Islamic Finance Theoreticians and Islamic Economists often get caught up in the doctrinaire. Rather than exploring the feasibility of an arrangement, they will find arguments against it based on legitimate (but to some extent overused) sources. In the case of short-selling, many would quote the truly famous hadith, where the Prophet (pbuh) was quoted to have said ‘Do not sell what is not with you.’ This hadith is the basis for much speculation about the inner meaning of Islamic Finance and has even been cited and miscited by Western Economists as a rationale for why Islamic Economic systems must be more stable than conventional. (see Kamali, Islamic Commercial Law: An Analysis of Futures and Options, chapter 10 for a deep discussion of this hadith).
We can only point to the recent announcements of Dubai World as an example of the lack of stability of any system based on huge amounts of leverage, as well as an opportune time for discussing the mechanisms for a short-sale. Certainly, shorting DP World or Nakheel a few months back might have made perfect sense, given the questionable support of the Abu Dhabi government for the speculative excesses of its super-trendy neighbour.
But, given the explicit authorization of bai as-salaam contract (forward sale, where payment is made upfront and the sales item is delivered at a later date), which certainly calls the applicability of the above-mentioned hadith into question, we leave the open debate (see for instance our Linkedin discussion here for a lively debate on the topic) of whether something should or should not be allowed behind in order to tackle the specifics of just how would short-selling be accomplished.
If this justification for our discussion were not sufficient, the possibility of Islamic Hedge Funds had been much in the news within the past two years. Perhaps this was just the dreams of structurers who always want to solve the next puzzle, rather than a case of genuine demand. And, recently the role of hedge funds in the Global Financial Crisis may call to question the wish to Islamize many of their activities. Nonetheless, the primary obstacle to the development of Islamic Hedge Funds was seen to be the lack of a short-selling mechanism, although some would cite at least three requisites in order to launch a hedge fund: leverage, short-sales, and compensation schemes (see, for example this article on the death of hedge funds from 1969). We hope to tackle issues of leverage (through Shariah-compliant repos for instance) in later articles. As we shall see here, the structuring teams have been very active when it comes to developing the means for short-sales.
Although we shall discuss four methods for short-sale below (with links to three already detailed in Islamic Finance Resources), further methods and nuances of each of these are likely to emerge over the coming years, given the level of activity and interest among market participants in finding solutions to the issue of Islamic Hedge Funds.
1. Short-sale by Salaam:
2. Short-sale by exchange of (conditional) promises (wa’dan)
3. Short-sale by Sale and Promise:
4. Short-sale by Arboon (down-payment sale):
We may very well see new developments and methods for short-sales in the future as well as a quest for dominance of one prime brokerage platform (and method) over the others. As different as those methods might be, it seems the lack of a cohesive approach to alternative investments represents yet another hurdle for this sector. Nonetheless, looking at the mechanisms for the individual methods (with their respective pros and cons) can give further insight into the plausibility of both hedging and benefiting from the speculative excesses of others.
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