Traders and investors who live in majority Muslim states comply with the rules of Sharia law, which states that interest, or “riba”, as well as excessive risk, or “gharar”, are haram and prohibited.
This creates unique circumstances for those engaging with the financial markets in these countries, as well as the intermediaries, such as brokerage firms and asset managers that facilitate trading on the financial markets.
In order to avoid violating Sharia law, many brokerages offer Islamic FX trading accounts that do not charge rollover interest on overnight holdings, complying with the “riba” restriction.
Sharia law regulates several aspects of trading and investing that are otherwise common on the financial market. To better understand how brokerage firms comply with Sharia law, we can look at several examples from the forex and stock markets in the sections below.
Islamic finance and the stock market
As expected, the approach of Islamic finance towards the stock market is considerably different from FX and other markets.
According to Shariaw Law, the following investments are prohibited:
● Stocks of interest-based financial institutions, such as commercial banks and insurance firms
● Stocks of weapons manufacturing companies and arms dealers
● Stocks of companies engaged in alcohol, tobacco and adult entertainment markets
● Margin trading and short-selling
● Day-trading and high-risk derivatives
● Stocks with a debt-to-equity ratio of over 33%
In order to avoid violating Sharia Law, asset managers and brokerage firms offering stock investing services to clients in Islamic countries, tend to add market-screening filters to hide stocks that are prohibited, while offering ETFs geared specifically towards Muslim investors.
Islamic finance is particularly strict when it comes to excessive risk-taking, which means that options and futures trading, as well as the use of leverage, is off the table for Muslim traders.
How brokerages comply with Islamic finance principles
Due to the strict prohibition on interest-based investments, Islamic finance basically prohibits bond investments altogether. In order to comply with Islamic finance principles, certain brokerage firms have developed “Sukuks”, or Islamic bonds, which are asset-backed alternatives to conventional bonds.
Sukuks provide investors with access to the underlying asset, with terms that state the possibility to buy back the instrument after the expiration date. Instead of interest, the investor generates income using other means, such as business and rental income from the underlying asset.
Sukuks are one of several financial instruments that are designed with the principles of Shariah law in mind, with swap-free accounts being particularly popular among forex brokerages.
Forex trading and Islamic finance
When it comes to trading on the foreign exchange market, the key challenge for traders comes from the overnight interest charged by brokerage firms, which is against Sharia Law.
In order to avoid violating the law, forex brokers offer special Islamic accounts, which are swap-free accounts. Furthermore, leverage and margin trading are also strictly prohibited.
For this reason, the spreads charged on Islamic accounts tend to be wider in order to make up for lost revenue from the removal of swap fees.
In some cases, a fixed commission is charged per trade, while highly speculative and volatile instruments are unavailable.
Reputable forex brokers often obtain Shariah board approval to demonstrate their compliance with the principles of Islamic finance – allowing their Muslim clients to rest assured and trade without the risk of violating religious laws.
Conclusion
Islamic finance refers to the principles that are governed by Shariah law and provide restrictions and guidelines for the financial instruments and investment practices that are prohibited by the law.
For example, the use of interest and margin trading are both prohibited, which is why many stock and forex brokerage firms offer swap-free accounts and instruments specifically designed with Islamic investors and traders in mind.
Overall, the principles behind islamic finance are quite simple, as overly risky instruments and charging interest are both considered haram.