L.C. Gupta
Naveen Jain

The high intra-day volatility exposes the hollowness of the claim, often made by the stock exchange administrations, that the "impact" cost of executing a fairly large-sized order is only around 0.1-0.2 per cent in India.

IN the recent Budget, the Finance Minister has proposed a transactions tax at 0.15 per cent and complete exemption of long-term capital gains on securities. The twin proposals have the potential of transforming the basic character of the Indian stock market.

Our market has been notorious as a "satta bazaar", prone to frequent crises, and characterised by high volatility and manipulative practices. The twin tax changes will make the Indian stock market a more sober place for long-term investors. It will also help to align share prices more closely with the fundamental long-term values and reduce the market's volatility.

"Day-trading" is over-whelming us: Our studies show that "day-trading" is estimated to be as high as 80-90 per cent of total trading volume in the case of both the cash market and the futures market. As a result, the percentage of delivery-based trading is only around 20 per cent of the total traded value even after the adoption of rolling settlement system.

The volume of day-trading has come to dominate the stock market in the same way as the erstwhile badla system in the olden days. This is because day-trading is free from the kind of salutary regulatory restrictions placed on it in the US in order to limit it severely and prevent its degeneration into gambling on a mass scale, based on intra-day price movements.

Because day-trading in India, is, more or less, free from regulation, day-trading "parlours" have proliferated not only in metros but also in a large number of small towns all over the country. Excessive short-term speculation has been the bane of the Indian stock market. In fact, speculative domination of the market has become more pronounced after the introduction of single stock futures. The total value of futures trading now exceeds that of cash market trading. The single stock futures are still not being settled by physical delivery, as they ought to be. A sound system of single stock futures (or any deliverable asset) requires settlement by delivery in order to maintain the market's link with the real economy. It may be mentioned here that the US introduced single stock futures in early 2003 and required settlement by physical delivery from the very first day of such trading.

Volatility and manipulation: Excessive short-term speculation always makes the market more volatile. Intra-day volatility in India, even in the case of blue chips, is frequently as high as 5-6 per cent. This makes non-sense of the argument, often advanced by brokers and market-operators, that increased liquidity arising from short-term speculative trading, promotes efficient pricing. Pricing is efficient only if it is linked closely to fundamental factors.

The high intra-day volatility exposes the hollowness of the claim, often made by the Indian stock exchange administrations, that the "impact" cost of executing a fairly large-sized order is only around 0.1-0.2 per cent in India. What solace can such low impact cost provide to the genuine investors who may often find that, at the end of the day, they have lost 5-6 per cent of the value of stocks purchased by them during the day?

The preliminary results of an all-India Household Investor Survey-2004, being conducted by us, reveal that the two most important worries of retail investors about the stock market are - too much volatility and too much price manipulation. Both these are facilitated and aggravated by excessive short-term speculation.

Akin to "Tobin Tax": The transactions tax proposal on securities is somewhat similar to a proposal made about 30 years ago by Nobel Laureate James Tobin for a tax on foreign exchange transactions in order to deter short-term currency speculation. While it was generally regarded as desirable in terms of the objective to be achieved, it was not found to be feasible because of implementation problems. It needed a lot of international cooperation. It could be easily avoided due to the existence of tax havens.

In contrast, the transactions tax proposal on listed securities is desirable from every viewpoint (including revenue consideration and market reform) and it is feasible too.

A suggestion: A slight change which may be worth considering is to fix a lower rate of transactions tax in the case of debt securities because our debt market is still to be developed and the profit margins on debt trading are much lower compared to equity trading. At the same time, we do not recommend any concessions to mutual funds in regard to transactions tax because portfolio churning needs to be restricted so that mutual fund managers be guided more by long-term fundamental factors rather than working like market operators.

Dr. L. C. Gupta is Director, Society for Capital Market Research & Development, Delhi, and former Member of SEBI, and Mr. Naveen Jain is Reader in Commerce, Hans Raj College, University of Delhi.

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