Derivatives -An Islamic Finance Perspective, By Beata M. Paxford

© Islamic Finance Today

BEATA PAXFORD is a lawyer and a Ph.d. candidate in banking law. Beata is currently writing her dissertation on Islamic banking at the Warsaw University in Poland. Her main areas of specialisation include corporate and banking law. She is an Islamic banking advocate in Poland and hopes to popularise Islamic based financing in the CEE countries.

Recent events in the world economy have sparked a global debate about so-called toxic financial instruments and the damage caused by them. Derivatives were cited as the main culprit of the recession and bankruptcies of the affected financial institutions. Nevertheless, thanks to the criticism of these detrimental derivatives, the world of banks and financial elites have finally come to see Islamic finance in a more positive light. The subject of the Islamic way of making money has been put forward as an alternative way to prosper economically without the danger of going under. Furthermore, Islamic banking has been applauded for its ethical standards and respect of moral values so much forgotten in contemporary conventional banking.

Nature of Derivatives
If one wants to look at the attitude of Islamic finance as well as Shari’ah scholars towards derivatives, one has first to fully grasp the meaning and scope of both derivatives and Islamic finance. Derivatives are financial instruments, whose value, in simple words, depends on the underlying, like e.g. currency, price of stocks, price of gold, silver; sometimes even weather conditions. Derivatives, contrary to popular belief, were not created only a few years ago. The first derivative-like contract was known a few centuries ago in England and the Netherlands. It was most similar to the present forward-contract. In a classic forward contract, the buyer purchases the item which will be obtained at a later time, e.g. fruit, vegetables. Thus, the subject matter of the contract basically does not exist at the time the contract is entered into. In the more complicated forward contracts, the buyer is entitled to demand from the seller delivery of the financial instrument upon which the transaction was based for the price agreed by the parties to the transaction. For instance, let’s say the buyer enters into a forward contract, where the underlying is US dollars. The seller obligates itself to sell a certain amount of US dollars to the buyer at an agreed price at a future date. The buyer earns if he buys the currency at higher rate than is on the market at the time the contract is being fulfilled. If the rate is lower on the market, the buyer loses.
From the aforementioned example, a few conclusions instantly come to mind. First, that the subject matter may not be in the possession of the seller at the time the transaction is entered into. Second, the contract is to be fulfilled at a future date. Third, neither the buyer nor the seller knows what the rate of the subject currency will be.
If we look at the example and the conclusions from the Shari’ah point of view, we have to admit that such a transaction would be deemed haram. Why? The transaction refers to the subject matter that may not be in possession of the seller neither at the time of entering into contract nor at the time of its fulfillment. Thus, the key resolution of the contract contains Gharar – e – Kathir and as such the whole transaction is deemed invalid. The existence of Gharar – e – Kathir or a major gharar renders the contract null and void and cannot be omitted. The Shari’ah scholars are unanimous in this respect.
Furthermore, the future fulfillment of the contract indicates that the parties are sure about the events of the future. As one of the most important aspects of Islam is that Allah is the one who knows the future, humans cannot arrogate to themselves such knowledge which is God’s domain alone. Moreover, the future is uncertain, which is why it could invalidate such a contract. Finally, neither of the parties to the contract know what the future currency rate will be, and hence it is all based on gambling and speculation. From the Islamic finance perspective, the presence of Maisir and Qimar in the contract renders it invalid.

Bai Salam Contract
Nevertheless, some say that the Islamic contract of Bai’ salam is similar to the forward contract. Yes, there are some similarities, but the whole idea behind Bai’ salam is totally different. Bai’ salam is defined as a contract, where the seller obligates itself to deliver a certain, specified thing of already defined qualities at some point in the future and the buyer pays the price upon entering into contract. To avoid any impermissible elements in Bai’ salam, the following conditions have been introduced. The whole price for a thing has to be paid at the moment the transaction is entered into. Partial payment is not permissible as it would mean the use of credit (Bai’ al – Kali bi al -Kali), which is prohibited in this context.

Moreover, payment of the whole price eliminates in a way the element of gharar on the side of the buyer who by paying the whole price ensures the purchase of the product. It also ensures that the essential reason for a salam sale, which is an urgent need, is met.
The subject matter of Bai’salam has to possess defined qualities; its quantity has to be clearly specified. Furthermore, it should be changeable. This means that the subject matter can be changed, which will not influence the contract. For instance, the seller sells 100 kg of grain. Thus, the seller can pick the grain or even buy them anywhere he wants. While in the case of a future sale of an animal, each animal possesses different qualities, so such a sale would not be permissible.
The other crucial aspect of bai’ salam is the fixed time and place of delivery. The term and the place for delivering the subject matter should be stipulated exactly in the contract to eliminate gharar and ensure its permissibility under Shari’ah. By providing the aforementioned, strict conditions, Shari’ah scholars want to ensure that the trade is done in a permissible, Shari’ah-compliant way. Moreover, it emphasizes the difference between a forward derivative and Bai’ salam. In respect of Islamic banking & finance, this type of contract is used for financing the agricultural sector. Though, it can also be used by banks to purchase a good with Bai’salam and then sell it through a parallel Salam.

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