Fee-based Foreign Exchange Transactions

Many international transactions require exchange of foreign currencies. The transactions could be related to travelers’ checks, cash, drafts, drafts, fund transfers, remittances, investments, or trade. In an era of fluctuating exchange rates it is important to manage the foreign exchange (FX) risk. Otherwise, a profitable trade could become a loss in case of unfavorable movement in exchange rates.

The most common type of FX transaction is called spot transaction, which is carried out on the same day where one currency is exchanged for another at the prevailing rate. The banks may charge a commission and also make a profit by giving different rates for buying and selling currency. There is no interest involved in these transactions so they are valid and Shari’ah compliant.

If the transaction is not spot and is to take place at a future date various hedging techniques are utilized by commercial banks to protect against the FX risk. These include forward, futures, options, swaps, and arbitrage. All of these contracts have either or both of gharar (uncertainty) and riba elements and are not acceptable in Shari’ah. However, hedging is a need of time and Islamic equivalent products have evolved to protect against the risk.

An Islamic forward contract is primarily used for the purpose of delivering or receiving a currency at a future date. These are Shari’ah compliant promised to sell contracts which are similar to Salam contracts where a customer pays for a currency at the time of contract, to be delivered or received at a future date at an agreed upon rate. No fee is charged for this transaction but a profit is built into the rates for the bank. There is a risk of customer failing to fulfill his obligation against which the bank can require a deposit to cover any losses to the bank.

As opposed to a forward contract, where currency is actually delivered, futures contracts are just a gamble on the future price of a currency. They are used to manage risk and currencies rarely exchange hands. Only the difference between market price on the future date and the contracted price is settled between the parties. Shari’ah rules do not allow for a futures contract, however, some scholars are looking into compliant futures contracts.

Similarly, none of variants of options contract, namely, call, put, and put-and-call have been deemed Shari’ah compliant. These allow the option but not an obligation for purchase, sale, or both of a currency at a certain price at a future date.

Swap contracts involve spot purchase and a forward sale of a currency to earn interest and gain liquidity in a certain currency. Swaps are not permitted in Shari’ah.

Arbitrage involves buying and selling of a currency in different markets to take advantage of different exchange rates. These are allowed in Shari’ah as long as actual delivery of currency is involved as it has a balancing effect on exchange rates.