Islamic Hedge Funds?

"Hedge fund" is a term that was originally used to describe a type of investment pool that uses sophisticated hedging and arbitrage tools to trade in the equity markets and explicitly pursues absolute returns on their underlying investments. The most widely-accepted definition of a hedge fund is that it is a fund that uses leverage, shorting and options to achieve its investment goals, beginning with the protection of investor capital.

The first hedge fund was set up by Alfred W. Jones in 1949, the first to use short sales and leverage techniques in combination. In 1966, a "hedge fund" run A. W. Jones shocked the investment community because it outperformed all the mutual funds of its time, despite their huge 20% fee.

According to some experts, hedge funds are believed to be highly speculative and thus may run contrary to the Shariah prohibition of gharar. At an even more fundamental level, however, hedge funds use short sales to neutralise the influence of market forces; and short sales involve the sale of what one does not really own, which is haram.

Toby Birch of Birch Assets Ltd doubts whether hedge funds could in principle be Shariah-compliant, calling Islamic hedge funds "something of an oxymoron," being an area of controversy, where such structuring might obey the letter of Shariah, it is not compatible with the spirit.

Often, in structuring Shariah compliant instruments, a number of contracts are combined to achieve the desired result, a solution that meets the financial or investment needs. On the surface, combines two or more Shariah concepts may sound perfectly acceptable but indiscriminately doing so may lead to what Tarek Diwany describes as “contractum trinius”. Ahmed Abbas, of Bahrain’s Liquidity Management Centre, criticised such mechanisms as false to the spirit of Shariah. “I don’t care, if you take 20 Islamic steps in order to short sell, you cannot sell what you don’t own. “Islamic banking is not about drawing an Islamic veil over something un-Islamic.”

There have been many opinions and views as well as fatwas on whether hedge funds are Shariah compliant or not. We should be looking at the purpose of a hedge fund rather than the mechanics of the fund. This way hopefully we can up with a solution to the problem rather than modifying an existing (probably incompatible) instrument to solve the problem.

To "hedge" means to manage risk. The key word here is risk management. Our objective is to manage risk in a Shariah compliant manner. We shouldn’t be talking about Islamising hedge funds to manage risk, we should be finding means to manage risk which do not contravene Islamic laws. We should not be finding ways to Islamise hedge funds just for the sake of creating or adding to market liquidity and to enhance rice discovery.

Managing risk is permissible in Shariah based finance provided the means of managing that risk complies with the rules of Shariah. Managing risk can come in the form of full transparency, honouring contractual obligations, being accountable and acting in a professional way. Shariah based financial transactions are after all partnership and risk/reward sharing arrangements. Actions undertaken to manage and/or minimise risk should be directly related to the business venture by ensuring that it is undertaken in the proper manner.

Fractional Reserve Banking causing Complete Banking Disaster

Fractional Reserve Banking is a system where banks are required to keep a certain percentage (determined by the Central Bank) in cash as reserves. They will then loan out the balance and the process is repeated. In a system based on fractional reserve banking, the banks have the power to create money. The amount a bank is allowed to give out as loans is determined multiple of the bank's reserves. For example if the reserve requirement is 10% then for every RM100 of deposits a bank can give out RM1000 worth of loans. This newly created money is termed as “fiat” money. Fiat money has NO intrinsic value and NOT backed by any physical (valuable) asset such as gold and hence cannot be redeemed for any commodity or asset. It is made legal tender through government decree hence the value of fiat money depends on the strength of the issuing country's economy and therefore, issuing more fiat money by reducing the reserve requirement could lead to inflation.

How did this fiat money come about? Back in the old days when gold was still the medium of exchange, rich people (those with lots of gold) deposited their excess gold with the goldsmiths for safekeeping. Whenever they need to purchase anything, they will go to the goldsmith and withdraw some gold to pay for their purchases. This is how the banking industry was at that time, a custodian for excess gold. As trade increased, and to overcome the need for frequent withdrawals (there were no ATMs back then) the rich started issuing IOUs to their suppliers when making purchases whereby the supplier will take the IOU and redeem the gold from the goldsmith. Some of the traders use the IOU for their own purchases instead of redeeming it with the goldsmith, causing the IOUs to circulate as a payment mode. Subsequently, the goldsmiths (who happen to be Jews by the way) realised that not everyone redeems their gold; some kept them in the vaults for years. This made the goldsmith realise that they themselves could issue IOUs and lend them out and earn interest in the process. They were effectively making money out of thin air using other people’s money! That was how fiat money evolved and the system has been made legal and still practiced today. The only difference is the banks are playing the role of the goldsmith.

Fiat money contradicts with the economic theory of scarce resources; fiat money makes capital unlimited.

The fiat money created by the banks are given out as loans and used to purchase assets. This effectively means that assets are bought on debt using debt. Another way of saying it is, we are borrowing borrowed money. These borrowed money we are borrowing is actually created out of nothing, i.e. not backed by real assets.

So, there are effectively two levels of borrowers, the consumer (or corporation), who is the end borrower and the banks, the initial borrower. So, when the end borrower defaults, it will cause the initial borrower to default too as the initial borrower would not have funds to repay their lender i.e. depositors.

Money creation is the major cause of inflation. Increases in asset value may not have any correlation with actual asset value; it merely reflects the amount of money in circulation. My untested theory is that money creation creates economic bubbles and business cycles. It causes the economy to grow beyond it capabilities.

Shariah based financing on the other hand forbids money creation; every financial transaction must be based on actual economic activity. Money is defined by Shariah as a medium of exchange, a tool to facilitate trade, it is NOT a commodity on its own hence money cannot have a price and cannot be traded. Money should not grow through artificial creation but via productive activities.

Fiat money, excessive speculation and over leveraging are the root of the sub-prime triggered economic crisis. There is a reason after all for the Shariah prohibition of those unfair activities. So, the money we use as a medium of exchange and as a measure of wealth has no intrinsic value. Is all the paper money in our pockets worthless then? But isn’t cash supposed to be king?