CTT will lower trade volumes and distort price discovery, while not raising government revenues.

Some sections in the financial markets are urging the Government to levy a transaction tax (CTT) on commodity derivative trades. This is conceived on the lines of the security market transaction tax (STT), ostensibly for creating a level playing field; it is suspected that for want of CTT, stock investors have shifted their investment business to commodity derivatives.

The truth is actually otherwise. While commodity derivative volumes are declining, F&O segments of equities and their indices are witnessing vertical growth, despite STT.

Lack of liquidity

Commodity exchanges aid physical-market functionaries through the entire supply chain — from producers to processors and import-export traders — in both price discovery and price risk management.

Commodity derivative trading in both soft and hard commodities in India as yet lacks adequate liquidity in comparison with such trading in the US and China.

To develop liquidity, what’s immediately required are steps towards legalising options on commodity futures, allowing commodity index derivatives, and permitting the entry of banks to act as proxy hedgers for producers and physical-market functionaries, who pledge their commodities with banks.With the resultant reduction in price risks, banks can lend against commodities with lower margins and lesser interest rates to bring about orderly marketing of commodities.

Hedge transactions

Price discovery and price risk management functions of commodity derivatives tend to reduce not only marketing and processing margins in commodities, but also the seasonal bands in them.

Unlike stock exchanges, where investors seek to gain from price increases, physical-market functionaries in commodity exchanges seek to insure their physical trades from price fluctuations. For, commodity derivative markets discover prices in the sense that they provide “reference prices” to the physical-market players for their forward purchases and sales in both domestic and overseas markets, so that they can also hedge simultaneously such forward commitments at those discovered prices.

Such price discovery and the consequent risk management of forward physical market commitments at the discovered prices tend to improve the efficiency of hedging. More importantly, a commodity derivative market also has an in-built mechanism to stabilise spot prices.

As with any economic activity, the decision to trade in a commodity derivative depends on the cost-effectiveness of such a trade.

Besides brokerage, transaction charges, loss of interest on margin and security deposits, an important, and by far the largest, element of trading cost in a commodity derivative market is the difference between the bid and ask prices on its trading platform.

This difference is certainly related inversely to the trading volumes in commodity derivative contracts. Smaller the trade volumes, higher is such bid-ask price difference, and vice-versa.

Therefore, the cost of commodity trades increases with the fall in trade turnover, and vice-versa.

For want of hedging facility, market functionaries in the domestic physical trade, be they merchants, manufacturers, or processors, will necessarily seek to recover the costs of such risks, or risk premium, by either reducing prices that they pay to their suppliers, or raise the prices at which they sell to their consumers.

Consequently, the marketing and processing margins in commodity trade and industry will indeed increase to the detriment of both the producers and consumers of not only commodities, but also their products.

Speculation

Like hedging, speculation in a commodity derivative market is also a zero-sum game at the aggregate level, not at the individual level, though. For, a gain to one is necessarily a loss to someone else.

Most of the permanent speculators, who generate trading volumes in a commodity derivative market, are day traders such as jobbers, scalpers, swing traders, and so on. They trade on slender intra-day price fluctuations, intra-day price trends, or more particularly, on bid-ask price spreads, and close their positions at the end of the day.

Their trades account for a lion’s share in commodity derivative trade volume. They play a vital economic role in keeping the bid-ask price spreads low, reducing the transaction costs, thereby.

To keep transaction costs in such markets as low as possible, it is essential to ensure the presence of a large number of active day traders, so that increased competition among them will bring down the bid-ask spreads. As CTT will add to such costs it will surely act as a disaster for commodity derivative markets.

Worse still, with the disappearance of hedgers, and thin trading volumes, commodity exchanges may prove fertile ground for easy manipulations.

Furthermore, as volumes shrink, and incomes of all classes of commodity derivative players dwindle, revenues from income and other taxes to both the Centre and States are sure to reduce considerably, so as to far exceed the revenues that the Centre may hope to earn from CTT. In short, CTT will boomerang, with more loss in revenue than gain.

Non-farm commodities

Yet another absurd submission made by some is that even if derivatives in agricultural commodities were exempted from CTT, non-farm commodities, such as precious and non-ferrous metals, and energy products such as crude oil and natural gas deserve to be taxed, because they think that derivatives in these commodities neither discover prices nor need any risk management.

But such thought is, again, far from true. The fact that prices of these non-farm commodities at Multi Commodity Exchange of India (MCX) are highly correlated with those at New York Mercantile Exchange (NYMEX) and at London Metal Exchange (LME), does not mean that MCX does not help in their price discovery.

With India being the largest importer and consumer of gold, the second largest importer of crude oil, and one of the major importers of most non-ferrous metals, their prices at MCX necessarily influence materially the global prices at NYMEX and LME. As for risk management, jewellery trade in precious metals, metal merchants and SME manufacturers of metal products, and quite a few crude oil and natural gas distributing companies, hedge their physical market trades in the respective commodity futures contracts at MCX.

In fact, had the various nationalised oil, petroleum, and gas companies in India hedged their import commitments in crude oil and natural gas derivatives, these companies could have averted their losses on such imports.

Canons of taxation

Finally, CTT obviously does not satisfy the major acknowledged canons of taxation, such as ability to pay, equity, elasticity, and productivity.

Since CTT will render day trading uneconomical, the criteria of ability to pay and equity are evidently not fulfilled for these traders. Certainly, it cannot be the objective of the authorities to eliminate day traders, as they really facilitate both price discovery and risk management, with their willingness to absorb hedge transactions with small bid-ask spreads.

Since CTT will discourage the physical-market functionaries from hedging, the productivity function of the commodity derivative market is also lost.

In fact, even from the viewpoint of revenue generation, the net revenue effect will be negative, considering its adverse impact on income-tax collection from commodity traders, day traders, commodity exchanges, and millions of people dependent on thousands of commodity exchange terminals, whose incomes will inevitably fall.

In the larger interest of the economy, the government should desist from levying CTT.

(The author was with Forward Markets Commission for nine years.)

(This article was published on February 14, 2013)
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