Legal Background of Islamic Finance in the UAE

Islamic finance institutions are very young compared to their conventional equivalents; however their products have come a long way in a short period of time. Idiosyncratic issues of Islamic finance may also result in the profitability and coverage of niche markets. United Arab Emirates (UAE) is one of the leading Islamic finance bases throughout the world, thanks to its proximity to various international finance markets as well as having a top-rated financial center, Dubai International Financial Center (DIFC).

When delving into the legal perspective of Islamic finance in the UAE, we should consider two different jurisdictions in the UAE. One of them is the ordinary course of financial services for residents and local companies that are given by retail banks, insurance companies, securities and investment firms etc-we may call this onshore jurisdiction, although there is no tax in the UAE-. Those financial institutions are mostly subject to the Central Bank’s legislation and overall supervision. These companies provide services not only to individual clients, but also to local companies as well as free zone establishments that allow %100 shareholding by foreigners.

The other jurisdiction in the UAE is Dubai International Financial Center, which is an offshore financial free zone having a separate legislative environment with its regulator –Dubai Financial Services Authority (DFSA)-, courts and administrative office. Although it is a free zone identical to other free zones in the UAE, its highly regulated environment distinguishes it from other free zones and adds value that carries it among world’s top ranking financial centers.

Since both jurisdictions vary in terms of allowed activities and scope of business, they have different legal perspectives over Islamic financial institutions. However, the concept and essence of products and services available under both models are mostly similar in terms of Islamic finance. E.g. both jurisdictions require Islamic Financial Institutions (IFI) to set up Shari’a systems and controls to ensure operations and activities are conducted in accordance with Shari’a. This article is written in order to give brief information about legal background applicable to Islamic finance in the UAE and possible improvement areas for offshore Islamic finance regulations.

Onshore financial institutions in the UAE are comprised of banks, Islamic finance institutions, securities and trading firms, asset management firms and takaful insurance providers. The Central Bank of the UAE specifically regulates majority of these onshore institutions and significant number of regulations govern their activities. Since the official religion of the UAE is Islam, there are provisions in the Civil Code (Federal Law No: 5 of 1985 Concerning Civil Transactions), which also affect Islamic financial business. The Civil Code mostly regulates the main types of Islamic products like Mudharaba, Musharaka, Murabaha, Ijara, Salam, etc, and their factual attributions in transactions.  Hence, we can say that Islamic finance business in the UAE has its base in the Civil Code.

The other important law regarding Islamic financial institutions operating onshore is the Federal Law No.6 of 1985 concerning Islamic Banks and Financial Institutions. It is a general framework law that describes the systems and controls of an Islamic financial institution regarding Shari’a and main principles of operating both domestically and abroad.

The difference between an onshore and offshore jurisdiction is that, it is prohibited to deal with local currency (and/or sometimes local people) in offshore jurisdictions. DIFC is an offshore financial center, in which UAE Dirham transactions are not allowed. This may be seen as a prohibition of the financial institutions in the offshore center from competing with their onshore equivalents. Additionally products and services such as current accounts (a long time debate issue in Islamic finance), credit cards, cheque issuance etc are also prohibited in DIFC as per the Islamic Finance Rulebook of DFSA. Institutions that operate in DIFC are mostly perceived as investment banks or agents that arrange high volume deals between different jurisdictions using various structured products. The firms in DIFC may operate as wholly Shari’a compliant or as conventional institutions with an Islamic window, like their onshore equivalents. Also clients of the DFSA-regulated companies should be professional clients, with minimum required asset size and necessary experience in financial markets.

Since the inception of the DIFC until the authorization of the Center’s first wholly Shari’a compliant bank in 2009, there had been no issues attracted the regulator’s attention over the legislation. But over time, the increasing demands of an expanding market always raise new issues and challenges; which can be hard to answer.

Offshore legislation in the UAE regarding Islamic finance draws an operating framework for firms rather than prescribing what is allowed in details. Major rules are described in DFSA’s Islamic Finance Rulebook (IFR) and other rulebooks regarding various types of authorized firms. Main areas of concern are the same as anti money laundering, corporate governance and Shari’a systems and controls. However, this legislation also has many areas that are subject to improvement. Those areas arise due to a common lack of expertise and standards in the Islamic finance environment.

One of the most important of those areas in DFSA legislation is the concentration rules applicable to Islamic contracts. Today, most jurisdictions have concentration rules regarding capital soundness of a financial institution. It is prohibited for firms to be exposed to a single counterparty in an amount which dangers its capital. Although this is a prudent way in terms of risk management, when it comes to Islamic finance, things are more complicated if an IFI wants to arrange a deal between two parties. Since the IFI will be an agent over which funds overflow, it is expected not to be subject to any concentration rules. However, depending on the contract type (restricted, or unrestricted), concentration rules are applicable as if the agent bears the credit risk.

Another grey area with the legislation is that it is not possible for a client of an IFI to place his money in the IFI without entering into any transactions and expecting no returns. It is a requirement to have an investment account and provide relevant disclosures such as profit sharing ratio and expense deduction to the clients. This may lead to having investment agreements in place, while the essence of the business is not investment (hence, there may be a conflict to Shari’a principles of having true and valid business purpose!). The consequence of having such an account may be that the authorized firm is in fact operating a current account by the regulator’s standard, which is strictly prohibited in DIFC and not Shari’a compliant in terms of offshore legislation.

There has been much debate in various jurisdictions about applying either IFRS or AAOIFI standards over the financial statements of IFIs, and the DFSA is about to conclude this in near future. Consultation paper of 79 was released in October 2011 regarding revocation of compulsory application of AAOIFI standards for IFIs. This will mean that IFIs will be able to apply IFRS with additional disclosures of Islamic finance products and services.

Although there is room for improvement, it is also a fact that DFSA legislation encourages transparent and well-governed Shari’a systems to protect investors and clients, which is something not often achieved in other offshore jurisdictions. Disclosure requirements as well as corporate governance standards are well established so that they can easily compete with its hundred-year old rivals in other jurisdictions. Also risk management requirements of IFIs are well established to ensure smooth running of those companies.

In conclusion, UAE market is not only a financial hub for Islamic finance, but it is also a safe haven in the region with social and cultural aspects. Its wide range of Shari’a compliant products together with a well established legal Shari’a background, make UAE a leading Islamic finance base for institutions as well as investors.

Published on Islamic Finance News Volume 9 Issue 5, February 2012