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.