Wagers & Games under Islamic Law

The objective of this post is not to discuss the rationale behind the prohibition of gambling. Instead, the objective is to clarify which activities are considered gambling in Islamic Finance. Every transaction in which gain and loss are obscure is known as Al-Qimar (gambling) and Al-Maysir (unearned income) under Sharia. The prohibition of such is derived from the Quranic verse,

O ye who believe! Strong drink and games of chance and idols and divining arrows are only an infamy of Satan’s handiwork. Leave it aside in order that ye may succeed. Quran (5:90)

Games of chance that are mentioned in this verse include all types of gambling. The Arabic word “Maysir” is derived from the root word “Yusur” which means ease. Since a gambler does not perform laborious work and winnings are considered easy money as opposed to earning through labor, gambling is called Al-Maysir. The divining arrows in the verse refer to Azlam, a game of chance played with special wooden dice in the shape of arrows. Therefore, any kind of wager and all forms of gambling are considered Haram or prohibited. Just as Riba is considered Haram, gambling is also considered Haram. The scholarly consensus on gambling is unequivocal and understood by all sects of Muslims as irrefutable.

Before elaborating on activities considered as gambling, let’s briefly discuss games under game theory; these can be zero-sum, positive-sum or negative-sum games. Any game where a party wins at the expense of another is called a zero sum game. In other words, this is a situation where a person’s gain is equivalent to another person’s loss, where the net change in wealth or benefit is zero. Such a game may have as few as two players or hundreds of participants. Common examples of a zero-sum game with only two players are tennis and chess where there can be only one winner. A game of poker may have more than two participants but the net effect is zero as the combined wins equal combined losses across the table. In the financial markets, options and futures are examples of zero-sum games where for every party that makes a gain on a contract, there is a counter-party that loses (transaction costs being excluded).

Casino games are generally negative sum games. In gambling, funds are allocated with a negative expected return, but there is also some possibility of substantial gain. Gambling involves the intentional assumption of risk i.e. risk-taking behavior is assumed where excessive risk is sought rather than avoided. This is the exact definition of Gharar as explained in our previous post, where activities which involve uncertainty or excessive risk are prohibited. According to scholars, gambling displays Gharar in its extreme form. Interestingly, in games involving skill like poker, professional gamblers make money at the expense of weaker players by capitalizing on their weaknesses. However, there are no professional gamblers in negative sum games that do not involve skill like roulette or craps. Another example of a zero sum game (sometimes negative sum game) is speculation. In speculation, funds are allocated with an even (or slightly negative) expected return, but there is also some possibility of a potential gain vis-à-vis other players.

games

A negative sum game can be defined as a lose-lose situation as opposed a positive sum game which can defined as a win-win situation. Examples of these in classical economics would be a war between two countries (negative sum game) as opposed to a trade agreement (positive sum game). Allocating funds with a positive expected return is called investing. Investing is defined as allocating funds for generating a reasonable rate of return plus the return of original investment, commensurate with the risk. Investment is usually backed by a rationale and may also be backed by historical data supporting the rationale. Just as participating in a zero sum game is speculation and/or gambling, participating in a positive sum game is investing.

Another difference between gamblers, speculators and investors is their intention. Gamblers intentionally assume the risk for thrill or excitement. Speculators only assume risk when they have identified an advantage or weakness in their opponents that compensate for the risk and their costs. Investors, on the other hand, avoid undue risk and do not allocate any thrill-seeking value to the process.

In light of the above, we will discuss the difference between Gharar & Business Risk and talk about Risk vs Return in our next post.

Uncertainty & Doubt under Islamic Law

 

We have so far analyzed the first and foremost prohibitive element of Islamic finance i.e. Riba (or interest). Now we deal with the next prohibition which is called Gharar or uncertainty. Unlike Riba, Gharar is not defined precisely by Sharia. It is also considered to have lesser significance than Riba but is prohibited nonetheless. Jurists define Gharar in two contexts, one implying uncertainty and the other deceit, both being forbidden. Analytically, some scholars consider Gharar to mean uncertainty and some consider it to mean doubt but most scholars agree that Gharar means both the unknown and the doubtful. Subsequently, any contract for sale or purchase that includes uncertainty or ignorance or deceit in either the species, or quantity, or price, or time of payment in a deferred sale, or the existence of an object, or the identity of an object, would be considered possessing Gharar.

Sharia law clearly forbids transactions which cause any form of injustice to either of the transacting parties, therefore any zero-sum game which leads to the gain of one party at the expense of the other is forbidden. Scholars agree that gambling displays Gharar in its extreme form. However, Gharar can take a number of other forms as well. The sale of a non-fungible asset like a car which the seller does not own is prohibited since only the owner of the car has the right to sell it. The thinking behind this prohibition is to prevent harm to the buyer if the seller is unable to acquire the asset before its delivery. It must be noted that Gharar is not necessarily linked to the non-existence of the object of exchange, rather it exists with the inability of the seller to deliver the object.  In other words, the modern day settlement risk (also called counterparty risk or default risk) is much closer to the definition of Gharar.

In the case of fungible items like wheat, a short sale is permitted. The holy prophet Mohammad (peace and blessings upon him) is reported to have allowed the farmers of Medina to short sell dates for delivery two and three years after commencement of the contract. Since the farmers had not grown the dates at the time of the sale, they were clearly engaged in selling what they did not own. Following such evidence, many jurists have distinguished between the short sale of fungible items which is allowed in some cases and the short sale of non-fungible items which is prohibited. The accepted contracts where such short sale is allowed are called Salam and Istisna which are considered exceptions rather than the rule. We will talk about the exceptions in a future post.

Scholars generally distinguish between contracts containing minor Gharar, which are considered acceptable, and contracts containing substantial Gharar, which are prohibited. For example, it is not possible to know whether each apple in a bushel is of edible quality, yet this is considered minor Gharar; the buyer can check a sample before buying the bushel and therefore such a sale is permissible. The thinking behind such permission is to facilitate ease of trade.

Gharar also refers to undue complexity in contracts. Sharia does not permit inter-dependent contracts. Therefore combining “two sales in one” is not permitted. Jurists require that composite products like lease-purchase, or parallel Salam, for example, should have multiple contracts that must be independent of each other.

 

There is nothing in the Book of Allah, nor in the teachings of the Prophet (peace and blessings upon him), nor in the statements of any of his companions to the effect that the sale of something non-existent is unlawful, neither by specific nor general reference. The Sunna admittedly bans the sale of some things which do not exist, just as there is a ban on some things which do exist. Hence the effective cause of prohibition is not the existence or non-existence but uncertainty and Gharar. This is when a thing cannot be delivered, whether existent or not. The essential element of a sale is the delivery of the sold thing, and if the seller is unable to deliver, this is Gharar, gambling, and risk.

Ibn al-Qayyim, Ilam al-Muwaqqiin, Vol. 1, p. 219

In contemporary finance, two areas where Gharar is most commonly found are insurance and financial derivatives. Scholars often argue against insurance contracts where the insured may collect a claim from the insurance company after paying only one monthly premium or conversely, the insured may make several monthly payments without ever collecting any claim. Since “insurance” or “security” itself cannot be considered an object of sale, the contract is considered invalid due to Gharar. Of course, conventional insurance is also prohibited due to Riba (interest) since insurance companies tend to invest significant portions of their funds in interest-bearing financial instruments like bonds.

As far as financial derivatives are concerned, all three forms i.e. options, swaps, and futures (and also forward contracts) are prohibited. Futures contracts are not permitted due to the absence of the object of sale at the time of the contract and uncertainty involved in the future delivery of the underlying asset; exceptions being the contracts of Salam and Istisna, as mentioned earlier. However, both these contracts are made under specific conditions and contemporary futures contracts do not fulfill those conditions.

The sale in contemporary options contracts is considered a suspended conditional sale and therefore considered invalid (called a Bay’ al-Muallaq). Similarly, the sale of contemporary futures contracts is considered non-concluded and therefore invalid by the scholars (called a Bay’ al-Mud). Both these sale contracts have elements of Gharar. The swaps, on the other hand, are prohibited due to the presence of Riba or interest. It is interesting to quote Warren Buffet here who famously declared derivatives to be the financial weapons of mass destruction.

According to Investopedia Gharar is observed within derivative transactions, such as forwards, futures, and options, in short selling, and in speculation. Therefore, most derivative contracts are forbidden and considered invalid because of the uncertainty involved in the future delivery of the underlying asset.

We will talk more about Gharar in the context of games of chance and zero-sum games when we discuss the concepts of Al-Qimar (gambling) and Al-Maysir (unearned income) in our next post.

 

Debt, Exchange & Interest in Islamic Law

The Sharia law provides human beings freedom to enter into contracts and do business transactions. However, this freedom is not unbridled. Like conventional law, Sharia regulates human dealings to safeguard the welfare and liberties of the transacting parties. The dealings could range from a simple contract like Nikah (marriage) to complex Bay’ (trade/commercial) transactions. The prohibitions that regulate financial dealings are mainly of three kinds, the foremost of which is the ban on interest. We will talk about the other two in our next post.

The prohibition of Riba (or interest) is central to Islamic financial law and ethics. It has been a topic of much scholarly effort and debate. The word Riba literally means increase or excess. Officially, Riba is an excess amount received on a loan stipulated over time. It is not only prohibited in loan or debt contracts but also in sale or exchange contracts.

Riba

  1. Riba in Loan

In a conventional loan transaction, there are three elements present; a loan amount, a stipulated excess amount and a time period. The Riba in this type of scenario is called Riba al-Nasia (or interest relating to delay). Therefore a loan amount of $100 accruing an interest rate of 5% annually has a Riba element of $5 at the end of the year. Under Sharia, a Qard (or loan) has to be at par, with zero interest and is called a Qard-e-Hasana (a beautiful loan). Therefore under Sharia, the loan and debt amounts are one and the same, essentially amounting to interest-free loans. In today’s world, a few economic sectors have employed this type of financing quite successfully; for example automobile loans on 0% financing and consumer loans advertising “No interest if paid in full in 12 months” for big-ticket items like furniture, electronics, and sometimes even dentists bills.

Under Sharia, if a debtor is unable to pay the full amount of debt, he is given additional time to pay without a financial penalty for the extra time taken. If the debtor is able to settle the debt, the matter is closed; if he is unable to pay, the creditor is encouraged to forgive the shortfall and the difference is considered a part of charity. However, this partial debt forgiveness is not considered “contractual” in nature. People are strongly encouraged to pay off their obligations under Sharia and the forgiveness of differential debt amount is more for exceptional cases, rather than a general rule.

This approach to debt is in stark contrast with contemporary 0% consumer financing contracts where if a debt is not paid within the stipulated period, or a payment is made too late, or if the debtor loses his ability to repay, a hefty interest rate plus retroactive interest is applied on the original amount from the date the contract was initiated.

Even though interest on a loan is prohibited, Sharia accepts the concept of time value of money. We will elaborate this in a future post when we discuss the transfer of debt.

  1. Riba in Exchange

Unlike a loan, in a sale or exchange transaction, another element is introduced which is goods or commodities. Any excess or increase resulting in such an exchange is called Riba-al-Fadl (or interest relating to surplus). This is based on a narration of the holy prophet Mohammad (peace and blessings upon him).

Sell gold for gold, silver for silver, wheat for wheat, barley for barley, date for date, salt for salt, in same quantities on the spot; and when the commodities are different, sell as it suits you, but on the spot

The narration explains Riba vis-à-vis six defined commodities which can be classified into precious metals and food based commodities. Based on this narration, jurists have developed a tripartite rule.

  1. If an exchange is made between the same items, it needs to be on the spot and the items should be of equal weight.
  2. If the exchange is of two different items within the same category, it needs to be on the spot, and
  3. If the exchange is made between items from each category, there is freedom of choice.

For example, gold exchanged with gold needs to be on the spot and of equal weight, otherwise, it would be considered having Riba of surplus. Secondly, gold exchanged with silver needs to be on the spot but commodities can have different weights. And lastly, gold exchanged with wheat need not be on the spot and the commodities can have different weights.

While all six items given in the narration may give rise to Riba, we will expand our discussion on the first category i.e. precious metals as these have the characteristics of the “nature of money”. Therefore, the Riba rules would apply to anything that has the nature of money i.e. paper currency, IOUs, etc. Under Sharia, the two conditions for exchanging money for money are on the spot and in equal quantity. This is known as a currency exchange contract (‘aqd al-sarf). Any violation of the above ruling will result in either form of Riba. If money is exchanged on the spot but in different quantities, it will result in interest of surplus (Riba al-Fadl) or if more money is exchanged for money with deferment it will result in interest of delay (Riba al-Nasia). The underlying element in most contemporary financial products is the Riba of deferment (Riba al-Nasia). The present discussion of the two kinds of Riba will have implications when we discuss financial products like futures contracts, derivatives, project financing, leasing etc. in our future posts.

Our next posts will deal with the other two prohibitions concerning financial transactions which are uncertainty and chance.

Permission & Prohibition under Islamic Law

In order to build a structure, the edifice is built upon a foundation, and the foundation of Islamic Finance is based on the Sharia Law. Like conventional law, Sharia (or divine law) also has its do’s and don’ts. In our previous post, we explained that Sharia is derived directly from the Quran, the holy book and the Sunna, the teachings and practices of the holy prophet, Mohammad, (peace and blessings upon him) and that together these two cover all aspects of human life. The study of Sharia law is called Fiqh (or Islamic jurisprudence). In other words, Fiqh can be described as the human understanding of Sharia.

Conventionally, Fiqh has been categorized into two groups. The personal aspects of the law are covered under fiqh-ul-Ibadaat while the social aspects are covered under fiqh-ul-muamulaat. Fiqh relating to muamulaat (dealings or transactions) covers the study of interactions between human beings. Conventional classifications of law like family law, contract law, property law, civil law, trust law, international law etc. all fall under this branch of Fiqh. Islamic finance is also considered a part of muamulaat (or dealings).

law

Just as conventional law encompasses and binds human actions, so does the Sharia law. At this point, it is beneficial to understand how Sharia categorizes human actions. The ‘amaal (or actions) of human beings can either be Halal (permissible) or Haram (prohibited). On a descending scale, these are very clearly categorized as

  1. Fard/Wajib (obligatory)
  2. Mandub (recommended)
  3. Mubah (permissible)
  4. Makruh (reprehensible)
  5. Haram (forbidden)

The Fiqh not only looks at human actions but also studies the circumstances (wadia’) surrounding those actions. Rules in relation to circumstances comprise of

  1. Shart (condition)
  2. Sabab (cause)
  3. Mani (prevention)
  4. Rukhsah, Azeemah (permission, enforcement)
  5. Sahih, Faasid, Batil (validity, corruption, invalidity)
  6. Adaa, Qadaa, I’ada (in time, deferment, repetition)

In future posts when we start our analysis of a simple exchange transaction, we will return to these definitions as we attempt to explain the functionality of Islamic finance.

As per Sharia, God has permitted Bay’ (exchange or trade) and forbidden Riba (interest). Aside from Riba (or interest), other prohibitions include Gharar (uncertainty and/or deceit), Al-Qimar (gambling) and Al-Maysir (unearned income). These rulings are unequivocal and understood by all sects of Muslims as irrefutable.  As a result, the point of departure between Islamic and contemporary financial transactions becomes one of permission vs prohibition. Usually, Islamic financial transactions are trade-based while contemporary financial transactions are interest-based. By extension, the same argument is applicable to Islamic banking versus contemporary banking.

In a conventional bank setting, the bank is basically a money lender, the fundamental component of a transaction is interest, and the bank and the corresponding transacting parties are in a debtor/creditor (or vice versa) relationship. Comparatively, in an Islamic bank, the transactions are trade-based or equity-based and are conducted within the framework of Sharia law. The bank can play many roles such as an agent, a partner, a guarantor, a buyer, a seller, a lessee or a lessor. Because of the prohibition of Riba (interest), Islamic finance proponents have engineered many interesting financial products to make the transactions Halal (or permissible).

Before we start our analysis of a simple Bay’ (exchange or trade) transaction, we need to elaborate more about Riba (interest) and what constitutes Riba under Sharia. In the next few posts, we will expand on the prohibitions concerning financial matters, especially matters relating to Riba before tackling the permissible under Sharia.

The Purpose of Islamic Law

Before we elaborate on Islamic financial products, let’s talk about the basis of Islamic finance, its essence, its sine qua non. Like all aspects of Islam, finance also takes its fundamental structure from Sharia (or the divine law). Sharia is derived directly from the Quran, the holy book and the Sunna, the teachings and practices of the holy prophet, Mohammad (peace and blessings upon him). Together these two form a basis of all aspects of human life.

The purpose of Sharia, like the purpose of any law in the world, is the promotion of human welfare. Usually, the classic definition of the purpose of conventional law explores the obligations and purposes of law and government to protect public health, safety, and morals, and to advance general welfare including protection of people’s fundamental rights and basic liberties. In this regard, Sharia law is not at all different from conventional law.

Many jurists have expounded on the purpose and objectives of Sharia, called Maqasid-e-Sharia. Two popular and widely accepted viewpoints are by Ghazali, the 12th-century Persian philosopher, jurist and mystic and by Shatibi, the 14th-century jurist, and theologian from Andalusia, Spain. According to Ghazali, the ultimate objective of Sharia is to promote human welfare which encompasses safeguarding of

  1. faith
  2. life
  3. lineage
  4. intellect, and
  5. property

Shatibi, on the other hand, elucidates the purpose of Sharia in elaborate detail. For him, the Maqasid-e-Sharia (or the purpose of Sharia) comprise of those benefits for which God revealed Sharia in the first place. Like Ghazali, Shatibi also believes that the aim of Sharia is to bring welfare to the people in this life and the afterlife. He classifies the objectives of Sharia as encompassing

  1. Daruriyat (vital necessities)
  2. Hajiyat (needs or requirements), and
  3. Tahsiniyat (embellishment or enrichment)

Maqasid Sharia

The Daruriyat are those necessities which are essential for the establishment of welfare in this world. If they are ignored, order and coherence cannot be established resulting in Fasaad (chaos and disorder). Shatibi classifies all five of Ghazali’s objectives regarding safeguarding human welfare under Daruriyat (or necessities).

Hajiyat are those goods and services which facilitate life or remove hardship. Tahsiniyat are enrichment or beautification of life. While having enough food to subsist living falls under necessities (Daruriyat), having ample nutritious food falls under needs (Hajiyat) and having delicious, gourmet food falls under enrichment (Tahsiniyat). According to scholars, Sharia not only puts comfort into human life but also beautifies it.

Interestingly, scholars classify Islamic Finance under Daruriyat or necessities. Interestingly, in modern times, Maslow’s Hierarchy of Needs which he proposed in 1943 has a somewhat similar structure in which he discusses the four basic deficiency needs (physical, security, love & friendship, and esteem) followed by self-actualization needs. While Maslow discusses how these needs affect motivation, both Ghazali & Shatibi talk about how human needs are met through the application of law (Sharia).

The next few posts will be about permissibility and prohibition under Sharia law as applicable to Islamic Finance followed by a discussion on Islamic finance from an economic viewpoint.

Demystifying Islamic Finance

Our team at the Finance Board is excited to bring a series of topics on Islamic Finance every week. Our goal is to make the concepts of Islamic Finance easier to understand, both for the man on the street as well as the consummate finance professional.

What is Islamic finance and what are its basis? How does this type of finance relate to contemporary finance? Is it practical or even possible to employ this kind of financing in today’s complex business and commercial transactions? These are the questions we endeavor to undertake every week on the Finance Board blog. Each week we will introduce a new concept in Islamic finance along with its counterpart in conventional finance and highlight the comparison between the two.

We will start by looking at Islamic Finance through the lens of the Sharia law followed by describing various Islamic financial products and how they are engineered. Our objective is to clarify the concepts starting from the simplest of transactions and leading up to complex project financing deals. Along the way, we will also opine on the question “Is Islamic Finance a viable alternative to contemporary finance?”

The weekly posts are brought to you by Ms. Qazi  who is a finance professional with over 28 years of experience in the fields of corporate finance, risk management, financial systems development and Islamic finance. She has lived and worked in the U.K., Thailand, Pakistan, Canada and the U.S. and presently resides in Chicago. For a brief bio on her, please check our management team profiles.

Our blog is open for your comments and we look forward to hearing from you. Thanks for visiting.