Islamic Finance - The New Mainstream Alternative

Although the Islamic finance sector suffered along with other investment sectors during the credit crunch of 2008 and 2009, its long-term future seems assured. Rushdi Siddiqui, Global Head of Islamic Finance at Thomson Reuters, told participants at the Middle East, North Africa and South Asia (MENESA) Forum on ‘The Challenges Ahead for Islamic Finance’ in May that Islamic Finance is on a firm footing to become a USD2 trillion industry in the next half decade. “It took the Islamic Finance industry 40 years to become a USD1 trillion industry. It will take another two to five years to become a USD2 trillion industry,” he said.

Speakers concluded however that the sector's problems include lack of standardization in the industry, the lack of consensus among Shari’ah scholars, poor “connectivity” between Islamic Finance institutions across the world, and the global shortage of experienced Islamic Finance professionals.

The Islamic finance industry's total assets scaled new heights in 2009 according to Moody's Investors Service, rising to just under USD1 trillion despite the gloomy economic landscape, although the ratings agency has urged the industry to continue to innovate, particularly in the area of risk hedging, if Islamic finance is to really thrive.

In a new Special Comment, Moody's estimates that the market's potential is worth at least USD5 trillion and the industry is continuing to expand globally. But the Moody's report suggests that the combined use of securitization and derivatives "offers considerable scope for reducing the risk exposures of Islamic financial institutions (IFIs) and thus improving their overall creditworthiness."

"In this context, IFIs are continuing to deliver Shari'ah-compliant returns whilst, at the same time, focusing on efficiently mitigating the associated risks through a new risk management approach, including the use of derivatives," says Anouar Hassoune, a Moody's Vice President and author of the report.

"If employed with care, derivatives can enhance efficiency in IFIs through risk mitigation, thereby making them more competitive as well as appealing to customers. However, their application in Islamic finance is highly controversial for reasons of speculation and uncertainty, two practices forbidden under Shari'ah," explains Hassoune.

Harris Irfan, the head of Islamic finance products at Barclays Capital and Barclays Wealth in Dubai told Bloomerg in May that Islamic banking is in fact in the "stone ages" and has a lot more evolving to do if the full potential of the industry is to be realized. “A Shariah-compliant customer only gets a fraction of what a conventional customer has access to,” Irfan told Bloomberg. “We’re almost at that stone age phase of sticking your money under the mattress.”

However Moody's estimates that the market's potential is worth at least USD5 trillion and the industry is continuing to expand globally. But a lack of sophistication in the industry so far, such as in the development of hedging products and mechanisms, may hold back future growth.

Islamic fund management has not seen much growth lately. The 4th annual Ernst & Young Islamic Funds & Investment Report released at the World Islamic Funds and Capital Markets Conference in June states that global Islamic fund assets stagnated at US$52.3bn in 2009, remaining at almost the same level as the US$51.4bn posted in 2008.

According to Sameer Abdi, Middle East Head of Ernst & Young's Islamic Financial Services Group, "This trend is reflective of a distinct shift in investors' preferences, and requires Islamic fund managers to adapt their strategies and operating models accordingly to meet the new levels of expectations."

Ernst & Young says that the silver lining for the industry is the continued strong growth in the overall Shari'a sensitive investable assets. Ashar Nazim, Director at Ernst & Young's Islamic Financial Services team in Bahrain says: "Shari'a compliant investable wealth pool grew by 20% to reach US$ 480 Bn in 2009. In 2008, this was US$ 400 Bn. The GCC remains the single biggest contributor to this growing wealth pool. It clearly represents substantial untapped opportunities for local and international players who can understand and respond to their investors' evolving needs."

A paper from the International Monetary Fund says that more and more countries are climbing aboard the sukuk issuance band-waggon in order to tap the massive pools of money in the hands of Muslim individuals and their companies. The UK, Japan, Thailand and France are among the countries which have recently begun to establish sukuk issuance programmes. This often requires significant changes to monetary and fiscal legislation, though, as does the opening up of domestic financial markets to Islamic finance. Dozens of countries have either already made these changes, or have indicated that they are about to do so.

The most prominent national issuers of Islamic debt instruments so far have been Malaysia, Qatar, Bahrain, and Pakistan, along with some of the multilateral institutions, including the Islamic Development Bank and the World Bank, although the market has been dominated by corporates, which have accounted for more than three-quarters of issuance to date.

Geographically, Asia, and especially Malaysia, have dominated the market, although issuance in the GCC (Gulf Cooperation Council) is rapidly catching up.

If 2006 was the year in which Islamic finance, a concept virtually unheard of outside banking circles a decade ago, finally crossed the border-line between slightly exotic alternative territory and the mainstream, 2007 saw an explosion of demand for alternatives to western banking products structured along ethically-aware Islamic principles. In early 2007 Islamic finance received the financial equivalent of the accolade when UK Chancellor Gordon Brown announced that the Islamic finance industry would be given the same tax treatment in the UK as other investments. The move was applauded by tax and finance experts, who say it put the City of London at the forefront of the nascent but rapidly growing global industry.

Although the size of the Islamic sector remains just a fraction of global assets, given a world Muslim population of around 1.5 billion people, the industry has enormous potential, and this is a fact that is starting to be recognised in boardrooms of some of the world’s largest western-based banking, fund management and insurance groups, many of which have now launched banking facilities compliant with Shariah law.

One of the attractions of the Islamic financial sector and the institutions which populate it is that they have remained largely untainted by the global credit crisis."Islamic finance does demonstrate good banking behavior that has been perhaps lost over the last 10 years or so," said Neil Miller, head of Islamic finance at Norton Rose and an adviser to the British government, to Associated Press. "Islamic banking is saying we are close to our clients and we're only going to do genuine transactions where we can see the asset, we understand the asset, we can make an assessment of that asset: whether it's financing a ship or an aircraft they will go and have a look at the business. It's giving guidance as to what banking should be."

What Is Islamic Finance?

It's almost no longer necessary to ask that question, but for the record, under the guiding principle of Shariah law, the goal of trade and enterprise within an Islamic-based society is the sharing of wealth and prosperity within the community through morally acceptable business activities. Likewise, Shariah law dictates that risk in trade and business should also be shared. This means that the accumulation of wealth through the receipt of interest, or riba, is prohibited, as interest income is deemed effortless profit. It also means that investment in certain business activities is forbidden on ethical and moral grounds, such as those involving alcohol, tobacco, pornography, armaments and gambling.

Whilst trade along Islamic lines is as old as the religion itself, modern Shariah banking didn’t really take off until the 1960s with the launch of the Social Bank in Egypt, a project later replicated in other areas. In the intervening years, some countries, such as Pakistan and Sudan, have made attempts to completely ‘Islamicise’ their financial systems, although the Islamic banking and investment industry has been, until recently, confined largely to the Middle East.

The concept of a bank making a profit without charging interest can be a difficult one to grasp for those of us brought up in a western-style capitalistic environment. However, numerous financial products and contracts have been developed and are appearing on the market place all the time, based on a number of structures which seek to eliminate the need for interest, and share both profit and risk.

Possibly the most popular of these is the contract known as Murabaha. Described as a cost-plus-financing contract, a Murabaha contract can be used to finance a variety of purchases. For example, in order to buy a house using this contract, the prospective buyer agrees a sale price with the seller and approaches a bank, which will buy the property and sell it back to the customer at a higher price. The house will be registered in the buyer’s name and he will agree to pay back the amount in instalments. This technique is also applied to the financing of other purchases, such as cars or household appliances. Murabaha contracts are also used to issue letters of credit and to provide financing for trade.

A similar method, known as Ijara, works in much the same way, except that the bank will buy an asset and then effectively lease it to the customer for an agreed period. During the term of the lease, the buyer is required to pay a form of rent, which is deemed by the bank to be reflective of the risk that it is taking as part of the transaction. This rent can be either fixed or variable, depending on the specific contract terms offered by the institution.

Another popular method of financing under Islamic law is Musharaka, which can be loosely translated to mean a partnership. This is widely recognised as perhaps the purest form of Islamic contract available within the modern banking framework because it has more of a basis in the profit and risk sharing principle. Within a personal banking context, a Musharaka arrangement may see the bank providing the funds to enable the customer to buy an asset, with the bank and customer agreeing a profit or equity sharing ratio for that asset. Losses are shared on a similar basis.

There are also variations on the above themes, such as Ijara-wa-iktana. This is similar to Ijara, the difference being that included in the contract is a promise from the customer to buy the asset or goods at the end of the lease period at a pre-determined price. Rentals paid during the period of the lease constitute part of the purchase price and often under these arrangements the final sale will be for a token sum.

Ijara with diminishing Musharaka means that an institution’s equity in an asset may be reduced as the buyer makes capital payments over and above the agreed rental payments or lease payments. This means that the bank’s ownership decreases and the customer’s equity increases over time, until ownership is eventually transferred entirely to the buyer.

Another important tool within the Islamic finance framework is the Mudharabah contract, which is used in the financing of new business ventures. In short, under this arrangement, one party known as the rabal-maal provides the funding, while the other party - the entrepreneur or mudarib - provides the effort and labour. Profit is shared at an agreed ratio at the start of the contract; however, in the event that the venture fails, any losses are borne completely by the owner of the capital, whilst the entrepreneur derives nothing for their efforts.

Instruments have also been developed to serve part of the investment industry that were previously off limits to the Islamic investor, such as the international bond markets, in which sukuks are fast becoming a visible feature. These certificates bear a resemblance to conventional bonds, but unlike their western counterparts, they are backed by an asset, such as pools of ijara contracts. The asset will be leased to the client to yield the return on the sukuk and backing by real assets ensures that a sukuk is also tradable in a Shariah-compliant secondary market.

Location Of The Islamic Finance Sector

Key locations for the rapidly developing Islamic finance sector are Dubai and Labuan, because they are sophisticated low-tax centres in Islamic regions with concentrations of wealthy investors, while London and the Cayman Islands, as existing banking and investment fund centres, are home to the highly skilled legal and financial professional communities needed to bring Islamic products to market.

Although starting late, Hong Kong may also become a major player. Chief Executive Donald Tsang noted in late 2007: "At present, assets worth more than US$300 billion are being held by some 300 Islamic financial institutions in 75 countries. A further US$400 billion is managed by the Islamic business units of international banks."

In August, 2008, the Hong Kong government said it hoped to be able to iron out tax issues that could complicate the issuing by local insititutions of Islamic bonds, or sukuk, by October. In the case of Hong Kong sukuks, it was feared that the intruments would be liable for stamp duty twice.

Stock exchanges around the world are queuing up to make markets in Islamic instruments, of course. In March 2008 the Luxembourg Stock Exchange announced that it had cemented its position as a key European listing centre for Islamic bonds, with the listing of its 14th Sukuk, issued by Salam Bounian Development Company Sukuk Limited. The face value of the issue, with a maturity of March 2018, was USD137.5mn. The Luxembourg Stock Exchange has been listing Sukuk instruments since 2002.

In July, 2008, the Johannesburg Stock Exchange, in partnership with FTSE Group launched the FTSE/JSE Shariah Top 40 Index, is a selection of Shariah compliant companies from the FTSE/JSE Shariah All-Share Index. The calculation of the index and the treatment of corporate actions are similar to the FTSE/JSE Top 40.

The FTSE/JSE Shariah Top 40 Index is suitable for the creation of financial products, such as index funds, warrants, certificates and Exchange Traded Funds.

“Internationally the market for Islamic investment products is growing exponentially, at an estimated 15-20% per annum,” explained Ana Forssman, Senior General Manager: Information Products Sales at the JSE, who went on to state:

“This index gives Muslim investors access to the top performing listed companies in South Africa without compromising religious beliefs."

Imogen Dillon Hatcher, Managing Director, EMEA - FTSE Group, added: “With approximately 1.5 billion Muslims worldwide, there is huge growth potential for investment vehicles with a faith-based mandate.

The constituents of the FTSE/JSE Shariah Top 40 Index are screened by Yasaar Research Inc, a well-respected authority on Shariah law.

To qualify as a constituent of the index, companies undergo a detailed screening process, which filters out any organisations considered unacceptable or non-compliant according to Shariah-law, including businesses involved in conventional finance, alcohol, pork-related and non-halaal food, entertainment, tobacco and weapons.

The remaining companies are then further screened according to Shariah compliant financial criteria.

In order to remain in the index, the companies are reassessed by Yasaar quarterly.

London's Growing Role

Already in 2005, the UK's RICS (the Royal Institution of Chartered Surveyors) was able to publish a report saying that London had become a major centre for Islamic banking and investment.

Britain has already licensed 5 Islamic banks, with Gatehouse Bank being the most recent; while other key European financial centers continue to develop opportunities for Islamic finance, including exciting initiatives in Germany, France, Italy and Belgium.

According to Angus McIntosh, Partner & Head of Research at King Sturge international property consultants: ‘UK business is now familiar with ethical funds but there is a real need to find out more about the growing opportunities for Shari'ah compliant real estate investment and the nature of the market as this area represents a crucial opportunity for many UK businesses.’

The most important factor considered by Shari'ah compliant funds when buying and selling property was tax status (cited by 65% of respondents), followed by the availability of specialist expertise (61%), the regulation of investment and risk assessment regulation (both 47%) and the transparency of transactions (41%).

UK-based HSBC has launched a number of Shariah-compliant products through its Amanah Finance division. The bank is also seeking to establish a firm foothold in the US market, offering Islamic banking services through 300 branches in the New York area. Other institutions, such as the UK’s Lloyds TSB and the US-based bank Citigroup, have also stepped into the market.

Gordon Brown's 2007 budget introduced two key measures to encourage growth in Islamic finance, namely a new regime for sukuk (Islamic securitisations) giving comparable tax treatment to conventional securitisations, and guidance clarifying the treatment of diminishing musharaka (partnership share) and takaful (insurance) products.

Commenting on the move, Darshan Bijur, Director, KPMG Islamic Finance Advisory, said this new legislation has created the framework for London to emerge as undisputed global leader in the Islamic finance industry.

“Sukuk will be the equivalent of Eurobonds, and the likely exponential growth in UK Sukuk issuance will ensure that Islamic finance moves from niche to the mainstream," he observed. “It will cost the UK next to nothing, and opens up the way for UK companies to access Islamic finance, and the Middle East wealth that has been generated by oil."

Peter Muir, tax partner at Deloitte, said: "The UK is the only country which is changing legislation to create a level playing field for both individuals and companies investing in Islamic finance products," he noted. "Reform of sukuk (Islamic bonds) is the latest addition to the suite of specific legislation that gives certainty to the taxation of Islamic financial products. Before this reform was introduced, there was ambiguity around how capital gains tax, income tax and capital allowances would apply to these products."

Muir added: “Gordon Brown seems to have taken a personal interest in ensuring Islamic products are brought into a level playing field. This is intended to meet the financial needs of the Muslim community as well as, increasingly, non-Muslim investors in these products."

"From a capital markets perspective, the reforms are a boost to the City of London, improving its global competitiveness in the Islamic finance market. Notably, the measures reach out to a potentially much wider group of international exchanges who can be given tax recognition in the UK in relation to ‘sukuk’ bonds.”

Mohammed Amin, tax partner, PricewaterhouseCoopers, said that Sukuk have become increasingly important in the Muslim world, as companies prefer to obtain finance directly from international investors.

"While London-based lawyers and bankers regularly structure and market sukuk for companies from Muslim countries, until today tax uncertainties have precluded them being issued from the UK," he stated. “The changes announced should enable the City of London to become the global centre for international sukuk issuance and trading, in the same way as it dominates the eurobond market. There should also be scope for mainstream UK companies to issue sukuk to both Islamic and conventional investors.”

In December, 2008, a joint Treasury–Financial Services Authority (FSA) consultation on proposals for the legislative framework for the regulation of alternative finance investment bonds, which include sukuk, was launched by Ian Pearson, Economic Secretary to the Treasury. Commenting on the launch of the consultation, Pearson said: “This consultation is an important part of the work government is doing to support the growth of Islamic finance in the UK and to increase our position as a leading global centre in this market."

“The government wants to ensure no one in the UK is denied access to good financial services on account of their religious beliefs. We value the contribution Islamic finance makes to London’s position as an international financial centre and we want to see this sector continue to grow and prosper in this country.”

Following the consultation, the government included measures in its December, 2009, pre-budget report that will equalize the tax treatment of property refinancing transactions.

Commenting on the changes, Mohammed Amin, UK Islamic finance leader, PricewaterhouseCoopers LLP, said that Britain's position as a leader in the Islamic finance industry has been strengthened further: "Over several years, the UK has become the leading Western country in Islamic finance by taking a series of measures to ensure that Islamic finance is taxed no worse, and no better, than conventional finance. The pre-Budget report continues this progress by including measures to equalize the tax treatment of property refinancing transactions," he observed, adding:

"After extended consultations with the industry, the Government has announced that, subject to appropriate safeguards, a sale for the purposes of refinancing in accordance with the tax rules governing Islamic finance will not give rise to a taxable disposal for capital gains tax purposes."

"While the relevant legislation exists to facilitate Islamic finance, it is neutral regarding religion. It applies to transactions by all citizens which fall within the tax rules, regardless of the religion of the taxpayer or whether the bank is an Islamic bank or is a conventional bank."

The proposals will make it possible for Muslims who own property (normally investment property or real estate used for a business) which has appreciated in value to obtain additional bank finance in a Shariah compliant way, using the property as collateral. Prior to the change, such refinancing often faced prohibitive tax costs.

Conventional refinancing typically involves taking on extra borrowing when a property has increased in value since its original purchase. Such extra borrowing does not give rise to any capital gains tax issues, since for tax purposes the property continues to be held by the owner, even if it is mortgaged to the lending bank.

Islamic refinancing cannot be done in the above manner. Instead, it typically involves the property being sold to the "lending" bank and then rented back. The bank’s customer will also be obliged to buy the property back eventually, to repay the financing. However, under current tax law the sale to the bank is a disposal for capital gains tax purposes, giving rise to capital gains tax if the property is worth more than the owner paid for it. (Principal private residences are an exception as gains on them are exempt.)

Then in January, 2010, the UK Treasury introduced measures in Parliament to support Islamic finance and the issuance of corporate sukuk.

The Financial Services and Markets Act 2000 Order 2010 will help to provide a level playing field for corporate sukuk within the UK. The Order provides clarity on the regulatory treatment of corporate sukuk, reducing the legal costs for these types of investments and removing unnecessary obstacles to their issuance.

Exchequer Secretary to the Treasury Sarah McCarthy-Fry said: “The government’s objectives on Islamic finance are to enhance the UK’s competitiveness in financial services by maintaining the UK’s position as a Western leader for international Islamic finance; and to ensure that everybody, irrespective of their religious beliefs, has access to competitively priced financial products.”

“This measure is another important step in the development of the Islamic finance sector in the UK and will help to provide a level playing field for Islamic financial products in this country. It is good news for the UK economy and for our Islamic finance industry.”

The Role Of Offshore Jurisdictions

Offshore jurisdictions have played a major role in the development of Islamic finance markets, particularly Labuan and Dubai, although Hong Kong and Bahrain are beginning to assume a higher profile.

Malaysia and Labuan

Kuwait Finance House, a leading Islamic banking group, announced in December, 2005, its intention to break into the South East Asian market through a new base in Labuan, which it hopes will come on stream in 2006.

Jamelah Jamaluddin, deputy chief executive of Kuwait Finance House in Malaysia, said that the group sees potentially lucrative investment opportunities in real estate, infrastructure assets and power plants within the region.

"We want to position Malaysia as a regional hub for KFH in this part of the world which includes Thailand, Singapore, the Philippines, to a certain extent China and India, and maybe Australia and New Zealand," Jamelah stated, adding that KFH is also attempting to make inroads into the Indonesian market.

KFH's Malaysian operation will initially focus on investment banking, and will later branch out into commercial and retail banking, providing consumer credit products such as mortgages, car financing, credit cards and insurance.

In September, 2008, Malaysia's Prime Minister, Abdullah Ahmad Badawi, unveiled plans to implement a series of economy-boosting measures in the country's 2008/2009 budget, which include hefty tax breaks for Islamic bonds, or Sukuk. The Prime Minister announced that in a bid to encourage fiscal growth, the government will award fees and profits gained from non-ringgit Islamic bond deals distributed outside of the country a three-year tax exemption.

Coming into effect from 2009, the exemption applies to the fees and profits on arranging, underwriting, distributing and trading non-ringgit sukuks. Making sukuks tax-free will further enhance Malaysia's current position as the world's largest sukuk market. In June 2008, Malaysia accounted for 62.6% of global outstanding sukuk issuance.

In addition to this, the Prime Minister also announced the introduction of a double tax deduction for Islamic finance courses on offer at one of the Malaysian universities to compensate for the shortage of industry experts.

In February, 2009, a report by Cerulli Associates revealed that Malaysia is now the closest rival to Saudi Arabia in terms of Shariah-compliant mutual fund assets, and has overtaken Saudi when it comes to the number of locally domiciled Shariah funds.

The report - entitled 'Shariah Investing: Market Sizing and Analysis - stated that in November 2008, Shariah funds domiciled and managed in Malaysia totaled 145, compared to just 131 in Saudi Arabia. These range from investments in money markets and sukuk (bonds) to regional and global equities.

Determined to make an impact on the global Shariah industry, Malaysia has, over the past few years, worked to establish itself as a center for Shariah fund manufacturing.

Today, Malaysia possesses the most highly developed regulatory structure for Islamic finance in the world, and has attracted more than eight international Shariah managers by offering a host of tax and other incentives.

However, Malaysian-domiciled Shariah funds are still unable to compete with Saudi funds in terms of asset size; the AlAhli Saudi Riyal Trade Fund is the world’s largest with USD3.6bn in assets under management as of October 2008. This is nine times the size of Malaysia’s biggest fund, the Public Ittikal Fund.

In total, Malaysian-domciled Shariah funds manage USD4.6bn of assets, compared to USD13.9bn held in Saudi funds.

In August, 2009, Petronas issued a landmark dual-tranche USD4.5bn bond/sukuk, domiciled in Labuan and managed by Bank Negara Malaysia. The Malaysian national oil company’s issue consisted of a USD3bn 10-year fixed-interest USD bond and USD1.5bn five-year sukuk. Foreign-currency issues out of the Labuan International Business and Financial Centre (LIBFC) have now been named “Emas”, in an attempt to provide added exposure for the LIBFC and Malaysia as a means of attracting funds.

It was hoped that the issue’s success would show that Malaysia could be utilized not only for the origination of domestic ringgit bonds and sukuk, but also for foreign-currency denominated bonds and sukuk.

In January, 2010, the Malaysian stock exchange, Bursa Malaysia Berhad (BMB), and the Bahrain Financial Exchange (BFX) announced the signing of a memorandum of understanding (MOU) to develop a joint commercial agreement between the two exchanges to provide financial products to the Islamic market.

The MOU will involve a feasibility study to identify shariah-compliant products, including a commodity murabaha trading platform to satisfy short-term financing needs. It will lay the foundation for both exchanges to work jointly on increasing the awareness of investment and liquidity management opportunities in their respective Islamic markets using acceptable shariah solutions.

In a press release, BMB's Chief Executive Officer, Dato' Yusli Mohamed Yusoff, who signed the MOU on behalf of the Malaysian exchange, which also owns the Labuan International Financial Exchange, said that "the collaboration with BFX is aimed at facilitating cross border development in the Islamic financial markets, widening market reach, exchanging technological expertise and building a sustainable business model for both exchanges."

"This is a major step towards consolidation in the Islamic finance world,” he added. “As both Exchanges come together on a single platform, this will add to the strength of this industry. This initiative will go a long way in addressing the issues of standardization, innovation and transparency, thus providing a new dimension to the Islamic finance market."

In addition, BFX board director, Arshad Khan, said: "This initiative is a major development for the Islamic finance market where the collaboration will seek to offer a wider risk management portfolio to global Islamic practitioners. By partnering with Bursa Malaysia we can ensure that the products offered are well defined, robust and fully shariah compliant.”

The signing ceremony was witnessed by Razif Abdul Kadir, Deputy Governor of the Bank Negara Malaysia; Nik Ramlah Nik Mahmud, Managing Director of Malaysia’s Securities Commission; and Abdul Rahman Al Baker, Executive Director, Financial Institutions Supervision, of the Central Bank of Bahrain.

Dubai and the UAE

International law firm, Walkers announced in January, 2006, that it had opened the first fully transactional office for an offshore law firm in the Dubai International Finance Centre (DIFC). The office is staffed jointly with a combination of regional lawyers and leading attorneys from London who specialize in Islamic finance and Middle Eastern issues.

"As the formation of investment funds, private equity funds, and Sukuks – a type of Islamic bond – continues to soar, the need to provide global counsel has grown too," the firm explained in a statement.

"Walkers recognizes that having counsel in Dubai doing the transactional work in the same time zone and same culture is vitally important to getting the job done. Walkers’ expertise in investment funds, structured finance, and international insolvency matters coupled with a presence in the Cayman Islands, London, the British Virgin Islands, Hong Kong and now Dubai, means that the firm can offer worldwide clients an even broader range of products and services," Walkers added.

According to a survey by McKinsey & Company, more than 75 percent of the top 30 global asset managers are now active in Dubai. The MAN Group plc, a leading hedge fund group that has operated in the Gulf Cooperation Council region (GCC) for more than 20 years and was part of the McKinsey survey, reported an upswing of institutional investments in hedge funds.

"Also driving the need for greater offshore legal expertise in Dubai are the international entities who invest in the GCC region through British Virgin Islands companies and regional investment in United Kingdom commercial real estate,” observed Mr Palmer.

“With Walkers’ strong presence and experience in those jurisdictions, we can now provide a complete suite of offshore legal service to our clients in Dubai," he added.

Companies in Dubai recognize multiple benefits from the jurisdiction, including zero tax on income and profits, 100 percent foreign ownership, no restrictions on foreign exchange or capital/profit repatriation, operational support, and business continuity facilities.

In March, 2007, Dubai Islamic Bank listed a $750 million Sukuk on the Dubai International Financial Exchange (DIFX) after selling the Islamic securities to investors in the Europe, Asia and Middle East, cementing the DIFX's position as the leading exchange for the listing of these Islamic instruments.

The Sukuk was the first ever issued by the bank, which specialises exclusively in Islamic financial services. Forty-five per cent of the Sukuk issue was placed with investors in the Middle East, 30% in Europe and the balance was placed in Asia.

The Sukuk was issued by DIB Sukuk Company Limited, a company incorporated in accordance with the laws of, and formed and registered in, the Cayman Islands. The Sukuk issue is rated A1 by Moody's and A by Standard and Poor's. The lead managers and bookrunners for the issue were Barclays Capital, Citigroup and Standard Chartered Bank.

Hamed Ali, Executive Officer of the DIFX, noted: “The DIFX intends to strengthen its focus on Sukuk. The total value of Sukuk issued globally in 2006 was $27.1 billion, more than twice as much as in 2005, as issuers turn increasingly to this Islamic asset class as an effective way to raise capital.”

Also in March, the Dubai Financial Services Authority (DFSA) entered into a mutual recognition agreement to facilitate cross border distribution of Islamic investment products with the Securities Commission of Malaysia (SC).

The agreement was signed by Dato’ Zarinah Anwar, Chairman of the SC, and David Knott, Chief Executive of the DFSA at a ceremony in Kuala Lumpur, witnessed by the Second Finance Minister of Malaysia, Yang Berhormat Tan Sri Nor Mohamed Yakcop.

This is the first mutual recognition agreement entered into by both regulators, and is a significant milestone for both the SC and the DFSA in the area of cross-border regulation of Islamic investment funds, and the development of deeper and broader investment markets. Under the mutual recognition framework, Islamic funds that have been approved by the SC may be marketed and distributed in the DIFC with minimal regulatory intervention, following the inclusion of Malaysia on the DFSA’s list of Recognised Jurisdictions. Similarly, Islamic funds which have been registered or notified with the DFSA will be able to access Malaysian investors. Supported by a bilateral memorandum of understanding, both regulators will work closely in the areas of supervision and enforcement of securities laws to ensure adequate protection for investors.

In November, 2007, the Dubai Financial Services Authority (DFSA) received the accolade of 'Best Regulator for Islamic Funds', which was awarded during the recent 5th Annual Islamic Funds World Conference.

The award was co-presented to the DFSA and the Malaysian Securities Commission (SC), at the Master of Islamic Funds Awards luncheon in Dubai, which took place on 13th November 2007. The award was co-sponsored by Dow Jones and Standard & Poor's, and recognises the DFSA’s efforts to facilitate cross-border marketing of Islamic investment funds.

In November, 2008, the Dubai International Financial Centre (DIFC) announced that it had enacted new regulations that enable companies within the financial district to quickly form Special Purpose Company (SPC) structures. The new regulations allow companies to create SPCs for facilitating both Islamic and conventional transactions as well as vessel registrations. Transactions that can be facilitated by the new law include acquisitions and financings.

Under the law, Special Purpose Companies can be easily structured and incorporated, while enjoying exemptions from some filing and disclosure rules relating to conventional companies in DIFC. For example, they are not required to hold annual shareholder meetings, can be administered by a corporate service provider and are not required to file annual returns.

Dr. Omar Bin Sulaiman, Governor of the DIFC said: "The SPC Regulations form part of DIFC's constantly evolving legal framework that aims to provide a supportive environment for financial services companies. DIFC is committed to providing a world-class regulatory framework that offers companies the flexibility necessary to structure a range of financing transactions. At the same time, our regulations ensure that we retain our strong focus on integrity, transparency and efficiency. The enactment of the SPC Regulations will provide a great boost for conventional and Islamic acquisitions and financings in the region."

In another late-2008 move, the DIFC, in association with the International Islamic Finance Market, organised a project briefing session to re-affirm support for the Master Agreements for Treasury Placement (MATP), a major initiative that facilitates the unification and growth of the Islamic financial services industry.

Key representatives of the Islamic Finance industry hailed the MATP as a landmark initiative for standardising the Commodity Murabaha, a tool customarily used by Islamic institutions for Shari’ah compliant liquidity management. Officials who spoke at the briefing session included Mr. Nasser Al Shaali, Chief Executive Officer of the DIFC Authority and Mr. Ijlal Ahmed Alvi, Chief Executive Officer of the International Islamic Finance Market (IIFM).

The MATP is a benchmark document and a global first for the Islamic finance industry. Its adoption will enhance cost, time and operational efficiencies of Shari'ah compliant deposit arrangements. The initiative caters to the Shari’ah compliant commodities market, which represents, in some cases, 90% of commodity Murabaha transactions. The agreements cover principal to principal as well as agency arrangements. The global Commodity Murabaha market is currently worth over USD100bn.

Nasser Al Shaali said: "The MATP represents a significant milestone in the development of the global Islamic Finance industry. As part of DIFC's mission to catalyse the growth of the regional capital market, we will be seeking to raise awareness and understanding of the MATP not just within the financial district but across the region. The agreement will facilitate more harmonious practices, lower costs and greater clarity for institutions involved in commodity Murabaha transactions. It will give a significant boost to the growth of the Islamic financial services industry and the development of Islamic capital markets across the world."

The agreement is the culmination of a consultation with over 40 regional and international market participants. The project was driven by IIFM's Shari'ah panel consisting of several leading scholars while the DIFC and the Central Bank of Bahrain played key roles in facilitating the complex agreement. DIFC hosted the final review of the MATP by the scholars of the IIFM Shari'ah Panel on August 14, 2008.

The agreement was finalised when a pronouncement approving the MATP, was signed by the IIFM Shari'ah Panel at a meeting in Jeddah on September 7, 2008.

In parallel with Dubai's distribution role, the Cayman Islands have emerged as the jurisdiction of choice for the listing of Islamic financial products.

The introduction of a new Arabic language facility by the General Registry in Cayman in March 2007 will trigger more valuable business from the Islamic region, according to international law firm, Ogier.

Ogier partner Gray Smith, who practices Cayman law from London, observed that the move demonstrated Cayman’s recognition of the Middle East as an important area for new business.

“We can now use both Arabic and English names on all documents when setting up a company and can also open bank accounts in both names. Previously we had to use only an English translation. The same ethos was applied to Chinese characters a few years ago and that was of huge benefit in Hong Kong, where both English and Chinese are used widely,” he explained .

Mr Smith went on to add that Cayman law particularly lent itself to Islamic finance structures because of its flexibility. It has become a centre for “sukuks” – bond issues that are Shari’ah compliant, prohibit interest payments and require tangible assets or equity as collateral.

“It’s straightforward, the processes are relatively easy and it’s very flexible, allowing for the drafting of articles and agreements that comply with the restrictions of Islamic law. Cayman is also a lighter regulation jurisdiction and a widely recognised international finance centre which suits Middle East companies looking for investments,” he revealed.

The Ogier partner also predicted further inflows of money into the Middle East as clients are increasingly marketing their funds outside the region.

“The inflow to Middle East funds is a new growth area. Furthermore, the establishment of the Dubai Finance Centre will enable the listing of Cayman funds on the Dubai Stock Exchange and dual listing, in Cayman and the Middle East or the Middle East and the UK,” he stated.

In December, 2009, DIFC has announced the release of its "DIFC Sukuk Guide," a comprehensive introduction to various sukuk structures, which also provides legal and regulatory information on issuing sukuk from the DIFC, and listing sukuk on NASDAQ Dubai.

The guide provides detailed descriptions of more than 10 sukuk structures, information on the history and current status of sukuk globally, an overview regarding the issuing and listing of sukuk in or from DIFC, and information on regulatory licensing in the district.

It is hoped that the guide will further reinforce the DIFC’s leading role in global Islamic finance, hosting the largest exchange for sukuk by listed value, with value of more than USD16bn.

“The changing global economic landscape and shift eastward of the economic center of gravity means DIFC is ideally situated to capture an even larger share of the global sukuk market,” commented Farhan Al Bastaki, Executive Director of Islamic Finance for the DIFC.

“With this guide, we are providing market participants with a clear understanding of this important sector and the supportive environment for sukuk at DIFC.”

According to the report, the United Arab Emirates is the leader in terms of sukuk issuance by value, accounting for USD26.8bn in issuances between 2000 and 2008, in a market that is estimated, by Standard and Poor’s, to be worth around USD50bn and growing.

Hong Kong

As part of its role as an international financial center and a gateway to China, Hong Kong is preparing tax changes to level the playing field for Islamic bonds with conventional bonds.

Speaking at the Islamic Finance Symposium 2009 in Tokyo, the Secretary for Financial Services & the Treasury, KC Chan, disclosed that Hong Kong is “best positioned to serve as a gateway to China to capitalize on China's growth. Hong Kong is a major asset management center in Asia. Our combined fund management business amounted to HKD5.8 trillion (USD750bn) in 2008, about 70% of which was sourced overseas.”

“Hong Kong is striving to develop into a global capital formation center, asset management center and offshore RMB business center, with regard to China,” he said. “Hong Kong is best placed to serve as an effective channel for orderly capital outflows from the Mainland, and Mainland financial institutions can manage their overseas investments through Hong Kong.”

"Indeed, Hong Kong serves as a unique portal for overseas funds and fund managers seeking business opportunities from the burgeoning Mainland economy,” Chan continued. “Overseas fund houses in Hong Kong also have the edge of gaining first hand information regarding Mainland assets and investments.”

Furthermore, he added: “Hong Kong is best placed to serve as a testing ground for the development of RMB business outside the Mainland. We have been working with the relevant Mainland authorities, our financial regulators and the trade to attract more RMB liquidity and to build a market offering a broad range of RMB products and services.”

It is against that overall background, he said, that the government will implement a platform in Hong Kong for the development of Islamic finance, the huge market potential of which has driven Islamic financers to look beyond historical boundaries to explore new territories, both within and outside the Muslim world.

"We believe Hong Kong is well placed to become a center for Islamic finance in Asia,” Chan stated. “Our sound financial services infrastructure and well-established legal system make Hong Kong an attractive location for such investments."

The city's unique advantage, he concluded, is its above-mentioned role in bridging the Mainland of China to the international market. By bridging the investment needs of the Middle East with the capital needs of the Mainland, Chan believes Hong Kong can be the trusted platform to link the two.

In February, 2010, the director of the Hong Kong Economic and Trade Office in Singapore, Subrina Chow, disclosed that Hong Kong would like to develop closer financial links with Brunei, particularly in the field of Islamic finance products.

Hong Kong’s government believes that there is an excellent opportunity to develop closer financial and other economic ties between Hong Kong and Brunei. John Tsang Chun-Wah, Hong Kong’s Financial Secretary, visited Brunei in March to discuss these issues.

Subrina Chow, in Brunei as a precursor to the visit, noted that, despite the issue of Islamic bonds from Hong Kong over the past few years, it is still a relative novice in Islamic finance. It therefore feels the need to diversify and increase the volume of the Islamic products and services it is currently able to provide.

The assistance that Hong Kong could offer to Brunei would lie, primarily, in the use that Brunei could make of Hong Kong’s well-developed capital markets, while Hong Kong would thereby develop a capability in Islamic finance and insurance. Subrina Chow added overseas businesses were welcome to list on the Hong Kong stock exchange and raise capital.

While, in the past, Hong Kong has developed ties with its closest trading partners – Singapore, Malaysia and Thailand – it is now looking further afield in the Asian region, to Indonesia and Vietnam, and now also Brunei.

Islamic Hedge Funds And Derivatives

In June, 2008, Barclays Capital, the investment banking division of Barclays Bank plc, and the Dubai Multi Commodities Centre Authority (DMCC), an agency of the Dubai government, announced the first Shariah compliant hedge funds to be launched on the Al Safi Trust alternative investment platform.

DMCC has committed to seed five commodity hedge fund managers on Al Safi with USD50 million each, a total of USD250 million, for a Shariah compliant fund of funds product to be offered under the Dubai Shariah Asset Management (DSAM) brand.

The commodity strategies and hedge fund managers approved by DMCC are Tocqueville Asset Management Gold, Lucas Capital Management LLC Energy/Oil & Gas, Zweig-DiMenna Intl. Managers Natural Resources, Ospraie Management Agriculture and BlackRock, Inc. Global Resources and Mining.

Al Safi is a comprehensive Shariah compliant platform comprised initially of single strategy alternative investment managers with Shariah Capital as the Shariah advisor and Barclays Capital as the prime broker and structured product distributor.

Al Safi is described as a “plug and play” solution offering an established process of due diligence which accepts only those hedge fund strategies and managers that meet the exacting criteria of its Shariah Supervisory Board. It claims to offer Islamic investors the same high-quality managers and strategies available to conventional investors including comparable returns, competitive fee levels, diversification across asset classes and access to customised structured products which can provide full capital protection, all within a pre-established Cayman trust framework.

Al Safi has been created in response to market demand for Shariah compliant alternative investments and the considerable impediments fund managers have faced meeting that demand.

In addition to the above commodity fund managers, other long/short equity hedge fund managers available on the Al Safi platform will be announced shortly. The Al Safi platform expects to include a range of alternative investment strategies as well as specialised investment funds.

Richard Ho, Head of Fund-linked Derivatives at Barclays Capital commented: “The DMCC’s provision of seed capital for five fund managers on Al Safi is a strong affirmation of the robustness of the platform’s Shariah framework and an exciting development in the alternative investments available to Islamic investors."

Ahmed Bin Sulayem, Executive Chairman, DMCC stated: “DMCC is pleased to work with globally renowned organisations Barclays Capital and Shariah Capital to offer the first Shariah compliant hedge funds on the Al Safi Trust alternative investment platform. We have worked closely with our international partners to engage world-class fund managers with excellent track records in order to offer investors premium Shariah-compliant investment solutions."

Eric Meyer, Chairman and CEO of Shariah Capital added: “With the capital support of a sovereign government and the prime broker and structuring expertise of Barclays Capital, the Al Safi Trust platform is a historic development that unites modern investment strategies with Shariah. The initial commodity hedge fund managers who will be available through Dubai Shariah Asset Management are truly world-class. They represent the best and most successful commodity strategists in the world, and they have agreed to accommodate Shariah within the strict guidelines established by our Shariah Supervisory Board."

Russell Lucas, Co-Founder and Co-Portfolio Manager of Lucas Capital Management said: “Al Safi is built from the ground up upon compliant assets and is controlled within a credible Shariah framework. Barclays Capital Prime Brokerage is the first to provide the needed Shariah equivalent solutions for hedge funds. We are very pleased to be one of the first to be working with the DMCC in providing hedge fund access to Islamic investors."

Dr. David Rutledge, Chief Executive of DMCC commented: “The Al Safi platform is ideal for the Shariah compliant asset management capability we are developing in commodities. It enables us to access exceptional managers with strong track records in order to achieve our goal of delivering diversified exposure across a range of commodity sectors to both institutional and individual investors interested in Shariah compliant investment products and solutions. We are privileged to seed these initial managers and support Barclays Capital with our commitment to the platform’s success."

January, 2010, witnessed a breakthrough in Islamic finance with the launch of the 'Tahawwut' (Hedging) Master Agreement, following an agreement between the Bahrain-based International Islamic Financial Market (IIFM) and the International Swaps and Derivatives Association, Inc. (ISDA). This marked the introduction of the first globally standardized documentation for privately negotiated Islamic hedging products.

“Given the growing nature of the Islamic finance industry, the institutions operating on Shari’ah principles can no longer afford to leave their positions un-hedged,” said Khalid Hamad, Chairman of IIFM and Executive Director of Banking Supervision at Central Bank of Bahrain. “Hence, some key hedging products are now becoming common across jurisdictions to mitigate risk. The ISDA/IIFM Tahawwut Master Agreement gives the industry access to a truly global framework document which is neutral in terms of treatment to both the transacting parties and at the same time strictly conforms to Shari’ah principles."

The DIFC has hosted a meeting of the Shari’ah Advisory Panel of the International Islamic Financial Market (IIFM), with the purpose of presenting guidance and explaining the benefits of its Tahawwut (Hedging) Master Agreement.

The Agreement provides a framework and mechanism on hedging or risk management transactions that can be undertaken by the Islamic finance industry. It has been developed by the IIFM jointly with the International Swaps and Derivatives Association (ISDA).

The DIFC meeting focused on the key features and mechanics of the Tahawwut documentation, which the IIFM and ISDA have developed in consultation with market participants and under the guidance of the IIFM Shari’ah Panel. The meeting was attended by scholars on the panel, legal counsel, officials from IIFM and ISDA, in addition to market participants including Standard Chartered Saadiq.

Farhan Al Bastaki, Executive Director of Islamic Finance at the DIFC Authority, stated that: "While the world has been searching for an alternative to the conventional banking system deeply impacted by the global financial crisis, few have realised that a more stable, asset-backed and efficient system already exists. Islamic Finance has withstood the negative impact of the global financial crisis, proving its resilience, effectiveness and relevance to the global financial industry.”

He continued: "The system is there, but its wider acceptability has to be created by spreading awareness as well as by providing depth to the market. The IIFM has been making significant efforts to provide depth to the Islamic finance industry such as through its latest framework for risk management.

Although the structure of the master agreement is similar to the conventional ISDA master agreement, the key mechanisms and provisioning such as early termination events, closeout and netting are developed based on the Islamic shari’ah principles.

“Given the growing nature of the Islamic finance industry, the institutions operating on shari’ah principles can no longer afford to leave their positions un-hedged,” said Khalid Hamad, Chairman of IIFM and Executive Director of Banking Supervision at Central Bank of Bahrain. “Hence, some key hedging products are now becoming common across jurisdictions to mitigate risk. The ISDA/IIFM tahawwut master agreement gives the industry access to a truly global framework document which is neutral in terms of treatment to both the transacting parties and at the same time strictly conforms to shari’ah principles.”

“Standardization is a key element in the progress of Islamic finance though it is not a simple process as evident from the efforts put in to the development of this master agreement,” continued Ijlal Ahmed Alvi, Chief Executive Officer, IIFM. “A record number of drafts - 24 drafts – were developed during the industry consultation and shari’ah guidance process before ultimately reaching the final version, which is comprehensive as well as practical in terms of usage with no compromise to shari’ah principles."

“Demand for customized, privately negotiated hedging tools that conform to the principles of Islamic finance has increased in momentum,” added Eraj Shirvani, Chairman of ISDA and Managing Director, Head of Fixed Income for the EMEA Region, Credit Suisse. “The tahawwut master agreement provides the critical framework for the growth and evolution of shari’ah-compliant hedging instruments.”

In addition to developing documentation for Islamic transactions, ISDA in coordination with IIFM is in contact with various regulators in a number of Islamic jurisdictions, such as the Gulf Cooperation Council region, namely UAE, Bahrain and Qatar, plus Pakistan to improve the local legal framework for hedging products and close-out netting provisioning.

Islamic Insurance

The world of insurance, which by its very nature runs counter to Shari'ah principles because its profits are derived through effectively gambling on uncertain outcomes, was an area that until recently Islamic investors either had to tolerate or abstain from altogether. However, this problem has been overcome with the development of the takaful insurance industry. Using the Islamic principle of Ta'awun, or mutual responsibility, the takaful industry rests on the same foundations of profit and risk sharing as other areas of Islamic finance. On a basic level, it provides mutual protection of assets and property in the event of loss or damage based upon joint risk sharing.

Takaful Re Limited, an Islamic insurance company, was licensed by Dubai Financial Services Authority (DFSA) in January, 2006, to operate from the Dubai International Financial Centre (DIFC).

Takaful Re is dedicated to offer Shari’ah compliant reinsurance and related services to the growing Takaful & Islamic insurance markets. Takaful Re will offer reinsurance capacity in all major lines of property, marine and family Retakaful business.

Because profits in the conventional insurance industry are effectively derived through gambling on uncertain outcomes the world of insurance has been largely off limits to those wishing to invest along Shari'ah principles. However, this problem has been overcome with the development of the takaful insurance industry.

Using the Islamic principle of Ta'awun, or mutual responsibility, the takaful industry rests on the same ideal of profit and risk sharing as other areas of Islamic finance. On a basic level, it provides mutual protection of assets and property in the event of loss or damage based upon joint risk sharing.

With an authorised capital of US$500 million and paid-up capital of US$125 million, Takaful Re has plans to focus on retakaful business in the Middle East, North Africa and other Islamic countries.

“This is a significant announcement for DIFC, especially when we already have some major international insurance companies located here," commented Dr. Omar Bin Sulaiman, Director General of the DIFC Authority.

”The DIFC is committed to actively promoting the growth and development of the Islamic insurance industry in accordance with Shari'ah principles. The Takaful market is one of the fastest growing in the world. It is expected to grow at nearly 20 per cent per annum to reach US$7.4 billion in global annual premiums in 15 years. Firms domiciled in the DIFC will complement the regional market and help it grow. By providing the ideal environment, both in terms of regulations and infrastructure, the DIFC aims to maximise this potential," Dr. Omar Bin Sulaiman added.

Meanwhile, Mr. Khalid Ali Al Bustani, Takaful Re Chairman, commented that: “We are pleased to associate ourselves with the DIFC which is renowned internationally. For Takaful Re, to be in the DIFC is a commitment for integrity, transparency and efficiency."

In December, the DIFC welcomed Tokio Marine Group to its growing portfolio of financial and management service providers. A leading Takaful insurance services provider with operations in the UAE and Saudi Arabia, Tokio Marine Group will expand across the Middle East North Africa (MENA) region through its new company, Tokio Marine Middle East Limited (TMME). Registered with and located within the DIFC, Tokio Marine Middle East Limited is regulated by the Dubai Financial Services Authority as an insurance management services provider.

Takaful is a form of insurance that conforms to the principles of Islamic finance. Using the Shariah principle of Ta'awun, or mutual responsibility, the takaful industry rests on the same foundations of profit and risk sharing as other areas of Islamic finance. At a basic level, it provides mutual protection of assets and property in the event of loss or damage, based upon joint risk sharing.

Nasser Al Shaali, CEO of the DIFC Authority, commented: "Takaful services are increasingly sought after in today's dynamic business environment and are of particular relevance to the region. DIFC is further consolidating its leading role in Islamic Finance with the addition of Tokio Marine Group, through its new company. The inception of a company dedicated to Takaful services also illustrates the DIFC's increasing focus on socially responsible financial services."

Tokio Marine entered the Takaful industry in 2001 through its conventional financial operations in Saudi Arabia, and subsequently became the first foreign company in the Kingdom to introduce property and casualty Takaful products. Recognising the potential in opening markets to new licenses, Tokio Marine Group established Tokio Marine Retakaful company, based in Singapore, in September 2004. In 2006, the Tokio Marine Group took a 35% stake in the new joint venture with Hong Leong of Malaysia for US$29m, to form Hong Leong Tokio Marine Takaful Berhad.

"We are pleased to establish this company with the objective of seeking new business opportunities and expanding the Group's existing business in the Middle East and North African markets," announced Hisato Hamada, President and CEO, Tokio Marine Group. He continued: "We are committed to providing products and services that are fully aligned with our customers' cultural and social values."

Hamada added: "Tokio Marine with its long history of a local presence believes that with its diverse portfolio, backed by conventional and Takaful expertise, is well placed to take advantage of opportunities that open up in the MENA region. The Group has set its goals to establish or acquire a number of operations in the MENA region to better serve the indigenous insurance needs. TMME will help the Group to achieve these goals."

TMME will be a technical and management services provider, instituting products, systems and procedures for the existing and new ventures fully or partially owned by the Group.

"Tokio Marine Group is committed to finding socially responsible ways of bringing insurance solutions to its customers. These solutions are in complete harmony with its environment and culture," continued Ajmal Bhatty, Chief Operating Officer and SEO of the Company. "Takaful may be a system that has its roots in the Islamic Shariah, but because of its ethical nature it has proven to be of benefit for everyone. Not only does a Takaful customer benefit from the surplus of the business when it does well, but he also gains the satisfaction of knowing that his contributions and premiums are only channeled towards ventures that are socially and environmentally responsible."

"The biggest challenge and potential for the region lies in the development of Family Takaful which is life insurance in compliance with Shariah principles. The cultural mind-set against conventional life insurance has been one of the main reasons why development of life insurance has been slow. With strong professional approach and innovative takaful solutions, the regional markets should be able to realize the excellent potential that exists in Family Takaful with its related savings and pensions products," he concluded.

In July, 2009, the Labuan International Business and Financial Centre (IBFC) said it was developing guidelines on shariah-compliant captive insurance. Further Labuan initiatives include provision for protected cell companies and amendments to the 1996 Insurance Act to allow for marine and aviation captive insurance companies.

Speaking at an industry briefing in Kuala Lumpur, Labuan IBFC chief executive officer Martin Crawford said guidelines on Islamic captive insurance were non-existent so far, as very few jurisdictions had a legal framework to accommodate Islamic finance with the necessary physical infrastructure. Crawford considers that Malaysia's shariah traditions and the comparatively low-cost nature of doing business in Labuan augur well. The Labuan IBFC already has 32 captive and four rent-a-captive companies in operation and may be the home of 40 captive insurance companies by the end of the year. This compares with 50 captives in the captive insurance market of Singapore.

Labuan has also introduced legislation for protected cell companies. A PCC is structured with core capital, cellular capital, cellular assets and liabilities, and core assets and liabilities. The various businesses within each 'cell' are ring-fenced and insolvency of one cell should not affect the solvency of the whole entity or the performance of the other cells. For any contract the PCC discloses which cell is contracting or whether it is a 'core' contract. 'Cellular' or 'non-cellular' shares may be issued, depending on whether they represent an equity interest in a specific business cell or in the core assets. The entity keeps accounts showing the corresponding patrimonial divisions among the segregated cells and the core cell.

Under an exemption from subsection 140(1) of the Insurance Act, any marine and aviation risks, including goods in international transit, can now be handled by Labuan-based insurance companies, whereas before April 1, 2009, the risks had to be insured through a local onshore insurance company.

Regulation Of Islamic Finance

Regulation and interpretation of Shari'ah law are two key issues in the Islamic finance industry. Before an institution can offer such products to the public, they must first be scrutinised and approved by a panel of Islamic scholars. However, this is by no means a clear cut issue, and the opinions of individual scholars can vary. Indeed, there are many academics in the Muslim world who have been quite critical of contemporary Islamic finance culture, and who have taken issue with certain forms of financing, notably Murabha and Ijara contracts which, it has been argued, are too similar to conventional forms of financing, and which do nothing to share risk and profit, the central tenet of Islamic capitalism.

To ensure a degree of quality control over the Islamic finance industry, regulating institutions, such as the Malaysian-based Islamic Financial Services Board (IFSB), have been set up to police the emerging industry. The IFSB serves as an international standard setting body of regulatory and supervisory agencies and its core mission is to guard the integrity and stability of the Islamic financial services industry across the spectrum of banking, capital markets and insurance. The board also provides guidance for institutions offering Islamic investment products and liaises with other rule-making bodies in the industry.

Whilst modern Islamic finance may not be as pure as some scholars and academics would like, the development of financial products to cover the whole gamut of the finance and investment industry, and the creation of the regulating institutions to oversee them, is evidence that the industry in its current form is likely to be here to stay. And the fact that the new industry has really only scratched the surface of potential demand for Shariah compliant and more ethically aware capitalism means that the Islamic banking and finance is likely to continue growing apace for some years to come.

In December, 2007, Deloitte appointed Mufti Hassan Kaleem as Shariah scholar in its Islamic Finance practice. The appointment makes Deloitte the first Big Four firm to appoint a Shariah scholar, who will ensure that products and transactions are fully compliant with the principles of Islamic finance.

There is a great shortage of qualified experienced Sharia’a scholars, but enormous demand. Deloitte revealed that Mr Kaleem possesses significant knowledge and experience, gained through a combined 16 years of education and practical experience. He holds a variety of consultancy posts in Pakistan with organisations ranging from Islamic bank and insurance companies to advisory committees for the State Bank and the Securities and Exchange Commission.

Deloitte believes that London is well positioned as a gateway for Islamic Finance, especially if the current Treasury consultation on the UK Sovereign Sukuk (Islamic bond) leads to an actual issuance. “London represents a key location for Islamic Finance, as the principal based governance and regulation is more adaptable to accommodate innovation such as Sharia’a compliant products,” commented Maghsoud Einollahi, global head of Islamic Finance at Deloitte.

Bankers and other finance professionals are concerned that the validity of many Islamic finance transactions is open to interpretation, and financial institutions look to guidelines set by Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) for guidance. Nonetheless, there is no definitive and binding set of rules saying that banks must stick to these rulings.

One Middle Eastern banker told Reuters recently that there was "real concern" among the conventional banks over the absence of an authoritative centralized body to frame rules. "Islamic finance was originally about establishing an Islamic economy but we don't even have synergy between banks in Malaysia and the GCC (Gulf Cooperation Council)," he told the news agency.

Afaq Khan, chief executive of Dubai-based Standard Chartered Saadiq, countered in the same report, however, that of the 6,500 rulings, or fatwas, already issued by Islamic scholars, there is a consensus on the overwhelming majority.

"The 5 per cent where the difference lies gives us hope that there will be more innovation," he said. "That 5 per cent is very important for change and evolution in the industry."

Taxation Of Islamic Finance

While the tax treatment of Islamic financial instruments in the main issuing jurisdictions has been covered above, many other countries are seeking to encourage Islamic investment by introducing tax incentives.

For instance, the South Korean government has announced that a tax exemption will be offered for revenues from Islamic bonds, starting in 2010.

The tax incentive is aimed at attracting Islamic funds, as it was said that the Islamic financial market has grown rapidly from only USD0.3bn in 2000 to some USD31bn in 2007. By tapping that market, the tax change is expected to improve corporate finances by broadening the sources of investment, as well as reducing dependence on the US and Europe for financing, thereby diversifying risk.

As interest is not allowed by Shari’ah law, earnings on Islamic bonds are taken as profit, which is subject to being taxed in South Korea. The tax so paid is said to be the equivalent of interest of between 1.3% and 3.4%. The government has therefore introduced a bill to offer the same tax incentives as are given to normal bonds - income and corporate tax exemptions for interest received on bonds denominated in foreign currencies.

The tax incentives will first be applied to two major Islamic bonds, Ijara Sukuk and Murabaha Sukuk. Withholding tax will be exempted for both Ijara Sukuk and Murabaha Sukuk, together with transfer, acquisition and registration tax exemptions for Ijara Sukuk, and value-added tax exemption for Murabaha Sukuk.

In May, 2010, Australian Assistant Treasurer, Senator Nick Sherry, announced the terms of reference for the Board of Taxation's review of the tax treatment of Islamic finance in Australia.

The review, which was announced on April 26, 2010 by the Assistant Treasurer and the Minister for Financial Services, Corporate Law and Superannuation, Chris Bowen, will be a comprehensive analysis of Australia's tax laws to ensure that, wherever possible, they do not inhibit the provision of Islamic finance, banking and insurance products.

"Islamic finance is a rapidly growing part of the global financial system," said the Assistant Treasurer. "The Islamic finance, banking and insurance market is worth almost AUD1 trillion (USD850bn) and could reach as much as AUD5 trillion."

"Attracting more of these funds and investment will develop business and boost jobs in Australia," Sherry continued. "This review is not about creating special treatment, but about creating a fair and level playing field for the provision of Islamic financial products into the Australian market."

"My recent trip to the Middle East illustrated the vibrancy and dynamism of this sector and there is no reason why we shouldn't address national tax laws that may be inhibiting local growth," Sherry noted. "Our funds management sector also has much to offer the wholesale Islamic finance sector - so the review will address any issue on that front also."

The Board of Tax has been asked to make recommendations on Commonwealth laws and findings on State and Territory laws that might be impediments and to review the progress made by other key jurisdictions in Europe and Asia in similar efforts.

"Ultimately, a guiding principle here is that the tax treatment of Islamic financial products should be based on their economic substance rather than their form wherever possible," said the Assistant Treasurer.

"Several other Western jurisdictions have made progress in achieving this - as have we - but now we need to move to the next level. The Board of Taxation review will enable us to do just that," he concluded.

The Board is being asked to provide a final report to the Assistant Treasurer by June 2011.

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