The Problem with Short Selling and Derivatives (And Why Islamic Finance is Right Again)
With the recent debacle of short-selling in Gamestop shares, where Wall Street investors lost billions of dollars in just days, we reflect on the problem with short-selling.
Short-selling is a bet that a stock price will fall. Normally, investors buy shares with the expectation of a rise in price. But with short-selling investors sell stock they do not own. They sell before they buy by borrowing the stock. So they not only do not own something they are selling, they “borrow” something in order to sell it. Sounds strange because it is strange. It simply makes no sense.
But conventional finance permits this because there are no limits to what may be structured. With short-selling there is no limit to how much you lose. Unlike normal share buying, where you only lose as much as you invest, with shorting, there is no end to losses because the share price could keep rising and the margin compounding, as it did with Gamestop’s 1500% jump in 2 weeks.
This is why derivatives are also not permitted in Islam. They “derive” their value from something else—a right, a bet, a contract, a promise.
Futures: An instrument that obliges a future purchase or sale, where the investor never takes actual delivery of the subject matter.
Swaps: An instrument that exchanges cash flows, but does not take actual ownership in anything real.
Options: An instrument that buys a right in a share, but does not take actual ownership in the share.
Islamic transactions, on the other hand, appeal to common sense:
- Own a tangible asset or service, not just a promise, a right, or something “borrowed."
- Own and possess something before selling it.
- No interest-based borrowing to buy more than you can afford to lose.
The infographic here shows just how oversized the derivatives market has become in relation to real assets like gold and silver, making markets that much more prone to collapse: https://ethica.institute/manifesto.aspx
(Approved by Ethica’s Shariah Board)
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