Treatment of Market Risk in Islam
The Holy Qur’an contains explicit and implicit teachings on economics, especially on enterprise and market risk management. The core concept is that risk must be fully apportioned among a broad base of participants. It does this by prohibiting fixing the value of obligations and rewards, thereby allowing valuations to reflect their true worth across time as economic realities change. It is a dynamic system, which mitigates the negative effects of constantly changing valuations in an economy. And it is in sharp contrast with conventional interest-based systems, whose weakness is in fixing the value of obligations and rewards for different enterprise participants in an economic regime of continuous valuational changes.
With respect to funding enterprises, Qur’anic teachings disallow lending money or value at a fixed rate of return1. Therefore, if it is needed to borrow capital, it must be loaned at’benevolent’ terms – at no interest, paid back whenever the lender wants. Such terms are not practicable for most instances, considering the time value of money and its opportunity cost.
A practical alternative is to enlist partner-investors. As with any investment, these will share in the risks and the rewards of the enterprise. If it fails, all lose in proportion to what has been invested, and no further payments are due. If it succeeds, all investors share in the rewards proportionately, just as their losses would have been shared. This system spreads enterprise risk from one individual to the enterprise-entity, reducing entry and start-up costs with respect to risk premiums being born disproportionally by any one party2.
Contrast this to a simple loan at interest. No matter what happens to the object for which the loan was obtained, the loan must, in any case, be paid back, even if the generator of future funds-the enterprise-has been lost. This is a disincentive for businesses and invention commercialisations because the risk premium on both sides is simply too high.
The effect of investor-partner funding is to push risk up the hierarchical management chain and place the greatest risk on the broadest shoulders, those of the enterprise as a collective form.
Consider the effect on enterprise risk caused by the prohibition against interest on borrowed capital: not only does it encourage – indeed, necessitate – partnering with others in enterprise start-ups, which spreads risk among partners in proportion to their importance to the enterprise, it broadens the human capital employed by the enterprise, greatly increasing its chances of survival. And this supports another teaching of the Qur’an, that we should consult on matters of importance with all those affected (economic externalities should be internalized).
Now consider the broader implications of this teaching on the economy in its entirety, using a simple example. Imagine that you have a new invention, which could conceivably cause a revolution in, say, information technology. But you are in need of funds to get it off the ground. You go to a bank, but they have little interest in your dream. You have no track record as a business operator, and your new idea is hard for the bank to evaluate: how much could it be worth? What about collateral? So, your new idea gets no loaned funds.
You are now introduced to a venture-capital investor. This person arranges investing for new ideas by finding partners, limited or full, who will give you the financing needed, in exchange for a share of the business ownership. Whatever it makes in future, the partners now own a share and get paid from its profits. They retain ownership of their shares until they want to sell out.
This scenario is from history, and describes the personal computer and Internet revolutions in the 1980s and beyond. Left to bank financing, none of that could have possibly had a start. This is not to say that Silicon Valley consciously followed Qur’anic teachings to fund a new industry; but that what occurred was in complete accordance with Qur’anic teachings on borrowed capital, and in fact could not have happened in lieu of the financing structure the Qur’an promoted.
Even without the requirement to be Shariah compliant in financial activities, the result of following these teachings enabled the appearance in a market sector employing millions of workers, paying trillions in taxes for infrastructural improvements, created many useful and convenient devices, making the entire economy more efficient, reducing costs for all of us, and enhancing our living standards
The reason why venture capital finance – promoted by the Qur’an – succeeds where bank financing fails is that bringing new things to the market is risky, and neither the borrower nor the lender is prepared to bear the full impact of fixing the assignment and the value of its risk if things go wrong. For the borrower, if the venture fails, all the funds must still be paid back. Few are so confident, or so crazy to take this risk lightly. For the banker, which lends out other people’s money at interest, it risks never getting repaid. If that happens a few times too many, the bank becomes insolvent and its doors are shut. That is because banks routinely have only about 6 per cent of assets available for depositors’ redemption at any time. If just some of the borrowers fail to repay, the bank fails.
The Qur’anic teaching on financing enterprises, leading to venture capitalism, has other implications; all aimed at assigning risk loads in proportion to reward prospects. It enables hiring needed workers at a low current wage while the new start-up is cash strapped, by promising to pay stock options, which gives the worker the right to buy company stock at a price below market, then sell them back to the market to recoup the price difference if they choose. That way, workers become worker-owners, partners in the enterprise and dedicated to its success in a way that an ordinary employee, who is paid a wage or salary and has no stake in the business beyond a desire for job security, can never be. Again, risk management utilizing Qur’anic teachings is a win-win: employers get dedicated workers and workers get a shot at some real money if the business takes off.
Many businesses today offer stock options with less pay initially, or higher pay and no stock options. Most times the options are chosen rather than the higher initial pay. Of course, the chances of a new business succeeding are not usually good, and the stock options could end up being worthless. Loosing a job is the real economic setback, far more serious than having worked for less, because all income is now lost. Being a well-paid x-worker or holding worthless stock options doesn’t change that. But the dream is there, and everyone remembers the story (perhaps actually true) of Bill Gates’s neighbour insisting on being paid cash for helping him move into office space from his home, rather than accepting several thousand shares in his new company, Microsoft.
The teaching in the Holy Qur’an prohibiting interest collection on borrowed capital forces entrepreneurs to find venture investors and eschew taking on unmanageable risk loadings. It is such a useful idea that venture capitalism is now a fixture of financing the world over, especially for new ventures with unknown dynamic outcomes. It is not necessary to show its origination in the Qur’an; many useful ideas are affirmed in the Qur’an, and many others are therein encouraged, promoted or inferred by its teachings, all of high value and eminent practicality.
Not only has it spawned venture capitalism and stock options, it has also led indirectly to the creation of other instruments designed to allow producers to offload their risks in exchange for a variable fee or percentage of profits. That keeps producers producing, adding value to our lives, and giving the risk to those who, by training, desire or constitution, choose to bear it in hopes of making a profit. Assuming such risks is never easy. A study of commodity participants found that, while hedgers gained clear advantages in being able to offload their price risks, 90 per cent of the risk-assumers, that is, the speculators, lost. These losses would otherwise have been fully born by the entrepreneurs themselves, resulting in needless liquidations, untimely redistributions of discounted productive assets, and increased unemployment.
The producer must always worry that for some unforeseen reason prices might turn against him, resulting in unexpected and potentially devastating losses. The farmer wants a great harvest, but unfortunately, that will mean everyone else is also likely to have a great harvest. And that might cause the market price of his harvest, being added to everyone else’s, will not cover costs, because the market now has more than it wants.
If the farmer can pre-sell his crop before harvest time at an acceptable price, then all he needs to worry about are the usual things like weather, labour, machinery breakdowns, water, energy, etc., but not what price he will receive for his production. This is obviously a great benefit to any producer, and explains the existence of the modern, securitized futures market, where contracts for the future delivery of numerous goods can be bought and sold.
In the short-run this is a zero-sum game; what the speculators lose is exactly what the hedgers gain. But in the long-run it is a positive-sum game, where all win over time. Even if the hedgers lose, their losses would have been scheduled, known quantities, rather than the unknown chance of a business-ruining loss. And the presence of willing participants who desire to assume price risk makes hedging possible, thereby reducing risk premiums for all.
In an economy there are two sets of activities in production: (1) Activities that directly add value in the form of better goods and services to end users; and (2) activities that do not add value, but rather, facilitate value-adding activities. The venture capitalist, the limited partner, the futures and options market traders, add no actual value to anything, but because they are willing to invest and share the risk, value-adding enterprises can commence. Without these facilitative risk-dispersing functions, because of prohibitive risk premiums the enterprise, with all its promise, never happens. Like catalysts in chemistry, facilitative activities are just as important as those activities that directly add value to what we consume3.
The teachings in the Qur’an allow other forms of risk dispersion than just venture capitalism. Just mentioned were stock options for employees and securitized hedging against negative future price movements. In fact, the Qur’an allows – indeed, encourages – risk market diversification, because that enables investors and producers to offload unwanted price risk at many levels, just as insurance protects against non-price economic losses. All forms of securitized futures, options and derivative contracts are acceptable just as long as they are not tied to a guaranteed payout amount based on a fixed return or valuation of the underlying economic entity. Valuations change with time, and returns must be allowed to fully reflect that reality. The Qur’an does not allow return fixity as this has the effect of divesting the economic entity of this dynamic reality.
Qur’anic teachings on economics support production and producers by encouraging venture capital investments and securitized futures, options and derivative markets where price risk can be offloaded and sold to those dedicated to its management. All these forms are allowed as long as they are not tied to any form of value fixity and are allowed to fully reflect underlying valuation changes through time.
Qur’anic economic structuring of risk is far more modern and efficient than conventional forms, which usually fix valuations at some point, and therefore increase risk when dynamical changes in valuations no longer reflect such fixed obligations. If we observe carefully, it is seen that much of the economic dislocations in currency and other markets today are due to dynamic valuation changes occurring within a regime of fixed financial obligations. Such a system will inevitably pile up risk on one side of the transaction while benefiting the other side in a zero-sum scheme, bringing fabulous wealth to some while leaving others in ruin. Such fixity within inherently dynamic systems is responsible for most of the financial damage from speculative bubbles.
The Qur’anic teachings on economics and finance impose risk sharing on all enterprise participants, and do not allow fixed obligations in the face of dynamical valuation changes. It fully allows assets to reflect underlying values as economic and financial realities change, and insists that all rewards and penalties arising from such changes be born by all in proportion to their investments and levels of responsibility. This is a system tailor-made to enhance production opportunities of high value goods and services by forming a financial regime that efficiently assigns risks and rewards from economic endeavors in a world of constant change.
1 There are exceptions based on various schools of interpretation of the Holy Qur’an. But it is universally accepted that charging interest, or any fixed rate of return, for lending out most forms of capital is disallowed in Islam.
2 It thereby anticipates the limited liability joint stock corporation, which is a legal entity having a separate identity from its partner-shareholders. It also formalises the enterprise cooperative business form.
3 Of course, facilitative activities extract payments from productive enterprises – a fee for their tangible services, which is the reason they are resented by those not understanding their essential role in production. How large should the facilitative sector be? Just large enough, and rich enough, to allow the economy to grow at its potential. Any less and the economy can’t grow; and any more and it becomes parasitic, extracting too much from productive enterprises.