Despite their importance in financial sector development, derivatives are few and far between in countries where the compatibility of capital market transactions with Islamic law requires the development of Shariah-compliant structures. Islamic finance is governed by the Shariah, which bans speculation, but stipulates that income must be derived as profits from shared business risk rather than interest or guaranteed return.
Based on the current use of accepted risk transfer mechanisms in Islamic finance, this article explores the validity of derivatives in accordance with fundamental legal principles of the Shariah and summarises the key objections of Shariah scholars that challenge the permissibility of derivatives under Islamic law. In conclusion, the article delivers suggestions for Shariah compliance of derivatives.
Types of Islamic Finance
Since only interest-free forms of finance are considered permissible in Islamic finance, financial relationships between financiers and borrowers are not governed by capital-based investment gains but shared business risk (and returns) in lawful activities (halal). Any financial transaction under Islamic law implies direct participation in asset performance, which constitutes entrepreneurial investment that conveys clearly identifiable rights and obligations, for which investors are entitled to receive commensurate return in the form of state-contingent payments relative to asset performance.
The Shariah does not object to payment for the use of an asset, as long as both lender and borrower share the investment risk together and profits are not guaranteed ex-ante but accrue only if the investment itself yields income. In light of moral impediments to passive investment and secured interest as form of compensation, Shariah-compliant lending requires the replication of interest-bearing conventional finance via more complex structural arrangements of contingent claims, subject to the intent to create of an equitable system of distributive justice and promote permitted activities and public goods (maslahah).
The permissibility of risky capital investment without explicit interest earning has spawned three basic forms of Islamic financing for both investment and trade:
- synthetic loans (debt-based) through a sale-repurchase agreement or back-to-back sale of borrower or third party-held assets
- lease contracts (asset-based) through a sale-leaseback agreement (operating lease) or the lease of third-party acquired assets with purchase obligation components (financing lease)
- profit-sharing contracts (equity-based) of future assets. As opposed to equity-based contracts, both debt- and asset-based contracts are initiated by a temporary (permanent) transfer of existing (future) assets from the borrower to the lender, or the acquisition of third-party assets by the lender on behalf of the borrower.
Implicit Derivatives in Islamic Finance
From an economic point of view, creditor-in-possession-based lending arrangements of Islamic finance replicate interest income of conventional lending transactions in a religiously acceptable manner. The concept of put-call parity illustrates that the three main types of Islamic finance represent different ways to re-characterise conventional interest, through the attribution of economic benefits from the ownership of an existing or future (contractible) asset by means of an implicit derivatives arrangement.
In asset-based Islamic finance, the borrower leases from the lender one or more assets A valued at S, which have previously been acquired from either the borrower or a third party. The lender entitles the borrower to (re)gain ownership of A at time T by writing a call option -C(E) with time-invariant strike price E subject to the promise of full repayment of E (via a put option +P(E)) plus an agreed premium in the form of rental payments over the investment period.
This arrangement amounts a secured loan with fully collateralised principal (ie full recourse). The present value of the lender窶冱 ex-ante position at maturity is ﾂ
