discuss some of the possible plus points that derivatives can bring to Islamic Finance. One of the very beneficial uses of derivatives for Islamic Finance is that it provides a way to hedge or manage risk. Islamic Finance unlike its conventional counterpart cannot charge interest for financing. Ideally, the Islamic Financial Institutions are supposedly meant to justify their earrings by taking a position as an investor and therefore exposes itself to risks that the conventional finance does not face because conventional finance passes on this risk to the borrower of funds by charging interest. Therefore, it would be in the best interest of the Islamic Financial Institution to hedge or manage this risk as to not be left with losses that could jeopardize the survival of the institution itself. By using derivatives, Islamic Financial Institutions could effectively manage this risk as to limit any losses that may occur.

The issue here is that whether the Islamic Financial Institution is simply passing on that risk to another party by way of derivatives. Some might say yes, but it really depends on how it is looked at. To not do anything could be argued as a lack of due diligence and is arguably reckless on the part of the Islamic Financial Institution. Likewise, there is no compulsion on the derivative counterparty to take the risk only that they do by being more optimistic than the Islamic Financial Institution. If both parties agree than arguably, there is not real injustice by doing so.

Overall, there is much debate needed before casting aside derivatives. It is very understandable that Islamic Finance should be weary of these instruments. However, Islamic Finance could also be doing itself a disservice by not considering derivatives as avenues for hedging and risk management. The scholars have debated the issue however, it may be beneficial to the industry to take into account the new realities of the modern economy where Islamic Finance and Businesses operate within a globalized environment and are subjected to new and unique risks that did not exist in the past. Having said that, Islamic Finance must always keep in mind the objectives of the Shariah when examining or adopting these instruments. If truly they are not permissible than they should be avoided. Although, to simply discount all derivatives on the premise that some forms are questionable would be to close the door knowledge and opportunities that could be beneficial to the industry as a whole.