Islamic and Finance Derivatives Distinction Report

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Introduction

Financial derivatives are essentially documents or agreements that govern two or more parties in a financial agreement. Financial derivatives normally have an underlying value determinant which may depend on many factors such as currency, stocks, price of gold, silver, and even factors such as the weather condition (Paxford, 2010). In other words, this is a financial agreement that is determined by the prevalent future values of a given asset which may be shares or currencies; whichever the agreement may be.

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Many kinds of derivatives are currently in existence but notable among them are swaps, futures, and options (Paxford, 2010). The scope of derivatives is virtually endless because they can be placed in any form of financial security. The real definition behind a derivative is therefore a financial agreement that is based on a contingent future outcome of an underlying factor (Paxford, 2010).

In this regard, there exists a common difference between Islamic derivatives and contemporary financial derivatives. In the analysis of Islamic derivates, it is essential that one effectively conceptualizes the true essence of these derivatives. In other words, the analysis has to be made concerning its meaning and scope. Contemporary financial derivatives should be analyzed in the same way if their true differences are to be effectively pointed out.

As the world slowly becomes a global village, cross-border investments are quickly becoming a financial norm and investors are interacting with Islamic financial institutions at many levels. Such investors need to be versant with both Islamic and contemporary financial derivates such that they can make informed decisions when dealing with institutions that deal in both (Kolb, 2003). Conflict always arises between the drafting of contemporary financial derivatives and Islamic derivatives especially when drawing up contracts because Islamic derivatives are under the sharia law while contemporary financial derivatives are governed by the English common law (Kolb, 2003). This study will therefore analyze the existing differences between the two derivatives concerning their scopes and meanings.

Literature Review

Many scholars equate the forward derivative in contemporary finance as equal to the Bai Salam in Islamic derivatives (Paxford, 2010). However, the concept of Bai Salam is fundamentally different from forwarding derivatives because, under Bai salam, the seller is under obligation to deliver a good to a buyer while the buyer pays the sum upon entering the contract.

Bai Salam is distinct from forwarding derivatives because it has the condition of payment upon entry into a contract. This entails payment in full. Partial payment under Bai Salam is prohibited because it involves the incorporation of terms of credit which is not a feature in Islamic derivatives. However, the forward contract has provisions for credit payment. Under Bai Salam, Gharar is eliminated because payment is made in full on the side of the buyer as it ensures full ownership of the good upon completion of the payment.

Under Bai Salam, the specifics or quality and quantity of a good are specifically defined in a contract (the same way as in a forward contract) though, under the Bai salam, these specifics can be changed without affecting the contract. The forward contract is more rigid on these terms because a change in specifics would affect the terms of the contract. Another distinct difference between Bai Salam and forward derivatives is that under Bai Salam, there is a fixed time and place of delivery as a provision of the derivative while in contemporary financial derivatives, this provision is absent. This provision is majorly enforced in agricultural products under Islamic derivatives and it is majorly enforced to ensure the contract is undertaken in a permissible manner.

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It should be noted that Islamic derivatives are distinct from contemporary financial derivatives because Islamic derivatives are intertwined with faith. Recent developments observe an increasing capitalization on debts through interests. However, Islamic derivatives prohibit this motive and act for the common good of all the parties. In other words, under Islamic derivatives, the provision of interests (riba) is prohibited because it seeks to empower one party at the expense of the other.

This is an intertwinement of faith because under the Islamic faith, brotherhood is highly advocated for and the empowerment of everyone in the society is also highly emphasized. Interest charging is therefore excluded from Islamic derivatives. Islamic derivatives keep in mind the fact that one party can easily make a windfall at the expense of another. The gain in derivatives is purely a matter of chance and is influenced by Masir and Qiram. A good example of derivatives is the option contract, especially enforced in contemporary financial derivatives.

These types of contracts are based on future profitability; for example through the appreciation of a currency concerning asset purchase. Under Islamic derivatives, options contracts are prohibited and are considered haram (Iqbal, 2010). The reasoning behind this prohibition is that option contracts are undertaken based on possibility and chance while no meaningful commodity is transferred between the two parties. Buyers, therefore, base their decisions on future possibilities and may even end up not affecting the transaction; especially when the odds are against him/her.

Moreover, options contracts are observed to bear the elements of Masir because it is based on chance and luck. At the same time, contemporary financial derivatives are heavily reliant on chance and luck because it considers it an easy way of making a profit without labor or arduous effort. Such tendencies are not permissible in Islamic derivatives. According to the principle of Zokat, any profits made should be for the interest of the whole community, though contemporary financial derivatives are exclusive to the benefit of the party and do not go further to explain how the profits should be used. In addition, contemporary financial derivatives are developed to make a profit because there is the possibility of doing so. Under Islamic derivatives, this could be equated to hoarding. In other words, it is against the principle of haram.

Under Islamic derivatives, this money should be used for community developments like building a factory, school, hospital, or such like community development structures (Kolb, 2003). However, the liberty of contemporary financial derivatives in this regard is considered selfish and sinful. There have however been arguments that the profits made under contemporary financial derivatives can be used to benefit the community but Islamic derivatives still cannot agree with this opinion because the profits can be easily transferred to a third party which would essentially translate to gharar.

Rationale

From the studies done on Islamic derivatives and contemporary financial derivatives, it is important to note that Islamic derivatives are highly based on the Islamic faith. Aspects that contract Islamic teachings are contrary to Islamic derivatives. Contemporary financial derivatives are however based on financial motives and the ability to make a profit. Financial motives are its basic justification and this creates a significant difference in its composition as opposed to Islamic derivatives (Al-Bashir, 2008). The huge emphasis on the good of the community in Islamic derivatives is not emphasized in contemporary financial derivatives and becomes the distinguishing basis in both derivatives.

Research Questions

Aim

Is there a significant difference between contemporary financial derivatives and Islamic derivatives?

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Objectives

  • To establish the difference between Islamic derivatives and contemporary financial derivatives to option contracts
  • To investigate the differences between Islamic derivatives and contemporary financial derivatives concerning interest and debts
  • To establish the difference between Islamic derivatives and contemporary financial derivatives with the concept of Urburn

Methodology

This study will be qualitative because it will seek to establish the underlying differences between the two derivatives. The scope and meaning of their differences will be the main focal point of this analysis.

Population and Sampling

The research will involve the study of different cases involving contemporary financial derivatives and Islamic derivatives. Different facts will be studied by referring to the legal implications. Cases that involved Islamic derivatives only will be studied first, followed by cases that involved contemporary financial derivatives. This will help in giving more information and insight into the study. The derivative cases chosen will help in identifying the success of the general outcomes as viewed by both sides. The difficulties in the enforcement of both derivatives will also be identified.

Data Collection Tools

The study will use questionnaires that will be issued to different parties from different companies which have had Islamic derivative cases and contemporary financial derivative cases. The questionnaires will be given to the legal officers representing different companies. Interviews will also be conducted with the legal representatives of different companies.

Possible Problems and Remedies

One of the fundamental differences between Islamic derivatives and contemporary financial derivatives lies in the diversity of practice and thoughts of Sharia law. There are different sharia schools such as Hanafi, Hanbali, and Shaf’ie within Sunni and others within Shia which have slight differences in their teachings. For instance, Hanafi teaching or school is common in Syria, Iraq, and Turkey whereas Maliki is common in Saudi Arabia and North Africa. These differences influence the concept of Islamic derivative analysis. For instance, drafting Islamic derivatives in Malaysia is more liberal compared to drafting Islamic derivatives in the Gulf region where they incorporate Sharia law in a very pure way. The difference between English law and Sharia law in terms of drafting Islamic and contemporary financial derivatives, rules and provisions, bring about several differences in their nature (Kolb, 2003).

Timeline of Project Milestones

The project is expected to take approximately five weeks. Two weeks will be dedicated to analyzing companies that have dealt in Islamic derivatives while the following two weeks will be used to analyze the derivatives of the companies that deal in contemporary financial derivatives. One week will be used to analyze the data.

Conclusion

Islamic financial derivatives are distinct from contemporary financial derivatives because of their affiliation to the Islamic faith. Islamic derivatives are strictly based on Quran and the sharia law but contemporary financial derivatives are based on the common law. Their distinction is therefore drawn from the affiliation or non-affiliation to faith

References

Al-Bashir, M. (2008). Risk Management in Islamic Finance: An Analysis of Derivatives Instruments in Commodity Markets. New York: BRILL.

Kolb, R. (2003). Financial Derivatives. London: John Wiley and Sons.

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Iqbal, Z. (2010). The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future. London: John Wiley and Sons.

Paxford, B. (2010). Derivatives- Islamic Finance Derivatives. Web.

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IvyPanda. 2022. "Islamic and Finance Derivatives Distinction." March 17, 2022. https://ivypanda.com/essays/islamic-and-finance-derivatives-distinction/.

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