Despite their importance in financial sector development, derivatives are few and far between in countries where the compatibility of capital market transactions with Islamic law requires the development of Shariah-compliant structures. Islamic finance is governed by the Shariah, which bans speculation, but stipulates that income must be derived as profits from shared business risk rather than interest or guaranteed return.
Based on the current use of accepted risk transfer mechanisms in Islamic finance, this article explores the validity of derivatives in accordance with fundamental legal principles of the Shariah and summarises the key objections of Shariah scholars that challenge the permissibility of derivatives under Islamic law. In conclusion, the article delivers suggestions for Shariah compliance of derivatives.
Types of Islamic Finance
Since only interest-free forms of finance are considered permissible in Islamic finance, financial relationships between financiers and borrowers are not governed by capital-based investment gains but shared business risk (and returns) in lawful activities (halal). Any financial transaction under Islamic law implies direct participation in asset performance, which constitutes entrepreneurial investment that conveys clearly identifiable rights and obligations, for which investors are entitled to receive commensurate return in the form of state-contingent payments relative to asset performance.
The Shariah does not object to payment for the use of an asset, as long as both lender and borrower share the investment risk together and profits are not guaranteed ex-ante but accrue only if the investment itself yields income. In light of moral impediments to passive investment and secured interest as form of compensation, Shariah-compliant lending requires the replication of interest-bearing conventional finance via more complex structural arrangements of contingent claims, subject to the intent to create of an equitable system of distributive justice and promote permitted activities and public goods (maslahah).
The permissibility of risky capital investment without explicit interest earning has spawned three basic forms of Islamic financing for both investment and trade:
synthetic loans (debt-based) through a sale-repurchase agreement or back-to-back sale of borrower or third party-held assets
lease contracts (asset-based) through a sale-leaseback agreement (operating lease) or the lease of third-party acquired assets with purchase obligation components (financing lease)
profit-sharing contracts (equity-based) of future assets. As opposed to equity-based contracts, both debt- and asset-based contracts are initiated by a temporary (permanent) transfer of existing (future) assets from the borrower to the lender, or the acquisition of third-party assets by the lender on behalf of the borrower.
Implicit Derivatives in Islamic Finance
From an economic point of view, creditor-in-possession-based lending arrangements of Islamic finance replicate interest income of conventional lending transactions in a religiously acceptable manner. The concept of put-call parity illustrates that the three main types of Islamic finance represent different ways to re-characterise conventional interest, through the attribution of economic benefits from the ownership of an existing or future (contractible) asset by means of an implicit derivatives arrangement.
In asset-based Islamic finance, the borrower leases from the lender one or more assets A valued at S, which have previously been acquired from either the borrower or a third party. The lender entitles the borrower to (re)gain ownership of A at time T by writing a call option -C(E) with time-invariant strike price E subject to the promise of full repayment of E (via a put option +P(E)) plus an agreed premium in the form of rental payments over the investment period.
This arrangement amounts a secured loan with fully collateralised principal (ie full recourse). The present value of the lender’s ex-ante position at maturity is , which equals the present value of the principal amount and interest of a conventional loan. In a more realistic depiction, the combination of a put and call option on the same strike price represents a series of individual (and periodically extendible) forward contracts on asset value S over a sequence of rental payment dates t, so that
where and denote the risk-free interest rate analogue and the market price of risk implicit in the pre-specified repayment of the lending transaction.
Overall, the put-call arrangement of asset-based Islamic lending implies a sequence of cash-neutral, risk-free (forward) hedges of credit exposure. Since poor transparency of S in long-dated contracts could make the time value of +P(E) appear greater than its intrinsic value, long-term Islamic lending with limited information disclosure would require a high repayment frequency to ensure efficient investor recourse.
In debt-based Islamic finance, borrower indebtedness from a sale-repurchase agreement (cost-plus sale) of an asset with current value PV(E), implies a premium payment to the lender for the use of funds over the investment period T and the same investor pay-off L1 as asset-based Islamic finance. In Islamic profit-sharing (equity-based) agreements, the lender receives a payout in accordance with a pre-agreed disbursement ratio only if the investment project generates enough profits to repay the initial investment amount and the premium payment at maturity T. Since the lender bears all losses, this equity-based arrangement precludes any recourse in the amount +P(E) in the absence of enforceable collateral.
Amid weak reliance on capital market financing in many Islamic countries, risk transfer mechanisms are subject to several critical legal hindrances that impact on the way derivatives, redress perceived market imperfections and financing constraints. While implicit derivatives in the form of forward contracts are essential to the put-call parity replication of interest through profit generation from temporary asset transfer or profit-sharing in Islamic finance, and thus are not deemed objectionable on religious grounds, the explicit use of derivatives remains highly controversial.
However, the implicit forward element of Islamic lending contracts – like forwards in conventional finance – involves problems of double coincidence and counterparty risk due to privately negotiated customisation. Parties to forward agreements need to have exactly opposite hedging interests, which inter alia coincide in timing of protection sought against adverse price movements and the quantity of asset delivery.
Moreover, forward contracts elevate the risk of one counterparty defaulting when the spot price of the underlying asset falls below the forward price prior to maturity, rendering the contract out-of-the-money and making deliberate default more attractive. Although the non-defaulting party does have legal recourse, the process of seeking contractual enforcement can be lengthy, cumbersome and expensive, especially in areas of conflicting legal governance as a matter of form (commercial law versus Islamic law).
These obvious shortcomings of forwards create the economic rationale for futures, which are exchange-traded, standardised forward contracts in terms of size, maturity and quality, and thus do away with the constraint of double coincidence in forward contracts. However, generic future contracts appear to contravene Shariah principles in the way they limit counterparty risk.
Futures are generally priced marked-to-market (MTM), which requires margin calls from the party that is out-of-the-money. Since the absence of underlying asset transfer renders MTM pricing unacceptable under Islamic law, a Shariah-compliant solution to this problem could be the marginal adjustment of periodic repayment amounts in response to any deviation of the underlying asset value from the pre-agreed strike price at different points in time until the maturity date.
But conventional futures still imply contingency risk. Options remove the exposure to discretionary non-performance in return for the payment of an upfront, non-refundable premium. Holders of a call option have the right (but not the obligation) to acquire the underlying asset, which could otherwise only be exercised by the purchase of the underlying asset at the prevailing spot price. Options do not only serve to hedge adverse price movements so much as they cater for contingencies regarding the delivery or receipt of the asset and offer the opportunity to take advantage of favourable price movements.
While the premise of eliminating contingency risk is desirable per se under Islamic law, the assurance of definite performance through either cash settlement (in futures) or mutual deferment (in options) like in conventional derivatives contracts is clearly not, as it supplants the concept of direct asset recourse and implies a zero-sum proposition. Instead, in Islamic finance, the bilateral nature and asset-backing ensure definite performance on the delivery of the underlying asset (unlike a conventional forward contract).
By virtue of holding equal and opposite option positions on the same strike price, both creditor and debtor are obliged to honour the terms of the contract irrespective of changes in asset value. The sequence of periodic and maturity-matched put-call combinations (with a zero-cost structure) preserves equitable risk sharing consistent with the Shariah principles of entrepreneurial investment.
Unlike in conventional options, there are no unilateral gains from favourable price movements (eg in-the-money appreciation of option premia) in the range between the current and the contractually agreed repayment amount. Any deviation of the underlying asset value from the final repayment amount constitutes shared business risk (in an existing or future asset).
Shariah scholars take issue with the fact that futures and options are valued mostly by reference to the sale of a non-existent asset or an asset not in the possession (qabd) of the seller, which negates the hadith (sell not what is not with you). Shariah principles, however, require creditors (or protection sellers) to actually own the reference asset at the inception of a transaction. Futures and options also continue to be rejected by a majority of Islamic scholars on the grounds that “... in most futures transactions delivery of the commodities or their possession is not intended”.
Derivatives almost never involve delivery by both parties to the contract. Often, parties reverse the transaction and cash settle the price difference only, which transforms a derivative contract into a paper transaction without the element of a genuine sale. Given the Islamic principle of permissibility (ibahah), which renders all commercial transactions Shariah compliant in the absence of a clear and specific prohibition, current objections to futures and options constitute the most discouraging form of religious censure (taqlid).
Besides the lack of asset ownership at the time of sale, other areas of concern shared by Islamic scholars about Shariah compliance of derivatives have centred on:
the selection of reference assets that are nonexistent at the time of contract;
the requirement of qabd (ie taking possession of the item prior to resale);
mutual deferment of both sides of the bargain, which reduces contingency risk but turns a derivative contract into a sale of one debt for another; and
excessive uncertainty or speculation that verges on gambling, resulting in zero-sum payoffs of both sides of the bargain.
Although Khan (1995) concedes that “some of the underlying basic concepts as well as some of the conditions for (contemporary futures) trading are exactly the same as (the ones) laid down by the Prophet Mohammed (peace be upon him) for forward trading”, he also acknowledges the risk of exploitation and speculation, which belie fundamental precepts of the Shariah.
For the same reasons, several scholars also consider options in violation of Islamic law. Nonetheless, Kamali (2001) finds that “there is nothing inherently objectionable in granting an option, exercising it over a period of time or charging a fee for it, and that options trading like other varieties of trade is permissible mubah, and as such, it is simply an extension of the basic liberty that the Quran has granted”.
With that in mind, strong opposition to derivatives seems to be inherited from the pathology of religious interpretation that turns a blind eye to the fact that derivatives are a new phenomenon in an Islamic context. The governance of derivatives has no parallel in the conventional law of muamalat and should therefore be guided by a different set of rules.
Establishing Islamic derivatives
The heterogeneity of scholastic opinion about the Shariah compliance of derivatives is largely motivated by individual interpretations of the Shariah and different knowledge about the mechanics of derivative structures.
Many policymakers, market participants and regulators are frequently unfamiliar with the intricate mechanics and the highly technical language of many derivative transactions, which hinder a more comprehensive understanding and objective appreciation of the role of derivatives in the financial system and their prevalence in a great variety of business and financial transactions. Risk diversification through derivatives contributes to the continuous discovery of the fair market price of risk, improves stability at all levels of the financial system and enhances general welfare.
In principle, futures and options may be compatible with Islamic law if they:
are employed to address genuine hedging demand on asset performance associated with direct ownership interest;
disavow mutual deferment without actual asset transfer; and
eschew avertable uncertainty (gharar) as prohibited sinful activity (haram) in a bid to create an equitable system of distributive justice in consideration of public interest (maslahah).
Shariah-compliant derivatives would also maintain risk sharing that favours win-win situations from changes in asset value. For instance, the issuance of stock options to employees would be an ideal candidate for a Shariah-compliant derivative. By setting incentives for higher productivity, firm owners reap larger corporate profits that offset the marginal cost of greater employee participation in stock price performance.
However, the de facto application of many derivative contracts is still objectionable due to the potential of speculation (or deficient hedging need) to violate the tenets of distributive justice and equal risk sharing, subject to religious restrictions lending and profit-taking without real economic activity and asset transfer.
Recent efforts of regulatory consolidation and standard setting have addressed economic constraints and the legal uncertainty imposed by both Islamic jurisprudence and poorly developed uniformity of market practices.
Private sector initiatives, such as an Islamic primary market project led by Bahrain-based International Islamic Financial Market (IIFM) in cooperation with the International Capital Markets Association (ICMA), have resulted in the adoption of a memorandum of understanding on documentation standards and master agreement protocols for Islamic derivatives.
Also, national solutions are gaining traction. In November 2006, Malaysia’s only fully-fledged Islamic banks, Bank Islam and Bank Muamalat Malaysia, agreed to execute a derivative master agreement for the documentation of Islamic derivative transactions.
Therefore, market inefficiencies and concerns about contract enforceability caused by heterogeneous prudential norms and diverse interpretations of Shariah compliance are expected to dissipate in the near future.
As Islamic finance comes into its own and companies turn to means of hedging their exposures more efficiently, financial institutions in Bahrain, Kuwait and Malaysia have been gearing up for more Shariah-compliant financial instruments and structured finance – both on the asset and liability side. Financial innovation will contribute to further development and refinement of Shariah-compliant derivative contracts.
Andreas A Jobst is an economist with the monetary and capital markets department of the International Monetary Fund.The views expressed in this article are those of the author and should not be attributed to the IMF, its executive board or its management.
This article first appeared in Islamic Finance news (Volume 4, Issue 50).