Every year when the Finance Minister rises to read the Union Budget statement, most members of the stock trading fraternity would be found fervently praying that the word STT or securities transaction tax does not feature in the document.

Even the slightest tweak to this tax tends to send a wave of panic through dealing rooms, making stock prices tumble.

While there is no denying that important changes impacting investors and traders such as the hike in STT should have been part of the Budget announcement and debated and discussed in Parliament before being passed, the insertion of the STT change as an amendment in the Finance Bill has prevented unnecessary volatility on the Budget day.

Initial reaction to the hike (STT on futures transactions increased by 25 per cent to ₹1,250 per ₹1 crore of turnover and on sale of option contracts by 23.52 per cent to ₹2,100 per ₹1 crore of turnover) was adverse with expectations that volumes will plunge and traders’ margins will be severely reduced. But a closer look reveals that the impact on traders and trading volume may not be too material. On the other hand, there are many positive ramifications from this change.

Negligible impact on trading

Though there was a small wobble last week when the STT hike was revealed, the Indian stock markets have been quite sanguine in the following sessions. Typically, stock market tends to sell-off sharply on such news in a bid to make the government retract the move.

The reaction this time seems to imply that the impact of this change may not be too material.

That could be due to the reason that the hike will not hurt options traders much. This is because the calculation for STT, while selling options, takes in to account the premium turnover. If the premium turnover while selling an option is ₹1 lakh, the STT would be just ₹21. This will not reduce the profitability of the trader much.

Profit margins of traders of stock futures will be impacted by this hike, but that will not dent volumes much. Stock options are the more popular since they need lower capital and entail lower risk. Trading in stock options accounted for 99 per cent of stock derivative trading on the NSE in 2022-23.

Also, no change has been made to the STT on cash-based trades or on mutual funds, which means that investors will not be impacted in any way.

Benefits galore

With futures becoming less attractive, traders are likely to shift from futures to options. That is not a bad thing since futures are more risky with potential to erode the entire trading capital; trading loss is limited to the premium in options. The share of individual traders in futures has anyway been declining, from 43 per cent in FY19 to 11 per cent in FY22, as per SEBI.

The stock market regulator has been trying to dissuade individual investors from futures segment and this STT hike may help in that direction.

Another segment which would be adversely impacted by this move would be high frequency automated trades. Since these are machine generated trades being executed at high-speed, the margins are wafer thin and could be hurt by the increase in transaction cost.

But again, some reduction in HFT may be good for the market since these trades tend to crowd out genuine traders and inundate the trading system with orders.

Curbing speculation

The Centre could also be trying to check the rampant speculation in equity derivatives through this move. According to SEBI, number of individual traders has increased over 500 per cent between FY19 and FY22. With the lock-down during the pandemic shifting many to day trading, many new investors have begun dabbling in equity derivatives. But most of them are not really making any money.

SEBI found that 9 out of 10 individual traders in equity derivatives incurred losses, with average loss of ₹1.1 lakh in FY22.

Such unproductive deployment of human capital is not good for the economy and needs to be discouraged.

Also, trading turnover in equity derivatives has been growing by leaps and bounds with the number of contracts traded more than doubling every year since FY20. While the STT hike may not dampen this trading fervour, some moderation would be welcome for the long-term health of the market.

It’s doubtful if the intention behind this move was to generate more money for the Centre. STT collections are estimated to be ₹27,625 crore for FY24, just 10 per cent higher than the revised estimate for FY23. This hike is clearly not going to reap a bonanza for the Centre as the number of new investors coming into the market has plateaued in recent months. The hike can, in fact, reduce high frequency trades and future trades. This can result in loss of revenue for the Centre.

But the increase will act as a statement of intent from the Centre that it is keeping watch on the heightened speculative activity in equity derivatives.

As far as the larger question on the need for STT goes, the consensus is shifting towards imposing such taxes. While transaction taxes are not equitable since they are also levied on loss making trades and are not linked to the return earned by the investor, they are easy to collect and hard to evade.

Many countries are therefore moving towards imposing transaction tax on stock trading to curb volatility and high frequency trades. The EU has put forth a proposal for a financial transaction tax where “each participating Member State will be allowed to set their respective rates above the given minimum of 0.1% for equities and bonds, and 0.01% on derivatives.”

Going forward, we could see regulators relying more on this tool to contain volatility in stock trades