Islamic Forex
Foreign exchange (FX) is an important activity in modern economy. A foreign exchange transaction is essentially an agreement to exchange one currency for another at an agreed exchange rate on an agreed date, it provides protection against unfavorable currency exchange rates and helps businesses associated with activities in a foreign currency to set a form of currency risk exposure. And when using techniques such as foreign exchange hedging capabilities, businesses can protect against adverse currency movements at a future date. FX transactions cover foreign currency payment transactions and fund transfers involving different currencies and countries and transactions such as travelers’ cheques, foreign currency cash, foreign currency drafts, foreign currency fund transfers/remittances, investments and trade services.
Permissibility of FX transactions
In Islamic finance, there is a general consensus among Islamic scholars on the view that currencies of different countries can be exchanged on a spot basis at a rate different from unity, since currencies of different countries are distinct entities with different values or intrinsic worth, and purchasing power. However, there were diametrically opposite views, in the past, on the permissibility of currency exchange on a forward basis, that is, when the rights and obligations of both parties relate to a future date. The divergence of views on the permissibility of currencies exchange contracts can be traced primarily to the issue of existence of the following elements; Riba (usury); Gharar (excessive uncertainty); and Qimar (speculation/gambling).
Regarding the comparison with Riba, some jurists compare paper currencies with gold and silver; which were universally acceptable as principal means of exchange in the early days of Islam. They refer to hadith of the holy prophet (peace be upon him) "Sell gold for gold, silver for silver... in same quantities on the spot; and when the commodities are different, sell as it suits you, but on the spot." However, the case of exchange involving paper currencies belonging to different countries, the intrinsic value or worth of paper currencies cannot be identified or assessed unlike gold and silver which can be weighed. Hence, the Shari’ah injunctions for Riba prohibition are not applicable to paper currencies. Such exchange would be permissible as long as it is free from any injunction regarding the rate of exchange and the manner of settlement.
Regarding Gharar and speculation, the prohibition of futures and forwards involving exchange of currencies is justified by the fact that such a contract involves sale of a non-existent object or of an object not in the possession of the seller. Some recent scholars have opined that futures, in general, should be permissible, because the efficient cause, that is, the probability of failure to deliver was quite relevant in a simple, primitive and unorganized market. However, this should be no longer cause for concern in today’s organized futures markets where the standardized nature of futures contracts and transparent operating procedures on the organized futures markets are believed to minimize this probability of failure. Nevertheless, such contention continues to be rejected by the majority of scholars; they underscore the fact that futures contracts almost never involve delivery by both parties. On the contrary, parties to the contract reverse the transaction and the contract is settled in price difference only. In addition, regarding the forecastability of exchange rates, they are volatile and remain unpredictable at least for the large majority of market participants. And any attempt to speculate in the hope of the theoretically infinite gains would be a game of chance for such participants.
Forex in Islamic banks
Islamic banks exchange currencies on the spot in transactions such as a bank transfer or remittance expressed in a foreign currency, payment for goods imported from another country, payment for services billed in a foreign currency, in the case of a sell or a purchase of a foreign currency in cash or traveler’s cheque or bank draft against another currency, or when a client deposits a cheque or bank draft made out in a foreign currency and requires payment in local currency.
In addition to spot transactions, an FX transaction may be undertaken by banks on the basis of forward contracts, futures contracts, option contracts, swap contracts and currency arbitrage. Even though, some of these transactions are controversial as Islamic financial instruments, because it is arguable that the element of speculation and interest is built into these contracts.
Also, while there are normally no up-front costs involved with FX transactions, Islamic banks still derive a financial benefit by incorporating a margin into the transaction or the contract rate. This means that the bank’s rate may be different from the market rate prevailing at that time, whereby the bank makes a profit on a transaction.
Hedging tools
Today’s currency markets are characterized by volatile exchange rates. In a volatile market, the participants are exposed to currency risk and Islamic rationality requires that such risk should be minimized in the interest of efficiency if not reduced to zero. Islamic FX hedging mechanisms are designed to achieve the objectives of the conventional currency hedging contracts while being in conformity with the Islamic commercial jurisprudence principles. This implies the need to ensure that the contract is free from Riba, Gharar and Maysir. Some these mechanisms are:
• A forward contract involving currencies allows one currency to be sold against another, for settlement on the day the contract expires; it eliminates the risk of fluctuating exchange rates by fixing a rate on the date of the contract for a transaction that will take place in the future.
• A futures contract involving currencies is an agreement to buy or sell a particular currency for delivery at an agreed-upon place and time in the future; however, these contracts very rarely lead to the delivery of a currency, because positions are closed out before the delivery date.
• A foreign currency option is a hedging tool, similar to an insurance policy that allows one currency to be exchanged for another on a given date, at a prearranged exchange rate, without any obligation to do so; foreign currency options eliminate the spot market risk for future transactions.
• A swap contract involving currencies is an agreement to exchange one currency for another and reverse the exchange at a later date; it is based on a notional principal amount, or an equivalent amount of principal, that sets the value of the swap at maturity but is never exchanged; Currency swaps are used to gain liquidity.
• Currency arbitrage aims to take advantage of divergences in exchange rates in different money markets by buying a currency in one market and selling it in another market to take benefit of the differing interest rates.
From the Shari’ah viewpoint, the problem with the above structures arises when the parties involved want to exchange currency sometime in future but already fixing a rate which is fixed today while the contract is sealed today. This contravenes to the basic Shari'ah rules governing the exchange of currency (Bai` Sarf). In Bai` Sarf, it is a requirement for an exchange which involves two different currencies to be transacted on spot basis. Hence it is prohibited to enter into forward currency contracts whereby the execution of a deferred contract in which the concurrent possession of both the counter values by both parties does not take place. Nevertheless, in order to minimize the risk of uncertainty of prices in the future, forwards, futures, options and swaps markets for currency-trading have also emerged for Islamic banks although the general ruling of Shari'ah scholars is that hedging is not permissible. Yet, these objections may be arguable, since hedging helps to eliminate Gharar by enabling the importer to buy the needed foreign exchange at the current exchange rate, since Islamic banks only invest the foreign currencies purchased by them in a Shari'ah-compliant manner as far as is possible and since the principle of protection of wealth is respected. In addition, genuine speculation is allowed in Islam, as opposed to professional speculation, where the speculator is not a genuine investor. Most of the Islamic financial contracts provided by Islamic banks will be exposed to foreign exchange fluctuations arising from general FX spot-rate changes in foreign operations and the resultant foreign currency receivables and payables. Islamic banks can charge fees based on various Islamic contracts and to curb speculation and misuse, hedging could be confined to foreign exchange receivables and payables related to real goods and services only.
Islamic FX Swap
The swap introduced by Islamic banks, based on concepts such as Wa’ad, Murabahah, Musawamah and Tawarruq is deemed by scholars as permissible as long as it is free from elements that contravene the Shari’ah, and for the purpose of fulfilling the need for hedging.
Therefore Shari’ah parameters in structuring and executing swap are very important to ensure market practitioners truly fulfill and adhere to the requirement outlined by Shari’ah. Two broad categories of Shari’ah parameters on Islamic FX Swap are suggested, namely the guidelines on combining various contracts in one single transaction and the other is on guidelines of how to demarcate Islamic swap purposes either to hedge or to speculate. The two commonly offered structures of Islamic FX Swap in the market are based on the contract Bai` Tawarruq or the concept of Wa’ad (promise/undertaking). The arrangement based on Tawarruq it is structured with the application of two sets of Tawarruq (at the beginning) to enable the same effect as FX Swap to be achieved. While the second structure based on the concept of Wa’ad involves exchange of currencies at the beginning, and promise or undertaking (Wa’ad) to carry out another Bai` Sarf at the future date based on the rate determined today. At the expiry date, the second Bai` Sarf will be implemented to get back the original currency.
Permissibility of FX transactions
In Islamic finance, there is a general consensus among Islamic scholars on the view that currencies of different countries can be exchanged on a spot basis at a rate different from unity, since currencies of different countries are distinct entities with different values or intrinsic worth, and purchasing power. However, there were diametrically opposite views, in the past, on the permissibility of currency exchange on a forward basis, that is, when the rights and obligations of both parties relate to a future date. The divergence of views on the permissibility of currencies exchange contracts can be traced primarily to the issue of existence of the following elements; Riba (usury); Gharar (excessive uncertainty); and Qimar (speculation/gambling).
Regarding the comparison with Riba, some jurists compare paper currencies with gold and silver; which were universally acceptable as principal means of exchange in the early days of Islam. They refer to hadith of the holy prophet (peace be upon him) "Sell gold for gold, silver for silver... in same quantities on the spot; and when the commodities are different, sell as it suits you, but on the spot." However, the case of exchange involving paper currencies belonging to different countries, the intrinsic value or worth of paper currencies cannot be identified or assessed unlike gold and silver which can be weighed. Hence, the Shari’ah injunctions for Riba prohibition are not applicable to paper currencies. Such exchange would be permissible as long as it is free from any injunction regarding the rate of exchange and the manner of settlement.
Regarding Gharar and speculation, the prohibition of futures and forwards involving exchange of currencies is justified by the fact that such a contract involves sale of a non-existent object or of an object not in the possession of the seller. Some recent scholars have opined that futures, in general, should be permissible, because the efficient cause, that is, the probability of failure to deliver was quite relevant in a simple, primitive and unorganized market. However, this should be no longer cause for concern in today’s organized futures markets where the standardized nature of futures contracts and transparent operating procedures on the organized futures markets are believed to minimize this probability of failure. Nevertheless, such contention continues to be rejected by the majority of scholars; they underscore the fact that futures contracts almost never involve delivery by both parties. On the contrary, parties to the contract reverse the transaction and the contract is settled in price difference only. In addition, regarding the forecastability of exchange rates, they are volatile and remain unpredictable at least for the large majority of market participants. And any attempt to speculate in the hope of the theoretically infinite gains would be a game of chance for such participants.
Forex in Islamic banks
Islamic banks exchange currencies on the spot in transactions such as a bank transfer or remittance expressed in a foreign currency, payment for goods imported from another country, payment for services billed in a foreign currency, in the case of a sell or a purchase of a foreign currency in cash or traveler’s cheque or bank draft against another currency, or when a client deposits a cheque or bank draft made out in a foreign currency and requires payment in local currency.
In addition to spot transactions, an FX transaction may be undertaken by banks on the basis of forward contracts, futures contracts, option contracts, swap contracts and currency arbitrage. Even though, some of these transactions are controversial as Islamic financial instruments, because it is arguable that the element of speculation and interest is built into these contracts.
Also, while there are normally no up-front costs involved with FX transactions, Islamic banks still derive a financial benefit by incorporating a margin into the transaction or the contract rate. This means that the bank’s rate may be different from the market rate prevailing at that time, whereby the bank makes a profit on a transaction.
Hedging tools
Today’s currency markets are characterized by volatile exchange rates. In a volatile market, the participants are exposed to currency risk and Islamic rationality requires that such risk should be minimized in the interest of efficiency if not reduced to zero. Islamic FX hedging mechanisms are designed to achieve the objectives of the conventional currency hedging contracts while being in conformity with the Islamic commercial jurisprudence principles. This implies the need to ensure that the contract is free from Riba, Gharar and Maysir. Some these mechanisms are:
• A forward contract involving currencies allows one currency to be sold against another, for settlement on the day the contract expires; it eliminates the risk of fluctuating exchange rates by fixing a rate on the date of the contract for a transaction that will take place in the future.
• A futures contract involving currencies is an agreement to buy or sell a particular currency for delivery at an agreed-upon place and time in the future; however, these contracts very rarely lead to the delivery of a currency, because positions are closed out before the delivery date.
• A foreign currency option is a hedging tool, similar to an insurance policy that allows one currency to be exchanged for another on a given date, at a prearranged exchange rate, without any obligation to do so; foreign currency options eliminate the spot market risk for future transactions.
• A swap contract involving currencies is an agreement to exchange one currency for another and reverse the exchange at a later date; it is based on a notional principal amount, or an equivalent amount of principal, that sets the value of the swap at maturity but is never exchanged; Currency swaps are used to gain liquidity.
• Currency arbitrage aims to take advantage of divergences in exchange rates in different money markets by buying a currency in one market and selling it in another market to take benefit of the differing interest rates.
From the Shari’ah viewpoint, the problem with the above structures arises when the parties involved want to exchange currency sometime in future but already fixing a rate which is fixed today while the contract is sealed today. This contravenes to the basic Shari'ah rules governing the exchange of currency (Bai` Sarf). In Bai` Sarf, it is a requirement for an exchange which involves two different currencies to be transacted on spot basis. Hence it is prohibited to enter into forward currency contracts whereby the execution of a deferred contract in which the concurrent possession of both the counter values by both parties does not take place. Nevertheless, in order to minimize the risk of uncertainty of prices in the future, forwards, futures, options and swaps markets for currency-trading have also emerged for Islamic banks although the general ruling of Shari'ah scholars is that hedging is not permissible. Yet, these objections may be arguable, since hedging helps to eliminate Gharar by enabling the importer to buy the needed foreign exchange at the current exchange rate, since Islamic banks only invest the foreign currencies purchased by them in a Shari'ah-compliant manner as far as is possible and since the principle of protection of wealth is respected. In addition, genuine speculation is allowed in Islam, as opposed to professional speculation, where the speculator is not a genuine investor. Most of the Islamic financial contracts provided by Islamic banks will be exposed to foreign exchange fluctuations arising from general FX spot-rate changes in foreign operations and the resultant foreign currency receivables and payables. Islamic banks can charge fees based on various Islamic contracts and to curb speculation and misuse, hedging could be confined to foreign exchange receivables and payables related to real goods and services only.
Islamic FX Swap
The swap introduced by Islamic banks, based on concepts such as Wa’ad, Murabahah, Musawamah and Tawarruq is deemed by scholars as permissible as long as it is free from elements that contravene the Shari’ah, and for the purpose of fulfilling the need for hedging.
Therefore Shari’ah parameters in structuring and executing swap are very important to ensure market practitioners truly fulfill and adhere to the requirement outlined by Shari’ah. Two broad categories of Shari’ah parameters on Islamic FX Swap are suggested, namely the guidelines on combining various contracts in one single transaction and the other is on guidelines of how to demarcate Islamic swap purposes either to hedge or to speculate. The two commonly offered structures of Islamic FX Swap in the market are based on the contract Bai` Tawarruq or the concept of Wa’ad (promise/undertaking). The arrangement based on Tawarruq it is structured with the application of two sets of Tawarruq (at the beginning) to enable the same effect as FX Swap to be achieved. While the second structure based on the concept of Wa’ad involves exchange of currencies at the beginning, and promise or undertaking (Wa’ad) to carry out another Bai` Sarf at the future date based on the rate determined today. At the expiry date, the second Bai` Sarf will be implemented to get back the original currency.
