Book Review for Hedging in Islamic Finance (2006) by Dr. Sami al Suwailem by Camille Paldi

Book Review for Hedging in Islamic Finance (2006) by Dr. Sami al Suwailem by Camille Paldi

 

Dr. Sami al Suwailem is a famous Islamic economist, who works at the Islamic Development Bank in Jeddah, Saudi Arabia. I had the chance to learn this book directly from him at the Bahrain Institute of Banking and Finance (BIBF) in Manama, Bahrain. I was extremely lucky in that this was the first time ever that he taught this book and class in English. The book is available for download off the internet in English and Arabic. This text gives a good overview of derivatives usage in Islamic finance from a Shari’ah perspective. Generally, Islamic finance has travelled the route of conventional derivatives usage and many Islamic scholars and Islamic finance practitioners advocate for or justify the use of derivatives in Islamic finance and banking. Dr. Sami al Suwailem is one of the few who remind us why derivatives are prohibited in the Shari’ah. In this book, Dr. Sami also discusses Islamic financial engineering and Islamic instruments for hedging.

 

Dr. Sami explains that derivatives can be described as financial instruments for trading risk including futures, options, and swaps. Dr. Sami says that, theoretically, derivatives are supposed to distribute risk among market participants in accordance with their ability to assume them. He states that derivatives are the main instruments used conventionally to hedge various types of risk, but that they are also the main instruments for speculation. Dr. Sami explains that this transfer of risk from hedgers to speculators is supposed to improve efficiency and productivity of the economy. However, Dr. Sami asserts that derivatives are actually instruments of loss and that they create a separate side economy totally de-linked from the real economy, which destabilizes the real economy and exposes firms to a whole new set of risks.

 

Dr. Sami refers to Warren Buffet in relation to derivatives. Warren Buffet describes derivatives as, “time bombs, both for the parties that deal in them and the economic system.” Buffet says that, “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Dr. Sami also makes reference to Alan Greenspan. Greenspan notes that derivatives are highly leveraged by construction and that this leverage makes the financial system highly vulnerable. Greenspan says that, “Leveraging always carries with it the remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked.” Alan Greenspan states that ‘Overall, derivatives are a zero-sum game: one counterparty’s market loss is the other counterparty’s market gain.” Derivatives are a dangerous game where one party’s loss leads to the other party’s gain, which can easily cascade out of control and crash the economy. These are fairly harsh statements against the use of derivatives by famous Americans. In fact, at many instances in history, many US states have banned derivatives. Islamic finance and Islamic hedging instruments may provide the United States with alternatives to relying 100% on derivatives usage for hedging risk. The concepts are worth exploring!

Dr. Sami illustrates that derivatives are clear examples of zero-sum games. He says that, “They are obligations to exchange certain amounts of money in a future date. The difference between prices at the time of contract and at maturity is debited from one party and credited to the other and that is why they are called contracts for differences. With the mark-to-market system, this is done on a daily basis. Even if the derivative is traded in a secondary market, the obligation as such survives throughout the life of the contract and whoever becomes party to it has to settle these differences.” Dr. Sami reminds us that risk cannot be severed and separated from real transactions as this will make risk transfer a zero-sum game. Dr. Sami says that in fact, derivatives deliberately sever wealth-creating activities from risk management, making them by construction zero-sum games.

 

Dr. Sami reveals that derivatives unbundle risk from real economic activity and make it trade separately, thereby transforming risk into a ‘commodity.’ Creating a market for risk actually makes risk multiply. Dr. Sami states that commoditizing risk, therefore, is likely to make risk multiply and proliferate, making the economy more risky and less stable. Artificially severing risk makes it return in more dangerous forms.

 

Dr. Sami shows us that derivatives allow for unbundling and repackaging or risks in any manner players find suitable for their preferences. Dr. Sami explains that this means that these instruments end up with risk-reward structures that differ greatly from those of the underlying real assets. Dr. Sami reveals that, “This production of artificial risk profiles creates arbitrage opportunities that are independent of real opportunities, which opens the door to pure speculation to take advantage of these artificial structures. In other words, artificial risk structures create artificial arbitrage opportunities that can be exploited through pure speculation with no connection to real economic activities. Pure speculation in turn distorts asset prices, leading to negative impacts on real investment opportunities. Consequently, capital committed to such speculation becomes exposed to risks unrelated to the real economy. Not only are these risks reflected back to the economy, they also distort asset prices, leading to negative impacts on real investment opportunities.” Dr. Sami states that in reality, trading in derivatives, such as futures and options, results in losses more than 70% of the time. Derivative are actually instruments of loss.

 

Dr. Sami illuminates the difference between salam, an Islamic mode of finance, which is technically a future sale, however, allowed as an exception under the Shari’ah and futures. Al-Suwailem states,

 

“In a futures market of a certain commodity, any change in the price of the commodity registers profits to one party and equals loss to the other. In a salam contract, in contrast, the price is paid in full in advance. The advanced payment provides the seller the possibility to utilize it in a manner that could compensate for moderate price increases of the commodity. On the other hand, since delivery is destined to a future date, the paid price is lower than the spot price. This discount provides a cushion for the buyer against moderate price declines. Therefore, the advanced payment provide a “safety margin” for both parties against moderate price fluctuations. This is in contrast to leveraged futures, where any price fluctuations presents a gain to one party and a loss to the other.”

In the remaining sections of the book, one may explore a plethora of Islamic hedging instruments and the philosophies behind Islamic financial engineering.  Underpinning Islamic financial engineering is the deletion of riba and the replacemet of riba with cost plus mark-up.  Dr. Sami states that, “Riba separates finance from real transactions. Since the two counter-values of a loan are identical, it follows that interest becomes purely the cost of time or the cost of pure finance.” Dr. Sami says that, “Interest is a self-replicating mechanism that makes debt grow and multiply independent of the real economy.  This eventually drains real resources to the benefit of lenders.  Mark-up, on the other hand, is time value integrated into the real transaction.  This eliminates the possibility of self-replication of debt.  Time value as such is not the issue; rather it is the growth of debt independent of real wealth that threatens social welfare.  By integrating time value with real transactions, this replicating mechanism is eliminated. ”

 

Dr. Sami writes about various Islamic hedging instruments, of which I will highlight two, the commodity-linked bond and value -based salam. Commodity- linked bonds are structured so that their coupon and/or principal payments are determined by the price of some commodity.  Commodity-linked bonds issued by governments prevent or reduce debt crisis, promote international risk sharing, and facilitate adjustment of fiscal variables to domestic economic conditions.  They also provide commodity-producing countries an opportunity to hedge against fluctuations in their export earnings.  Commodity linked bonds differ from diversified price sukuk in that bonds pay money in exchange for money while a diversified price sukuk pays in kind and money in exchange for a good.  However, both instruments work to relieve the borrower from interest burdens and thus provide risk-sharing features.

 

Dr. Sami also reveals the benefit of value-based salam as a hedging instrument in Islamic finance.  In salam, the bank pays in advance at a discount for delivery of goods in the future.  Dr. Sami says that the main problem with salam is the price value of the good at maturity.  Dr. Sami explains that this price might differ greatly from the expected price and the gap might wipe out the benefits of the discounted advanced payment.  Dr. Sami says that one solution to address the price fluctuation is the value-based salam.

 

Dr. Sami explains that the buyer pays in advance the full price, say 10,000, in exchange for Good A.  Traditionally, the quantity of Good A shall be determined upfront.  Value is defined as quantity times unit price or number of Good A multiplied by Good A’s price.  Let’s say the value agreed upon is 11,000.  This means that the buyer pays 10,000 for an amount of Good A, the value of which at maturity is 11,000.  At maturity, the price of Good A is determined from the market and thus the quantity becomes also determined (by dividing the value by the price of Good A).  So, if the price of Good A at maturity is 50, then the quantity of Good A to be delivered is 220.  (220 x 50 = 11,000).

 

Dr. Sami reveals that the buyer in this arrangement is able to hedge against price fluctuations of the future good.  If the price at maturity declines, the quantity to be delivered will rise to compensate for the price reduction.  If the price rises, the quantity declines.  Thus, price fluctuations are internalized through the value determined at the outset.

 

Dr. Sami illustrates that value-based salam provides an opportunity for the two parties to gain from the transaction.  Let’s use the above example.  If the market price of Good A at maturity is 50, but the company is able to get Good A through another means at 30, this means the actual cost for the company is 6,600, which is less than the total price it received.  That is, the company is able to save 3,400, while the buyer is able to make 1,000.  Both parties win.  Dr. Sami says that this could not happen in a pure loan since the two sides of the loan are identical be design.  In the value-based salam, the two sides are different, which allows both parties to gain.

 

Dr. Sami illuminates that value-based salam differs from artifices of riba like tawarruq and bai al inah in an important dimension. Dr. Al Suwailem says that, “In these artifices, the same commodity may be used successively, by the same agent and others, to generate additional debts without limit.  There exists no upper boundary on how many times the commodity is sold for the deferred price and then resold for cash.  A single commodity could therefore create huge debts in a short time (similar to fractional reserve banking).  In salam and value-based salam, this is impossible since the moment the commodity is delivered, debt is extinguished.  At any given time, a single commodity cannot generate debt that exceeds its value plus the mark-up.  The instrument self-regulates the amount of generated debt and internally imposes an upper boundary on the size of the debt.  This is consistent with the nature of Islamic finance in the absence of artifices as all debts are used to finance real transactions.  Consequently, possible debt size is bounded by real activities.  This is in contrast to an interest-based economy, where debt can grow indefinitely, irrespective of the size of the real economy.”

 

I highly recommend this book for students, academics, governments, legislators, practitioners, professionals, and anyone working in capital markets, Islamic finance, Islamic capital markets, law, finance, banking, and/or business.

 

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