Islamic finance strives for fairness, the empowerment of all stakeholders, the pursuit of ethical practices and social responsibility — values that sit at the heart of the growing global shift toward sustainable finance. While largely a niche sector, the similar values mean Islamic finance has the potential to rapidly grow and play a more active role in fostering a sustainable future. To this day, few financial hubs are as well positioned to support the international development of Islamic finance as Luxembourg given its historical expertise in Islamic finance and its commitment to developing sustainable finance solutions.
Islamic and sustainable finance — a close connection
The COVID-19 pandemic has acted as a catalyst for sustainable finance, shining a light on the need to ensure that any economic recovery is sustainably minded. This has seen the issuance of sustainable securities double in a couple of years and a growing demand for new and innovative sustainable products — green Sukuk included. Islamic finance benefits from a great opportunity in this regard to combine value creation and the pursuit of environmental, social and governance (ESG) impacts for all stakeholders.
Both offer products that serve Muslim and non-Muslim investors alike and possess strong practices and policies which complement each other. Indeed, contractual equality, ethical governance and responsible investing are core principles of Islamic finance and this holds true for sustainable finance. Islamic finance inherently applies certain practices that are widely used in sustainable financing, such as negative-based screening to avoid specific activities, industries or products that are deemed immoral or unlawful under Shariah law. ESG principles could also be integrated in Shariah compliant products as a complementary methodology by operating inclusion-based screening for specific sectors, products or practices with positive impacts. Although Sukuk remains the preferred financial vehicle for green financing, this could assist in the further development of the social financing sector via products such as Zakat, Sadaqah and Waqf.
With Islamic finance particularly focused on financial inclusion, microfinance is critical for providing access to many communities that lack access to Shariah compliant facilities. Luxembourg, as the leading European domicile for microfinance vehicles (MIVs), is well poised to provide support in this regard. The Grand Duchy accounts for almost a third of global MIVs and more than 50% of global MIV assets under management (AuM).
From a regulatory perspective, Islamic institutions looking to expand internationally can face challenges setting up operations in jurisdictions lacking knowledge or compatibility with Shariah principles. Whether the project in question is setting up a bank, a Sukuk or an investment fund, the supervisory authorities will seek to ensure that all applicable Luxembourg and European legal requirements are complied with. It is important to note that Islamic funds or investments looking to integrate ESG criteria to be marketed as a ‘sustainable Islamic fund’ or ‘ESG Islamic fund’ must respect the mandatory requirements of regulations on sustainable finance, in addition to Shariah principles, to be acknowledged as such and avoid greenwashing.
An established sustainable fund industry hub and EU gateway for Islamic asset managers
Given the close connection between Shariah compliant and sustainable finance products, Islamic institutions are no strangers to the growing sustainable finance trend. With the fund industry set to play a predominant role in the transition to a sustainable economy, Shariah compliant products can too play an outsized role; however, this will require specialist financial hubs’ expertise to support their growth.
With EUR5.6 trillion (US$6.47 trillion) in AuM and investment funds distributed in 79 countries, Luxembourg is the prime location for investment fund domiciliation and cross-border fund distribution. The country handles more than 56% of cross-border investment funds worldwide. Although a majority of the Islamic funds and Islamic financial assets are still domiciled in the Middle East and in Southeast Asia, Luxembourg has become one of the six largest Islamic fund centers globally with over EUR11 billion (US$12.72 billion)-worth of AuM and is now the world’s leading non-Muslim domicile for Islamic investment funds with more than 49 Shariah funds under management.
This strong expertise is also a key factor and enabler to the success of the financial hub and to its growth as the leading global sustainable investment hub. Sustainable funds’ net assets accounted for 11% of total net assets and the Grand Duchy captured almost half of total net flows across all European domiciles in 2020. Further, almost a third of the total net assets in sustainable funds at the end of 2020 were already domiciled in Luxembourg, making it the ideal location for ESG Shariah compliant mutual funds intended for international distribution to retail and institutional investors.
A leading private equity and venture capital hub, Luxembourg provides various alternative investment fund products which can also be structured in full compliance with Shariah law. Flexible structures such as the Specialised Investment Fund (SIF) or the Reserved Alternative Investment Fund (RAIF), which allow for a wide variety of different investment strategies, can be used for Shariah compliant private equity, property or other alternative investment schemes. These structures, used either for Shariah compliant funds or for conventional funds, have proven highly successful with Middle Eastern investors.
The specificities of the SICAR (investment company in risk capital) as a venture capital investment vehicle makes it well suited for Islamic finance investments in and through Luxembourg. Luxembourg securitization vehicles (SVs), on the other hand, provide a flexible and tax-neutral regime for financial products. One of the driving factors of the popularity of Luxembourg SVs among Islamic investors is the wide range of eligible assets (other than interest-bearing assets) which can be securitized. Luxembourg SVs have been used in several Murabahah and Ijarah structures.
A solid European capital market infrastructure for Islamic investors
The capital market sector represents a key manner in which to foster the transition to a sustainable economy and will likely be a key sector where the convergence of ESG and Islamic finance can materialize through green or sustainable Sukuk. The Luxembourg Stock Exchange (LuxSE) is already a prime listing location for Sukuk in Europe and it has been the case since the first European Sukuk facility was listed by Malaysia on its platform in 2002. Ever since then, 21 sovereign and corporate Sukuk have been listed on the LuxSE. Since 2002, the aggregate amount raised through Sukuk at the LuxSE has reached EUR7.9 billion (US$9.13 billion).
An increasing portion of the Islamic debt securities are green Sukuk and sustainability-linked Sukuk in general are expected to grow significantly in the coming years. As a matter of fact, several green Sukuk were already issued by Malaysia, one of the leading global Islamic financial hubs. Luxembourg is also an ideal place for listing sustainable securities and is therefore well equipped to support growth in green Sukuk listing globally. Luxembourg indeed became the first country to have opened a stock exchange platform exclusively dedicated to sustainable securities in 2016, the Luxembourg Green Exchange, now listing more than half of the sustainable securities in the world, and more than 1,000 bonds with a volume of more than EUR500 billion (US$578.03 billion).
Bringing Islamic finance to the globe
But pre-existing synergies between ESG and Shariah compliant finance alone will not be sufficient for Islamic financial players to become global leaders. Islamic investors looking to expand globally will need to rely on experts trained in both sustainable and Islamic finance to conceptualize highly adaptable strategies and investment methodologies. Despite its outsider position in the Muslim world, Luxembourg has built a long-standing reputation over the last 25 years as a major Islamic finance center in Europe with consolidated expertise to support the development and structuring of Islamic finance products for global investors. The Luxembourg financial sector supervisory authority (CSSF) and the insurance sector regulator (CAA) have many years of experience in the authorization and supervision of Shariah compliant fund and insurance structures.
Connections here date back to 1983 when Luxembourg acted as a pioneer in Europe for Islamic insurance with the establishment of Solidarity Takafol, the first authorized Islamic insurance firm in the bloc. Luxembourg was also the first European market to list a Sukuk facility in 2002 and the first sovereign state to issue a euro-denominated Sukuk facility in 2014. Additionally, the Grand Duchy’s central bank became the first European central bank to join the IFSB and was one of the founding members of the International Islamic Liquidity Management Corporation. Luxembourg has since developed a deep understanding of Shariah compliant financial solutions, combined with a long history of cooperation with Muslim countries and communities. The CSSF, for example, signed MoUs with Qatar and Abu Dhabi in 2015 and 2017 respectively to provide mutual assistance and exchange of information in the sector.
The Grand Duchy furthermore benefits from an extensive double tax treaty network with many Middle Eastern and Southeast Asian markets given its active role as an investment hub for Islamic companies and individuals. Located at the heart of Europe and sharing borders with France, Belgium and Germany, Luxembourg serves as a key gateway to Europe for Islamic financial institutions looking to set up Shariah compliant products and services.