For many international lawyers, the term Islamic finance immediately calls to mind images of the sleek Persian Gulf financial centers of Dubai and Doha.

Kuala Lumpur is working to change that.

The Malaysian capital already has the world’s largest market in sukuk, the debt instruments that are the basic unit of Islamic capital markets. Because of the Muslim faith’s ban on the charging of interest, sukuk pay investors a rental fee tied to an underlying asset. According to Islamic International Financial Market, a global standards body for Islamic finance, Malaysia issued some $115 billion in sukuk over the past decade, almost 60 percent of the world total.

“Here is definitely where any Islamic finance lawyer would want to be,” says Madzlan Hussain, a partner at Zaid Ibrahim & Co., one of Kuala Lumpur’s leading law firms advising on Islamic finance. He says other countries’ infrastructure and expertise are “miles behind” that of Malaysia.

There are several caveats to such confidence though. Malaysia’s sukuk issues are still mainly for a domestic market rather than an international one. And Islamic finance is in any case still only a tiny part of global finance. Ernst & Young estimates that there are currently a little over $1 trillion being held in sharia-compliant financial assets, roughly half a percent of the global total. Several of the Islamic world’s biggest sovereign wealth funds, including the Abu Dhabi Investment Authority and the Kuwait Investment Authority, notably do not restrict themselves to Islamic investments.

But Islamic finance is growing fast: the $84 billion of sukuk issued last year was 62 percent more than in 2010. Deutsche Bank predicts the market will double again by 2016. In January, the Malaysian government issued a record-breaking $10 billion sukuk to fund the privatization of the country’s roads. That was followed last week by the announcement of another $9.9 billion issue to finance a mass rail project in Kuala Lumpur.

If the trend continues, lawyers at both international and Malaysian firms agree the Southeast Asian country has positioned itself well to become a global hub for Islamic finance.

“The Malaysian domestic Islamic finance market is probably the largest in the world,” says Gregory Man, an Islamic finance specialist in the Hong Kong office of Clifford Chance, noting that the size of that market has allowed Malaysia to develop a greater infrastructure around such securities. “Given that fact, it is difficult to overplay its importance to the international market.”

The Malaysian government has not been blind to the opportunity. In 2006, it set up the Malaysia International Islamic Financial Centre (MIFC), a set of initiatives aimed at attracting foreign issuers and underwriters. This included easing regulations to allow foreign banks to conduct the full range of Islamic finance, or even buy a share of Malaysian Islamic banks.

“As a country, Malaysia hasn’t been a central hub [for finance] in the same way as Singapore and Hong Kong,” says Davide Barzilai, a Hong Kong-based Islamic finance partner with Norton Rose. “That’s what they’ve been trying to achieve with the MIFC. They’re pushing very strongly in a well thought-through and developed way to make Islamic finance their unique selling point for this financial center. And it’s starting to work.”

Indeed. Deutsche Bank, Standard Chartered, and HSBC have all set up Islamic finance arms in Kuala Lumpur. Nearly half of Malaysia’s sukuk issuers now come from overseas, and have included General Electric and The World Bank. The investors have become more international, too. When Malaysian sovereign wealth fund Khazanah Nasional Bhd. issued exchangeable sukuk worth $550 million in 2008, half the investors were based in the Middle East; 26 percent were in Europe; and 11 percent were in the U.S. More than half the investors in a $2 billion Malaysian sovereign sukuk last year were in Singapore and Hong Kong.

Despite Islamic finance’s roots in religion, many of the newest participants in Islamic finance are drawn to it for more earthly reasons, says Man, who is not Muslim himself. “I think that in many ways it is viewed as an alternative source of funding,” he says, noting that non-Islamic issuers of sharia-compliant securities are seeking to tap a new base of investors in Middle Eastern and other Islamic countries. For this reason, other regional financial centers, including Hong Kong, Singapore, Tokyo, Seoul, and Australia have introduced reforms designed to make it easier for companies to issue sukuk on their exchanges.

Mark Lim of Wong & Partners, Baker & McKenzie‘s affiliated Malaysian firm, says Kuala Lumpur will try to stay ahead through innovation, something he says already distinguishes Islamic finance in Asia from the Middle East.

“Islamic finance in Asia accepts a larger variety of sharia principles and structures than Islamic finance in the Middle East,” says Lim. “In Asia they take a slightly more liberalized approach. There is much more innovation vis-à-vis the structures that are used.”

Hence the emergence of exchangeable and hybrid sukuk, and more recently, sukuk denominated in Chinese renminbi and Japanese yen–all of which appeared for the first time in Malaysia.

International firms have managed to get in on Malaysia’s sukuk action–Allen & Overy and Clifford Chance respectively advised the Malaysian government and the underwriters on a $1.3 billion sovereign sukuk in 2010–but they have had to do so at some remove. Foreign firms are not permitted to have offices in Malaysia or to practice Malaysian law.

Man says that greater international participation in the Malaysian sukuk market will foster further liberalization in the legal market. Already, he notes, “Investors draw comfort from some of the key financing documents being drafted under English law rather than, say, Malaysian or Indonesian law, with which they may be less familiar or which may present greater uncertainties.”

Zaid Ibrahim’s Hussain says there are many in the country’s financial sector that are calling for the country’s legal market to be opened to foreign law firms, albeit limited to advising on Islamic finance transactions. “News about liberalization of the legal service market in Malaysia has been more imminent than ever in recent years,” he says, ”hence the scope for potential change in the market for Islamic legal services over the next few years in terms of the law firms that advise on such deals.”

Email: blewis@alm.com