The Chancellor Guide to the Legal and Shari'a Aspects of Islamic Finance

eBook.

Chapter 1

Background to Islamic Finance and Banking

Dr Humayon A. Dar and Umar F. Moghul

In the Name of Allah, the Merciful, the Mercy-Giving

Praise belongs to Allah alone, Lord of the Worlds, and peace and blessings be upon His Final Emissary, upon his Family, his Companions and all those who follow his precedent with excellence until the Day of Reckoning.

Contemporary Islamic banking and finance has emerged as a legalistic phenomenon that emphasises transaction forms, with an intended objective to develop financial products substantively different from products already available in the marketplace. This intended emphasis on substance is, however, only implicit and therefore is not appreciated by many observers who tend to criticise Islamic financial products due to their close similarity (in form) with conventional products.

While this book does not directly contribute to the debate on form versus substance, Shari’a analyses of Islamic financial products documented so as to conform to local laws (which in most cases are not Islamic) must allow the reader to appreciate why in many cases the intended objective of substantial differentiation is not achieved in practice. In fact, there is often a trade-off between achieving Shari’a compliance and conformity to the local. As such, structuring Islamic financial products is an art requiring deep understanding of the Shari’a and experiential knowledge of conventional laws and practice. The required Shari’a input is provided by qualified Shari’a scholars, either individually or as members of Shari’a advisory boards of financial institutions or of Shari’a advisory firms. Law firms document such products and transactions. Financial structuring is normally done by the sponsor institution but could also be procured by an independent Islamic financial consultancy with assistance from legal counsel and Shari’a scholars.

This compendium is one of the first of its kind as a guide for practitioners written by experts in Islamic law and finance, whose work regularly encompasses matters of Islamic law commonly known in Arabic as Shari’a and in particular Islamic laws pertaining to finance and wealth This book brings all three relevant skills for structuring Islamic financial products into one volume, offering the reader an understanding of the related issues in a holistic framework. Furthermore, it covers all important areas in Islamic banking and finance, from retail banking to capital markets and investment banking.

Published amidst an economic crisis triggered by problematic lending and credit-based financial instruments, this work hopefully becomes of greater importance as the global financial community seeks to redress these ills and contemplate the underpinnings and purposes of Islamic law as a possible inspirational source, not only for practitioners, regulators, policymakers and think-tanks specialising in conventional financial services, but also for Islamic banks and other financial institutions offering Islamic financial services. Undoubtedly, Islamic banking and finance has emerged as a winner in the current financial crisis but it must be noted that it has only just escaped the storm. Mainstream, but not unanimous, Islamic legal opinions prohibit trading in debt thereby preventing Islamic financial institutions from securitising and selling debt in the secondary capital markets. There is a clear relevance of the principle of prohibition of trading in debt for policymaking and financial regulation in the West. US financial, and as a consequence of that, global markets probably would have avoided the current turmoil had discounted trading in debt not taken place.

Having said that, it must be emphasised that the book at hand is not about the financial crisis. It remains focused on legal and Shari’a aspects of Islamic banking and finance.

Contemporary Islamic banking and finance continues to learn from the dominant conventional financial mechanisms and systems. And though it still stands in its infant stages, Islamic banking and finance has evidently much with which it can instruct the global financial community. These lessons may very well come not only in the form of law, but in ethical and spiritual forms as well, guiding and inspiring human behavior to remain within established norms.

Islamic ethical and moral norms discipline and regulate the profit motive and curb excess. They are understood and countenanced, within Islam, as law. Yet, this is not to say that they are all necessarily governmentally enforced, whether as a matter of legal theories developed classically by Muslim jurists or simply practically speaking in the contemporary context. We begin thus to appreciate the contributory role that is to be played by the human conscience and human spirituality for the qualitative and quantitative successes of Islamic finance. Built upon the foundations of broadly articulated higher principles, Islamic law sets detailed guidelines in certain areas of finance to inform as to appropriate targets of, and mechanisms for, financing and investment.

The shoulders of Islamic finance practitioners, Shari’a scholars and the broader society and its various institutions together bear the responsibility for effectuating and maintaining the Islamic spiritual ethic. This is a significant challenge as classical Islamic laws are applied in the contemporary context, raising various novel questions of law, morality and policy. While the technical responsibilities for bringing business and finance into accordance with the details of Islamic law lies with those with the requisite training and experience, the very intent and purpose of doing so is borne more generally. This responsibility engenders a concern as well as a curiosity to inquire into the underlying rationale and purpose of classical Islamic law and the sources from which it has been expounded. Both this substance and the legal form which rests upon it are to be implemented on both a holistic level and on a transaction by transaction basis.

Although there are numerous differences between Islamic and conventional banking, there are at least three areas that distinguish the former from the latter. Firstly, Islamic banking is closer to the real sector, ie it prefers to finance real economic activities rather than supporting pure financial ventures. Admittedly, this is partially due to the lack of sophistication of Islamic financial technology. However, there is a basic emphasis in Shari’a prohibiting trading in debt, as such trading may give rise to a pyramid of obligations that may prove difficult to be honored at one point in time. Secondly, and related with the point above, Islamic banks do not favor investing in highly leveraged companies, especially if the debt happens to be based on interest (in which case they would prefer ideally not to invest at all). Thirdly, disclosure requirements in Islamic banking are much more stringent than conventional banking. Because of this, Islamic banks are less prone to financial fraud and crime. This was proven to be the case when a massive scrutiny was carried out by different government authorities around the world on Islamic banks, in wake of the terrorist attacks in New York.

Islamic laws as they pertain to various realms of finance and wealth are the subject of this work. Each chapter, composed by leading practitioners, addresses a different substantive area. Followed by this Introduction, Chapter 2 offers comprehensive guidelines on doing business in one of the newly emerging regional centres of Islamic finance. Written by Nick Thani, Executive Director Islamic Finance at Dubai International Financial Centre (DIFC), the chapter reviews the legal and Shari’a requirements of doing Islamic business at DIFC.

Chapter 3 on Islamic Contracts in a Modern Legal Context (written by Dr Dominic Selwood) offers an overview of different Islamic contracts popularly used in Islamic financial structures and products highlighting important Shari’a issues with reference to some of the most commonly used Islamic contracts.

Murabaha and trade finance based thereon have dominated Islamic banking and finance for long. Chapter 4 on this important topic is written by a veteran in the Islamic financial industry, Stella Cox, along with Dr. Shana Sadiq. Ms. Cox is a pioneer of commodity Murabaha, and Dr. Sadiq has vast experience of legal documentation of Murabaha-based transactions and offers a useful analysis of different Murabaha transactions.

Chapter 5, contributed by Mohammed Amin, an internationally renowned expert on taxation related with Islamic financial products, is on Islamic Financial Products and Taxation. Using example of the UK taxation regime, the chapter exemplifies relevance of importance of knowledge of taxation while structuring Islamic financial products.

Chapters 6 and 7 are on Islamic wealth management, contributed by John Sandwick and Jo Summers, respectively. Sandwick concentrates on Islamic asset management with reference to modern portfolio theory and maintains that while wealth and asset management is primarily a technical issue, Shari’a requirements for stock selection and portfolio constructions serve as pre-requisite for offering these services to Shari’a sensitive investors. Summer’s focus is on the role of Islamic inheritance laws in wealth management for high net worth individuals and families.

Chapter 8 is on Islamic Securities and Funds. Contributed by a pioneering figure in Islamic investing, Rushdi Siddiqui and his former colleague Lisa Meyer at Dow Jones Indexes, this is an authoritative account of contemporary Shari’a principles of investing in listed companies. The authors use the developments of Dow Jones Islamic indexes to exemplify various legal and Shari’a issues related with investing in stocks and equities of publically traded companies. As this is a contemporary development, it is bound to have serious implications for Islamic juristic thought in the years and decades to come. For those fund managers who contemplate entering into Islamic investing, this and the next chapter should be useful in developing understanding of Shari’a and legal requirements of investing in equities. Although the chapter refers to public equity, the issues are equally relevant to private equity, with of course certain technical differences,

Chapter 9, contributed by Dr Asmadi Mohamed Naim, a Shari’a consultant with Hong Leong Islamic Bank Malaysia, focuses on Shari’a criteria for investing in companies that are engaged in activities not entirely in line with the Islamic injunctions of doing business. Although the chapter refers to Sukuk issuance, it equally applies to investing in public equities

Chapter 10, written by Michael McMillen, offers a comprehensive analysis of Islamic project finance. McMillen, an experienced lawyer who has advised on a number of project Islamic project finance transactions, discusses Shari’a and legal issues surrounding project finance.

The next chapter is on syndicated deals in Islamic banking and finance. In this chapter, Suhail Zubairi, CEO of Dar Al Shari’a (a Shari’a advisory firm), focuses primarily on Shari’a requirements for syndication. Read in conjunction with Chapter 10, this chapter offers great insight into Islamic legal philosophy with respect to different contracts that may be used for Shari’a compliant syndication deals.

In Chapter 12, Mian Muhammad Nazir discusses Islamic real estate transactions. This chapter offers insight into practical Shari’a and legal aspects of Islamic real estate. to which most financial institutions in the Arabian Gulf region have heavy exposure.

Drs. Asyraf Wajdi Dusuki and Nurdianawati Irwani Abdullah analyze Takaful in great detail in the next chapter.

Islamic private equity, a fast growing field within Islamic finance, is the topic of Chapter 14, contributed by Umar Moghul, an experienced Islamic finance lawyer who has advised on a variety of Islamic products and transactions.

Chapter 15, jointly written by Dr Humayon Dar and Robert Rilk, covers a very important area of recent Islamic financial innovation – the case of Islamic derivatives. This chapter brings in analysis of Islamic hedge funds and how a European jurisdiction (in this case Swiss) may accommodate Islamic alternative investments within its wealth management framework.

Lastly, Chapter 16, written by Dr Salman Khan, is an important contribution in the field of Shari’a advisory.

This comprehensive coverage of the book is expected to make it a great reference for those interested in structuring Islamic financial transactions.

Dr Humayon Dar is the Chief Executive Officer of BMB Islamic, with offices in London and Dubai. He is a leading player in the Shari'a advisory business, having been associated with most of the recent innovative developments in Islamic banking and finance, including but not limited to structuring Islamic put options, Shari'a-compliant short-selling techniques, and Islamic financial futures contracts. His most recent contribution to the Islamic financial industry is in the form of first-ever Islamic SRI screening methodology, bound to be a pathbreaking development in Islamic investing. As CEO of BMB Islamic UK Limited and a member of its own and other Shari'a Supervisory Boards, Dr Dar is actively involved in enhancing Shari'a authenticity of Islamic financial products. His work was acknowledged by Euromoney in 2006 and 2007, when the team led by him received the Best Islamic Advisory & Assurance award for two consecutive years.

Dr Dar holds a BSc (Hons) and MSc (both in Islamic Economics) from the International Islamic University Islamabad, where he studied with a number of top Islamic jurists and Muslim thinkers. He also has an MPhil and PhD (both in Economics) from Cambridge University, where he conducted research on Islamic finance. His post-doctoral research has exclusively been on Islamic economics, banking and finance. Dr Dar is widely consulted by corporates, governments and regulatory bodies on matters related with Islamic banking and finance, and is frequently interviewed by print and electronic media including the Financial Times, BBC, and CNN.

Umar F. Moghul is a Partner with Murtha Cullina LLP, in Hartford CT, USA. He practises in the area of Islamic finance and law, banking and finance, private equity and mergers & acquisitions. Mr. Moghul has represented an array of financial institutions, businesses, joint ventures and high net worth individuals (many of which operate according to Islamic principles), in a variety of cutting edge financing transactions. He has advised on conventional and Islamic private equity transactions (both controlling and non-controlling). In the realm of real estate, Mr. Moghul's practice has included the establishment of real estate investment funds and one-off financing transactions, a novel Islamic warehouse financing transaction, and the design and documentation of novel Islamic residential, commercial and construction financing products. His legal practice also encompasses counselling financial institutions with respect to their obligations under the USA Patriot Act. Mr. Moghul has published several articles and has spoken at numerous forums regarding Islamic law and Islamic finance. He is a lecturer in law at the University Of Connecticut School Of Law where he teaches Islamic law. Mr. Moghul earned his JD from Temple University and his BA and MA from the University of Pennsylvania.

Chapter 2

Regulation of Islamic Funds and Securities in the DIFC

Nik Norishky Thani

2.1 Introduction

Islamic finance emerged in the 1970s across the Middle East as a niche industry. Since then it has expanded across the global financial markets at a phenomenal rate. Much of the recent expansion can be traced back to the incredible growth and demand for Shari’a compliant capital market products, specifically Sukuk. Given the regional and international listing of Sukuk this has propelled Islamic finance into the spotlight of the international financial markets. The pace of growth has also highlighted the untapped potential of the Islamic financial industry.

The profile of Islamic finance has clearly moved from niche to mainstream. In recent years there has been movement in mergers and acquisitions within the Islamic financial industry, both within jurisdictions and across jurisdictions further fuelling the growth and size of the Islamic financial industry. Islamic finance is currently practised in over 75 countries across the globe and in many markets it is growing faster than certain conventional sectors¹. It is high on the agenda of several others and such rapid growth is now perpetuating a race amongst jurisdictions to become a financial hub for or a centre of excellence for Islamic finance.

This chapter serves to examine one of those international financial jurisdictions which are demonstrating their position to become a centre of excellence for Islamic finance. That jurisdiction is the Dubai International Financial Centre (DIFC) – the financial free zone located in the Emirate of Dubai in the United Arab Emirates (UAE).

This chapter examines the key role which the DIFC plays in facilitating the growth of Islamic finance within the regulatory framework applicable to institutions intending to offer Islamic finance in or from the DIFC. It also discusses the operating environment in place in the DIFC in the area of Shari’a compliant capital market products such as Sukuk and investment funds. A major focus in on timely market issues affecting Islamic finance, such as the role of Shari’a in legal systems and the associated legal and Shari’a risks, which the market may soon face. The chapter concludes by highlighting the DIFC as a role model for Islamic finance, both regionally and internationally.

2.2 The DIFC

To begin, it is pertinent to provide a brief introduction to the DIFC. The DIFC is a financial free zone located in the Emirate of Dubai in the United Arab Emirates, and is the world’s fastest growing global financial hub. What began as a vision of the leaders of Dubai in 2002 was declared open for business in 2004. It is a financial centre ideally located to bridge the gap between existing financial centres of London and New York in the West and Hong Kong and Tokyo in the East, and aims at servicing a region with the largest untapped emerging market for financial services. The vision of the DIFC is to shape tomorrow’s financial map as a global gateway for capital and investment. Its mission is to be a catalyst for regional economic growth, development and diversification by positioning itself as a globally recognised financial centre.

The objectives of the DIFC include attracting regional liquidity back into investment opportunities within the region and to contribute to its overall economic growth, facilitate privatisation in the region and enable initial public offerings by privately owned companies, giving impetus to the programme of deregulation and market liberalisation throughout the region, develop insurance and reinsurance capacity as well as develop a global centre of excellence foe Islamic finance.

International banks like Goldman Sachs, Barclays, Morgan Stanley, and Deutsche Bank, among others, are able to benefit from a number of advantages provided by the DIFC including 100 percent foreign ownership, 0 percent tax rate on income and profits, wide range of double taxation treaties, no restriction on foreign exchange, and freedom to repatriate capital and profits, to name a few. In terms of financial sectors, the DIFC is home to all, including banking, brokerage, capital markets, wealth management, insurance and reinsurance and of course, Islamic finance.

The DIFC is well known for being the first specifically created international financial free zone in the GCC and its three years of operations demonstrate the strong platform it is providing for growth and development in the field of finance. However, the DIFC also acts as a conduit for supporting services, such as Hawkamah, Waqf and education.

2.2.1 Hawkamah - First specialised Corporate Governance Initiative in the GCC

In February 2006 the DIFC established Hawkamah, the Institute for Corporate Governance with the objective of shaping corporate governance throughout the region by promoting the core values of transparency, accountability, fairness, disclosure and responsibility. It is a groundbreaking development for institution building, corporate sector reform, good governance, financial market development, investment and growth in the region. Since its inception in 2006, it has already contributed positively to the region by contributing to the development of the first corporate governance code in the Arab world, partnered with a regional capital market authority to develop a model for capital market corporate governance codes, developed the GCC’s first corporate governance survey across the Gulf, and has launched four regional task forces to address the state of corporate governance.

2.2.2 Waqf Initiative

The DIFC’s Investment arm, the DIFC Investments (DIFCI), jointly established the Waqf Trust Services Ltd (Waqf) with Dubai Islamic Bank in 2007. Waqf Trust Services is a unique proposition that offers a broad range of Shari’a compliant trust services, including:

Personal Trusts providing solutions for succession planning, asset protection, estate and tax planning;

Corporate Trusts for the protection of assets; and

Charitable Trusts solutions.

This unique model provides flexibility, freedom and Shari’a compliant solutions to individuals, families and charities to manage their wealth during and after their lifetime.

2.2.3 Centre of Excellence

The DIFC is also home to the DIFC Centre of Excellence, which provides a platform for the world’s best education facilities and programmes. Currently the DIFC Centre of Excellence is home to the International Bar Association (IBA), London Business School, and Queens Business School, inter alia. The DIFC Centre of Excellence boasts to offer the first-ever Executive MBA in Islamic Finance, developed and delivered by CASS Business School. The ability of the DIFC to attract the world’s best is evident. The academic institutions that are attracted to the DIFC clearly see the potential of the world’s newest international financial centre. As these and other initiatives of the DIFC demonstrate, the DIFC takes a leading position in the region and internationally in many fields. In the context of Islamic finance, the DIFC’s leadership is illustrated in a number of areas as will be discussed in this chapter.

2.3 The Financial Services Industry in the DIFC

The DIFC is home to an expansive financial services industry, with an increasing number of international and regional players deciding to operate from here. The popularity of DIFC owes to the strong regulatory framework it has developed in a short span of time. The regulatory structure of the DIFC is represented by an integrated, cross-sectoral, risk based regulator staffed by regulators from the key international markets. The integrated regulatory model allows the regulator to view regulatory issues across the market and across the financial sectors allowing for financial institutions to flourish within the confines of regulatory parameters defined by international best practice.

Although a single financial services licence is issued by the DIFC’s regulator, the Dubai Financial Services Authority (DFSA), the financial institutions that operate within the DIFC are categorised according to a prudential risk profile. Certain financial services give rise to a certain prudential risk profile. In order to apply the appropriate prudential and financial obligations to an institution, five prudential categories are used within the DIFC. These are given in Figure 2.1, opposite.

These prudential categories are also applicable to Islamic financial institutions. The underlying Islamic structure must be mapped into the financial services definitions of the DFSA to identify the appropriate prudential category. Islamic financial institutions can potentially fall into any one of the above mentioned five prudential categories, depending on the Islamic structures to be offered. Islamic Windows can fall within any of the prudential categories 1-4.

2.3.1 Islamic Finance in or from the DIFC: General Remarks

In the context of the DIFC, there are a number of ways that institutions can participate in the Islamic financial industry. Firstly, by seeking to become an authorised entity, referred to as an Authorised Firm² (a financial institution authorised by the DFSA is often referred to as an Authorised Firm or Firm), to conduct Islamic Financial Business (broadly defined by the DFSA as being the offer of financial services in accordance with Shari’a) in or from the DIFC. Secondly, an institution may wish to trade in or offer Islamic securities in or from the DIFC, in which case the relevant provisions of the markets legislation applicable within the DIFC become relevant.

In relation to conducting Islamic Financial Business or seeking to offer or trade Islamic securities in or from the DIFC, one must firstly consider the regulatory regime applicable within the DIFC. Financial institutions that are authorised to conduct financial services in or from the DIFC may also be authorised to conduct Islamic Financial Business in or from the DIFC, by virtue of an endorsement across its financial services licence, (called Islamic endorsement). An Islamic endorsement is applied to the financial services licence to reflect the fact that the regulator is satisfied that the financial services to be offered will be in compliance with Shari’a, after the implementation of an appropriate Shari’a system. The term Shari’a system refers to the well defined regulatory obligation for firms that offer Islamic finance to have robust systems and controls to ensure compliance with Shari’a. Such systems provide a tangible measurement to identify the issued rulings or Fatwas, process for monitoring, and process for executing transactions in line with the applicable Shari’a rulings issued by the Shari’a scholars engaged by an institution.

DFSA authorised firms may either take the form of a wholly Islamic financial institution, a financial institution whose entire operations are intended to comply with Shari’a, or an Islamic window, an entity within a conventional financial institution that also provides Shari’a compliant services in addition to its conventional financial product offerings. A firm will be required to seek an Islamic endorsement where it is holding itself out to the market as being a provider of Shari’a compliant financial services, for example where the Firm is marketing to actual and potential clients that it is to operate an Islamic fund. This is to ensure that before it offers products to the market and associates such products as Shari’a compliant, appropriate internal processes and systems are in place to ensure Shari’a compliance. This in turn protects the confidence of actual and potential customers of Islamic financial products offered by DFSA authorised firms. Figure 2.2 depicts two different models of Islamic financial offerings from or in DIFC.

2.3.2 Islamic Endorsement

In order to seek an Islamic endorsement, the firm must implement an appropriate Shari’a system to ensure that the business has effective systems for Shari’a compliance³. The Shari’a system must have a number of core elements, including but not limited to:

Identifying the Islamic structures to be offered, and specifically the risk profile, underlying transactions and the role the institution will play in relation to the relevant Islamic structure. From this profiling exercise the appropriate DFSA financial services definitions can be selected and applied to the proposed activities of the firm.

Appointment of at least a three-member Shari’a Supervisory Board (SSB) in accordance with the governance standards promulgated by Auditing & Accounting Organisation for Islamic Financial Institutions (AAOIFI), referred to as Governance Standard for Islamic Financial Institutions (GSIFI). The firm must conduct due diligence on each scholar to be appointed to assess their fitness and properness, competence, experience and relevant qualifications and to identify and manage any potential conflict of interest which may arise as a result of the appointment. Such conflicts may arise as a result of the number of boards which the scholars already sit on. However, given the limited number of scholars in the market at the moment, such conflicts have to be managed as expeditiously as possible.

Implementing an Islamic financial business policy (as defined by the DFSA), which sets out exactly how the business will comply with Shari’a. This policy is perhaps the most important aspect of the DIFC’s regime as it provides a tangible tool for applying, monitoring and managing Shari’a compliant business without the need to address specifically the finite points of Shari’a. This reflects on commitment of the DIFC to ensure that only Shari’a authentic products are developed and offered in and/or from the DIFC. This conservative but engaging approach is adopted by only few other contenders of the status of centre of excellence in Islamic finance.

Implementation of a Shari’a review process: the DIFC’s Shari’a system also requires that periodic Shari’a reviews are undertaken to monitor the firm’s ability to ensure that the business is operating in accordance with Shari’a as determined by the firms Shari’a structures and scholars. The Shari’a review process has two elements to it. Firstly, ongoing internal Shari’a reviews and monitoring must be undertaken to ensure that transactions have been affected in accordance with the Fatwas issued by its SSB. Secondly, the DIFC’s Shari’a system requires an external Shari’a review to be undertaken by the SSB. Effectively, these Shari’a reviews provide a tool to assess the quality and efficiency of the systems and controls put in place to ensure compliance with Shari’a.

Implementation of an adequate risk management structure: firms must also identify the risk posed to their business as a result of the proposed Shari’a compliant business and must ensure that the risk can be monitored, measured and mitigated to the extent possible. In respect of Shari’a compliant services the issue of default and mitigation to prevent default are sensitive Shari’a issues. Thus the firm must ensure that robust and Shari’a compliant risk mitigation techniques are available to them in all aspects of their Shari’a compliant business.

The firm’s systems must ensure that the relevant provisions of AAOIFI are adhered to with respect to Shari’a reviews and disclosures for all Islamic financial institutions, in general, and Islamic windows, in particular.

2.3.3 Level Playing Field

In many jurisdictions across the globe, Islamic institutions operate alongside conventional institutions. In such jurisdictions regulators have made it clear that Islamic institutions will be expected to operate in accordance with the same regulatory requirements applicable to conventional institutions to ensure a level playing field exists in practice. This is certainly also the case in the DIFC where international standards, including IOSCO, Basel, FATF and IAIS, are applied across the DIFC laws and regulations. However, one distinct advantage of the DIFC is that during the development stage of the laws and regulations, Islamic finance was a key feature from the outset and thus was incorporated within the entire architecture of the legal and regulatory structure applicable to all types of institutions, including Islamic firms. This has been helpful in accommodating Islamic financial institutions and transactions without any significant compromises – a possibility in other jurisdictions where Islamic finance rather emerged gradually within a regulatory system which was developed only for conventional financial institutions. The DIFC’s regulatory regime sought to implement international standards across all types of financial institutions duly modified to incorporate the recognised standards of AAOIFI and IFSB.

AAOIFI’s standards were introduced into the DIFC regime to provide a more appropriate accounting and oversight regime in respect of Islamic finance. Additionally, AAOIFI’s governance standards, although focused largely on wholly Islamic institutions, provide sound guidance for the internal and external supervision of the Shari’a aspect of businesses. To maintain the confidence of actual and potential customers, AAOIFI’s Governance Standards were extended to Islamic windows, to ascertain that an appropriate Shari’a system exists to ensure that the products undergo a thorough process before being held out as Shari’a compliant by a wholly Islamic financial institution or an Islamic window. This ensures a level playing field across all types of financial institutions.

The work of the Islamic Financial Services Board (IFSB) has also been useful in the guidelines issued, particularly in seeking enhanced disclosure and implementing recognised capital adequacy standards in the context of Islamic finance. To further enhance the quality of laws and regulations across the DIFC, appropriate modification were implemented within the legal and regulatory architecture based on international standards to ensure that unique risks and issues specific to Islamic finance were adequately addressed. Some of these key modifications are as follows:

Recognition of specific and unique aspects of managing a Profit Sharing Investment Account (PSIA), which does not otherwise fit into the financial services definitions of the DFSA Rulebook. This substantiates the DIFC’s commitment to create an appropriate regulatory regime for Islamic finance rather than try to accommodate the industry within a conventional framework which may not be entirely applicable.

Specific capital charge in the form of displaced commercial risk (or rate of return risk) for PSIA to reflect the specific prudential risks which may arise in the common practice of fund mobilisation and application through PSIA structures.

Specific disclosure obligations and enhanced disclosure in respect of PSIA to ensure that periodic information pertaining to their investments is provided to alleviate some of the concerns, which exist in other markets where limited information is presented to investors.

Significantly, an extension of AAOIFI’s Governance Standards (which are otherwise largely directed at wholly Islamic financial institutions) to Islamic windows is a step forward in the right direction by the DIFC. The obligations to undertake periodic internal and external Shari’a reviews is so fundamental to the intrinsic value and character of Islamic finance that this obligation should also applicable to Islamic windows to, in essence, ensuring a level playing field across Islamic financial institutions and conventional institutions offering Islamic finance.

The DIFC is one of the few jurisdictions across the world which has successfully implemented such a model specifically devised for the regulation of Islamic finance which provides a tangible structure as well as a fair and transparent model.

2.3.4 Offering Islamic Finance in or From the DIFC

Once an institution has been endorsed to offer Islamic financial business, subject to regulatory reviews and approvals, the institution may provide Shari’a compliant financial services. The internal systems must ensure that it can support the Shari’a compliant business. Where the institution is an Islamic window, it must ensure that the conventional business is adequately segregated from the Shari’a compliant business to prevent tainting of Shari’a compliant activities or income.

2.3.4.1 Islamic Funds In or From the DIFC

Investment funds are a key growth area and a potential instrument to allow greater mainstream access to investment opportunities. The funds industry generally includes a range of structures, from plain vanilla long only equity funds to alternative investment in the form of hedge funds, private equity and the real estate funds. There is also a range of other funds like fixed income funds, ethical funds and.some with pure charitable focus. In the context of Islamic funds, the growth is just beginning. Assets under management (AuM) of Islamic funds is estimated to be anywhere between 50 and 100 billion US dollars⁴. Early Islamic fund structures have consisted of long equity funds, but have since moved into Shari’a compliant REITs and the ‘controversial’⁵ domain of Shari’a compliant hedge funds. More innovative fund structures are being offered into the market such as Shari’a compliant fixed income funds, such as Sukuk funds. Given the pace and growth of the Sukuk market there is clearly greater opportunity to establish Sukuk based fund structures.

Recent market reports have indicated that the greatest opportunities for Islamic funds lie in the GCC given the numbers of mass affluent investors. The DIFC provides conducive environment for Shari’a compliant funds having implemented a comprehensive regulatory regime for funds, based on international best practice.

Firms in the DIFC may become engaged in Islamic Funds in the following ways (subject to the authorisation in respect of any appropriate financial services):

Establish and operate Islamic funds, which will require the implementation of an appropriate Shari’a system applicable to the fund;

Manage Shari’a compliant funds established in the DIFC or elsewhere, such funds will be managed in line with the investment guidelines issued or approved by the fund’s SSB;

Market Shari’a compliant funds in or from the DIFC provided that they are either designated funds (term used to define certain funds from certain recognised jurisdictions which can be marketed and offered in or from the DIFC), or meet the specific requirements to be marketed in or from the DIFC as defined by the DFSA; and

Additionally, firms may provide the back office support in respect of Islamic funds, including administration and registry functions.

The DIFC Islamic funds are established under the relevant DIFC Laws, ie the DIFC Collective Investment Law as well as the DFSA Collective Investment Rules (CIR). Such Islamic funds must have an operator (broadly defined as the entity with overall responsibility for the fund) that will be required to implement an appropriate Shari’a system to ensure that the fund is operated in accordance with Shari’a. A DIFC Islamic fund can either be private, ie a fund which is confined to 100 or less investors, or public that can be offered to more than 100 investors. In case of a DIFC Islamic public fund, an oversight panel must also be appointed to oversee the activities of the operator through periodic reviews and reporting to ensure that the interests of the investors are protected.

The DIFC’s regime is very flexible, allowing Shari’a screening methodologies investment guidelines to invest in Shari’a compliant shares and securities to be advised by the fund’s appointed SSB. The DIFC does not, at this stage, issue a list of Shari’a compliant stocks for investment purposes as is provided in some other jurisdictions. This flexibility to develop one’s own Shari’a compliant stock universe, subject to the approval of the Firm’s own appointed scholars, is deemed helpful at this early stage of development of the Islamic funds industry. As discussed below, the DIFC does, however, recommend a string of indices for the market.

The DIFC has set up a precedence of entering into a mutual recognition regime involving the DFSA and Securities Commission (SC) Malaysia. This allows the two Islamic jurisdictions to facilitate the cross border flow of Shari’a compliant capital market products. Initiated in March 2007, the DFSA and SC Malaysia agreed to facilitate the flows of Islamic funds from their respective jurisdictions with minimal regulatory intervention, attempting to streamline the regulatory requirements applicable to Islamic funds. Another significant feature of the initiative is that additional Shari’a disclosures, in terms of the Fatwa and the rationale for deeming the product to be Shari’a compliant, paves the way for greater cross border flows of Shari’a capital market products. This is because it enables investors to take an informed decision in respect of the Shari’a qualities and characteristics of the respective Islamic fund being offered into the DIFC from Malaysia and vice versa. This is significant given the current debate amongst a number of policy makers and industry bodies on greater transparency and disclosure in Islamic finance. The initiative is one of great significance as it provides a model for other securities regulators (even conventional ones) to enter into such mutual recognition regimes⁶ for cross border capital market flows. With further vision and foresight, combined with an element of Shari’a standardisation this model could be developed into a full MENA fund passporting model for GCC Islamic funds. Given the comments in the 2007-08 WIBC McKinsey Competitiveness Report on the industry that the greatest opportunities in Islamic funds are in the GCC, such a MENA passporting model could be a key catalyst for the region as well as for the Islamic financial services industry generally.

2.3.5 Offering Sukuk In or From the DIFC

Turning next to the highly popular issue of Sukuk, which literally took the global capital markets by storm by the end of 2007. Impressed by the trend, some conventional, non-Islamic governments have also announced their intention to issue sovereign Sukuk.⁷ Sukuk are simplistically described as similar to bonds although there are some key differences between the two. Sukuk offer mechanism to raise finance by issuing certificates to investors, who as Sukuk holders obtain beneficial ownership of the underlying assets. As owners, the investors must assume the risk of loss as well as the potential entitlement to profit. The GCC, and Dubai in particular, has been one of the leading jurisdictions in terms of Sukuk issuance to date and further issuances are likely to follow. It has recently been reported that the market for Sukuk will expand further particularly in the GCC given the large number of infrastructure projects currently in progress, and planned, across the region.⁸

2.3.5.1 Sukuk In or From the DIFC

Institutions intending to offer Sukuk in or from the DIFC become subject to the relevant Markets Law and associated DFSA Rulebooks, including specifically the DFSA Offered Securities Rules (OSR) Module as well as the DIFX’s requirements. An institution intending to offer Sukuk in or from the DIFC must ensure that the appropriate offer documents exist. Most Sukuk issuances in or from the DIFC to date have included the following key features:

Prospectus;

Appointment of Shari’a scholars;

Disclosure of Shari’a scholars in the prospectus;

Disclosure of the underlying Shari’a structure, for example whether the underlying structure is an Ijara, Mudaraba or Musharaka;

Details of the terms of the offer, the periodic payments, dissolution terms and guarantor details; and

Initial and ongoing disclosure obligations also exist (including disclosures in relation to any changes to the members of the SSB, and in certain cases disclosures mandated by AAOIFI’s Shari’a Standards in respect of Sukuks may also need to be disclosed).

Putting the Sukuk sector into context, the global value of Sukuk issuance by the end of June 2008 was USD 88 billion, of which USD 16 billion is listed on the DIFX.⁹ This is clearly one of the most impressive and high profile aspects of Islamic finance. However, more Sukuk could be offered in differing maturities to deepen the primary market to facilitate or stimulate secondary market activity in Sukuk. Short term Sukuk could even be used as a form of short term Shari’a compliant liquidity, subject to appropriate Shari’a approvals.

Sukuk across the region have for many years been based on the leasing structure, ie Ijara, however in recent times newer innovative structures have been used, such as the Sukukal-Mudaraba model, which was also used by DIFC Investments for its Sukuk issued in 2007. Structure of this innovative Sukuk is given in Figure 2.3.

2.4 Role of the DFSA as a Regulator of Islamic Financial Services

A fundamental question to consider in the context of Islamic finance is the role that a financial services regulator can and should play. In many jurisdictions, the role of the regulator is to confine itself to the oversight of financial activities. In the context of Islamic finance, the regulators somehow have preferred to create dichotomy in terms of regulation of financial services and regulation of Shari’a advisory services – In this way, financial services regulator are able to regulate the systems in place to ensure Shari’a compliance without needing to regulate Shari’a advisory services.

As discussed above, the regulatory model for the DIFC in respect of Islamic finance is based on its innovative Shari’a system model, which combines international best practices and standards with appropriate modifications to reflect the specifics of Islamic finance. This model provides a well defined regulatory framework, prescribing the systems and controls required to offer Islamic financial business. Once such systems are in place, there is full flexibility to innovate and develop new products in consultation with the firm’s own SSB.

Strength of the DIFC’s regulatory model is further demonstrated by the DFSA being an integrated regulator. This means that it is able to view regulatory risks and issues across the market and across firms as a whole, thereby being in a better position to form regulatory responses to the firm specific issues. Furthermore, the cross-sectoral nature of an integrated regulator is more conducive to the cross-sectoral nature of Islamic finance, which a sectoral regulator might have not been able to regulate efficiently. Again, this feature provides a key advantage to the firms that wish to have flexibility, efficiency, and clarity of regulatory and Shari’a infrastructure within which to operate efficiently.¹⁰ Such a specific regulatory framework is perhaps an example of how to implement one of the critical factors to drive the growth and success of the Islamic financial services industry, one of a number of critical success factors indicated in the 2007-08 WIBC McKinsey Competitiveness Report on the industry.¹¹

2.5 Role of Shari’a Scholars in the Context of Regulating Shari’a Advisory Services

In respect of Shari’a oversight of Islamic finance, a single scholar or a board of Shari’a scholars is appointed to ensure that the Islamic products meet the necessary Shari’a requirements. The role of Shari’a scholars is important, as it defines the word ‘Islamic’ in respect of specific products, across certain jurisdictions, or across certain religious perspectives, ie