By Maria Trombly | Securities Industry News | June 6, 2005

This fall, Dubai--one of seven federated princedoms that make up the United Arab Emirates and already a major commercial center on the Persian Gulf--embarks on a bold experiment. Federal and local authorities are in the process of opening the Dubai International Financial Center (DIFC), home to the Dubai International Financial Exchange (DIFX), the first international exchange in the Middle East.

What makes DIFX different from other exchanges in the region is that it will be located in a self-contained trade center outside of Dubai's legal system. If it succeeds, it could serve as a catalyst for change at other exchanges in the region and open a new time zone for global traders.

But the DIFX faces some significant challenges, including concerns about transparency, government regulation, lack of a track record, and whether it's possible to combine the principles of Islamic banking and financial law with international finance.

GhosainiAccording to Fadi Ghosaini, head of business development at the DIFX, the driving force behind the project comes from the highest levels of government. "Sheik Mohammed [bin Rashid al-Maktoum, crown prince of Dubai] has a vision to build in Dubai a knowledge economy," he says. "This is why the financial center is being built; that is why we have an Internet City, a Media City. We are developing a Dubai Biotech Park."

The independence of the financial center is guaranteed by federal decree, Ghosaini adds. "If the son of Sheik Mohammed wanted to create a bank within the DIFC and the bank is not up to standards, he will not be allowed to set it up," he says.

The crown prince himself is president of the DIFC. Eventually, the exchange will go public and be answerable to investors. "It will actually take several years until we break even and begin to generate a profit," Ghosaini explains. "So we need someone to incubate us."

The sheik's patronage will likewise ensure that the exchange and financial center are free from local legal restrictions. "It is a place where shari'a [the Islamic moral and legal code administered by senior religious scholars Ed.] does not override the rule and law of the center," says Ghosaini. "Islamic law has no case law, no law of precedent. You can go to court on one thing today and be ruled that you are in the right, and tomorrow you go and be ruled that you are wrong."

London on the Gulf

In effect, the DIFC is a free-trade zone for financial products. "It is totally distinct from the rest of the United Arab Emirates and the Gulf Cooperation Council," Ghosaini says. "We have taken the regulations that govern the City of London and effectively imported that into the Dubai financial center."

It wasn't an easy thing to achieve, Ghosaini notes. "It has taken us three years to do it. But we got it, and we have it by federal decree."

That is not to say shari'a has no place on the DIFX, says Michael Dalby, head of the DIFX Markets Authority, the regulatory body that oversees the exchange. In fact, shari'a-compliant securities are encouraged to list on the DIFX, and there will be mechanisms in place to ensure that those issues are, in fact, compliant with shari'a in addition to the more standard international securities requirements.

"There is such a thing called the sukuk,' for example," Ghosaini explains, referring to lease-backed debt contracts resembling Western-style securitizations and functioning like bonds. Paying or receiving interest is a violation of shari'a law. "You can have a shari'a-compliant security that you can list on the DIFX. What we have to do is to make sure that they are shari'a compliant, because these are representations which have been made to investors."

Modern in All Respects

The DIFX will not only observe international law, but will be based on technology familiar to the global securities industry: a trading platform provided by AtosEuronext and clearing and settlement software from Tata Consultancy Services of India. Tata's eClearSettle system will help eliminate default risk and increase efficiency, the DIFX claims. Post-trade management functions include clearing, central securities depository and registry services.

Last week, the exchange announced an application service provider agreement with GL Trade for connectivity between DIFX and member firms in remote locations. "The DIFX will be the first in our region to have such a sophisticated system," says DIFX chief executive Steffen Schubert, formerly the CEO of Easdaq in Brussels and managing director of the Bavarian Stock Exchange in Munich. "We are talking about a state-of-the-art financial center with a state-of-the-art international stock exchange that is open to any company that is able to meet the standards that we are going to set."

MartinOne of the major advantages that DIFX has from the get-go is the lack of legacy systems to slow it down, says David Martin, CEO of M-CAM, a global intellectual property and intangible-financial-risk assessment company. This includes not just technology, but international harmonization and compliance issues as well, Martin explains.

"The strongest market opportunity is they do not have legacy," Martin says. "They can benefit from watching everybody else struggling. They can learn from legacy but they do not have to worry about it themselves."

Eastward Interest

The DIFX has already drawn attention from major players with a real interest in this region and in how the exchange develops. According to Ghosaini, a recent membership workshop drew 160 attendees, twice as many as expected. The practitioners committee--functionally speaking, the DIFX's advisory board--includes Morgan Stanley, Goldman Sachs, Deutsche Bank, Credit Suisse First Boston, ABN Amro and HSBC.

"So far they've done a good job bringing brokerages in as members," says Douglas Naismith, managing director at Fidelity Investments in Hong Kong. "The question is, will they get the listings? So far, all they've got is a building. I've seen it, and it's huge."

FikryRaising the bar in terms of listing requirements is not likely to deter companies from listing on the exchange, Dalby says. Seif Fikry, general manager of EFG-Hermes UAE, a local branch of the largest brokerage in Egypt and the oldest in the region, notes that, "ownership limitations will not apply within the center."

"There is a high level of willingness among potential issuers to make sure that they comply with the world's best standards," Fikry says. "The reason for that is that it would allow them to get the respect at an international level."

Global Shari'a

International players are also getting into the game, as previously reported here (Securities Industry News, Sept. 27). Deutsche Bank, for example, has produced a range of fully shari'a-compliant structured products. They "allow us to generate a kind of product that people need in this region and generate the kind of return that our shareholders need, and so serve the Islamic investor, who is very poorly served at the moment," says Harris Irfan, a vice president of Deutsche Bank in Dubai.

"What we are trying to do here is to act as a catalyst for the development of the capital market in the region," says Ghosaini. "We have economies that are growing very, very rapidly, economies that have got prospects going further in the future, where we have companies needing to begin to attract more capital in order to grow and to take their place in terms of the international arena."

Dubai was the first locality in the region to take the initiative and move forward on the financial front, Fikry says--though the rival Bahrain Stock Exchange likes to claim some first-mover status for itself.

"Not only as a local but as a Middle East brokerage, we find it a positive development," says Fikry, whose firm has applied to trade on the market. "The DIFX will affect the whole region going forward. East Asia has a hub, there is one in Europe, in London and in Frankfurt. In the U.S., it's New York. The DIFX will become the regional financial hub."

Ayman Khaleq, a securities lawyer at Vinson & Elkins LLP in Dubai, says that neighboring markets should benefit from the presence of the DIFX as well. "Market competition is better for investors," he says. "It forces the stock exchange to actually develop further--to be more transparent and require a higher level of disclosure."

Trackless in Arabia

Khaleq praises the quality of the arrangements being made in Dubai. "However, no one can judge until we have a track record," he says. "It is good to say that it is independent and the rules are up to standards, but we need time to tell if they are going to enforce these rules--when it comes to disclosure requirements for listed companies for example."

Other exchanges that already offer a combination of shari'a and conventional investments provide a point of comparison.

Malaysia, for example, is a Muslim nation that allows its citizens to decide how to invest and companies to decide how to list. "We're very liberal that way," says Zaha Rina Zahari, CEO of RHB Securities in Kuala Lumpur and a former regulator in Malaysia.

Zahari also voices doubts about DIFX's ability to deliver on its promises. "Dubai is developing too fast, too soon," she says. "The aim is good, but the people and the exchange and the systems are not ready yet."

Meanwhile, Qatar is planning to create a financial center of its own in the Gulf, Zahari notes. "It's good to have competition," she says. "You can have more than one center."

Betta Plebani contributed to this report.