Understanding The Theory and Practice of Islamic Forex Trading

Before we understand Islamic forex trading we need to acquaint ourselves, albeit briefly, with Islamic finance.

Islamic forex trading will increasingly be in demand. Before we understand Islamic forex trading we need to acquaint ourselves, albeit briefly, with Islamic finance.

Islamic finance

The theory and practice of finance according to Islamic principles is called Islamic finance. Islamic principles determine the objectives and the operations of Islamic finance. Modern finance theory informs today’s conventional finance while ethical imperatives drive Islamic finance. The principles and prohibitions of Islamic finance are expounded in the Shari’a or Islamic law.[i]

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Two features of Islamic finance distinguish the system from conventional finance. First, Islamic finance proposes a risk-sharing philosophy whereby the lender must share in the borrower’s risk. According to the Islamic view, a non-Islamic, interest-based loan guarantees a return to the lender but the burden of risk falls disproportionately onto the borrower. This unequal distribution of risk where the borrower bears more than the lender is exploitative, socially unproductive and economically wasteful.

Secondly, the purpose of Islamic finance is to promote economic and social development, through specific business practices. Conventional finance has profit maximization as the goal, whereas Islamic finance is driven by ethical and religiously inspired goals as stated in the Shari’a.

The Shari’a is the religious law Allah directly gave to his Prophet (peace be upon him). As such, the purpose of Islamic finance is ethically driven because the aim of the Shari’a is also the aim of Islamic finance because finance is only one part of life and society. The objective of Shari’a is the happiness and well being of the people in this worldly life as well as in the life Hereafter. Accordingly, the objective of Islamic finance is also the well being of people in this life and in life Hereafter. Islamic finance must contribute to the development and the good of the Islamic community. How finance achieves this purpose is guided by principles written down in the Holy Qur’an. Not surprisingly, therefore, the fundamental feature of Islamic finance is socio-economic and distributive justice.

Prohibitions

All business and financial contracts in Islamic finance must conform to Shari’a rules. Basic prohibitions in Islamic finance are:

(1) Interest or riba.

(2) Excessive risk or gharar.

(3) Speculation or gambling

 

Prohibition against interest (riba)

There is little or no disagreement among Islamic scholars and legal scholars about the prohibition against interest. Making money from money is not Islamically acceptable and interest based transactions are a sin. Primary sources of Shari’a i.e. the Holy Qur’an and the Sunnah, are quite clear in condemning the practice.

Interest is any predetermined payment over and above the actual amount of principal of loans and debts, regardless of whether interest is charged on commercial or personal loans. Islam allows only one kind of loan and that is the interest free loan or the qard al Hassan (good loan).

 

Islamic scholars propose five reasons for prohibiting interest or riba.

  • Interest is unjust. The generally accepted arguments are that earning money through interest involves no self-exertion by the lender, and causes oppression to the borrower.
  • Interest corrupts society.
  • Interest implies the unlawful taking of property.
  • Interest leads to negative growth. While riba increases money in quantitative terms, it does not generate growth in social wealth.
  • Interest demeans and diminishes the human personality. Charging interest affects a culture negatively by distancing that which is human and focusing on that which is monetary.

Of course, there is a widely understood argument that interest carries benefits. The Shari’a does not gainsay this argument but rather, it stresses that the danger of ribā is greater than its benefit.

 

Islamic Forex Trading

 

Accordingly, forex trading must also conform to Islamic finance principles. Forex trading generally involves what Islamic finance terms as ‘ribā al-nasī’a’, defined as “[interest] in a money-to-money exchange provided exchange is delayed or deferred and additional charge is incurred with such deferment.”[ii] Thus, a nasī’a transaction can arise with respect to foreign exchange trading. When an agreement between two foreign exchange traders calls for one of them to make (or receive) payment of a currency on a delayed basis, then the transaction is characterized as “nasī’a.” As suggested, ribā al-nasī’a is forbidden.

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An exchange of money-for-money of different currencies, but equal values – such as U.S. dollars for Emirati dirhams of the correct foreign exchange value – is permissible. In other words, there is no interest in a spot currency or foreign exchange transaction. The problem arises when one payment is deferred, or delayed, as in a loan transaction, foreign exchange forward or futures contract, or currency swap.

 

The marketplace currently offers swap-free forex trading accounts allowing clients to trade in any currency pair, carry it overnight and not have any reward or withdrawal. In an effort to be Shari’a compliant, the accounts do not have interest involved but still allow open positions for indefinite long periods. The result of trading then depends only on currency rate movements for that period. In this way, the providers hope to emulate spot currency or foreign exchange transactions permissible under Shari’a finance.

 

To be legitimately Shari’a compliant, financial mechanisms and transactions should be permitted by Shari’a Supervisory Boards (SSB). The SSB seal of approval is mandatory to ensure financial instruments and transactions are permissible according to Shari’a. SSBs review and endorse not only the products and services but also all relevant documents pertaining to the products and services. Banks and financial institutions should appreciate that clients who wish to be in accord with Shari’a finance seek transactions and instruments that are SSB approved.

 

SSBs review financial transactions and services to ensure they do not involve interest (especially in a surreptitious way) and also that they do not carry excessive risk. In the second installment of this series on Islamic finance, I shall look in greater detail at risk or gharar, as it relates to currency and commodity trading.

 

 

 

 

 

 

 

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

 

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

 

Read part two of this series here.

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