Finance Minister Nirmala Sitharaman announced an increase in the securities transaction tax (STT) on futures and options (F&O) in the Union Budget 2024.
Analysts had anticipated this tax hike due to the strong participation of retail investors in the derivatives market. In recent years, derivative trading in India has grown significantly as investors seek quick profits. However, many of these investors face losses due to a lack of understanding of derivative trading.
Despite repeated warnings from SEBI, which has highlighted that 90% of active retail traders lose money in derivative contracts, the popularity of derivative trading continues to rise.
In the Union Budget, the Finance Minister proposed to increase the rates of STT on the sale of an option in securities from 0.0625% to 0.1% of the option premium and on the sale of a futures in securities from 0.0125% to 0.02% of the price at which such futures are traded.
Earlier in May, Nirmala Sitharaman and Chief Economic Advisor V. Anantha Nageswaran sounded caution about growing retail participation in the equity futures and options market.
The Economic Survey 2024, which was released a day before the budget, noted the increasing interest of these investors in derivative trading.
“Derivatives trading holds the potential for outsized gains. Thus, it caters to humans’ gambling instincts and can augment income if profitable. These considerations are likely driving active retail participation in derivatives trading,” the survey said.
The survey emphasizes the need for increased investor education and ongoing financial literacy to alert individuals about the potential for low or negative returns from derivatives trading.
“A significant stock correction could see losses that are more considerable for retail investors participating in capital markets through derivatives. Investors’ behavioral response would be to feel ‘cheated’ by unseen more considerable forces. They may not return to capital markets for a long time. That is a loss to them and the economy,” the survey noted.
How big is the Indian derivatives market?
Derivative trading in India has gained significant momentum post-COVID-19 pandemic, attracting retail investors who view it as a quick way to earn returns on their capital.
This surge has propelled Indian equity derivatives volumes to the highest in the world. According to recent data, the monthly turnover in the F&O segment reached ₹8,740 lakh crore in March 2024, a sharp increase from ₹217 lakh crore in March 2019.
Simultaneously, the average daily turnover in the equity cash segment was ₹1 lakh crore, while the F&O segment saw an average daily turnover of approximately ₹330 lakh crore.
RBI and SEBI raise concerns
Last week, Reserve Bank of India (RBI) Governor Shaktikanta Das expressed concerns about the widening gap between credit and deposit growth, noting a shift in household savings away from traditional deposit accounts.
Estimates suggest that a significant portion of stock market investments are now shifting towards derivative trading, raising alarms within the government.
At an asset management committee event last week, the SEBI Chairperson highlighted the substantial losses incurred by an increasing number of young investors involved in derivatives in recent years.
“It has now reached a scale where we believe that the micro-objective of protecting the individual investor has changed and morphed to thinking about the macro issue. Is this what our market is designed to do – facilitate a lot of speculative transactions?” she questioned.
From hedging tools to speculative investment
Derivatives were originally designed as hedging instruments to help investors minimize potential losses by entering into contracts such as futures and options. They were first introduced to protect farmers from crop losses and were later extended to stocks, currencies, and bonds.
However, derivatives are now widely used as speculative tools globally. Investors aim to generate substantial profits with a relatively small capital investment compared to stocks. This lower initial investment in futures and options has particularly attracted many young investors to trading.
Will there be a shift towards long-term investing?
Commenting on the recent developments, Vipul Bhowar, Senior Director, Listed Investments, Waterfield Advisors, said, “The decision to raise taxes comes amid a dramatic increase in derivative trading volumes, which have grown significantly since 2020.”
“Retail investor participation in the derivatives market has surged from 2% in 2018 to 41% in 2023. Regulators have expressed concerns that this surge in trading is leading to speculative behavior that could be detrimental to individual investors and the broader economy.”
Vipul Bhowar said that the change in tax policy should encourage retail investors to shift their focus from speculative trading to long-term investments. This shift could potentially reshape market dynamics in the near term, leading to a more stable and sustainable market environment.
“The government’s tax adjustments demonstrate a proactive approach to managing the risks associated with the rapid growth of retail participation in the derivatives market. The aim is to foster a more stable trading environment. The increase in taxes may have a significant impact on trading volumes, potentially affecting market liquidity and dynamics. High-frequency trading firms, which operate on narrow margins, are particularly sensitive to changes in transaction costs, and this sensitivity could lead to significant changes in the market landscape,” he noted.
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