TOWARDS AN ISLAMIC STOCK MARKET
MOHAMAD ELGARI
In the search for new approaches to transactions in conventional stock markets, which was started some few years ago, the aim has been to isolate the core and separate the basic substance. Once this is done, a Sharia point of view can unfold. It is only then that the right questions can be posed and a model that retains the essence can be developed with appropriate limitations and restrictions suited to an Islamic stock market within the parameters of the Sharia.
Options are an essential part of any modern market. Is it therefore possible to have a model, which is efficient enough to be a substitute for conventional options within the Sharia boundaries?
In financial and commodity markets, an option is a choice and is packaged as an instrument that can be traded in an organised market. Activists in the market are either sellers or buyers. Options, therefore, are designed to serve the needs of the players in the market, giving the right to sell or the right to buy in the form of a contract. In a stock market, a call option entitles the holder to buy a number of shares at a stated price on or before the date of expiry.
A put option, on the other hand, is the right to sell a number of shares, also on or before the expiry date. Th e option contract, therefore, creates an entitlement and an obligation. Th e party who receives the price, called the ‘option writer’, carries the obligation, while the party who pays enjoys the right. This right is either to buy or to sell.
The idea of options in sale contracts and other exchange transactions in general is not new. In these contracts the buyer or the seller gives the priority to conclude or walk out of the contract. What is different is the standardisation and listing of these options.
An option becomes an independent and self-contained contract. Th e standardisation of option contracts also includes the terms of the contract, which are designed on a cycle of a specific number of months, usually three.
Varieties of contracts in the market are quite limited, which makes them easier to evaluate and compare by traders. This creates an active secondary market. The emergence of a secondary market has been possible because there is no need for a direct relationship between the seller and buyer Each contract with an intermediary in the market is known as the ‘clearing house’.
The clearing house becomes the writer of the contract vis-a-vis the buyers, and the buyer of every contract vis-a-vis the writers. Needless to say, the clearing house will then guarantee the performance of each party against the other. The forces of supply and demand will always guarantee a price that clears the market, making the total obligation of the house no more than its total assets.
In a stock market, each contract gives an option to buy or sell a number of shares. The contract, however, is independent of the underlying stocks. It means that at the time of initiation of the contract, the writer and the buyer need not own shares, despite the fact that one is obliged to provide them on or before the maturity date. This is an important point to consider from an Islamic point of view.
Because their relationship is only with the clearing house and not with each other, each party can cancel their initial contract, and clear their position by writing or buying another opposing one.
For example, a writer of a call option is obliged to sell 100 shares on or before 30 October, at $15 each. He can cancel this position by buying an option contract, which gives him the right to buy 100 shares (of the same company) on or before 30 October. The second position will then cancel the first. This actually introduces a great deal of efficiency in the options market, reduces the risk undertaken by the option holder and increases the liquidity of investment in options trading.
It is well known that trading options is big business. This particular activity, however, is not under discussion. Rather, it is restricting the examination of options as part of a normal activity by investors in shares in a stock market.
Options produce many advantages for the market and to the participants in the market transactions. The principal effect of options trading is to alter the risk and reward in his overall stock investment. Owners of shares can no longer be held under the constraints of stock transactions bearing more risks than they actually prefer.
Furthermore, options enable investors to limit their portfolio risk by insuring against unfavourable changes in the prices of stocks they are holding. In effect, options can be used as investment insurance, hence options trading is a stabilising factor in the investment portfolio.
If no option is available, an investor would either sell his shares or take unwanted risks if he expects that the price of shares will fall.
With options he can keep his stocks and change the risk-reward trade-off through the purchase of a put option. If, on the other hand, the price is expected to go up, he need not wait until such event takes place, nor risk his investment by buying new shares. He is able to buy a call option that gives him the right to buy at the current price at a later time.
The idea of options in exchange contracts is well known in the Sharia. In fact, a chapter on options is a central part of any book on the contractual jurisprudence in Islam. There are no less than seven types of options in the Sharia. What is relevant to the discussion here is called Khyar Asshari or a contract with an option condition. There are, in fact, major differences between the Khyar Asshari option in the Sharia and the option model in modern stock markets.
In the Sharia, an option is a right that can only be a part of or a condition in, an exchange contract. In a sale contract, for example, there are conditions where one of the parties may keep for himself an option to execute or repeal the contract. Mr X may want to buy a certain automobile, while not giving the owner a final decision, in order to have some time to think it over.
After the price has been decided, he may advance a small portion of it. If he decides to go ahead with the purchase, the advance payment will be a part of the overall price. If he retracts, the seller is entitled to retain the advance as a compensation for giving the option to the buyer
In comparing the model of a stock option in the modern market with the form acceptable in the Sharia, the following three differences are worth noting.
Firstly, unlike the conventional option, the option in the Sharia is not detached from the exchange contract nor priced separately; needless to say, this is the most important difference. This, nevertheless, does not mean that such option is to be provided free.
Secondly, since the general rule of contracts in the Sharia declares that only tangible items can be the subject of an exchange contract, the subject of the option contract in the Sharia is only a right or an obligation. Abstract objects have no actual material existence and hence can have no price of their own in a standard Sharia position.
Thirdly, many Sharia scholars object to options trading because such contracts are believed to be very speculative. In their view, they sei-ve no useful purpose. Such contracts, to many people, are no different from roulette in a casino.
There is no denying the fact that options can be very speculative and can even be abused and manipulated. The rules and regulations governing options trading have been revised more than once in the United States of America, to ensure the existence of an environment consistent with fair and orderly markets which serve the public interest and protect the investors.
However, this is a misuse of the instrument and not the natural consequence of its existence. Needless to say, many legitimate objects can be used for illegal ends.
One can say that the model of modern option contracts has no parallel in known Sharia contracts. It is an established fact that the Sharia, unlike many secular legal codes, has no canon-style contracts. Known Sharia contracts are only a benchmark, which may serve as a guide to the rules governing contractual relationships.
What is significant is whether the contract is free of elements which generally nullify contracts in the Sharia. If the modern options contract does bear any of these elements, then it may be presumed incompatible with the Sharia. But if not, then contracts may be acceptable even if the model is a new contractual relationship that has no parallel in standard Sharia exchange contracts.
Four conditions which can nullify exchange contracts are: Riba, Gharar, sale of unowned goods and Jahala.
Riba is stipulated as any increase in a loan contract. This definition has been determined by Islamic scholars, who also define interest as a form of Riba. When an exchange contract includes such elements, it is illegal in the Sharia. While any exchange transaction, including options, may include interest in one form or another, the aforementioned option model need not have any Riba (interest) element.
Because modern financial market transactions are loaded with interest-bearing contracts, there is no way of judging the pure option model. This is to say that interest is not a fundamental part of the working of the model and it can function without it.
Gharar in the view of the Sharia arises when the rights and obligations of the parties to a contract are not well-defined from a contractual point of view. A good example of an exchange contract that is nullified in the Sharia because of gharar, is gambling. In gambling, one pays a price to initiate the contract. It is not clear at that point what the buyer is exactly buying. He may receive no gain or win a lump sum of money. The problem is that “a chance” is not an acceptable object in an exchange contract as it is not a material object, as mentioned above.
Exchange contracts in the Sharia ought to be free of such elements. One may say that an options contract is replete with gharar since the eventuality of the contractual relationship is not actually known, as it depends on whether the holder decides to exercise or forego it.
This, however, ignores the fact that what is being traded in an options contract is only the obligation and not the underlying stock. In fact, there is a type of option where the underlying object is only the stock index, which means that the option contract is not connected to any actual exchange of stocks but settled financially in money terms.
Sale of un-owned property: for sale contracts, to be valid in the Sharia, the contracts must deal in goods that are owned by the seller at the time of sale. If one sells goods that are yet to be purchased by him, the contract, from the Sharia point of view, is void.
It is obvious that the option contract does not have this problem, for the simple reason that no goods are being transacted in such contracts. One may say that the naked option contract, where the short sale of stocks is part of the transaction, does not have such a problem. It, therefore, makes little difference from the Sharia point of view whether an option is covered or naked.
Non-ownership of stock, it is thought, does not fall into the category of ‘sale of concerned property’, since the object of the contract is the right or obligation. Furthermore, a naked option is only one form of option and even if such options are banned, the efficiency of the market will not be affected.
Jahala and unacceptable contracts: there are other sources of contractual invalidity in the Sharia when, for example, the price or the condition of the object of the contract is not known to one party or both. Also, if the contract includes conditions that contradict the purpose of the transaction, such as selling goods with a condition that the buyer does not sell to a third party, it would be an invalid contract.
To establish the Sharia position vis-a-vis options contracts one needs to adopt the right approach. Firstly, there is the notion that the model of options contracts has no parallel in known Sharia-permissible contracts. While it is a sale, the subject of the contract is a right or obligation and not a material or tangible item.
The Fuqua, Islamic jurists, seem to be resolute that abstract articles cannot be the subject of sale contracts. However, when the rules of Fiqh are served, one may find many exceptions which can be used as a basis for designing a model of options contracts acceptable in Sharia. For example:
• Contemporary scholars have ruled that the company’s goodwill can be the subject of a sale contract, although goodwill is clearly abstract and intangible.
• They have also ruled that a patent for a scientific innovation and copyright for intellectual property are all permissible under the Sharia, as objects of sale contracts, though they are clearly abstract.
Many well-known jurists have permitted a number of abstract rights and obligations to be the subject of sale. They have allowed payment of money by one to another so that the latter does not participate in bidding against the former. The most interesting and relevant of these abstract rights is known as the sale of Arboon.
The feature of Arboon can be added to any exchange contract to introduce an element of call option. It is similar to any ordinary contract except that the buyer desires to have an option, to enjoy the privilege of exercising or foregoing that contract during a specific period of time.
During this period, the seller is obliged to keep the goods till the expiry date. For this, the buyer advances a portion of the price. If the contract is not concluded, for instance if the buyer decides to forgo, the advance money is kept by the seller. It, however, becomes part of the price if the contract is concluded. It is clear that the advance payment is the price of an option.
There is a slight disagreement on the permissibility of such sale contracts. Nevertheless, one major Fiqh school, the Hanbali, and a number of jurists from other schools, do permit the sale of Arboon. It is quite obvious that such contracts do include the idea of a call option. There are, however, two dissimilarities.
Firstly, the options contract is not separated from the sale contract and it has no independent existence. This means that the option itself was not intended. It came only incidentally. Secondly, the payment of an advance, if it is kept by the seller, appears to be the price of the option. It may be concluded that the Sharia door is not entirely shut against transactions which include the sale of an abstract obligation.
In looking at options from the Sharia point of view, the question which recurrently occurs is the permissibility of the sale of an abstract object. It seems that such sales are not exactly inconceivable in the Sharia.
There does, however, remain one important difference between the standard options and the examples listed above. In all the examples, an abstract object is sold, but it was not produced for the market. It came into being because of the circumstances of other activities.
Aside from this, the options contract is no different from an array of many abstract objects that the jurists have permitted for sale. Those who insist on the non-permissibility of Arboon agree that the seller is entitled to compensation for damage by the buyer who dishonours his part of the deal.
This means that the Islamic jurists think the advance payment is only a compensation for the damage and not a price of the option. If damage does not take place, it has to be returned to the buyer.
Based on the foregoing, a stock-option model can be proposed which may be compatible with the Sharia. The model is basically similar to the conventional sale and put options in so far as the writer (seller) carries the obligation to buy or sell the underlying stock at a certain price on or before a specified date, and the buyer of the option holds the right to buy or sell the same.
However, to guarantee that such transactions in an Islamic market remain within the boundaries of Sharia compatibility, the following important conditions are to be maintained.
Only those who already own a stock can sell a call option. In other words, receiving a price to carry an obligation to sell at a certain price on, or before, a specified date. On the other hand, a put option can only be bought by those who already own the stock. More simply, all naked strategies are not allowed. This restriction helps the market to avoid the speculative tendency. It is preferable that options be all of the European type, to be only exercised on, not before, the expiry date. This will also help reduce the speculative aspect of options trading.
Options are hedging instruments that can be used for insurance-like coverage of investors. An investor who expects prices to go up may want to buy a call option giving the right to buy on a later date at prices similar to those of today. An opposite strategy may be used by an investor who expects the price to fall, where a put option is more likely. In both cases, what an investor does is to protect himself from the risk of price changes by paying a premium, which is the option price.
In an Islamic stock market, one would think of co-operation among investors so that risks and rewards are pooled and then distributed to all the participants. This can be done through an ‘offsetting’ co-operation in the market.
Standardisation of options contracts regarding number of shares and maturity is not objectionable from the Sharia point of view. On the contrary, it may be an effective means of reducing Gharar and the possible misuse of options trading. Standardisation of contracts and transactions will be in line with the objectives of the Sharia.
Flexible options contracts may not be allowed. In such a transaction, the option contract tracks the value of a basket of stocks in a manner similar to the stock index options, except that the ‘flex option’ is customized to the needs of the investors.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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