Budget moves to tame frenzied trading in derivatives

The frenzied trading in derivates that had regulators scrambling for the alarm bells is expected to dampen, at least for a while, with the government increasing taxes on transactions in a major blow to investors and traders.

The changes announced in the Union Budget on Tuesday follow the Economic Survey’s warning a day earlier about the sharp increase in retail, or individual, investor participation in the stock markets. The Securities and Exchange Board of India is also planning measures to rein in retail speculation in trading in futures and options.

The budgetary proposals include increased securities transaction tax, or STT, on derivatives as well as higher capital gains levies on listed financial instruments, which market experts say would affect trading volumes, particularly those involving professional high-frequency traders.

Finance minister Nirmala Sitharaman in her budget for 2024-25 proposed raising the STT on the sale of options from 0.0625% to 0.1% of the premium, and on futures from 0.0125% to 0.02% of the trading price. 

She also raised the short-term capital gains tax on listed financial instruments from 15% to 20%, and the long-term tax from 10% to 12.5%.

Also read | Why Sebi and RBI want retail investors to stay away from derivatives

For options traders, the securities transaction tax will increase by about 60%, said Roop Bhootra, chief executive officer of investment services at Anand Rathi Shares and Stock Brokers.

“This move would definitely have a negative impact on professional traders who are trading more on intraday basis and generating exceptionally high-volume trades as it will increase their trading costs,” he said.

The securities transaction tax was introduced in 2004 to rein in speculative trading and rake in revenue from the financial markets. Investors and traders must pay STT regardless of whether they make a profit or a loss.

On expected lines

Average daily turnover in equity futures on the National Stock Exchange increased by 1.5 times between 2018-19 and 2023-24, and in options by 18 times, said Krishna Rao, managing director and co-head, equity broking, at JM Financial Services Ltd.

Data on NSE, the world’s largest equity derivatives marketplace, show that the notional turnover of equity derivatives jumped to ₹79,928 trillion in 2023-24 from ₹3,445 trillion in FY20.

“The increase in STT on derivatives was on expected lines and a right step so as to limit the F&O transactions by the high-frequency traders,” Rao said.

Also read | Retail investors and the draw of options trading, and why regulators are worried

High-frequency traders usually work with thin profit margins and at very low cost. The higher STT is expected to adversely affect such traders, forcing them to slash volumes in the near term. Some market experts, however, believe these traders would adjust their strategies and not be discouraged in the long term.

“HFTs may cut back on their volumes immediately (post 1 October) as their spreads will get narrower due to the hike in STT,” said Dhiraj Relli, managing director and chief executive of HDFC Securities Ltd. 

But if the stock markets continue to be volatile, especially on the bullish side, these traders may seek to compensate with higher volumes, he said.

Ajay Menon, MD and CEO, broking and distribution, at Motilal Oswal Financial Services Ltd, said the higher STT will impact profitability for F&O traders. 

“We may see the volumes getting impacted in the near term, particularly for clients who were trading in thin margin spreads,” he said. “For positional traders, there will be some impact but we expect volumes to recover gradually.”

Curbing the retail frenzy

Relli of HDFC Securities said traders would have to also wait for the outcome of the consultation paper to be floated by Sebi, which will outline measures to address the retail frenzy in F&O trading. 

“If other steps to curb F&O volumes are taken then it may cumulatively impact the F&0 volumes and even HFTs will have to adjust to this new norm,” he said.

Also read | F&O trading: Sebi to discuss ways to tighten the screws on retail speculation

On Monday, the Economic Survey for 2023-24 said the sharp rise in retail investors in the stock market warranted careful consideration. “This is crucial because the possibility of overconfidence leading to speculation and the expectation of even greater returns, which might not align with the real market conditions, is a serious concern,” the survey said.

Derivatives trading seems to be fueling the surge in active retail participation, it added. 

“Derivatives trading holds the potential for outsized gains. Thus, it caters to humans’ gambling instincts and can augment income if profitable,” the Economic Survey said, adding that a major stock market correction could lead to more substantial losses for retail investors involved in derivatives trading.