Derivatives in Islamic Finance

During the late 1980's an opportunity came my way to become an option dealer in the London capital market. At that time I was not a practising Muslim and, given that the pay in this line of work could be enormous, I accepted without a second thought. As the years went by, it occurred to me that the size of my pay packet bore little relation to the benefit enjoyed by society as a result of my work. Others had misgivings of their own. Accountants complained of the hidden risks that banks were taking 'off balance sheet' and, from time to time, government ministers would make a scapegoat of the derivatives market when other excuses were not forthcoming. Regulators scrambled to recruit staff who could understand what the traders were doing but offerred low rates of pay and, therefore, sufferred from a persistent lack of qualified staff.

As the derivatives booty trickled down in ever greater quantities, the financial establishment began to seek a wider economic justification for the existence of this market. The business schools, progenitors of modern option valuation techniques, were only too happy to help. The increasing diversity of hedging products provided a more complete spectrum of risk management tools and was therefore of benefit to society, they told us. But we in the market saw a different story unfolding. XYZ bank would lure the poorly paid treasury manager at the Kingdom of Somewhere-Or-Other into a complex swap deal that only a PhD in Nuclear Physics could properly value. So the bank would book a multi-million dollar profit the very day the deal was closed and the Kingdom's officers would never know any better. Derivatives departments began to swarm around corporate clients like bees around a honey pot.

Of course the scam couldn't last forever. By the early 1990's, Bankers Trust traders were caught discussing the size of the "rip-off factor" on a Procter and Gamble derivatives deal. We know this because the episode was taped and made public on behalf of the company. It was one of many large derivatives losses accrued by clients that had acted on the eager encouragement of their bankers. Soon Orange County and Metallgesellschaft would fall into the same trap at a cost of hundreds of millions of dollars more.

"We can protect you against market volatility" the investment bankers tell their clients. But the market volatility is caused by the activities of those very same investment bankers, and so the clients are sold nothing for something. Protection against a danger that never needed to exist in the first place. Sadly, the world learned little from the derivatives explosion. By the time the internet boom collapsed, a new generation of clients was learning about the motivations that really drive bankers and advisors. The clients tend to be offerred the products that provide financial institutions with the highest profit margin.

What if every country had pure gold coins as its currency? Then what would be the point of the foreign exchange market? What would be the point of exchanging one ounce of American gold for one ounce of Japanese gold? Who would need currency derivatives? Who would need to pay commission on foreign currency transactions? We see very quickly where this idea leads. An end to a trillion-dollar-a-day market that produces huge profits for the financial establishment. But of course profit is not necessarily indicative of productive effort. Theft is a good example of this principle. If we want to achieve a more efficient economy, we must promote systems in which people work in productive pursuits rather than unproductive ones. The foreign exchange market is an unproductive pursuit in that it exists because of an unnecessary monetary convention. Change the convention, in other words adopt a different monetary standard, and all those clever dealers can become doctors and teachers instead!

But back to options. Modern option contracts have a variety of features in common that can be summarised as follows. An option is a right not an obligation to enter into an underlying contract of exchange at or before a specified future date (the expiry date). The buyer of that option pays a price (the premium) to the seller (the writer) of the option. The option may give its holder the right to buy a specified asset (the underlying) from the option writer, gold for example, such being a call option on gold. Or the option may give its holder the right to sell the underlying asset to the option writer. This would be a put option. Every option has a strike price, this being the price at which the holder may buy or sell the underlying upon exercise of the option. And every option has a nominal size, this being the amount of underlying that the option holder may buy or sell at the strike price. A 15 December 2001 European call on gold at $400 per ounce in 100 ounces gives its holder the right to buy 100 ounces of gold from the option writer at $400 per ounce on the 15 December 2001, if the holder so wishes.

If we exclude those financial contracts which are of themselves haram (bonds and forward foreign exchange for example), then we are left with a set of underlyings such as equities and commodities upon which a derivative contract may be based.

Curiously, even where acceptable forms of underlying such as these are concerned, a key valuation element in arriving at the fair value of an option contract remains the rate of interest. The Black Scholes formula proposes that since an option can be perfectly hedged through constant trading in the underlying, the option position should be riskless and hence earn the buyer the riskless rate of interest on the premium that was paid for it. (In reality, constant trading of the underlying asset to achieve the perfect hedge is unattainable, and so option prices behave in ways that are not entirely predicted by Black-Scholes.) For the unhedged option, the contract becomes one of pure uncertainty. Neither party knows whether the option will be exercised, as it is dependent upon the condition of the market at a future date.

The first problem with the standard option contract from a Shari`ah perspective is that a contract of exchange in which both payment and underlying are deferred is widely held to be prohibited. The second problem is the uncertainty that exists with regard to whether or not the option will be exercised. Thirdly, if the option contract is judged to be halal, the question then arises as to whether that option can itself be sold to a third party, as is the case in the market for warrants for example. Fourthly, by buying a put option and selling a call option, a trader can replicate a short position in an underlying asset. Where these options are cash settled, the trader can be seen to achieve the same cash-flows as a short seller of that underlying. Shari`ah scholars have agreed that selling what one does not own is a prohibited commerical activity, and the possibility that such an activitiy can be synthesised through the use of options must therefore call into question their validity under Shari`ah. There is a fifth problem that pertains to more complex option contracts where the strike price itself varies according to an agreed formula. Such is the case with a serial option. For example, a one month 'at-the-money' serial call with daily resets gives the holder a series of one day call options whose strike price is the price of the underlying asset at the previous day's close of trading. As this price is unknown in advance, the strike price itself cannot be known. This represents further gharar.

Under Bay al-Urban, a deposit is paid on an item that a prospective buyer may purchase at a later time. Should the buyer not complete the purchase, the deposit is lost. This contract has been used as a justification for Islamic options by some writers who argue that the deposit can be seen as the premium paid by the buyer of a call option. The problem is that the scholars do not widely allow bay al-Urban. According to Ibn Rushd in Bidayat al-Mujtahid:
Within this topic is the sale of the urban (sale with earnest money). The majority of jurists of different regions hold that it is not permitted, but it is related from a group of the Tabi'un that they permitted it, among them are Mujahid, Ibn Sirin, Nafi ibn al-Harth and Zayd ibn Aslam. The form it takes is that a person puchases a thing and delivers to the seller part of the price on the condition that if the sale is executed between them this earnest money will form part of the price of the goods, if it is not executed the buyer will forgo it. The majority inclined toward its prohibition, as it is from the category of gharar, mukhatara and the devouring of wealth of others without compensation. Zayd used to say, "The messenger of Allah (God's peace and blessings be upon him) permitted it". The Ahl al-Hadith said that this is not known from the messenger of Allah (God's peace and blessings be upon him).

Under Khiyar, which is allowed by the jurists, the buyer of an item has the right to undo his purchase if the seller specifically allows as part of the terms of the sale. This is in other words an option to cancel a previously agreed sale. All buyers have a right to cancel a sale following purchase but before leaving the presence of the seller (khiyar al-majlis). This right is different to that expressly given by the seller to the buyer under sale with an option (bay al-khiyar), where the buyer may leave the presence of the seller for a specified period of time before returning to cancel the sale and take back the money that was paid.

Ibn Rushd in Bidayat al-Mujtahid comments:
Permissibility of option is upheld by the majority, except for al-Thawri and Ibn Shubrama, as well as a group of the Zahirities. The reliance of the majority is on the tradition of Hibban ibn Munqidh, which contains the words "and you have an option for three days", and also what has been related of the tradition of Ibn Umar: "The parties to sale have an option as long as they have not parted, except in sale with an option". The reliance of those who prohibit it is (on the argument) that it constitutes gharar and that the basis of sale is that it is binding, unless definitive evidence is produced for the permissibility of sale with an option from the Qur'an or authentic sunna or ijma. They also said that the tradition of Hibban is either not authentic or it is specific to the case of a person who complained to the Prophet (God's peace and blessings be upon him) that he was deceived in sales. They said that the tradition of Ibn Umar and the words in it, "except sale with an option", have been interpreted through another version of this tradition in which the words "that he says to his counterpart: 'Choose'," have been recorded.

In khiyar it is difficult to see any analogy that would lead us to the acceptance of the modern option contract as described above. Khiyar relates to a halal contract of exchange that has already taken place, whilst a modern option relates to an exchange that is yet to take place. In the case of khiyar, the exchange of one or both countervalues is effected immediately. In the case of the modern option contract, future delivery applies to both the payment and the underlying asset. In addition, uncertainty as to the materialisation of the exchange exists with the modern option contract but not in khiyar.

Disagreements among traditional scholars in the matter of khiyar arise in minor details, such as the length of time for which the buyer has the option to return the goods, or who is liable for any damage to the goods whilst the buyer is in posession of them during the option period. These scholars do not seem to have disagreed upon those fundamental principles which distinguish khiyar from the modern option contract.

It is my view, having been involved in derivatives dealing, that the potential exists in this market to cause a serious breakdown in the financial system. The degrees of leverage that are afforded by option contracts can be so high that large unpredictable market moves in underlying prices may one day lead to the insolvency of a major financial institution. Liabilities cannot be perfectly hedged even where that is the intention, and some traders deliberately do not hedge their option portfolios because such action would limit the potential for high returns. The case of Long Term Capital Management in the United States, rescued by a Federal Reserve bail out in 1998, demonstrates the degree of risk that can be incurred. The question is whether the central bank or other authorities will be able to move quickly enough, or in large enough measure, to prevent future failings.

When looked at from the Islamic perspective, as with so many other Islamic financial products, it seems that theory needs to be stretched in order to justify an Islamic option contract. The macro-economic arguments for their existence are of dubious merit, based as they are on minimising risks which do not need to exist in the first place. Better to structure the economic system such that it does not suffer from continuing volatility. If there was no such thing as interest, there would be no such thing as interest rate options. The same with foreign currency. What we are seeing in the Western world is the emergence of financial products that are a symptom of a system that has gone wrong. Islamic financiers who look at the products of this system as a paradigm are making a big mistake.

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