While short-selling is not permitted by the Shariah, more and more Islamic institutions and hedge funds claim to offer Shariah-compliant shorting solutions. Islamic short-selling is often being presented as if it were a major innovation or a significant breakthrough for Islamic finance. In reality, however, basically every contract can be 窶露slamised窶兪using concepts from modern financial engineering. The question is rather how high the transaction costs are, and, especially, whether one regards such mechanics as Shariah-compliant, or as just an undesirable ploy, which strikes at the foundations of the objectives of Islamic finance.
This article briefly reviews the characteristics of conventional shorting, before outlining three approaches based on Salam, Arbun and Wa窶囘, and discussing the pros and cons of each one of them.
The Mechanics of Conventional Shorting
Conventional shorting is usually comprised of the following steps:
- The investor instructs his broker to short a specific asset for him.
- The broker checks whether any of his other clients is holding the respective asset in his portfolio.
- If this is the case, the broker borrows the asset from that client and sells it in the market in the usual way for the investor.
- At some indefinite future date, the investor closes out his short position by purchasing the asset on the market.
- The broker replaces the purchased asset in the account of the client from whom the asset was borrowed.
In practice, there are several issues and risks connected with conventional shorting:
- If at any time the broker runs out of shares to borrow, the investor is forced to close out his short position immediately, even if that leads to financial losses for him.
- The lender of the asset incurs a credit exposure to the borrower and will thus seek collateral in the form of the cash received by the borrower from the sale of the asset.
- As the asset窶冱 price is likely to fluctuate, usually a collateral amount exceeding the value of the asset, the so-called hair-cut, is asked for, meaning that the full proceeds of the short sale may not be available to the investor.
- Usually assets can be borrowed only for short periods of time, ranging from overnight to a few weeks, with costs increasing sharply with the borrowing length.
- Equally, the costs of borrowing can rise strongly when the demand for borrowing an asset exceed its supply.
Salam-based Shorting
With the Salam contract, Islamic finance offers a natural possibility to sell assets for a price to be paid upfront for an asset to be delivered later. Salam, which is often compared to forward contracts, differs in important aspects from short-selling:
- Salam contracts do not entail borrowing the underlying asset from another party. It is likewise not identical to naked shorting, which is usually restricted to a T+3 delivery.
- The underlying of a Salam contract can be a single asset or a basket of securities.
- Salam is an individual contract between two parties, which does not affect any third parties.
- Salam is a fixed-term contract.
- As a consequence, the investor has no risk of being 窶
