Another capital market product which I would like to briefly discuss about is derivatives.
But before I do that, let me explain that while stocks and bonds are publicly traded at market price, there is another shade of capital market where much greater returns are discreetly made, as well as lost. I am talking about private equity where you can never judge how the nerves are.
There have been instances that the very low investments made in the private equity universe by the venture capitalists and angel investors resulted in returns far superior than the publicly listed and traded securities. Equally, the losses were far greater than you may have seen in the listed space. It could go either way in private equity and the key to successfully exploring this dynamic sector is the quality of research and the depth of homework before taking the jump.
So, how do we deal with private equity investment from the Shariah perspective? Well, this will be my next discussion point under the subject of asset management. Nevertheless, briefly, the same Shariah screening parameters shall apply here as well which are used for publicly listed shares before a stake is acquired.
Derivatives
Coming back to derivatives, these are not primary securities such as stocks and bonds. Derivatives are regarded in the capital market as secondary or ancillary tools to either hedge the risk of a primary security, or to indulge in speculation in anticipation of a windfall. Remember, heavy trading in derivatives was one of the causes for the mother of all financial crises in 2008 (well so far the title of ‘mother’ is with that crisis and I hope it remains that way).
There are various types of derivatives and they use options, swaps, forwards and futures, etc. The reason why Islamic banks and financial institutions came out safely from the financial crisis of 2008 was that by default, they were not permitted by the Shariah boards to invest or trade in derivatives.
Shariah permissibility
The reason for non-permissibility of dealing with derivatives is the use of conventional options as well as the forward and future contracts where both considerations, ie delivery and price, are deferred to a future date.
I have explained earlier the golden Shariah principle to avoid any financial calamity is to either defer the price, as in the case of a Murabahah contract where the delivery is made upfront but the payment of the price may be deferred, or defer the delivery as done in a Salam contract where the price is paid upfront in full and the delivery is deferred to a future date, but you are not allowed to defer both considerations at the same time.
If the conventional financial world wanted to avoid a recurrence of such grave financial turmoil in future, they could have taken a leaf from the Islamic finance book but alas, I see no improvement. So tighten your belt for any other future calamity emanating from the conventional financial world. There have been laws to tighten the derivative market but as we have seen in the past, these are never enough.
The Shariah scholars have permitted the use of derivatives in a limited sense provided the purpose is to mitigate the risk and not to speculate for unrealistic gains.
In the past, I had dealt with Shariah scholars while developing for the first time, the Shariah compliant risk mitigation techniques for fluctuation in currency. The limited use allowed by the Shariah board was for the purpose of hedging against the currency fluctuation for the import of goods by Islamic bank customers on the usance basis where the payment is made upon completion of the supplier’s credit.
The newly approved product at the time facilitated the Islamic bank to allow customers to also establish the usance letters of credit for which they were forced to deal with conventional banks since no currency hedging facility was available with the Islamic bank. Subsequently, profit rate swap Islamic derivatives were also innovated for selective use.
The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.
Sohail Zubairi is an Islamic finance specialist and AAOIFI-certified Shariah advisor and auditor. He can be contacted at [email protected].
Next week: Wrap-up discussion on capital market shall continue.