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Management Articles

Derivatives in Islamic Finance  

It is generally perceived that derivatives in Islamic Finance are not permissible. In totality, this perception is not correct.

Derivatives in their object are financial products, whose prices are derived from the value of something else. So basically derivatives are financial products for trading risk. They came in to existence on becoming financial markets volatile, so in fact they are products for hedging risks, but on market expansions and becoming profitable, they turns lucrative for speculators as well, and at this point, risks enter in to the business.

Islamic Finance in its operation is also subject to such risks. However, while managing such risks, it has to follow some basic principles that are; should be riba free, should avoid uncertainty, should have some underlying asset and in transactions to ensure real possession and not to make any investment in some haram business. 

In derivatives, no real transaction takes place in most of the cases, with no transfer of ownership, so apparently it dose not have any place for Islamic finance. Secondly derivatives unbundle risk from real economic activity, making it a commodity separate from real economic activities, so in this form, it is also not acceptable. In fact derivatives make the economy more risky in this form.

Islamic approach for defining risk has been explained by Ibn Taymiah (728H-1328G) as: Risk falls in two categories: Commercial risk, where one would buy a commodity so as to sell it for profit, and rely on Allah for that. The other type of risk is that of gambling, which implies eating wealth for nothing. This is what Allah and his Messenger (peace be upon him) have prohibited.

Considering commercial risk, Ibn Taymiah further explains that reward of deed (or business) should be based on their usefulness and not on their hardness. In other words, value of an economic decision should not depend on, how much risk one intends to take, but should be determined by wealth it creates and value it adds. So risk is appreciable, in case it creates wealth and adds value. In this respect hedging techniques in derivatives qualify for Islamic finance, which is generally denoted for neutralizing and minimizing risks. However the matter is not very simple as it appears. Shariah does no approve zero sum nature of derivatives; hence to design hedging products without maisir (betting) is a challenge for Islamic Finance.

Going forward, the question of conditions comes in, under which risks can be tolerated. Generally Muslim scholars agree that with following conditions risk can be tolerated; 1) it is inevitable 2) it is insignificant 3) it is unintentional.

It is generally agreed that willingness to take risk is essential to the growth of a free market economy; however Shariah does not allow pure exchange of liability (risk) for a given price. In other words, it has to be ensured that failures should occur less than that of success. From Islamic perspective, uncertainty in the market requires the decision makers to take proper causes to achieve desirable results, and entrust Allah to avoid possible but less likely failures. Example is of lottery, where winning prize is not sure; hence it is not permissible in Shariah.

Islamic finance promotes positive sum game instead of zero sum game. Example is of Musharkah where both or all partners gain, if the project succeeds and lose if it fails. Hedging in Islamic Finance has to follow this principle.

The possible hedging strategies in Islamic Finance are outlined as:

1.     Economic hedging.

2.     Cooperative hedging.

3.     Contractual hedging.

Economic hedging stems from the decision makers and needs no explicit arrangements. 1) The oldest example is of diversification 2) Another example is of alignment of assets and liabilities, since in most of the cases, risks come from the asymmetry between revenues and costs or assets and liabilities. “Khan and Miraokhor” of IMF, in their paper on Islamic Finance, has pointed out that Islamic banks are supposed to enjoy much more symmetric and aligned balance sheets and thus much more stable structure. Thus alignment of balance sheet appears as an essential property of the Islamic system. Aligning assets and liabilities to reduce interest rate or currency risks is also called natural hedging. Balance sheet hedging can be done by altering asset and or/liability reprising characteristics or volumes to reduce interest rate risk exposures. An exporter with US$ liability can hedge its currency risk through his export proceeds or a bank can reduce its currency risk by managing ‘multicurrency based share capital”. A Scandinavian Bank did this by reconstituting its Sterling capital in four currencies: US$, Swiss frank, Deutsce Marks and Sterling . If share capital is denominated in a mix of currencies to match the volume of business assets and liabilities, then capital ratios will not change by much during exchange rate fluctuations. 3) Another example is to find out a portfolio that pays the same payoff as the derivatives pay at maturity without any payment except the initial investment.

In cooperative hedging the economic problems are solved through cooperation rather than for profit arrangements 1) one example is of Islamic insurance (Takaful). The main difference between conventional insurance and Takaful lies on their liability arrangements.  A conventional insurance is liable to pay the claims regardless of the size of available funds from subscription. Islamic insurance on the other hand is limited by the size of available funds: if funds are not sufficient, then either policy holders would voluntarily contribute the deficit or the compensation would be reduced in proportion. In this way, limited liability structure enhances incentives to monitor and discipline the members to avoid exploiting the system thus reducing problem of moral hazard. AIG of US is one of the recent examples that have been bailed out by the government since it was unable to meet its claims due to its high exposures. 2) To hedge currency risks, Islamic institutions can establish a cooperative fund to diversify the risk of its members efficiently, having different risk profiles. 3) Bilateral mutual adjustment mode can be used to design bilateral risk sharing between the financier and the customer in ordinary Islamic Finance. In case of lease agreement the same can be renewed mutually but in case of Mudarbah the risks can be shared by speeding up the payments in case mark up goes up or by lowering amount of installment with longer period payments, in case rate of returns comes down.

The strategy of contractual hedging focuses on contractual instruments. In case of Mudrabah, normally three kinds of risks are involved i.e. 1) risk of misreporting 2) risk of loss 3) risk of liquidity. Risk of misreporting can be avoided by due diligence and careful examination of companies requesting finance. Further Credit Based Mudarbah can be used for this purpose as well i.e. bank will not provide capital except after the transaction or deal is closed. This is based on Hanbali view that Mudarbah essentially is a labor contract and thus capital or money needs not be paid upfront. In Mudarbah and in most form of partnership (Musharkah), investor faces downside risk.i.e risk of losing their capital. One alternative to avoid this kind of risk is to combine deferred sale with partnership. For example, the financier instead of providing money to the company would sell required inputs, say, in return for a deferred price plus a deferred share of the company’s assets. This allows the financier to hedge the downside while share in the upside. Another way to hedge the downside risk is through a third party. The investor provides money to the company through Musharkah by which the financier becomes the passive shareholder in the company. This allows him to sell all or part of his shares to the third party. The remaining shares if he keeps, allow the investor to participate in the company’s profit, while the deferred price protects his investment.

Sale with deferred price or Bay ajil is common in Islamic finance. It carries three kinds of risks. They are: Credit risk, liquidity risk and rate of return risk. Credit risk can be treated mostly, the same way conventional credit risk is i.e. by taking collateral and guarantees and for late payments to charge the customer and add to his debt. Since deferred price is a monetary debt so under Shariah principles it can not be sold for cash. This means that on long term basis, bank can face liquidity risk. For this, there are two solutions i.e. to exchange debt with commodities or to combine monetary debt with real assets in to one portfolio with debts not exceeding 50% (on %, Shariah scholars in allows it up to 67%) and then securitize the portfolio. Since the deferred price is a debt, it can not be increased after the sale is concluded. For this, parties can address it, by changing the installment amount, in case rates vary on higher or lower side. Deferred price structure can also be diversified through deferred price Sukuk. These Sukuks are different from commodity linked bonds in a sense that bonds pay money in exchange for money while a diversified price pays in kind and money in exchange for a good.

Currency risk in Murhabah (principal+ markup) can be transferred to counterparty. For example if an Islamic bank provides Murhaba to a customer in Euro but capital is in US$, the customer (debtor) shall pay in US $ instead of Euro. The customer may not like to take the risk so he may arrange a forward with  his bank ( say a conventional bank) who may pay a payment guarantee to the Islamic bank in US$. If the customer is an Islamic entity that may not use forwards than the deal can be done through parallel Murhabah: the Islamic bank would sell to the customer’s bank in US$, which in turn sells to the customer in Euro.

Salam is another Islamic product that means advancement of payment in exchange for a specified quantity of a defined good that provides financing to the seller as well as price discount to the buyer. The main problem with Salam is the price value of the good at maturity that can change. This problem can be solved through value based Salam i.e. value rather than the quantity is determined upfront, hence quantity alters at change of value. This arrangement has been approved by Ibn Taymiah.

Islamic Finance is not very simple to adopt and requires lot of work to do on its financial engineering, in order to make it a reality. But it must not be ignored at all if we want its benefits.

Ashraf Ghori