Abstract
Islamic finance prohibits speculation, gambling, and mandates that income must be derived as profits rather than interest. The article discusses the legal rules underlying Islamic finance with a view towards developing equivalents to derivatives according to shari’ah principles. The article analyses the differences between conventional financial derivatives and Islamic financial instruments, evaluating those religiously acceptable. The article argues that Islamic finance already includes a number of contracts and instruments with derivative-like features that can help reduce risks and form the basis for designing shari’a-compatible derivatives. However, the absence of uniform principles affects the development of new shari’a-compliant instruments that can be used to manage risks.
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REFERENCES AND NOTES
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The derivatives market is divided into the exchange-traded and over-the-counter markets. The exchange-traded market consists of trades on those markets recognised by applicable provincial legislation. The over-the-counter market is comprised of those trades in derivatives and securities occurring outside recognised exchanges. Exchange-traded derivatives are negotiated on an exchange's trading floor or through its computerised trading system based on standardised terms. By contrast, over-the-counter trades are negotiated by telephone inter partes, or more commonly via a financial intermediary such as a bank, with terms customised to the needs of the buyer. See Kraus, B.W. (1999) The use and regulation of derivative financial products in Canada. Windsor Review of Legal and Social Issues 9, 31, 36(1).
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The clearinghouse is the institution that guarantees the contracts and takes on default risk, which it minimizes by imposing margins on its members than cover the obligations of those who default.
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It is interesting to highlight that there is no direct equivalent of a futures contract in Islamic finance. Not only because the postponement of both the price of the good and the payment is religiously unacceptable for Muslims, but also because futures contracts require a daily marking to market, which is also forbidden to Muslims. Also, there is no direct equivalent of a swap contract in Islamic finance.
Shari’a is an Arabic word meaning way. The shari’a was compiled during the first three centuries after Muhammad's (s.a.w) death. See Yamani, A.Z. (1979) The Eternal Shari’a. New York Universty Journal of International Law and Politics 12 (2): 205–206.
The Qur’an is divided into 114 chapters, known as surahs. Each surah is divided into verses, called ayas which mean signs, referring to signs from and of Allah. There are roughly 6000 verses.
Ballantyne, W.M. and Stovall, H.L. (2002) Arab Commercial Law: Principles and Perspectives. Chicago, IL: American Bar Association, 28–30, See also Walbridge, J. (2000) Logic in the Islamic intellectual tradition: The recent centuries. Islamic Studies 39(1): 55, 68 (Islamic law is divided into two disciplines: fiqh, which the content of the sacred law, and usul al-fiqh, the principles by which it is deduced. Usul is a system of rules by which new law is derived from a fixed body of source materials. It deals with such problems as how to derive a general rule from a known particular case, how words can legitimately be interpreted and so on).
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Islam embraces two principal branches: Sunnism, the majority faith, and Shi’ism. The most important group in Shi’ism is the Twelvers. Other Shi’ism schools include Ismailism and Zeydism. See Richard, Y. (1995) Shi’ite Islam: Polity, Ideology, and Creed, (Antonia Nevill trans). Vol. 1. London: Blackwell, pp. 5–9, See Bonderman, D. (1968) Modernization and changing perception of islamic law, Harvard Law Review 81: 1169, 1174 (schools of law in Sunni appeared in the first and second centuries of Islam. They developed initially due to geographical separation-one at Medina, one at Kufa in Iraq, one in Syria- for example. After a few centuries, each school became personalised and took the name of its leading scholar. Each school developed its own body of legal doctrine, but they were similar in broad precepts. They disagreed as to particular points of law).
Al Shafi’i, the founder of al- Shafi’i law school, has been known as the founder of Islamic jurisprudence. He was the first jurist to compile and systematise Islamic sources of law.
According to Islamic law, the presumption of general permissibility governs until the contrary is established by an injunctive authority. See Iqbal, M. and Khan, T. (eds.) (2005) Introduction. Financial Engineering and Islamic Contracts 1: 2–3, UK, Palgrave Macmillan.
The Qur’an states, ‘Allah has made buying and selling lawful and usury unlawful’. See Qur’an 2: 275–278. From a comparative viewpoint, Judaism and Christianity have prohibited riba as well. See Seznec, J.-F. (1999) Ethics, Islamic banking and the global financial market. SPG Fletcher World Affairs 23, 161, 165 (interest and usury are discussed in the Bible in Ezekiel 18:8 and Deuteronomy 23:19. These paragraphs, which apply to Jews and Christians, clearly forbid the use of usury in dealing with people. For centuries, Christians had a very strong prejudice against interest, which they used however reluctantly. The Catholic Church only lifted the ban on interest in the mid-nineteenth century). See also Klein, D. (1995) The Islamic and Jewish laws of usury: A bridge to commercial growth and peace in the Middle East. Denver Journal of International Law & Policy 23: 535, 541–544.
Riba is of two kinds: riba al-fadl, in which a person acquires an unlawful, excessive profit, and riba al-nasi’a, in which a person gains an unlawful advantage by speculating on uncontrollable risks. Riba al-nasi’a is form of gharar.
The core of the debate is what constitutes riba. Some classical Muslim jurists define riba broadly to include any interest or increase. Other modest jurists define it narrowly to include excessive interest or doubling beyond the real value of money if the borrower defaults during specific time. In the latter view, excessive interest should be prohibited and not any mere increase. Prohibition of riba is applied variably in Muslim countries such as Iran, Pakistan, Saudi Arabia, and Sudan. For more see Seniawski, B.L. (2001) Riba today: Social equity, the economy, and doing business under Islamic law. Columbia Journal of Transnational Law 39 (3): 701, 707–720.
The ‘bit more’ presumes devaluation of currency. However, there could be a scenario where the price of the currency increases. As such, the lender would perhaps receive double the amount he gives. In this case, the terms of the agreement between the parties ought to be adjusted to ensure fairness.
See M.A. El-Gamal (2006) Islamic Finance: Law, Economics, and Practice 59. See also Hamoudi, H.A. (2008) The Muezzin's Call and the Dow Jones Bell: On the necessity of realism in the study of Islamic law. American Journal of Comparative Law 56 (2): 423, 444.
Mankabady, S. (1989) Insurance and Islamic law: The Islamic insurance company. Arab Law Quarterly 4 (3): 199, (some Muslim scholars differ on the legality of insurance. Abu Zhra, a Hanafi scholar, believed that cooperative insurance is legal. Other types of insurance could not be placed under the groups of contracts known in Islamic law: sale, donation, and hire). See Masum Billah, M. (1993) Life insurance? An Islamic view. Arab Law Quarterly 8: 315–319 (other grounds against the validity of life insurance include riba since the beneficiaries of the assured will gain more than the assured has paid to the insurer. This additional gain is riba). See also Al-Ghadyan, A.A. (1999) Insurance: The Islamic perspective and its development in Saudi Arabia. Arab Law Quarterly 332–335.
See Qur’an 31:34.
Islamic insurance functions like conventional cooperative insurance. In cooperative insurance, resources in insurance companies are pooled whereby policyholders are considered shareholders sharing in profits. However, in a takaful company, policyholders and shareholders are distinct in which both own capital and share in annual profits. Retakaful insurance also functions like conventional reinsurance.
For more on this matter, see Jasimuddin, S.M. (2001) The stock exchange and Islamic finance: Some thoughts for a reconsideration. The Islamic Quarterly 14 (2), 105, 108. (Some Islamic scholars found stock exchange objectionable because Islamic law does not permit the sale of an article until one has the physical possession of it. Trading in stocks is usually done without their physical possession and there is an element of chance. Therefore, trading in shares, bonds, and debentures is objectionable. Stock exchange is further objectionable for its elements of speculation. On the other hand, other Islamic scholars argue that speculation in the stock exchange is a process that involves the intelligent forecasting of future prices. This is not the same as tossing dice.).
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Ibid.: 223.
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Efforts to develop legal standards for shari’ah-compliant derivatives have started only recently. The Accounting and Auditing Organization of Islamic Finance Institutions, the Islamic Financial Services Board, the General Council for Islamic Banking and Finance Institutions are working on new regulatory norms. See Accounting and Auditing Organization of Islamic Finance Institutions, Standards under Development, http://www.aaoifi.com/aaoifi/Publications/KeyPublications/tabid/88/language/en-US/Default.aspx, accessed 12 October 2012.
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Conventional financial markets provide ample means for managing risks such as deterioration in quality or another party's outright default. In Islam, where default remedies are limited by religious principles (for example, no interest or penalty can be charged subsequent to a default), the only way to protect against credit risk is a third-party guarantee against such a default.
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The author would like to thank the two outside referees and Professor Giuseppe Mastruzzo for their efforts, attention to details and comments which helped improve the article.
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Malkawi, B. Financial derivatives between Western legal tradition and Islamic finance: A comparative approach. J Bank Regul 15, 41–55 (2014). https://doi.org/10.1057/jbr.2012.18
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DOI: https://doi.org/10.1057/jbr.2012.18