• Wednesday, February 28, 2024
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Arbitrage trading : Islamic finance perspective

Arbitrage

The aspiration for wealth has surged among young Nigerians, creating a perception that financial success often outweighs the values of hard work and ethical practices. This cultural shift is attributed to the emergence of individuals known for their extravagant lifestyles, flaunting the latest cars and gadgets under the guise of newfound prosperity. Some identify as “yahoo boys,” while others attribute their wealth to opportunities presented by the digital age, encompassing cryptocurrency, coding, freelance work, arbitrage trading, and social media exploits.

While Islam does not condemn the pursuit of wealth, it places emphasis on how it is acquired and spent. In this article, I delve into the Islamic perspective on one popular avenue – arbitrage trading – aiming to clarify its meaning and address Shariah compliance issues.

What is Arbitrage?

Arbitrage is the simultaneous purchase and sale of the same or similar asset in different markets in order to profit from any tiny difference in the asset’s listed price. It can be used whenever any stock, commodity or currency may be purchased in one market at a given price and simultaneously sold in another market at a higher price. The situation creates an opportunity for a risk-free profit for the trader [Investopedia.com].

This practice requires quick execution and is based on the idea that market inefficiencies can create temporary opportunities for profit. Popular examples are Forex arbitrage, Round Tripping, Triangular pricing arbitrage, crypto-arbitrage, cross platform arbitrage and contractor arbitrage.

Practical Example 1

As a straightforward example of arbitrage, the shares of company x is trading at #37 on NGX, while , at the same moment, it is trading for #37.5 on Lagos stock exchange (LSE). A trader can buy the stock on NGX and immediately sell the same shares on the LSE, earning a profit of 50 kobo per share. The trader can continue to exploit this arbitrage until the specialist at NGX runs out of inventory of company X’s stock or the LSE adjusts their prices to wipe out the opportunity.

Practical example 2

Another example can be found in the currency market using triangular arbitrage. In this case, the trader converts one currency to another, converts that second currency to a third bank, and finally converts the third currency back to the original currency.

Suppose you have #1 million and you are provided with the following exchange rates: NGN/USD = #750/1$, USD/GPD = 1.2557$/1£, NGN/GPD = #1092/1£

With these exchange rates, there is an arbitrage opportunity:

1. Sell naira to buy dollars : #1 million ÷ 750 = $1333

2. Sell dollar to buy ponds : $1333 ÷1.2557 = £1062

3. Sell pounds for naira : £1062 × 1092 = #1,159,704

4. Subtract the initial investment from the final amount : #1,159,704 – #1,000,000 = #159,704

From these transactions, you would receive an arbitrage profit of #159,704 (assuming no transaction costs or taxes).

Practical example 3

Cross platform arbitrage, this involves buying an asset low on one platform and selling it high on another. It usually involves trading a substantial amount of money and the split seconds opportunity it offers can be identified and acted upon only with highly sophisticated software (bots). There are several other variations but all involve identifying market inefficiencies.

Practical example 4

Then, we have Forex arbitrage which to me is just dollar racketeering, the cbn calls it round tripping and yes it’s illegal. These arbitrageurs take advantage of the price imbalance between the Nigerian black markets rates and bank rates. The Nigerian government has continuously pushed out policies to prevent this recteering; however, there are still certain loopholes.

Practical example 5

Contractor arbitrage typically involves hiring contractors or freelancers from lower-cost regions and charging clients higher rates for their services.

Shariah Compliance Review

Islamic finance rests on the application of Shariah – it seeks to avoid injustice, asymmetric risk and moral hazard (where the party who causes a problem does not suffer its consequences) and unfair enrichment at the expense of another party.

Triangular Pricing Arbitrage may be viewed sceptical within the islamic financial framework. It contradicts certain principles governing islamic finance – Avoidance of exploitation – Risk should be shared – Prohibition on Investments in transactions that involve speculation or extreme risk (Gharar).

The shariah seeks to eradicate all roots of injustice and exploitation – The seller’s ignorance about the current market price of the stocks or asset is usually exploited. However if the seller having knowledge of the market price, still proceeds with the contract or in a bigger deal in a trade pact with the buyer – it can be assumed that he has agreed to the price which he is selling, although it is below the market value of the asset/stocks, hence the element of exploitation disappears.

The asymmetric and excessive Risks involved. Arbitrageurs face excessive counterparty risk under the guise of easy profits. Arbitrage opportunities are like grasping at a falling knife, in a matter of seconds the stock trader at LSE in the earlier example might adjust the prices upward. Also if an exchange is greatly out of sync with the market it is going to be more difficult to convert to cash. That means you may have difficulty closing your position and locking in your profits. These are asymmetric risks affecting only the trader.

There is the presence of Gharar, which means uncertainty or speculation. There is usually uncertainty regarding price in arbitrage trading which may result in the oppression or injustice and loss of properties to one or even both of the parties.

However, it is always a question of interpretation which present day phenomena would conform with the shariah as Interpretations differ widely. Additionally, the specific contractual agreement and relationships between all parties involved would need to be examined to determine their compliance with Islamic ethical guidelines.

It would be advisable to consult a qualified religious authority or scholar who can provide guidance based on islamic principles and teachings .

Conclusion

With the desire to be wealthy among youths in the country and several “updates” being released, muslims should know that they are to follow the Quran and sunnah in their worship and muamalat (dealings). It is important to consider whether our hustle aligns with islamic finance principles.

I would leave us with this narration:

Abu said related that the prophet said: The truthful and trustworthy businessman will be in the company of prophets, saints and martyrs on the day of judgement. ( Darimi, Trimidhi)

Written by : Suleiman Sakariyah

A chartered Accountant with key interest in Islamic Finance and Actuarial studies

Emalil: [email protected]