Reconciling the Impermissibility of Conventional Options Contracts with the Bai’ al-Urbun

This commentary explores the nature of Sharī’ah arbitrage, using the bai’ al-urbun to highlight the dynamism of modern Islamic financial engineering processes.

One need not look far to find critics of modern Islamic finance practice. Many have opined on its ineffectiveness, whether real or perceived, and on the inability (or unwillingness) of practitioners to privilege conventional economic products over other, often less profitable, Sharī’ah-compliant tools. Timur Kuran famously argues this point, claiming that inefficiencies in Sharī’ah-compliant finance have blocked “transformations essential to global competitiveness” and limited the availability of those “rhetorical toolkits” which are essential prerequisites to financial modernization and innovation.[1] In contrast to such views, I argue that the process of Sharī’ah arbitrage evidences an industry that is not organized in opposition to transformation, but is instead driven by it. For example, the widely accepted prohibition against engaging in the conventional derivatives market by way of an option contract appears to bolster the picture of Islamic finance practice as anti-global and anti-modern in orientation. However, the development and subsequent use of the ‘urbun contractual form – created through the process known as Sharī’ah arbitrage – counters such a monolithic, concretized vision of Sharī’ah-compliant finance. The ‘urbun illustrates the extent to which Sharī’ah arbitrage is enacted in the modern context and demonstrates the dynamic engineering of conventional finance products in order to meet standards of Sharī’ah-compliance.

In conventional finance, the derivatives market plays a significant role in the generation and accumulation of wealth (i.e. speculation), and in the allocation and transfer of risk between parties (i.e. hedging). In particular, the options market allows one party the right to buy or sell a specific quantity of an underlying asset at a predetermined price within an allotted time or on a certain date. Conventional options contracts are objectionable from a Sharī’ah-compliance perspective because first, as most classical jurists opined, the uncertainty in an option contract as to whether a buyer will ultimately conclude the transaction constitutes gharar.[2] Second, though certain options-like rights such as revocation and inspection are indeed countenanced under Islamic law, these elements cannot be legally separated from the underlying agreement and then contracted around, as is common practice in the conventional options market.[3] The modern fatawa cited herein [Link to IslamOnline Fatwa and Link to IslamWeb Fatwa] are similarly unequivocal with regard to the impermissibility of options. As will be described below, however, inventive financial engineering has produced a workaround in the form of the modern ‘urbun.

In the ‘urbun contractual form, buyer pays seller an agreed upon amount (akin to a down payment) in advance of the exchange of an asset. At the time of exchange, buyer can elect to complete the sale at the previously agreed upon price or leave the transaction incomplete, with the down payment forfeited to seller as a gift. If the sale is in fact undertaken, the price to be paid is equal to the agreed upon purchase price less the amount paid to enter into the ‘urbun contract in the first instance. This represents a significant divergence in the ‘urbun contract from the conventional option contract, as the latter requires full payment of the strike price at exercise without reference to the amount initially paid for the option. Arguably, including the down payment in the ultimate purchase price may incentivize ‘urbun purchases in those cases where the decision to exercise depends on real world variables (i.e. whether purchaser of the ‘urbun actually has an interest in possessing the underlying asset) at least as much as in those instances in which purchaser is only interested in profiting from price fluctuations. It can be said, therefore, that from a buyer’s point of view the ‘urbun’s incentive structure militates toward Sharī’ah-compliance by encouraging a non-speculative use of the product.

There exist a number of challenges with regard to both the ‘urban contract’s efficacy as compared to conventional options and to its legality under Sharī’ah law. First, from the ‘urbun seller’s perspective, that the down payment constitutes a portion of the final price in the case that the contract is enforced, rather than as a profit on top of purchase price, renders the ’urbun far less attractive than a conventional option contract. Seller only stands to profit if the ‘urbun is not exercised during the agreed upon period. If purchaser chooses to exercise the option granted under the ‘urbun, seller will not be additionally compensated in any way for his entrance into the initial agreement. Second, some argue that the ‘urbun is problematic because seller is not sufficiently compensated for the period during which he cannot sell or use the underlying asset to his benefit.[4] Third, seller holds the premium paid for the ‘urbun during the earnest period between contract formation and sale, which itself can be viewed as an impermissible misappropriation of property.[5]

Despite the potential for contrasting views on its Sharī’ah–compliant status and the widespread prohibition of its closest conventional analog, the options contract, contemporary jurists have come to a consensus on the permissibility of the ‘urbun in modern Islamic finance practice. Of course, there is a cognizable claim to be made that the ‘urbun is a product of creative financial engineering which, while perhaps adhering to the general form of Sharī’ah-compliance, does not truly comply with the spirit of Islamic finance. When considering the broader implications of accepting products like the ‘urbun, however, jurists, academics, and practitioners would do well to view these arbitraged tools through the lens of their practical efficacy. Though the ‘urbun contract may blur the lines between conventional derivatives and Sharī’ah-compliant practice, I believe widespread use of such arbitraged products will engender greater industry standardization and, paradoxically, serve ultimately to increase confidence in the Sharī’ah foundations of Islamic finance tools and products.

Those who subscribe to the view of Islamic finance as a concretized and unyielding approach to finance in a globalized society are ignoring the ingenuity that is central in industry practice today. As exemplified herein by ‘urbun contract, the industry is certainly engaged in growing and evolving financial tools that can be used to approximate the returns of conventional finance and to further expand the scale and scope of the Islamically-mediated market. Contemporary Islamic finance practitioners must highlight the creativity employed and harnessed in the development of these tools in the modern context. Islamic finance is not stagnant and unresponsive to the needs of modern financial actors. The sector is in constant conversation with both its conventional financial analogs and its classical juridical base in an effort to move the industry forward. Thus, the more pressing inquiry actually revolves around whether Sharī’ah arbitrage produces a framework for modern Islamic finance that is devoid of the ethical-religious values meant to underpin the industry. That question, however, turns not on any academic theory, but on the individual and his purpose in participating in the Islamic, rather than conventional, finance market in the first instance.

 

[1] Timur Kuran, The Long Divergence (2011). 279.

[2] El-Gamal, Mahmoud E. Islamic Finance: Law, Economics, and Practice (2006). 91.

[3] Eds., Kabir Hassan and Michael Mahilknecht, Islamic Capital Markets: Products and Strategies (2011).

[4] El-Gamal, 92.

[5] Obaidullah, Mohammed. Financial Engineering with Islamic Options. Section 2.3.