Overview of Conventional Derivatives & Prohibitions of Shariah on Conventional Derivatives
Overview: In business, presence of risk cannot be avoided, but it can be transferred to other parties. Conventional derivatives are not in harmony with Shariah rules, but the use of them is not acceptable in the Islamic environment. The means of dealing with financial risks are called derivatives.
There are three basic types of derivatives:
Prohibitions of Shariah:
There are some formal and technical Shariah-based objections to the conventional derivatives as well as possible solutions.
Forwards and Futures:
Forwards and futures allow a buyer to purchase goods that are non-existent at the time of the contract that violates the Shariah principle that the object must exist at the time of the actual contract. It also allows the seller to hold property title but according to Shariah seller must have the ownership of the object. Another aspect is that it allows the buyer to resell the object that is prohibited by Shariah due to possession and delivery requirement.
The concepts of forwards and futures contracts are the same. These are contracts which obligate one party to buy the underlying at the fixed price at a certain time in the future from a counterparty who is obligated to sell the underlying at that fixed price.
For this purpose, two most important exceptions are Islamic Istisna and Salam that covers the problems of non-existence and non-ownership. The scholars suggested that possession requirement may be fulfilled by “Actual physical possession” or “Constructive possession.” A forward or future contract is about the future sale, so it is prohibited due to gharar. As the market changes, the market price on the maturity date may be higher than the agreed price, so there is the element of uncertainty.
It is similar to the down payment or Arbun Sale. A person buys an item and pays a certain amount of money to the seller on the understanding that if he will take the item, the amount will be part of the total price but if he did not he would lose his money as fee or penalty and the seller would keep it.
There are two types:
- Call options
- Put options
These are prohibited as the maturity level is beyond three days and it involves gharar because neither buyer nor seller is certain that the sale will take place. Another reason for the prohibition is that options does not lies in any category of pure rights.
Conventional derivative instruments are not suitable for Islamic system. Shariah provides risk management solutions and strategies that are compatible with conventional derivatives. The solutions are ethical and in compliance with Shariah rules and thus acceptable in the Islamic environment.