8.01  Bridging the gap between traditional Islamic transaction structures and conventional derivatives continues to be among the most urgent challenges facing the global Islamic finance industry, not least to provide Islamic financial institutions with a crucial tool for risk management. In this chapter we examine examples of how conventional derivatives, especially futures, options, and swaps, have been or (p. 202) may be based on bay’ salam, bay’ ‘urbun, and other traditional Islamic transaction structures.²

8.02  Salam and ‘urbun clearly illustrate the nature of the challenge to create Shari’a-compliant derivatives. Paradoxically, it is their deviation from the standard conditions for a valid sale contract ‘that allows them to function to some extent as proxies for conventional derivatives.

8.03  Among jurists a consensus (ijma’) emerged as to the validity of salam,³ although special conditions were imposed not only to minimize gharar (uncertainty) and the kindred contractual defect of jahl (lack of knowledge) but also to reduce the possibility of riba (unlawful gain). There is still considerable debate among the various schools of law as to whether ‘urbun constitutes a valid sale contract under the Shari’a.⁴

8.04  Salam or salaf⁵ can be simply described as a sale with advance payment for future delivery. Expressed more technically, it involves future delivery of the subject matter of the sale (al-musallam fihi) by the seller (al-musallam ilayhi) while the price (ra’s al-mal) is fully paid by the buyer (al-musallam) at the time of entering into the sale contract (majlis al-’aqd).⁶ An example of such a transaction would be prepayment of the entire price for a fungible commodity of a specified quality and quantity, such as wheat, to be delivered on a specified date in the future. Such a transaction would in the terminology of modern finance approximate a forward sale contract.⁷

(p. 203) 8.05  Salam is categorized by jurists as a variant of the basic contract of sale (bay’), to which, with certain modifications, the general rules still apply. Thus it falls within the overarching permission for commercial transactions derived from the Qur’anic verse: ‘Allah hath permitted (wa-’ahalla) trade (al-baya’) and forbidden (wa-harrama) usury (al-riba).’⁸ Another Qur’anic verse provided more specific justification:

You who believe, when you contract a debt for a stated term (bi-dayni ila ajalin musamman), put it down in writing: have a scribe write it down justly between you. No scribe should refuse to write: let him write as God has taught him, let the debtor dictate, and let him fear God, his Lord, and not diminish [the debt] at all … Do not disdain to write the debt down, be it small or large, along with the time it falls due: this way is more equitable in God’s eyes, more reliable as testimony, and more likely to prevent doubts arising between you. But if the merchandise is there and you hand it over, there is no blame on you if you do not write it down.⁹

It has been observed that during the pre-modern era salam was a device whereby customers could extend credit to artisans or small traders.¹⁰ In the hadith literature salam is used in an agrarian setting and classical jurists, although innocent of modern notions of probability theory and risk management, were nevertheless sensitive to the need of farmers to sell on credit to cover the cost of seeds and other necessities, if only to tide them over until the next harvest.¹¹ And so, despite the absence of a basic condition for a valid sale contract—namely, the simultaneous exchange of countervalues—jurists, yielding explicitly to practical necessity, deemed salam to be compliant with the Shari’a.¹² To this end, jurists relied on a Prophetic tradition narrated by Ibn ‘Abbas (d. 687–688 CE/68 AH), a Companion of the Prophet: ‘Whoever pays in advance the price of a thing to be delivered later should pay it for a specified measure at specified weight for a specified period.’¹³

(p. 204) 8.06  Mature works of fiqh composed by Muslims jurists in the eleventh and twelfth centuries, responding to the growth of regional trade, fuelled not only by agricultural products but also demand for textiles and other manufactured goods, treat salam as an investment contract, as opposed to a pure sale contract.¹⁴ They understand the subject matter of the contract not so much as a tangible good to be delivered in the future but rather as a personal obligation of the seller—in other words, as a relationship between parties rather than between things—thereby transforming the parties from buyer and seller into creditor and debtor until the time of delivery. In classical Islamic law ra’s al-mal, even if nominally the purchase price, has in effect become capital to be invested. From the eighteenth century onwards the salam contract played a crucial role in the modernization of agriculture and manufacturing in the Middle East.¹⁵ During the twentieth century its use subsided until its recent exploitation by the global Islamic finance industry.

8.07  Mutuality of benefit, individually and especially when projected across the global Islamic finance industry, provides another important justification according to the principle of maslaha, because it can be shown that such transactions promote the public interest.¹⁶ As in any hedging transaction, the parties will attempt by contract to resolve, to their mutual benefit, uncertainty about price movement, for the principal objective will be to guard against financial loss. Commodities, owing to their characteristic price volatility, are routinely the subject matter of such contractual arrangements. It is therefore not surprising that agricultural products and precious metals are the main focus of the hadith literature. Accordingly, a buyer can protect itself against the risks of inflation and other causes of upward price movement because the discount attributable to the time value of money and potentially other factors means the contract price will tend to be lower than the expected spot price at the time of delivery.¹⁷ Both Hanbali and Hanafi jurists of the classical period accepted that the buyer can profit from the effective insolvency (p. 205) of the seller to extract a price lower than that prevailing in the open market,¹⁸ although the commodity may ultimately be sold for a price lower than the prevailing market price, full prepayment of the purchase price should enable the seller better to manage its liquidity requirements.¹⁹

8.08  Because the observable price differential enjoyed by buyers resembled interest and could therefore be interpreted as unlawful gain, special conditions were considered necessary to avert a potentially invalidating combination of gharar, jahl, and riba, despite the salam contract being exempt from the general rule that the subject matter must be owned by the seller at the time of entering into the sale contract.²⁰

8.09  In addition to the standard conditions for a sale contract under the Shari’a,²¹ a valid salam transaction requires compliance with special conditions with regard to: (i) price, (ii) subject matter, and (iii) delivery. Agreement about the broad outlines has not precluded considerable diversity of opinion among the various schools of law regarding the detailed regulation of salam transactions.²²

8.10  Variously translated as capital, consideration, or price, ra’s al-mal may, as in a normal sale transaction, be in any legal form, whether in cash or in kind, including services or a usufruct (manfa’a) with regard to a particular asset, such as having the use of an aircraft or vessel for a certain period.²³ In contemporary practice cash payment is not required; instead, the price may be credited to the seller’s account, a welcome development given the trend towards settlement of conventional derivatives transactions by means of electronic payment systems.²⁴ Although money technically does not transfer until the settlement date, the widely applicable accounting requirement that the price of derivatives, including futures, options, and swaps, be periodically updated to reflect their fair value, or (p. 206) marked-to-market, which can result in a counterparty having to deposit funds into a margin account in order to sustain a trading position, does not conform easily to the principles of Islamic law. Such intertemporal (re-)pricing between the execution date of the derivatives contract and the settlement date without an actual transfer of asset ownership is prohibited for the reason that it converts the transaction into the sale of a debt for a debt (bay’ al-dayn).²⁵ A mechanism has, however, been devised to navigate around this problem in the standardized documentation discussed below in paragraph 8.44.

8.11  To avoid riba al-nasi’a (unlawful enrichment by way of delay),²⁶ the purchase price and the subject matter of the salam transaction should not belong to the same genus whether or not there is an excess with regard to one or the other of the exchanged countervalues (‘iwad).²⁷ For example, the purchase price and the subject matter may not both be currencies (athman) or both be foodstuffs (at’ima).²⁸ Gold and silver are subject to the same prohibition. This prohibition is based on the well-known ‘six-commodities’ hadith, in which the Prophet was reported to have said:

[Exchange] gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt, like for like (mithlan bi-mithlan), equal for equal (sawa’ an bi saw’in), and hand to hand. If the commodities differ, then you may sell as you wish, provided that the exchange is hand to hand.²⁹

This hadith was interpreted to mean that in any sale transaction involving the commodities mentioned in the hadith the exchange may only be ‘hand to hand’, that is, on a spot basis. Eventually the four surviving Sunni schools of law extended the prohibition to other commodities. Rigorous application of this principle would, of course, limit the ability to trade gold or silver on a forward basis. This had led Islamic financial institutions to request fatawa from their respective Shari’a Supervisory Boards as to the permissibility of participating in the international gold market. Such responses have, however, been inconclusive.³⁰ Debate on (p. 207) this issue has also turned on the body of doctrine regulating monetary exchange (sarf).³¹ Some contemporary jurists have argued that it is permissible because gold has ceased to function as a medium of exchange (thamaniyya) and should therefore be treated as a mere commodity, although recent events in currency markets call this assumption into question. According to this view, the original prohibition arose because gold was customarily accepted as a medium of exchange but in this regard has since been superseded by various circulating currencies. Others reject the argument based on change of circumstance, insisting that the nature of gold is immutable. Limitations affecting currency trading, discussed in paragraph 8.41, are equally strict.

8.12  Since the subject matter of a salam contract is considered to be a debt, exchange for another debt, such as an existing loan obligation, would conflict with the general prohibition of the sale of a debt for a debt, a transaction known as bay’ al-dayn.³² Defined in opposition to ‘ayn, which is a tangible and unique property, dayn literally means ‘debt’. Under Islamic law dayn refers not to the obligation as such but rather to the property which is the subject matter of the obligation, usually a fungible or other goods of indeterminate category, and is considered to be the present property of the debtor, except the usage of dayn is a fiction in circumstances where such property at the time of contracting does not exist or has not been identified.³³ If both debts, being the relevant countervalues, are to be discharged in the future, the requirement of simultaneous exchange would be violated. Debts may, however, be assigned by both debtors and creditors pursuant to a hawalat al-dayn contract.³⁴

8.13  Although deferred delivery of the subject matter is an essential feature of a salam transaction, the price must be paid in full during the contractual session. In this regard salam differs crucially from a typical forward sale contract, for which no advance payment is required. If less than the full price is paid, the salam contract is (p. 208) invalid for the unpaid portion. There is disagreement among jurists as to whether partial payment renders the entire salam contract invalid. Maliki jurists are exceptional among the various schools of law by allowing the parties to agree that payment shall be up to two to three days after the time of entering into the contract, reasoning that such delay is negligible and is thus satisfies the requirement for advance payment of the purchase price.³⁵ They also accept that payment may be postponed for a longer period so long as the delay is not a condition of the contract.³⁶ For the parties merely to agree on price is ineffective.

8.14  Whether a floating price is permissible was addressed in a fatwa promulgated in 1984 at the Second Al-Baraka Symposium on Islamic Economy, a widely recognized international forum in the area of Islamic finance. Asked if the parties could refer to the market price on the date of delivery of the fungible minus 10 per cent, the fatwa committee, narrowing the parties’ scope for price determination, answered that it was in all cases impermissible to contract on the basis of the future market price.³⁷

8.15  With regard to a salam contract the seller assumes a personal obligation to deliver the subject matter to the buyer at some future date.³⁸ At the time of contracting the seller lacks title to the subject matter but undertakes to make it available to the buyer whether or not the seller will at any time become the owner. In fact, it is lawful even if the subject matter does not yet exist when the parties enter into the salam contract, such as crops yet to be planted.

8.16  Since the buyer is deprived of the right to repudiate the sale by exercising what is known as the ‘option after inspection’ (khiyar al-ru’ya), the subject matter must be sufficiently identifiable at the time of entering into the contract, so that dispute between the parties on delivery is avoided.³⁹ For the main Sunni schools of law, as well as for the Ibadis, articles that are measurable (kayli, makil) or weighable (p. 209) (mawzun, wazni) generally satisfy this requirement. Except for the Shafi’iyah, for whom heterogeneous articles accounted for by number are acceptable, the subject matter must always be fungible (mithli). That would exclude an object with idiosyncratic characteristics, such as a particular parcel of land, or the value of which could change according to subjective assessment, such as antiques or jewellery.⁴⁰ Nowadays Shari’a scholars accept as valid any article that can be procured according to standardized units, including grains, metals and other commodities, and products that are regularly and widely available, or thought to be so, such as carpets and packaged goods.⁴¹

8.17  It is permissible for the buyer to obtain a pledge or security with regard to a salam transaction.⁴² In the event of a default the pledgor is entitled to acquire the stipulated commodity in the market and retain the proceeds of the sale to the extent they do not exceed the purchase price. When exercising this right the pledgor must, to ensure fairness, collaborate with the buyer in its capacity as pledgee.

8.18  Delivery of the fungible in a salam transaction is by definition deferred, although exceptionally the Shafi’is permit immediate delivery.⁴³ The delivery date must be clearly stipulated. Thus it is forbidden for the delivery date to correspond to a seasonal event, such as the harvest time, or any other indefinite occurrence, such as, to give a modern example, when a company achieves profitability, because the resulting ambiguity would lead to both gharar and jahl.⁴⁴ The period of deferment should not be unduly short, otherwise the transaction could be deemed invalid for being nothing more than a legal stratagem (hila) to evade the strictures applying to riba.⁴⁵ If the subject matter is a usufruct, delivery is deemed to coincide with access.⁴⁶ In contrast to the rule regarding payment, it is permissible for the subject matter to be delivered in instalments. Delivery prior to the contractually agreed date is also permissible so long as it does not result in inconvenience or loss for the buyer. If delivery does not occur, the purchase price must be refunded. It is recommended that an extension be granted if delivery is delayed owing to insolvency of the seller.⁴⁷ A penalty may not be imposed for delayed delivery because (p. 210) such a payment is considered to be a debt and no penalties may apply to delayed settlement of a debt.⁴⁸

8.19  In all cases the buyer must accept delivery of the goods and, if refused, performance can be compelled, so long as they conform to the contractual specifications. A seller may, however, deliver goods of superior quality. A buyer may refuse delivery only if the seller demands a higher price or the quality of the goods as contractually specified, such as the grade of a mineral, is absolutely essential. Goods of inferior quality may be refused, even at a discounted price, unless there is agreement between the parties.

8.20  Place of delivery must be specified. This requirement is necessary to avoid a dispute between the buyer and the seller, which might force one party to incur unanticipated shipping or other expenses. The general rule is that if the parties do not agree on a place of delivery, it shall by default be where the salam contract was executed.⁴⁹ If delivery at such place is not possible, it should be determined according to customary practice.

8.21  Cancellation (iqala) of the entire salam contract is permissible by mutual consent so long as the purchase price is fully refunded. Partial cancellation, resulting in a proportional reduction of both the purchase price and the quantity of the subject matter, is also permitted.

8.22  Prior to delivery, according to the majority of madhahib, the buyer may not sell its right to the commodity that is the subject matter of the salam contract to a third party, although it may be sold back for the price originally paid.⁵⁰ Neither may the seller assign its delivery obligation to a third party. As protection against fluctuation in the value of the commodity the buyer or the seller, as the case may be, could enter into an independent, or ‘parallel’, salam contract with a third party. As a result, the position of the parties under the first salam contract would effectively be reversed. But since both salam contracts survive it does not involve complete rescission or reversal of the initial transaction. Although parallel, the two salam contracts may not be interdependent. Thus a breach under one salam contract must not trigger a cross default under the other.

(p. 211) 8.23  For the purpose of facilitating multiple salam transactions, it is permissible for parties to enter into a master agreement, documenting their intention to buy and sell according to a general framework that includes a description of the consideration, quantity of goods, security, and other conditions. On this basis the parties could at different times enter into separate salam contracts, each incorporating by reference the conditions set out in the master agreement.⁵¹

8.24  In the example illustrated by the diagram (see Figure 8.1) the actual goods, such as wheat, are, for the reasons discussed in paragraph 8.05, purchased at a discount from the supplier, such as a farmer, by the intermediating party with a view to selling them at a premium to a third party, such as a miller, should the spot price increase during the term of the first salam contract. The first salam contract creates a primary market in which the parties are the original traders. A secondary market is created by the second salam contract. It is possible for the intermediating party to enter into multiple salam contracts, each at a different price, so long as the ultimate volume does not exceed the amount of wheat to be delivered under the first contract. All salam contracts that constitute the secondary market can be entered into at any time after the execution date of the first one. Even so, the date of delivery would in all cases have to coincide.

• View full-sized figure

Figure 8.1  ‘Parallel’ salam

Both the discount and the premium can be calculated by reference to a benchmark rate, such as LIBOR,⁵² plus a margin. Against this background it has been proposed that an Islamic futures market could result from a clearing house acting (p. 212) as the intermediating party to facilitate a series of transactions.⁵³ A more ambitious proposal is that the intermediating party would be a mudaraba fund established to broker trades in one or more highly fungible commodities, such as crude oil or wheat.⁵⁴ Such a fund could, on the one hand, contract with a large producer for delivery within a specified period of a substantial quantity of the particular commodity while, on the other hand, it would enter into parallel salam contracts with multiple small consumers. By making a market in the commodity it would benefit financially from the spread between the ‘wholesale’ price paid and the ‘retail’ price at which it was sold. A further stage of development would be for the fund, in the manner of a clearing house, to announce ‘bid’ and ‘ask’ prices for the commodity as the basis for entering into retail salam contracts with either the buyer or the seller. Beyond that, the fund could guarantee the performance of both parties to a salam contract, who would as a consequence of the fund’s intermediation transact anonymously with each other. The fund would recoup its costs from administrative fees. The functional equivalent of collateral would be effected by means of a pledge (rahn) by the seller of its performance under the salam contract.⁵⁵ As the number of such funds proliferated a full-blown market could emerge. Two major limitations distinguishing a conventional commodity market from the market as envisaged in the proposal are that the buyer must pay the full price at the outset and settlement would unfold only as the actual goods are transferred through a chain of parallel salam contracts.

8.25  As a transaction structure with an ancient pedigree, ‘urbun, which can be translated as either down payment sale or earnest sale, involves a down payment of less than the full amount of the purchase price.⁵⁶ According to classical doctrine, (p. 213) the buyer is granted an option to acquire the subject matter of the sale. If the buyer decides to complete the sale, the down payment is considered to be a proportion of the purchase price. If, however, the buyer does not proceed, the down payment is forfeited without recourse against the seller, as the down payment is recharacterized as a gift. It is considered by jurists to be the sale of a service (bay’ al-ijara) and is regulated as such.⁵⁷ Although there is scant detail about the regulation of ‘urbun in the Islamic legal sources, it has been analogized to a sale with a stipulated option in favour of the buyer, so that it can be assumed, for example, that title passes to the buyer when the initial payment is made, the seller cannot dispose of the goods, and the buyer bears the risk of loss unless the goods are fungibles.⁵⁸

8.26  Whether ‘urbun is a valid form of sale contract under the Shari’a is a question that has long exercised the critical faculties of Shari’a scholars. It was addressed in a hadith by Malik ibn Anas (d. 795 CE/179 AH), the eponymous founder of the Maliki school of law, as follows:

Yahya related to me from Malik from a reliable source from ‘Amr ibn Shu’ayb [d. 735–36 CE/118 AH] from his father from his father’s father that the Messenger of Allah, may Allah bless him and grant him peace, forbade down payment sales (bay’ al-’urban).

Malik said, ‘That is, in our opinion, but Allah knows best, that for instance, a man buys a slave or slave-girl or rents an animal and then says to the person from whom he bought the slave or leased the animal, “I will give you a dinar or a dirham or whatever on the condition that if I actually take the goods or ride what I have rented from you, then what I have given you already goes towards payment of the goods or hire of the animal. If I do not purchase the goods or hire the animal, then what I have given you is yours without liability on your part.” ’⁵⁹

8.27  A majority of the Sunni schools of law held ‘urbun to be a prohibited transaction. According to these jurists, ‘urbun is invalid because it involves gharar and riba. In the same vein it has been viewed as coming within the meaning of the term maysir, a game of chance prohibited in the Qu’ran that within the Islamic tradition became representative of gambling in general.⁶⁰ Retention of the down (p. 214) payment in the event the sale is not completed is for them tantamount to misappropriation of the property of others. To support their view on the basis of the Sunna these jurists relied on the Prophetic hadith quoted in paragraph 8.26 that flatly prohibits bay’ ‘urbun, although its authority was for some diminished by the fact of having a weak (da’if) chain of transmission (isnad). Another objection is that it combines a commutative contract (‘uqud mu’awada) with a donative contract (‘uqud tabarru’at) within a single transaction.⁶¹

8.28  Only the Hanbali school of law, of which Ibn Qudama was an adherent, is of the view that ‘urbun is permissible. Among the proponents of this view was Ahmad ibn Hanbal (d. 855CE/241 AH), the eponymous founder of the Hanbali school of law, who relied on a hadith which, despite having a weak isnad, contains a report that the early caliph and Companion of the Prophet ‘Umar ibn al-Khattab (d. 644 CE/23 AH) agreed that, if he did not complete the purchase of a house that was to be converted into a prison, he would forfeit the down payment to the seller.⁶² Both classical and later jurists argued not only that transactions of this type were commonplace but also that the down payment was justifiable compensation for the delay experienced by the seller in disposing of the subject matter in the event the sale is not completed. An important modern development occurred in 1993 when the Fiqh Academy of the Organization of Islamic Conference (OIC Fiqh Academy) ruled ‘urbun to be a permissible transaction, albeit only if a time limit is specified.⁶³ ‘Urbun has also been recognized as a valid sale contract in the civil codes of Egypt, Jordan, Kuwait, and Syria.⁶⁴ However, in 2004, when the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) confirmed the legality of ‘urbun, it maintained that the buyer is not entitled to trade the right to revoke the contract.⁶⁵

8.29  Despite a lack of consensus among jurists regarding the validity of ‘urbun, it has often served as a basis, either by itself or combined with other traditional Islamic transaction structures, for reasoning by analogy to propose Shari’a-compliant financial instruments that exhibit the properties of conventional derivatives, especially call and put options, which are discussed in paragraphs 8.34–8.38. Thus one international bank has, with an approving fatwa, introduced a product that combines ‘urbun with a murabaha contract to replicate the payout of a (p. 215) zero-plus-call structure (see Figure 8.2).⁶⁶ In such a transaction ‘urbun is a proxy for a call option, with the investor, after making a non-refundable down payment, being entitled, although not obligated, to buy assets at an agreed price at any time until contract maturity. The value of the assets, which are carried by the bank, is variable, so that the difference between the agreed price and their value at maturity is the measure of the investor’s return.

• View full-sized figure

Figure 8.2  Bay’ ‘rbun

8.30  Under Islamic law the different types of khiyarat (options), unlike istisna’ and salam, are not classified as nominate contracts,⁶⁷ ’ but, instead, are viewed as contractual stipulations that can be incorporated into and thereby modify an underlying contract.⁶⁸ Of these, the one most relevant to conventional derivatives is khiyar al-shart or, as it is sometimes known, khiyar al-tarawwi, whereby an absolute option to ratify (imda’) or rescind (faskh) a contract may (p. 216) be conferred on one party, both parties, or even a third party.⁶⁹ Unlike khiyar al-’ayb (option of defect) and khiyar al-ru’ya, it arises only by contract rather than by operation of law. Its economic rationale is that it protects the parties against price movement with regard to the underlying assets as well as unrelated events.

8.31  All the main Sunni schools of law recognize the permissibility of khiyar al-shart on the basis of consensus (ijma’) despite concern that khiyarat in general interfere with the integrity of contractual obligations since their purpose, however legitimate the motive, is to modify terms that are otherwise valid, binding, and enforceable.⁷⁰ There has, however, been disagreement among jurists as to whether it is permissible as a matter of principle or, like salam, merely to be tolerated as an exceptional type of contract.⁷¹ Even so, the Hanbalis declare it to be invalid in exchanges involving ribawi goods, that is, property subject to the rules of riba, which are those sold according to measure and weight, such as currencies and foodstuffs.⁷²

8.32  According to classical jurists, the option period begins as soon as the agreement is formally concluded but the right must be exercised within three days.⁷³ Eventually the prevailing view became that an option can be of unlimited duration so long as it is known and defined at the time of contracting.⁷⁴ For the Hanbalis, as opposed to the Hanafis, because title transfers at the time of entering into the contract, both parties are restricted from either altering the condition or disposing of the respective countervalues, thereby preventing its sale to a third party during the option period. Should the restriction be breached the defaulting party is deemed to have rescinded the contract. Use of the stipulated option is prohibited with regard to forward sales, such as salam and by analogy ‘urbun, that involve abstractly defined (dayn) rather than physical, goods, except by the Malikis, for whom it is permissible so long as the period is brief.

8.33  By itself khiyar al-shart is arguably an inadequate basis for the creation of Shari’a-compliant derivatives.⁷⁵ Three considerations have shaped debate on this. To (p. 217) begin with, there is controversy as to whether the party granting the option may be compensated as it would be in the case of a conventional option contract.⁷⁶ Doubt also exists as to whether an option can be detached from the underlying contract and bought or sold as a separate financial instrument. In classical jurisprudence khiyarat were considered in each case to be embedded within the underlying contract, although there is persuasive authority for the view that stipulations are additional and extraneous.⁷⁷ Whether a valid sale contract is formed if one of the countervalues consists of the granting of a right (haqq), as opposed to a tangible asset (mal), can, however, be resolved by assimilating options to the concept of usufruct (manfa’a), as the latter was over time included by jurists within the definition of mal.⁷⁸

8.34  Because of obstacles associated with khiyarat, it has been argued that ‘urbun is the most congenial basis for creating a Shari’a-compliant proxy for a conventional call option.⁷⁹ The down payment functions much like a premium and the purchaser has the right to exit from the transaction without further payment, both of which are essential properties of a conventional call option. A further advantage is that the buyer’s right to ‘call’ the underlying assets according to the quantity, price, and timescale as contractually specified eliminates the defect of gharar. But it can function only as a rigidly constrained version of a conventional call option. Conventional option pricing techniques⁸⁰ are inapplicable, because the seller is legally proscribed from trading on the underlying assets.⁸¹ That settlement must involve the exchange of tangible assets, not cash, means the seller has no alternative but to accumulate inventory to cover its exposure, which is hugely, if not fatally, impractical.

8.35  Proponents of the khiyarat model have, as discussed in paragraph 8.30, attempted by reason, rather than by adducing established juridical precedent, to overcome these obstacles. That is why they must assume that khiyarat are separable from the (p. 218) underlying sale contract and that the right granted is in the nature of a usufruct (manfa’a). Sometimes, by invoking the doctrine of daman,⁸² they rationalize payment of a premium as compensation for the disadvantaged party, in this case the seller, who bears the risk that the transaction will unwind. This view has, however, been criticized for being inappropriate, because daman, like tort liability, arises only for an illicit (ta’addi) or negligent act.⁸³

8.36  Undeterred by persistent doubt about their validity, Islamic financial institutions have, in practice, been marketing call options in the guise of ‘urbun transactions.⁸⁴ In such cases investment banks acting as advisers or partners manage the portfolio and structure the financial products. Investors can thereby refrain from directly engaging in options trading.

8.37  Put options can be implemented in a roundabout way by utilization of at least two transaction structures compliant with Shari’a principles. The first of these, which has been approved, although not without dissent, by Shari’a scholars and embodied in the civil code of several Arab polities, is effectively structured as a reverse ‘urbun. In such a transaction, the parties agree that if the seller breaches any of its contractual obligations, the buyer shall be compensated by an amount greater than the original down payment.⁸⁵ The second of these (see Figure 8.3), sanctioned by common practice, involves an Islamic bank providing a third-party guarantee, stipulated as a condition of sale, for instalment payments owed for an asset being purchased pursuant to a murabaha transaction.⁸⁶ The buyer compensates the bank by payment of an administrative fee that cannot, however, be calculated as a percentage of the contract value. The bank’s primary remedy should a default occur would be to seize and sell the asset. From the buyer’s perspective the third-party guarantee is conceptually a put option granted by the bank as consideration for the premium. At any time during the performance of the contract the buyer could, in theory, cease paying future instalments to the seller and forfeit the asset to the bank, in which case the strike price is equal to the (p. 219) value of the future instalments, unless the buyer is contractually bound to make the bank whole for any loss suffered.

• View full-sized figure

Figure 8.3  Put options

8.38  As a functional equivalent to a conventional put option the third-party guarantee is not without its shortcomings.⁸⁷ For it to simulate the premium paid for a conventional put option the administrative fee would also have to vary in response to the price movement of the underlying asset. Yet such variation would be unacceptable under Islamic law, according to which no fee, however characterized, should be levied for provision of a guarantee. Obtaining a guarantee to speculate on the price movement of an asset is equally problematic even if the role of conventional put options as an instrument of risk management is generally protective.

8.39  According to classical Islamic legal doctrine, in contrast to the common law, a mere promise (wa’d),⁸⁸ whether bilateral or unilateral, is legally unenforceable.⁸⁹ In this sense it is the complete opposite of a contract (‘aqd), a legally binding obligation that is generally understood to arise from the formal acts of offer (ijab) and acceptance (qabul).⁹⁰ A mere promise is substantively similar to an oath (yamin), (p. 220) which is in the nature of a moral commitment.⁹¹ An oath is a mutual undertaking witnessed by God.⁹² Failure to fulfil such an undertaking is an affront to God and may provoke moral censure but is without legal redress.⁹³ An oath can, however, be forsaken if hardship would ensue and a ritual act of atonement is performed. That a mere promise cannot be enforced under Islamic law is a situation greatly at odds with the requirements of conventional derivatives. See Figure 8.4 for an example of a bilateral promise.

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Figure 8.4  Wa’d granted by each Party A and Party B

8.40  As a way to expand the market for Shari’a-compliant derivatives and other financial products, Shari’a scholars have been re-evaluating the enforceability of promises. There is by now widespread acceptance of the binding nature of a unilateral promise, as reflected in various standards and resolutions that have been officially adopted by the AAIOFI and the OIC Fiqh Academy.⁹⁴ In its decision with regard to a murabaha to the purchase order the latter opined that:

According to Shari’a, a promise (made unilaterally by the purchase orderer or the seller), is morally binding on the promisor, unless there is a valid excuse. It is however legally binding if made conditional upon the fulfillment of an obligation, and the promisee has already incurred expenses on the basis of such a promise. The binding nature of the promise means that it should be either fulfilled or a compensation be paid for damages caused due to the unjustifiable non-fulfilling of the promise.⁹⁵

(p. 221) In 2013 this position was at once buttressed and extended by publication of a Shari’ah Standard devoted entirely to the consideration of bilateral and unilateral promises.⁹⁶ In addition to affirming that a unilateral promise is binding on the promisor, if not on the promisee, it upheld the enforceability of bilateral promises where it is necessary to comply either with general commercial custom or legal requirements, provided the aim of the parties is not solely to provide financing. Examples of such transactions are international trade conducted by means of documentary credits and supply agreements. Even so, the contract will not become effective automatically in the future. Because not technically a future contract, formal offer and acceptance are still required at the relevant time. If one party fails to perform at the relevant time, it is permissible for the other party to seek injunctive relief from a court. If, however, specific performance is not an available remedy, the defaulting party will be liable to indemnify the other party for its actual losses but not for opportunity costs. The documentary framework underpinning the standardized documentation being developed by the International Islamic Financial Market (IIFM), which is discussed in Section VII of this chapter, is also validated in this standard.⁹⁷ To justify these rules the AAOIFI reproduces a brief excerpt from a resolution of the OIC Fiqh Academy on the same topic.⁹⁸

8.41  Currency trading is an activity where attention has been especially focused. The Shari’a Supervisory Boards of several Islamic financial institutions have approved a transaction whereby the parties mutually promise to buy different currencies from each other at the exchange rate prevailing on such date with simultaneous delivery to occur sometime in the future.⁹⁹ Permission has been forthcoming only because this arrangement is not legally binding and so does not by itself really advance the proposition that performance should as a matter of law be compelled on the basis of a bilateral promise. This position was encapsulated by the AAOIFI:

A bilateral promise to purchase and sell currencies is forbidden if the promise is binding, even for the purpose of hedging against currency devaluation risk. However, a promise from one party is permissible if the promise is binding.¹⁰⁰

The specific prohibition continues in effect despite an acknowledgement that, in practice, Islamic financial institutions treat a bilateral promise as binding even if formally it is not.¹⁰¹

(p. 222) 8.42  In support of a new financial product corresponding to a total return swap the Shari’a Supervisory Board of an Islamic finance boutique affiliated with an international bank gave further impetus to the debate over enforceability by arguing for a fundamental equivalence between the nature of promissory obligations in both the common law and the Shari’a, by offering moral rather than utilitarian justifications.¹⁰² This and other innovative transactional structures that have recently been proposed all depend on a liberal approach to established doctrine, one grounded more in policy than in precedent. For this reason they have not been immune from criticism by Shari’a scholars.¹⁰³

8.43  In Malaysia, where the Shafi’i school of law predominates, a w’ad has been deemed enforceable by the Shariah Advisory Council of Bank Negara Malaysia (SAC) by virtue of an amendment to the Central Bank of Malaysia Act 1958.¹⁰⁴ And a w’ad may very well be enforced by an English court as a unilateral promise. In fact, w’ad is a primary component of the new standardized documentation for Islamically acceptable derivatives transactions, for which either English or New York law is intended to be the governing law. Under English law, to be enforceable, a w’ad would have to be executed in the form of a deed.

8.44  On 1 March 2010 the IIFM¹⁰⁵ and the International Swaps and Derivatives Association, Inc. (ISDA)¹⁰⁶ launched standardized documentation known as the (p. 223) ISDA/IIFM Tahawwut (Hedging) Master Agreement.¹⁰⁷ Since then, often in collaboration with ISDA, the IIFM’s project to generate more standardized documentation has steadily gained momentum, as evidenced by the publication of additional Shari’a-compliant templates for cross-currency swaps, a collateralized murabaha agreement, foreign exchange forwards, and both fixed and floating rate profit rate swaps.¹⁰⁸ All of these enlarge on the documentary framework created by the ISDA/IIFM Tahawwut (Hedging) Master Agreement. Later in this chapter we consider the templates for cross-currency swaps (Himaayah Min Taqallub Asʿaar Assarf), foreign exchange forwards (Wiqayah Min Taqallub Asʿaar Assarf) and profit rate swaps (Mubadalatul Arbaah).¹⁰⁹

8.45  The ISDA/IIFM Tahawwut (Hedging) Master Agreement is similar in both content and form to the ISDA Master Agreement that for decades has provided the documentary framework for conventional derivatives transactions applicable across jurisdictions. Key differences between the ISDA/IIFM Tahawwut (Hedging) Master Agreement¹¹⁰ and the ISDA 2002 Master Agreement, which are discussed below, are necessary to ensure Shari’a compliance. It was preceded in 2006 by standardized documentation, known as the Islamic Derivatives Master Agreement, executed by the Bank Islam Malaysia Berhad and Bank Muamalat Malaysia Berhad, Malaysia always being at the cutting edge of the global Islamic finance industry. There is the desire in both cases to increase liquidity by eliminating the inconsistencies, inefficiencies, and uncertainties that inhibit trading when parties negotiate bespoke agreements.

8.46  After executing the ISDA/IIFM Tahawwut (Hedging) Master Agreement the parties must separately either enter into the actual transactions, each defined as a Transaction and documented by a Confirmation, or submit an undertaking (wa’d) with regard to future transactions, each defined as a Designated Future Transaction (DFT) and documented in a DFT Terms Agreement.¹¹¹ A DFT will crystallize as a Transaction only when actually completed. Confirmation for a (p. 224) Transaction is evidenced by ancillary documentation but will at the same time be subject to the terms of the ISDA/IIFM Tahawwut (Hedging) Master Agreement.

8.47  As currently drafted, Part 5 of the Schedule to the ISDA/IIFM Tahawwut (Hedging) Master Agreement presupposes that the parties will enter into murabaha transactions involving the purchase or sale of (i) commodities, (ii) moveable or immoveable property, or (iii) Shari’a-compliant securities. The parties may amend the agreement to accommodate other types of Shari’a-compliant transactions.

8.48  In the Explanatory Memorandum it is made clear that for the task of ensuring Shari’a compliance, a term defined in section 3(h), the IIFM Shari’a Advisory Panel considered the ISDA/IIFM Tahawwut (Hedging) Master Agreement but none of the ancillary documentation, for which the parties must obtain independent advice. General guidance is, however, provided, such as that (i) transactions should be entered into only to hedge actual risks rather than to speculate, (ii) the asset must be halal, and (iii) no interest, whether or not denoted as such, is chargeable, including on defaulted or deferred deliveries and payments.

8.49  In section 3(h) the parties represent to each other that they shall enter only into Shari’a-compliant transactions and that they have conducted their own investigation in this regard, which may involve seeking an opinion from their respective Shari’a advisor, Board, or panel. This provision is reinforced in section 3(i), in which they expressly disclaim reliance on any other party regarding such compliance.

8.50  Although included as a miscellaneous provision, as section 9(h), the agreement by the parties that no interest shall be paid or received is among the most important. The parties agree to waive any rights they may have to receive interest, including as an arbitral or judicial award or by operation of law. Any interest that is actually received must be donated to a charitable organization. Such a provision is commonplace in agreements that aim to be Shari’a compliant.

8.51  Two types of undertaking (wa’d) are contemplated under the ISDA/IIFM Tahawwut (Hedging) Master Agreement (TMA). The first of these, as discussed in paragraph 8.46, is to enter into a DFT. The second of these, which arises when there has been an early termination, is to enter into a musawama pursuant to section 2(e). The obligation to enter into a musawama is actuated by the exercise by one party of the other party’s undertaking (wa’d) or vice versa. Since the exercise of such right by one party is distinct from the identical right conferred on the other party the underlying asset will in each case be different. Musawama is not a defined term in the agreement. Nor is much illumination provided in the Explanatory Memorandum. In Arabic its root meaning is to offer a commodity for sale and as a common noun it is generally translated as ‘bargaining’. But in Islamic finance it has a more specialized meaning as a commodity trading arrangement similar to a murabaha transaction, except that at (p. 225) the time of contracting the seller is not required to disclose its cost with regard to the underlying asset.¹¹² This may be because it is difficult, if not impossible, to ascertain the cost, as when the subject matter consists of a pool of products. But even if the seller knows the cost it is under no obligation to disclose it. As with a murabaha transaction, the seller adds a mark-up that represents its profit margin and generally operates as a surrogate for interest. The customer is at liberty to accept, refuse, or negotiate the price. If accepted, the customer pays the entire price to the seller in instalments. A musawama is consistent with the standard conditions for a valid sale contract under Islamic law: the underlying assets must be in existence and in the seller’s possession at the time of contracting, there must be a simultaneous exchange of countervalues, and the subject matter must be usable and of value.

8.52  To be Shari’a-compliant, the Close-out Amount, defined in section 6(d)(i), is calculated, on the one hand, with regard to all Transactions under which all deliveries have been made (any Fully Delivered Terminated Transaction)¹¹³ and, on the other, with regard to all Transactions under which all deliveries have not yet been made (any Non-Fully Delivered Terminated Transaction and Terminated DFT Terms Agreement)¹¹⁴ as of the Early Termination Date rather than as a single net calculation. The Early Termination Amount due with regard to Transactions under which all deliveries have been made may be set off against amounts due with regard to Transactions under which all deliveries have not yet been made. If early termination occurs, payments due for all Transactions under which all deliveries have been made are accelerated and must be paid immediately and in full without a discount to adjust for the time value of money and, of course, without interest. With regard to Transactions under which all deliveries have not yet been made a Relevant Index Amount for each such Transaction, which may be positive or negative depending on whether they are in or out of the money, will be determined with reference to the Market Quotation for replacement trades.¹¹⁵ If, however, such value cannot be determined or would produce a commercially unreasonable result for an individual Transaction, it will be with reference to the loss incurred but which, for the sake of Shari’a compliance, excludes cost of funding, loss of bargain, or losses resulting from liquidating, obtaining, re-establishing, or terminating any hedge or related trading position. (p. 226) Because payment without delivery of the underlying assets would not comply with the Shari’a the undertaking by each party to enter into a musawama means that the party to whom the value of the Relevant Index is owed may require the other party to purchase such assets.¹¹⁶ Failure to purchase the underlying assets means the selling party will be liable for liquidated damages. Payment of the Set-Off Amount is likewise bifurcated, with such amount to be allocated between the Early Termination Amount and the purchase price payable under the musawama.

8.53  Certain other provisions of the ISDA/IIFM Tahawwut (Hedging) Master Agreement have been included to ensure Shari’a compliance. In section 5(a)(vi) the definition of Cross Default has been broadened to encompass transactions having the commercial effect of a borrowing, as many traditional Islamic transaction structures dispense with the terms and conditions of a conventional financing. In section 6(b)(ii), following a Termination Event, a party is now required to ‘redesignate’ rather than ‘transfer’ its right and obligations to another branch or office of such party. Behind this provision is a concern that novation of trades will involve the prohibited transaction known as bay’ al-dayn.¹¹⁷

8.54  According to section 13 any disputes shall be settled, by prior election of the parties, by either an arbitral or a court proceeding under English or New York law. Principles of the Shari’a are expressly excluded from all references to ‘law’ or ‘laws’ in section 1(d). Choice of governing law can be decisive, for in several jurisdictions where Islamic finance is most active, such as Saudi Arabia, close-out netting may not be legally enforceable, in which case the gross credit exposure of the non-defaulting party could be perilously magnified.¹¹⁸

8.55  It is as yet uncertain to what extent the ISDA/IIFM Tahawwut (Hedging) Master Agreement will be embraced by the global Islamic finance industry. Most financial institutions have already devoted considerable resources to developing their own documentation.¹¹⁹ In due course, IIFM and ISDA jointly prepared a series of template confirmations, including product specific confirmations for cross-currency swaps and profit rate swaps. Credit support documentation to enable parties to the ISDA/IIFM Tahawwut (Hedging) Master Agreement to enter into (p. 227) Transactions and DFT Terms Agreements on a collateralized basis has also been introduced.

8.56  The literal meaning of Himaayah Min Taqallub Asʿaar Assarf is protection from (or hedge against) fluctuating exchange rates. Sarf, already referred to in paragraph 8.11, is one of several nominate contracts recognized in classical Islamic law and originally applied only to exchanges involving gold and silver. Rules that apply specifically to this transaction evince a predictable concern about the potential for riba, including a strict requirement consistent with the ‘six-commodities’ hadith for equality of exchange regardless of the physical state in which the gold or silver is to be traded. Contemporary jurists have, in their turn, sought to reconcile classical doctrine with the usages of modern currency exchange. According to guidance provided by the IIFM, a unilateral undertaking to buy or sell currencies on one date (the dealing date) with delivery to occur on a later date (the value date) does not contravene the prohibition of riba because a binding legal obligation does not arise until the actual date of delivery.¹²⁰

8.57  Since it operates within the documentary framework of the ISDA/IIFM Tahawwut (Hedging) Master Agreement, the cross-currency swap, just like the foreign exchange forwards and profit rates swaps, contemplates that both parties will, as discussed in paragraph 8.46 and illustrated by the diagram (see Figure 8.5), enter into one or more Transactions or DFTs, premised on a unilateral undertaking (wa’d) to be actuated by the effective counterparty.¹²¹ Similarly, each DFT must be evidenced by a Confirmation. Failure to comply with this requirement will result in an Event of Default, as such term is defined in the ISDA/IIFM Tahawwut (Hedging) Master Agreement. To transpose a conventional cross-currency swap into a Shari’a-compliant structure it is necessary for both parties at the same time to confirm identical DFT Terms representing both legs of the transaction, so that assets, invariably a metal such as copper or zinc, and cash denominated in different currencies will ultimately (p. 228) flow in both directions. A conventional cross-currency swap would, by contrast, be documented with a single confirmation and treated as a single transaction. With regard to a Shari’a-compliant cross-currency swap, as illustrated by the diagram (see Figure 8.5), one party, in the capacity of buyer, therefore agrees to purchase from the other party, in the capacity of seller, a stipulated quantity of Shari’a-compliant assets on the relevant exercise date in accordance with a murabaha contract, the terms of which are set forth in Part 3 and Annex 2 of the DFT Terms Agreement. The parties’ respective commitments will be funded by means of multiple murabaha contracts with matching maturities, to be performed on different payment dates, in addition to those at the outset and termination of the transaction. By this mechanism, the relative position of the parties can be periodically adjusted, as illustrated by the timeline (see Figure 8.6).

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Figure 8.5  ISDA/IIFM tahawwut (hedging) transaction structure

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Figure 8.6  Example of Timeline of entry into Murabaha Sale at the start of each Calculation Period

■ This diagram illustrates an example of entry into Murabaha Sale at the start of each Calculation period:

■ Purchase Date at start of Calculation Period

■ Payment Date at end of Calculation Period

8.58  A fixed and floating rate or a fixed combined with a floating rate cross-currency swap can be consummated with the standardized documentation. To calculate the rate of return on a specified currency, which constitutes the profit element of the payment amount, the fixed rate will be known in advance while the floating rate will be determined with reference to a benchmark. Under the standardized documentation the parties may blend fixed and floating rate profit types. Either party can serve as the calculation agent, whose duties are spelled out in the DFT Terms Agreement, or this role can be delegated to a third party, presumably an Islamic financial institution or the Islamic window of a conventional bank.

8.59  Himaayah and wiqayah, however transliterated, are synonymous inasmuch as they both mean protection. The templates for the Himaayah Min Taqallub Asʿaar Assarf, introduced in 2015, and the Wiqayah Min Taqallub Asʿaar Assarf, introduced approximately six months later in 2016, are built on the same conceptual foundations, not least because the point of departure in each case is the ISDA/IIFM Tahawwut (Hedging) Master Agreement, whose terms are incorporated by reference. Much of the ancillary documentation is similar, if not always identical. Although both templates depend on the legal efficacy of a wa’d, parties to the Wiqayah Min Taqallub Asʿaar Assarf may employ either a single or double wa’d structure (see Figures 8.7 and 8.8),¹²² although only one of the unilateral (p. 230) undertakings will ever be exercisable, because individually they will be subject to opposing conditions. Which party will be obligated to perform its unilateral undertaking will depend on whether the spot rate is less than or equal to the forward rate on the exercise date or vice versa. They also differ with regard to the terminology specific to cross-currency swaps or foreign exchange forwards, as the case may be.(p. 231)

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Figure 8.7  Double binding wa’d structure documentation architecture

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Figure 8.8  Single binding wa’d structure documentation architecture

8.60  Standardized documentation for the Mubadalatul Arbaah¹²³ appeared several years in advance of the others, which are merely variations of this template, although all of them were under consideration as far back as a meeting of the IIFM’s Shari’a advisory panel in 2010. It was in this context that the single and double wa’d structures were originally conceived. It likewise contemplates either a fixed or floating rate swap or a combination of these as well as a series of murabaha contracts. Because (p. 232) of the well-known aversion under Islamic law to combining contracts, the fixed and floating rate legs of the transaction are separately documented by reciprocal DFT Terms confirmations. Only one of the undertakings will be exercised—by the party whose profit is positive—with respect to a single-sale structure, resulting in only one asset flow and one cash flow between the parties, while both will be exercised with respect to a structure involving two sales, resulting in assets and cash flowing to both parties. By way of example, to accommodate a party that desires to hedge its exposure to a variable rate sukuk linked to one-month LIBOR, the template, as executed, would provide for twelve one-month Calculation Periods, as such term is formally defined. Because sukuk technically represent an equity investment, the amount being swapped is treated as profit.

8.61  Although providing a legal basis under Islamic law, there is actually little correlation between salam, ‘urbun or, for that matter, istisna’ and the specific features of conventional derivatives, specifically futures, options, and swaps. It is therefore not surprising that as recently as 1992 the OIC Fiqh Academy declared: Option contracts (‘aqd al-khiyarat) currently applied in the world financial markets are a new type of contracts [sic] (‘aqud mustahdatha) which do not come under any of the Shari’a nominate contracts. Since the subject of the contract is neither a sum of money nor a utility nor a financial right which may be waived, then the contract is not permissible in Shari’a. As these contracts are primarily prohibited, their handling is also prohibited.¹²⁴

8.62  Resistance to the use of such products has not stymied the efforts of financial institutions to create Shari’a-compliant products that generate returns that are comparable to those of conventional derivatives and provide similar protection. Innovative products are regularly announced by both Islamic and Western financial institutions. Sometimes these are based on heavily reasoned or even tenuous legal justifications, which have provoked intense debate.¹²⁵ Within the global Islamic finance industry replication of conventional derivatives may ultimately be limited by concerns about gharar, jahl, and riba, especially when the emphasis shifts from hedging to speculation. Yet the gap between traditional Islamic transaction structures and conventional derivatives is inexorably filled in by incremental changes in both commercial practice and legal doctrine.¹²⁶ The imperatives of (p. 233) commercial practice may cause market participants to bend or even depart from the strict requirements of legal doctrine. But legal doctrine will likely continue to evolve, for, according to Islamic legal theory, the Shari’a is infinitely resilient.¹²⁷ Diversity of opinion among contemporary jurists, reflected in fatawa issued by Shari’a Supervisory Boards, legal commentary, and other juridical sources, is evidence of how jurists are responding to these imperatives while striving to achieve a balance between imagination and rigour.(p. 234)