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.
What is a derivative?
A derivative is any financial instrument, whose payoffs depend in a direct way on the value of an underlying variable at a time in the future. This underlying variable is also called the underlying asset, or just the underlying. Usually, derivatives are contracts to buy or sell the underlying asset at a future time, with the price, quantity and other specifications defined today. Contracts can be binding for both parties or for one party only, with the other party reserving the option to exercise or not. If the underlying asset is not traded, for example if the underlying is an index, some kind of cash settlement has to take place. Derivatives are traded in organized exchanges as well as over the counter [OTC derivatives]. Examples of derivatives include forwards, futures, options, caps, floors, swaps, collars, etc
Here's one 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 favour 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 favour ("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 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 Kamali (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.
(Note : Some parts of this post is extracted from Iqtisad al-Islami)
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