Islamic Forex and the Prohibition of Gharar

Read part one of this series here.

The existence of excessive gharar, the Islamic concept of uncertainty and risk, in most forms of Forex Forex Foreign exchange or forex is the act of converting one nation’s currency into another nation’s currency (that possesses a different currency); for example, the converting of British Pounds into US Dollars, and vice versa. The exchange of currencies can be done over a physical counter, such as at a Bureau de Change, or over the internet via broker platforms, where currency speculation takes place, known as forex trading.The foreign exchange market, by its very nature, is the world’s largest tradi Foreign exchange or forex is the act of converting one nation’s currency into another nation’s currency (that possesses a different currency); for example, the converting of British Pounds into US Dollars, and vice versa. The exchange of currencies can be done over a physical counter, such as at a Bureau de Change, or over the internet via broker platforms, where currency speculation takes place, known as forex trading.The foreign exchange market, by its very nature, is the world’s largest tradi Read this Term futures, forwards, options, and Swaps Swaps Swaps can be defined as a derivate contact composed of two parties that exchange to cash flow between two separate financial instruments.They are generally divided into two categories. This includes contingent claims (options) and forward claims, where forward contracts, swaps, and exchange-traded funds (ETFs) are exchanged. Commodity price, equity price, interest rate, and foreign exchange rate are common variables used as one of the cash flows in swaps upon initiation. Different Types of Swaps Swaps can be defined as a derivate contact composed of two parties that exchange to cash flow between two separate financial instruments.They are generally divided into two categories. This includes contingent claims (options) and forward claims, where forward contracts, swaps, and exchange-traded funds (ETFs) are exchanged. Commodity price, equity price, interest rate, and foreign exchange rate are common variables used as one of the cash flows in swaps upon initiation. Different Types of Swaps Read this Term probably makes these transactions impermissible according to the Shari’a.

Transactions with Gharar and Why the Prohibition?

In Islamic finance, transactions that involve excessive risk are forbidden. Gharar refers to the uncertainty or hazard, caused by the lack of clarity with the price in a contract or exchange. The literal translation of “gharar” is “trick”. A definition of Gharar is:

[Gharar is] the sale of probable items whose existence or characteristics are not certain, the risky nature of which makes the transaction akin to gambling.[1]

A sale or any business contract that has an element of gharar is prohibited. The reason for prohibiting gharar is not risk or uncertainty per se but as the definition above suggests, gharar, in the sense of trickery, and gambling involve unjust enrichment. Prohibiting gharar protects the weak from exploitation. The general financial or business instances when gharar is present are:

• The liability of or the payment from any of the contracting parties is uncertain or contingent
• Delivery of one or more of the products or services being bought or sold is not in the control of any of the contracting parties and is therefore, uncertain.
• Payment of one or more of the products or services being bought or sold is uncertain.
• The sale of a product or service is not presently in the possession or the selling party
• Contracting parties to a sale or purchase do not know if the sale or purchase will actually take place.
• The object of a legal transaction does not exist.

Gharar refers more to uncertainty than to risk as commonly used in financial terminology. The uncertainty pertains to the existence of the product or service in question, the rights of or benefits to the parties involved in the contractual relation, and the consequences of the contract. What of unknown objects, such as when the purchaser does not know what she has bought or a seller does not know what she has sold? The Zahiri school of thought considers a transaction gharar only when unknown objects are involved. The majority of jurists include both the unknown and the uncertain in calculating if a transaction is gharar.

To be sure, every financial transaction involves some risk, such as currency risk, credit risk, legal risk, country risk, and political risk. While some transactions do not involve significant risk, others carry considerable risk. The Holy Qur’an and literature on Islamic finance are not clear on the extent of risk allowed and, unlike riba, does not have a great deal to say about gharar. To ascertain which transactions or instruments are non-Shari’a compliant, scholars have taken on the task of differentiating between Gharar-e-Kathir and Gharar Qalil (too much and nominal uncertainty). Their decision on the matter is only those transactions involving too much or excessive uncertainty in respect of the product, service, or financial instrument, and their price in a contract should be prohibited. Although gharar is more difficult to define than riba, there is now a consensus over the level of acceptable gharar that makes a transaction Shari’a compliant. Thus, while any amount of riba is prohibited, a certain degree of gharar in the sense of uncertainty is acceptable in Islamic finance and business.

Short Selling and Gharar

Whether short selling is prohibited in Islamic finance is still debated. Short selling is the sale of an asset that the seller does not own and possibly does not even possess. The asset can be a stock, bond, commodity, currency or other financial instrument. Typically, the short seller sells short a security to a buyer. The short seller does not own the any shares but instead borrows the shares from a lender of securities. The short seller pays a fee and interest to the lender and must eventually buy shares to return to the lender. The goal is to buy the securities at a cheaper price than the price obtained from the short sale.

Clearly, there is gharar involved in the short selling transaction.

1. It is uncertain if the short-seller will make a profit. The short seller is betting the price of the security will fall in order to make a profit.
2. This bet (or gamble) involves a potentially unlimited liability. The price of the security could shoot up and wipe out the capital of the short seller.
3. There could be damage to the general stock market if short sellers depress the price of shares, thereby spreading panic.

In the various modes of Islamic financial transactions, the seller is generally prohibited from selling an asset she does not own and possess at the time of sale. The mechanism of short selling clearly steps over this prohibition. Thus, the Shari’a does seem to strongly incline against the practice of short selling.

Forex Futures and Forwards

It would seem the existence of gharar prohibits forex futures and forwards because these contracts involve the sale of a non-existent object or of an object not in the possession of the seller. Islamic scholars generally are in agreement that future sales, suspended sales, and down payment sales all have the element of gharar in their contracts. Options and futures, considered as very risky, are deemed as forbidden. So too are forward foreign exchange transactions, as forward exchange rates are determined by interest rate differentials. In addition, exchange rates are volatile and are, for most mortals, unpredictable.

The problem with forwards, futures, options, swaps and currency arbitrage is the fixing of a rate today for a currency exchange sometime in the future. Yet, there are a few circumstances where these transactions may be permissible. In the next installment of this series on Islamic finance, I discuss the circumstances.

This article is largely excerpted from the author’s forthcoming book, International Investment Management: Theory, Ethics, and Practice. London, England: Routledge, April 2016.

[1] Bhala, Raj, Islamic Law (Shari’a). Durham, North Carolina: Carolina Academic Press, 2016.