Islamic Finance and the Concept of Halal Derivatives

Risk diversification using derivatives helps to continuously determine the fair market value of risk, increases financial system stability at all levels, and raises overall welfare.

A memorandum of understanding on documentation standards and master agreement protocols for Islamic derivatives has been adopted as a result of private sector initiatives, such as an Islamic primary market project run by Bahrain-based International Islamic Financial Market (IIFM) in collaboration with the International Capital Markets Association (ICMA).

National solutions are also becoming more popular. Bank Islam and Bank Muamalat Malaysia, the two fully functional Islamic banks in Malaysia, concurred to sign a derivative master agreement for the documentation of Islamic derivative transactions in November 2006

As a result, market inefficiencies and worries about contract enforceability brought on by disparate prudential standards and varying interpretations of Shariah compliance are anticipated to disappear soon.

Financial institutions in Bahrain, Kuwait, and Malaysia have been preparing for more Shariah-compliant financial products and structured finance - both on the asset and liability side - as Islamic finance gains traction and businesses look to methods of more effectively hedging their exposures. Shariah-compliant derivative contracts have been anticipated to continue to develop and improve as a result of financial innovation.

How They Differ from Conventional Derivatives

Halal derivatives are constructed based on profit and loss sharing principles, which makes them consistent with Islamic financial principles. Conventional derivatives are based on debt and the payment of interest.

Glaring flaws in forward contracts give rise to the economic case for futures, exchange-traded contracts that standardise forward contracts in terms of size, maturity, and quality and eliminate the restriction of double coincidence in forward contracts.

However, the way that general future contracts restrict counterparty risk appears to go against Shariah rules.

Futures are typically priced MTM (marked-to-market), and the party that is out of the money must make margin calls. A Shariah-compliant solution to this issue could be the marginal adjustment of periodic repayment amounts in response to any deviation of the underlying asset value from the pre-agreed strike price at various points in time until the maturity date. This is because Islamic law considers MTM pricing unacceptable in the absence of an underlying asset transfer.

However, traditional futures continue to include contingency risk. Options eliminate the risk of discretionary under-performance in exchange for a one-time, non-refundable premium. In contrast to other options, which can only be exercised by purchasing the underlying asset at the current spot price, call option holders have the right (but not the responsibility) to purchase the underlying asset. Options offer the chance to profit from favourable price movements in addition to serving as a hedge against bad price changes. They also cover potential delivery or receipt delays for the item.

While the idea of eliminating contingency risk is desirable in and of itself according to Islamic law, the assurance of definite performance through either cash settlement (in futures) or mutual deferment (in options), as in conventional derivatives contracts, is obviously undesirable because it replaces the idea of direct asset recourse and implies a zero-sum situation. The bilateral character and asset-backing of Islamic financing, on the other hand, provide definite performance on the delivery of the underlying asset (unlike a conventional forward contract).

Both the creditor and the debtor are obligated to uphold the terms of the contract regardless of changes in asset value because they each hold equal and opposing option positions with the same strike price. In accordance with the Shariah principles of entrepreneurial investing, the sequence of periodic and maturity-matched put-call combinations (with a zero-cost structure) maintains equitable risk sharing.

Contrary to conventional options, favourable price changes (such as in-the-money appreciation of option premia) in the range between the current and the contractually agreed repayment amount do not result in unilateral gains. Shared business risk is any difference between the ultimate payback amount and the value of the underlying asset (in an existing or future asset).

Examples of Halal Derivatives

Islamic options, futures, and swaps, which are structured based on underlying assets like commodities or stocks rather than debt instruments, are some instances of halal derivatives.

Gharar can be seen in financial transactions involving derivatives, such as forwards, futures, and options, as well as short selling and other types of speculation. The majority of derivative transactions are prohibited and regarded as illegitimate in Islamic finance due to the uncertainty surrounding the delivery of the underlying asset in the future.

Scholars distinguish between small and large gharar, and while the majority of derivative products are forbidden because they involve too much uncertainty, other actions regarded as gharar, like commercial insurance, are essential to the functioning of the economy. Additionally, it is legal for a seller to short-sell fungible goods like wheat and other commodities that will be supplied to a buyer at a later time.

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