QRFM-06-2015-0024Shari'ah Issues, Challenges, and Prospects For Islamic Derivatives

Qualitative Research in Financial Markets
Shariah issues, challenges, and prospects for Islamic derivatives: a qualitative

study
Muhammad Rizky Prima Sakti Ahmad Syahid Mohammad Ali Tareq Akbariah Mohd Mahdzir
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QRFM
8,2
Shariah issues, challenges, and
prospects for Islamic derivatives:
a qualitative study
168 Muhammad Rizky Prima Sakti, Ahmad Syahid,
Received 25 June 2015
Mohammad Ali Tareq and Akbariah Mohd Mahdzir
Revised 13 February 2016 Malaysia-Japan International Institute of Technology (MJIIT),
Accepted 2 March 2016 Universiti Teknologi Malaysia, Kuala Lumpur, Malaysia
Abstract
Purpose The purpose of this study is to investigate shariah scholars views and experiences
pertaining the shariah issues, challenges and prospects in Islamic derivatives. Specifically, this paper
critically examines the criticisms toward conventional derivative instruments and the controversies
surrounding underlying contracts and current Islamic derivative products.
Design/methodology/approach This study uses qualitative methods to form a deeper
understanding of shariah scholars perception and experience on Islamic derivatives. Semi-structured
interviews were conducted with five shariah scholars who are currently working in Islamic financial
institutions in Malaysia and Singapore. This study used phenomenological techniques for its data analysis.
Findings This study has found that shariah scholars are aware of the shariah issues surrounding
Islamic derivatives and have provided comprehensive insight on the solution to these issues. It was
found that it is important to take into account the derivatives instruments in Islamic financial industry
because of the need for hedging and risk mitigation within Islamic financial institutions. Nonetheless,
the study has also found that the use of waad contracts to structure Islamic profit rate swaps and
foreign currency exchanges are problematic because of it having features of bay al-kali bil-kali (the sale
of one debt for another).
Originality/value This study is one of few studies that highlight the shariah issues of Islamic
derivatives in Islamic banking and finance industry. This paper is of value in discussing risk management
and Islamic derivatives in Islamic financial institutions and how there are many issues under the
investigation process, particularly issues related to controversial underlying contracts and products.
Keywords Qualitative, Malaysia, Singapore, Risk management, Shariah, Islamic derivatives
Paper type Research paper
1. Introduction
Islamic banking and finance industry has grown tremendously over the past decades.
The increase in the complexity of Islamic financial products has resulted in a similar
increase in the variety of risks these products carry. Islamic banking and financial
institutions are also exposed to the same risks as its conventional counterparts; business
risk, exchange rates risk, commodity price risk and operational risk. In fiqh muamalat,
the risk management lies on the scope of public interest or maslahah, which is a licit
Qualitative Research in Financial foundation of consideration in shariah principles. Shariah principles govern
Markets
Vol. 8 No. 2, 2016 risk-taking according to the principle of al-kharaj bil al-daman (i.e. with profit comes
pp. 168-190
Emerald Group Publishing Limited
1755-4179
DOI 10.1108/QRFM-06-2015-0024 JEL classification G21, D81
responsibility) and al-ghorm bil al-ghonm (i.e. with profit comes risk) and while Shariah
simultaneously avoiding gharar (excessive uncertainty), maisir (gambling) and riba issues,
(usury). The search for better risk management tools has led the creation of Islamic
derivatives by the Islamic banking and finance industry.
challenges,
Derivative provides a tool for off-balance sheet technique to hedge the risk of and prospects
economic loss arising from the volatility in the value of the underlying assets. Moreover,
as intermediary institutions, banks may utilize derivative as a risk management 169
instrument to hedge on-balance sheet transactions. Islamic banks, in particular, have an
exposure to the exchange rates risk and commodity prices risk because of the volatility
in the value of the underlying assets used to facilitate its transactions. This additional
risk necessitates Islamic banks hedging activities (Malkawi, 2013).
Because hedging and risk management are valid economic activities, shariah does
not proscribe it. However, derivatives can also be used for speculation, which is
detrimental to the financial system and society generally. There are diverging opinions
from shariah on the subject of financial derivatives. Some of the arguments for the
prohibition of financial derivatives includes the element of gharar as well as the
speculation element inherent in such instruments (Obaidullah, 1998). The arguments for
the permissibility of derivatives in Islamic finance stems mainly from the risk
management and reduction financial instruments such as futures and options provide
(Kamali, 1999).
Banks and companies use derivatives both for speculation and hedging. In
conventional finance, risk management is a necessity in strategic business planning,
which has led to the use of derivatives as a risk management tool. There is also an
element of leverage in derivative trading, the chance of large gains or losses from a small
capital base because of small movements in the derivatives underlying assets. These
have led to the argument that derivatives exhibit elements of gharar (uncertainty), riba
(usury), jahalah (ignorance) and are used for speculative purposes, all of which are
inconsistent with shariah principles (Haron, 2014) .
The permissibility of derivative instruments in Islamic finance is contentiously
debated by shariah scholars. Kamali (1999) stated that derivatives are a new
phenomenon with no precedent in previous fiqh literature. The Jeddah Fiqh Academy,
which uses a stringent approach in its shariah rulings, rules against the permissibility
of derivatives in Islamic finance because of the ill-effects that could result from its use
and posits that derivatives do not have the basis to be classified as an asset. However,
the Shariah Advisory Council of Securities Commission Malaysia allows the trading of
derivatives in Islamic finance, citing factors such as urf tijari (common business
practice), maslahah (public interest) and avoidance of hardship.
This divergence in opinion also exist in conventional finance, where some consider
derivatives a financial weapon of mass destruction because of its inherent risk,
complexity and opacity. Obversely, derivatives are viewed as instruments to provide
liquidity and risk hedging for the financial markets. Both views are justified with
equally strong data and analyses. This divergence in opinion demonstrates the
incomprehension of derivatives, in both conventional and Islamic finance. The subject
of derivatives requires further deliberation and research to arrive at proper
understanding of its nature, motives and impact to the economy and society.
Furthermore, the subject discourse on derivative must take into account in the light of
shariah analyses to arrive at accurate decision pertaining its permissibility or not.
QRFM This study is laid out to achieve a number of objectives. First, the study will focus on
8,2 examining the shariah issues pertaining to derivatives from the Islamic point of view.
This is meant to provide a clear picture of the operations and shariah parameters of
derivatives, as governed by Islamic jurisprudence. Second, this study critically traces
the experiences of shariah scholars on controversial issues concerning derivatives and
their underlying contracts. Finally, this study also aims to investigate the challenges
170 facing and prospects of shariah-compliant derivative instruments. Correspondingly,
this study is attempts to answer following research questions:
RQ1. What are the shariah considerations for proscription and allowing the usage
of derivative in Islamic finance.
RQ2. What are the most controversial Islamic derivative instruments currently in
use?
RQ3. What are the challenges and prospects of Islamic derivative?
Prior studies have been conducted on the derivative instruments in Islamic finance but
few have been concentrating on the shariah issues, controversies of its current products
and contracts, and the challenges and prospects ahead. As the shariah issues and
controversies of derivatives products cannot be explained just through quantification,
the qualitative method was used. This study has gone some way from the practitioners
and shariah scholars in Islamic finance industry in Malaysia and Singapore and makes
several contributions to the literature and practitioners. First, the study can paint a
comprehensive picture of the shariah and operational aspects of Islamic derivatives by
synthesizing shariah issues and controversies surrounding its usage. By drawing
from Islamic finance practitioners perspective, this study will also establish
recommendations for Islamic banks and financial institutions to allow for
shariah-compliant use of hedging instruments for risk management. The study also
recommends for Islamic banks and financial institutions to revisit the use of waad
contracts to structure Islamic profit rate swaps (IPRSs) and foreign currency exchanges
because of it having features of bay al-kali bil-kali (the sale of one debt for another). This
study will also help policymakers establish sound and comprehensive regulations of
risk management practices in the Islamic finance based on maqasid al shariah
(objectives of shariah). The findings of this study helps regulators to set up enforcement
for the prudent use of shariah compliant derivatives to not jeopardize the financial
system.
This study is organized as follows. Section 2 will comprehensively presents the
literature review on the discourse of risk derivative instruments and its shariah-related
counterpart. Section 3 presents the data and methodology behind this study. Section 4
reports the result and discussions of this study. Finally, Section 5 will present the
conclusions of this study.
2. Literature review
According to the Horcher (2011), the substance of risk is the uncertainty that have
likelihood of loss and exposure. In Islam, the existence of uncertainty is fundamental for
human well-being. Quran (31:34) states that:
Indeed, Allah has knowledge of the hour and sends down the rains and knows what is the Shariah
wombs. And no soul perceives what it will earn tomorrow, and no soul perceives in what land
it will die. Indeed, Allah is Knowing and Acquainted.
issues,
challenges,
Concerns raised in Elgari (1993) include the requirement in Islam to protect wealth from and prospects
various types of risks. In Islamic legal maxim (qawaid Fiqhiyah), there is a maxim
known as al-ghorm bil-ghonm (i.e. with profit comes risk). This maxim indicates that it
is necessary to take risks to compensate the returns for sustainable wealth creation. 171
Another maxim in Islamic finance known as al-Akhdah bil-asbab; desired ends should be
sought through legitimate means including through proactive risk management. Based
on these maxims, Al-Shubaili (2012) summarized that any profit reaped without the
consideration of risks is not permissible. Similarly, Al-Suwailem (2006) also found that
it is necessary to take risks for economic progress and concluded that the economic
growth cannot take place without accepting risks.
The contemporary practice of risk management in Islamic finance industry resulted
in fluctuations in market prices of several financial instruments, namely, sukuk, salam
and murabahah assets, and foreign exchange rates (IFSB, 2005). This finding is
consistent with findings in Dowd (2005), which concluded that market risk occurs
because of movement in market prices, interest rates and exchange rates. Moreover,
both conventional and Islamic banks are exposed to the presence of risks such as
interest rate risk. Bacha (2004) confirms that Islamic banks in Malaysia is subjected to
interest rate risk because of its common economic horizon and customers, along with
conventional banks.
Apart from that, Islamic banking and finance industry also subjected to exchange
rates risks. IFSB (2005) asserts that Islamic financial institutions are also exposed to
foreign exchange fluctuations arising from general spot rate changes in both
cross-border transactions and the resultant foreign currency receivables and payables.
These exposures may be hedged using shariah-compliant method (IFSB, 2005). In
addition, Islamic banks are also subject to rate mismatch risks, because of the different
levels of benchmarking between foreign and locally denominated assets. Foreign
currency assets and liabilities are normally valued using foreign currency benchmark
(i.e. LIBOR), while the locally denominated assets and liabilities will be priced using
local currency benchmark (i.e. KLIBOR). In that scenario, both the bank and its
counterparties are exposed to rate mismatch risk. Islamic banks exposure to this risk
should be managed to mitigate losses that may arise.
Having discussed these exposures, it is necessary for Islamic banking and finance
institutions to construct risk strategy frameworks. Previous discussions have pointed
out the inevitability of market risk as well as the necessity of Islamic banks to minimise
this exposure to price and rate volatility using hedging instruments. The rationale
behind hedging comes assumes a lower cost of internal capital, higher growth potential
through hedging and the improvement of competitiveness using hedging instruments
(Froot et al., 1993).
With regard to the relative cheapness of internal funding, a large volume of previous
risk management literature show that the use of hedging ensures the sufficiency of
internal funds by lowering the variability of free cash flows (Shapiro and Titman, 1986;
Smith and Stulz, 1985; Breeden and Viswanathan, 1998). Ayoub (2013) argues that
Islamic finance industry seeks to use hedging as a risk retention strategy to improve its
growth and profitability potential. Hedging instruments can also enhance the
QRFM competitiveness of Islamic financial institutions by, within the global financial context,
8,2 reducing its cost barriers to market entry (Ayoub, 2013). This can then increase the
market share of Islamic financial institutions through stable and competitive pricing of
Islamic financial products. Disregarding risk management is also found to be
contradictory to Islamic principles, as Ahmad and Halim (2014) has shown that a part of
maqasid al-shariah (objectives of shariah) is the protection of assets.
172 Hedging is an activity to reduce or mitigate risks of another investment (Khan and
Ahmed, 2001). Findings in previous literature on the use of hedging have shown that it
can reduce future volatility for parties involved in foreign currency exchanges (Bacha,
1999). This finding concurs with other works that advocate the use of hedging to cover
potential losses from undesired risks (Toporowski, 2002; Clark and Ghosh, 2004; Kolb
and Overdahl, 2006). Al-Suwailem (2006) believes that hedging activities should be used
only to reduce risks. A more recent study by Elgari (2010) has considered hedging as a
tool to avoid risks. In contrast, Kolb and Overdahl (2006) has found evidence suggesting
hedging as an activity to gain profits based on market price volatility. This academic
disagreement on the concept of hedging, inextricably linked to derivatives, show that
there is still perplexity surrounding hedging use. According to Hull (2011), a derivative
is a financial instrument emerged as a contract or payment exchange agreement whose
value is derived from underlying assets; commodities, equities, interest rates and
foreign exchange rates. Derivatives can be used both as a hedging device in the risk
transfer process and also as an investment product with the flexibility to be tailored to
a market players risk appetite and yield preferences.
The discourse on the use of derivative in Islamic finance begin after the exceptional
growth of these instruments in the conventional markets in the 1970s, with discussions
among Islamic scholars in the Makkah Fiqh Academy as early as 1984. Derivative
markets have existed in the Islamic world prior to that date, with Kamali (2002)
evidencing the existence of the cotton futures market in Alexandria, Egypt since 1861.
Other contemporary examples of commodity futures in Muslim countries can also be
found in the study by Ayoub (2013).
In contemporary Islamic finance, a number of studies by practitioners and shariah
scholars have highlighted the necessity of derivative instruments, particularly to
augment the potential growth of Islamic finance (Elgari, 1993; Bacha, 1999; Kamali,
2002; Khan and Ahmed, 2001; Jobst, 2007; Al-Amine, 2008; Dusuki, 2008; Ayoub, 2013;
Ahmad and Halim, 2014). The current risk management practices in Islamic banking
and finance and the disagreement amongst shariah scholars on the subject of
derivatives have resulted in inconsistent resolutions between various standard-setting
bodies. Askari et al. (2012) posited that:
[] the debate on derivative will continue in Islamic finance, but at present they have very
limited acceptability and it is unlikely that the practice of derivative will be as widespread as
seen in conventional markets any time soon. However, as Islamic finance grows, its own
version of hedging mechanisms and financial products with embedded options will emerge.
Prohibitions of derivative, however, do not preclude an Islamic financial intermediary from
designing a risk-sharing or risk-mitigating scheme. This can be achieved through the creation
of a risk-mitigating instrument synthetically using existing instruments.
The Makkah Fiqh Academy (1984) have resolved, after debating the use of derivatives
in Islamic finance, to prohibit its use because the derivative markets do not address any
maslahah (public interest) which is a licit foundation in Islamic law. Detailed reasoning Shariah
include: issues,
derivative contracts are not real transactions in a sense that the market challenges,
participants do not transfer any actual underlying asset; and prospects
in most cases, the sellers are selling what they do not own to their counterparties;
the derivative contracts are oftentimes sold and resold until maturity date to other
parties; and
173
the derivative markets serve the appetite of large traders at the expense of small
traders by a way of market manipulations which in turn lead to market crashes
(Makkah Fiqh Academy, 1984).
An investigation in the use of options in Islamic finance by the OIC Jeddah Fiqh
Academy (OIC, 1992) concluded that options are a new form of contracts unclassifiable
under the current shariah nomenclature (i.e. salam, urbun, khiyar al-shart) and are
therefore prohibited under Islamic jurisprudence. This is based on the reasoning that
option contracts carry features including:
the lack of ownership of the underlying asset;
selling of non-existent asset at time of the contract;
partaking in gambling and speculation activities by market participants;
the transacting of this options contract is independent its underlying asset;
the transfer of these contracts to third parties is impermissible; and
lack of delivery and receipt by the parties involved in this contract.
These reasons are consistent with the previous resolution by the Makkah Fiqh Academy
(1984).
Usmani (1999) asserts that forward contracts are different from salam contracts, but
are instead more akin to the sale of one debt for another (Bay Al-Kali Bil-Kali) which
is forbidden by Islamic law. The proscription of Bay Al-Kali Bil-Kali comes from a
hadith by the Prophet Muhammad (PBUH) is the focal argument by shariah scholars
for the prohibition of derivative instruments, as it can be used to facilitate the trading of
debt (Al-Amine, 2008; Al-Suwailem, 2006). Usmani (2010) comprehensively examined
future transactions and reasons that these contracts are prohibited, for both hedging
and speculation, because:
buying and selling cannot be affected for a future date;
the delivery is not intended and hence the settlement executed through price
differentials;
if the delivery is intended, the seller does not possess full control of their
underlying asset and could be construed as a form of deception to the buyer; and
the transactions are involved together which is impermissible in Islamic law.
Another legal maxim on ownership axiomatic to the discourse on derivatives relates to

Al-Kharaj bi Al-Dhaman (with profits come bearing the liability for losses) (Al-Suwailem,
2006; El-gamal, 2007; Obaidullah, 1998). The interpretation of this legal maxim is questioned
in Ayoub (2013) on whether owner can be taken to mean merely possession. The
QRFM deliverability of the underlying assets is unanimously seen as a necessary element in
8,2 shariah principles (Al-Amine, 2008; Kamali, 1999; Khan and Ahmed, 2001).
The Islamic Research and Training Institute (IRTI, 2000) showed that option contracts is
neither a sum of money nor a utility or a financial right which can be waived thus is
impermissible based on Islamic law, consistent with the views of the Jeddah Fiqh Academy
(n.d.). Additionally, forward contracts are forbidden because of the lack of an opposing
174 transaction during the exchange (IRTI, 2000). The Accounting and Auditing Organization
for Islamic Financial Institutions (AAOIFI, n.d.) is also in favor of the impermissibility of
forward contracts because of its contradiction with shariah standards.
Ayoub (2013) found that the prohibitive opinions on the use of interest rate and
foreign currency derivatives for speculation and risk management by scholars and
standard setters stems from their views of these instruments intractability with
speculative and gambling activities. This has taken attention away from the debate on
the benefits of derivatives to society and the management of such instruments, creating
a rift in opinions between academia and practitioners (Ayoub, 2013). He extend his
arguments posit that the prohibition of any way of hedging mechanisms from shariah
scholars (i.e. Usmani) and standard-setting bodies (i.e. OIC Jeddah Fiqh Academy,
AAOIFI) were merely pertaining the hesitance of speculation and gambling activities
and its possibly creates on financial imbalances. Nevertheless, none of these
shariah-standard setting bodies address the discourse on the issue whether derivative
are beneficial to public society and how should they be managed? In addition, there is
disparity between industry and shariah scholars as evidenced by the perplexing and
difference opinions regarding this discourse.
Recent studies have demonstrated the thriving use of derivative instruments in
Islamic finance. This includes discourse of on whether khiyar al-shart (contractual
stipulations) or urbun (earnest money), which are forms of shariah contracts, can be
used as a basis to allow options instrument in Islamic finance. Kamali (1999) and
Obaidullah (1998) argue that khiyar al-shart is a licit foundation in shariah law to form
the basis of an option instrument. Other authors argue for the use of urbun to design
option instruments (Al-Amine, 2008; Elgari, 1993; Vogel and Hayes, 1998). The salam
contract, a forward sale that stipulates immediate payment and delivery of a good on
specific future date, has been declared permissible for risk management purposes by the
OIC Jeddah Fiqh Academy (IRTI, 2000).
A growing number of studies support the permissibility to use options, forwards and
futures in Islamic finance. However, the slow industry uptake can be attributed to the
lack of consensus on the acceptability of underlying contracts; khiyar al-shart, urbun
and salam. The lacklustre development of risk management and derivatives in Islamic
finance can be attributed to the rigidity of classical Islamic risk management products
(Rosly and Bakar, 2003), insufficient demand for Islamic risk management instruments
(Bacha, 1999; Ismal, 2010) and the absence of a central regulator for risk management in
Islamic finance (El-Hawary et al., 2004).
3. Methodology
3.1 Approach
A qualitative approach was selected for this study because this approach is beneficial
for studies seeking the reflection of individual reality and enables a researcher to see
how people interpret their experiences, construct the world and the associate meanings
with it (Merriam, 2009). A qualitative approach also allows the generation of Shariah
comprehensive insights, for the purpose of this study, of shariah scholars perception issues,
and experiences on Islamic derivatives.
challenges,
3.2 Paradigm and prospects
Because Islamic derivatives has not received adequate attention from scholars, this
study will attempt to gather data that are hoped to lead to new insights and 175
establishment of new theories (induction), in lieu of using a theory to explain findings
(deduction). This study also aims to explore and form a deeper understanding of Islamic
derivatives through inductive research. This study will also adopt a phenomenological
approach to gain a deeper understanding of participants experiences (Bowen, 2009).
This approach can also incorporate single or multiple interviews with a particular
interviewee, streamlining data collection (Creswell, 2003).
3.3 Sampling
This study uses the unique sampling methodology where sample selection was based on
their uniqueness and typical attributes. To this end, interviews were conducted with
shariah scholars whom are Islamic banking and finance experts with varying
backgrounds and from different institutions. Five interviewees from three different
countries; Malaysia, Indonesia and Singapore with different exposure, insight, and
experience in risk management, derivative and shariah law were chosen for this study,
as shown in Table I.
3.4 Data collection

The data were collected through semi-structured interviews to understand shariah
scholars perspectives on Islamic derivatives. The use of semi-structured interviews also
gives flexibility to the authors to explore further areas of interest, as well as give the
interviewees freedom to express ideas on the subject (Horton et al., 2004). The interviews
were conducted between March and May 2015, with each interview lasting an average of
30 min. To guarantee privacy and confidentiality, interviewees names has been
anonymized.
4. Findings and discussion

4.1 Risk management in shariah perspective
The interviewees are all in consensus that risk management is encouraged in Islam
and should be addressed by each Islamic financial institution. The interviewees also
agree that risk management has become a crucial part of both conventional and
Islamic financial institutions and that risk management practices should be
Interviewee Gender Education Nationality Affiliation
A Male Master Singaporean Zayn Associate Singapore

B Male Master Indonesian AFFIN Islamic Bank
C Female PhD Malaysian ISRA
D Male PhD Malaysian Al-Rajhi Bank Table I.
E Male PhD Malaysian Standard Chartered Saadiq Interviewee profile
QRFM embedded in the operationalization of Islamic banking and finance. More so, the risk
8,2 management becomes crucial part whether for conventional or Islamic financial
institutions. In this regard, Interviewee D, a member of the Shariah Board of
Al-Rajhi Bank stated that:
So, in general, if we ask risk management, its a crucial part whether Islamic or non-Islamic.
But from shariah perspective, there is nothing wrong with that and we have also encouraged
176 to have extra cautious in doing a things.
In the same context, Interviewee C emphasized the importance of risk mitigation
functions, because the existence of excessive risk can be considered as gharar. The
mitigation of risk is also consistent with the objectives of shariah; maqasid al-shariah.
In this regard, Interviewee C from International Shariah Research Academy for Islamic
Finance (ISRA) said:
The concept of risk is twofold. One is that, in shariah, you need a risk to enjoy the profit. We
find it from the sunnah of the Prophet, for example, tying the camel, its a part of hadith. We
find it also from legal maxim. At the same time, we encouraged to mitigate risk because an
excessive risk is considered to be gharar. And also the risk itself must be mitigated because we
need to preserve the maqasid al-shariah which is the one of the requirement in maqasid.
This is in line with the findings of Elgari (1993), who concluded that Islam encourages
wealth protection from various forms of risk. Risk management is desirable, as it
facilitates the preservation of wealth, an important part of maqasid al-shariah. Ahmad
and Halim (2014) also posit that risk management in shariah is important because asset
protection is part of maqasid al-shariah. Therefore, neglecting risk management
activity is contradictory to Islamic jurisprudence.
Interviewee E stressed the importance of risk management in Islam and the extent to
which it is encouraged in Islam, highlighting the verses in the Quran in which it was
mentioned:
In the verse of the Quran, risk management is very much encouraged because Allah SWT says
in surah Al-Baqarah says ya ayyuhal ladzina amanu idza tada yantum bi dainin ila ajalim
musamma faktubuh. So Allah mentioned that, O you who have believed, when you contract
a debt for a specified term, write it down. Allah SWT suggested us to write it down. Why we
have to have a script or to write it down? Risk management! [] Allah SWT asked us to do a
script or writing it down very clear agreement. So all of that is risk management in Islam.
Additionally, Interviewee B evidences that the practice of risk management in Islam is
not a novel concept. It can be traced back during the time of Prophet Yusuf A.S,
highlighting the history of risk mitigation in Islam:
Talking about risk management, it is basically a concept which is not new in Islam. Risk
management has been widely used even before Prophet Muhammad era. Prophet Yusuf has
managed to mitigate the risk for seven years crises. So I think during that time, Prophet Yusuf
has given us some examples of how to mitigate and manage the risk.
Another issue highlighted by interviewees is the intractable link between Islamic and
conventional banking operations in Malaysia under its dual banking system. Islamic
banks are not sheltered from and cannot eschew any risks faced by conventional banks.
According to Interviewee E, a Shariah advisor for a number of Islamic financial
institutions in Malaysia states:
In Islamic finance, as we all know, financial institution is not free from conventional risk. For Shariah
example from the conventional finance risk, commodity prices risk, business risk, inflation
risk, etc. So, as Islamic financial institutions we cannot escape our self from these because we issues,
are operating our self under this umbrella. challenges,
This is consistent with the fact that market risks in Islamic finance stem from changes
and prospects
in the market prices; equities and commodities prices, and interest and currency
exchange rates (Dowd, 2005). This statement also confirms that Islamic banks in 177
Malaysia are subjected to interest rate risks because of having the same economic
horizon and customers as conventional banks (Bacha, 2004).
In addition to that, Interviewee A from Zayn Associate Singapore mentioned that
risk management is part of every financial institutions governance, both conventional
and Islamic, that needs to be adhered to. Because of this, being part of the financial
system, Islamic banks have an obligation to put in place risk management processes. As
expressed by Interviewee A:
Risk management is part of governance, and it is also part of what is stated by Basel. For
Islamic banks and financial institutions, we have to perform as what have stated in
conventional. The risk management is also decided by the central bank, so Islamic banks must
be conforming to what have been stated by central bank, as part of their risk management
processes. It is important that, whether its banks, firms, or Islamic financial institutions, to
conform to the risk management policy and they have to ensure that Islamic banks is also part
of the system.
Overall, the interviewees shared the common understanding that risk management
practices are encouraged in shariah. Risk mitigation is consistent with maqasid
al-shariah, especially on excessive risks may lead to gharar. The interviewees were
concerned on the practices of risk management in the Quran, Hadith and qawaid
fiqhiyah (Islamic legal maxim). The interviewees also agreed that Islamic banking
and finance, operating within same horizon as conventional finance, cannot escape
exposure from exposure to risks faced by conventional banks. Because of these reasons,
Islamic finance is in dire need to find risk management tools which are both religiously
acceptable and allows risks to be managed effectively, a bill fitting for Islamic
derivatives. Latter sections of this study will discuss the shariah issues, prospects and
challenges facing the use of Islamic derivative instruments.
4.2 Criticism of conventional derivative

In conventional finance, derivatives can be defined as a security whose price is
dependent upon or derived from an underlying asset. This instrument was initially
created for the purpose of hedging or risk mitigation. Interviewee C mentioned that:
First of all, in conventional finance, derivative were actually created to mitigate a risk. [] at
the beginning, when the derivative first started it was to enable farmers, for example, to
mitigate the risk against price fluctuation for their crops and so forth. So, actually, the initial
idea of derivative is to mitigate risk.
This statement shows that the development of Islamic derivatives parallels those of
conventional derivatives, as shown in Hull (2011), where the earliest conventional
derivatives were forward contracts that guaranteed the prices of commodities to be
delivered at a future date. The interviewees also showed a general agreement that
hedging practices can bring benefits to market players. As said by Interviewee C:
QRFM So, my views on derivative, if it is used for hedging or risk mitigation, it is an useful tool, But,
8,2 if it is used for speculation or for gambling, it is a harmful tool.
Numerous studies have attempted to explain risk management and hedging. A number
of studies have acknowledged the benefit of hedging for risk mitigation to cover
potential loss from undesired risks (Toporowski, 2002; Clark and Ghosh, 2004; Kolb and
178 Overdahl, 2006). Khan and Ahmed (2001) also reveal that hedging is an activity to
reduce or mitigate the risks of another investment.
One of the issues emphasized by the interviewees is the ill-effects of speculation. In
conventional finance, the speculative nature of derivatives is heavily emphasized.
Conventional derivatives allow market participants to speculate on commodities and
financial instruments, reaping profits from changes in their prices. Interviewees in this
study believe such speculation is detrimental to the financial system, as said by
Interviewee E:
If you are talking about conventional derivative, absolutely I will say that almost 90 per cent
of derivative users are coming from the speculators and arbitrageurs. So that we can say that
normally derivative be engaged by speculators. [] so if you are talking about conventional
derivative, I am with majority whom says that derivative is a time bomb! Waiting to do a
damage to the financial institutions.
Similarly, Interviewee C also mentioned the negative effect of speculative transaction:
[] but at the same time, derivative had been used for speculative. Over time its being used for
speculation because it can easily be used for betting in the market. Because of that, derivative,
the way it has been used it gives a negatives impact. If it (derivative) is used for speculation or
for gambling, it is a harmful tool.
The above statements are similar with numerous studies in the literature on the
discourse of hedging. Kolb and Overdahl (2006) discovered that hedging can facilitate
market participants to profit from market price volatility. Similarly, Elgari (2010) also
indicated that profit is necessary in hedging activities, as profits gained is meant to
compensate for adverse price movements. In contrast, Interviewee A disagreed about
the speculative aspect of derivatives:
Generally, most try to avoid derivative. And most allow derivative to be used as hedging
instrument and not for speculative instrument []. Generally at present, our scholars are very
opened on the use of hedging to risk management, to reduce the losses or to ensure capital
protection. But generally, in speculation, mostly said it is impermissible and mostly said it is
discouraged []. For any derivative instrument to succeed, it must have two tales. We need the
speculators and we need the hedgers.
In addition, Interviewee A also placed high emphasis on the importance of speculators in
the workings of derivatives. He frankly mentioned that the derivatives cannot function
without the presence of speculators in the market:
In the conventional side, derivative are being used for speculative purposes. For any derivative
instrument to succeed, it must have two tales. We need the speculators as well as we need the
hedgers. If we have the hedgers, but we do not have the speculators, nobody will buy the
products. If we want to allow hedging, but we disallowed speculators, and the market cannot
be practiced. The market cannot succeed because we need speculators to ensure that the
hedgers can implement the products.
There was a consensus among the interviewees that hedging activities using Shariah
derivatives can be beneficial and useful, and that it should be encouraged and issues,
supported, especially during market shocks as measure to protect wealth and
investments. Moreover, most of the interviewees also agreed that speculation using
challenges,
derivatives will bring negative effects to the financial ecosystem and jeopardize the and prospects
economic environment.
Nevertheless, the salient feature of derivative product requires the hedgers and 179
speculators to work together in the market. Derivatives provide a tool for off-balance
sheet risk management to hedge against economic loss arising from the volatility of
underlying assets. One of the basic features of derivatives is to hedge (insurance) or
mitigate risks in the underlying asset. However, the use of derivatives is not limited to
hedging alone. Depending on the risk appetite of investors, it can be utilized as a

profit-making instrument should the value of the underlying asset change in the
investors favor. The opinion of Interviewee A, who deals mainly in the Singaporean
market, on speculative activities using derivatives contrasts with those from other
interviewees in this study. This shariah scholar believes that the market requires both
hedgers and speculators for derivatives to function in the market. Speculation does not
exist only in the derivatives but also in other financial instruments. He expressed:
If I allow such speculating to be done in the share market, I should allow myself also to
speculate in the derivative market.
In addition, Interviewee A also emphasized the importance of understanding derivative
products comprehensively, rather than merely its theoretical aspects, but also its
technical and operationalization aspects. He said that:
But if we dont understand the product and we just based on theoretical understanding, then
we might have the wrong understanding in giving the opinions.
The statement above is also consistent with the findings in Alsayyed (2009), who found
that Middle Eastern shariah scholars have less sophisticated product knowledge, such
as in market operationalization and arbitrage techniques, compared with their
countrymen whom are practitioners in Islamic banking and finance.
Another important issue emphasized by the interviewees is the use of conventional
derivatives in Islamic finance for hedging purposes. In this context, there were divergent
opinions among interviewees. For instance, Interviewee C clearly expressed that:
Islamic financial institutions cannot use conventional instruments. I think, a lot of research has
been done by the shariah scholars. And the majority had believed that the conventional
instrument have element which not accepted under the shariah, its not shariah compliance.
One of the main reason is gharar. I think gharar because a lot of the contracts especially
forward, future, and these two contracts which used selling something in the future. The
counterparties do not have to exchange anything. Its not like salam, its not like istisna.
Interviewee E has more specifically addressed the opinions among the scholars of the
pros and cons pertaining the use of conventional derivative for hedging purposes in
Islamic finance:
For some scholars, for example Hashim Kamali, Bashir Al-Amanie, they are saying that it is
permissible to use conventional derivative for hedging. Lately, I found some of other scholars,
Syeikh Nizam Yaqubi also says that future and forward and also options of conventional are
acceptable. But normally what happened in the Middle Eastern countries, the scholars reject
QRFM the conventional derivative. And in Malaysia, I can say the same approach applied where the
shariah scholars rejected the conventional derivative except for some of them with condition.
8,2 For example [] Single stock futures but with some conditions.
The statements above evidence that, in most cases, the interviewees unanimously
disagree on using conventional derivative instruments for hedging purposes. Hedging
via conventional derivatives is not in line with maqasid shariah, as there is too much
180 gharar involved in conventional derivative instruments. Only a minority of shariah
scholars are in the opinion that conventional derivative products can be utilized by
Islamic financial institutions, while the majority were opposed to it.
These findings are by conclusions in previous literature, that derivative products do
not promote maslahah (public interest) and is deemed as impermissible in Islamic
financial transactions (Usmani, 1999; Al-Suwailem, 2006). Furthermore, the arguments

above are acknowledged in the study by Usmani (2010) who concluded that derivative
contracts are totally prohibited, without regards to the purpose of these contracts;
speculation or hedging.
4.3 Shariah issues on current Islamic derivative practices

After investigating opinions on derivative practices from shariah scholars, we further
explore the perception of the interviewees about shariah-related issues on
contemporary Islamic derivative products. Based on the philosophy of muammalah in
shariah teachings, Interviewee B expressed that:
Talking about derivative, basically we can go back to the basic of muammalah in Islam. The
scholars said al-ashlu fil muamalah al-ibahah illa an yadulla ad-dalilu ala tahrimiha.
Everything in muammalah, in financial transaction, is permissible unless there is evidence
which is indicated otherwise. So, as long as there is no clear prohibition from the Al-Quran and
Sunnah or other Divine revelation, there is no harm basically to apply derivative.
According to the Interviewee B, currently with AFFIN Islamic bank, the initial ruling for
derivative products is that they were permissible and valid, unless there is evidence
indicating otherwise. Even so, there is no clear evidence from Quran and Sunnah
specifically forbidding derivatives. The derivative products must be in line with the
objectives of the shariah (maqasid-al shariah) and subject to strict requirements to
ensure that it is consistent with shariah principles, as noted by Interviewee B:
[] subject to the restrict requirement to ensure that its (derivative) in line with shariah
principles. So, as long as derivative are structured in such a way that its in compliance with the
shariah principles/shariah requirements, there is no shariah prohibition to do that.
The aforementioned arguments contradicts with Ahmad and Halim (2014) who
considers the use of derivative is open to opportunities for gambling and speculation.
Because the speculative uses of derivatives are greater than its hedging uses, it is less
useful for risk management and is therefore contradictory to maqasid al-shariah.
Interviewee C justified the need for derivatives in Islamic banks and financial
institutions. This is consistent with Bacha (2004) who indicated that the necessity for
hedging instruments in Islamic finance industry because of future price movements:
From my research, Islamic derivative have been allowed mainly because of necessities and
there is a need for risk mitigation. Banks need instrument for risk mitigation. Otherwise, there
will be a lot of losses incurred. [] so, you need some kinds of instruments that can help banks
manage the risk and also consumer to manage the risk, especially when they come to currency Shariah
risk. Otherwise, these costumers will go to conventional banks! issues,
Another the important issue highlighted by the interviewees is the basis for prohibiting challenges,
and allowing the use of derivative instruments from the shariah point of view. The and prospects
interviewees views supported the findings in Islamic financial literature that argued for
the use of derivatives, but with the prerequisite that it be used only for hedging and risk
management, and that any hedging must be associated with real economic activities. 181
(Al-Suwailem, 2006; Elgari, 2010; Ahmad and Halim, 2014). In this regard, Interviewee C
expressed that:
Its used only for hedging purposes [] the Islamic derivative, the underlying must be halal.
The contract must be shariah compliance. And the minimize gharar by specifying all the
requirements. So, its controlled. As compared to conventional, its controlled.
Interviewee E also held similar views, arguing that the basis for allowing derivatives are
merely to mitigate risks:
We have to mitigate our self. So, can we say, we cannot mitigate yourself, we have to be fully
expose to that risks! Islam encouraged us to protect our self from further harm and further
damage. So that is the first reason why we say the Islamic derivative should be encouraged,
but for the mitigate purposes.
More specifically, Interviewee E described the basis for allowing derivatives is because
of the necessity to safeguard from risks faced by conventional banks, as both operate on
the same economic horizon. This is consistent with previous arguments that, in the
current financial system, without instruments to mitigate risks, particularly during
economic downturns, would see an exodus of Islamic finance practitioners toward
conventional finance. As said by Interviewee E:
Why we need derivative in Islamic finance? Firstly because, just like I said, we are operating
our self under the umbrella of conventional finance and conventional monetary system. In
conventional monetary system, the currency always changes. They are changes in their value
and that hurt a lot, and that create damages, and that create risks. So how we can say to the
Islamic financial institutions not to do anything and just tawakkal alallah. No! So we have to do
something to mitigate that risks because of undesired risks. Secondly, if we are to say that
Islamic derivative is no way to be approved, we are actually, in the long-term we will kill
Islamic financial institutions. Because that will be no matched to the conventional finance.
Conventional finance, they have these tools to mitigate their risks. When the risk is low, so they
can offer the better price. For Islamic finance, if they dont have these tools [] so they will lose
in the battle field.
Overall, the interviewees showed intimate understanding of the basis for allowing
derivative products from the shariah point of view. According to the interviewees, for
derivatives to be approved for use in Islamic finance, it should be designed for risk
mitigation/hedging purposes and both the contracts and underlying products must be
halal. Interviewee B discussed the shariah parameters of Islamic derivatives, as
released by ISRA:
the underlying contract in Islamic derivative and the underlying assets are
shariah compliant;
the use and mechanism of Islamic derivative is not for speculation and gambling
but for hedging purposes only;
QRFM the risk on derivative instrument should be always linked with the underlying
8,2 asset; and
the transaction based on the real underlying risk rising from real investment.
Aside from the criteria for shariah-compliant derivative, the interviewees also
highlighted reasons hampering the adoption of derivative instruments in Islamic
182 finance. Interviewee D was more concerned on the uncertainty and possible injustice
arising from derivative contracts that make derivatives impermissible. He expressed
that:
The prohibition is very clear, to avoid any uncertainty or any injustice to contracting parties
because we buy something which is not in existence.

Moreover, Interviewee B and C shared common ideas that the development of Islamic
derivative was hampered by its investment and speculation possibilities. Islamic
derivative should be utilized only for hedging and not for other purposes as said by
Interviewee C:
Islamic derivative are used purely for hedging only. Islamic derivative should not be used for
investment purposes. I dont know now whether some banks are allowing it, but as far as I
know from my research, the shariah scholars are quite strict, and they only want that the
Islamic derivative to be used for hedging purposes.
The aforementioned arguments is in line with Usmani (2010) who expressed that
derivative contract is totally impermissible, regardless whether these contracts are
entered for speculation or hedging. These views are also supported in Obaidullah (2002)
who argued that derivative products are prohibited because these instruments are
transacted for speculative purposes.
Furthermore, one of the issue that was given high emphasis by interviewees is the
divergent legal opinion among shariah scholars on derivatives (Ayoub, 2013; Elgari,
2010). Interviewee A opinions that the differing understanding between scholars will
lead to different opinions and fatwas:
The divergence of fatwas will depends on the understanding of the scholars with regards to the
issues. And we need to understand that for the scholars to give their opinions, they must first
understand the product very well. There is a principle stated that al-hukmu ala shaih, faruun
antasa wurihi, the law regarding certain object is strongly based on the understanding. So if
we understanding the product well, then we can give the correct opinion or the correct fatwa.
But if we dont understand the product and we just based on theoretical understanding, then
we might have the wrong understanding in giving the opinions. The divergence in view of
Islamic products, then we should go back to scholars who are in depth in Islamic financial
market, or for the practitioners in Islamic financial market, and who have a long experiences
and history in Islamic finance.
This argument is strengthened by Interviewee C whom explained that different juristic
school of thoughts in Islam would lead to different legal opinions:
Why there is a divergence? In Fiqh, we have different schools. Some schools may allowed. To
certain extent, for example, if you look at the Hanafi school, they are actually allow khiyar or
hilah, the legal tricky. But if you look at Maliki School they dont allowed it. In Shafii school,
does not recognized it and does not endorsed it.
In contrast, Interviewee B indicated that there are no dispute of legal opinions (fatwa) Shariah
among shariah scholars on derivatives. A majority of the scholars allow these issues,
instruments to be utilized in the market, based on the permissibility of either the challenges,
products or the underlying contracts:
and prospects
I dont think there is a divergence on fatwas. I think you cannot just refer to the fatwas on
derivative; you also refer to the fatwas of Islamic hedging involving derivative. Because you
see, there are some fatwas issued by the Middle Eastern based organization which allowed 183
Islamic hedging instruments. [] if you refer to the underlying contract as well, commodity
murabahah which is also permitted by the Middle Eastern based organization. So I dont think
so far, as far as I was concerned, there is a divergence of fatwas in term of the permissibility
and impermissibility.
In general, the interviewees were in agreement that the different legal opinions (fatwas)
on derivative products was because of different understanding of derivative products
among shariah scholars. However, only one of the interviewee had different view,
perceiving that there was no dispute in Islamic legal opinions on derivatives.
4.4 Controversies in Islamic derivative products and contracts

The assessment for the shariah compliance for derivative instruments has been
heterogeneous at best; shariah scholars have not come to an agreement on the
interpretation of derivatives because of its complexity. Although different madzhab
(school of thought) provides guidance on the interpretation of these instruments, no
consensus has been reached for the eligibility of derivatives use in Islamic finance, even
between scholars from the same madzhab. This section examines the issues
surrounding contemporary Islamic derivatives akad (contract) and products.
The interviews evidence that all interviewees are aware of the controversies
surrounding the underlying contracts or shariah compliance of derivative products.
The interviewees are on the same page with previous studies on the controversies
surrounding waad (promissory) contracts (Al-Saati, 2002; Bello and Hassan, 2013;
Wisham et al., 2011). Interviewee C believes that foreign currency exchanges with a
waad, as its underlying contract is still a markedly controversial product:
FX (foreign exchange) Waad, in my opinion, its quite controversial. [] its not been permitted
in Malaysia yet, shariah scholars have not allowed it, but its been used in Middle East. It is
structured whereby the fees is paid by the customers. When the customers give the waad, the
customers give the fees. Its option actually. And it is up to customer whether or not in
the future to exercise the waad. Promised is made. The banks must own the promise if the
customers decide to do so. Promise is made up front and the fees is paid up front. And the other
latter day the customers will see if it is favourable for him, he will exercise it or not exercise it.
[] it is usually used for currency exchange. For example costumer is not sure what is the
currency exchange rate of USD will be, Malaysian to USD in the future, so you can make the
promise to sell it at certain rate in the future. And in the future, if it is favourable to you, you can
exercise it. But the fee is paid. And that fee paid for waad is what is controversial. Whether or
not you can pay a fee for a right. Some scholars said yes, some scholars say no. Because it is not
a mal, it is not a properties.
Similarly, Interviewee B also sees waad as a controversial underlying contract. He
points on the IPRS as a more controversial shariah-compliant derivative with a waad
as its underlying contract and expressed that:
QRFM If you asked me one of the most controversial products that many shariah scholars are not
comfortable with is IPRS. Because in IPRS involve unilateral binding promise or we called
8,2 wadan. One of the scholars from USA, Yousuf Talal DeLorenzo, argued that how can the
promise can make profit. You can generate profit in IPRS by simply putting your promise. If
you argue that the promise is not the contract meaning that the promise will not affect
anything, will not generate any income/profit. But in IPRS, the promise will give you the
profit/return just using that kind of promise. So, the use of promise/waad should be used in
184 very prudent manner, because if you allow this for all kind of products meaning that
everything in conventional products can be structured by using waad, because waad is just
like magic tick that you can use for any reasons/objectives/motives/purposes. You can easily
legitimate riba by way of promise.
In most cases, the interviews shared the general agreement that waad contract is
problematic for structuring derivatives. According to Usmani (2010), the waad contract
is a contract which one party promises to fulfill an obligation at a certain future time,
such as to pay certain amounts or to buy particular goods. Abdullah (2010) argues that
waad, in fiqh muammalat, is a promise which express the willingness of a person or
group to purchase particular product.
Usmani (1999) argued that derivative instruments are impermissible in Islamic
financial transactions because these instruments are similar to bay al-kali bil-kali (the
sale of one debt for another) which is prohibited by Islamic law. Studies have revealed
that the maxim of bay al-kali bil-kali has been turned into a focal point among shariah
scholars which led to the prohibition of derivative (Al-Suwailem, 2006; Kamali, 2007;
Al-Amine, 2008). Interviewee E viewed that waad contract has a problem in structuring
Islamic derivative products because of it having features of bay al-kali bil-kali:
[] from the hadith bay al kali bil kali, so the prophet Muhammad (pbuh) prohibited purchase
with delayed delivery and payment. Futures and forward fall under that category, so they say
this is haram. In order to make it halal so Islamic financial institutions will not subscribe to
these products, they have their own products based on waad basis. So, yes, waad can be quite
controversial as well. But for this moment, it can be the way out; exit, or makhraj. So when I do
waad, for example, I will purchase a dollar from you at the latter date with the price of lock-in
price. Only one party make the promise, the other party will not do any promise. So when one
party do a promise and binding on me, not binding on you, so majority of the scholars say now
it is halal. So, that can replicate the conventional effect of futures and forward.
These arguments contradict Abdullah (2010) who argued that the use of waad is
necessary for risk mitigation instruments to ensure the parties commitment hold their
end of the contract. Practically, the waad contract is used in Islamic banking as a show
of commitment between parties to execute the contract, subject to certain conditions. As
an example, a waad should not include a bilateral promise; a promise that is binding to
both parties, as noted by Interviewee D:
This waad is permissible. This is regarded to be like a promise, a unilateral promise, one-sided,
waad from one party. Not bilateral promise! [] the unknown two parties. This is not two
parties or bilateral promises. But one sided or one unilateral promise which does not along to
a contract. So we have shariah issues if its binding from both parties.
Similarly, Interviewee E also mentions the problems arising from bilateral promises:
Waad is the entrance of the commodity murabahah. Waad to give the commitment to do
trading in the future. [] Waad, if it will be issued by one party, there is no problem. But some
institutions in Malaysia they are off their opinions that both parties based on waad are also
acceptable. So, that is the controversial part! Because Securities Commission of Malaysia Shariah
agreed that there is no problem with the double waad from both parties even though they are
binding. But, Middle Eastern scholars normally feel that this is problematic. That is almost issues,
alike the conventional forward and future. So thats why they reject Malaysian products. challenges,
In contrast, Interviewee B argued that both unilateral and bilateral waad can be used in
and prospects
structuring shariah-compliant derivative products:
The concept of waad/promise either it is unilateral binding promise or two lateral binding 185
promise can also be structured together in Islamic derivative.
Another issue highlighted by interviewees is the labeling of derivatives as Islamic.
Some questioned the using term Islamic to describe derivatives as problematic and
inaccurate, as expressed by Interviewee E:

As for the name, the Islamic derivative, for my opinion, it is also not quite accurate. You cannot
say Islamic derivative actually. It is not Islamic derivative but we called it Islamic derivative
just to give to the general public that these products can matched some of the conventional
derivative.
Specifically, Interviewee E argued that this is problematic because the value of Islamic
derivatives is derived from trading activities, whereas conventional derivatives derive
its value from its underlying assets. The term Islamic derivative was coined solely to
demonstrate that Islamic finance also has instruments that can replicate the effects of
conventional instruments:
There is no name actually. Its only trading. For Islamic derivative, all of the Islamic derivative
engine are based on what we called trading. So the trading effect will help to hedge the
institutions. So can we called it derivative? I dont know. Its not derivative because derivative
derived their value from the other things, but these one derived their value from the trading.
The value is coming from the commodity that will be traded. So its not derivative per se. But
we just called it Islamic derivative to give idea that the impact of the product can replicate the
conventional derivative.
In the same context, Interviewee D also expressed:
I dont regard to be Islamic. Because like options they are there in the market. Future, options
they are there in the market [] the majority dont regard them to be Islamic and then [] most
of the banks, for example, Islamic banks they dont regard these to be a valid or permissible
instrument investment avenue. You cannot regard these to be a means to make profit for
investment.
According to the interviews, the labeling of derivatives as Islamic is inappropriate,
because of the derivatives characteristics. Islamic derivative applies different
epistemological properties compared to conventional derivatives. Islamic instruments
are created solely for risk mitigation purposes, with its value derived from trading
activities. Therefore, these products cannot be used for speculation or investment.
4.5 The challenges and prospects of Islamic derivative

After examining the controversial issues surrounding the derivative products and its
underlying contracts, we attempt to address the current challenges and future prospects
of shariah-compliant derivative instruments. The primary challenge concerns the
permissibility of derivative use. The divergent opinions on the acceptability of
QRFM derivatives in Islamic finance from different jurisdictions is a point agreed upon by most
8,2 interviewees in this study, including Interviewee B:
I think the challenge in structure Islamic derivative is that not all jurisdictions may approve/
accept some of the shariah contracts used. For example, in the case of Indonesia, there is some
restrictions/constraints to apply for commodity murabahah or for tawarruq. So that,
derivative market is not well established as in the case of Indonesia. So the challenge is in term
186 of internationalization of products. So how structure can be accepted across jurisdictions, its
one of the challenge.
Another challenge highlighted by interviewees is the understanding of market
mechanisms and product regulations, as mentioned by Interviewee A:
The challenges, firstly, to understand the products and also to understand the market. Because
the market functions today is not as the same as what the market function 1,400 years ago.
How the market runs today? Its extremely regulated. Any financial product that is offered in
the jurisdictions in a country will have to be regulated by the central bank. All financial
products are extremely regulated by the central regulatory body. Previously, 1,400 years ago,
there were no such regulatory bodies. When you look in the global system, there are also global
financial bodies that ensure the regulation of these products. Its very tightly need system. Our
understanding of Islamic financial products cannot be taken as products per se. We must take
it as its part of the system.
Interviewee E placed more emphasis on the technical aspects of derivatives, particularly
on the difficulties of operating shariah-compliant derivative because of the small size of
Islamic banks:
The challenge is the size. Because in order to make the derivative, normally derivative means
that you are distributing the risk between the other institutions. Now you are having these
risks, you are to transfer this risks to another parties, maybe some of them. But unfortunately
because the size of Islamic financial institutions is still small so they may have difficulties to
find partners to do a square off.
Because of the inability of Islamic banks to bear high risk exposures, they would still
need to rely on conventional banks and conventional instruments, as said by
Interviewee E:
So Islamic derivative, you will have difficulties because the chain of Islamic financial
institutions is not so strong at current time. So some times, for example Standard Chartered
Saadiq, they are Islamic bank, they do derivative with you but they will do the derivative to
square off their position with the Standard Chartered conventional bank their parent bank. So
they are still need a help by the conventional bank. [] for example, if you have the exposure
of RM100 millions of currency risk, you want to do derivative with Islamic banks, very little
Islamic banks can take that risk. Its so big amount for them. But for conventional banks,
RM100 million is nothing!
Notwithstanding the challenges facing Islamic derivatives, interviewees were
optimistic of the prospects of these instruments in the future. This is because of the
tremendous increase in Islamic derivative products and its use within Islamic financial
institutions, as expressed by Interviewee E:
The uses of derivative within Islamic financial institutions today are growing fast in many
products. If you dont have these products you will lose the battle.
In addition, Interviewee B also expressed positive views on the development of Islamic Shariah
derivatives and hopes that it could be structured in a less controversial manner, from a issues,
shariah perspective: challenges,
With the establishment of dedicated institutions for Islamic finance like INCEIF, most of the and prospects
universities offering Islamic finance program, I believe there will be additional talent for
Islamic finance, for the shariah scholars in Islamic finance in the future that can bring and
offer the structure of the Islamic compliant products including Islamic derivative [] So 187
moving forward, I still believe that Islamic derivative can be structured in more acceptable
manner avoiding some controversial issues like the use of waad/urbun/commodity murabahah
in the coming of new talents in Islamic finance.
In contrast, Interviewee C holds a pessimistic view on the future of Islamic derivative

and disagreed that Islamic derivatives would flourish as an investment product, as it
could enable yet more speculation and gambling. Rather, Islamic derivatives should
function merely as a hedging and risk mitigation instrument:
Derivative or Islamic derivative in my opinion should be left to hedging alone. I am not keen on
extending their function to the investment. In my opinion, the prospective or the future for
Islamic derivative should be very narrow.
5. Conclusions and recommendation

This study provides insight of shariah scholars perceptions and experiences on
shariah issues, challenges and prospects of Islamic derivatives. The findings showed
that the interviewees have comprehensive insights and awareness of the current
shariah issues facing derivatives. The interviews criticized the derivative practices in
conventional finance; its use for speculation and gambling that could jeopardize the
financial system, with only a minority of conventional derivatives being used for its
intended purpose, hedging and risk management. Additionally, hedging via
conventional derivative products is a practice that is not in agreement with maqasid
al-shariah as conventional instruments involves an unacceptable level of gharar. For
these reasons, the interviewees agree that conventional derivative cannot be utilized in
Islamic finance for hedging.
Interviewees reflected on the criticisms surrounding Islamic derivative products and
underlying contracts. Most of interviewees agreed the use of that waad contracts to
structure IPRS and foreign currency exchanges are problematic. Philosophically, the
labeling of derivatives as Islamic is also seen as problematic because of the differing
epistemological properties attached to these instruments; its shariah compliance and
hedging-only purpose.
A number of challenges faced by Islamic derivatives were gleaned from the
interviews:
the divergent opinions on the permissibility and approval of derivatives use from
differing jurisdictions;
the understanding of market mechanisms and product regulations; and
the difficulties of operating shariah-compliant derivative because of the small
size of Islamic bank.
QRFM Meanwhile, the interviewees are also optimistic about the growth and development of
8,2 Islamic derivatives in the future.
The findings of this study is relevant to practitioners, policymakers and regulators as
the first study in Malaysia to investigate Islamic derivatives shariah issues, from
shariah scholars perspective. This study contributes to the literature on risk
management and derivatives in Islamic finance and is hoped to guide Islamic financial
188 institutions in establishing more shariah-compliant derivatives. This study is limited
by its sample size; five interviewees and future studies should have increased sample
sizes for richer and more meaningful analyses. Future studies should also triangulate its
results with quantitative data and use mixed-method techniques to produce more robust
results.
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Corresponding author
Muhammad Rizky Prima Sakti can be contacted at: sakti.finance@hotmail.com
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Qualitative Research in Financial Markets

Shariah issues, challenges, and prospects for Islamic derivatives: a qualitative

Qualitative Research in Financial Markets, Vol. 8 Iss 2 pp. 168 - 190

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Another legal maxim on ownership axiomatic to the discourse on derivatives relates to

3.4 Data collection

4. Findings and discussion

Interviewee Gender Education Nationality Affiliation

A Male Master Singaporean Zayn Associate Singapore

4.2 Criticism of conventional derivative

hedging alone. Depending on the risk appetite of investors, it can be utilized as a

financial transactions (Usmani, 1999; Al-Suwailem, 2006). Furthermore, the arguments

4.3 Shariah issues on current Islamic derivative practices

because we buy something which is not in existence.

4.4 Controversies in Islamic derivative products and contracts

inaccurate, as expressed by Interviewee E:

4.5 The challenges and prospects of Islamic derivative

In contrast, Interviewee C holds a pessimistic view on the future of Islamic derivative

5. Conclusions and recommendation

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