When the British government said last month it would issue its first Islamic bond, the implications went far beyond the debt market: it was a signal that London will not back down in an escalating tussle among cities for Islamic financial business.

London has long been the default center for international firms to issue sharia-compliant bonds, part of a fast-growing Islamic finance sector that will be worth $2 trillion globally next year, according to consultants Ernst and Young.

But it faces a mounting challenge from two centers: Dubai and Kuala Lumpur.

Dubai, at the heart of the wealthy Gulf, announced a push into Islamic finance this year. It has an entrepreneurial culture which has already made it the Middle East’s top conventional banking center, and big state-run firms which can be expected to support the government’s strategy.

The Malaysian capital has a reputation for efficient regulation of Islamic finance and a huge domestic market for local-currency Islamic bonds, which is now starting to attract foreign issuers.

The final result of the three cities’ rivalry may not be known for years, but thousands of jobs and large amounts of direct investment in companies and real estate are likely to depend on the outcome.

“You need a critical mass of borrowers and investors,” said Khalid Howladar, senior credit officer at Moody’s Investors Service. “You have multiple centers that are looking to establish their pre-eminence in the Islamic space.”

Growth

Islamic banking, which obeys religious principles such as bans on interest and pure monetary speculation, is still dwarfed by conventional banking with over $100 trillion of assets.

But the top 20 Islamic banks have been growing 16 percent annually in the last three years, far outpacing their conventional rivals, according to Ernst and Young. That makes Islamic finance tempting for many non-Muslim institutions.

In an unstable global market environment, the conservatism of Islamic financial structures may be helping the industry. Its access to big pools of Islamic investment funds in the Gulf oil-producing states and southeast Asia is certainly a factor.

Over the past year, the industry has been expanding from its traditional bases in those two regions across many nations with significant Muslim populations, from North Africa and Kazakhstan to Nigeria and Djibouti. European financial firms have tapped Islamic funds by issuing sharia-compliant bonds, known as sukuk.

That promises big rewards for the financial centers which arrange issues of sukuk and other Islamic products, employ the experts who structure them, and host the scholars who vet them for religious permissibility.

“The pent-up demand for short-term papers to manage liquidity in Islamic finance is huge, and to meet this will require other market players to come in,” Malaysia’s central bank governor Zeti Akhtar Aziz told Reuters.

Dubai laid claim to such business in January this year when its ruler, Sheikh Mohammed bin Rashid al-Maktoum, announced a drive to develop the emirate as an Islamic financial center.

Its main competitors responded. In March, Britain launched a publicity campaign involving government junior ministers and private sector executives to burnish London’s Islamic credentials.

In May and June, Malaysia took steps to strengthen its regulation of the industry while making it easier for its Islamic insurers to invest their money overseas.

The most high-profile—and most cut-throat—area of competition between the three centers is arranging sukuk. London has led in attracting issues by big international companies because of the massive size of its conventional financial markets and its globally respected legal system.

Malaysia, however, has the advantage of a vibrant market in local-currency sukuk, thanks to a Muslim-majority population; Kuala Lumpur has accounted for about two-thirds of all sukuk issued globally this year. That is persuading some foreign firms, from as far afield as Kazakhstan, to issue in Malaysia.

Dubai lists relatively few sukuk on its exchanges; traditionally its state-owned companies have gone to London to issue. But a determined campaign by Dubai’s government is now convincing its companies to issue at home, and could attract business from firms in neighboring Gulf states.

British Prime Minister David Cameron appeared to be trying to head off that threat last month with his plan for Britain to become the first Western country to issue a sovereign sukuk.

“The UK sukuk announcement has really helped to galvanize the market,” said Farmida Bi, European head of Islamic finance at law firm Norton Rose Fulbright in London, predicting the sovereign issue would help to trigger corporate issues.

However, Dubai won a victory this month when the Jeddah-based Islamic Development Bank, which has long operated sukuk issuance programmes in London and Kuala Lumpur, said it would set up a $10 billion program on the NASDAQ Dubai exchange.

“I do believe Dubai can reach a leadership position, although progress has been slow and it will take a few years to reach the level of Malaysia,” said Apostolos Bantis, emerging markets credit analyst at Commerzbank in London.

Because London is not located within a natural pool of sukuk issuers and European customers will remain a limited group, its position looks weakest among the three centres from a long-term perspective, Bantis added.

Insurance

Other areas of competition include Islamic insurance, known as takaful, and asset management. Once again, London’s sheer size gives it an advantage, while Kuala Lumpur benefits from its location in a vast, predominantly Muslim area of southeast Asia.

British-based firm Cobalt struck a blow for London earlier this year by developing a novel syndication model for takaful. The model offers A-rated capacity which most carriers in the Gulf lack, said chief executive Richard Bishop.

This could clash with Dubai’s plans to expand in takaful. Abdulaziz al-Ghurair, head of the authority overseeing Dubai’s financial center, said last month that since there were only 19 Islamic reinsurance firms globally, takaful firms were forced to transfer some of their risk to conventional reinsurers.

That creates a window for Dubai to set up Islamic reinsurers, he said without detailing how this would be done.

Ultimately, much will depend on which financial center can establish “thought leadership” in Islamic business, creating standards and structures which come to be accepted across regions and, ideally, across the global industry.

Traditionally, Malaysia has been influential because of its centralized model of regulation, which minimizes disputes among different boards of Islamic scholars. But some Gulf scholars view Malaysian regulation as too liberal, arguing that it permits structures which too closely mimic conventional finance.

Dubai has a chance to chart a path between these two camps; it has said that after consulting the industry, it will issue sukuk standards that are more detailed and comprehensive than others, hopefully resolving conflicts between the regions.

“This is very important. We think it’s a basic requirement but it doesn’t exist as we speak. But this will not come from the sharia scholars—it has to come from the industry,” said Hamed Buamim, director-general of the Dubai Chamber of Commerce& Industry, which is promoting the emirate’s Islamic push. (Additional reporting by Carolyn Cohn, Shadi Bushra and Marie-Louise Gumuchian in London; Editing by Andrew Torchia and Peter Graff)