Until recently, Islamic businesses have lacked a straightforward Shariah compliant structure to enable them to manage foreign exchange risk.
27 July 2016
Foreign exchange risk arises whenever business is done between countries that use different currencies.
In conventional finance, derivative contracts, such as foreign currency forwards and foreign currency swaps, are regularly used to manage foreign exchange risk. However Shariah scholars do not consider such contracts to be Islamically permissible. Accordingly businesses which wish to be Shariah compliant have been at a serious disadvantage compared with conventional businesses. Either they have been unable to manage their foreign exchange risks or they have had to resort to tools which are less efficient than the tools available to conventional businesses.
Accordingly, I was very pleased to learn of an approved model of Islamic foreign exchange forward, and made that the subject of my July 2016 column in Islamic Finance News. You can read it below.
I have added some hyperlinks to give further information; the magazine columns are always written without any hyperlinks.
Cross border transactions always give rise to foreign exchange transaction risk.
Imagine UK Dealerco imports excavators from the USA. When the £/$ spot exchange rate is £1 = $1.5, Dealerco agrees to import an excavator costing $150,000 (=£100,000) with payment being due in three months’ time. Dealerco sells the excavator to a UK contractor for, say, £105,000.
In three months’ time, if £1 still equals $1.50, Dealerco will buy $150,000 for £100,000, so making an overall profit of £5,000. However, in three months’ time the £/$ exchange rate could be almost anything. If say £1=1.40, then $150,000 will cost Dealerco £ 107,143 so overall instead of making the expected £5,000 it actually loses £2,143. (Conversely if in three months’ time £1=$1.60, the $150,000 will only cost Dealerco £93,750, so its overall profit becomes £11,250.)
Dealerco can eliminate this risk using a forward foreign exchange contract with a conventional Bank.
Dealerco and Bank sign a contract today under which Dealerco commits that in three months’ time it will buy (and Bank commits to sell) $150,000 from Bank at a fixed price of, say, £100,671. The implied rate of £1=$1.49 is called the forward rate. (The forward rate is not a guess by either party. It is set by taking into account three-month interest rates in pounds and dollars.) Effectively at a fixed cost of £671 Dealerco protects itself against unfavourable exchange rate movements, while also giving up the opportunity to profit from a favourable exchange rate movement.
Shariah scholars generally consider such conventional forward contracts impermissible. AAOIFI: Shariah Standard No. 1: Trading in Currencies says “A bilateral promise to purchase and sell currencies is forbidden if the promise is binding, even for the purpose of hedging against currency devaluation risk..........”
However, the need for protection against foreign exchange transaction risk is a real need. Islamic finance will always struggle against conventional finance if it lacks Shariah compliant instruments to meet such real needs.
Accordingly, I was pleased by the International Swaps and Derivatives Association (ISDA) and the International Islamic Financial Market (IIFM) recently publishing template documentation for Islamic Foreign Exchange Forwards. These templates are intended to be used under the umbrella of the ISDA/IIFM Tahawwut Master Agreement. Two counterparties enter into one (quite long) Master Agreement between them, and then enter into much shorter agreements for specific transactions such as the Islamic Foreign Exchange Forwards (IFXF).
The IFXF involves two independent unilateral promises (wa’ads in Arabic) being made. Each promise is intended to be legally binding. If the parties use English law, each promise will be executed as deeds, making it legally enforceable.
In our example, Dealerco promises that if, in three months’ time, the spot value of £1 greater than, or equal to, $1.49, it will buy $150,000 from Bank for a fixed price of £100,671. Meanwhile Bank separately promises Dealerco that if, in three months’ time, the spot value of £1 is less than $1.49, it will sell $150,000 for a fixed price of £100,671. Obviously only one of these conditions will be satisfied, but regardless of which it is, Dealerco will get the $150,000 it wants for £100,671.
ISDA and IIFM also published a single promise version, which I will not discuss for lack of space.
As the economics of the IFXF are identical to that of the conventional forward contract, it is up to each individual Muslim to decide if there is a real religious difference. However, this documentation does enable corporate organisations to protect against foreign exchange transaction risk while remaining compliant with the requirements of their Shariah Supervisory Board.