Are derivatives acceptable in Islamic finance? Of course the answer is yes, but one must appreciate the difference between Islamic derivatives and their conventional counterparts. Furthermore, while the use of derivative contracts is acceptable in Islamic finance, there are limits to trading in them. On a philosophical level, almost all Islamic financial products are in fact examples of derivative contracts. For example, a Sukuk (an Islamic equivalent of a bond) may link the returns of an asset (e.g., a property) to an interest rate mechanism such as LIBOR. What are derivatives? Any financial product that may derive its returns from an asset other than what it immediately invests in may technically be a derivative product. The most common examples of derivative products include options, forward and futures contracts. While the commonly held view amongst shari’a scholars is that trading in such contracts is forbidden in Islam, the financial engineering in Islamic banking and finance has resulted in a number of Islamic options, forward and futures contracts that may be used for risk management and hedging.
Amongst the contemporary shari’a scholars, Professor Hashim Kamali is perhaps the only one who has taken an unambiguous view on derivatives. Most other scholars’ opinions are in line with the rather conditional view of the Fiqh Academy of the Organisation of Islamic Conference (commonly known as the OIC Fiqh Academy), which states that the way derivatives are structured and traded in conventional financial markets is not permissible.
It must, however, be emphasised that trading in options (rights to buy and sell), forwards and futures contracts is not permissible under shari’a. The use of such contracts is permissible solely for hedging purposes and not for pure speculative reasons. Consider the following example: Party A is a Pakistan-based commodity broker who has bought soya beans from a US-based commodity broker for a price of $3m to be paid in one month. Party A would like to hedge against this foreign exchange (dollar) exposure in a shari’a compliant manner. This can be done in various shari’a compliant ways including the following: This structure is based on two promissory arrangements:
A bank gives a promise to Party A at a given time to buy Rs210 million for a price of 1.3c per one rupee on a future date – Promise 1. Simultaneously, Party A gives a promise to the bank to sell $3m for a price of Rs.70 per dollar (or a price of one rupee for $0.01428) on the future date – Promise 2.
The following are important shari’a considerations for promises:
1. Promises in Islamic law are not like contracts, i.e., while contracts are binding on both the transacting parties, promises are binding only on the promisor if the promisee decides to call upon it.
2. Only unilateral promises (or two or more unequal promises) are binding.
3. Two equal and oppoaite promises are considered as a contract, and if such an arrangement gives rise to a binding forward sale contract, this is deemed not in compliance with shari’a.
4. Two promises are considered as equal and opposite if they are given by the same two parties on the same object for the same price exercisable at the same time (or during the same period) but one of them is a promise to purchase and the other is a promise to sell.
5. Two promises are not considered as equal and opposite if at least one of the following conditions is not met:
(a) The two promises are given by the same two parties;
(b) Promises are given on the same object;
(c) Promises are given for the same price;
(d) The two promises are given for the same date (or period); and
(e) One promise is to purchase and the other promise is to sell.
In the above example, the condition 5(c) is not met, as the agreed exchange rates differ (one rupee = 1.428c versus one rupee = 1.3c). Hence, they are not equal and opposite, and are therefore not considered together as a binding forward sale contract. In conclusion, we assert that it is possible to structure derivatives in conformity with shari’a.
The writer is a shari’a advisor to a number of banks and can be contacted at email@example.com