In the Name of Allah, the Entirely Merciful, the Especially Merciful

All praise is due to Allah, Lord of the worlds, may the blessings and peace of Allah be upon our master Muhammad, the seal of prophets, on his family, and all his companions

Resolution No. 238 (9/24)

on

Hedging Transactions in Islamic Financial Institutions

The Council of the International Islamic Fiqh Academy of the Organization of Islamic Cooperation, held its twenty-fourth session in Dubai (United Arab Emirates), on 7-9 Rabi al-Awal 1440, corresponding to 4-6 November 2019,

Having reviewed the recommendations of the scientific seminar on Hedging Transactions in Islamic Financial Institutions, held by the Academy in Jeddah (Kingdom of Saudi Arabia), in cooperation with the Iqra Waqf for Development and Employment, on 24-25 Rajab 1440, corresponding to 31 March-01 April 2019,

Having listened to the discussions on the subject,

Resolves the following

First, confirming the resolutions of the IIFA (OIC member) regarding hedging in financial transactions; in particular, the Academy resolution no. 224 (8/23) on Hedging in Financial Transactions, Regulations and Rulings, adopted at its twenty-fourth Session in al-Madinah al-Munawarah on 19-23 Safar 1440, corresponding to 28 October-01 November 2018, including all its paragraphs, as follows:

• – The concept of
• – The concept of
• – The concept of
• – Shariah position towards risks hedging.
• – Shariah regulations for hedging formulas and methods.

Second, the general meaning of hedging (i.e. covering) transactions:

There is a range of transactions that can generally serve as a basis for hedging and covering formulas. It is one of the activities of financial institutions, and it is deemed permissible under Shariah law, in particular :

1. Economic hedging: It consists of a diversity of assets, investment portfolios and formulas. It is required according to Shariah, in order to achieve good resources
2. Cooperative hedging: It is based on takaful formulas by concluding takaful insurance contracts to compensate for damages and losses that the Islamic financial institution may face. This formula is not objected by Shariah, due to the lawfulness of cooperative insurance on projects, as well as on physical and financial assets. Hence, the Academy resolutions no. 9 (9/2) and no. 200 (21/6) confirmed the lawfulness of cooperative insurance and its different formulas.
3. Parallel contractual hedging: It is a contractual contract parallel to the original contract, with the same terms and specifications, whereby the financial institution protects itself against the risks of the original contract, such as-salam (i.e. advance payment sale), parallel salam (salam muwazi), istisna’ (i.e manufacturing), and parallel Istisna (parallel manufacturing) contracts, as stated in the recommendations of Academy resolution no. 224 (23/8) on hedging.

One of the essential regulations of Shariah regarding the lawfulness of parallel contracts is not to associate the first contract with the second contract, but each contract should remain independent in all its rights and commitments.

4. Combined contracts: combining contracts to cover risks for the purpose of combination, neither as a requirement, nor to include a contract within a contract. Example; the combination between a sale and binding commitment, between wakala (agency) and murabaha. Among the most important of these formulas are as follows:
5. The combination of Murabaha and Musharaka: by dividing the investment portfolio into two parts: the first part is allocated to Murabahah(s) with creditworthy entities, at a fixed profit; and the second part is invested in a Musharaka contract, such as trading stocks or real estate shares, and so on. Therefore, capital hedging is achieved through a Murabaha contract, with the possibility of loss for the second part.
6. The combination of ijara and musharaka: hedging mechanism in this formula is equivalent to the previous method. However, hedging is applied with an ijara contract instead of a murabaha contract, such as investing a part of the investment portfolio in the purchase of sukuk al-ijara, with an income enough to cover the capital. The remaining amount shall be invested in musharaka contracts.
7. The combination of Murabahah and Bai’yul Urbun (i.e. earnest money) by dividing the capital into two parts: the first part consists of Murabaha with solvent companies and a certain profit, while the second part consists of bai’yul urbun for the purchase of shares.

If an asset rate increases, the purchasing contract shall be concluded, the shares shall be received and sold, and its selling amount should be delivered to the seller, and the profits shall return to the fund.

However, if rates do not increase, the first party should cease proceeding the contract and might lose in the sale. The capital remains covered thanks to the murabaha contract. In this process, it is compulsory to comply with Shariah regulations for bay’ul urbun (advanced deposit sale), which includes keeping the subject matter of the deposit without trading it from the moment the contract was signed until the settlement between the two parties.

5. Hedging using conditional options (Khayar al-Shart) to cover against the insubordination of the client: For example; Murabaha, and Ijara contracts ending with ownership. The Academy resolutions on the two commitments confirm that it is permissible under conditional options for committing parties, or for one of them. Without this condition, the transaction is not permissible.

It should be noted that in the resolutions in which the Academy allowed the “binding commitment” by one of the parties, regarding it as a hedge against insubordination of the client, and protection of the company against losses, the right to opt shall then be given to the other party.

6. Hedging using guarantees to protect the investment capital:

There are diverse mechanisms which are included within the guarantee formulas to cover risks arising from loss or non-profit in investment projects. The Academy resolutions confirmed its permissibility. Such formulas are as follows:

• Third-party guarantee: It is a natural or legal person independent from both parties in the contract if he undertakes to donate the guarantee in a specified project. The Academy resolution no. 30 (4/3) confirmed that this guarantee is permissible if the guarantor is independent in his personality as well as in his financial responsibility towards both parties of the contract, by donating an interest-free contribution to compensate the loss of a specified project providing that it is an independent
• Charging the mudarib (mudaraba operator) to prove the loss: the Academy stressed in its resolution no. 212 (22/8) that transferring the responsibility of proving the loss to the bank (of the mudarib/mudaraba operator) is contrary to basic Shariah principles providing that there is evidence contrary to his claim of non-violation.

Third, hedging transactions that are generally prohibited by Shariah include:

1. Hedging mutual loans in two different currencies under conditions:

This formula is utilized to cover against currency rate fluctuations and disclosure of correspondent accounts. If a financial institution has a surplus of a particular currency that it lends to another institution; that institution would lend it another currency that it needs, under an explicit, implicit or customary condition. It is a kind of lending a loan per the condition of receiving/borrowing another loan, which is not permissible in Shariah, based on a consensus by legal schools, because of the association between two loans (i.e. when the lender requires the borrower to give him a loan in return) whether the deadlines of the two loans are similar or different.

2. Hedges to secure financial capitals in assets and sukuk:

Sukuk issuance includes a number of hedges, requirements and commitments which are incompatible with Shariah regulations and to the Academy resolution no. 30 (3/4) adopted in 1988 on Muqarada (i.e. an arrangement between one or more investors and an agent ) and investment securities; and to the Academy resolution no. 188 (3/20) on completing the resolution concerning Islamic Sukuk, notably:

• Guaranteeing the nominal value by the issuer (mudarib, managing partner, investment agent).
• The Mudarib undertaking to lend the sukuk portfolio to guarantee a certain rate in the distribution of

(3) Requiring that sukuk holders shall not have the capacity to utilize the leased assets in case of installments payment default.

(4) Non-transfer of sukuk assets ownership to investors or to sukuk holders means that they are not included in the guarantee and not entitled to disbursement, as their holders and investors did not bear covering the profits. This is proved by the fact that these assets often remaining part of the issuer’s budget.

(5) Requiring to include in the issuance prospectus the manager’s loan to sukuk holders if the actual profits falls below a fixed percentage. This requirement is often backed by the fact that if the profit exceeds this percentage, the excess shall fully be returned to the manager as an incentive.

Fourth, Alternative hedging instruments for financial derivatives and their Shariah rulings:

These instruments can be divided into three essential types:

Type I: Hedging against the risk of future currency rate fluctuations. Among its most significant transactions are:

1. A binding commitment between the two parties to enter into a disbursement agreement in the future:

Formula: Both parties make a binding commitment to enter into a disbursement agreement on a specified future day and at a fixed currency rate.

Shariah Ruling:

(A) It is not permissible to utilize the binding commitment as the hedging formula for disbursement agreement. The Academy resolution no. 102 (11/5) on trading currencies, stated that it is not permissible to sell currencies in bay’ al-aajil (i.e. forward sale with cash advance) or to make of it a disbursement commitment.

This is because the binding commitment is similar to the contract/agreement, as stated in the Academy resolution no. 40 (5/2) on fulfilling commitment, and on the murabaha with order to purchase (Murabahahat lil-amir bi al-shera), which stated that the sale binding commitment is equivalent to the sale itself.

(B)This formula does not include exceptional cases mentioned in the Academy resolution no. 157 (17/6), on binding commitment and agreement in contracts; but it allowed binding commitment in exceptional cases while confirming that in such exceptional cases, binding commitment should not include riba.

2. The two mutual commitments (the binding commitment with specific conditions, faced with a binding commitment with diverse conditions in a future disbursement agreement).

Formula: The first party shall make a binding commitment to the second party to sell an amount of a currency at a fixed rate, at a specified time if currency rate direction is not compatible with his interest. But if rates are in his favour, he shall not make a commitment. The second party shall also make a binding commitment to purchase the same currency, at the same fixed rate, at the same specified time, if the currency rate direction is compatible with his interest. However, if it is not compatible with its interest, nothing shall be undertaken on his behalf.

Shariah ruling:

Mutual commitments are not allowed to hedge against currency rate fluctuations, as their real form is similar to disbursement binding commitment that is prohibited by Shariah, by virtue of the Academy resolutions above.

3. An offer extended for a fixed period requiring the offeror to enter into disbursement agreement.

Formula: The first party issues an offer, extended to a given day, in which the disbursement agreement is concluded, by selling the currency at a fixed rate and amount. The other party makes a binding or non-binding commitment to issue its agreement within the agreed deadline.

Shariah ruling:

(A) It is not permissible to apply the principle of extended offer to the disbursement agreement, due to the existence of the condition of taqabud (i.e. to take delivery of the object of sale and to pay its price) during the contract meeting; whether or not it is faced with a binding commitment on behalf of the other party, as stated in the Academy resolution no. 52 (3/6) on concluding contracts by modern communication devices. See Article IV.

(B) If the extended and binding offer is faced with binding commitment from the other party, it is then similar to the binding commitment, but even worse because of the existence of an offer, regarded as one of the two pillars of the contract.

4. Execution of two mutual tawaruq transactions (tawaruq mutaqabil):

Formula: The execution of structured tawaruq results in the demonstration of debt with the amount of the first currency required to be paid, then a reverse tawaruq transaction is carried out to result in a debt with the amount of the second currency required to be received. This will result in two mutual debts on both sides of the transaction, each in a different currency.

Shariah ruling:

It is prohibited because it is based in its structure on a type of Tawaruq prohibited by Shariah. The Academy resolution no. 179 (5/19) on tawaruq and its types, confirmed that both types of tawaruq (structured or reverse) are prohibited, as there is explicit, or implicit, or customary agreement between the financier and the mustawriq (securitizer), to collect money deceitfully more than that’s owed, and that is riba.

5. The bilateral binding commitment to conclude a murabaha transaction or a future sale with loss; whose profit or loss is based on an agreed index.

Formula: This transaction is executed through a binding commitment by both parties to make a murabaha / sale with loss transaction, from the first party to the second party, or from the second party to the first party on a future day. The profit or loss is calculated based on the positive/negative variance in a future day agreed for the calculation of the index.

Shariah ruling:

• The basic principle is that it is not permissible to make a bilateral (mu’awada) binding commitment between the two parties, in accordance with the Academy resolution no. 40 (5/2).
• This formula does not include exempted cases allowed by the Academy resolution no. 157, as stated above in paragraph IV, article I/I/A.

6. Both mutual commitments (a binding commitment with specific conditions faced with a binding commitment with different conditions, to execute murabaha / sale with loss transaction in the future).

Formula: The first party makes to the second party a binding commitment to execute a Murabaha / sale with loss transaction at a specified moment if the direction of the currency rate index is not compatible with his interest. However, if the direction of the currency rate index is compatible with his interest, therefore he does not make a commitment.

The second party shall also execute a murabaha / sale with loss transaction at the same specified moment if the direction of the currency rate index is contrary to his interest. However, if the currency rate index is favourable to his interest, he shall not make a commitment. The profit or loss of the sale is calculated based on the agreed index.

Shariah ruling:

The two mutual commitments are not permissible as their real form resembles a binding commitment that is prohibited by Shariah according to the above paragraph IV, article V.

Type II: Hedging against fluctuations in interest-rate indices associated with profit rates in Islamic formulas.

1.The binding commitment of both parties to enter into a future Murabaha or sale with loss contract, whose profit or loss will be calculated on an agreed index.

Formula: This transaction is made with a binding commitment by the two parties to carry out a series of Murabaha/sale with loss transaction from the first party to the second party, or from the second party to the first party, in a series of days in the future. The positive/negative variance is used to calculate the profit or loss of each transaction in each coming day, agreed upon to calculate its index.

Shariah ruling:

(A) It is not permissible to utilize the bilateral binding commitment as a hedging form to exchange fixed and floating interest rates, because bilateral sale binding commitment is similar to the disbursement agreement, as stated in the Academy resolution no. 40 (5/2) on commitment observance, and murabaha lil-amir bi al-shera (i.e. murabaha with order to purchase) because sale binding commitment is similar to the sale itself.

(B) This formula does not include exempted cases allowed by the Academy resolution no. 157, and described above in paragraph IV, article 1/1/A.

2. The two mutual commitments (a binding commitment with specified terms, faced with a binding commitment with different conditions, to execute a future Murabaha/sale with loss transaction)

Formula: The first party makes a commitment to the second party to undertake a series of Murabaha / sale with loss transactions at a specified time, if the direction of the interest rate index is not compatible with his interests. If the direction of the interest rate index is compatible with his interests, he shall make no commitment.

The second party also undertakes to execute a series of Murabaha/sale with loss transactions at the same specified times if the direction of the interest rate index is not compatible with his interests, but if the direction of the interest rate index is compatible with his interests, he shall make no commitment. The profit in Murabaha or the sale with loss is calculated based on the agreed index.

Shariah ruling:

It is not permissible to make two mutual commitments, as their real form is equivalent to the bilateral binding commitment prohibited in Shariah, in accordance with paragraph VI, mentioned above.

3. Execution of mutual tawaruq transactions:

Formula: Executing a structured tawaruq transaction resulting in the demonstration of indebtedness at the required fixed interest rate. Then proceeding to a reverse tawaruq transaction resulting in the demonstration of indebtedness at variable interest rates. This will allow the two debts to be offset against each other on each day up to their deadlines. Compensation is then made by paying only the variance. Three methods can be utilized to achieve a variable interest rate in tawaruq transaction:

(1)-Contracting variable-rate tawaruq.

(2)-Contracting fixed-rate tawaruq with a commitment to discount any excesses in interest rate index for each future instalment day.

(3)- Cyclical tawaruq by executing a series of short-term tawaruq transactions, each at a fixed price to create a floating rate debt at the end.

Shariah ruling:

It is not permissible because the transaction is based on a formula prohibited by Shariah (tawaruq), as stated in paragraph IV, Article IV.

Type III: The one-party binding commitment as an alternative to options transaction

Formula: Issuance of a binding commitment by one party to execute a murabaha transaction with the second party, with the amount of the positive variance, on an agreed day or within an agreed period, at the request of the second party.

This binding commitment is sold at a fixed price which shall be paid in the beginning.

The first party issues a binding commitment that shall be equal to the option seller, and the second party with the binding role of making the commitment shall be equal to the option purchaser.

Shariah Ruling:

It is not permissible to compensate for the binding commitment.

The IIFA resolution (no. 63) on financial markets stated the following points:

“Second: Options

A- Options contracts: The meaning of options contracts is to offset the commitment to sell or purchase a specific item at a fixed price, within a given period, either directly or through an authority guaranteeing the rights of both parties.

B- Shariah ruling: Options contracts, as currently traded in the international financial markets, are new contracts that do not fall under any of the Shariah-compliant contracts. Furthermore, the subject matter of the contract is neither an amount of money, nor a benefit, nor a financial right that can be compensated, so this is why Shariah prohibits such contracts. Moreover, since these contracts are basically not permissible, their dealing is not permissible as well.”

The International Islamic Fiqh Academy also adopted resolution no. 224 on hedging that included hedging regulations that Shariah permits. It stated that: “Hedging formulas should not lead to the sale of abstract rights, such as the options sale, whose prohibition was confirmed by the Academy resolution no. 63(1/7), paragraph 2/B. Neither should it lead to the offsetting of the commitment, such as payment for the guarantee, which the Academy prohibited in resolution no. 12 (12/2)”.

Recommendations

1. The Academy recommends Shariah Councils, Fatwa and Shariah Supervisory Boards, scholars and researchers, to reconcile between compliance with the fundamental objectives of Shariah and its specific regulations regarding contracts when practicing Ijtihad in structuring Islamic financial products in general, and in drafting hedging contracts in particular. Also, to consider the outcomes of these contracts and their effects, because the consideration of outcomes is a basic principle in Shariah.

2. The Academy recommends investment and treasury departments at the institutional level (local), as well as authorities in charge of drafting monetary and financial policies on states level (global), to ensure a balance between commitments and debts on the one hand, and between wealth and real activities on the other, and to avoid dumping in debts that affects economic activity in general.

Allah Knows Best