Sharia-compliant derivatives – a contradiction in terms?

Quoted from Financial Times. Available at:

Reuters is running an interesting story on Islamic banks’ struggles to develop hedging tools to cope with market volatility. Not all Islamic scholars believe the use of derivatives is permitted by Sharia law – which leaves more conservative institutions with “few instruments to guard against wild swings in currency and interest rate movements,” according to the Reuters story.

“To the extent there are not enough sharia-compliant liquidity and risk management products, then clearly Islamic finance would be disadvantaged compared to conventional banks and would be less able to manage their liquidity risks,” said Hussein Hassan, head of Islamic structuring at Deutsche Bank . The $1 trillion industry bans banking structures that are vague or ambiguous to avoid exploitation — a rule which some argue shuts out the use of common hedging instruments such as currency and interest rate swaps and futures contracts.

There are two major schools of thought on derivatives in the the world of Islamic finance. One view is that derivatives are necessarily speculative, and so would contravene the prohibition on gambling. Scholars who take this approach also tend to argue that since it is not always clear what the underlying assets referenced by a derivative are, use of the product violates the prescription that only tangible assets can be bought or sold.

The second, less conservative view is that derivatives are permitted as long as they are used solely to hedge existing positions. Of course, derivatives do exist in Islamic finance. Reuters cites some examples: Last year, CIMB Islamic, the world’s top arranger of Islamic debt, launched a forex hedging tool where investors enter into an Islamic transaction with the bank.

The net proceeds — which are similar to the premium paid for conventional options — gives investors the right to exercise the option at the agreed rate on the maturity date. Another type of options contract is ‘arbun’, which Reuters explains thus: Under an arbun contract, a purchaser makes a deposit (which forms part of the purchase price) to buy particular assets at a later date. Should the sale not proceed, the seller keeps the deposit.

Much of the impetus for the creation of Sharia-compliant derivatives has come from industry groups like ISDA, which has long been working to standardise derivatives contracts and documentation in a way that would facilitate their use in Islamic finance. And for a time – up to and including those halcyon days of June 2007 – it looked like more scholars were coming around to the use of derivatives. Now, months into a crisis which is being blamed at least in part on these products, the case is less convincing.

Put another way, among the few institutions to have emerged relatively unscathed from the crisis are Islamic banks, as the FT’s David Oakley noted late last year. This apparent resilience is not just due to a restrained relationship with derivatives, of course – these insitutions also tended to be conservative in their lending and underwriting and have little, if any, exposure to mortgage-backed securities. But the crisis – and its components – has caused both scholars and practitioners of Islamic finance to take a step back, and in some cases, to adopt a more conservative view. Which brings one back to the initial question – what, then, is a worried Sharia-compliant banker to do?

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