As the Islamic finance industry continues to grow, so have the need and demand for more sophisticated products, including tools for risk management. However, different Shariah interpretations of what is considered permissible according to Islamic law remain a big challenge.
Hedge funds have been at the heart of an intense debate among Islamic scholars over whether fund practices — particularly short-selling — can be complied with in view of the prohibitions on riba or paying interest, on gharar (uncertainty) sales and excessive speculation. This article looks at the main forms of hedging and examines the debate surrounding the use of derivatives in Islamic financial markets.
The case for hedging
All businesses and financial investments carry risks. For example, the nature of some businesses exposes participants to price or currency volatility that may result in higher costs, reduced revenue, reduced profits and even losses.
Hedging is an investment strategy to minimize exposure to business risks, while at the same time allowing a business to gain profit from investment activities. It is closely associated with the use of derivatives as financial instruments to minimize losses of an investment.
A derivative is simply a financial instrument or asset that derives its value from the value of an underlying asset. The most common instruments are forwards, futures and options.
A forward contract is a contract between two parties to undertake the sale and purchase of an asset, the completion of which is at a future date and at a price that is determined today. The development of a forward market came about more as a result of necessity in business and trading; for example, to secure future supply of a commodity as well as the need to lock in the price amid the possibility of price fluctuations.
Undoubtedly, derivatives as instruments of hedging are important risk management tools, but they can also be used by speculators to speculate. While a hedger uses derivatives to reduce his exposure to risks, a speculator uses the same instrument to gain exposure to risks in order to make a profit.
Shariah issues in hedging
While scholars may agree that hedging in order to reduce risk or protect investment is allowed in Islam, most are uncomfortable about the use of derivatives to make speculative gains, as are commonly used by hedge fund managers.
Shariah scholars argue that hedging is allowed if the sole purpose is to hedge (protect) against loss of value as a result of, for instance, currency fluctuation in the transaction of real assets. But according to some Shariah scholars, speculators who expose themselves to risk in order to gain profit are as good as gambling and, therefore, prohibited in Islam.
There seems to be a consensus that speculation using the derivatives market through the forward, futures, swaps and options transactions are not in line with Shariah principles as they involve elements of gharar (uncertainty) and maysir (gambling or game of chance).
In addition, because speculation in the derivatives market is done in view of profit and not to facilitate trading or a real business activity, the actual delivery of the underlying asset seldom occurs. This kind of speculation can be highly destabilizing and the danger of excessive speculation has been well documented, for example in relation to currency and financial crises and, recently, in the oil price hike.
The danger is caused by the fact that speculative activities may no longer be tied to real economic activities and may distort the demand and supply conditions of the real economy.
Shariah scholars also point to the highly leveraged derivatives market, and that the fact that the trading volume of derivatives is much larger than the underlying asset volume, signifying the highly speculative nature of the market. The leveraging strategy involves sale of debt and promises (which is prohibited in Islam) many times over and this has contributed to the creation of layers of leverage activities, which render investors vulnerable to extremely high risks.
Islamic alternatives to short selling
A short sale is generally a sale of a security by an investor who does not own it. In order to deliver the stock, the seller will borrow the security. The short seller will later buy the security on the open market (at a cheaper price if he is to realize expected/speculated profits) and return to the lender.
A short sale, therefore, involves loans that typically include elements of interest and if the stock the short seller borrows is one that pays dividends, then the short seller also has to pay dividends to the person or firm making the loan.
In general, short selling is utilized to profit from an expected downward price movement, to provide liquidity in response to buyer demand or to hedge the risk of a long position in the same or related security.
Some Shariah concepts or contracts that can be used as alternatives to conventional short selling include:
Khiyaral-shart (stipulated option)
This is legitimized in several hadiths (sayings of the prophet) and involves an unconstrained right to rescind an otherwise binding contract for a fixed duration.
Bai Arbun (down payment)
In this case, a buyer concludes a purchase and makes an advance of a sum of payment less than the purchase price. If he decides not to take the goods and settles the balance, then the seller keeps the advance. Of all the Islamic contracts, this offers the closest analogy to the option contract.
Bai Salam (full payment for deferred delivery)
This is the sale of goods for delivery at a later date but full payment is made immediately. The goods are usually agricultural goods but the principle can be extended to other assets.
Salam sale — an Islamic alternative to short selling
The Shariah has not prohibited all forward transactions. It has allowed the forward purchase and sale of agricultural commodities (Salam) or manufactured goods (Istisna) — an allowance for the time it takes to produce the goods.
In a Salam sale, a seller sells a commodity to a buyer against immediate full payment for delivery of commodity at a future date.
Shariah scholars now agree that the Salam sale contract can be extended to be used to structure an Islamic derivative instrument as an alternative to short selling.
The existence of the goods at the time of contract is not required and this represents an exception to the general rule. An investor in stocks can hedge part of his exposure to cover downside risk by selling stock as Salam.
In the case of conventional short selling, there are two distinct transactions: “borrowing” of stock at interest and selling the stock. In Salam, there is a sale but no borrowing of the stock.
The sale price may incorporate the time value of money (financing cost) but early delivery of goods will not reduce the price as the full price is paid upfront.
For short selling, dividend during the borrowing period belongs to the lender. In Salam, it needs to be estimated and factored into the price.
On the whole, Shariah scholars would agree that the practice of short selling in the derivatives market using forwards, futures and options contracts, either for hedging or for speculative gains, is not permissible in Islam.
With this conclusion, Islamic financiers have to resort to structuring their own Shariah compliant hedging instruments. But innovative products can only be structured if the industry can cope with the many Shariah issues it faces.
Certainly, Shariah principles need not be compromised; however, scholars do need to consider Islamic law in the light of today’s financial demands and problems.
Saadiah Mohamad
Director, WIEF-UiTM International Centre
Universiti Teknologi MARA
40450 Shah Alam, Malaysia
Tel: +603 5521 1444
saadiah228@salam.uitm.edu.my/saadiahuitm@yahoo.com
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