Understanding the theory of Islamic trading
Understanding Islamic trading is simple but can be better understood with the proper knowledge of Islamic finance.
What is Islamic Finance?
The practice of finance, according to the principles of Islam, is known as Islamic Finance. Islamic principles determine the objective and process of Islamic finance. The modern finance theory is what determines the operation of conventional finance, while ethical laws drive Islamic finance. Every simple principle and constraint of Islamic finance is explained in Islamic law, also known as Shari’a.
The two significant factors that distinguish Islamic finance from the conventional finance system are:
- Islamic finance recommends that the philosophy of the financial system should be a risk-sharing philosophy where the lender must partake of the borrower’s risk. A non-Islamic interest-based loan assures a return to lenders or creditors with the burden of risk falling solely on the one who borrowed the money. From an Islamic standpoint, this is an uneven distribution of risk where the risk falls exclusively on the shoulders of the borrower and is deemed as economically wasteful and unfair.
- Islamic finance looks to promote social and economic growth through exact business practices. We know that the principal objective of conventional finance is basically profit maximization; however, the aim of Islamic finance is to achieve financial goals religiously and morally, as stated in the Shari’a law.
The religious laws of Shari’a are the guidelines that many followers of Islam live by. These laws are driven by ethics and are a major part of Islamic finance as they are an integral part of society and life in general in the Muslim world. We can therefore say that the objective of Islamic finance is creating a financial environment with distributive and socio-economic justice.
Prohibition in Islamic finance
Using the principle of Islamic finance, all financial contracts and business transactions must follow the Shari’a rules. Some of the basic prohibitions in Islamic finance are:
- ‘Gharar’ or excessive risk
- ‘Riba’ or Interest
- Gambling or gossip
Prohibition against interest (riba)
Amongst Islamic and legal scholars, there is no disagreement regarding interest. According to Islamic law, making money from money is not acceptable and any transaction based on interest is a sin with the primary source of the Shari’a law condemning the practice.
Interest, of course, signifies the amount paid above the principal amount collected as a loan or debt regardless of whether it is charged on personal or commercial loans. It is not unlawful to give or obtain a loan under Islamic law. However, the only type of loan allowed in Islam is an interest-free type, also known as ‘qard al Hassan’.
According to Islamic scholars, here are the reasons why Islam prohibits interest, or riba, on loans:
- Interest-based loans corrupt society.
- Taking interest on loans implies the dishonest taking of property.
- Taking interest in loans leads to negative growth because taking profit on loans increases money quantitatively and reduces growth in social wealth.
- The collection of interest is unfair on the basis that a lender collecting interest from a borrower which causes oppression to the borrower and involves no labour on the part of the lender.
- The collection of interest does not depict humanity positively. Charging interest on a loan affects culture in a negative way by trading morality for monetary gain.
Money and interest are things that benefit the lender of the loan. Shari’a does not oppose this point but argues that the danger associated with the collection of interest is greater than the associated benefits.
Islamic Trading
Islamic trading must conform with the knowledge of Islamic finance principles. Typical forex trading involves what is known in financial terms as ‘riba al-nasi’a’, which means the interest in a money-to-money exchange provided the exchange is deferred or delayed with an additional charge incurred with such a deferment of payment.
Thus, such a transaction can arise with regards to foreign exchange trading. When such an agreement between two foreign exchange traders calls for the payment of a currency on the basis of delay, then the transaction is ‘a nasi’a’.
The exchange of money-for-money in different currencies of equal values is permitted. That is to say that there is no interest in a foreign exchange or spot currency transaction. The only problem that can occur in this transaction is when payment is delayed, as in a currency swap, loan transaction, or foreign exchange.
The online market offers swap-free trading accounts that allow clients to trade in any currency pair, carry it overnight, and still not get any withdrawal or reward. For Islamic trading to be shari’a-compliant, the accounts do not have any interest but still have open positions for unspecified long periods. Trading results then depend on the rate of currency movement for that period. This way, providers look to match spot currency transactions under Shari’a finance.
As a trader, for you to be Shari’a compliant, there are many financial transactions and mechanisms that must be permitted by the Shari’a Supervisory Board (SSB). This board provides a seal of approval, which is compulsory to make sure that the financial transactions and laws are allowed according to shari’a. This board reviews and endorses products and services as well as essential documents relating to the products and services. Financial institutions should appreciate that customers who wish to trade in accord with shari’a finance are interested in transactions that are approved by the SSB.
These reviews of financial services ensure that transactions are void of interest with less risk. So, in essence, Islamic trading is trading based on Islamic principles meant to prevent excess profit while trading.
Bottom Line
Islamic trading is a profitable way of trading for members of this society who deem it acceptable vs. conventional trading, which, according to their rules, is not. It is a peaceful way of trading any kind of investment. As long as both parties understand and agree on the terms of the deal, then there should be no conflict, which makes it a win-win scenario for all.