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SHORT-SELLING REPLICATION
IN ISLAMIC FINANCE: INNOVATION
AND DEBATE IN MALAYSIA
AND BEYOND
Ryan Calder,1,2
Introduction
The short-selling of stocks has long been considered impossible in
Islamic finance. This chapter begins by reviewing why. It then moves
on to the search to develop Islamic alternatives to conventional
short-selling. Several systems have recently come on the market that
aim to replicate short-selling in Shariah-compliant ways. This includes
one being developed by Bursa Malaysia and the Malaysia Securities
1
Please address correspondence to Ryan Calder at rcalder@berkeley.edu.
I thank the following people for their time, advice, and support: Maia Sieverding,
Dato Dr. Nik Norzrul Thani, Dr. Aida Othman, Dr. Megat Hizaini Hassan, Zalina
Ahmad Ramli, Dr. Angelo Venardos, Juliet Lee, Asharul Huzairi Mohd. Mansor,
Prof. Dr. Engku Rabiah Adawiah Engku Ali, Roslan Abdul Razak, Prof. Dr. Mohammad
Hashim Kamali, Dr. Mercy Kuo, Dr. Md. Nurdin Ngadimon, Zainol bin Ali, Bindesh
P. Shah, and the staff of the IBFIM Knowledge Management Centre in Kuala
Lumpur. All errors are mine alone.
2
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Commission that replicates stock borrowing and lending using Wad
(unilateral promise). Other industry players have endorsed shortsale replication systems that use the Salam contract, the Arbun
contract, or Wad in a different way. Hedge funds and other institutional investors seeking to be Shariah-compliant are keen to adopt
an Islamic alternative to short-selling, but each method has advantages and disadvantages, with its proponents and detractors. This
chapter guides the reader through different structures Islamic
institutions are using to replicate short-selling, the state of the
nascent market for short-sale replication, and the outlook for the
future.
What Is Short-Selling?
Investors engage in short-selling in order to turn a profit from a
decline in the price of a security. In a conventional short sale, an
investor (with the help of a prime broker) will borrow a security
from someone else, sell it immediately, wait until the price of the
security goes down, buy the security back from the market, and then
return it to the lender. This allows the investor to earn a profit on
the security’s decline in price.
United States law defines a short sale as the “sale of a security
which the seller does not own or any sale which is consummated by
the delivery of a security borrowed by, or for the account of, the
seller” (United States C.F.R. 2009). Short-selling, also known as
“shorting” or “going short”, is thus the opposite of “going long”, which
is simply the act of buying and holding a security in the expectation
that its price will increase.
Who Engages in Short-Selling, and Why?
People engage in short-selling for various reasons. Some people shortsell a security because they expect its price to fall. The simplest reasons
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to expect a price drop are because a company appears overvalued
or market conditions are worsening. Alternatively, investors may
expect a share-price decline because they anticipate imminent
merger or acquisition activity. This leads them to use short-selling
in a practice known as merger arbitrage (“merge-arb” for short).
In merger arbitrage, an arbitrageur will buy the target company’s
stock after the terms of an acquisition are announced in
the assumption that it will rise when the acquisition is completed.
The arbitrageur simultaneously shorts the acquirer’s stock,
which he expects to fall because the acquirer will issue its own
shares to exchange for the target’s shares, diluting the acquirer’s
shares.
However, betting against one company’s securities is often not
the rationale behind short-selling. A large portion of short-sellers
are in fact employing strategies not predicated on a particular
outlook for the company whose securities they are shorting
(Clunie and Ying 2006:6). Instead, they seek to take advantage of
relative movements between different securities. For example, in
a market-neutral strategy, a portfolio manager takes both long
and short positions on securities expected to behave similarly so
as to reduce the volatility in his or her portfolio while exploiting
market inefficiencies. In convertible arbitrage, a buyer of convertible bonds hedges his position by shorting the underlying
security. In index arbitrage, a trader might buy the index while
shorting the individual stocks that compose it, again exploiting
minor market inefficiencies. Likewise, an investor practicing
index futures arbitrage or index options arbitrage might
go long in index futures or index options respectively while
shorting the individual stocks that make up the index — a
strategy driven by deviations in futures and options prices from
their theoretical values (Fung and Fung 1997; Lo and MacKinlay
2001:347–368). These types of approaches are usually not based
on the expectation that one particular stock is overvalued;
they instead seek to take advantage of exposure to the price
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movements of related securities. Hedge funds are avid practitioners of such strategies.
Problems with Conventional Short-Selling as Viewed
from the Islamic Perspective
People have long maintained that the short-selling of stocks is unacceptable in Islamic finance (Khan 1983:95; Zaky 1992:81; Zaher and
M. Kabir Hassan 2001:191; Archer and Karim 2002:22; Al-Alwani
2005:151; Venardos 2006:43; Iqbal and Mirakhor 2007:176; Ayub
2007:75; Schoon 2009:23–28). Those who argue that Islamic finance
is fundamentally more conservative than conventional finance often
cite the ban on short-selling as an example of this guarded approach.
So why is the short-selling of stocks Haram? Here, I review some of
the Islamic objections to conventional short-selling.
Selling an Item Without Owning It
First, many Shariah scholars frown on selling an item before it is
owned. One of the most frequently cited Ahad ith3 in Islamic commercial jurisprudence (Fiqh Al-muamalat) reads:
Lā tabi c mā laysa cindaka
“Do not sell what is not with you” or “Do not sell what you do not have”
or “Do not sell what you do not own” (depending on translation).
This Hadith would seem to make a prima facie case against shortselling, since a short-seller sells a security that she has borrowed but
does not own.
3
Ahadith is the plural of Hadith.
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Case closed? It depends whom you ask. Mohammad Hashim
Kamali, for example, has noted (in a context unrelated to shortselling4) that issues have been raised regarding this Hadith (Kamali
2000:110–116). There may be weakness in its authenticity: it appears
in the collections of Abu Daud and Al-Tirmidhi, but not in those of
Al-Bukhari and Muslim Ibn Al-Hajjaj (ibid.: 110). Even scholars who
acknowledge the Hadith as authentic disagree as to its exact chain
of transmission (Isnad) (ibid.: 110, 111). Moreover, Kamali asserts
that there is “room for interpretation regarding the precise legal
value” of this Hadith: he feels it may not be entirely clear “whether it
conveys a total ban (Tahrim), or abomination (Karahiyyah), or even
mere guidance and advice of no legal import” (ibid.: 111).
Let us assume, however, that we accept this Hadith as both
authentic and binding. The issue of interpretation then arises: What
exactly does this Hadith mean? Fuqaha (scholars of Islamic jurisprudence) have debated this for centuries.
The Arabic preposition inda, which appears in this Hadith, is
one of the sources of ambiguity. One of the most common words in
the Arabic language, inda can refer in different contexts to “having”
in the most general sense, or to ownership, or possession, or access,
or proximity in time or place.5 As a result, scholars have disagreed
for centuries about what exactly this Hadith prohibits.
Its simplest interpretation, adopted by many fuqaha past and
present, is that a seller must own an item outright when she sells it.6
Along the same lines, the Shariah board of the Accounting and
Auditing Organization for Islamic Financial Institutions (AAOIFI)
4
It is important to note that Kamali’s discussion of this Hadith was part of a book
arguing that commodity futures and commodity options should be considered
Halal, and was not part of a discussion about the short-selling of securities. Kamali
does not discuss the short-selling of securities in the book.
5
Karin C. Ryding summarises the meanings of inda in her excellent book A
Reference Grammar of Modern Standard Arabic (Ryding 2005:399, 400). She also notes
that inda is actually not a true Arabic preposition but rather a “semi-preposition”.
6
For a good summary of the positions of classical scholars from different schools of
jurisprudence on this question, see Al-Islambuli (2005).
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has ruled explicitly that “it is not permitted to sell shares that the
seller does not own”, adding that “the promise of a broker to lend
these at the time of delivery is of no consequence”. AAOIFI’s rationale
is that “the sale of something that is not within the liability of the
seller nor in his ownership” is “prohibited according to the Shari’a”
(AAOIFI 2007b:390).
However, other Fuqaha have taken a more liberal stance, arguing
that certain types of objects may be sold before ownership is established. Imam Al-Shafii (150 A.H.–204 A.H./767 C.E.–820 C.E.),
who founded the Shafii madhhab (school of jurisprudence) that is
dominant today in Southeast Asia, maintained that “one may sell
what is not with one provided that it is not a specific object, for the
delivery of a specific object cannot be guaranteed if the seller does
not own it” (Al-Shafii 1940:337; in Kamali 2000:113). Following this
line of reasoning, it would be unacceptable to sell a house or a piece
of land without owning it, because those are unique objects with
highly specific attributes; but it might be acceptable to sell a unit of
a highly fungible commodity, such as a bushel of a particular kind of
wheat, that could be replaced with an identical quantity of the same
good to facilitate future delivery.
Ibn Taymiyah (661 A.H.–728 A.H./1263 C.E.–1328 C.E.) and Ibn
Qayyim Al-Jawziyah (691 A.H.–751 A.H./1292 C.E.–1350 C.E.), both
of the Hanbali school, also take a liberal perspective on this question,
though a slightly different one. They argue that this Hadith prohibits
“the sale of what is not present and which the seller is unable to
deliver” (Kamali 2000:113, 114). Like Imam Al-Shafii, they emphasise
the ability of the seller to say confidently that she will be able to
present the item at the agreed future date of delivery.7
7
Following the perspective of Ibn Taymiyah and Ibn Qayyim Al-Jawziyah, the Salam
contract — which many jurists view as an exception to the rule that “one may not sell
what one does not have” — is in fact not an exception, but rather an extension of the
same underlying logic: that of seeking to ensure that the seller will be able to present
the good as promised at the agreed future date of delivery. (I thank Prof. Dr. Engku
Rabiah Adawiah Engku Ali for bringing this to my attention.)
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The upshot is that one might find it acceptable to sell shares without owning them depending on (a) which schools of jurisprudence
one adheres to and which jurists’ opinions one finds most compelling,
(b) whether one considers shares to be fungible commodities, and
(c) whether the sale of shares without owning them does not run
afoul of other injunctions, such as the ban on dealing in Riba (this
would clearly contravene the sale of shares in conventional banks,
for example).
Stock Borrowing and Lending (SBL)
Aside from the issue of selling something that one does not own, the
short-selling of stocks as practiced in conventional finance is potentially problematic for a second reason: many Shariah scholars
consider it impermissible to borrow and lend shares.
Different scholars take different views on what kind of good may
be the subject of a loan contract. Many jurists feel that “a loan contract can be validly concluded with regard to every property on
which Salam is valid” (although some scholars, especially from the
H
. anafi Madhhab, take a more restrictive view) (Dusuki 2008:206).
A Salam contract, or forward-sale contract, is one in which a
buyer pays in full now for a product that the seller will deliver to him
later. In the case of Salam, there is scholarly consensus that the
goods need not be in the seller’s possession, or even in existence at
all, to be the subject of a sale. This makes sense when one considers
that traditionally, Salam sales often financed agriculture, as when a
farmer required capital to purchase seeds or other inputs in advance
of planting and harvesting (Cuno 2006; Doumani 2006).
There are specific conditions as to how a Salam may be transacted — including the types of goods that may be traded with it.
Scholars agree that goods can only be the subject of a Salam sale if
they can be “precisely determined in terms of quality and quantity”,
yet “not particularised to a specific unit” (Ayub 2007:244; see also
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Thomas et al. 2005:94). For example, a specified type, quality, and
quantity of corn may be the subject of Salam (and may therefore be
the subject of a loan contract), but a particular ear of corn may not.
Such rules aim to eliminate uncertainty (Gharar) as to: (a) exactly
what was lent, (b) whether equivalent goods will be available on the
market at the time of delivery in the event that the borrower cannot
produce the goods himself, and (c) whether the delivered goods are
precisely equivalent to what was promised.
As technologies and economies of production have evolved
through history, the kinds of goods that scholars have considered
sufficiently standardised to serve as the subject of a Salam sale have
changed. During the classical age of Islamic jurisprudence (1st–7th
centuries A.H./7th–13th centuries C.E.), jurists debated whether
items as diverse as cane, bread, honey, cheese, precious stones,
musk, carpets, perfumes, shoes, bowls, fish, leopards, and even
trained dogs were sufficiently standardised to be the subject matter
of Salam (Ayub 2007:244). On occasion, scholars even argued that
one kind of wheat was “Salam-able” but another not: Jurists ruled
that Iraq wheat, Khorasan wheat, or Ferghana wheat could be sold
through Salam because they came from regions that regularly produced wheat in sufficient quantities to supply markets reliably; but
they averred that the wheat of Herat, which came only from that one
city, could not be the subject of a Salam sale because it was not
produced in sufficient quantity to ensure guaranteed circulation
(Johansen 2006).
Today, however, mass production and the technologies of modern markets have made it easier to specify the characteristics of
standardised goods with great certainty and to predict reliably that
they will be available at a future date. Commodities of many types
are accepted with a high degree of consensus as the subject of valid
Salam contracts today. Indeed, the AAOIFI’s standard for acceptable
subject matter (Al-Muslam Fihi) of Salam includes not only “fungible
goods (such as wheat and other cereals)”, but “also … items of material
value (such as livestock)” (AAOIFI 2007a:165), and even “the general
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usufruct of a particular asset, such as … having the use of an aircraft
or a ship for certain period”. Nevertheless, the AAOIFI still rules out
Salam on “anything for which the seller may not be held responsible, like land, buildings, or trees” and on “articles whose values
change according to subjective assessment, like jewellery and
antiques” (AAOIFI 2007a:165). Thus while the items that are “Salamable” have changed through history, the principles underlying their
permissibility or impermissibility have remained static.
We now return to our original question: Can stocks be the
subject of a loan contract? Some scholars argue yes, contending that
different shares8 in a corporation are fungible goods — that is,
goods with homogeneous (Mithl i) properties that make them freely
exchangeable or replaceable (Dusuki 2008:206,207). This means
they can be the subject matter of a Salam contract, and therefore of
a loan contract as well.
Others say no. This includes the AAOIFI Shariah board, whose
ruling focuses less on whether different shares are fungible items
and more on the equivalence of shares compared over time —
that is, whether a share in a company today can be considered
equivalent to a share in the same company tomorrow. In ruling
that it is impermissible to lend shares, the AAOIFI’s Shariah board
states:
The basis for the impermissibility of lending the shares of corporations is that the share at the time of repayment — in consideration
of what it represents — does not represent the same thing that it
did at the time of lending due to the constant change in the assets
of the corporation. (AAOIFI 2007b:390)
In the end, we face the question of just what a share of a corporation
is. Is one share in a corporation fungible with another? And is a share
8
By “different shares”, I refer to shares of the same type, but merely with, say,
different serial numbers. I am not referring to different types of common stock, or
of common stock versus preferred stock, etc.
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in January equivalent to a share in June? The ontology of shares is
at issue here: do we conceive of a share as something uniform, standardised, fungible, and existing in the abstract universe of a traded
market — in short, first and foremost as a financial security? Or do we
conceive of it as a unique bundle of contractual rights that vest the
shareholder with the ability to make decisions affecting a concrete,
complex, and dynamic business operation with real assets and real
employees — in other words, as a participatory ownership stake?
“Western” securities law is generally untroubled by the Janus-faced
nature of shares, but Islamic commercial jurisprudence must grapple
with it.
Ontological dilemmas aside, however, the reality on the ground
is that a large and relatively stable majority of prominent Shariah
scholars active in Islamic finance today find stock lending — as practiced in conventional finance — to be problematic. For the time
being, this makes its commercial adoption by Islamic financial
institutions untenable.
Entanglement with Ribaa
A third potential problem with conventional short-selling as viewed
from the Islamic perspective is that interest typically gets involved in
the process. In a conventional short sale, when an investor borrows
stock and then sells it, he or she must leave the full market value of
the sold stock in a margin account with his or her broker, plus an
additional margin requirement (under United States law, this is
initially at least 50% of the short-sale value). The brokerage house
will then use the money in this account to earn interest for itself.
(Of course, if the brokerage house were willing to invest the money
in the margin account in a Shar iah-compliant way — e.g., by investing in Murabahah instead of in interest-bearing instruments — this
problem could be avoided.)
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Form versus Substance
A fourth potential problem with short-selling — whether conventional
short-selling or any system that claims to replicate or approximate it
in a Shar iah-compliant way — is the meta-issue of “form versus
substance”. A few observers of Islamic finance argue that some, if
not all, of the Islamic-finance industry’s operations today are misguided because they simply reflect adherence to the letter of Islamic
law at the expense of fulfilling its spirit (El-Gamal 2006a; see also
Habil 2007 for a discussion of the tension within Islamic finance on
this topic).
Mahmoud El-Gamal is an ardent expositor of this view, and he
sees efforts to replicate short-selling as an example of what is wrong
with Islamic finance today. In his view, Islam prohibits short-selling —
not merely in form, but in substance. El-Gamal argues that while it
may be easy to synthesise short sales from “Islamic” instruments,
doing so makes “a mockery of Islam”. He writes:
Every contract can be ‘Islamized’ in the age of financial engineering
[italics original]… It is a silly game. The distinction between
contracts that are “now allowed in Islam” and those that aren’t is
only a function of who is willing to pay sufficient fees for the renta-jurists to certify an engineered product, and how high are the
transaction costs of the reengineering. (El-Gamal 2006b)
Not surprisingly, El-Gamal’s views raise the ire of many practitioners
and Shariah scholars involved in the Islamic-finance industry. But
while they may bristle at El-Gamal’s strident language, they remain
cognizant of the broader issue of form versus substance, which is the
core of many legal debates — not only in Shar iah and Fiqh, but in
the history of Western law as well (Kennedy 1976).
Those in the industry have several responses to the argument
that much of Islamic finance is founded on mere mechanical adherence to the letter of the law. Some assert that Islamic finance is a
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work in progress, and that taking imperfect steps in the direction of
a holistic Islamic financial system is better than nothing. Others
argue that Islamic financial institutions must offer products and
services — like replicated short-selling — comparable to those their
conventional counterparts offer, or else they will lose all but their
most loyal customers. That, they argue, would render Islamic financial institutions unprofitable and bring the project of Islamic
finance grinding to a halt. Still others contend that replicating
short-selling is acceptable because that which Islam does not prohibit is permitted, and that Shariah is intended to make life easier,
not to bring hardship. Still others contend that short-selling brings
benefit to society by smoothing out speculative asset-price increases
and imparting useful price information to the market.
Efforts to Construct a Shar iah-Compliant Short Sale
So far, I have reviewed the many arguments made against allowing
conventional short-selling in Islamic finance. Indeed, the vast majority of Shariah scholars interested in Islamic finance today consider
conventional short-selling to be Haram.
The Market for An Islamic Alternative to Short-Selling:
Islamic Hedge Funds and Islamic ETFs
However, demand for an Islamic alternative has grown in recent
years, driven by the prospect of Islamic hedge funds and Islamic
exchange-traded funds (ETFs). Why do hedge funds and ETFs need
to short-sell? Hedge funds frequently engage in short-selling as part
of long-short strategies and other market-neutral strategies. As hedge
funds have become heavyweights of the conventional financial
universe — with total global hedge-fund assets under management
tripling between 2000 and 2007, reaching US$1.7 trillion by mid-2007
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(Farrell et al. 2007:24) — Islamic-finance practitioners and investors
have begun to envision Islamic hedge funds. Since 2006, a handful
have launched. Islamic ETFs are proliferating as well: financial institutions from around the world have listed them on stock exchanges
in Kuala Lumpur, Singapore, London, Zurich, Istanbul, and
Abu Dhabi, with more sites on the way (Abu Bakar 2008). Islamic
ETFs are keen to find an Islamic alternative to short-selling because
conventional ETFs rely on short selling as an integral part of the
creation and redemption of ETF creation units and shares (since
the original stock shares deposited in a trust to form the ETF’s
underlying asset base are borrowed shares).
History of Efforts to Construct a Shar iah-Compliant Short Sale
The history of efforts to implement Shar iah-compliant shorting has
been a back-and-forth one. At the end of 1995, Malaysia first introduced conventional regulated9 short-selling using securities
borrowing and lending (SBL). Shortly thereafter, the Malaysia
Securities Commission began exploring Shar iah-compliant means
of shorting. Through the mid-1990s, it worked with Shar iah scholars
to develop an alternative based on Ijara (lease), which I discuss
further below. Just as the Malaysia Securities Commission had come
close to finalising its Ijara-based platform, however, the Asian financial
9
“Regulated” means, among other things, that “naked” short selling is not allowed.
A naked short sale is one in which the short-seller, before having borrowed the security or perhaps even ascertaining for sure that he can borrow it, commits to selling
it. (The opposite of a naked short sale is a “covered” short sale — one in which the
short-seller has already secured access to the security when he commits to selling it.)
Most national regulatory authorities prohibit naked short-selling, although
many — including for some years the U.S. Securities and Exchange Commission
(SEC) — have had difficulty enforcing the ban in practice (Bris et al. 2004). In addition to prohibiting naked short sales, the Malaysia Securities Commission also
imposes other regulatory requirements on short sales, such as limiting short-selling
to specified stocks that meet liquidity requirements.
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crisis struck. Facing a volatile stock market and capital flight, the
government of Prime Minister Mahathir Mohamad suspended all
short-selling at the end of 1997. Nevertheless, the Securities
Commission’s Shariah board officially endorsed an Ijara-based form
of SBL in March 1998, despite the fact that it would not be implemented because all forms of SBL had been banned.
Through the 2000s, Islamic finance boomed worldwide.
Innovation proceeded apace as high oil prices and economic
growth channeled capital to Muslims in the Gulf, Southeast Asia,
and elsewhere. Liberalising national financial markets and the
emergence of an international Islamic-finance infrastructure also
bolstered double-digit annual increases in Shar iah-compliant assets
(Warde 2010).
Inspired by the success of conventional hedge funds and
undaunted by the fact that many Shar iah scholars frowned on the
idea, a few people began envisioning Islamic hedge funds. In 2001,
hedge-fund manager Eric Meyer met in the United States with
Shar iah scholar Shaykh Yusuf Talal DeLorenzo and discussed the
possibility of an Islamic hedge fund. Out of this conversation
emerged Shariah Capital, a company of which Meyer is CEO and
DeLorenzo is chief Shar iah officer and an executive director.
Shariah Capital provides technologies and advisory services to support hedge funds and other financial institutions seeking to be
Shar iah-compliant. In 2008, Shariah Capital, together with prime
broker Barclays Capital, launched the Al Safi Trust Platform for
hedge funds. Adopted the same year by several Dubai-based funds,
the Al Safi platform employs an Arbun-based short-selling structure
that Shaykh DeLorenzo has endorsed. At the same time, other players have also been targeting the market for Islamic hedge funds.
Fimat, the prime-brokerage arm of France’s Société Générale,
launched some of the earliest Islamic hedge funds at the end of
2006, employing a Salam-based short-selling structure (Hedgeweek
2008). And in 2009, Amiri Capital introduced a short-selling replication mechanism based on Wad as part of a push to establish
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Shar iah-compliant long-short equity funds and prime-brokerage
services.
Meanwhile, the issue of short-selling had arisen yet again in
Malaysia. In March 2006, the country’s Securities Commission reintroduced conventional short-selling after a hiatus of more than
eight years. Shortly thereafter, Bursa Malaysia (formerly the Kuala
Lumpur Stock Exchange) began developing a Wad-based shortselling platform with the support of the Securities Commission and
the approval of the Securities Commission’s Shariah board, led by
Aznan Hasan. Demand from Islamic ETFs was the strongest motivation, although Islamic hedge funds were an important driver as well.
As of 2009, this platform is under development, with Bursa Malaysia
chief executive Yusli Mohamed Yusoff publicly endorsing the project
to the press (Liau 2009).
Based on this brief but eventful history of the “Islamic short sale”,
we can make two observations. First, it is clear that demand has been
strong enough to elicit a number of very different approaches from
industry players. Each has advantages and disadvantages relative to
the others, as I discuss below. Second, it is worth noting that the impetus behind innovation differs in different parts of the world. While
Islamic hedge funds have been driving short-selling innovation in the
Gulf market, which has a high concentration of ultra-high-net-worth
Islamic investors, Islamic ETFs have been the driver in Malaysia,
where there are fewer ultra-high-net-worth investors but a solid and
growing base of increasingly sophisticated small and medium-sized
Islamic investors as well as a national government and regulatory
authority committed to shepherding a robust Islamic financial architecture into being (Thani and Hassan 2009).
Attempts to Construct a Shar iah-Compliant Short Sale
There are a number of ways to replicate a short sale with instruments already being used in the Islamic-finance industry. After
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reviewing how a conventional short sale works, this section describes
potential and existing alternatives and evaluates advantages and
disadvantages of each.
Conventional Short Sale
First, let us review how a conventional short sale works. (For simplicity’s sake, the examples below leave out brokerage fees and
other ancillary expenses.) Assume a hypothetical investor named
Sharif wants to short-sell 100 shares of stock in XYZ Company. He
currently owns no XYZ stock. Leila, another hypothetical investor,
owns the stock. Leila, through a prime broker, lends 100 shares of
XYZ stock to Sharif. Sharif immediately sells the stock, which is
currently trading at RM40, receiving RM4,000 for the sale. Two weeks
later, after XYZ has fallen to RM35 per share, he buys back
100 shares from the market and returns them to Leila, realising a
profit of RM500.
Ijara-Based Structure
As early as the mid-1990s, the Malaysia Securities Commission
looked to Ijaara (Islamic lease10) as the basis for a Shar iah-compliant
alternative to conventional SBL. The mechanics of an Ijara-based
short sale are simple: instead of Sharif borrowing a stock from Leila,
he leases it from her. Sharif’s rental payments to Leila compensate
her for the privilege of using her stock. Just as in conventional SBL,
Sharif returns the stock to Leila at the end of the lease term.
10
More specifically, Ijara is the hiring or renting of an asset, a commodity, or labor
to benefit from its usufruct (Ayub 2007:279). Ijara can also be thought of as a
contract to purchase the usufruct that derives, over a specified period of time, from
the asset, commodity, or labor (Abu Ghuddah n.d.).
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The advantage of an Ijara-based short-sale system is that from a
mechanical standpoint, it works just like conventional SBL. This
makes it relatively easy to adapt an existing conventional SBL system
into an Ijara-based one.
The stark disadvantage, however, is that Ijara-based short selling
is very controversial from a Shar iah perspective. At least two points
of controversy arise. First, many scholars disapprove of the idea that
Sharif may sell to a third party the stock that he is leasing from Leila.
One of the defining characteristics of an Ijara is that “the leasing
agency [in our case, Leila] must own the leased object for the duration of the lease” (Iqbal and Mirakhor 2007:84). As we have seen
earlier, it is highly problematic to sell an asset owned by someone
else. Moreover, “the Ijara contract is intended for utilization of the
asset and not for consumption of the asset” (ibid.:85). Second, many
jurists frown on allowing a financial asset to be the subject of an Ijara
contract. Property and capital assets that can be utilised without
being consumed — such as land, machinery, and houses — are common subjects of Ijara. The labor of, say, a doctor or a carpenter may
also be the subject of Ijara (Ayub 2007:280). However, leasing
“financial and monetary” assets raises eyebrows.
Nevertheless, the Malaysia Securities Commission’s Shariah
Advisory Council (SAC) approved Ijara on stocks in 1998 as a basis
for the implementation of SBL. The SAC justified this through the
principle of Istihsan (application of discretion in a legal decision)
based on Maslahah (that which serves welfare) (Securities
Commission Malaysia 2007:74). It argued that an exception should
be made to allow the lessee (“Sharif”) to sell the leased shares to a
third party without nullifying the Ijara contract because this was not
only beneficial to the original shareholder (“Leila”) but also
because it could “provide liquidity to the share market”. In other
words, making an exception to the normal rules of Ijara was acceptable because the outcome was good for the market.
Critics argued that turning thus to Istihsan and Maslahah established a slippery slope. If selling leased stocks was acceptable because
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it provided market liquidity, what else might be justified in the name
of market liquidity?
Ironically, this debate remained essentially a legal and philosophical one, because SBL using Ijara never gained traction.
Between 1997 and 2006, all SBL was suspended in Malaysia
anyway. After 2006, regulated short-selling with SBL resumed, but
Bursa Malaysia and the Malaysia Securities Commission began
development of the Wad-based short-selling system shortly thereafter. The Ijara short-selling question faded into the background.
For its part, Bank Negara Malaysia, the central bank, stated in
2009 in a draft of its Shariah parameters that shares of a company
may not be the subject of Ijara (Bank Negara Malaysia 2009:9,
Item 34).
Salam-Based Structure
The Salam sale, or Bay Al-Salam, is a forward sale. The basic concept
of a Salam is to pay now and take delivery later. The buyer is
required to pay in full at the time the contract is established.11 At
that time, the buyer and seller also fix the terms of delivery, such as
the quantity and quality of goods, the mode of delivery, and the date
of delivery. As discussed above, Salam is only applicable to certain
goods, and has a long history of being used to finance agriculture as
well as the production of other items — such as textiles (Cuno 2006;
Doumani 2006) — in which it is useful to provide capital up front
before production has occurred.
Earlier, I noted that Shariah scholars disagree about whether a
share of a company may be the subject of a Salam contract. If one
11
Some Shariah scholars consider it permissible, in some cases, to allow the buyer
a brief window of time after the agreement of a Salam contract in which to pay the
seller. AAOIFI, for example, writes: “The capital in a salam contract must be paid
immediately at the place where the contract is concluded. However, as an exception
to this ruling, payment may be delayed for two or three days at most” (AAOIFI
2007a:165).
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does assume that a Salam sale on a share is valid, then it is easy to
use Salam to approximate a short sale.
The most basic Salam-based alternative is even simpler than the
conventional version in that no lending or borrowing takes place.
Our hypothetical short-seller Sharif simply enters into a Salam contract to sell 100 shares of XYZ stock to Leila for future delivery. Leila
gives Sharif RM4,000 today, paying the current market price of
RM40 per share. Sharif agrees to deliver the 100 shares to Leila in
two weeks. In two weeks, the price has fallen to RM35 per share.
Sharif buys 100 shares of XYZ from the market and gives them to
Leila. He realises a profit of RM500.
One advantage of a Salam-based alternative to conventional
short-selling is that no securities borrowing and lending (SBL) is
involved. If a streamlined Salam-based system were developed for
matching stock users and stock suppliers, this could potentially give
Salam-based shorting a technical advantage over SBL. At the
moment, no such system has appeared on the market, but it is not
impossible to envision. However, Salam-based shorting seems
unlikely to enjoy a significant Shariah-compliance advantage over
SBL. This is because, as discussed earlier, those scholars who consider stocks to be “Salam-able” are also likely to consider stocks valid
for lending, while those who do not consider stocks to be Salam-able
will probably not consider stocks valid for lending.
Salam-based shorting has at least two major disadvantages relative
to other Shar iah-compliant possibilities for replicating short-selling.
First, as discussed, many scholars — including the members of
AAOIFI’s Shariah board — do not accept stocks as the basis of a Salam
contract. However, some scholars do, such as the Shariah Advisory
Council of the Malaysia Securities Commission (Securities Commission
Malaysia 2009).12 Yet even aside from the Shariah-compliance question,
12
The Shariah Advisory Council (SAC) of the Malaysia Securities Commission ruled
that trading shares under the Salam contract is permissible as long as: (a) the shares
are not considered to be too specific (Muayyan) an item; (b) the category, type, and
amount of the shares can be determined; and (c) the shares’ date of delivery can
be ascertained. (Securities Commission Malaysia 2009:2).
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there is a major practical obstacle to widespread Salam-based shorting, especially in stock exchanges. Note that in the example above,
Leila (the stock supplier) had to pay Sharif (the short-seller) up front
at the time the Salam contract was agreed. This is very different from
a conventional short sale, in which Leila pays Sharif nothing. Even
if one were somehow to avoid requiring a cash outlay by Leila, such
as by having Leila enter into a simultaneous Salam with some
middleman (e.g., a broker), the fact remains that someone (e.g., the
broker) must pay Sharif RM4,00013 up front when the Salam is
written. While this does not necessarily rule out a Salam-based alternative to conventional short-selling, it might pose a challenge to its
widespread adoption on stock exchanges. Market participants may
not be used to such a model, and existing IT systems and regulatory
frameworks might have trouble adapting to it.
Nevertheless, financial institutions have found ways to offer
Salam-based short-selling. Newedge (formerly Fimat), a joint venture between French banking giants Société Générale and Calyon,
launched a platform for Shar iah-compliant hedge funds in 2005
incorporating Salam-based short-selling. A number of hedge funds
based in Europe and the United States have signed up to use the
platform. Newedge’s global head of prime brokerage maintained
that “although different solutions seem more acceptable for different regions, many Saudi scholars prefer the Salam contract for
equities” (Davidson 2008). Permal has also managed a long/short
Islamic hedge fund called Alfanar employing a Salam-based shortselling system. (It is important to note that Newedge and other
13
In actuality, Leila (or the broker) would probably end up paying Sharif less than
the full market value of RM4,000. When a Salam contract is written on a commodity (e.g., wheat), the Salam sales price is typically lower than the spot price for
the same commodity because the seller (Sharif) receives payment up front but does
not have to deliver until later. In the case of a Salam on stocks, this discount could
serve as compensation to the stock supplier (i.e., Leila and/or her broker), akin to
the fees that stock lenders receive in conventional short-selling.
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institutions offering Salam-based short selling may or may not use
the structure described above.)
Wad-Based Structures
At least two industry players have proposed structures that aim to
replicate short-selling by using Wad (unilateral promise). The first is
London-based Amiri Capital, which is launching the Amiri Equity
Alternative Strategies Fund (AEAS), an Islamic fund of long-short
equity fund managers. Newedge Group is the fund’s prime broker,
and Dar Al Istithmar its Shariah advisor. The Dar Al Isithmar Shariah
board, which approved the AEAS Fund, includes Sheikh Hussain
Hamid Hassan (chair), Ali Al Qaradaghi, Abdul Sattar Abu Ghuddah,
Daud Bakar, and Aznan Hasan.
The AEAS Fund’s short-sale replication mechanism involves two
parties — AEAS and some counterparty — each entering into a Wad
with the other to buy or sell stock in the event that the stock price
moves in one direction or the other. Only one of the promised transactions will be exercised, since the price will either go up or down
relative to the starting price, but not both. The mechanism is thus
analogous to what conventional financiers call a synthetic short sale:
buying a put option and writing (i.e., selling) a call option.
Meanwhile, Bursa Malaysia (the Malaysian stock exchange),
with the oversight of the Malaysia Securities Commission, is developing (as of late 2009) a different mechanism to replicate
short-selling using Wad. Although the initial impetus for development was demand from Islamic ETFs, the system may attract Islamic
hedge funds as well.
There are two cornerstones of the system. The first cornerstone
is that no lending and borrowing will take place. Instead, the “supplier”
of stock (comparable to the stock lender in the conventional
scenario) will actually sell the stock to a central facilitation agency
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(CFA), which will then sell it on to the “user” of the stock (who is
comparable to the “borrower” in the conventional scenario). Later,
the user will sell the stock back to the CFA, which will then sell it
back to the supplier. The Wad agreements serve to ensure that the
user will sell the stock back to the CFA, and that the supplier will
then buy the stock back from the CFA at prices and terms specified
in advance.
The second cornerstone of the Bursa Malaysia system is that the
Bursa itself will act as the CFA, and thus the counterparty, for all
transactions. It will establish and manage the constantly changing
database of the pool of stocks that suppliers are willing to offer, and
then will operate a real-time bid-ask system to match these with the
stocks that users request.
Let us revisit our hypothetical scenario. Sharif wants to short 100
shares of XYZ stock, which currently trades at RM40 per share. He
puts in an electronic request to Bursa Malaysia’s CFA system, which
scans its database of potential suppliers and locates Leila, who is willing
to supply 100 shares of XYZ. The CFA confirms the deal, automatically establishes the necessary Wad agreements, and begins executing
the trade. First, Leila sells 100 shares to the CFA (Bay 1).14 Delivery
is immediate, but settlement is deferred, with the CFA paying Leila
in monthly installments.15 Next, the CFA sells the 100 shares on to
Sharif (Bay 2). Again, delivery is immediate, but settlement is
deferred into monthly payments. Both Bay 1 and Bay 2 are true sales
that transfer ownership.16 They are both executed at the price of
14
Bay means “sale” in Arabic.
These monthly installments are not equal monthly installments. Rather, they fluctuate based on the changing value of the stock’s market price. Also, they depend on
the maximum period over which the user may use the stock, which will be determined in advance by Bursa Malaysia and may be in the range of 18 months,
24 months, or some comparable period.
16
In this sense, the Wad-based short sale is somewhat similar to a conventional repo
(repurchase) agreement, in which a (usually fixed-income) security serves as
collateral for a cash loan, with the security actually changing ownership rather than
simply being lent.
15
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RM40 per share, but in Bay 1, the CFA pays Leila a pre-determined
markup (x%) that is distributed across the installments to compensate her for making shares available; and in Bay 2, Sharif pays the
CFA a slightly higher markup (x% + ε%). The CFA retains the
difference (ε%) as compensation for running the system. Sharif
then sells the shares on the market for RM40 per share. All of the
above happens virtually instantaneously.
Two weeks later, assume XYZ shares are trading at RM35. Sharif
decides to cover his short position. He buys 100 shares of XYZ stock
back from the market and notifies the CFA. As Wad 1 requires him
to do, Sharif now sells the 100 shares back to the CFA at the price of
RM40. As Wad 2 requires her to do, Leila now buys the 100 shares
back from CFA, also at RM40. The transaction is complete.
An advantage of a Wad-based system is that while it does not
involve stock borrowing and lending, it operates in a way similar
enough to conventional SBL that it can be adapted from a conventional SBL system, as Bursa Malaysia is doing. Pricing under the
Wad-based system at Bursa Malaysia, for example, will likely be the
same as pricing for the conventional short-selling system.
One possible disadvantage is that not everyone agrees whether a
Wad can be binding. In the Bursa Malaysia system, each Wad is a
Wad Mulzim (binding unilateral promise): Wad 1 is Sharif’s promise to sell XYZ shares back to the CFA when he is done with his short
sale, and Wad 2 is Leila’s promise to buy the shares from the CFA
when the CFA wants to sell them back to her.
There are three main perspectives in the debate over whether
Wad can be binding:
•
The “non-binding view”: Fulfillment of a unilateral promise,
though commendable, is neither mandatory (Wajib) nor legally
enforceable. Classical jurists endorsing this view include Imām
Abu Hanifah (founder of the Hanifi school of jurisprudence),
Imam Al-Shafii (founder of the Shafii school of jurisprudence),
Imam Ahmad Ibn Hanbal (founder of the Hanbal school of
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•
•
Ryan Calder
jurisprudence), and several Maliki jurists (Uberoi et al. 2009a:1). A
number of contemporary jurists echo this view; see Saudi scholar
Rafic Yunus Al-Masri’s clear exposition of it (Al-Masri 2002).
The “binding view”: Fulfillment of a unilateral promise is mandatory (Wajib) and incurs both moral and legal obligation, making
it enforceable in court. This was the view of only a minority of
classical jurists, but among their number were notable figures
such as Samrah bin Jundab (a Companion of the Prophet),
Umar Ibn Abd Al-Aziz (one of the most respected Umayyad
caliphs), Hasan Al-Basri, Imam Bukhari (compiler of one of the
great Hadith collections), and Ibn Arabi (the great medieval
Iberian polymath).
The “conditionally binding view”: Although not normally binding, a unilateral promise becomes binding and potentially
enforceable in court if it has caused the promisee to incur
liabilities. The Islamic Fiqh Academy issued a Fatwa taking this
position in December 1998, and many of the Fuqaha most
prominent in the Islamic finance community today endorse this
stance (Uberoi et al. 2009b).
The direction this debate takes will have a major impact on innovation strategies in Islamic finance. The binding view and the
conditionally binding view make the Wad-based short sale possible,
but the non-binding view rules it out.
Beyond just short-selling, the question of whether Wad can be
binding has generated much discussion as Islamic financial institutions increasingly employ Wad as a structuring tool — in Murabahah
products, Musharakah Mutanaqisah (diminishing partnership),
Sukuk, cross-currency swaps, and Islamic derivatives. In one usage
that garnered attention in Islamic finance circles, Deutsche Bank
used Wad in 2007 to construct what is in effect a total return swap:
clients invest in liquid Shar iah-compliant assets whose returns are
swapped for the returns on non-Shar iah-compliant assets such as a
hedge fund. The Shar iah board that approved the structure was a
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Who’s Who of Islamic-finance luminaries: Hussain Hamed Hassan
(chair), Ali Al Qaradaghi, Abdul Sattar Abu Ghuddah, Mohamed
Elgari, and Daud Bakar. However, another prominent Shariah
scholar, Shaykh Yusuf Talal DeLorenzo, directly questioned the
product’s authenticity in a public paper, arguing that while Wad
itself may be “widely seen to comply with Shariah norms,” “products
that use a Wad to deliver returns from non-compliant investments”
are unacceptable (DeLorenzo 2007). It is clear that the various uses
of Wad continue to foster debate.
Although it is too early to say definitively how this debate will play
out and whether Wad Mulzim (binding unilateral promise) will gain
complete acceptance across the world of Islamic finance, the fact that
Bursa Malaysia received no major Shariah-related objections from
the international Shariah scholars at a 2008 International Islamic
Capital Market Forum in Kuala Lumpur where it presented its plans
to develop the Wad-based short sale is anecdotal evidence that the
Islamic finance community may be heading toward acceptance.
Arbun-Based Structure
In addition to Salam and Wad, the Arbun (down payment, also
known as “earnest money”) sale is also being used to structure
Islamic alternatives to short-selling. In an Arbun sale, a buyer makes
a down payment when a sale is agreed, and is committed to pay the
remainder later if and when he decides to take the goods. If the
buyer decides not to take the goods, then he forfeits the down payment and must return the goods. In this regard, Arbun is similar to
a conventional option contract. (See Billah 2003:72–83 for a discussion of the contract and the positions taken on it through history by
jurists and schools of jurisprudence.)
In 2008, Shariah Capital, together with prime broker Barclays
Capital, launched the Al Safi platform for hedge funds. Al Safi
employs an Arbun-based short-selling structure that Shariah
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Capital’s chief Shariah officer Shaykh Yusuf Talal DeLorenzo has
endorsed.
Shaykh DeLorenzo explains Shariah Capital’s “Arboon Short
Sale” in a white paper entitled “A Shariah Compliant Alternative to
Selling Short with Borrowed Securities” (DeLorenzo 2008). Based
on Shaykh DeLorenzo’s explanation, it appears that in the Arboon
Short Sale, the prime broker agrees to sell stock to the short-seller
(an investment manager) at the quoted market price. The shortseller makes a down payment to the prime broker that is equal to the
margin-account deposit that would have been made in a conventional short sale. As stipulated in a “Master Securities Arboon Sale
Agreement”, this down payment transfers ownership of the stocks to
the short-seller. Now that he has ownership, the short-seller sells the
stocks (through the prime broker) to some third party in the market at the market price. Then, at some time in the future, the
short-seller decides to close out the transaction. He buys back the
required number of shares from the market (again through his
prime broker) and then returns them to the prime broker, who
retains the down payment.
Since the specifics of Shariah Capital’s Shar iah-compliant short
sale are not public and are based on a proprietary model, its
mechanics may well differ from the theoretical Arbun-based structure outlined above. Indeed, the devil is often in the details when it
comes to developing a Shar iah-compliant short-sale alternative,
particularly because of the challenge of simultaneously meeting
Shariah requirements and government regulatory requirements.
Shariah Capital CEO Eric Meyer has commented that while achieving Shariah compliance required “a great deal of intellectual
capital”, “the most demanding part” of bringing the Arboon Sale to
market “was reconciling Shariah principles and precepts with the
realities of U.S. Securities and Exchange Commission regulations
that are based on the Securities Act of 1934 and the Investment
Company Act of 1940” (Meyer 2006).
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In general, an advantage of Arbun-based short-selling is that its
mechanics are similar to those of a conventional short sale. For
example, a parallel exists (albeit not an exact one) between the
down payment in an Arbun sale and the margin deposit in a conventional short sale. And unlike in a Salam-based structure, the
stocks in an Arbun-based structure can move in the same way as in a
conventional short sale: first from the prime broker to the shortseller, then on to the market, and then from the market back to the
short-seller and to the prime broker. These similarities may make an
Arbun-based structure easier to understand for both clients and
service providers and may render it more adaptable to the platforms
that prime brokers already use for short sales.
Yet like the other structures discussed, Arbun-based short-selling
may be potentially controversial from a Shariah perspective —
depending whom you ask. Classical Fiqh is particularly critical of the
Arbun sale. Through the history of jurisprudence, most scholars
from the Maliki, Hanaf i, and Shafıi schools have held that Arbun is
invalid. They refer to a Hadith included in Al-Muwatta’, the monumental Hadith collection of Maliki school founder Imam Malik bin
Anas, that reads
c
Rasūl allāh s.allá allāhu calayhi wa-sallam nahá can bay al-curbān
The Messenger of God, peace be upon him, forbade curban17 sale
(Malik Ibn Anas 1986).
Different scholars have taken different approaches to this Hadith,
which is also recorded in the Sunan of Abu Daud and the Sunan of
Ibn Majah, two of the other Hadith collections considered most
important by Sunni Muslims (Abu Daud Sulayman Ibn Al-Ash’ath AlSijistani 1996; Ibn Majah 1998). Some have questioned its
17
Urban, Arban, and Urbun are different Arabic spellings of the same word.
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authenticity. A minority of classical scholars — largely Hanbalis,
including Hanbali school founder Imam Ahmad Ibn Hanbal —
have relied on a conflicting report saying that Umar bin al-Khattab
(one of the Prophet’s companions and the most powerful of the
four Rashidun caliphs) himself practiced Arbun sale, and that
Umar’s son validated it (Kamali 2000:201). However, the historicity
of that account has been questioned too.
In the face of conflicting historiographies, some prominent contemporary Fuqaha argue that Arbun sale should be accepted because
they feel it can benefit people in the modern era. Among them is
Yūsuf Al-Qaradawi, who asserts that the best course is to apply reason to present circumstances and permit Arbun so as to remove
hardship and bring benefit to people (Kamali 2000:202; Al-Amine
2008:239). Another is Mustafá Al-Zarqa’, who stresses the utility of
Arbun to modern commerce (Al-Amine 2008:239).
Modern scholars and financial institutions have responded to
some classical objections. One criticism of Arbun over the centuries
has been that it may harbour Gharar (uncertainty) if it includes no
time limit for contract cancellation. The Islamic Fiqh Academy
addressed this issue by stipulating that every Arbun contract include
a time limit for cancellation (Majis Majma Al-Fiqh Al-Islami AlDuwali 1993) — a possibility that some classical Hanbali jurists
raised (El-Gamal 2006a:91). The Fiqh Academy’s decision has lent
Arbun credibility. Indeed, Shaykh DeLorenzo cites the Fiqh
Academy’s 1993 decision accepting the use of Arbun by “modern
Islamic banks and investment houses” (DeLorenzo 2008). However,
some object that Arbun still contains Gharar because the seller does
not know whether the buyer will conclude the sale (El-Gamal
2006a:91) — a questioning of the Shariah validity of the option
concept itself.
Another potential issue with using Arbun to replicate a short sale
as described above is that it is not in accord with the traditional
usage of Arbun as a down payment. In the theoretical Arbun-based
short sale above, if the short-seller is actually planning to complete
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the short sale, then he knows in advance that he will not be “keeping” the stocks on which he has made a down payment. He knows
from the beginning that he will be returning them to the prime
broker, forfeiting his deposit as the cost of making a short sale. He
does not enter into the Arbun thinking that he probably — or even
maybe — will later complete the transaction and buy the goods in
full after making his initial down payment, but rather enters the
contract knowing in advance that he will not accept the goods.
Conclusion
Efforts to develop Shar iah-compliant short-selling alternatives are
part of an ongoing wave of innovation in the Islamic finance industry that gained pace in the mid-2000s. This innovation wave, which
we might call the “post-sukuk” wave, has had multiple causes: high
oil prices, deregulation, the internationalization of finance, the evolution of more robust national and international standard-setting
frameworks for Islamic finance, and an increase in the number of
scholars versed in both fiqh and finance (Kahf 2004; Warde 2010).
In addition to short-selling alternatives, it has encompassed efforts
to develop Islamic derivatives and hedging techniques (e.g., profitrate swaps, Islamic currency swaps and forwards, Islamic options),
new types of Shar iah-compliant securities (e.g., securities referenced
to commodities, equities, funds, and baskets), Islamic credit cards,
Islamic mortgages, and novel project-finance and trade-finance
structures — to name a few.
What is the Status of the Market?
For the moment, the market for Shar iah-compliant alternatives to
short-selling is nascent but growing fast. As this chapter has discussed,
several offerings are available. Most target Islamic hedge funds as
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their primary client base: these offerings include Amiri Capital’s
Wad-based structure, Newedge’s Salam-based structure, and Shariah
Capital’s Arbun-based structure. Meanwhile, Bursa Malaysia, the
Malaysian stock exchange, is targeting Islamic ETFs using a Wadbased structure incorporated into the workings of the exchange
itself.
Thus the fledgling market for short-sale replication is somewhat bifurcated by both client base and geography. On one side
are the players targeting Islamic hedge funds. They are based in the
United Kingdom (Amiri Capital), continental Europe (Newedge),
and the United States (Shariah Capital). Their clients are primarily
headquartered (though not necessarily domiciled) in the United
States and the United Kingdom, for that is where the majority of
Islamic hedge funds are based at the moment. These funds’
investors reside largely in the GCC, although some come from
Southeast Asia and elsewhere in the Islamic world. Meanwhile, on
the other side of the market for short-sale replication is Bursa
Malaysia, the lone exchange-based contender, which will target
Islamic ETFs in particular.
What should Potential Customers Keep in Mind?
Investors and fund managers choosing a short-selling platform must
realise that their options are not mere variations on a single theme,
as competing financial products often are, but that they differ in
structurally fundamental ways. Even though all have been developed
with the oversight and active involvement of some of the world’s
most prominent Shariah scholars, not all will necessarily be popular
with every Shariah expert. That said, it would be difficult to argue
that one of the structures described above is clearly more universally
accepted than the others; differences of opinion arise on a productby-product, scholar-by-scholar, and Madhhab-by-Madhhab basis.
Therefore, investors and fund managers should take the time to
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understand each structure well and consider whose opinions — past
and present — are most important to them.
Beyond Shariah considerations, investors and fund managers
should evaluate which options are best suited to the legal enviroment
in which they do business. Developers of Shar iah-compliant platforms
to replicate short-selling attest that while the basic structures they
employ — as shown above — may be simple, harmonising Shariah
requirements with securities law adds tremendous complexity. It is
therefore critical that investors and fund managers “do their homework” to make sure the platform they choose will function properly in
the jurisdictions in which they are domiciled and do business.
In particular, investors and fund managers should explore what
contingencies are built into the platform for unexpected mishaps.
Platforms replicating short-selling, like other complex legal structures, prove their mettle under extreme or unusual market
conditions. Aware of this, platform developers expend great effort
ensuring that they have Shar iah-compliant, legally sound structures
to deal with infrequent but potentially critical situations. Amiri
Capital, for example, spent an entire year of its two-and-a-half-year
product-development process developing a netting structure for its
short-sale replication mechanism that could complete the physical
transfer of assets required by Shariah even in the event that one of
the counterparties to the transaction went bankrupt (Shah 2009).
Other players likewise incorporate contingency plans for unlikely
events into their platforms.
Where is the Market Headed?
Prognosticating about finance is treacherous. Nevertheless, I hazard
some thoughts about the future of Shar iah-compliant alternatives to
short selling. First, the broad trend among Shariah scholars toward
gradual acceptance of techniques to replicate short selling is more
likely to continue than not. None of the replication techniques
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I have discussed has the acceptance of every Shariah scholar, but this
has not kept replicated short-selling from going from being a pipe
dream to being increasingly accepted in half a decade. This is due
in part to providers’ efforts to integrate leading scholars into their
product-development processes. But is also due to an increase in the
visibility of Islamic finance and a proliferation of training and certification programs in the past few years. This trends have made
Shariah scholars in general more familiar and more comfortable
with complex financial transactions and instruments. In other
words, as the intellectual enterprises of fiqh and financial structuring
have spent more time brewing together in the cauldrons of Islamic
financial institutions, new techniques like Islamic short-sale replication have bubbled to the surface.
A second and contrasting point, however, is that a ruling against
short-sale replication by one or two leading Shariah scholars could
dampen the market’s prospects considerably. In 2007, Sheikh Taqi
Usmani presented a paper at the meeting of the AAOIFI Shariah
council that suggested the structures employed by about 85 percent
of Sukuk are un-Islamic (Usmani 2007). This threw the sukuk industry into turmoil and sent prices tumbling. The possibility exists that
a prominent jurist could rule similarly against some of the short-sale
replication techniques discussed above, or even against the idea of
Shar iah-compliant short-sale replication tout court.
Yet while that may sound like a nightmare scenario to providers
of short-sale replication, such an event could prove beneficial in the
long run. Nothing would focus more energy and attention on developing novel structures, and on improving existing ones, than an
unexpected jolt to the business of short-sale replication.
Third, the vitality of the market for replicated short-selling will
depend on macroeconomic health in the GCC and Southeast Asia.
In the GCC, the global financial crisis that began in 2008 popped
speculative bubbles in property and equity markets. The capital pouring into Islamic investment vehicles, including the nascent Islamic
hedge-fund sector, slowed to a trickle. If global recovery from the
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present crisis is robust and global oil demand is sustained in the
medium term, GCC investors are likely to regain confidence and
feel warmer about Islamic hedge funds. That would strengthen
demand for Shar iah-compliant short-sale alternatives.
In Southeast Asia — which has not been struck as hard by the
global crisis as North America, Europe, and the Gulf — sustained
stable growth over the 2010–2015 horizon is also the formula most
likely to attract investors to Islamic hedge funds and Islamic ETFs.
Moreover, unless Southeast Asia experiences an economic meltdown worse than the 1997–1998 crisis, governments are unlikely to
halt short-selling (Islamic or otherwise) the way Prime Minister
Mahathir Mohamad’s administration did in Malaysia in 1997. In
Malaysia in particular, the state now views Islamic finance as a lever
of economic growth and has been an enthusiastic champion of
Islamic-finance infrastructure and innovation (Muhyiddin 2009),
making another government “crackdown” on conventional shortselling or replicated short-selling unlikely.
Fourth, while it is possible that the market for Islamic short-selling
alternatives could converge toward a single standardised structure,
convergence appears unlikely in the short or medium term.
Competitors’ claims aside, there is no single replication structure
that is clearly superior to the others along one dimension or other,
whether that be Shariah compliance, regulatory harmonisation, tax
considerations, or economic efficiency. This contrasts with the case
of Sukuk, for example, in which some structures — like Sukuk
Al-Ijara — are frequently described as more “orthodox” and less
controversial than others.
The fact that short-selling can be replicated in a number of
different ways also suggests that the market for it will continue to grow.
Replicating short-selling using Islamic contracts and instruments is not
difficult from a theoretical perspective (see, for example, Hassan
and Lewis 2007:90–95). The challenge stems from the need to harmonise Shariah with regulatory requirements, tax considerations,
and legal contingency plans. Seeing multiple avenues open in front
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of them, new competitors are likely to continue bringing new structures onto the market in the next decade as the Islamic finance
industry grows.
Meanwhile, as new players enter, existing players will expand
their offerings into new markets. Bursa Malaysia, for example, will
be well positioned to offer its exchange-based short-sale replication
system to other stock exchanges if the system succeeds in Kuala
Lumpur. (In this regard, Bursa Malaysia will enjoy an advantage relative to other exchanges that would seek to develop their own
in-house Islamic short-sale replication system because it has benefited from strong government support and significant coordination
among Bursa Malaysia, Securities Commission Malaysia, and the
central bank, Bank Negara Malaysia.) In short, innovation in this
field is just beginning, and Islamic short-selling alternatives will
likely become more widespread in the next decade.
Is All This a Good Thing?
The question may long remain, however, whether Islamic short-sale
replication is in line with Maqasid Al-Shar iah — the objectives of
Islamic law. It is one thing to say that a technique used to replicate
short-selling complies with the letter of Islamic commercial law
(Fiqh Al-Muamalat), but it is another thing to show that the benefits
(Masalih) it engenders outweigh the evils (Mafasid). The hope is
that complying with the letter of the law — however interpreted —
does indeed lead to social good and to outcomes consonant with
Maqasid Al-Shariah. However, when the letter of the law comes to us
via juristic interpretations formulated in the classical age of Islamic
jurisprudence but the substantive impact of financial instruments is
felt in a twenty-first-century economy, the possibility arises that
adherence with the letter of the law and with its spirit may not necessarily guarantee each other. In a globalised economic system
founded on complex and intertwined financial markets behaving in
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unpredictable ways, it may be rash to assume that adhering to classical juristic rules insures us against the deleterious effects that even
“Shar iah-compliant” financial structures could have, whether at the
individual level or the systemic.
Ultimately, we may have to wait and see what kinds of effects
Islamic short-sale replication has. The history of conventional shortselling is instructive here. On one hand, short-sellers have been
vilified for centuries as vultures who undermine market confidence,
being blamed as early as the 17th century for financial crises
(De Marchi and Harrison 1994; Ferguson 2008). On the other
hand, many economists insist that short-sellers provide information
that helps smooth out markets, acting as one of the few safety valves
to relieve upward price pressure driven by “irrational exuberance”
during speculative asset bubbles (see, inter alia, Figlewski 1981;
Jones and Lamont 2002).
What about Islamic short-sale alternatives? Do they have positive,
neutral, or negative effects on the individuals that use them and the
markets and societies in which they are used? What criteria should
be used to evaluate them? Do Shariah experts have the breadth of
knowledge necessary to evaluate them, or is a wider dialogue
needed (Siddiqi 2007)? What can religious texts, and their classical
and contemporary interpretations, reveal about how to achieve the
Maqasid Al-Shar iah as societies, markets, and technologies change?
After all, debates over what is Haram and what is Halal have always
been linked to changes in societies, markets, and technologies — as
the history of the Salam contract shows, for example. We should not
be surprised if debates over Islamic short-sale replication continue.
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