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Corresponding author: Andreas Jobst, Bermuda Monetary Authority (BMA), 43 Victoria Street, Hamilton, Bermuda, e-mail: firstname.lastname@example.org; Juan Solé, Secretariat to the Financial Stability Board (FSB), Bank for International Settlements (BIS), Centralbahnplatz 2, Basel, Switzerland, e-mail: email@example.com. The paper was completed when both authors were economists in the Global Financial Stability Division of the Monetary and Capital Markets Department (MCM).
The views expressed in this paper are those of the authors and should not be attributed to the IMF, its Executive Board, or its management or the current employers of the authors. Any errors and omissions are the sole responsibility of the authors. We are grateful for comments and feedback received from Sheik Yusuf DeLorenzo, Ali Ibrahim, Basil Mustafa, Laura Kodres, Priya Uberoi, and Peter Werner. We thank several conference participants for their comments on segments of this paper presented at the Second Islamic Finance Roundtable in Oxford (April 15, 2009) and at the seminar series of the Centre for Islamic Studies at the University of Oxford. A first version of this paper was presented at the International Conference on Islamic Capital Markets held in Jakarta/Indonesia (August 27-29, 2007), jointly organized by Islamic Research and Training Institute (IRTI) of the Islamic Development Bank (IDB), Jeddah/Saudi Arabia, and Muamalat Institute, Jakarta/Indonesia.
A “derivative” or “derivative product” is a financial contract, whose value derives from one or more underlying reference assets, such as securities, commodities, market indices, interest rates, foreign exchange rates, or other agreed upon quantitative measures, and whose fulfillment or settlement is to occur at a future date not subject to extension.
While financial globalization facilitates greater diversification of investment and enables risk to be transferred across national boundaries, the growing volume of international trade and capital flows also raises interdependence of financial markets and the potential of greater fluctuations of cross-border capital flows. In this regard, derivatives play a critical role in facilitating the effective management of risks related to a greater market determination of interest and exchange rates. Derivatives also support risk management strategies aimed at cushioning potential currency mismatches of cross-border capital flows from unhedged external lending and borrowing and serve as access instruments for foreign investment in local markets.
shari’ah is not a codified body of law but a principles-based legal system that is subject to interpretation in the way it governs social, economic, and political relationships and institutions (Tredgett and others, 2008).
Kamali (1999) defines gharar as “risk, uncertainty, and hazard [in transactions]. In a [sales contract (bay)], gharar often refers to uncertainty and ignorance of one or both of the parties over the substance, characteristics or attributes of the object of sale, or of doubts over its existence [or possession/ownership by the seller] at the time of contract.” However, the term gharar defines a broad concept, whose interpretation varies by the type of contracts. In the most generic sense, it refers to contracts with a zero-sum proposition, i.e., the parties enter into a transaction they would rationally reject if they had perfect knowledge about their future payoffs.
It should be noted that, although there seems to be general agreement among scholars for rejecting conventional derivatives as such, the reasons can vary substantially among scholars.
The latter refers to the record of the sayings and deeds of the prophet Mohammed, which are clarified in the hadith, a collection of reports of statements and actions of the prophet (and the approval of something said or done in his presence) as an essential supplement to the qu’ran. For Sunni and Shia Muslims rely on six and three major hadith collections, respectively.
In practical terms, the principle of permissibility (ibaha) under established religious principles is generally taken to mean that all commercial transactions are shari’ah-compliant in the absence of a clear and specific prohibition by way of religious censure (taqlid) (Uberoi, 2010).
Riba is generally understood as the realization or prospect of an economic advantage by way of excessive compensation (riba al-fadl) or deferment of asset delivery and/or payment (riba al-nasi’a). It applies to any transaction that involves profitable exchange of two or more species (anwa) that belong to the same genus (jins) and are governed by the same efficient cause (illah). The prohibition of riba is upheld if deferred settlement is disallowed even if the rate of exchange between two objects involves no gain to either party.
The general consensus among Islamic scholars is that riba covers not only usury but also the charging of interest and any positive, predetermined rate of return that is guaranteed regardless of the performance of an investment or granted benefit (Iqbal and Tsubota, 2006; Iqbal and Mirakhor, 2006). While the elimination of interest is fundamental to Islamic finance, shari’ah-compliant investment behavior also aims to eliminate exploitation pursuant to Islamic law.
Although trading of debts is forbidden in many Islamic jurisdictions, it is allowed in others (e.g., Malaysia) under the concept of bay al-dayn.
While even a slight delay (nasi’a) might render a transaction invalid, in some cases, such delay would be in violation of pristine shari’ah principles and can be justified only as within the doctrine of extreme necessity.
There is no standard definition of gharar, which may also result from ignorance, inadequate information or lack of transparency.
Hedging defines the process of reducing risk in return for the payment of a fair price for such risk transfer, which contrasts with speculation, which aims at risk-seeking without full protection against any loss event.
Fulfilling unilateral promises (wa’ad) is considered honorable by all Islamic schools of thought (madh’hab) under Sunni and Shia Islam, but not necessarily a legal requirement. Note that the general permissibility of forward contracts under shari’ah could be deduced from the concept of salaf (forward trade), which requires the identification of a specific quantity, specific weight and for a specific period of time – conditions that a generally met in contemporary futures market trading.
Note, however, that financial and/or economic leverage in Islamic finance can arise from one (or more) contracts with unilateral deferment of payment, delivery or both. For instance, a long (short) position in a bay bithaman ajil (istisna’a) contract implies the right to buy (sell) an asset at a specified maturity date at a pre-agreed price for spot delivery (payment) but delayed payment (delivery), which generates leveraged returns compared to spot settlement. In the case of unilateral promises (wa’ad), the contract terms are fixed while both payment and delivery are delayed to some future date subject to willingness of the promisee to exercise the option to buy or sell.
Also covered short-selling (without prior endowment) can occur if short and long positions in salam and murabaha contracts are combined to replicate profit from borrowing an asset that is assumed to decline in value in the future. In this case, the acquisition of an existing asset in a cost-plus sale from a third-party (murabaha) contract is funded by a short position of a salam contract, which implies the obligation to sell the asset at a specified future date. The seller realizes a profit from a decline in value of the asset over a pre-determined maturity term if the spot price received for the forward sale of the deliverable asset via the salam contract exceeds the spot price paid for purchase of the asset via the murabaha contract (or the discounted fair value of the asset at maturity). While this transaction does not satisfy the strict definition of short selling, which involves the sale of an asset that is not owned by the seller, its economic result is the same. Alternatively, for uncovered short-selling, the murabaha contract could be replaced with a long position in a bay bithaman ajil contract to buy the asset at the maturity date of the salam contract, which would leverage the transaction (with the short seller holding both the asset and the proceeds from sale until the final settlement of both contracts). Similarly, a short position in a leaseback-repurchase agreement (ijara thumma al-bay) implies profits (to the seller) from a decline in the value of the reference asset if the repurchase price is higher than the future value of the spot price at the time of repurchase (after controlling for interim lease payments). See also Mohamad and Tabatabaei (2008).
Khan (1995) substantiates the permissibility of futures contracts on the grounds of the accepted forward trade (salaf) for a specific quantity, specific weight and for a specific period of time—much like modern day futures contracts. However, this line of argumentation ignores the fact that unless the price to be paid at a future date is pre-specified the payment event is not considered to occur with certainty. See Bacha (1999) for a more detailed summary of some inconsistencies in arguments among scholars in this regard.
In his discussion of different types of transactions in currency markets, Khan (1991) concludes that conventional contracts in forward, futures and swaps markets do not accord with Islamic principles.
MTM defines the process of constantly matching the valuation of an asset to the current market price, which involves monitoring the effect of variations to contingencies (e.g., market conditions, micro- and macroeconomic indicators, price volatility, quality considerations, political risk, etc.) on the forecasted spot price (i.e., expected future price) of an asset on a specified delivery date in order to price a derivatives contract. For instance, if the asset price falls below (increases above) the contracted strike price a call option would be “out-of-the-money” (“in-the-money”).
Thus, these derivatives almost never involve delivery by both parties to the contract and “… in most […] transactions [,] delivery of the commodities or their possession is not intended” (Usmani, 1996).
In a similar manner, the issue of close-out netting in derivatives contracts long delayed the draft guidelines of the ISDA-IIFM master agreement (Khasawneh, 2008). It appears, however, the valuation of certain positions in derivatives contracts rather than settlement concerns seem to have been the root cause of much of the debate prior to the current proposal.
A shari’ah-compliant solution to this problem could be the periodic adjustment of total (re-)payment commensurate with any deviation of the underlying asset value from a pre-agreed sales price at pre-agreed points in time.
In contrast to the majority of scholars, the Sharia Advisory Council of the Securities Commission of Malaysia, however, has certified the permissibility of futures trading of commodities as long as the underlying asset meets shari’ah requirements.
However, it is worth noting that under the rules of sarf, the concept of al-muqasah allows the settlement of debts in different currencies between two parties.
Even if options were considered permissible under Islamic law, there are further aspects to be considered. An interim value change of the reference asset during the maturity term of an option contract implies unilateral gains from shared business risk, which would only be shari’ah-compliant if the option had no intrinsic value at inception for a pre-specified strike price in the future. The realization of these gains, however, is conditional on eventual asset ownership (after execution of the option) rather than the sale of the option.
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 Qur’an has granted.”
The relation between the put and call values of a European option on a non-dividend paying stock of a traded firm can be expressed as PV(E)+C=S+P. PV(E) denotes the present value of a risky debt with a face value equal to exercise price E, which is continuously discounted by exp(-rT) at a risk-free interest rate r over T number of years. In our case of a lending transaction, the share price S represents the asset value of the funded investment available for the repayment of terminal value E.
The asset-based lending arrangements provide collateralization until the lender relinquishes asset ownership at the maturity date.
The lease payments received from the borrower wash out in this representation.
The “implicit derivative” in basic Islamic contracts, such as ijara, with permanent asset transfer constitutes a series of individual (and periodically extendible) cash-neutral (i.e., self-funding), risk-free forward contracts (-C(E)+P(E)) ensures definite performance.
Derivative elements are also part of debt- and equity-based Islamic finance. In debt-based Islamic finance, lenders create borrower indebtedness from the lender’s purchase of a tangible asset from a third party on behalf of the borrower. Borrowers pay the call option premium C(E) as periodic payment to the lender for the use of the reference asset over the investment period T. In profit-sharing (equity-based) agreements, the lender receives a pay-out C(E) in accordance with a pre-agreed disbursement ratio only if the profits from the investment exceed the initial investment amount at maturity T.
That said, any deviation of the future asset value from the final repayment amount constitutes accepted business risk at inception.
In general, reliance interest defines the losses which the innocent party has sustained as a consequence of relying on the wrongdoer’s promise. If payments have been made, this could also involve interest in recovering the amount by which one party has enriched or benefited the other (“restitution interest”).
In conventional finance, these obvious shortcomings of forwards have motivated the use of futures, which are standardized forward contracts in terms of size, maturity and quality. In Islamic finance, however, futures appear to contravene shari’ah principles in the way they limit counterparty risk through cash settlement without underlying asset transfer.
A commodity murabaha is a frequently used form of wholesale debt-based Islamic finance between a bank and its client to replicate short-term money market deposits and medium-term syndicated loans. Such a contract involves the sale on a deferred payment basis of a commodity, usually metals, at the market price plus an agreed profit margin to the borrower, who raises the required funds by immediately selling the asset to a broker or a financial institution.
Salam contracts are mostly used in agricultural finance. They closely resemble conventional futures contracts and are sometimes considered an independent asset class outside the asset spectrum of murabaha. Salam contracts are exempt from the requirement that the seller of the good must be in possession of the good at the time of signing the contract. On the other hand, the concept of salam applies only to commodities. See Batchvarov and Gakwaya (2006) for a more detailed discussion of salam from a market perspective.
A bay bithaman ajil (BBA) contract is primarily used for long-term financing and does not require the lender to disclose the profit margin.
The valuation difference between a call option and arbun arises from the deduction of an ex ante down payment from the strike price, which increases the likelihood of the option “being in the money” in return for an initial investment.
Three schools of thought (madh’hab) under Sunni and Shia Islam have declared arbun contracts void.
In conventional finance, we generally distinguish between two main types of swap contracts: (i) “interest rate swaps,” wherein interest payments are made in the same currency, and (ii) “currency swaps,” which involve different currencies. The swapped interest rate payments can either be floating, fixed, or a mixture of floating and fixed.
One example is the recently issued Master Agreement for Treasury Placement (MATP), which will contribute to the standardization of documentation rules for the shari’ah-compliant commodities market with a view to enhancing cost, time, and operational efficiencies of deposit arrangements for liquidity management.
The voluntary adoption of standards issued by various relevant international bodies such as IIFM, AAOIFI, and the IFSB is very underdeveloped, with national practice taking precedence over the less well-established international organizations.
Almost all standards issued by various relevant international bodies, such as International Islamic Financial Market (IIFM), Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), and the Islamic Financial Services Board (IFSB), are voluntary unless they have been incorporated in national law.
In November 2006, the Malaysian banks, Bank Islam Berhad and Bank Muamalat Malaysia Berhad broke new ground by agreeing to execute a master agreement for the documentation of Islamic derivatives transactions (Jobst, 2008a). This standardization initiative was sponsored by the Malaysian Financial Market Association (Persatuan Kewangan Malaysia) with the participation from both Islamic and conventional Malaysian banks.