The International Financial Services Centres Authority (IFSCA) is mulling allowing alternative investment funds (AIFs) to issue offshore derivative instruments (ODIs) or participatory notes from GIFT IFSC, said two people familiar with the matter.

P-notes allow overseas investors to take indirect exposure to Indian securities without registering with the country’s market regulator.

This year’s Budget recognised ODIs as a valid contract if issued by offshore banking units registered as foreign portfolio investors (FPIs) in the International Financial Services Centre (IFSC).

Better pricing

A working group has been formed to assess the viability of extending this to AIFs. Doing so would broaden the market for P-note issuers, currently dominated by foreign banks, allowing for better pricing and availability, said experts.

“The regulatory environment is key in the success or failure of financial innovations. By proactively adapting to emerging market needs, the IFSCA could set a benchmark for how financial centers evolve to serve both domestic and international investors better. While it is unclear whether AIFs will be allowed to issue P-notes, doing so would make IFSC attractive to a diverse set of investors,” said Suresh Swamy, Partner, Price Waterhouse & Co.

Sixty-three AIFs are currently registered at IFSC but not all of these are FPIs.

How it works

This is how it may work. An AIF registered in IFSC will take up an FPI licence. It will buy, say, RIL shares listed on National Stock Exchange or BSE and issue a contract against that in IFSC to a non-resident or foreign investor. Accordingly, the AIF in IFSC will hold the RIL shares and pass on the returns to the investor at an appropriate date.

Regulations will have to be tweaked to allow AIFs to manage a segregated portfolio.

Prime brokers, which are arms of foreign banks, typically get into one-on-one contracts with investors that want to invest in P-notes. AIFs, however, cannot get into such contracts. That’s because these funds are pooled vehicles, with returns linked to units that are assigned a common net asset value.

“We understand that there are ongoing discussions with IFSCA and the other regulators to permit AIFs to issue ODIs. However, there would be challenges like that of portfolio segregation that need to be thought through,” said Sunil Badala, Partner and Head, Financial Services, Tax, KPMG in India.

Transfer provision

Transfer of P-notes or distributions made by an offshore banking unit at an IFSC to a foreign investor is currently exempt from tax. A similar provision will have to be made available for AIFs as well.

An email sent to IFSCA over the weekend did not get an immediate response.

P-notes were issued with cash equities, debt or derivatives as underlying. In 2018, the market regulator banned FPIs from issuing P-notes with derivatives as underlying, except for hedging purposes.

At its peak, P-note issuances formed 7-8 per cent of total FPI assets under custody. This has dwindled to about 2 per cent post the ban.