There is a wide use of financial derivative in the current finance markets. The derivatives are those financial instruments that derive their value from an underlying actual asset and these are actually the contracts made between parties based on some future delivery dates.
Those derivatives that involve any kind of ribbah (interest) based transactions are already out of the Islamic financial system because dealing in interest is haram (prohibited) act in Islam. Before going into the discussion, first take a look at a hadith (saying of MUHAMMAD S.A.W.W) regarding trading In advance, and then the discussion on the derivative’s use will be furthered.
Sahih bukhari: Volume 3, Book 35, Number 451:
Narrated Abu Al-Bakhtari:
I asked Ibn Umar about Salam (the fruits of) date-palms. He replied, "The Prophet forbade the sale of dates till their benefit becomes evident and fit for eating and also the sale of silver (for gold) on credit." I asked Ibn 'Abbas about Salam for dates and he replied, "The Prophet forbade the sale of dates till they were fit for eating and could be estimated."
The hadith mentioned above talks about one very basic and important aspect of trading. We cannot sell what we do not have. How can we sell dates when they are not ripened yet, or when they are still on trees? Similarly, we cannot sell or buy an asset which we do not possess or about which we are uncertain. This hadith tells us that do the trade of that tangible asset that you have in hand and that you measure or at least try.
In another hadith , another aspect of the dealing in advance has been shown:
Sahih bukhari: Volume 3, Book 35, Number 443:
Narrated Ibn 'Abbas:
The Prophet came to Medina and the people used to pay in advance the price of dates to be delivered within two or three years. He said (to them), "Whoever pays in advance the price of a thing to be delivered later should pay it for a specified measure at specified weight for a specified period."
Similarly, in another hadith, it is said that
Sahih bukhari: Volume 3, Book 35, Number 455
Narrated Ibn 'Abbas:
The Prophet came to Medina and the people used to pay in advance the prices of fruits to be delivered within two to three years. The Prophet said (to them), "Buy fruits by paying their prices in advance on condition that the fruits are to be delivered to you according to a fixed specified measure within a fixed specified period." Ibn Najih said, " ... by specified measure and specified weight."
So, in islam, the dealing can be made even in advance payment for those items which can be measured and can be delivered on the due date. Here an important thing to be noted is that unlike today’s contracts, the contract permissible at the time of messenger of ALLAH swt were paid in advance.
Holy Quran also speaks about the contracts made based on future transactions. It is mentioned in:
surah Al-bakrah: 2:282
“Oh you who believe! When you contract a debt for a fixed term, reduce it to writing. Let a scribe record the terms in a fair manner. The scribe whom Allah has taught to write should not refuse to write. He should record (the transaction). The one who incurs the debt should spell out the terms. He should fear Allah and not omit anything. If the borrower lacks understanding, or is feeble (minded), or is otherwise unable to dictate, then his guardian should dictate (the conditions of the loan) in a fair manner. Call upon two of your men to act as witnesses (to the contract). Should two men not be available (to act as witnesses), then take one man and two women _ if one of them errs, the other would remind her _ that are acceptable to you as witnesses. The witnesses should not refuse if called upon to testify. Do not neglect to write down (all) the (specific) terms (and provisions) of the contract, be they small or big. That, according to Allah is a more reliable evidence, and more likely to dispel doubts (and suspicions). You bear no sin if you fail to record the on-the-spot exchange of goods for cash, that goes on between you (all the time). But, take witnesses when you enter into a commercial contract. Do not harass or harm the scribe or the witnesses. It would be wicked and immoral for you to do so. Fear Allah! (Of course) Allah teaches you (righteousness). Allah has full knowledge of every single thing!”
The verse quoted above speaks about two aspects, number one is to write down a written and tangible contract whenever one undergoes into any business deal or debt second is the thing described is that there is no need of writing down of daily transactions that are made as a daily matter.
Opinion of Scholars
We know that all the future transactions based on financial derivatives involve at least one risk. The most common risk in such trades is the risk of default. Second thing is that these deals are even made when one party does not have in hand, the asset for which it is dealing which increases the risk to a great extent. The risk factor whenever involved in the business or in any deal makes it uncertain. This uncertainty has been addressed by different schools of thought as below.
The Holy Qur’an prohibits gambling (games of chance involving money), and “bayu al-gharar” (trading in risk, where the word gharar is taken to mean “risk”). Different schools have differing interpretations, of which the three major interpretations are:
The Hanafi madhab (legal school) in Islam defines “gharar” as “that whose consequences are hidden”;
The Sjafi legal school defined “gharar” as “that whose nature and consequences are hidden” or “that which admits two possibilities, with the less desirable one being more likely”; and The Hanbali school defined it as “that whose consequences are unknown” or “that which is undeliverable, whether it exists or not.”
The modern scholar of Islam, Professor Mustafa Al-Zarqa wrote that, “gharar is the sale of probable items whose existence or characteristics are not certain, due to the risky nature which makes the trade similar to gambling”. There are a number of “hadith” (traditional sayings, many of the Prophet) that forbid trading in gharar, often giving specific examples of gharhar transactions (e.g. selling “the birds in the sky or the fish in the water”, “the catch of the diver”, “an unborn calf in its mother’s womb”, “the sperm and/or unfertilized eggs of camels”, etc.). Jurists have sought many complete definitions of the term. They also came up with the concept of yasir (minor risk); a financial transaction with a minor risk is deemed to be halal while trading in non-minor risk (bayu al-ghasar) is deemed to be haram.
Though, the written contract, as prescribed in Quranic verse given above, makes it a legal binding on the payee party but then, in the modern day transactions, many payee parties were defaulted or they disappeared causing huge losses to the other party.
The scholars are divided over the issue of Islamic derivative. Some of them make their use an haram (impermissible) and others consider it halal (permissible) by quoting the ahadith and base their opinion on them.
On Futures there are two opinions:
Mufti Taqi Usmani of the Fiqh Academy of Jeddah in an article answering a set of posed questions on the topic (New Horison, June 1996, pp 10-11), argues that futures contracts are invalid because:
"Firstly, it is a well recognized principle of the Shariah that purchase or sale cannot be effected for a future date. Therefore, all forward and futures contracts are invalid in Shariah; secondly, because in most futures transactions delivery of the commodities or their possession is not intended. In most cases the transactions end up with the settlement of the difference in price only, which is not allowed in the Shariah."
Conversely Fahim Khan (Islamic Futures and their Markets, Research Paper No.32, Islamic Research and Training Institute, Islamic Development Bank, Jeddah, Saudi Arabia, 1996, p.12) states that:
"we should realize that even in the modern degenerated form of futures trading, some of the underlying basics concepts as well as some of the conditions for such trading are exactly the same as were laid down by the Prophet (PBUH) for forward trading. For example, there are clear sayings of the Prophet (PBUH) that he who makes a Salaf (forward trade) should do that for a specific quantity, specific weight and for a specified period of time. This is something that contemporary futures trading pays particular attention to." (Fahim Khan does go on, however, to criticize the modern futures contract for its exploitation of small farmers.)
On Options, there are again are divided opinions of scholars:
A number of scholars have found option contracts objectionable (Ahmad Muhayyuddin Hasan, Abu Sayman and Taqi Usmani to mention a few notable ones). However, in perhaps the most comprehensive study of the subject thus far, Hashim Kali (Islamic Commercial Law: An Analysis of Options, 1995), concluded that:
"there is nothing inherently objectionable in granting an option, exercising it over a period of time or charging a fee for it, and that options trading like other varieties of trade is permissible mubah and as such it is simply and extension of the basic liberty that the Quran has granted."
These two derivatives have been discussed in detail because they involve very less chances of risk that is present in everything we do daily, but even these types of financial derivatives are not liked by many muslim scholars. This issue could be solved only when there is IJTEHD of ulema over this issue. And ijtehad can be done only when due attention and understanding is given to this aspect of shariah ruling.
Holy Quran: 2:275
(On the Day of Judgment), those who take (the income from) interest and usury would not (be able to) stand straight. (When resurrected), they would stand like a crazed and confounded man _ as if Shaitan had touched and afflicted them. That is because they say, “Usury (and interest) is just like (the profit from) commerce.” But Allah has permitted (the profit from) commerce, and He has prohibited interest (and usury). Whoever stops (taking interest) after he receives admonition from his Lord, will not be punished for his past actions. His matter rests with Allah. But those who persist shall be the inmates of the fire. There, they shall stay forever.
To conclude with, the above verse of Holy Quran says that interest (ribah) is not permissible because it is not profit, rather an extra amount earned with no specific business or any justified basis. So no business deal that makes one party pay more than the other or that involves those risks that can be avoided, are not permissible in islam.