Islamic Trading Accounts Explained
There are many similarities between regular and Islamic trading accounts. However, it is important to understand that the latter one is a type of account especially made to conform to the teachings of Islam on Online Forex Trading. Therefore, it differs from the regular trading account in several respects, such as:
- There are no swaps paid or received for leaving the positions open overnight.
- Islamic trading accounts in general tend to have wider spreads.
- With many brokers, traders can not trade some emerging market currencies with Islamic trading accounts
- Commodity trades like silver and gold on the Islamic trading accounts are backed by the physical gold.
Now let us go through the details of each of these specific differences and their implications of the Forex trading.
Eliminating Interest in Forex Trading
It goes without saying that there are many Muslims who wonder whether Forex trading is legal in Islam or in other worlds is day trading Halal or Haram. Now these two latter terms might be unknown for some people. However, their meaning is very well defined.
Haram is something forbidden and sinful in Islam, while Halal is something permitted and acceptable in this religion. Now, in order to make the Currency Trading Halal, the brokerage companies do have to eliminate any type of interest from the equation, since there is a very strong prohibition of charging or receiving interest in Islam.
Now, with regular trading accounts, if traders leave their positions open overnight, they will have to either pay or receive interest, this is also known as swap or rollover. Whether a market participant will receive or have to pay the swap, depends on the relative central bank interest rates of two currencies, involved in the currency pair. In addition to that, the brokerage company also adds some percentage of commission on top of these interest rate differentials.
In sharp contrast to this structure, the Islamic accounts eliminate all of these dynamics. Here, traders can keep positions open without having to worry about the rollover charges with different currency pairs.
This can be beneficial in many respects. The fact of the matter is that the traders in their analysis might conclude that currencies with negative interest rates, such as the Japanese yen (JPY) and Swiss franc (CHF) are well-positioned to make gains in the future against some of their peers.
This assumption might be based on some technical indicators, or the reasons for this prediction might be the fact that due to typically low inflation rates of these currencies, the purchasing power parity indicator very often favors their appreciation. The reason for this is the fact that according to the PPP theory, in the long term the currencies with low inflation rates tend to appreciate against the ones with higher CPI rates.
However, opening the long positions for the Japanese yen and Swiss franc and holding them for a considerable amount of time can be very problematic with a regular trading account. Due to the interest rate differentials, it is highly likely that the traders will face significant swap charges, which over time can add up to a significant amount. So as we can see, the regular trading accounts discourage traders from buying lower yielding currencies. This limits the trader’s ability to take advantage of some of the long term trading opportunities.
This might not be a significant problem for scalpers and day traders. After all, the market participants with this type of trading style, typically tend to close their positions before the end of the trading day, so they do avoid rollover charges anyway. However, for swing and long term traders, this can be a significant problem and can have a sizable negative impact on their earnings.
On the other hand, swap-free trading accounts allow the market participants to choose any positions with major currencies, without having to worry about the rollover expenses. So they can make their trading decisions only based on technical and fundamental indicators, without having to factor in the interest rate differentials between two currencies. After all, if brokers started charging interest to these clients, that would make Forex trading haram and it will no longer be a halal trading account.
One thing to remember here is that the Islamic trading account also eliminates the possibility of carry traders. The reason for this is the fact that this Forex strategy involves borrowing in the low yielding currency in order to buy the higher yielding currencies and then receive an income from the interest rate differentials. However, since there are no swap payments with Islamic trading accounts, one can not use carry trading strategies.
It goes without saying that swap interest charges are one of the sizable sources of income for the brokerage companies. However, since they can receive any revenue from this category with Islamic trading accounts, they have to come up with something to compensate for this loss of income.
In order to address this concern, nearly all brokers apply wider spreads
for the Islamic trading accounts. This allows them to increase their earnings from spreads and offset the loss of revenue due to the removal of the swap charges.
Now, this might have different implications, depending on the trading style of the market participant. It goes without saying that this makes scalping not very compatible with the swap-free accounts. The fact of the matter is that this type of trading involves opening and closing positions with 1 to 15 minute time frames. Consequently, some scalpers are executing 50 or even more trades per day. Therefore, due to the wider spreads, the commission expenses for traders can add up to a significant amount.
This might also have a sizable impact on day traders, although to a lesser extent. However, the fact of the matter is that when a trader executes a large volume of trades within a short period of time, the existence of wider spreads can reduce their earnings significantly.
On the other hand, for most swing and long term traders, this is not a major concern. After all, with Islamic trading accounts, they are avoiding a daily swap expense. Therefore, just having a one-off expense with wider spreads is very unlikely to have any meaningful impact on their overall trading performance.
Limitations on Currency Pairs
Another interesting feature of the Halal Forex trading is the fact that many brokerage companies limit the trader’s ability to open positions to major and minor currency pairs. With the majority of brokers, these traders are not able to trade exotic currency pairs, such as for example, the Russian ruble (RUB), the South African rand (ZAR), the Turkish lira (TRY), and the Mexican peso (MXN).
This might be surprising for some traders, but this makes a lot of sense. The fact of the matter is that in most cases, the emerging market currencies have higher central bank interest rates. Consequently, it is usually quite expensive in nominal interest rate terms to borrow funds in those currencies. The brokerage companies can not offset those costs by charging its clients on Islamic trading accounts an interest. That would be haram Forex trading.
Consequently, many brokerage companies do not allow market participants to exchange exotic currencies with Islamic trading accounts. As a result, the brokers can avoid expenses associated with the large interest rate differentials between the major and emerging markets currencies.
This might not represent any problem for some traders. The reality of the matter is that some market participants prefer to only trade just the currency pairs made up entirely of 8 major currencies. Those are the US dollar (USD), the Euro (EUR), the British Pound (GBP), the Japanese yen (JPY), the Canadian dollar (CAD), the Australian dollar (AUD), the Swiss franc (CHF) and the New Zealand dollar (NZD).
Those pairs tend to be relatively less volatile and more predictable than the emerging market currencies. Also, 8 currencies make up between themselves 28 currency pairs, which for many traders is more than enough to find enough trading opportunities.
On the other hand, the exotic currency pairs are more susceptible to large unpredictable market swings and sometimes can be very unpredictable. As a result, some people stay away from them in order to reduce their risk exposure.
However, it goes without saying that there are some traders who find great value in trading the emerging market currencies. Consequently, this might represent a significant limitation to those individuals.
Trading Commodities with Islamic Accounts
Another important aspect of the Islamic Halal day trading is the fact that with those accounts the commodity trades, such as gold and silver are backed by the actual precious metals holdings by some brokerage companies.
The standard arrangement is that the broker will purchase the physical gold and silver from the dealer and store it in a bank vault. Then the firm will increase or reduce those holdings in accordance with the trades on the Islamic trading accounts.
At the same time, it is important to remember that just like with currency pairs, there are no rollover charges for holding positions on commodities open overnight with these types of accounts.
It goes without saying that this is a great benefit for those traders who are interested in taking long term positions with commodities. Also, in those cases, the market participants are more confident about the solvency of the brokerage company. After all, if for example, the price of gold suddenly surges and traders make some massive gains, the broker will always have an option to sell some of its precious metal holdings and pay off its clients.
It is also worth noting that, just like with the currency pairs, the spreads with commodities are typically wider with the Islamic trading accounts, compared to regular accounts, to account for the loss of revenue due to the elimination of swaps.