It has been claimed that futures contracts are not recent discoveries, but in fact go back to the 16th century. It is a known fact that futures have been traded on the Chicago Board of Trade since 1865. Their importance, however, is quite contemporary. Therefore, the classical Islamic jurists did not address the subject of futures contracts directly.
The relevant Shariah injunctions on futures trading are mainly sales contract, Salam contract, contract in suspense and exchanging debt for debt.
Sales contracts
Sales contracts might involve the exchange of money for goods (Bai) or the exchange of money for money (sarf). It is an established rule in Shariah for the second category of contracts that such an exchange must be on-the-spot. Neither the sold currency nor the price (the other currency) may be different. Such a rule is based on authentic narrations from the Prophet Muhammad, and therefore is not a subject for reinterpretation.
Salam contract and deferred payment sale
Shariah does recognize the need for inter-temporal transactions. Shariah compliant exchange contracts can be on-the-spot, where both the price and the items sold are instantaneously exchanged.
The items can also be forward, where the price or the item sold is deferred for future delivery. Bai Bithaman Ajil (BBA) is an example of a deferred payment sale, while the Salam contract is an example of a sale contract where the delivery of goods is deferred.
However, both BBA and the Salam contract are a far cry from modern futures transactions. An exchange contract in Shariah is an agreement where two parties exchange a price for a priced item (goods or services). The contract itself must always create rights and obligations immediately, resulting in a complete or partial delivery of the object of the contract. It is thus not permitted to engage in contracts that only create mutual obligations that are to be disposed of in the future.
Contracts in suspense
A contract is definitive when the offer and acceptance are both categorical and the contract is validly concluded. A contract is suspensive when the offer and acceptance are kept in suspense, i.e. for future effect. The latter is not permitted in Shariah, particularly in sale contracts. Hire contracts, to the majority of scholars, may be suspensive.
Contracts in suspense are relevant to futures because in the latter there is only offer and acceptance but no contract is concluded. Effectively, futures are similar to sale contract in suspense.
Exchanging debt for debt
Debt obligations (such as receivers) are not to be sold except in very restrictive cases where it would not lead to usurious transactions, for example when the debt obligation is not money but a commodity. Debt is sold in deferred payment.
Shariah objections to conventional futures contracts
Focusing specifically on the form of contemporary futures contracts, we can identify certain flaws that can be summarized as follows:
1. A commodity bought for future delivery must – if it is to be acceptable from a Shariah point of view – be on a Salam basis. As part of the requirements of Salam, the full price must be paid immediately at the time of contracting. This is based on an authentic narration from the Prophet and hence is not subject to reinterpretation. An essential part of the futures program, as practiced in organized markets, is that sellers and buyers only pay a small percentage of the total price and even then such percentage is paid to the clearing house and not to the counterpart. Therefore, a futures contract will not be accepted on a Salam basis.
One may ask why we insist on Salam. The point is that when the sold item in a sale contract is not identified but only described, it becomes a “debt obligation” on the seller, similar to any other debt. Such sale contract must be on Salam basis, for Salam is the exchange of money (price) for a well described (but not definite) item. Had the sold item been in existence at the time of sale and can be exacted by the parties – such as a car or a house – the buyer will then take the risk of that item, not the credit risk of the seller. It should be apparent, therefore, that we have no alternative but to apply the rules of Salam to futures if they are to be acceptable from a Shariah point of view.
2. Even if the futures contract can be adopted into the Salam model of sale (i.e. the parties consent to pay the full price at the time of contracting), there remains another problem. To the majority of jurists a commodity bought on Salam basis cannot be disposed of by sale before the actual delivery. When a forward (or future for that matter) contract is effected, the buyer must wait until delivery to be able to sell the same. This is not what happens in the futures market. Commodities in the organized futures markets are bought and sold several times before actual delivery, otherwise the market will fail to provide liquidity, which is an essential part of the mechanism. But from a Shariah perspective, even in standard sale contracts, it is not permitted that the buyer sells before actual receipt of the purchased items.
These two objections fly in the face of conventional futures and make it virtually impossible to accept conventional futures contracts.
Towards Shariah acceptable futures trading
It is an established economic fact that risk sharing and inter-temporal smoothing are essential elements of welfare in any society. It is also an established Shariah fact that the main objective of the Islamic Shariah is the good and welfare of Muslim society. Therefore, it is unthinkable that Shariah will lack the ways and means to provide the necessary facility for Muslims’ legitimate needs in the realm of finance and investment.
We know already that all the modes of partnership in Shariah are geared toward risk participation. Not only that risk sharing is the most important element in the principles of Mudarabah and Musharakah, but also that when the form of contract of such partnership is altered to shield one partner from risk, the contract becomes null and void, for it no longer serves the basic purpose of risk/reward sharing. In fact, the main reason for the prohibition of interest is because a loan contract shifts the commercial risk of the profit generating venture to the borrower. Hence, the other party deserves to get no share of such a profit, which is essentially a reward for risk taking.
However, it is one thing to say that risk sharing is a legitimate objective, but quite another to say that risk per se can be the subject of an exchange contract. Speculators have no commercial interest in the commodities being exchanged in futures markets. Rather, they make money out of the “purchase” and “sale” of risk. Unlike the need for hedging against risks, speculation is a deplorable activity. The point is how can we distinguish hedgers who have a legitimate need from speculators? Unfortunately, there is no practical way.
Inter-temporal smoothing is a legitimate objective. It is a built-in component in every contract that bridges present to future. Shariah does not lack such a facility. As a matter of fact, Salam itself is an inter-temporal smoothing device.
Furthermore, one major effect of futures trading is creating the means whereby relevant and useful economic information is internalized into the market mechanism. This is not only in line with Shariah, but it is a requirement for all exchange contracts. It is because of this that a number of contracts become void or prohibited when they are made a means to conceal information from the other party.
Having said all that, is it sufficient to say that a conventional futures contract is not permissible from the Shariah point of view? The answer is negative. We must venture into developing a Shariah acceptable form of futures contract.
At this stage, however, we can only set the foundation for future research tasks and set the agenda for other works to follow.
First, the need for hedging risks is a legitimate one from a Shariah point of view. Efforts to design new instruments for this purpose that are in line with Shariah requirements should be encouraged.
Secondly, such legitimate needs are found in the realm of the production of real assets and services. Therefore interest rate, currency and stock index futures have no place in an Islamically valid futures market.
Thirdly, we have always assumed that a futures contract is actually a sale contract. Therefore, we have insisted that it should abide by the Shariah acceptable rules for such contracts. However, there are those who think that futures are not actually a sale contract but a promise to buy and sell. In his book International Investments (3rd edition), Bruno Solnik described futures as “simply a commitment to buy or sell.” This area must be explored from the Shariah point of view.
Certainly a binding commitment is a contract. The fact of the matter is that such commitment is not binding. Neither buyer nor seller is obliged to receive or deliver. He is only required to compensate the other party for any damage caused by such commitment, i.e. the difference in price. This perspective actually takes the whole matter to a different chapter in the jurisprudence of contracts.
In a momentous decision, the Islamic Jurisprudence Academy of the Organisation of Islamic Cooperation (OIC) has established a distinction between a contract and a binding promise to buy (or sell). Based on the Malki school of thought, a promise to purchase is not a purchase contract. Yet it creates an obligation on the promising party to compensate the other for any loss caused by not honoring one’s promise. The profit generated would be that of compensation.
Fourthly, building a model of futures trading on the basis of the Salam contract should not be excluded altogether. The requirement in a Salam contract to pay the full price when the contract is transacted will clearly reduce the possibilities for speculators and hedgers. As for liquidity, some classical jurists differentiated between food and non-food items in the case of Salam. To the majority of the Maliki scholars, the sale of Salam-based goods before actual receipt is acceptable for non-food items. These possibilities must be explored.
The author is a Professor of Islamic economics at King Abdulaziz University, Jeddah, Saudi Arabia.