By Peter Bokma
Foreign exchange transactions are one of the largest activities banks worldwide daily execute on behalf of their customers. Islamic banks activities are very much focused on offering good foreign exchange services to their customer base.
Islamic banks can offer customers spot value date transactions, which are for settlement in two working days, or at a pre-agreed date and price in the future, which would be covered under the “foreign exchange wa’ad”.
Islamic foreign exchange swap is a contract that is designed as a hedging mechanism to minimise market participants’ exposure to volatile and fluctuating market of currency exchange rates.
The foreign exchange swap is a derivative instrument that has a specific objective to hedge against the risk of fluctuations in the exchange rate. The conventional structure of a foreign exchange swap normally involves two foreign currency monetary exchanges: one at the beginning and one at the expiry date (FX swap involves exchange and re-exchange of foreign currency). The dual exchange makes this FX swap different from a forward contract. In the forward contract, the exchange only takes place once.
The FX swap involves two stages of exchange at the beginning when the first currency exchange takes place and the dollar or other currency is converted to the other currency based on the spot rate. On the same day, both sides will sell a forward contract to other currency back to the dollar or other exchanged foreign currency at a forward rate.
From a Shariah point of view, the problem with the conventional FX swap structure arises when the parties involved want to exchange currency sometime in the future, but fix the rate on the day the contract is concluded. This contravenes basic Shariah rules governing the exchange of currency “sarf”.
Under “sarf” it is prohibited to enter a forward currency contract, where the execution of a deferred contract in which the concurrent possession of both the counter values by both parties does not take place.
This rule applies in the case of a FX swap, since the contract of exchanging two foreign currencies is done on a forward basis, and where the contract is concluded today, but the exchanges actually happen in the future (on the date of maturity).
The most widely used Shariah-based method and adopted concept is the wa’ad, which is a promise of undertaking. The wa’ad is an Arabic word which literally means “a promise”. The value of the wa’ad in Shariah is similar to the value of a social promise in the common law. The promise may have moral force, in that breaking it may provoke opprobrium (social blame), but it does not entail legal obligations or legal sanctions. Under the civil law, the wa’ad can be binding or non-binding, depending on the intention of the party who is giving the promise.
The OIC Islamic Fiqh Academy, based in Saudi Arabia, has decided that the wa’ad is “obligatory not only in the eyes of God but also in a court of law” when it is made in commercial transactions, or when it is a unilateral promise, or when it has caused the promise to incur liabilities.
Also, it is a requirement that the actual sale, if the promise was in respect of selling a certain asset, be concluded at the time of exchange of the offer and the acceptance (known in Arabic as majlis al-aqd) and not at the time of the wa’ad.
In conclusion, the FX wa’ad is widely used by the Islamic banks and has been instrumental in assisting the customers in hedging their exposures and limiting the potential risk from the extreme fluctuations FX markets undergo daily.
Peter Bokma is chief of treasury and investments at International Islamic. The views expressed are his own.
