Derivatives in Islamic finance:

A. The implementation of derivatives in Islamic finance faces several Shariah challenges

due to the fundamental principles of Islamic law.

Since risk-shifting fundamentally violates basic principles of shari’ah law, derivatives are
not readily accepted in Islamic finance as permissible financial instruments due to their often
speculative and unfunded nature

These challenges include:

1. Prohibition of Gharar (Excessive Uncertainty): Derivatives often involve

uncertainty regarding payoffs, delivery, and pricing, which can lead to excessive risk
or ambiguity.

Since the object of a transaction may not exist at the time a contract is signed, Islamic
scholars argue that derivatives can lead to excessive uncertainty, unnecessary risks
(gharar), or speculation that verges on gambling (maisir) due to state-contingent
pricing and the absence of predetermined object characteristics, and points 1 and 2
above.

This contravenes Shariah principles that require contractual certainty and identifiable
characteristics of the transaction.

From the standpoint of Islamic jurisprudence ( fiqh al-muamalat), financial contracts

must satisfy a number of requirements that seem absent in the use and trading of
conventional derivatives

2. Prohibition of Maisir (Speculation or Gambling): Many derivatives are used for

speculative purposes rather than genuine hedging, which is akin to gambling and is
prohibited under Shariah law.

Despite their demonstrable importance for financial sector development, derivatives

are few and far between in countries where commercial transactions are subject to
Islamic law. Legal scholars allege that derivatives contain excessive uncertainty
(gharar),2 encourage speculative behavior akin to gambling (maisir), and/or enrich
claimants unjustly from exchanges between counterparties where money alone
(rather than the creation of real assets) is the primary subject of the transaction—
three concepts that contravene fundamental principles of Islamic law

Speculative behavior undermines equitable risk-sharing and creates zero-sum payoffs.

 However, many derivatives contracts are used for speculation (and are deficient of
actual hedging need), which belies equal risk-sharing (sharik) in actual ownership of
the reference asset(s) by all contractual parties subject to religious restrictions
governing lending and profit-taking ( Jobst [2007b]; Ahmad [2000]).

3. Prohibition of Riba (Interest): Conventional derivatives often involve interest-based

income or leverage, which is strictly forbidden in Islamic finance.

Islamic finance is governed by the shari’ah, which bans interest, short selling, and
speculation, and stipulates that income must be derived as profits from shared
business risk rather than guaranteed return

Shariah-compliant derivatives must avoid any form of interest or debt-based profit.

Since risk-shifting fundamentally violates basic principles of shari’ah law, derivatives
are not readily accepted in Islamic finance as permissible financial instruments due
to their often speculative and unfunded nature

4. Asset Ownership and Underfunding: Shariah requires that the reference asset in a
transaction must exist and be owned by the seller at the time of the contract.

Asset ownership and prohibition of leverage (underfunding). Shari’ah principles

align financial claims with investments in real assets

Many derivatives involve the sale of non-existent or non-owned assets, violating the
principle of qabd (possession).

Another key argument presented against derivatives in Islamic finance pertains to the
counterparty risk (and associated potential of avertable uncertainty) from the sale of
a non-existent asset or an asset not in the possession of the seller (qabd) (i.e., taking
possession of the item prior to resale, which negates the hadith “sell not what is not
with you”)

5. Deferred Payment and Delivery: Conventional derivatives often involve deferred

payment or delivery, which can lead to exploitation or unfair gains.

Both concepts stand in opposition to the contingency risk of actual performance of

financial derivative instruments and agreements aimed at speculative trade (rather
than genuine hedging and/or equitable risk-sharing (sahrik)) that result in payments
without an underlying asset transfer

Shariah-compliant contracts require immediate payment or delivery to avoid such

issues.
 Shari’ah law requires contractual certainty regarding the generation and distribution
of profits arising from mutual contributions of transacting agents

6. Cash Settlement: Many derivatives rely on cash settlement rather than physical
delivery of the underlying asset, which is considered non-compliant with Shariah
principles.

While such arrangements typically help mitigate the contingency risk of asset delivery
and ensure definite performance by means of cash settlement (if physical delivery
fails or one party defaults), they have been deemed non-compliant with Islamic law,
given that the same object of exchange cannot be bought and sold between two
parties at different prices and with time delay of payment, delivery, or both (bay al’
inah).

This creates a pure cash exchange without asset ownership or transfer.

Similarly, offsetting a contractual obligation via cash settlement (contingent on a

particular economic outcome) would portend to a pure cash exchange without asset
ownership and/or the creation of real assets

7. Speculative Leverage: The inherent leverage in derivatives, such as options, can lead
to disproportionate gains or losses, which contradicts the Shariah principle of
equitable risk-sharing.

Since risk-shifting fundamentally violates basic principles of shari’ah law, derivatives

are not readily accepted in Islamic finance as permissible financial instruments due
to their often speculative and unfunded nature.

8. Lack of Standardization: The absence of standardized documentation and

universally accepted terms for Shariah-compliant derivatives creates delays and
inconsistencies in transactions.

In particular, the lack of standardized documentation based on universally

acceptable terms often delays the execution of transactions in Islamic finance

9. Legal and Governance Issues: The fragmented opinions of Shariah scholars and the
lack of unified principles across different schools of thought lead to heterogeneity in
the interpretation of Shariah compliance.

Thus, the absence of unified principles (and no precedent) on which shari’ah scholars
decide regarding the religious compliance of products and activities has spawned a
plurality of interpretations of shari’ah principles.

This complicates the enforceability of contracts and dispute resolution.

The absence of definite guidance on shari’ah compliance and universal enforcement

based on common standards also affects the legal integrity of transactions in the case
of dispute resolution.
 10. Challenges in Close-Out Mechanisms: Conventional derivatives use net present
value calculations for early termination, which is not recognized in Shariah law.
Shariah-compliant alternatives, such as musawama contracts, introduce complexities
in valuation and settlement.

These challenges highlight the difficulty of reconciling the features of conventional

derivatives with the ethical and legal requirements of Islamic finance.

The fundamental features of derivatives—including the uncertainty of payoffs, the absence of

risk-sharing, and the potential of speculative use—are not accepted in the tradition of
Islamic finance.

Efforts like the ISDA/IIFM Tahawwut Master Agreement aim to address some of these
issues, but widespread adoption and further innovation are needed to align derivatives with
Shariah principles.

The launch of the Tahawwut Hedging Master Agreement (TMA) in March 2010 by the
International Islamic Financial Market (IIFM) in cooperation with the International Swaps
and Derivatives Association (ISDA) has been welcomed as an important step toward the
standardization of bilateral hedging arrangements in Islamic finance.
 B. Examples of Shariah-compliant derivatives that already exist include financial
instruments designed based on accepted Islamic contracts that avoid prohibited
elements like riba (interest), maisir (gambling), and gharar (excessive uncertainty).
These include:
1. Islamic Forward Contracts based on Salam and Istisna’ contracts, where payment is
made in advance for goods to be delivered later, ensuring actual asset delivery and
avoiding uncertainty.

"There are already a number of Islamic financial instruments with derivative-like

features that can help investors design shari’ah-compatible derivatives. These include
forward contracts based on salam and istisna’..."
Salam and Istisna’ are listed as “Forward Contracts” under “Islamic Financial
Instruments with Derivative-Like Features.”

2. Islamic Options structured using contracts like Bai’ al-Urbun (earnest money sale),
which gives the buyer the right but not the obligation to purchase an asset, with a
down payment that is forfeited if the option is not exercised.
Bai’ al-‘Urbun is listed as “Option Contracts” under “Islamic Financial Instruments
with Derivative-Like Features.”
3. Islamic Swaps designed through permissible contracts such as Qardh (loans) and
other Shariah-compliant arrangements to manage currency or rate risks without
involving interest.
Currency swaps are listed under “Islamic Financial Instruments with Derivative-Like
Features,” with “Qardh” and “Wa’ad” as underlying contracts.
"...and swaps based on a combination of permissible contracts (e.g., wa’ad, murabaha, and
qardh)."

These Shariah-compliant derivatives are developed to fulfill the risk management and
hedging functions of conventional derivatives while adhering to Islamic legal principles,
particularly ensuring asset backing, avoiding speculation, and ensuring certainty in contracts.

"Many shari’ah scholars now accept the application of hedging of actual exposures as an
essential element of sound risk management and acknowledge the opportunity cost imposed
by a lack of Islamic hedging tools."
"Shari’ah principles align financial claims with investments in real assets. This marginalizes
the possibility of underfunding through leverage while fostering equity ownership (in lieu of
financial leverage from debt creation without underlying asset values). Thus, any reference
asset is required to be in the (constructive) ownership and possession of the creditor... in
order to ensure the asset-backing of financial obligations..."