Islamic Commercial Law and Financial Transaction

Dr. Ata Rahmani

ata_rahmani@hotmail.com

First semester 2016, Dundee

 Lecture 10:

Financial Engineering and Islamic Contracts

LECTURE PLAN
• Financial engineering
• History
• financial Derivatives
• Examples of Derivatives
• Justification
• Engineering method
• The process
• Challenges
• Future
• Non Islamic elements of future
• Futures Islamisation
• Options
• Option as Mal
• Options and Daman
• Call option and bai al-urbun
• Options and Riba
• Options and Gharar
• Islamisation of a financial derivative
• How to Islamise a financial derivative
• Conclusion
FINANCIAL ENGINEERING
• Search for new and innovative solutions to financial problems within
the Islamic framework in order to meet legitimate financial needs of
Muslims and to enhance efficiency of the financial system
• While financial markets are becoming more and more sophisticated,
and competitive, financial engineering and innovation are becoming
more imperative in Islamic finance
• Islamic financial products have essentially been limited to classical
modes that developed centuries ago and fall short of meeting new and
more sophisticated financial needs of today’s world
• financial engineering in the Islamic world has begun since mid 20th
century when notions of return to Sharia law and Islamic principles
were spread in many Muslim countries from Egypt to turkey and Iran
• If the needs are genuine, then the innovative instruments should be
created or developed
 HISTORY
• Concurrent to the demise of the ottoman empire and industrial revolution of the west,
many Muslim countries attempted to westernise, most notably in the areas of industry,
trade and finance
• Traditional Islamic contracts and financial instruments have been replaced by western
model financial instruments and institutions
• The wholesale adoption of the French civil code occurred in Egypt, Turkey, Iran and
other Middle Eastern countries
• Since the start of the twentieth century, strong resistance to western influence and a
return to Islamic values has emerged among Islamic scholars and socio-economic and
political activist (Egyptian Muslim Brothers Movement, Mohammad Bagher al-Sadr
in Lebanon, and Ayatollah Khomeini in Iran)
• Financial engineering has also begun most notably with abolishment of the western
style banking system on the ground that it violated Islamic principles, most notably
the prohibition of usury
• Using financial engineering techniques many Islamic countries have now reformed
their conventional banking with the Islamic principles and they did so successfully
using Islamic contracts that are Sharia compliant
• Islamic finance has yet to be engineered to meet legitimate demands. This is
particularly true about financial derivatives
 FINANCIAL DERIVATIVES

• Contractual instruments under which the parties agree to payments

to be made based upon the value of an underlying asset at a
particular point in time
• The main types of derivatives are futures, forwards, options and
swaps
• The main use of derivatives is to minimize risk for one party while
offering the potential for a high return (at increased risk) to another
• The underlying asset can cover different types such as commodities,
equities (stocks), bonds, currencies, interest rates and exchange rates
EXAMPLES OF DERIVATIVES
• A European investor purchasing shares of an American company would be
exposed to exchange-rate risk (Euros to Dollars) while holding that stock. To
hedge this risk, the investor could purchase currency futures to lock in a specified
exchange rate for the future stock sale and currency conversion back into Euros
(Futures)
• An oil producer plans to produce 1 million barrels of oil ready for delivery in
exactly 365 days. Assume the current price is $50 per barrel. The producer could
take a gamble, produce the oil, and then sell it at the current market prices one
year from today. Given the volatility of oil prices, the market price at that time
could be at any level. Instead of taking chances, the oil producer could lock-in a
guaranteed sale price by entering into a futures contract (Futures)
• Share prices are now at a desirable level. An investor planning to purchase shares
next year but is worried about a likely rise in share price would enter into an
option contract which gives him/her right (not obligation) to buy certain numbers
of shares at a certain price and at a certain future date. In return for a small fee, the
buyer would avoid the risk of loss due to any share price rise. If the stock price
goes up he/she will use his option and buys shares at a lower price and will take
the difference as profit. If the stock price goes down he/she will not use the
option, but will only have to take a small charge (Option).
 JUSTIFICATION
• The conventional derivative instruments of forwards, futures, swaps
and options in the present form are not considered as Sharia complaint
because they often involve non-Islamic elements; being too uncertain,
speculative, chance taking and interest bearing (Mohamad, Tabatabaei
2008)
• There is a unanimity of opinion on the need for Sharia-complaint
products. Most policy makers, scholars and practitioners believe that
such instruments are in public interest (Masalih) and enhance
efficiency of the Muslim financial sector
• Islamic scholars also agree that financial products that aim to hedge in
order to reduce risk or protect investment allowed in Islam
• Islamic financial system is geared toward the promotion of trade and
partnership and is based on profit / risk sharing
• These are more compatible with short-term traditional trade (cost-
plus financing/Murubuhu) and sales based financial transactions
• Financial instruments to accommodate medium to long term needs are
yet to be engineered
ENGINEERING METHOD

• Ambiguity about how to comply these instruments to Sharia

• Academics and practitioners adopted one of the two following
ways in creating innovative instruments that are Shari’a-
compliant:
• Adaptation from conventional menu
• Invention of new Sharia compatible alternatives
 THE PROCESS

• The process of introducing a new product is subject to the rules

defined by Islamic law
• Any new financial instrument is permissible provided that it does
not incorporate elements considered unlawful in Islam
• Freedom from Riba, Gharar, Qimar, Mal al-Haram and Ikrah

• Complying with positive Islamic law of the country which is monitored

by national courts

• Gaining approve from religious boards / Councils (at both organisational

and national levels)
CHALLENGES
• Not just one Islamic law; there are many different Islamic laws and different
schools and countries
• Underdeveloped financial markets in many Islamic countries
• In Malaysia the use of Islamic derivative transactions over certain
standardized assets has been readily accepted (Tahawwut Master
Agreement, International Swaps and Derivatives Association (ISDA) and
International Islamic Financial Market (IIFM), 2010)
• In 2011, Turkish Derivatives Exchange (Turkdex) market introduced the
TurkDEX-Live Cattle Futures contract which is to a great extent Sharia
Compliant
• Middle East countries have stayed cautious and still are on evaluation phase
• Financial engineering in Islamic finance depends on: 1) development of
strong Islamic financial markets; and 2) a close collaboration between
Islamic countries and between Islamic scholars of fiqh from different
schools, something which seems very difficult to achieve today
 FUTURES AND OPTIONS

• Two examples of financial derivative contracts; i.e. futures and

options; will be considered further below
• Findings can be extended to other instruments like forwards
and swaps
 FUTURES
• A bilateral contract between two parties that allows one party, the
seller, to sell a particular reference asset at a forward price for
settlement at a future date, and second party, the buyer, to purchase
the reference asset at a forward price on the named date
• Futures and forward contracts: forward contracts relate to non-
standardized assets and involve a single settlement of cash flows at
maturity. The futures relates to standardized assets and work on a
daily settlement of cash flows basis
• Futures and Bai Salam: in Salam the price for an asset is paid upfront
while Futures involve only exchange of obligations at both ends
• Futures and options: options give the holder the right to buy or sell
the underlying asset at expiration, while the holder of a futures
contract is obligated to fulfill the terms of his contract
NON ISLAMIC ELEMENTS OF FUTURE
• Futures are a type of forward contracts and involve sale of goods that
are not existent at the time of contract; no goods are delivered at the
time and no price is paid
• Futures consist of short selling, in which the seller does not own or
possess the item he sells
• Futures sales fall short meeting the requirements of qabd or taking
possession of the item to resale. Nearly all sales and purchases in the
futures market take place without physical delivery
• Deferment of both counter-values to a future date turns futures sales
into the forbidden sale of one debt for another (bay’ al-kalī bil-kalī)
• Futures trading involve speculation that verges on gambling and
gharar (Dali, Ahmad, 2006)
 FUTURES ISLAMISATION (1)
• Bai-Muajjal: a contract under which the seller sells certain
specific goods to the buyer at an agreed fixed price payable at a
certain fixed future date in lump-sum or within a fixed period by
fixed instalments
• It involves passing of ownership risk
• It also fails the hedging function

• Bai Istisna: a long-term contract whereby a party undertakes to

manufacture, build or construct assets, with an obligation from
the manufacturer or producer to deliver them to the customer
upon completion. Subject matter non-existent and counter values
can both be deferred
• fails the liquidity requirement of financial derivatives
• fails the hedging function
 FUTURES ISLAMISATION (2)
• Bai Salam: a form of forward contract when the price for an asset
is paid upfront at the time of the contract for an asset or commodity
to be delivered later
• But salam is an exception to the normal rules of the Sharia, and cannot be
extended. the goods are not in existence at the time of the bargain. Also
Futures refers to exchange of future promises from both ends and is
therefore a deferment of both counter-values to a future date which is
forbiden

• Sulh contract: Futures is a contract of Sulh (Compromise) which is

a nominate agreement in Islamic law and tolerates uncertainty and
Gharar much more than the standard Bai. As it is not analysed
within the Bai framework, the forbidden elements would not apply
to a Sulh based Futures (Salehabadi, Aram, 2002)
• Most scholars reject the Sulh argument analysis
 OPTIONS
• A right, either to confirm or to cancel the contract within a stipulated time
period;
• The options are all in the nature of rights embedded in a contract;
• They are specific to binding exchange contracts (Lazim), as parties in non
binding contracts (Jayez) have always a core contractual right to terminate their
contract
• They have not been recognised in the classical Islamic theory of contract as
independent contracts that can be traded for a price
• condition or stipulation option (khiyar al-shart)
• defect option (khiyar al-ayb)
• inspection option (khiyar al-ruyat)
• acceptance option (khiyar al-majlis)
• Do they violate shariah?
• Minority view: valid contract comes into existence with the acceptance of the terms of
contract by both parties
• Majority view: permissible on grounds of several larger benefits to the society through
minimizing gharar and parties’ risks. This is backed by Hadis and claims of Ijma
 OPTION AS MAL AND SUBJECT MATTER OF SALE

• Conventional view: Not Mal because it is not a tangible object /

commodity. Also although Mal includes intangibles such as service and
usufruct, yet an option is neither of them, as it is only a pure right (al-
haqq al-mujarrad) (Islamic Fiqh Academy of Jeddah (Resolution
No.65/1/7 on Financial Markets of the Council of the Islamic Fiqh
Academy, Jeddah, Saudi Arabia, adopted by the Seventh Session of the
Council on 9-14 May 1992)
• Minority modern view: an option involves a benefit (a right without
obligation) for the purchaser. Trading of such benefit is permissible
because Mal can extend to any kind of legitimate usufruct Manafi.
Options satisfy the concept of “haqq al-mali” and “haqq tamalluq”
which are transferable in most Schools. (Ahmad, Shaikh Azmi (1996),
Islamic Investment Study Group: A Report, Malaysia: Securities
Commission)
OPTIONS AND THE PRINCIPLE OF DAMAN

• Modern minority view (Hanbali) : charging a premium by the

option holder may be treated as a compensation within the
framework of daman and is justified on the basis of permissibility
of general stipulations under khiyar al-shart in contracts (Kamali
1995)
• Conventional view (Hanafi and Shafii): options and other
contractual stipulations are merely tolerated by way of exception.
Daman cannot justify option as it operates where one commits a
tortious act (taaddi and tafrit) and is required to pay compensation
to the wronged person (Ahmad Muhayyuddin Hassan 1986)
 CALL OPTION AND BAI AL-URBUN

• Call option: agreement that gives an investor the right to buy a

particular number of shares, or other financial assets, at a fixed price
and before a fixed date
• bai al-urbun: a down-payment or a deposit for a future transaction. It is
a sale in which the buyer deposits earnest money with the seller as a
part payment of the price but agrees that if he fails to ratify the contract
the seller will forfeit the deposit money
• seller in both does not return the premium if buyer does not exercise the
purchase option. however, in case of a call option, the buyer loses the
option premium even if the option is exercised whereas in case of bai
al-urbun, the option premium is adjusted in sale price when the contract
is confirmed
• All the schools of fiqh except the Hanbali school find bai al-urbun
unacceptable because it is akin to misappropriation of the property of
others
 OPTIONS AND RIBA
• Debt securities involve riba and is considered un-Islamic. Hence,
options relating to such securities are un-Islamic too
• Currency options are not permissible, since most jurists equate it
with bai al-sarf in which spot settlement (qabd) by both the
parties is a validity requirement
• Options relating to equity stocks may be regarded permissible
provided that the business activities of the issuing company is
halal, so options on stocks of companies belonging to the
breweries, entertainment, interest-based banking and finance and
other similar industries where the major line of business is haram
fall into the forbidden category
OPTIONS AND GHARAR
• As prices of the underlying assets fluctuate randomly, gains
and losses are random too and the game is reduced to a
game of chance
• While the gains, if they materialize, are in the nature of
maisir or unearned gains, the possibility of equally massive
losses do indicate a possibility of default by the loser and
hence, gharar
• The economic rationale of conventional options is believed
to be their potential use as a hedging device. Yet majority of
transactions are speculative and not meant for hedging
HOW TO ISLAMISE A FINANCIAL
DERIVATIVE

• A financial derivative may become compatible with Islamic

law if they:
• are employed to address genuine hedging demand from parties with
direct ownership interest

• disallow mutual deferment without actual asset transfer

• reduce uncertainty (gharar) to the minimum possible level

WHAT DO YOU THINK?
• None mutual deferment means pass of risk at least for one end.
That would further follow that the devised instrument could
hardly be used for the main purpose of a financial derivative
which is thought to be “hedging”
• If risks are minimised, then again the main purpose of a
financial derivative which is thought to be “hedging” would be
lost. What risk one is going to hedge from?
 SOME FURTHER REFERENCES
• Mohammed Obidullah, “Financial Engineering With Islamic Options”, (November
1998), Islamic Economic Studies, Vol. 6, No. 1, 73103.
• Mohamad, S. and Tabatabaei, A., (2008) Islamic Hedging: Gambling or Risk
Management? , Islamic Law and Law of the Muslim World Paper No. 08-47; 21st
Australasian Finance and Banking Conference 2008 Paper.
• Kamali, M. H. (2005), Fiqhī Issues in Commodity Futures. in Financial Engineering And
Islamic Contracts 20-43 (Iqbal, Munawar & Tariqullah Khan, eds.), Palgrave Macmillan
• Salehabadi A., Aram M (2002) Islamic Justification of Derivatives Instruments,
International Journal of Financial Services. Vol 4, No. 3
• Muhammad Al-Bashir Muhammad Al-Amine, “Istisna and Its Application in Islamic
Banking”, (2001), 16 Arab L.Q. 22.
• Nicholas C. Dau-Schmidt, “Forward Contracts-Prohibitions on Risk and Speculation
Under Islamic Law”, (2012), 19 Ind. J. Global Legal Stud. 533.
• Walid S. Hegazy, “Contemporary Islamic Finance: From Socioeconomic Idealism to
Pure Legalism”, (2006-2007), 7 Chi. J. Int'l L. 581.
• Haider Ala Hamoudi, “Jurisprudential Schizophrenia: On Form and Function in Islamic
Finance”, (2006-2007), 7 Chi. J. Int'l L. 605.
Thank you