Translate and edited by TYC Finance Ali

The majority of Shariah scholars are of the view that conventional Futures and Forward contracts are not Shariah compliant. This was the resolution of the International Islamic Fiqh Academy as well as the Islamic Fiqh Academy of Muslim World League9 . The AAOIFI Standard No.20 states:

“5/1 Futures 5/1/1 A contract that is binding under law. It is concluded on the trading floor of the exchange for the sale and purchase of commodities or financial instruments for a period linked to the near future. The transaction is arranged with the mentioning of the quantity, type and category along with the statement of the date and place of delivery. As for the price, it is the sole element that varies, and it is ascertained in the trading hall. 5/1/2 The Shari’ah rule for futures contracts It is not permitted according to the Shari’ah to undertake futures contracts either through their formation or trading.” The Shariah scholars object to Forwards and Futures contracts due to the following reasons:

1. Trading before possession

The majority of buyers and sellers in futures and options transactions reverse out of their position before delivery or maturity. This means that physical delivery hardly ever takes place in futures and options; for example, 99% of all futures contracts are settled before maturity. This feature of derivative trading, i.e. sale before delivery is made or selling something one does not possess, has been subject to intense criticism by Islamic scholars. A primary objection to this feature is that a number of intermediaries make money without adding any form of utility to the commodity; i.e., they earn money without giving anything in recompense. Actual physical delivery of the commodity is good because it creates jobs from storage, transport and packaging10. The Islamic Fiqh Academy, in Resolution No. 63 (7/1) of its seventh session in 1412 AH (9-14 May, 1992) describes this method of commodity sale: “The contract provides for the delivery of described merchandise (as a pending obligation) at some future date, with payment of its price on delivery. The contract, however, does not stipulate that it shall end with the actual delivery and receipt of the merchandise, and thus it may be terminated by an opposite contract. This type of contract is the most prevalent in the commodity markets. It is not at all permissible.”

2. Qimar activity

Shariah scholar Shaykh DeLorenzo argues that futures are part of zero-sum markets where gains result from corresponding losses. He opines that this sort of economic activity is clearly forbidden under Shariah. He adds that, while proponents of futures market may argue that such activities function to stabilise prices and regulate risk, as far as the Shariah is concerned such markets produce nothing of value. He concludes that futures amount to bets on the direction the market is moving in. Obviously, the ethics of this market are unacceptable11 . Al-Suwailem explains that, in a zero-sum game, one party gains at another’s expense, i.e., it is a “transfer of wealth for no counter-value”; this he opines is “condemned in the Qur’an”. He explains that the direct conflict of interest inherent in a zero-sum game may create hatred between the two parties, which is one reason the Qur’an prohibits Maysir: “Satan only wants to plant enmity and hatred among you through wine and Maysir” (6:91). Al-Suwailem argues that the use of derivatives is a clear example of a zero-sum game, obliging an exchange of underlying assets for money, or certain amounts of money, at a future date.

3. Sale of debt for debt

The exchange of a debt for a debt also known as Bay’ al Dayn bil Dayn or Bay’ al-Kali bil Kali. The AAOIFI Shariah Standard No.10 states: “Again, any delay in payment of the capital and dispersal of the parties renders the transaction a sale of debt for debt which is prohibited, and the scholars agreed on its prohibition. Ibn Rushd said: “As for sale of debt for debt, Muslim scholars are unanimous regarding its prohibition.” This general prohibition has been prescribed to futures, where it is concluded that the sale of futures contracts, where the parties can offset their transactions by selling the ‘debts’ owed them to other parties before the delivery of the underlying asset, will amount to a sale of a debt and is therefore prohibited.12

Shariah compliant alternatives

There are a few Shariah compliant contracts available that could be considered as a basis for futures and forward contracts. Bay’ Salam is one potential contract. Bay’ Salam is a transaction where two parties agree to trade an underlying asset at a predetermined future date but at a price determined which is fully paid at the time of contracting. This is similar to a conventional forward contract however, the big difference is that in Bay’ Salam, the buyer pays the entire amount in full at the time the contract is initiated. The idea behind such a ‘prepayment’ requirement has to do with the fact that the objective in a Bay’ Salam contract is to facilitate working capital financing for the seller. Since there is full prepayment, a Salam sale is clearly beneficial to the seller. As such, the predetermined price is normally lower than the prevailing spot price. This price behavior is certainly different from that of conventional futures contracts where the futures price is typically higher than the spot price by the amount of the carrying cost13. A Forward contract resembles Bay’ Salam more than a Futures contract due to the standardised nature of Bay’ Salam. Thus, some of the problems of forwards; namely “double-coincidence”, negotiated price and counterparty risk can exist in the Salam sale. Counterparty risk however would be one sided. Since the buyer has paid in full, it is the buyer who faces the seller’s default risk and not both ways as in forwards/futures. In order to overcome the potential for default on the part of the seller, the Shariah allows for the buyer to require security which may be in the form of a guarantee or mortgage14. Since Salam involves actual trading of the underlying asset, financial institutions who do not want to trade in the underlying asset, may engage in a parallel Bay’ Salam where the asset is sold in a Salam contract to another buyer. Alternatively, the bank can enter into a Wa’d agreement to sell the commodity on a certain date without entering into a Salam agreement to move the commodity on. Another potential Shariah compliant alternative to futures and forwards is a model using two independent unilateral promises (Wa’dan). One party can make a unilateral promise to buy 10,000 bushels of soybean on x date at a forward price of $3.5/bushel if the price is less than $3.5/bushel. The seller can make a unilateral promise to sell 10,000 bushels of soybean on a specific date at a forward price of $3.5/bushel if the price is $3.5 or more. The concept and use of Wa’dan is still debated among Shariah scholars in the Islamic finance industry.

Conclusion

Forwards and futures are common derivatives. A derivative is a financial instrument whose value is derived from an underlying asset or group of assets. Derivative products initially emerged as hedging devices to trade specific risks such as interest rate risk, currency, equity and commodity price risk, credit risk etc. A forward contract is a private agreement between two parties giving the buyer an obligation to purchase an asset. Forward contracts have two limitations: (a) illiquidity (b) counter-party risk. Futures contracts are designed to address these limitations. A futures contract is a bilateral contract in which two counterparties agree to buy/sell an underlying at a predetermined price at a specified date in the future. Futures are traded on organized markets (exchanges), so they are standardized contracts. The majority of Shariah scholars are of the view that conventional Futures and Forward contracts are not Shariah compliant. This was the resolution of the Islamic Fiqh Academy of Muslim World League. The AAOIFI Standards also explicitly state the non-compliance of such contracts. Forwards and futures are prone to the Shariah prohibition of trading before possession. As such, these contracts contain Gharar (gross uncertainty). Shariah scholars also argue that these contracts contain elements of Qimar (gambling) in that they are zero-sum games. Another non-compliance factor in futures and forwards is the existence of a debt for debt trade where parties offset and close their positions before delivery of the underlying assets. Shariah compliant alternatives do exist in the form of Bay’ al-Salam. However, such a contract is not identical to the needs of the buyer and seller of a forward contract. The application and use of two Wa’ds (promises) can help structure a parallel Shariah compliant contract to that of futures and forwards.

Notes: This article is excerpted from SHARIYAH REVIEW BUREAU