Reports earlier this week that the Government has abandoned — or is at least privately going cold on — plans to issue Islamic bonds were not received warmly by finance lawyers. London owes its position as Europe's leading financial centre in part to the enthusiasm with which successive governments have embraced innovative products and, more importantly, their willingness to pass legislation to make those products viable.

The UK's early and so far enthusiastic embrace of Islamic finance is an obvious example. Having already proven it has the will to legislate for Sharia-friendly bank accounts and residential mortgages, the UK looked set to steal another march on its rivals by extending this to the institutional investment market.

Although the value of Sharia-friendly finance deals to date is tiny as a percentage of the overall bond market, the numbers have been growing fast, and there are strong signs that it will continue to grow. In 2006, $7 billion worth of sukuk were sold, an almost 80 per cent increase on the previous year. With Muslim counties rapidly emerging among the new powerhouses of global finance, rating agency Standard & Poors estimates sukuk issuance could reach $100 billion before 2010.

A sukuk is a relatively simple and transparent financial instrument. Investors receive regular payments from the issuer in the same way a bondholder does, except the payments derive from revenue earned by a collection of assets. This circumvents the Islamic prohibition on charging interest. Investors can either hold the sukuk to maturity and reclaim the original amount of money he paid, as with a bond, or sell it on a secondary market such as the London Stock Exchange.

Currently, millions of dollars of sukuk issued by Arab governments and companies are traded daily. The UK Government's plan to sell its own sukuk was central to hopes of extending this market to Western issuers. Not only would the Government provide the necessary legal and regulatory framework to entrench the flourishing Sharia market in London, it would lead from the front with its own bond issue.

Much of the legal ground work needed to turn the idea of UK companies selling Sharia bonds into a reality has already been done by working committees and focus groups. It would be a great shame if this were now to go to waste — particularly as lawyers familiar with the situation say the legislative issues, while complicated, are by no means insurmountable.

At present, there are a few stumbling blocks to wider access. One is that sukuk investors own a share of the underlying assets. That makes them more like collective investment schemes such as unit trusts than normal bonds, an important distinction given that collective investment schemes are treated differently from a regulatory point of view. Reform would be required.

Another stumbling block is tax. How do you tax a UK-issued sukuk where the issuer must pay the investor from profits generated by underlying assets? It could create a "double-tax" problem that doesn't exist with normal bonds. Tax brains are already hard at work on how to solve this.

It would be a mistake to dismiss Islamic finance as a foreign concept with little value to offer UK businesses or investors.

For one thing, a thriving domestic sukuk market would allow British companies to tap the vast, growing reserves of Islamic investors. The number of individuals and institutions with a Sharia-only investment policy is limited but their numbers and influence are expected to grow. Earlier this year, in a deal arranged from London, Ford agreed to sell its UK-based subsidiary Aston Martin to a private equity consortium including two Middle-Eastern, “Sharia-only” investment funds in a deal partially financed by sukuk.

On the flip side, more UK investors will be enticed to pursue opportunities in the Middle East if they can buy Sharia bonds in London rather than Dubai.

From a legal perspective, there's another upside. If Islamic finance is good for UK Plc, it naturally follows that it will be good for the lawyers who advise on the structuring, regulation and tax implications.

The leading City firms — Norton Rose was the early innovator, but finance giants Clifford Chance and Allen & Overy have also made great strides — have already embraced Islamic finance, with specialist teams and offices in the Middle East. Further down the chain, smaller firms are also setting out their stalls in anticipation of growth, with the likes of Denton Wilde Sapte and Taylor Wessing now boasting their own experts.

If London dithers, however, other financial centres will take its place.

It is understandable that after the summer's credit crunch the Government is wary of financial instruments, but the City's position as the leading Western centre for Islamic finance is by no means assured. Ireland and Luxembourg are already coveting a slice of the market. If their legislators are quick on their feet, they could grab some of London's share.

Explore Law

• Columnists

• Law Panel

• Law Reports

• Student Law

Times Recommends

• Legal school 'earned £1m by exploiting bar course'
• Axe may fall on 5,000 more City lawyers
• Prince Charles named in £81m court battle