Big Picture. How a widening scope of CTT will impact the commodities market

In Budget 2020-21, the demand for abolition of financial transaction taxes — the Commodities Transaction Tax (CTT) in commodities market and the Securities Transaction Tax (STT) in securities market — went unaddressed.

While the STT has been in effect since 2004, the CTT was first proposed in 2008-09 at a rate of 0.017 per cent for transactions in non-agricultural commodity derivatives. But it was not implemented in view of stiff opposition from stakeholders who cited that the commodities market in India was in a nascent stage. However, it was reintroduced in the Finance Act, 2013, and became effective on July 1, 2013. Agricultural commodities continue to be exempted and so are the transactions carried out at the International Financial Centre (IFC).

Trading volumes

Trading volume at the Multi Commodity Exchange (MCX) significantly dropped after the CTT was introduced. Data show that traded value of derivatives slumped from ₹148.9-lakh crore in 2012 to ₹51.3-lakh crore in 2017.

But an uptick in traded value can be seen in the past couple of years. In 2019, traded value at the MCX stood at ₹79.1-lakh crore.

“CTT is the biggest cost for the commodity trader today. While trading volume fell significantly because of the introduction of CTT, the market seems to have adjusted to it. In the last one year, trading volumes have picked up because of the volatility in the market,” says Nithin Kamath, CEO and co-founder of Zerodha, a discount brokerage.

Existing mechanism

For a transaction in futures contract of a commodity, the seller of the contract will pay CTT on the price at which the contract is being traded. For instance, a seller of gold futures contract will pay 0.01 per cent of the total traded value.

If the contract is traded at ₹40,000, the traded value will be ₹40 lakh (lot size of gold derivatives is 1 kg and price quoted is per 10 grams). Here, the seller’s liability will be ₹400.

Similarly, a seller of an option contract (where the underlying is the futures contract) will pay CTT, but 0.05 per cent on the option premium. Assuming that a call options contract of gold with strike-price as 42,000 is traded at ₹150, the traded value will be ₹15,000. Here, the seller’s liability will be ₹7.5.

If the above option is exercised, the buyer, too, will be liable to pay a CTT of 0.0001 per cent of the value based on the settlement price, ie, the closing price of the futures contract on the day when the option expires.

Suppose the settlement price is ₹45,000, the value will be ₹45 lakh. Here, the option buyer’s liability will be ₹4.5.

Moreover, on exercising, the option contract will devolve into a futures contract where the option buyer will have futures long position and the option seller will have futures short position.

This futures contract will attract CTT as well, payable by the seller. The charge will be 0.01 per cent of the value based on the settlement price. Suppose the settlement price is ₹45,000, the value will be ₹45 lakh. Here, the seller’s liability will be ₹450.

Recent inclusions

In the Finance Bill 2020, in addition to the existing transaction types and rates, it was proposed to levy CTT on sale of index futures and on sale of options in goods (where the underlying is the actual commodity),effective from April 1, 2020. Since only the underlying varies in comparison to the existing derivatives contracts, the computation of CTT will be on the same lines.

An exception can be energy commodities, as their derivatives are cash-settled. Thus, it can be taxed at 0.125 per cent on the difference between the settlement price and the strike price, as per the new proposal.

Participants’ perspective

The inclusion of derivative contracts on indices and option in goods provides more choice for participants. The futures on indices enable participants to take exposure on the overall commodity market, and it can be highly liquid.

On the other hand, comparing option in goods and option in commodity futures, the latter can be a better choice, especially for commodities that are less liquid. When the holder of in-the-money option is unable to liquidate on the expiry day, the option in commodity futures will devolve into futures contract.

But in the case of option in goods, this can result in compulsory delivery which leads to huge cash outflow, whereas futures position can be held with far lesser margin.

SEBI is mulling raising margin requirements for commodity futures. If margins go up, the case for options will get stronger.

One, for lesser initial margin and two, lower outflow as CTT.

“Increase in margin requirements for futures contract along with CTT can move businesses to options contract,” says Kamath.

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