Financial Engineering 251
it, using equivalent instruments from the set of Shari’ah - approved instru-
ments. This approach is very similar to a common practice where conven-
tional instruments are disguised under Shari’ah - friendly names such that
Shari’ah “wrapping” takes place around the conventional instruments to
produce an Islamic instrument.
The major advantage of this approach is the instant recognition and
understanding it gets from the practitioners of conventional fi nance; this
paves the way for effi ciency and the integration of Islamic fi nancial markets
into the conventional system. This approach may be used for determining
the legitimacy of a product when it is introduced into a conventional market.
This will make it easy for the regulatory authorities of the host country
to understand the instrument, which will facilitate its speedy approval.
Extreme care is required in this approach in order to avoid any misiden-
tifi cation of close substitutes. Any misidentifi cation or use of a wrong
substitute can not only break the trust of investors, but will also create a
reputation risk for the industry. All efforts should be made to avoid any con-
tamination from instruments that are close substitutes but not fully Shari’ah -
compatible. Contamination may occur when an Islamic instrument or con-
tract is used where its intended usage is either doubtful or questionable, or
some important features or conditions of the contract are compromised.
This danger of contamination will increase as the level of complexity of the
instrument increases.
Innovative Engineering A second approach to fi nancial engineering, prefer-
able in principle to “reverse engineering,” is to design instruments de novo
from an established menu of Islamic instruments. The result will be a new
array of instruments, each with a unique risk/return profi le, that can be
bought and sold in specialized markets compatible with Shari’ah principles.
Since this approach requires a deep understanding of the Islamic economic
and fi nancial system as well as the risk/return characteristics of each basic
building block, it is a long - term solution and requires extensive research
and commitment. Although this approach is better aligned with the essence
of the Shari’ah, pioneering new frontiers in a different paradigm always
poses new challenges and takes time. Some of the prerequisites of or for
an Islamic fi nancial system, such as effi cient markets, information symme-
try and Shari’ah - compatible property rights and regulatory and supervisory
laws, are absent from most of the developing Islamic countries.
Although this second route is, in principle, the better approach, opera-
tional diffi culties associated with it impose constraints and force compro-
mises. It is conceivable that given the pressing need for innovation, the fi rst
approach will dominate in the short term, and that some combination of
the two approaches will be adopted in the medium term. However, the full
potential of the system will only be achieved if serious efforts are made to
introduce new instruments that provide unique risk/return characteristics
that are equally desirable for Islamic and non - Islamic fi nancial markets.