Trading FX within Islamic finance.
Where once Islamic finance was seen as a niche banking system, it has now grown to be an integral component of international finance with total global financial assets estimated to now be at around $2 trillion. According to a report from the Malaysian Financial Centre, in the past five years the growth has been the most significant, at 17.3 per cent compounded annual growth rate. Gone is the time when Islamic finance was only accessible in key regions; now advanced economies are turning to this growing market and recognising the importance of providing access to Shari'ah- compliant investments.
Shari'ah-compliant FX trading accounts are often also called swap-free forex trading accounts because no swaps or rollover charges are applied to positions held overnight. Understanding Shari'ah-compliant FX trading requires recognition of the difference between FX interest and non-interest accounts, and also the valuation method of the Tom/Next rollover (T/N rollover). The latter is critical to being able to identify where the interest elements lie in the valuation and how this can be eliminated when dealing with Islamic FX accounts.
By breaking down the components of the interest T/N rollover, we are able to ascertain the interest elements, which makes it easier to take out the interest part out, and thus comply with Shari'ah principles, wherein the payment and receipt of interest is strictly prohibited.
WHAT IS TOM/NEXT ROLLOVER (T/N ROLLOVER)?
Most traders in the currency markets are speculators and don't intend to actually take physical delivery of the currency they are trading. If a trader buys and sells within the same business day, there is no issue with delivery, but if they want to carry over their trade to the next business day they are required to use Tom/ Next rollover procedures.
All open FX positions held overnight are subject to a debit or credit interest rate revaluation to reflect the position being rolled over to the next day. This operation known as the Tom/Next Rollover (T/N rollover) is applied to spot positions held at 17:00 Eastern Standard Time (New York time) on any given trading day.
The'rollover' is made up of two components, the T/N swap points and financing of unrealised profits or losses. The accumulated combined rollover credit or debit is added or deducted from the opening price of the position.
Swap points are the calculation of the interest rate difference between two traded currencies when holding the position overnight.
The swap points used in the rollover are usually defined by a T/N swap feed from a liquidity provider, such as a Tier-1 bank, with a default mark-up or down corresponding to +/- 0.45 per cent of daily market overnight interest rates, plus interest for unrealised profit or loss. The accumulated swap points and interest component are added or deducted to the previous opening price of the position.
INTEREST ON UNREALISED PROFIT AND LOSS
Any unrealised profits or losses on the forex spot position being rolled over from one day to the next are subject to an interest credit or debit. These are added to the swap points to calculate the rollover credit or debit.
The unrealised profits or losses are usually calculated as the difference between the original traded rate (possibly adjusted for previous T/N rollovers) and the end of day rate of the traded currency cross at 17:00 Eastern Standard Time (New York time).
COMMISSION-BASED, NON-INTEREST ISLAMIC PROFILE
One of the core principles that governs Islamic finance is prohibiting the collection and payment of interests or fees on loans ('Riba' or 'usuary'). Money itself does not have an intrinsic value and therefore, the concept of making money from money is not allowed under Shari'ah principles.
Another important aspect in Islamic finance is prohibition of uncertainty ensuring that all aspects (such as price, nature of the goods, description, etc.) of a contractual transaction or relationship need to be clear and documented.
In order to comply with those two principles when dealing with T/N rollover, the interest rates needs to be eliminated while agreeing on a fixed commission which can be agreed with the client and in which reflect the costs of holding the client position to the next value date (usually, the next day). By doing so, both the interest rates and the uncertainty on the price will be eliminated.
The bank can agree not to credit or debit any T/N rollover rate on FX positions left open at the end of the business day before their value date. As compensation for removing these charges, the client who is holding an FX position overnight will be charged a one-time commission of x units in the traded currency per 100,000 traded (applies for both opening and closing of positions as well as when increasing or reducing). I.e. a trade of 100,000 EURUSD may result in a charge of EUR 5.
While it is commonplace for banks offering Islamic finance accounts and trading to clearly specify if they are swap-free, knowing the true make-up of interest T/N roller empowers traders to confidently trade in the safe knowledge that they are complying fully with Shari'ah principles.
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