Qualitative Research in Financial Markets

Shari’ah issues, challenges, and prospects for Islamic derivatives: a qualitative study
Muhammad Rizky Prima Sakti Ahmad Syahid Mohammad Ali Tareq Akbariah Mohd Mahdzir
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Muhammad Rizky Prima Sakti Ahmad Syahid Mohammad Ali Tareq Akbariah Mohd Mahdzir , (2016),"Shari’ah issues,
challenges, and prospects for Islamic derivatives: a qualitative study", Qualitative Research in Financial Markets, Vol. 8 Iss 2
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 Shari’ah Issues, Challenges, and Prospects for Islamic Derivative:
A Qualitative Study

Abstract

Purpose – The purpose of this study is to investigate shari’ah scholars’ views and
experiences pertaining the shari’ah issues, challenges, and prospects in Islamic derivatives.
Specifically, this paper critically examines the criticisms towards conventional derivative
instruments and the controversies surrounding underlying contracts and current Islamic
derivative products.
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Design/Methodology/approach – This study employs qualitative methods to form a deeper

understanding of shari’ah scholars’ perception and experience on Islamic derivatives. Semi-
structured interviews were conducted with five shari’ah scholars who are currently working
in Islamic financial institutions in Malaysia and Singapore. This study used
phenomenological techniques for its data analysis.

Findings – This study has found that shari’ah scholars are aware of the shari’ah issues
surrounding Islamic derivatives and have provided comprehensive insight on the solution to
these issues. It was found that it is important to take into account the derivatives instruments
in Islamic financial industry because the need for hedging and risk mitigation within Islamic
financial institutions. Nonetheless, the study has also found that the use of wa’ad contracts to
structure Islamic profit rate swaps and foreign currency exchanges are problematic due to it
having features of bay’ al-kali’ bil-kali (the sale of one debt for another) .

Originality/value – This study is one of few studies that highlight the shari’ah issues of
Islamic derivatives in Islamic banking and finance industry. This paper is of value in
discussing risk management and Islamic derivatives in Islamic financial institutions and how
there are many issues under the investigation process, particularly issues related to
controversial underlying contracts and products.

Keywords: Islamic Derivatives, Risk Management, Shari’ah, Qualitative Study, Malaysia,

Singapore

Paper type – Research Paper

JEL Classification: G21, D81

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 1. Introduction
Islamic banking and finance industry has grown tremendously over the past decades.
The increase in the complexity of Islamic financial products has resulted in a similar increase
in the variety of risks these products carry. Islamic banking and financial institutions are also
exposed to the same risks as its conventional counterparts; business risk, exchange rates risk,
commodity price risk, and operational risk. In fiqh muamalat, the risk management lies on the
scope of public interest or maslahah, which is a licit foundation of consideration in shari’ah
principles. Shari’ah principles govern risk-taking according to the principle of al-kharaj bil
al-daman (i.e. with profit comes responsibility) and al-ghorm bil al-ghonm (i.e. with profit
comes risk), and while simultaneously avoiding gharar (excessive uncertainty), maisir
(gambling), and riba (usury). The search for better risk management tools has led the creation
of Islamic derivatives by the Islamic banking and finance industry.
Derivative provides a tool for off-balance sheet technique to hedge the risk of
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economic loss arising from the volatility in the value of the underlying assets. Moreover, as
intermediary institutions, banks may utilize derivative as a risk management instrument to
hedge on-balance sheet transactions. Islamic banks, in particular, have an exposure to the
exchange rates risk and commodity prices risk because of the volatility in the value of the
underlying assets used to facilitate its transactions. This additional risk necessitates Islamic
banks’ hedging activities (Malkawi, 2013).
Because hedging and risk management are valid economic activities, shari’ah does
not proscribe it. However, derivatives can also be used for speculation, which is detrimental
to the financial system and society generally. There are diverging opinions from shari’ah on
the subject of financial derivatives. Some of the arguments for the prohibition of financial
derivatives includes the element of gharar as well as the speculation element inherent in such
instruments (Obaidullah, 1998). The arguments for the permissibility of derivatives in Islamic
finance stems mainly from the risk management and reduction financial instruments such as
futures and options provide (Kamali, 1999).
Banks and companies use derivatives both for speculation and hedging. In
conventional finance, risk management is a necessity in strategic business planning, which
has led to the use of derivatives as a risk management tool. There is also an element of
leverage in derivative trading; the chance of large gains or losses from a small capital base
due to small movements in the derivatives’ underlying assets. These have led to the argument
that derivatives exhibit elements of gharar (uncertainty), riba (usury), jahalah (ignorance)
and are used for speculative purposes, all of which are inconsistent with shari’ah principles
(Haron, 2014) .
The permissibility of derivative instruments in Islamic finance is contentiously
debated by shari’ah scholars. Kamali (1999) stated that derivatives are a new phenomenon
with no precedent in previous fiqh literature. The Jeddah Fiqh Academy, that uses a stringent
approach in its shari’ah rulings, rule against the permissibility of derivatives in Islamic
finance due to the ill-effects that could result from its use and posits that derivatives do not
have the basis to be classified as an asset. However, the Shari’ah Advisory Council of
Securities Commission (SAC-SC) Malaysia allows the trading of derivatives in Islamic
finance, citing factors such as ‘urf tijari (common business practice), maslahah (public
interest), and avoidance of hardship.
This divergence in opinion also exist in conventional finance, where some consider
derivatives a ‘financial weapon of mass destruction’ due to its inherent risk, complexity, and
opacity. Obversely, derivatives are viewed as instruments to provide liquidity and risk
hedging for the financial markets. Both views are justified with equally strong data and
analyses. This divergence in opinion demonstrates the incomprehension of derivatives, in

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 both conventional and Islamic finance. The subject of derivatives requires further deliberation
and research in order to arrive at proper understanding of its nature, motives, and impact to
the economy and society. Furthermore, the subject discourse on derivative must take into
account in the light of shari’ah analyses, to arrive at accurate decision pertaining its
permissibility or not.
This study is laid out to achieve a number of objectives. Firstly, the study will focus
on examine the shari’ah issues pertaining to derivatives from the Islamic point of view. This
is meant to provide a clear picture of the operations and shari’ah parameters of derivatives, as
governed by Islamic jurisprudence. Secondly, this study critically traces the experiences of
shari’ah scholars on controversial issues concerning derivatives and their underlying
contracts. Finally, this study also aims to investigate the challenges facing and prospects of
shari’ah-compliant derivative instruments. Correspondingly, this study is attempts to answer
following research questions: (1) What are the shari’ah considerations for proscription and
allowing the usage of derivative in Islamic finance. (2) What are the most controversial
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Islamic derivative instruments currently in use? (3) What are the challenges and prospects of
Islamic derivative?
Prior studies have been conducted on the derivative instruments in Islamic finance but
few have been concentrating on the shari’ah issues, controversies of its current products and
contracts, and the challenges and prospects ahead. As the shari’ah issues and controversies of
derivatives products cannot be explained just through quantification, the qualitative method
was used. This study has gone some way from the practitioners and shari’ah scholars in
Islamic finance industry in Malaysia and Singapore and make several contributions to the
literature and practitioners. First, the study can painting a comprehensive picture of the
shari’ah and operational aspects of Islamic derivatives by synthesising shari’ah issues and
controversies surrounding its usage. By drawing from Islamic finance practitioners'
perspective, this study will also establish recommendations for Islamic banks and financial
institutions to allow for shari’ah compliant use of hedging instruments for risk management.
The study also recommends for Islamic banks and financial institutions to revisit the use of
wa’ad contracts to structure Islamic profit rate swaps (IPRS) and foreign currency exchanges
due to it having features of bay’ al-kali’ bil-kali (the sale of one debt for another). This study
will also help policy-makers establish sound and comprehensive regulations of risk
management practices in the Islamic finance based on maqasid al shari’ah (objectives of
shari’ah). The findings of this study helps regulators to set up enforcement for the prudent
use of shari’ah compliant derivatives to not jeopardise the financial system.
This study is organized as follows. Section 2 will comprehensively presents the
literature review on the discourse of risk derivative instruments and its shari’ah related
counterpart. Section 3 presents the data and methodology behind this study. Section 4 reports
the result and discussions of this study. Finally, section 5 will present the conclusions of this
study.

2. Literature Review
According to the Horcher (2011), the substance of risk is the uncertainty that have
likelihood of loss and exposure. In Islam, the existence of uncertainty is fundamental for
human well-being. Quran (31:34) states that:

“Indeed, Allah has knowledge of the hour and sends down the rains and knows what is the
wombs. And no soul perceives what it will earn tomorrow, and no soul perceives in what land it
will die. Indeed, Allah is Knowing and Acquainted.”

3
 Concerns raised in Elgari (1993) include the requirement in Islam to protect wealth
from various types of risks. In Islamic legal maxim (qawaid Fiqhiyah), there is a maxim
known as al-ghorm bil-ghonm (i.e. with profit comes risk). This maxim indicates that it is
necessary to take risks to compensate the returns, for sustainable wealth creation. Another
maxim in Islamic finance known as al-Akhdah bil-asbab; desired ends should be sought
through legitimate means, including through proactive risk management. Based on these
maxims, Al-Shubaili (2012) summarized that any profit reaped without the consideration of
risks is not permissible. Similarly, Al-Suwailem (2006) also found that it is necessary to take
risks for economic progress and concluded that the economic growth cannot take place
without accepting risks.
The contemporary practice of risk management in Islamic finance industry resulted in
fluctuations in market prices of several financial instruments, namely, sukuk, salam, and
murabahah assets, and foreign exchange rates (IFSB, 2005). This finding is consistent with
findings in Dowd (2005), which concluded that market risk occurs due to movement in
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market prices, interest rates, and exchange rates. Moreover, both conventional and Islamic
banks are exposed to the presence of risks such as interest rate risk. Bacha (2004) confirms
that Islamic banks in Malaysia is subjected to interest rate risk due to its common economic
horizon and customers, along with conventional banks.
Apart from that, Islamic banking and finance industry also subjected to exchange rates
risks. IFSB (2005) asserts that Islamic financial institutions are also exposed to foreign
exchange fluctuations arising from general spot rate changes in both cross-border transactions
and the resultant foreign currency receivables and payables. These exposures may be hedged
using shari’ah compliant method (IFSB, 2005). In addition, Islamic banks are also subject to
rate mismatch risks, due to the different levels of benchmarking between foreign and locally
denominated assets. Foreign currency assets and liabilities are normally valued using foreign
currency benchmark (i.e LIBOR) while the locally denominated assets and liabilities will be
priced using local currency benchmark (i.e KLIBOR). In that scenario, both the bank and its
counterparties are exposed to rate mismatch risk. Islamic banks’ exposure to this risk should
be managed to mitigate losses that may arise.
Having discussed these exposures, it is necessary for Islamic banking and finance
institutions to construct risk strategy frameworks. Previous discussions have pointed out the
inevitability of market risk as well as the necessity of Islamic banks to minimise this
exposure to price and rate volatility using hedging instruments. The rationale behind hedging
comes assumes a lower cost of internal capital, higher growth potential through hedging, and
the improvement of competitiveness using hedging instruments (Froot, Scharfstein, & Stein,
1993).
With regard to the relative cheapness of internal funding, a large volume of previous
risk management literature show that the use of hedging ensures the sufficiency of internal
funds by lowering the variability of free cash flows (Shapiro & Titman, 1986; Smith & Stulz,
1985; Breeden & Viswanathan, 1998). Ayoub (2013) argues that Islamic finance industry
seeks to use hedging as a risk retention strategy to improve its growth and profitability
potential. Hedging instruments can also enhance the competitiveness of Islamic financial
institutions by, within the global financial context, reducing its cost barriers to market entry
(Ayoub, 2013). This can then increase the market share of Islamic financial institutions
through stable and competitive pricing of Islamic financial products. Disregarding risk
management is also found to be contradictory to Islamic principles, as Ahmad & Halim
(2014) has shown that a part of maqasid al-shari’ah (objectives of shari’ah) is the protection
of assets.
Hedging is an activity to reduce or mitigate risks of another investment (Khan &
Ahmed, 2001). Findings in previous literature on the use of hedging have shown that it can

4
 reduce future volatility for parties involved in foreign currency exchanges (Bacha, 1999).
This finding concurs with other works that advocate the use of hedging to cover potential
losses from undesired risks (Toporowski, 2002; Clark & Ghosh, 2004; Kolb & Overdahl,
2006). Al-Suwailem (2006) believes that hedging activities should be used only to reduce
risks. A more recent study by Elgari (2010) has considered hedging as a tool to avoid risks. In
contrast, Kolb & Overdahl (2006) has found evidence suggesting hedging as an activity to
gain profits based on market price volatility. This academic disagreement on the concept of
hedging, inextricably linked to derivatives, show that there is still perplexity surrounding
hedging use. According to Hull (2011), a derivative is a financial instrument emerged as a
contract or payment exchange agreement whose value is derived from underlying assets;
commodities, equities, interest rates, and foreign exchange rates. Derivatives can be used
both as a hedging device in the risk transfer process and also as an investment product with
the flexibility to be tailored to a market player’s risk appetite and yield preferences.
The discourse on the use of derivative in Islamic finance begin after the exceptional
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growth of these instruments in the conventional markets in the 1970s, with discussions
amongst Islamic scholars in the Makkah Fiqh Academy as early as 1984. Derivative markets
have existed in the Islamic world prior to that date, with Kamali (2002) evidencing the
existence of the cotton futures market in Alexandria, Egypt since 1861. Other contemporary
examples of commodity futures in Muslim countries can also be found in Ayoub (2013).
In contemporary Islamic finance, a number of studies by practitioners and shari’ah
scholars have highlighted the necessity of derivative instruments, particularly to augment the
potential growth of Islamic finance (Elgari, 1993; Bacha, 1999; Kamali, 2002; Khan &
Ahmed, 2001; Jobst, 2007; Al-Amine, 2008; Dusuki, 2008; Ayoub, 2013; Ahmad & Halim,
2014). The current risk management practices in Islamic banking and finance and the
disagreement amongst shari’ah scholars on the subject of derivatives have resulted in
inconsistent resolutions between various standard-setting bodies. Askari, Iqbal, Mirakhor, &
Krichene (2012) posited that:

[….] the debate on derivative will continue in Islamic finance, but at present they have very
limited acceptability and it is unlikely that the practice of derivative will be as widespread as
seen in conventional markets any time soon. However, as Islamic finance grows, its own
version of hedging mechanisms and financial products with embedded options will emerge.
Prohibitions of derivative, however, does not preclude an Islamic financial intermediary from
designing a risk-sharing or risk-mitigating scheme. This can be achieved through the creation of
a risk-mitigating instrument synthetically using existing instruments.

The Makkah Fiqh Academy (1984) have resolved, after debating the use of
derivatives in Islamic finance, to prohibit its use because the derivative markets do not
address any maslahah (public interest) which is a licit foundation in Islamic law. Detailed
reasoning include: (1) derivative contracts are not ‘real’ transactions in a sense that the
market participants do not transfer any actual underlying asset; (2) in most cases, the sellers
are selling what they do not own to their counterparties; (3) the derivative contracts are
oftentimes sold and resold until maturity date to other parties; (4) the derivative markets serve
the appetite of large traders at the expense of small traders by a way of market manipulations
which in turn lead to market crashes (Makkah Fiqh Academy, 1984).
An investigation in the use of options in Islamic finance by the OIC Jeddah Fiqh
Academy (OIC, 1992) concluded that options are a new form of contracts unclassifiable
under the current shari’ah nomenclature (i.e. salam, urbun, khiyar al-shart) and are therefore
prohibited under Islamic jurisprudence. This is based on the reasoning that option contracts
carry features including: (1) the lack of ownership of the underlying asset, (2) selling of non-
existent asset at time of the contract, (3) partaking in gambling and speculation activities by

5
 market participants, (4) the transacting of this options contract is independent its underlying
asset, (5) the transfer of these contracts to third parties is impermissible, and (6) lack of
delivery and receipt by the parties involved in this contract. These reasons are consistent with
the previous resolution by the Makkah Fiqh Academy (1984).
Usmani (1999) asserts that forward contracts are different from salam contracts, but
are instead more akin to ‘the sale of one debt for another’ (Bay’ Al-Kali’ Bil-Kali) which is
forbidden by Islamic law. The proscription of Bay’ Al-Kali’ Bil-Kali comes from a hadith by
the Prophet Muhammad (PBUH) is the focal argument by shari’ah scholars for the
prohibition of derivative instruments, as it can be used to facilitate the trading of debt (Al-
Amine, 2008; Al-Suwailem, 2006). Usmani (2010) comprehensively examined future
transactions and reasons that these contracts are prohibited, for both hedging and speculation,
because: (1) buying and selling cannot be affected for a future date, (2) The delivery is not
intended and hence the settlement executed through price differentials, (3) if the delivery is
intended, the seller does not possess full control of their underlying asset and could be
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construed as a form of deception to the buyer, and (4) the transactions are involved together
which is impermissible in Islamic law.
Another legal maxim on ownership axiomatic to the discourse on derivatives relates
to Al-Kharaj bi Al-Dhaman (with profits come bearing the liability for losses) (Al-Suwailem,
2006; El-gamal, 2007; Obaidullah, 1998b). The interpretation of this legal maxim is
questioned in Ayoub (2013) on whether owner can be taken to mean merely possession. The
deliverability of the underlying assets is unanimously seen as a necessary element in shari’ah
principles (Al-Amine, 2008; Kamali, 1999; Khan & Ahmed, 2001)
The Islamic Research and Training Institute (IRTI, 2000) showed that option
contracts is neither a sum of money nor a utility or a financial right which can be waived thus
is impermissible based on Islamic law, consistent with the views of the Jeddah Fiqh
Academy (n.d.). Additionally, forward contracts are forbidden due to the lack of an opposing
transaction during the exchange (IRTI, 2000). The Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI, n.d.) is also in favour of the impermissibility of
forward contracts due to its contradiction with shari’ah standards.
Ayoub (2013) found that the prohibitive opinions on the use of interest rate and
foreign currency derivatives for speculation and risk management by scholars and standard-
setters stems from their views of these instruments’ intractability with speculative and
gambling activities. This has taken attention away from the debate on the benefits of
derivatives to society and the management of such instruments, creating a rift in opinions
between academia and practitioners (Ayoub, 2013). He extend his arguments posit that the
prohibition of any way of hedging mechanisms from shari’ah scholars (i.e. Usmani) and
standard-setting bodies (i.e. OIC Jeddah Fiqh Academy, AAOIFI) were merely pertaining the
hesitance of speculation and gambling activities and its possibly creates on financial
imbalances. Nevertheless, none of these shari’ah-standard setting bodies address the
discourse on the issue whether derivative are beneficial to public society and how should they
be managed? In addition, there is disparity between industry and shari’ah scholars as
evidenced by the perplexing and difference opinions regarding this discourse.
Recent studies have demonstrated the thriving use of derivative instruments in Islamic
finance. This includes discourse of on whether khiyar al-shart (contractual stipulations) or
urbun (earnest money), which are forms of shari’ah contracts, can be used as a basis to allow
options instrument in Islamic finance. Kamali (1999) and Obaidullah (1998b) argue that
khiyar al-shart is a licit foundation in shari’ah law to form the basis of an option instrument.
Other authors argue for the use of urbun to design option instruments (Al-Amine, 2008;
Mohammad Ali Elgari, 1993; Vogel & Hayes, 1998). The salam contract, a forward sale that
stipulates immediate payment and delivery of a good on specific future date has been

6
 declared permissible for risk management purposes by the OIC Jeddah Fiqh Academy (IRTI,
2010).
A growing number of studies support the permissibility to use options, forwards, and
futures in Islamic finance. However, the slow industry uptake can be attributed to the lack of
consensus on the acceptability of underlying contracts; khiyar al-shart, urbun, salam. The
lacklustre development of risk management and derivatives in Islamic finance can be
attributed to the rigidity of classical Islamic risk management products (Rosly & Bakar,
2003), insufficient demand for Islamic risk management instruments (Bacha, 1999; Ismal,
2010), and the absence of a central regulator for risk management in Islamic finance (El-
Hawary, Grais, & Iqbal, 2004).

3. Methodology
Approach
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A qualitative approach was selected for this study because this approach is beneficial
for studies seeking the reflection of individual reality and enables a researcher to see how
people interpret their experiences, construct the world, and the associate meanings with it
(Merriam, 2009). A qualitative approach also allows the generation of comprehensive
insights, for the purpose of this study, of shari’ah scholars’ perception and experiences on
Islamic derivatives.

Paradigm
Because Islamic derivatives has not received adequate attention from scholars, this
study will attempt to gather data that is hoped to lead to new insights and establishment of
new theories (induction), in lieu of using a theory to explain findings (deduction). This study
also aims to explore and form a deeper understanding of Islamic derivatives through
inductive research. This study will also adopt a phenomenological approach to gain a deeper
understanding of participants’ experiences (Bowen, 2009). This approach can also
incorporate single or multiple interviews with a particular interviewee, streamlining data
collection (Creswell, 2003).

Sampling
This study uses the unique sampling methodology where sample selection based on
their uniqueness and typical attributes. To this end, interviews were conducted with shari’ah
scholars whom are Islamic banking and finance experts with varying backgrounds and from
different institutions. Five interviewees from three different countries; Malaysia, Indonesia,
and Singapore with different exposure, insight, and experience in risk management,
derivative, and shari’ah law were chosen for this study, as shown in table 1.

Table 1 Interviewee profile

Interviewee Gender Education Nationality Affiliation
A Male Master Singaporean Zayn Associate Singapore
B Male Master Indonesian AFFIN Islamic Bank
C Female PhD Malaysian ISRA
D Male PhD Malaysian Al-Rajhi Bank
E Male PhD Malaysian Standard Chartered Saadiq

Data Collection
The data was collected through semi-structured interviews to understand shari’ah
scholars’ perspectives on Islamic derivatives. The use of semi-structured interviews also

7
 gives flexibility to the authors to explore further areas of interest, as well as give the
interviewees freedom to express ideas on the subject (Horton, Macve and Sruyven, 2004).
The interviews were conducted between March and May 2015, with each interview lasting an
average of 30 minutes. To guarantee privacy and confidentiality, interviewees’ names has
been anonymised.

4. Findings and Discussion

Risk Management in Shari’ah Perspective
The interviewees are all in consensus that risk management is encouraged in Islam and
should be addressed by each Islamic financial institution. The interviewees also agree that
risk management has become a crucial part of both conventional and Islamic financial
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institutions and that risk management practices should be embedded in the operationalization
of Islamic banking and finance. More so, the risk management become crucial part whether
for conventional or Islamic financial institutions. In this regard, interviewee D, a member of
the Shari’ah Board of Al-Rajhi Bank stated that:

So, in general, if we ask risk management, it’s a crucial part whether Islamic or non-Islamic.
But from shari’ah perspective, there is nothing wrong with that and we have also encouraged to
have extra cautious in doing a things.

In the same context, interviewee C emphasized the importance of risk mitigation

functions, because the existence of excessive risk can be considered as gharar. The
mitigation of risk is also consistent with the objectives of shari’ah; maqasid al-shari’ah. In
this regard, interviewee C from ISRA (Islamic Research and Training Institute) said:

The concept of risk is twofold. One is that, in shari’ah, you need a risk to enjoy the profit. We
find it from the sunnah of the Prophet, for example, tying the camel, it’s a part of hadith. We
find it also from legal maxim. At the same time, we encouraged to mitigate risk because an
excessive risk is considered to be gharar. And also the risk itself must be mitigated because we
need to preserve the maqasid al-shari’ah which is the one of the requirement in maqasid.

This is in line with the findings in El-Gari (1993), who concluded that Islam
encourages wealth protection from various forms of risk. Risk management is desirable as it
facilitates the preservation of wealth, an important part of maqasid al-shari’ah. Ahmad and
Halim (2014) also posit that risk management in shari’ah is important because asset
protection is part of maqasid al-shari’ah. Therefore, neglecting risk management activity is
contradictory to Islamic jurisprudence.
Interviewee E stressed the importance of risk management in Islam and the extent to
which it is encouraged in Islam, highlighting the verses in the Quran in which it was
mentioned:

In the verse of the Qur’an, risk management is very much encouraged because Allah SWT says
in surah Al-Baqarah says ya ayyuhal ladzina amanu idza tada yantum bi dainin ila ajalim
musamma faktubuh. So Allah mentioned that, “O ye who believe, if you want to make a
purchase or selling where the payment will be on deferred basis, so faktubuh (write-down).
Deferred basis to a specific time, faktubuh. Allah SWT suggested us to write it down. Why we
have to have a script or to write it down? Risk management! […] Allah SWT asked us to do a
script or writing it down very clear agreement. So all of that is risk management in Islam.

8
 Additionally, interviewee B evidences that the practice of risk management in Islam is
not a novel concept. It can be traced back during the time of Prophet Yusuf A.S, highlighting
the history of risk mitigation in Islam:

Talking about risk management, it is basically a concept which is not new in Islam. Risk
management has been widely used even before Prophet Muhammad era. Prophet Yusuf has
managed to mitigate the risk for 7 years crises. So I think during that time Prophet Yusuf has
given us some examples of how to mitigate and manage the risk.

Another issue highlighted by interviewees is the intractable link between Islamic and
conventional banking operations in Malaysia under its dual banking system. Islamic banks
are not sheltered from and cannot eschew any risks faced by conventional banks. According
to interviewee E, a Shari’ah advisor for a number of Islamic financial institutions in
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Malaysia:

In Islamic finance, as we all know, financial institution is not free from conventional risk. For
example from the conventional finance risk, commodity prices risk, business risk, inflation risk,
etc. So, as Islamic financial institutions we cannot escape our self from these because we are
operating our self under this umbrella.

This is consistent with the fact that market risks in Islamic finance stems from changes
in the market prices; equities and commodities prices, and interest and currency exchange
rates (Dowd, 2005). This statement also confirms that Islamic banks in Malaysia are
subjected to interest rate risks due to having the same economic horizon and customers as
conventional banks (Bacha, 2004).
In addition to that, interviewee A from Zayn Associate Singapore mentioned that risk
management is part of every financial institution’s governance, both conventional and
Islamic, that needs to be adhered to. Because of this, being part of the financial system,
Islamic banks have an obligation to put in place risk management processes. As expressed by
Interviewee A:

Risk management is part of governance, and it is also part of what is stated by Basel. For
Islamic banks and financial institutions, we have to perform as what have stated in
conventional. The risk management is also decided by the central bank, so Islamic banks must
be conforming to what have been stated by central bank, as part of their risk management
processes. It is important that, whether its banks, firms, or Islamic financial institutions, to
conform to the risk management policy and they have to ensure that Islamic banks is also part
of the system.

Overall, the interviewees shared the common understanding that risk management
practices are encouraged in shari’ah. Risk mitigation is consistent with maqasid al-shari’ah,
especially on excessive risks may lead to gharar. The interviewees were concerned on the
practices of risk management in the Qur’an, Hadith, and qawaid fiqhiyah (Islamic legal
maxim). The interviewees also agreed that Islamic banking and finance, operating within
same horizon as conventional finance, cannot escape exposure from exposure to risks faced
by conventional banks. Because of these reasons, Islamic finance is in dire need to find risk
management tools which are both religiously acceptable and allows risks to be managed
effectively, a bill fitting for Islamic derivatives. Latter sections of this study will discuss the
shari’ah issues, prospects, and challenges facing the use of Islamic derivative instruments.

9
 Criticism of Conventional Derivative
In conventional finance, derivatives can be defined as a security whose price is
dependent upon or derived from an underlying asset. This instrument was initially created for
the purpose of hedging or risk mitigation. Interviewee C mentioned that:

First of all, in conventional finance, derivative were actually created to mitigate a risk. […] At
the beginning, when the derivative first started it was to enable farmers, for example, to
mitigate the risk against price fluctuation for their crops and so forth. So, actually, the initial
idea of derivative is to mitigate risk.

This statement shows that the development of Islamic derivatives parallel those of
conventional derivatives, as shown in Hull (2011), where the earliest conventional derivatives
were forward contracts that guaranteed the prices of commodities to be delivered at a future
date. The interviewees also showed a general agreement that hedging practices can bring
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benefits to market players. As said by interviewee C:

So, my views on derivative, if it is used for hedging or risk mitigation, it is an useful tool, But,
if it is used for speculation or for gambling, it is a harmful tool.

Numerous studies have attempted to explain risk management and hedging. A number
of studies have acknowledged the benefit of hedging for risk mitigation to cover potential
loss from undesired risks (Toporowski, 2000; Clark and Gosh, 2004; Kolb and Overdahl,
2006). Khan and Ahmad (2001) also reveal that hedging is an activity to reduce or mitigate
the risks of another investment.
One of the issues emphasized by the interviewees is the ill-effects of speculation. In
conventional finance, the speculative nature of derivatives are heavily emphasised.
Conventional derivatives allow market participants to speculate on commodities and financial
instruments, reaping profits from changes in their prices. Interviewees in this study believe
such speculation is detrimental to the financial system, as said by interviewee E:

If you are talking about conventional derivative, absolutely I will say that almost 90% of
derivative users are coming from the speculators and arbitrageurs. So that we can say that
normally derivative be engaged by speculators. [….] So if you are talking about conventional
derivative, I am with majority whom says that derivative is a time bomb! Waiting to do a
damage to the financial institutions.

Similarly, interviewee C also mentioned the negative effect of speculative transaction:

[….] But at the same time, derivative had been used for speculative. Over time its being used
for speculation because it can easily be used for betting in the market. Because of that,
derivative, the way it has been used it gives a negatives impact. If it (derivative) is used for
speculation or for gambling, it is a harmful tool.

The above statements are similar with numerous studies in the literature on the
discourse of hedging. Kolb & Overdahl (2006) discovered that hedging can facilitate market
participants to profit from market price volatility. Similarly, Elgari (2010) also indicated that
profit is necessary in hedging activities since profits gained is meant to compensate for
adverse price movements. In contrast, interviewee A disagreed about the speculative aspect
of derivatives:

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 Generally, most try to avoid derivative. And most allow derivative to be used as hedging
instrument and not for speculative instrument. […] Generally at present, our scholars are very
opened on the use of hedging to risk management, to reduce the losses, or to ensure capital
protection. But generally, in speculation, mostly said it is impermissible and mostly said it is
discouraged. […] For any derivative instrument to succeed, it must have two tales. We need the
speculators as well as we need the hedgers.

In addition, interviewee A also placed high emphasis on the importance of speculators

in the workings of derivatives. He frankly mentioned that the derivatives cannot function
without the presence of speculators in the market.
In the conventional side, derivative are being used for speculative purposes. For any derivative
instrument to succeed, it must have two tales. We need the speculators as well as we need the
hedgers. If we have the hedgers, but we do not have the speculators, nobody will buy the
products. If we want to allow hedging, but we disallowed speculators, and the market cannot be
practiced. The market cannot succeed because we need speculators to ensure that the hedgers
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can implement the products.

There was a consensus among the interviewees that hedging activities using
derivatives can be beneficial and useful, and that it should be encouraged and supported,
especially during market shocks as measure to protect wealth and investments. Moreover,
most of the interviewees also agreed that speculation using derivatives will bring negative
effects to the financial ecosystem and jeopardize the economic environment.
Nevertheless, the salient feature of derivative product requires the hedgers as well as
speculators to work together in the market. Derivatives provide a tool for off-balance sheet
risk management to hedge against economic loss arising from the volatility of underlying
assets. One of the basic features of derivatives is to hedge (insurance) or mitigate risks in the
underlying asset. However, the use of derivatives are not limited to hedging alone. Depending
on the risk appetite of investors, it can be utilized as a profit making instrument should the
value of the underlying asset change in the investor's favour. The opinion of interviewee A,
who deals mainly in the Singaporean market, on speculative activities using derivatives
contrasts with those from other interviewees in this study. This shari’ah scholar believes the
market requires both hedgers and speculators for derivatives to function in the market.
Speculation does not exist only in the derivatives but also in other financial instruments. He
expressed:

If I allow such speculating to be done in the share market, I should allow myself also to
speculate in the derivative market.

In addition, interviewee A also emphasized the importance of understanding

derivative products comprehensively, rather than merely its theoretical aspects, but also its
technical and operationalization aspects. He said that:

But if we don’t understand the product and we just based on theoretical understanding, then we
might have the wrong understanding in giving the opinions.

The statement above is also consistent with the findings in Alsayyed (2009), who
found that Middle Eastern shari’ah scholars have less sophisticated product knowledge, such
as in market operationalisation and arbitrage techniques, compared with their countrymen
whom are practitioners in Islamic banking and finance.

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 Another important issue emphasized by the interviewees is the use of conventional
derivatives in Islamic finance for hedging purposes. In this context, there were divergent
opinions among interviewees. For instance, interviewee C clearly expressed that:

Islamic financial institutions cannot use conventional instruments. I think, a lot of research has
been done by the shari’ah scholars. And the majority had believed that the conventional
instrument have element which not accepted under the shari’ah, its not shari’ah compliance.
One of the main reason is gharar. I think gharar because a lot of the contracts especially
forward, future, and these two contracts which used selling something in the future. The
counterparties do not have to exchange anything. Its not like salam, its not like istisna.

Interviewee E has more specifically addressed the opinions among the scholars of the
pros and cons pertaining the use of conventional derivative for hedging purposes in Islamic
finance:
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For some scholars, for example Hashim Kamali, Bashir Al-Amanie, they are saying that it is
permissible to use conventional derivative for hedging. Lately, I found some of other scholars,
Syeikh Nizam Yaqubi also says that future and forward and also options of conventional are
acceptable. But normally what happened in the Middle Eastern countries, the scholars reject the
conventional derivative. And in Malaysia, I can say the same approach applied where the
shari’ah scholars rejected the conventional derivative except for some of them with condition.
For example, […] Single stock futures but with some conditions.

The statements above evidence that, in most cases, the interviewees unanimously
disagree on using conventional derivative instruments for hedging purposes. Hedging via
conventional derivatives is not in line with maqasid shari’ahas there is too much gharar
involved in conventional derivative instruments. Only a minority of shari’ah scholars are in
the opinion that conventional derivative products can be utilized by Islamic financial
institutions, while the majority were opposed to it.
These findings are by conclusions in previous literature, that derivative products does
not promote maslahah (public interest) and is deemed as impermissible in Islamic financial
transactions (Usmani, 1999; Al-Suwailem, 2006). Furthermore, the arguments above are
acknowledged in Usmani (2010) who concluded that derivative contracts are totally
prohibited, without regards to the purpose of these contracts; speculation or hedging.

Shari’ah issues on current Islamic derivative practices

After investigating opinions on derivative practices from shari’ah scholars, we further
explore the perception of the interviewees about shari’ah related issues on contemporary
Islamic derivative products. Based on the philosophy of muammalah in shari’ah teachings,
interviewee B expressed that:

Talking about derivative, basically we can go back to the basic of muammalah in Islam. The
scholars said ‘al-ashlu fil muamalah al-ibahah illa an yadulla ad-dalilu ‘ala tahrimiha’.
Everything in muammalah, in financial transaction, is permissible unless there is evidence
which is indicated otherwise. So, as long as there is no clear prohibition from the Al-Qur’an
and Sunnah or other Divine revelation, there is no harm basically to apply derivative.

According to the interviewee B, currently with AFFIN Islamic bank, the initial ruling
for derivative products is that they were permissible and valid, unless there is evidence
indicating otherwise. Even so, there is no clear evidence from Qur’an and Sunnah specifically
forbidding derivatives. The derivative products must be in line with the objectives of the

12
 shari’ah (maqasid-al shari’ah) and subject to strict requirements to ensure that it is consistent
with shari’ah principles, as noted by interviewee B:

[…] subject to the restrict requirement to ensure that its (derivative) in line with shari’ah
principles. So, as long as derivative are structured in such a way that its in compliance with the
shari’ah principles/shari’ah requirements, there is no shari’ah prohibition to do that.

The aforementioned arguments contradicts with Ahmed and Halim (2014) who
considers the use of derivative is open to opportunities for gambling and speculation. Because
the speculative uses of derivatives are greater than its hedging uses, it is less useful for risk
management and is therefore contradictory to maqasid al-shariah.

Interviewee C justified the need for derivatives in Islamic banks and financial
institutions. This is consistent with Bacha (2000) who indicated that the necessity for hedging
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instruments in Islamic finance industry due to future price movements.

From my research, Islamic derivative have been allowed mainly because of necessities and
there is a need for risk mitigation. Banks need instrument for risk mitigation. Otherwise, there
will be a lot of losses incurred. […] So, you need some kinds of instruments that can help banks
manage the risk and also consumer to manage the risk, especially when they come to currency
risk. Otherwise, these costumers will go to conventional banks!

Another the important issue highlighted by the interviewees is the basis for
prohibiting and allowing the use of derivative instruments from the shari’ah point of view.
The interviewees' views supported the findings in Islamic financial literature that argued for
the use of derivatives, but with the prerequisite that it be used only for hedging and risk
management, and that any hedging must be associated with real economic activities. (al-
Suwailem, 2006; Elgari, 2010; Ahmad and Halim, 2014). In this regard, interviewee C
expressed that:

Its used only for hedging purposes […] the Islamic derivative, the underlying must be halal.
The contract must be shari’ah compliance. And the minimize gharar by specifying all the
requirements. So, its controlled. As compared to conventional, its controlled.

Interviewee E also held similar views, arguing that the basis for allowing derivatives
are merely to mitigate risks:

We have to mitigate our self. So, can we say, we cannot mitigate yourself, we have to be fully
expose to that risks! Islam encouraged us to protect our self from further harm and further
damage. So that is the first reason why we say the Islamic derivative should be encouraged, but
for the mitigate purposes.

More specifically, interviewee E described the basis for allowing derivatives is

because of the necessity to safeguard from risks faced by conventional banks, as both operate
on the same economic horizon. This is consistent with previous arguments that, in the current
financial system, without instruments to mitigate risks, particularly during economic
downturns, would see an exodus of Islamic finance practitioners towards conventional
finance. As said by interviewee E:

Why we need derivative in Islamic finance? Firstly because, just like I said, we are operating
our self under the umbrella of conventional finance and conventional monetary system. In
conventional monetary system, the currency always changes. They are changes in their value

13
 and that hurt a lot, and that create damages, and that create risks. So how we can say to the
Islamic financial institutions not to do anything and just tawakkal alallah. No! So we have to
do something to mitigate that risks because of undesired risks. Secondly, if we are to say that
Islamic derivative is no way to be approved, we are actually, in the long-term we will kill
Islamic financial institutions. Because that will be no matched to the conventional finance.
Conventional finance, they have these tools to mitigate their risks. When the risk is low, so they
can offer the better price. For Islamic finance, if they don’t have these tools [….] so they will
lose in the battle field.

Overall, the interviewees showed intimate understanding of the basis for allowing
derivative products from the shari’ah point of view. According to the interviewees, for
derivatives to be approved for use in Islamic finance, it should be designed for risk
mitigation/hedging purposes and both the contracts and underlying products must be halal.
Interviewee B discussed the shari’ah parameters of Islamic derivatives,as released by ISRA:
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(1). The underlying contract in Islamic derivative and the underlying assets are shari’ah
compliant
(2). The use and mechanism of Islamic derivative is not for speculation and gambling but
for hedging purposes only
(3). the risk on derivative instrument should be always linked with the underlying asset.
(4). the transaction based on the real underlying risk rising from real investment

Aside from the criteria for shari’ah compliant derivative, the interviewees also
highlighted reasons hampering the adoption of derivative instruments in Islamic finance.
Interviewee D was more concerned on the uncertainty and possible injustice arising from
derivative contracts that make derivatives impermissible. He expressed that:

The prohibition is very clear, to avoid any uncertainty or any injustice to contracting parties
because we buy something which is not in existence.

Moreover, Interviewee B and C shared common ideas that the development of Islamic
derivative were hampered by its investment and speculation possibilities. Islamic derivative
should be utilized only for hedging and not for other purposes as said by interviewee C:

Islamic derivative are used purely for hedging only. Islamic derivative should not be used for
investment purposes. I don’t know now whether some banks are allowing it, but as far as I
know from my research, the shari’ah scholars are quite strict, and they only want that the
Islamic derivative to be used for hedging purposes.

The aforementioned arguments is in line with Usmani (2010) who expressed that
derivative contract is totally impermissible, regardless whether these contracts are entered for
speculation or hedging. These views are also supported in Obaidullah (2002) who argued that
derivative products are prohibited because these instruments are transacted for speculative
purposes.
Furthermore, one of the issue that was given high emphasis by interviewees is the
divergent legal opinion among shari’ah scholars on derivatives (Ayoub, 2013; Muhammad
Ali Elgari, 2010). Interviewee A opinions that the differing understanding between scholars
will lead to different opinions and fatwas:

The divergence of fatwas will depends on the understanding of the scholars with regards to the
issues. And we need to understand that for the scholars to give their opinions, they must first
understand the product very well. There is a principle stated that ‘al-hukmu ala shaih, faru’un
antasa wurihi’, the law regarding certain object is strongly based on the understanding. So if

14
 we understanding the product well, then we can give the correct opinion or the correct fatwa.
But if we don’t understand the product and we just based on theoretical understanding, then we
might have the wrong understanding in giving the opinions. The divergence in view of Islamic
products, then we should go back to scholars who are in depth in Islamic financial market, or
for the practitioners in Islamic financial market, and who have a long experiences and history in
Islamic finance.

This argument is strengthened by interviewee C whom explained that different juristic

school of thoughts in Islam would lead to different legal opinions:

Why there is a divergence? In Fiqh, we have different schools. Some schools may allowed. To
certain extent, for example, if you look at the Hanafi school, they are actually allow khiyar or
hilah, the legal tricky. But if you look at Maliki School they don’t allowed it. In Shafi’i school,
does not recognized it and does not endorsed it.
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In contrast, interviewee B indicated that there are no dispute of legal opinions (fatwa)
among shari’ah scholars on derivatives. A majority of the scholars allow these instrument to
be utilised in the market, based on the permissibility of either the products or the underlying
contracts:

I don’t think there is a divergence on fatwas. I think you cannot just refer to the fatwas on
derivative; you also refer to the fatwas of Islamic hedging involving derivative. Because you
see, there are some fatwas issued by the Middle Eastern based organization which allowed
Islamic hedging instruments. […] if you refer to the underlying contract as well, commodity
murabahah which is also permitted by the Middle Eastern based organization. So I don’t think
so far, as far as I was concerned, there is a divergence of fatwas in term of the permissibility
and impermissibility.

In general, the interviewees were in agreement that the different legal opinions
(fatwas) on derivative products was due to different understanding of derivative products
among shari’ah scholars. However, only one of the interviewee had different view,
perceiving that there was no dispute in Islamic legal opinions on derivatives.

Controversies in Islamic derivative products and contracts

The assessment for the shari’ah compliance for derivative instruments have been
heterogeneous at best; shari’ah scholars have not come to an agreement on the interpretation
of derivatives due to its complexity. While different madzhab (school of thought) provides
guidance on the interpretation of these instruments, no consensus has been reached for the
eligibility of derivatives use in Islamic finance, even between scholars from the same
madzhab. This section examines the issues surrounding contemporary Islamic derivatives
akad (contract) and products.
The interviews evidence that all interviewees are aware of the controversies
surrounding the underlying contracts or shari’ah compliance of derivative products. The
interviewees are on the same page with previous studies on the controversies surrounding
wa’ad (promissory) contracts (Al-Saati, 2002; Bello & Hassan, 2013; Wisham, Muneeza, &
Hassan, 2011). Interviewee C believes that foreign currency exchanges with a wa’ad as its
underlying contract is still a markedly controversial product:

FX (foreign exchange) Wa’ad, in my opinion, its quite controversial.[…] Its not been permitted
in Malaysia yet, shari’ah scholars have not allowed it, but its been used in Middle East. It is
structured whereby the fees is paid by the customers. When the customers give the wa’ad, the

15
 customers give the fees. Its option actually. And it is up to customer whether or not in the future
to exercise the wa’ad. Promised is made. The banks must own the promise if the customers
decide to do so. Promise is made up front and the fees is paid up front. And the other latter day
the customers will see if it is favourable for him, he will exercise it or not exercise it. […] it is
usually used for currency exchange. For example costumer is not sure what is the currency
exchange rate of USD will be, Malaysian to USD in the future, so you can make the promise to
sell it at certain rate in the future. And in the future, if it is favourable to you, you can exercise
it. But the fee is paid. And that fee paid for wa’ad is what is controversial. Whether or not you
can pay a fee for a right. Some scholars said yes, some scholars say no. Because it is not a mal,
it is not a properties.

Similarly, interviewee B also sees wa’ad as a controversial underlying contract. He

points on the Islamic profit rate swap (IPRS) as a more controversial shari’ah compliant
derivative with a wa’ad as its underlying contract and expressed that:
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If you asked me one of the most controversial products that many shari’ah scholars are not
comfortable with is Islamic profit rate swap. Because in Islamic profit rate swap involve
unilateral binding promise or we called wa’dan. One of the scholars from US, Yousuf Talal
DeLorenzo, argued that how can the promise can make profit. You can generate profit in
Islamic profit rate swap by simply putting your promise. If you argue that the promise is not the
contract meaning that the promise will not affect anything, will not generate any income/profit.
But in Islamic profit rate swap, the promise will give you the profit/return just using that kind
of promise. So, the use of promise/wa’ad should be used in very prudent manner, because if
you allow this for all kind of products meaning that everything in conventional products can be
structured by using wa’ad, because wa’ad is just like magic tick that you can use for any
reasons/objectives/motives/purposes. You can easily legitimate riba by way of promise.

In most cases, the interviews shared the general agreement that wa’ad contract is
problematic for structuring derivatives. According to Usmani (2010) the wa’ad contract is a
contract which one party promises to fulfil an obligation at a certain future time, such as to
pay certain amounts or to buy particular goods. Abdullah (2010) argues that wa’ad, in fiqh
muammalat, is promise which express the willingness of a person or group to purchase
particular product.
Usmani (1999) argued that derivative instruments are impermissible in Islamic
financial transactions because these instruments are similar to bay’ al-kali’ bil-kali (the sale
of one debt for another) which is prohibited by Islamic law. Studies have revealed the maxim
of bay’ al-kali’ bil-kali has been turned into a focal point among shari’ah scholars which led
to the prohibition of derivative (Al-Suwailem, 2006; Kamali, 2007; Al-Amine, 2008).
Interviewee E viewed that wa’ad contract has a problem in structuring Islamic derivative
products due to it having features of bay’ al-kali’ bil-kali:

[…] from the hadith bay al kali bil kali, so the prophet Muhammad (pbuh) prohibited purchase
with delayed delivery and payment. Futures and forward fall under that category, so they say
this is haram. In order to make it halal so Islamic financial institutions will not subscribe to
these products, they have their own products based on wa’ad basis. So, yes, wa’ad can be quite
controversial as well. But for this moment, it can be the way out; exit, or makhraj. So when I do
wa’ad, for example, I will purchase a dollar from you at the latter date with the price of lock-in
price. Only one party make the promise, the other party will not do any promise. So when one
party do a promise and binding on me, not binding on you, so majority of the scholars say now
it is halal. So, that can replicate the conventional effect of futures and forward.

These arguments contradict Abdullah (2010) who argued that the use of wa’ad is
necessary for risk mitigation instruments to ensure the parties’ commitment hold their end of

16
 the contract. Practically, the wa’ad contract is used in Islamic banking as a show of
commitment between parties to execute the contract, subject to certain conditions. As an
example, a wa’ad should not include a bilateral promise; a promise that is binding to both
parties, as noted by interviewee D:

This wa’ad is permissible. This is regarded to be like a promise, a unilateral promise, one-
sided, wa’ad from one party. Not bilateral promise! […] the unknown two parties. This is not
two parties or bilateral promises. But one sided or one unilateral promise which does not along
to a contract. So we have shari’ah issues if its binding from both parties.

Similarly, interviewee E also mentions the problems arising from bilateral promises:

Wa’ad is the entrance of the commodity murabahah. Wa’ad to give the commitment to do
trading in the future. […] Wa’ad, if it will be issued by one party, there is no problem. But
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some institutions in Malaysia they are off their opinions that both parties based on wa’ad are
also acceptable. So, that is the controversial part! Because Securities Commission of Malaysia
agreed that there is no problem with the double wa’ad from both parties even though they are
binding. But, Middle Eastern scholars normally feel that this is problematic. That is almost
alike the conventional forward and future. So that’s why they reject Malaysian products.

In contrast, interviewee B argued that both unilateral and bilateral wa’ad can be used
in structuring shari’ah compliant derivative products:

The concept of wa’ad/promise either it is unilateral binding promise or two lateral binding
promise can also be structured together in Islamic derivative.

Another issue highlighted by interviewees is the labelling of derivatives as ‘Islamic’.

Some questioned the using term ‘Islamic’ to describe derivatives as problematic and
inaccurate, as expressed by interviewee E:

As for the name, the Islamic derivative, for my opinion, it is also not quite accurate. You cannot
say Islamic derivative actually. It is not Islamic derivative but we called it Islamic derivative
just to give to the general public that these products can matched some of the conventional
derivative.

Specifically, interviewee E argued that this is problematic because the value of

‘Islamic’ derivatives are derived from trading activities, whereas conventional derivatives
derive its value from its underlying assets. The term ‘Islamic’ derivative was coined solely to
demonstrate that Islamic finance also has instruments that can replicate the effects of
conventional instruments:

There is no name actually. It’s only trading. For Islamic derivative, all of the Islamic derivative
engine are based on what we called trading. So the trading effect will help to hedge the
institutions. So can we called it derivative? I don’t know. Its not derivative because derivative
derived their value from the other things, but these one derived their value from the trading.
The value is coming from the commodity that will be traded. So its not derivative per se. But
we just called it Islamic derivative to give idea that the impact of the product can replicate the
conventional derivative.

In the same context, interviewee D also expressed:

17
 I don’t regard to be Islamic. Because like options they are there in the market. Future, options
they are there in the market […] the majority don’t regard them to be Islamic and then […]
most of the banks, for example, Islamic banks they don’t regard these to be a valid or
permissible instrument investment avenue. You cannot regard these to be a means to make
profit for investment.

According to the interviews, the labelling of derivatives as ‘Islamic’ is inappropriate,

due to the derivatives’ characteristics. ‘Islamic’ derivative apply different epistemological
properties compared to conventional derivatives. Islamic instruments are created solely for
risk mitigation purposes, with its value derived from trading activities. Therefore, these
products cannot be used for speculation or investment.

The Challenges and Prospects of Islamic Derivative

After examining the controversial issues surrounding the derivative products and its
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underlying contracts, we attempt to address the current challenges and future prospects of
shari’ah compliant derivative instruments. The primary challenge concerns the permissibility
of derivative use. The divergent opinions on the acceptability of derivatives in Islamic
finance from different jurisdictions is a point agreed upon by most interviewees in this study,
including interviewee B:

I think the challenge in structure Islamic derivative is that not all jurisdictions may
approve/accept some of the shari’ah contracts used. For example, in the case of Indonesia,
there is some restrictions/constraints to apply for commodity murabahah or for tawarruq. So
that, derivative market is not well established as in the case of Indonesia. So the challenge is in
term of internationalization of products. So how structure can be accepted across jurisdictions,
its one of the challenge.

Another challenge highlighted by interviewees is the understanding of market

mechanisms and product regulations, as mentioned by interviewee A:

The challenges, firstly, to understand the products and also to understand the market. Because
the market functions today is not as the same as what the market function 1,400 years ago. How
the market runs today? It’s extremely regulated. Any financial product that is offered in the
jurisdictions in a country will have to be regulated by the central bank. All financial products
are extremely regulated by the central regulatory body. Previously, 1,400 years ago, there were
no such regulatory bodies. When you look in the global system, there are also global financial
bodies that ensure the regulation of these products. Its very tightly need system. Our
understanding of Islamic financial products cannot be taken as products per se. We must take it
as its part of the system.

Interviewee E placed more emphasis on the technical aspects of derivatives,

particularly on the difficulties of operating shari’ah compliant derivative due to the small size
of Islamic banks:

The challenge is the size. Because in order to make the derivative, normally derivative means
that you are distributing the risk between the other institutions. Now you are having these risks,
you are to transfer this risks to another parties, maybe some of them. But unfortunately because
the size of Islamic financial institutions is still small so they may have difficulties to find
partners to do a square off.

Because of the inability of Islamic banks to bear high risk exposures, they would still
need to rely on conventional banks and conventional instruments, as said by interviewee E:

18
 So Islamic derivative, you will have difficulties because the chain of Islamic financial
institutions is not so strong at current time. So some times, for example Standard Chartered
Saadiq, they are Islamic bank, they do derivative with you but they will do the derivative to
square off their position with the Standard Chartered conventional bank –their parent bank. So
they are still need a help by the conventional bank. […] For example, if you have the exposure
of RM100 millions of currency risk, you want to do derivative with Islamic banks, very little
Islamic banks can take that risk. Its so big amount for them. But for conventional banks,
RM100 million is nothing!

Notwithstanding the challenges facing Islamic derivatives, interviewees were

optimistic of the prospects of these instruments in the future. This is because of the
tremendous increase in Islamic derivative products and its use within Islamic financial
institutions, as expressed by interviewee E:
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The uses of derivative within Islamic financial institutions today are growing fast in many
products. If you don’t have these products you will lose the battle.

In addition, interviewee B also expressed positive views on the development of

Islamic derivatives and hopes that it could be structured in a less controversial manner, from
a shari’ah perspective:

With the establishment of dedicated institutions for Islamic finance like INCEIF, most of the
universities offering Islamic finance program, I believe there will be additional talent for
Islamic finance, for the shari’ah scholars in Islamic finance in the future that can bring and
offer the structure of the Islamic compliant products including Islamic derivative […] So
moving forward, I still believe that Islamic derivative can be structured in more acceptable
manner avoiding some controversial issues like the use of waad/urbun/commodity murabahah
in the coming of new talents in Islamic finance.

In contrast, interviewee C holds a pessimistic view on the future of Islamic derivative

and disagreed that Islamic derivatives would flourish as an investment product, as it could
enable yet more speculation and gambling. Rather, Islamic derivatives should function
merely as a hedging and risk mitigation instrument:

Derivative or Islamic derivative in my opinion should be left to hedging alone. I am not keen on
extending their function to the investment. In my opinion, the prospective or the future for
Islamic derivative should be very narrow.

5. Conclusions and Recommendation

This study provides insight of shari’ah scholars’ perceptions and experiences on
shari’ah issues, challenges, and prospects of Islamic derivatives. The findings showed that
the interviewees have comprehensive insights and awareness of the current shari’ah issues
facing derivatives. The interviews criticized the derivative practices in conventional finance;
its use for speculation and gambling that could jeopardize the financial system, with only a
minority of conventional derivatives being used for its intended purpose; hedging and risk
management. Additionally, hedging via conventional derivative products is a practice that’s
not in agreement with maqasid al-shari’ah as conventional instruments involves an
unacceptable level of gharar. For these reasons, the interviewees agree that conventional
derivative cannot be utilized in Islamic finance for hedging.

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 Interviewees reflected on the criticisms surrounding Islamic derivative products and
underlying contracts. Most of interviewees agreed the use of that wa’ad contracts to structure
Islamic profit rate swaps and foreign currency exchanges are problematic. Philosophically,
the labelling of derivatives as ‘Islamic’ is also seen as problematic due to the differing
epistemological properties attached to these instruments; its shari’ah compliance and
hedging-only purpose.
A number of challenges faced by Islamic derivatives were gleaned from the
interviews; (1) the divergent opinions on the permissibility and approval of derivatives use
from differing jurisdictions, (2) the understanding of market mechanisms and product
regulations, and (3) the difficulties of operating shari’ah compliant derivative due to the
small size of Islamic bank. Meanwhile, the interviewees are also optimistic about the growth
and development of Islamic derivatives in the future.
The findings of this study is relevant to practitioners, policy makers, and regulators as
the first study in Malaysia to investigate Islamic derivatives’ shari’ah issues, from shari’ah
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scholars’ perspective. This study contributes to the literature on risk management and
derivatives in Islamic finance and is hoped to guide Islamic financial institutions in
establishing more shari’ah compliant derivatives. This study is limited by its sample size;
five interviewees and future studies should have increased sample sizes for richer and more
meaningful analyses. Future studies should also triangulate its results with quantitative data;
employ mixed-method techniques to produce more robust results.

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