Islamic Banking & Finance Page 01-11-2019

Use of Derivatives by Islamic Financial Institutions

What are Derivatives? A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes. These assets are commonly purchased through brokerages.

Everybody knows that it is not possible in this world to completely remove uncertainty from real life events and humans are not capable of foreseeing the future. Therefore, business transactions cannot be considered free from the uncertainties and the need remains to have some financial arrangement for covering such risks.

For these contracts using Derivatives are employed. However there exists a chance that “gharar” (Uncertainty) may imply higher degrees of vagueness in the contracts regarding the subject matter, the price, or delivery. Hence it is forbidden in Islam. In essence, gharar is such a sale of probable items which has uncertain characteristics and it makes a risky business quite similar to gambling in nature.

Derivative transactions, as already mentioned, contain gharar that can be understood from the nature of most of the contracts. The sale without possession is a common feature of these contracts that leads to gharar. Particularly, in the case of derivatives, the possession and delivery is not intended even. As the payment is also due in future, the customers need only a little amount to enter into high volume trade transactions. This results in inflation of the trade activity to the disadvantage of the genuine traders.

The practitioners in Islamic finance markets are of the view that in case the IFIs are not allowed to deal in derivatives market, it could have serious implication for their business. To some IFIs one can only enter only in Salam transactions for commodity forwards. As such, they may lose in terms of opportunity cost of investment in comparison to traditional forwards where payment is also deferred. They may not be able to reap the benefits of hedging and as per conventional finance ideology there will obviously be lower number of investors due to involvement of real commodities and assets and markets will be hosting only high net worth individuals. This argument neglects, however, some core principles related to IF. Islam draws a clear line between permissible (h.al¯al) and impermissible (h.ar¯am) modes of trade, and mere earning profit at any cost is not the objective of any Islamic institutions. Rather, all business by the IFIs has to be subject to observance of the tenets of the Shar¯ı‘ah.

Furthermore, even now conventional finance is shifting towards instruments that are engrained in economic reality after the global financial crisis of 2008 and there is ongoing criticism on the derivative instruments. There is growing awareness among conventional financial institutions to practice ethics in commercial activities and refrain from dealing in arms, drugs and gambling. IFIs are more required to observe the Divine ethics to save the human society from the problems created by ‘financialisation’ by involving derivatives and other complicated financial products engineered to deceive the masses. In this scenario, IFIs have to select among three options.

They can either continue trading in derivatives markets as their business need. But Islam does not accept this.

The following hadith adequately defines and sums up various elements of gharar:- The Prophet (PBU) forbade two kinds of sales: i.e. al-limais and an-nibadh (the former is a kind of sale in which the deal is completed if the buyer touches a thing, without seeing or checking it properly and the latter is a kind of a sale in which the deal is completed when the seller throws a thing towards the buyer giving him no opportunity to see, touch or check it) and (the Prophet (PBU) forbade) also ishtimal as-samma’ and al-ihtiba’ in a single garment  business or earnings as if that involves any of the principal Shar¯ı‘ah prohibitions. Hence, this may threat even their very existence as Islamic finance is being evolved solely upon the basis of Islamic principles.

The second option is to completely refrain from securitization and taking part in trading of investment instruments thereby suffering losses in terms of lost opportunities. The most viable solution seems the introduction of distinguished instruments and products while maintaining one-to-one relationship between finance and the real economy. Islamic financial experts and engineers must know that the derivatives have been used overwhelmingly for speculative purpose and as such, they cannot become a means of evolving a stable and really Shar¯ı‘ah compliant financial system. This is why, even Warren Buffet, an American business magnate and the chairman/CEO of Berkshire Hathaway, took a stronger stance against derivatives than some Islamic academics and considered derivatives as “financial weapons of mass destruction”.

The ultimate solution is establishment of dedicated markets having specifically designed innovative IF products. The concerned parties should try to evolve such markets that can bridge this gap for investors and IFIs.

Some scholars have stressed the importance of derivatives and mentioned that a more rationalist deduction of provisions of fundamental principles of Islamic law establish the permissibility of some of the derivative instruments. They argue that the growth of modern technology has given new meanings to the concept of uncertainty and there is a need to look back and redefine the terms like gharar and jah¯alah. It is, of course, crucial to observe that permissions for some derivatives have been given for the purpose of genuine hedging and the IFIs have been suggested to observe the relevant rules of Islamic business and trade. Sole and Jobst (2012), an economist at the IMF qualified Islamic derivative with such conditions observance of which would not yield the return that the IFIs would wish to earn, while competing with the conventional hedge funds. These conditions included effective and intended delivery/ownership in an identifiable asset or venture, rejecting deferment of contractual obligations, and avoiding all prohibited activities like gambling, gharar and jahal. Further, these arguments apparently seem to hold some ground, but there are many challenges involved in acceptability of these contracts.

Firstly, they contain serious issues like non-existent subject matters, h.ar¯am underlying assets, rib¯a based transactions and the presence of qim¯ar , maysir, jah¯alah and gharar. But the issues in the financially engineered “Islamic derivatives” as being used in some markets, lead to separation of risk from ownership, trading in excessive risk, short selling and netting-off by using some grey area concepts and terms like wa‘d, tawarruq and muq¯as. s.ah. As a whole, it implies avoiding the implication of transfer of possession and bearing business risk the major requirement of valid business contracts. This is what caused the collapse of big corporate entities in recent years, and this is why such practices have been prohibited in the Divine law. This is precisely why financial derivatives had never been among the most appreciated transactions even from conventional law and finance point of view.

As a result, international standard setters like OIC Fiqh academy and AAOIFI have declared them not permissible. Secondly, the proposed Shar¯ı‘ah compliant derivatives are, in no way, different from their conventional counterparts in terms of economic reality. Finally, in addition to their flawed legal form, derivatives do not contribute to achieve objective of Shar¯ı‘ah. Our argument is based on the assessment of innovative IF-derivative products. For example, forward foreign exchange transactions based on unilateral binding promise tailored for the purpose of risk management do not involve exchange. Similarly, the returns on Islamic Profit Rate Swaps are not the result of actual sales. Likewise, the options product is a set of engineered transactions and the returns are based on interest rates, instead of returns resulting from the economic activity. Evidently, these transactions do not contribute to achievement of objectives of Shar¯ı‘ah , owing to their inability to promote employment or remove hardships or assist in providing necessities to the stakeholders.

However there are several recommendations to conclude. In order to perform effective risk management, IFIs should come up with the innovative ideas and products to replace conventional derivative instruments. Similarly, as there are conflicting views regarding derivative products developed through financial engineering in certain jurisdictions, it is the role of AAOIFI and IFSB to issue detailed standards covering the innovations while ensuring Shar¯ı‘ah compliance. Additionally, from the legal point of view, there is a need for clarification of some concepts in the light of new circumstances and global conditions. For example, a practical difficulty in international commodity dealings is ascertainment of possession (qabd. ) in case of inter-related transactions. The trading volume is usually very high in international markets and countless contracts are executed and settled on daily basis. Therefore, delivery and sale occur simultaneously most of the times and it becomes very difficult to be sure of the fact that there is no overlap in the roles of buyer and seller. The similar problem is faced by IFIs who work as agents in tawarruq transactions. The Shar¯ı‘ah scholars and other standard setters should deliberate on relevant texts in Fiqh literature and define suitable conditions to clearly identify qabd, in case of such contracts to avoid selling something which is not in possession and risk.

Finally, it is again stressed that Muslim countries need to develop their own markets and come up with distinguished instruments that can be practiced on these platforms so as to fulfill the religious obligations attached to the trade activity. The core principle has to be the transactions engrained in economic reality instead of artificial transactions that result only in more uncertainty and vulnerability of financial system.