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Risk is not desirable. No one likes to take risk unnecessarily yet no one can avoid taking risk if they wish to earn some reward. Shari’a recognises this

inevitability of assuming risk and in fact makes assuming risk as a pre-requisite for earning a legitimate return. The shari’a maxim of “al-ghunumu bil-ghurum” (“No Risk No Reward”) is a testimony to this. It must, however, be clarified at the outset that taking unnecessary risk and putting one’s property to undue or excessive risk is against the objectives of shari’a (maqasid al-shari’a).

In fact, the Islamic prohibition of riba (interest) can also be partially explained with the help of the shari’a stance on risk. Islam prohibits charging interest because the lender assumes no risk on the deployment of the funds lent by it. It merely charges interest on the funds lent to a business. It must be clarified here that credit risk is not recognised in Islam to become a basis for reward and return. In fact, there are clear injunctions in the Holy Quran, which prohibit pricing default, and hence credit risk. For example, verse 280 of sura al-baqara states:

“If the debtor is in a difficulty, grant him time till it is easy for him to repay. But if ye remit it by way of charity, that is best for you if ye only knew.”

It is clear from the above verse that unwitting default demands compassion.

Credit risk is the risk that a borrower will fail to pay back the loan or debt and hence will incur a financial loss on the lender. As a matter of principle, anything related with credit, whether it is risk or something else, cannot be legitimately bought and sold in Islam. Hence, financial products like credit default swap (CDS) are prohibited in Islamic finance.

How does a CDS work? Suppose a party A extends a loan of $100,000 to another party B. A third party C issues (sells) a CDS to a fourth party D, which allows the latter to receive the full amount of loan ($100,000) from the former, if B defaults on its loan from A. The party D must of course pay a fee to party C to buy the CDS, which may be a one-off but generally a frequent (e.g., monthly) payment.

In this form a CDS is nothing but a speculative instrument, which is akin to gambling from a shari’a viewpoint. In Islamic finance, there are a number of hedging and risk management tools that can be used to minimise credit risk exposures of Islamic banks and other financial institutions. Securitisation is one option but something similar to a CDS can also be structured as long as the following conditions are met:

The issuer of CDS must be the party that in fact has a 1. risk exposure, i.e., the financing bank itself rather than a third party;

By Professor Humayon Dar

Shari’a Issues

RiskManagement

in

Hedgingand

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The buyers of such a CDS must be 2. the parties other than those who have received financing from the issuer through the contracts which are underlying assets for the issuance of CDS; andThe governing contracts for the 3. issuance of CDS must be shari’a compliant.

The first condition is required to ensure that the instrument serves a real economic purpose and not mere speculation by a third party, based on its perception of the quality of the credit owned by a financial institution. Absence of this condition will certainly lead to gambling that is unambiguously prohibited in Islam. The second condition is required to ascertain that there is no trading in debt involved in the issuance of CDS. Trading in debt is prohibited by the Prophetic tradition. If the debtors to a bank are allowed to buy part or all of the debt they owe to a bank for a price other than the face value, this will lead to the prohibited interest (riba). Meanwhile, the third condition is required to ensure that the issuer and the buyer of CDS share risk in a shari’a compliant way. Shari’a does not allow naked trading in risk, which is very much the case in conventional CDS market.

Thus contrary to a view held by some, hedging is acceptable in Islam as long as it is done for pure risk management purposes. It is important to understand hedging before pronouncing it to be shari’a compliant or otherwise. Hedging involves reducing risk of an investment by making an offsetting investment. For example, if someone buys 10,000 stocks of a company X for 25 cents per share, then the person has a total (risk) exposure of $2,500 in this investment. In an extreme case of the stock X losing all its value, the investor will lose all its investment. If the stock goes down to 15

cents per share, the investor loses $1,000 when he sells it back in the market.

One possible way of hedging against market price fluctuations entails the investor part buying and part borrowing the same stock. For example, the investor may decide to buy 10,000 of stock X for 25 cents per share and also borrows 5,000 stocks X from a brokerage firm by paying 1% premium (interest) for a period of three months. Thus, the investor’s portfolio comprises of 10,000 purchased stocks and $1,250 in cash that he received from the sale of the borrowed stocks. Suppose that after three months, the price of stock X goes down to 20 cents per share. The investor loses 5 cents on its purchased shares (ignoring transaction costs), with a total loss of $500. However, the investor buys 5,000 X stocks from the market for a price of 20 cents per share for a total price of $1,000, and delivers these to the broker to close his borrowing position with him. In this second leg of the transaction, the investor makes a gross profit of $250 (or a net profit of $237.50, which takes into account the interest payments). This strategy reduces the loss of the investor from $500 to $262.50.

Shari’a Compliant?The question arises: Is it shari’a compliant to do so? The above example is that of a long-short strategy for hedging. The following shari’a matters must be considered when adjudging a long-short hedging strategy:

Purchase of stocks of companies 1. that are involved in shari’a compliant activities is permissible. Borrowing stocks for a premium 2. (interest) is not acceptable in Islam.There is a general consensus amongst 3. the contemporary jurists that onward sale of a borrowed item (including

shares of listed companies) is not allowed.

So, the way the above long-short strategy is implemented in conventional financial markets, is not permissible. However, there are other ways of hedging risks in a shari’a compliant way. For example, one may wish to limit their exposure by way of using shari’a compliant options. A simple call option is based on the concept of ‘arbun, which is a sale that allows a buyer to pay a fraction of the price upfront as deposit to confirm the sale later when he is obliged to pay the remainder of the price and takes delivery. A major difference between Islamic options and conventional options is that while the latter can be sold separately before an actual sale may take place; the former cannot be sold for a price other than what is determined as part of the price of the object of sale. Shari’a does not allow sale of unbundled options. This is primarily due to the fact that Islam does not allow trading in derivative contracts. However, it is legitimate to minimise risk in trading by way of hedging it, using shari’a compatible techniques.

Although there now an increasing number of hedging tools and products available in Islamic finance, the industry still faces dearth of shari’a compliant hedging instruments available in the market. However, following the IIFM-ISDA Tahawwut (Hedging) Master Agreement, the use of shari’a compliant hedging and risk management has increased significantly.

Pro fe s s o r H u m ayo n D a r i s t h e Chairman, President & CEO of Edbiz Consulting Ltd, a London-based Islamic financial consulting firm. He is a leading spokesman for the Islamic financial services industry, and has played lead roles in a number of global initiatives for the development of Islamic finance.

Credit risk is the risk that a borrower will fail to pay back the loan or debt and hence will incur a financial loss on the lender. As a matter of principle, anything related with credit, whether it is risk or something else, cannot be legitimately bought and sold in Islam. Hence, financial products like credit default swap (CDS) are prohibited in Islamic finance.