Luxembourg: A Prime Location for Islamic Finance

Despite the current economic turmoil, the Islamic finance (IF) industry recorded compounded annual growth rates of 28 per cent from 2006 to 2009[i]. Although projections differ, it is commonly agreed that the market for IF products is forecast to grow at a 12 to 15 per cent per annum over the next 10 years[ii].

In addition to a growing Muslim population in the world, IF is gaining wider recognition as an ethical alternative to the conventional financial system. Among other features such as the prohibition of uncertainty (gharar), of speculation (maysir) and of the payment and receipt of interest (riba), Shari’a compliant investments may not be performed in specific business areas forbidden by the Shari’a. Interestingly, the Vatican’s official publication L’Osservatore Romano dated March 4, 2009[iii], states that the ethical principles that underlie IF could bring banks closer to the customers and to the true spirit of services that should characterize each banking service. While IF appears to be increasingly considered in the category of socially responsible finance, growth may be expected through investors who are attracted by its ethical features rather than faith based considerations.

The emerging new agenda

According to a recent publication from KPMG[iv], “in the last 10 years the industry debates among practitioners and authorities within IF have focused on issues such as the doctrine underpinning Shari’a-compliant versus Shari’a-based products, the extent to which Islamic banking did or should simply replicate conventional products and generic standardization.

However, KPMG firms have captured discussions with a number of institutions across the globe, which demonstrate that this stage of development is over. The debate has moved on. It is important for IF to progress in the right direction as it and conventional finance recover from the global crisis. The IF industry is now not only addressing the credit and liquidity restraints that linger following the crisis, but is also focusing on its key business activities; principally how best to provide customers with suitable products which meet their specific requirements and which offer the return, transparency and ethical structure demanded. It is also re-examining the wider approach to asset and liability management given the lessons learned during the crisis. The issue of standardization is still pertinent to the growth of the industry, but differences in Shari’a in different regions are becoming less significant, although some of these variances still pose issues relating to liquidity management in terms of acceptable instruments.

A new agenda is emerging in the industry – it will be those institutions which can most effectively embrace the new contextual environment that will lead the market in the exciting next stage of IF’s future development.”

Luxembourg – a global hub for Islamic finance

Islamic Finance is not new to the Grand-Duchy of Luxembourg. The first Islamic institution set-up in a Western country was established in Luxembourg back in 1978. Only a few years later, Takafol s.a., the first Shari’a compliant life insurance company in Europe, was created in Luxembourg.

The Grand-Duchy is currently ranked fifth in terms of market shares of Shari’a compliant investment vehicles in the world. There are currently around 40 Shari’a compliant funds and sub-funds domiciled in Luxembourg.

A year ago the Al Mi’yar platform, aimed at facilitating the listing of Shari’a compliant securities, was established by Deutsche Bank. Other platforms are currently under development in Luxembourg.

One strength of Luxembourg is that its Government is openly concentrating efforts to promote the development of IF - in 2008, it set up a dedicated task force.

Earlier this year, a circular was issued by the Luxembourg Tax Authorities describing the major principles of IF and their tax treatment, testifying to the commitment to the continued growth of IF offerings in Luxembourg.

In particular, the circular sets the framework for the tax treatment of Murabaha and Sukuk in Luxembourg, applicable to all companies except for UCIs. This comes in addition to the Luxembourg Stock Exchange being the first European stock market to list Sukuk and to Luxembourg's recent admission as the first European Member State to the Council of the Islamic Financial Services Board on 23 November 2009. The Luxembourg Central Bank was among the 11 central banks and two multilateral organizations that signed the articles of agreement for the establishment of the International Islamic Liquidity Management Corporation (IILM) in Kuala Lumpur on 25 October 2010.

Besides the tax treaties with Malaysia, Indonesia, Morocco, Tunisia and Turkey, the recent entry into force of a tax treaty with the United Arab Emirates on 1 January 2010 and with Qatar on 9 April 2010 cements Luxembourg's favourable status as an Islamic investor-friendly environment (entry into force of tax treaties with Kuwait and Bahrain is pending).

The signature on 11 and 12 January 2010 of a memorandum of understanding between Bahrain and Luxembourg, and between the Dubai International Financial Center and Luxembourg for Finance respectively, secures the already strong existing business relationship and further enhances bilateral cooperation and wide-ranging industry development (market access, financial regulation and infrastructure).

Furthermore, on 17 June 2010, the Luxembourg Indirect Tax Authorities published a new circular that clarifies and confirms the treatment of Murabaha and Ijara contracts under Luxembourg registration duty and VAT laws.

In addition to the strong commitment of the Government to IF, the importance of having professional and skilled service providers such as advisory firms, auditors, lawyers, custodian banks, etc. is paramount to the success of Luxembourg as an Islamic hub. Also, certain actors of the Luxembourg IF market have close connections with IF scholars.

The priorities of the industry are evolving and it is important to consider governance and risk management supervision as priorities.

A key feature of the Luxembourg financial centre is its multilingual and multicultural workforce, with a fair proportion of employees that are knowledgeable in the area of IF. Education initiatives have flourished such as the Luxembourg Banking Training Institute (IFBL) in partnership with ICMA Centre of the University of Reading, offering a Diploma in IF, and more recently, the collaboration between Luxembourg School of Finance (LSF) and INCEIF - the leading University in IF from Malaysia.

Shari’a compliant investment funds and Sukuk in Luxembourg

Luxembourg is currently Europe’s number one investment fund centre, second worldwide behind the US[v], and the global leader in the cross-border distribution of retail investment funds.

In July 2010, the number of investment funds domiciled in Luxembourg amounted to 3,582, representing net assets under management of EUR 2,019.2 billion[vi]. In comparison, Luxembourg for Finance agency (LFF) estimated in June 2010 that the assets under management for non-regulated was US$1,093 million as opposed to regulated Islamic funds in Luxembourg which was US$488 million[vii].

Shari’a compliant investment funds in Luxembourg are managed by major players in the world such as HSBC, Citi, BLME and BNP Paribas, among others.

Additionally, there are currently around 16 Sukuk listed on the Luxembourg Stock Exchange such as Salam Bounian Development Company Sukuk Ltd (US$137,500,000), Qreic Sukuk LLC (US$270,000,000), Petronas Global Sukuk Ltd (US$1,500,000,000) and Wings FZCO (US$550,000,000). The Luxembourg Government has indicated that it is analysing the opportunity to potentially issue Sukuk in the future.

Shari’a-compliant microfinance

Luxembourg is also a well positioned hub in the field of microfinance. Indeed, around 25 per cent of microfinance investment vehicles (MIV) are domiciled in Luxembourg[viii], representing 46 per cent of the World’s MIVs assets.

Microfinance is acknowledged to have a positive impact in terms of alleviating poverty as long as the instruments being used are tailored to the social and cultural context and are applied professionally.

It is interesting to note that both microfinance and IF share similar objectives including ethical investment and profitability, but at the same time currently face similar challenges in terms of regulation and supervision.

However, though microfinance is considered an effective development tool, many low income Muslims reject conventional products that are often viewed as not being Shari’a compliant.

The potential of Islamic microfinance to offer them an access to financial services is promising, thereby improving quality of life. However, effective business models are required for this nascent industry to meet its objectives.

The 8^th Islamic Financial Services Board summit to be held in Luxembourg in 2011

The IFSB is an international standard-setting organisation that promotes and enhances the soundness and stability of the IF services industry by issuing global prudential standards and guiding principles[ix].

As previously mentioned, the Central Bank of Luxembourg (BCL) was the first central bank of a European country to become an Associate Member of the IFSB.

The BCL will be hosting the 8^th Islamic Financial Services Board (IFSB) Summit in May 2011. The topic of this summit will be “Enhancing Global Financial Stability: Challenges and Opportunities for IF”.

Conclusion

The 2011 IFSB summit in Luxembourg will certainly increase the international awareness of Luxembourg as a prime location for IF. The various Shari’a compliant vehicles and instruments developed by local stakeholders and advisors benefit from tax efficient structures made possible by the Government’s tax and legislative framework. In the meantime, innovative initiatives supported by the local players and the total commitment of the Government, shall benefit the growth of Shari’a compliant finance in Luxembourg.

[i] Banker’s Top 500 Islamic Financial Institutions survey published in association with HSBC Amanah, www.ameinfo.com/214968.html, November 5, 2009.

[ii] Source: Dubai Islamic Finance Center, http://www.difc.ae/

[iii] « Dalla finanza islamica proposte e idee per l’Occidente in crisi », L’Osservatore Romano, March 4, 2009

[iv] Frontiers in Finance – Supplement Islamic Finance, KPMG International, October 2010

[v] Source : Luxembourg for Finance, http://www.lff.lu

[vi] Source: Association Luxembourgeoise de Fonds d’Investissement, http://www.alfi.lu

[vii] Source: Commission de Surveillance du Secteur Financier / Finesti

[viii] Source: Commission de Surveillance du Secteur Financier

[ix] Source: Islamic Financial Services Board, http://www.ifsb.org