Sharia and securities trading is the impact of conventional financial markets activity for those following the Islamic religion and particularly sharia law. Sharia practices ban riba (earning interest) and involvement in haram. It also forbids gambling (maisir) and excessive risk (bayu al-gharar).Farooq, Riba-Interest Equation and Islam, 2005: p. 3–6Khan, What Is Wrong with Islamic Economics?, 2013: p. 216–226 This, however has not stopped some in Islamic finance industry from using some of these instruments and activities, but their permissibility is a subject of "heated debate" within the religion.
Of particular interest are financial markets activities such as margin trading, short selling, day trading and derivative trading including futures, options and swaps which are considered by some as haram or forbidden.
History The Islamic banking and finance movement that developed in the late 20th century as part of Islamic schools and branchesUsmani, Introduction to Islamic Finance, 1998: p. 6 sought to create an alternative to conventional banking that complied with sharia (Islamic) law. Following sharia it banned from its practices riba (usury) – which it defined as any interest paid on all loans of money – and involvement in haram (forbidden) goods or services such as pork or alcohol. It also forbids gambling (maisir) and excessive risk (bayu al-gharar).
This meant that not only were interest-bearing loans, accounts, and bonds not allowed, but many financial instruments and activities common in conventional financial markets have been forbidden by most Muslim scholars because of their connection with maisir or gharar (and also sometimes because they involve payment of interest). These include margin trading, day trading, short selling, and financial derivatives such as forwards, futures, options, and swaps.
This, however has not stopped the Islamic finance industry from using some of these instruments and activities. While they often involve more risk than other investments and are used by speculators, they are defended as having useful economic functions. They are used in a large number of financial procedures, help manage risk and volatility (among other things), and provide incentives for employee productivity and innovation.
Scriptural basis The Quran states in aya 2:275 that "Allah has permitted trade and forbidden usury."Quran 2:275, SAHIH INTERNATIONAL translation But not all trade is allowed in Islam. The Qur'an prohibits gambling (maisir, games of chance involving money). While the Quran does not specifically mention gharar (risk), several hadith prohibit selling products like "the birds in the sky or the fish in the water", "the catch of the diver", or an "unborn calf in its mother's womb". These have been called bayu al-gharar (literally "trading in risk", defined as sales in which gharar is the major component).
Jurists have distinguished between this kind of forbidden gharar, and gharar considered minor (yasir) and so permissible (halal),An Economic Explication of the Prohibition of Gharar in Classical Islamic Jurisprudence |Mahmoud A. El-Gamal | First version: May 2, 2001 but disagree (according to at least one source, Abu Umar Faruq Ahmad), over what constitutes each kind, and have not agreed on an exact definition of the meaning and concept of gharar.
Fiqh The Hanafi and Shafi'i madhab (schools of jurisprudence) define gharar as "that whose consequences are hidden," the Hanbali school as "that whose consequences are unknown" or "that which is undeliverable, whether it exists or not." One modern scholar of Islam, Mustafa Al-Zarqa, defines gharar as "the sale of probable items whose existence or characteristics are not certain, due to the risky nature that makes the trade similar to gambling."
Instruments and services Commonly used financial instruments and practices that are often considered haram are: margin trading: borrowing money to buy shares of stock or other financial instruments; short selling: borrowing/renting shares of stock or some other instrument and selling it on the hope that it can be later repurchased at a lower price for a profit; day trading: very short term buying and selling of financial instruments; and derivatives: contracts that derive their value from the performance of an underlying asset; (These form a very large market. The "notional value" of the world's over-the-counter derivatives at the end of 2007, (according to the Bank of International Settlements) was $596 trillion. The gross market value of all outstanding derivatives was $14.5 trillion at the end of 2007.) The most commonly used derivative are: CFD: contracts where traders don't own any shares or commodities of an organization. In these contracts, a profit or a loss is made through estimation of the future price (almost identically to the case with purchasing a real stock); forwards: customized contracts to buy or sell an asset at a specified price on a future date. unlike futures contracts forward contracts are not traded on any exchanges; futures: a legal agreement to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future; options: contracts offering the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date); swaps: contracts through which two parties exchange financial instruments to transfer risk.
Forbidding Options, futures and "other derivatives" are "generally" not used in Islamic finance "because of the prohibition against maisir" (according to Thomson Reuters Practical Law). Margin trading, day trading, options, and futures are considered prohibited by sharia by the "majority of Islamic scholars" (according to Faleel Jamaldeen). Margin trading (because it involves borrowing money to buy what is being traded) involves interest payments in margin accounts, day trading (because it involves buying and selling financial instruments within the same trading day) is not concerned about the underlying product or economic activity of what is traded. One source (Investopedia) states "gharar is observed within derivative transactions such as forwards, futures and options, as well as in short selling and in speculation."
Derivatives Juan Sole and Andreas Jobst write that "legal scholars" have alleged that derivatives "contain excessive uncertainty (gharar)" and "encourage speculative behavior akin to gambling (maisir)". According to economist Feisal Khan, derivatives (essentially securities whose price is dependent upon one or more underlying assets) "fail" the tests of Islamically permissible by lacking `materiality` (i.e. a direct link "to a real underlying economic transaction"), and involving speculation. Furthermore, "almost all conservative Sharia scholars" have ruled that `when applied to modern financial contracts, the prohibition of gharar eliminates futures, options, and some life assurance contracts`".Khan, Islamic Banking in Pakistan, 2015: p.111 Taqi Usmani forbids most futures transactions because their "delivery or possession is not intended and therefore the niah [goal, purpose] of the contracting parties is questionable". Investopedia states "In Islamic finance, most derivative contracts are forbidden and considered invalid because of the uncertainty involved in the future delivery of the underlying asset.
Faleel Jamaldeen writes that the majority of Islamic scholars agree that options have features of speculation and gambling. In addition, the investor (second party) doesn't intend to hold the asset (which is generally considered crucial for an investment to be sharia-compliant). Based on these characteristics, most Islamic scholars believe that options are prohibited investments.
Short selling Raj Bhala calls the short selling of stocks an example of common financial trading forbidden by sharia law — forbidden because the short seller borrows rather than owns the stock shorted. Taqi Usmani gives short selling as an example of an economic activity banned according to "divine restrictions".Usmani, Introduction to Islamic Finance, 1998: p.11 According to Humayon Dar (CEO of a shari'ah advisory firm), there is "no dispute by all main scholars" that short selling is haram.
Day trading Jurist Yusuf Talal DeLorenzo notes in connection with injunctions against day trading that owning stocks for less than a day does not show a commitment to stewardship in ownership consistent with Islamic teaching. Focus Business Services of the UAE notes that the short period of "ownership" means day traders do not truly own what they trade, and furthermore pay interest, as marketable securities "generally have a multi-day settlement period, during which time the underlying instruments, while cleared, are not formally registered in the name of the purchaser. As day traders do not wait for settlement to complete, they are using a type of credit cushion provided by their broker."
Margin trading Faleel Jamaldeen includes margin trading as one of the activities prohibited by the "majority of Islamic scholars", the reason being it involves borrowing funds to invest, and the lender of the funds charges interest. Moreover, losses can be greater than the amount borrowed, because margin trading amplifies the risk to the investor, increasing as percentage of debt or leverage increases.
Defense and benefits On the other hand, some Islamic finance practitioners and critics find benefit in at least some uses of derivatives and short selling.
At least one scholar (Mohammed Hashim Kamali) finds "nothing inherently objectionable" in selling and using options, which like other kinds of trade (he believes) is mubah (permissible) in fiqh, and "simply an extension of the basic liberty that the Quran has granted".Kamali, M.H. (1997) "Islamic commercial law: an analysis of options", The American Journal of Islamic Social Sciences, v.14 n.3, pp. 17-18
Economist critic Feisal Khan points out the "current relatively strict interpretation" by ulama of ahadith related to trade and commercial transactions have a wide-ranging impact on basic bank functions since "virtually all" financial instruments involve the interest rate "in some way or form". Thus the "current relatively strict interpretation of the hadith related trade and commercial transaction" would ban "not only speculative financial transactions such as options and futures but also, for example, hedging by forward sale, interest-rate swaps, and any transaction involving items not physically in the possession of the seller (e.g. short sales) and all other forms of derivatives, i.e. financial securities that have no underlying real transactions.Khan, Islamic Banking in Pakistan, 2015: p.89Usmani, Introduction to Islamic Finance, 1998: p.106 ... Activities such as bill discounting and government debt issue with a fixed coupon rate, inflation indexing, securitized debt obligations, and foreign exchange dealings would also be prohibited unless cumbersome intervening steps reminiscent of the medieval contractum trinius are undertaken."Khan, Islamic Banking in Pakistan, 2015: p.90
Opposition by conservative Islamic scholars to use of derivatives as a form of gambling that violates sharia law exposes the Islamic Finance industry "to risks of increased volatility" when markets deteriorate, according to Y-Sing. Agil Natt, chief executive of the International Centre for Education in Islamic Finance, asks, "when does risk management end and gambling begin?"