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NEWHORIZON Rajab–Ramadan 1429

ACADEMIC ARTICLE

exchange contracts and general forms of

financial options and similar derivatives.

As with all Shari’ah-compliant products, any

hedge fund strategy would have to be

certified by a recognised Shari’ah scholar via

a fatwa (a ruling on a particular issue). There

are, to date, various potential mechanisms in

place which aim to reproduce as near as

possible the equivalent derivative trading

techniques of conventional hedge funds. In

particular, the aim of producing a Shari’ahcompliant

methodology, which replicates the

economic effects of short selling, seems to

have been established in a number of cases to

manage risk in similar means to conventional

hedge funds. The success of a Shari’ahcompliant

hedge fund will also depend upon

the hedge fund being able to combine the

techniques and strategies used with the

ethical requirements of openness.

Several such funds have been adversely

affected by articles in the regional and

Islamic financial press that criticise the lack

of transparency in their short selling

methodology, despite an initial Shari’ah

sign-off or fatwa. The need for transparency

causes a problem over intellectual property

for the institution developing the product.

However, the rewards for being transparent

should far outweigh the risk of being copied

by competitors.

Within the long/short hedge fund

methodology, there are various issues that

need to be addressed before scholars will issue

their fatwa on a fund. These will include:

Stock selection

All investments must meet certain

qualitative criteria such that any company

undertaking haram (prohibited) activities is

excluded (a common example is a company

producing alcoholic drinks). A second test

is to ensure that any company financed in a

haram manner (e.g. with too much debt) is

also excluded.

Leverage

Many hedge funds are heavily leveraged,

but the fund will not be allowed to borrow

money in a conventional manner such that

interest is paid; leveraging can usually be

achieved within the structure using a

murabaha (a financial institution buys and

sells the items required by the customer) or

another Islamic contract.

Short sale

This is the major hurdle for the fund manager

to overcome, as it is a fundamental principle

of Shari’ah that you cannot sell what you do

not own. Several institutions have attempted

to use various forms of Islamic contract,

some of which are discussed below, as a

means of effecting a transaction akin to a

short sale of shares. However, the use of an

Islamic contract can lead to problems in itself;

prime brokers and other financial institutions

will have established systems based upon

internationally accepted forms of contract

and may not be willing to change their

systems for only one fund.

The more common forms of contract that have

been proposed in these circumstances are:

Salam. This is a sale contract with a deferred

delivery and was the method generally

favoured by early funds. However, Shari’ah

Standard 21, issued by the Accounting and

Auditing Organisation of Islamic Financial

Institutions (AAOIFI), which came into

effect in January 2007, stated that it was not

appropriate to use salam contracts for

transactions in company shares.

Arboun. This is a sale contract with a nonrefundable

deposit. Whilst the Hanbali school

of Islamic jurisprudence generally allows

arboun’s use in transactions over shares, the

Hanafi school seems to declare it haram.

The main effect of this would be to harm the

marketing of a fund which uses arboun in

areas where the residents generally follow the

Hanafi school, such as much of Saudi Arabia.

Wa’ad. This is strictly not a ‘contract’ but a

unilateral undertaking (promise) by one

party to another. It is widely used in Islamic

finance but the methodology has its critics.

In 2007, Sheikh Yusuf DeLorenzo, one of

the world’s leading scholars, published an

article titled ‘Total Returns Swap and the

Shari’ah Conversion Technology’, which

considers the implications of using wa’ad

contracts in structured finance transactions,

including hedge funds. DeLorenzo was

particularly critical of certain structures that

have been approved where a wa’ad has been

used to convert profits earned from haram

activities into halal (permissible) income.

The debate over DeLorenzo’s article is likely

to have a major bearing on the future

structuring of Islamic hedge funds.

Shari’ah-compliant or Shari’ah-based?

Several leading experts in Islamic finance

have questioned the appropriateness of

using forms of contract derived from an

agricultural economy of several hundred

years ago in modern financial transactions.

A recurring theme in scholarly ideas is a

move from Shari’ah-compliant product

structuring to Shari’ah-based product

development. This move suggests a back-tobasics

approach in Islamic finance, such

that transactions are structured around the

principles of Shari’ah and not by

‘Islamising’ conventional products.

As far as characterisation of hedge funds as

highly speculative is concerned, this may be

a reason why they have been seen as

difficult to achieve in a Shari’ah-compliant

context. However, of course, the theory is

that hedging is seeking to minimise rather

than take advantage of risk. It is at least

arguable that there is no greater speculation

or gharar element in Shari’ah-compliant

hedge funds than in Shari’ah-compliant

private equity funds. It may, ironically, be

that the current global credit crisis may be

the point at which conventional hedge

funds are reassessed. However, even in this

crisis there may be promise for the

development of Shari’ah-compliant hedge

funds. This is because of the ethical rules

which may restrict the leveraged and debt

positions taken by such funds and may lead

Shari’ah-compliant hedge funds to be less

susceptible to such losses.

This back-to-basics approach should lead to

a much wider acceptance in financial circles

of Islamic funds (which are often unfairly

criticised as being re-engineered

conventional financial products) and should

lead to the development of a truly Islamic

hedge fund. In any event, the development

of the various Shari’ah-compliant hedge

funds has resoundingly demonstrated that

Islamic finance is constantly evolving.

www.newhorizon-islamicbanking.com IIBI 33

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