Derivative Instruments and Islamic Finance
Introduction
The ever-increasing application and innovation of the methodologies associated with derivative instruments have revolutionized the global financial industry over the past two decades. Simultaneously, document standardization in transacting derivative based transactions has reached the point of uniform application in conventional markets and products, thus removing an immense amount of uncertainty and risk previously associated with these types of transactions. In this day and age, it can safely be said that derivatives have become de rigueur in the international financial arena.
Yet the doubt associated with the permissibility of derivative instruments under Islamic finance generally remains. Derivative instruments also still remain an enigma to many, mostly due to the unfamiliarity with their basic mechanics and the highly technical language in terms of which explanations are often attempted. This is a hindrance in trying to get across a proper understanding and appreciation of the matters at hand.
This is an introductory article on derivatives. Its object is twofold: (a) explaining some very basic concepts and transactions; and (b) pointing out the objections of the scholars of the Shariah. How they may be addressed can be considered at a later stage.
Some basic concepts and transactions
These instruments are called "derivatives" because their inherent value are derived from, and exist by reference to, independently existing underlying assets, or their prices, such as securities or commodities.
What does this mean? Here's a basic example: A miller and grain farmer conclude an agreement today for the delivery of a specified quantity and quality of grain on an agreed future date, let's say six months ahead. The important element of this transaction is that the price to be paid for the grain is fixed on today's date. The primary reason for the immediate price determination is to remove the uncertainty for both parties of what the actual spot price for grain would be six months from now. Either party may stand to lose or gain a great deal from this uncertainty if the price movement is against him or in his favor but it does not bode well for one's financial planning. Since the parties face risk in the opposite directions of price movement, it will make financial sense for them to meet and agree on a price, which will suit both of them, to eliminate the price movement risk in the commodity (called "hedging the price"). The grain farmer then knows what input costs he can safely invest in his harvest to still turn a profit; the miller, on the other hand, knows at what price he can sell flour into a competitive market six months into the future and can plan and market his product accordingly.
What has been explained above is a basic forward contract. The derivative element present in this simple set of facts is that, from the first day subsequent to this contract being concluded, the contract itself gains a value derived from the underlying price movements and future expectations of the spot price of grain on the agreed delivery date.
How does this work? The day the parties agreed the price of grain six months into the future it wasn't a matter of mere guesswork. Both parties probably considered a plethora of elements and contingencies in what they considered to be relevant in determining a fair price of grain six months into the future (e.g. market conditions, micro and macro economic indicators, price volatility, weather patterns, quality considerations and many more). Every day thereafter, the input data on these elements and contingencies will vary constantly to the extent that had the parties known about the changed conditions at the time they contracted on the price of the grain, they would have come to a different conclusion. For example, it does not rain in many farming areas during the early planting season and a bad harvest is forecasted, thus increasing demand and the expected future price of grain with it. The farmer who agreed on a price with normal weather patterns and rain forecasted now realizes that he is selling his bumper crop probably cheaper than he would have, had he known about the coming drought in certain areas.
This process of constantly monitoring the variations in the contingencies pertaining to the forecasted spot price of grain on the delivery date of the grain in our example (called "marking to market") can give the contracting parties an indication whether the contract is in their favor ("in-the-money") or not in their favor ("out-of-the-money"). If drought prevailed, as in our example above, the grain farmer would most probably have found his contract's mark-to-market value to be out-of-the-money. However, receiving a price lower than the expected market price was a risk he was willing to take at the outset, to hedge his position. Things might just as well have turned out the other way. It is this mark-to-market value (i.e. derived from translating present market conditions into an expected future price of the commodity on a future date) that represents the derivative value of the contract in question. It should be clear by now that this a value independent of the underlying commodity but at the same time it exists only because of changes in the variables determining the future price of the underlying commodity.
The forward contract is the most basic of derivative contracts. It may be of particular use in purchasing foreign currency from authorized dealers in currency (for particular reasons) but in other areas it has certain obvious shortcomings. Firstly, it is not often where parties have an exact match in (a) the opposite directions of price movement of the underlying instrument or commodity; and (b) the timing and the quantity of delivery (called the problem of "double-coincidence"). Secondly, the risk of the counterparty defaulting (so-called "counterparty risk") on his obligations is a higher than normal risk in these circumstances and can negate all good intentions when it comes to financial planning. If one refers back to the example of the grain farmer and the miller, it will soon be obvious why possible default is a higher than normal between the parties. If the miller saw a substantial dip in the spot grain price (far below his forward contract price, thus rendering his contract out-of-the-money) a few days before he was to take delivery of the grain in terms of the contract in our example, the attraction to default in terms of his forward contract with the farmer will be substantial. The same can be said of the farmer if there was a big increase in the spot price of grain way above the forward contract price a few days before delivery was due. Although the non-defaulting party will have recourse in law against the other, this can be a tedious and expensive exercise to bring to eventual fruition, which, once again, will undo all good intentions in respect of financial planning.
Enter the next tool in the evolution of derivatives, futures contracts. Designed to take care of both problems of double coincidence and counterparty risk, a futures contract is a standardized forward contract with respect to size, maturity and quality interposing a futures exchange (in between the original buying and selling parties) as the buyer to each seller and the seller to each buyer. Each party can then buy the number of contracts that will suit its individual needs. Because a large number buyers and sellers deal via the exchange the problem of double coincidence is easily overcome. Also, by doing daily marking to market and making margin calls from the party that is out-of-the-money, the futures exchange substantially reduces counterparty risk.
The final basic concept to consider under this heading is that of options. As was the case in our evolutionary tale before, the inadequacies of futures contracts gave rise to the development of options. Futures contracts have the underlying assumption of actual delivery of the merchandise concerned at the price initially agreed upon. The only way of avoiding definite performance under the contract is to enter into an equal and opposite sale or purchase of the underlying merchandise on the exchange at the prevailing mark-to-market price for the goods. It is clear that this does not cater for contingent scenarios (where actual obligations are not certain) that might arise in a business on a daily basis. It also does not allow parties to take advantage of favourable price movements in their favour.
To properly understand this, let us revert once again to the example of the grain farmer and the miller. Firstly, the grain farmer is not exactly sure how much grain he will produce or what quality it will be. Is it then sound financial planning to enter into a contract for the delivery of a specific amount and quality of grain in the early planting season? If he had taken out an option to sell the grain at a specific price to the miller (called a "put option') and paid an upfront non-refundable minimal amount for such an option (called a "premium"), he would have had the right (but not the obligation) to sell his goods at a specific price to the miller. If he couldn't deliver due to contingencies beyond his control, he merely would not exercise his option and will only lose the minimal amount of the premium paid for the put option. At least he would not be caught in a situation where he would be obliged to deliver, as would be the case under the futures contract. Secondly, if the farmer was capable of getting a far better spot price for his grain at the time, he also wouldn't exercise his put option but rather sell his grain onto the open market. Thus, by having taken a put option instead of a futures contract, he (a) covered the price risk on his goods; (b) catered for contingencies beyond his control regarding delivery of the goods; and (c) still had the opportunity to cash in on favourable movements in the spot price for grain, all in return for the premium. Conversely, the same reasoning applies for the miller. Instead of binding himself to one farmer, who may, or may not, be able to deliver, why not pay a premium for an option to purchase from more than one (called a "call option")? This way he caters for contingencies on one farmer not being able to deliver, and if there is a favourable downturn in the spot price of grain, he need not take any of the farmers up on his call option.
Although the examples given above seem oversimplified, their basic elements are present in a great variety of business transactions worldwide on a daily basis. It should be clear by now that there is an acute need for these instruments in businesses that require sound financial planning to give it the edge in the competitive world of global markets of modern times. It should also be clear that once these basic principles are clearly understood, it doesn't take much to make the quantum leap to realize that derivative values can be realized in almost anything tradable in the open market (equities, securities, currencies, interest rates, credit risk, any commodity imaginable, indexes thereof and/or baskets of any combination of the above) and be utilized for a variety of purposes, notably those pertaining to hedging, arbitrage and speculation.
The objections of the scholars of the Shariah
From an outsider's perspective (i.e. not schooled in the Shariah and only having access to English papers written on the subject), the prevailing impression one gets is the inconsistency in arguments and opinion from the learned scholars regarding these instruments. Here are a few examples:
Futures
Mufti Taqi Usmani of the Fiqh Academy of Jeddah in an article answering a set of posed questions on the topic (New Horison, June 1996, pp 10-11), argues that futures contracts are invalid because:
"Firstly, it is a well recognized principle of the Shariah that purchase or sale cannot be effected for a future date. Therefore, all forward and futures contracts are invalid in Shariah; secondly, because in most futures transactions delivery of the commodities or their possession is not intended. In most cases the transactions end up with the settlement of the difference in price only, which is not allowed in the Shariah."
Conversely Fahim Khan (Islamic Futures and their Markets, Research Paper No.32, Islamic Research and Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia, 1996, p.12) states that:
"we should realize that even in the modern degenerated form of futures trading, some of the underlying basics concepts as well as some of the conditions for such trading are exactly the same as were laid down by the Prophet (PBUH) for forward trading. For example, there are clear sayings of the Prophet (PBUH) that he who makes a Salaf (forward trade) should do that for a specific quantity, specific weight and for a specified period of time. This is something that contemporary futures trading pays particular attention to." (Fahim Khan does go on, however, to criticize the modern futures contract for its exploitation of small farmers.)
Options
A number of scholars have found option contracts objectionable (Ahmad Muhayyuddin Hasan, Abu Sayman and Taqi Usmani to mention a few notable ones). However, in perhaps the most comprehensive study of the subject thus far, Hashim Kali (Islamic Commercial Law: An Analysis of Options, 1995), concluded 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 and extension of the basic liberty that the Quran has granted."
It appears that most scholars agree that, in principle, futures and option contracts may be compatible with Shariah principles. What makes them worth objecting to, is the manner in which they have found application in the marketplace in certain instances, such as with speculation and exploitation of certain counterparties. The objections of the learned scholars differ in accordance with their individual interpretation of the Shariah and their understanding of the instruments under discussion.
As this deprives businesses from an array of benefits and advantages that, if understood and appreciated properly, appear to be halal in many instances, a concerted effort may be necessary to address the social disadvantages it is placing on such businesses in today's global economy.
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