Gharar is a fundamental concept in Islamic finance, derived from the Arabic word for uncertainty, ambiguity, deception or risk. It is often translated into English as excessive risk, hazard or speculation.

In Islamic finance, Gharar refers to transactions where the terms or subject matter are uncertain, leading to a significant imbalance of information - information assymetry - or a high probability of loss for one or more parties.

This includes contracts with unknown outcomes, poorly defined specifications, or contingencies that are difficult or impossible to quantify or assess.

Examples include selling something that doesn’t exist yet (except in specific permissible forms like Istisna or Salam), or engaging in pure speculation. For example gambling is a prohibited activity.

The prohibition of Gharar aims to promote fairness, transparency, and the protection of all parties in financial transactions. By avoiding excessive uncertainty and speculation, Islamic finance seeks to ensure that contracts are based on mutual understanding, clear terms, and reasonable balance of risk and reward.

Gharar is one of the major prohibitions in Islamic finance alongside Riba (interest) and Maysir (pure speculation/gambling)

Considerations for Risk Management and Compliance in Islamic Finance

Risk managers, compliance officers, and auditors are responsible for checking that uncertainty in Islamic financial products is properly managed and follows Shariah rules.

Considerations include:

  • Understanding Risk: Looking at how likely different outcomes are and how they could affect everyone involved.
  • Sukuk Risks: Sukuk (Islamic bonds) can involve assets with different levels of risk. The total risk must be measured and shared fairly.
  • Shariah-Compliant Systems: Islamic financial institutions use defined systems to ensure risks are handled in line with Shariah principles. These systems include testing on how products would handle different situations, explaining how risks are shared, and being transparent about risks.
  • Compliance Checks: Compliance would make sure the products are both practical for the market and meet Shariah requirements.
  • Role of Auditors: Auditors would check that the way products are managed and used follows Shariah rules and the defined risk systems.

Further reading

  • Shariah-compliant systems
  • Shariah supervision
  • Stress testing
  • Risk sharing
  • Mudarabah