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.