Transaction taxes and stock exchange competition

Transaction taxes and stock exchange competition

Ever since the Bimal Jalan committee report came out late last year, much has been written about the lack of competition in the stock exchange space. A number of commentators have said that the committee has ignored the need for greater competition in the market place. Some have even said that the committee’s recommendations would kill competition in the industry.

But even if, for argument’s sake, the Jalan committee’s recommendations had encouraged competition, there would still be one major factor that would work against new entrants. And the interesting thing is that this lies completely outside the purview of the market regulator, Securities and Exchange Board of India.

India’s unusual practice of charging securities transaction tax (STT) essentially means that exchanges can’t effectively compete with each other on price. The market leader, National Stock Exchange (NSE), charges a minimum of Rs3 per lakh for transactions in the cash market and Rs1.75 per lakh in the futures market. These charges apply on both the buy and sell legs of transactions. The rate at which the government charges STT is far higher. For cash market transactions that don’t result in delivery, STT is charged at the rate of Rs25 per lakh on the sell leg of the transaction. In other words, STT charges are around 4 times the fee charged by NSE. STT on the sell leg of futures transactions is charged at the rate of Rs17 per lakh, again more than 4 times the fee charged by the incumbent exchange.

Even if a new entrant were to waive transaction fees completely, it may not succeed in attracting order flow. To attract participants on its platform, it may have to provide a rebate that covers the transaction tax. Why else would traders want to shift volumes from a venue that’s already offering high liquidity? But of course, giving that large a rebate won’t be feasible.

This is one of the reasons the Bombay Stock Exchange’s (BSE) attempt at introducing maker-taker pricing in the country has failed. The exchange tried to incentivize traders who put limit orders on its derivatives platform, as means to reward them for enhancing its order book. Traders who took away liquidity by hitting existing orders would pay a higher rate. This form of pricing has worked to the advantage of a number of new entrants in the exchange space the world over. Of course, in developed markets, alternative trading systems even provide a rebate to traders who put limit orders in the system.

But even if BSE were to provide a rebate, it would have to be high enough to offset the STT charge on the sell side of the transaction. Otherwise, it just doesn’t make sense for traders and market makers to take advantage of the differential pricing on the exchange.

The only solution would be to scrap STT. In any case, it doesn’t make sense to tax traders and investors regardless of whether they make a profit or a loss on the transaction. Besides, as is evident from the outsized growth of the index options market and the currency futures market that market liquidity gets enhanced when transaction taxes are not levied or are insignificant.

In the options market, STT is charged only on the premium received by option writers. Option buyers pay STT only when they exercise options. This wasn’t always the case. Originally, STT was charged on the notional size of the contract. When the rules were changed about three years ago, options volumes rose sharply. For perspective, the STT payable for one at-the-money Nifty options contract is less than Rs1, while the STT payable on a Nifty futures contract is almost Rs50. It’s little wonder that index options are now the most popular segment in the Indian markets.

When traders shift to segments of the market where transaction costs are lower, liquidity and hence discovery in other segments gets weaker. The decision to scrap STT, therefore, won’t merely help in enhancing competition in the marketplace; it will also improve market liquidity and price discovery.

Karl Habermeier and Andrei Kirilenko of the International Monetary Fund conclude in a paper titled Securities Transaction Taxes and Financial Markets, “Transaction taxes can have a substantial effect on the transformation of investor demands into transactions. STTs can obstruct price discovery and price stabilization, increase volatility, reduce market liquidity, and inhibit the informational efficiency of financial markets." It’s time policymakers in India woke up to this and discontinued charging transaction taxes in the securities markets.

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