Don't kill commodity derivatives

The proposed tax will drive up transaction costs to such levels that hedgers will move to overseas and other markets.

The previous fiscal year proved to be quite a contrast in some ways. While the year started with the banning of a few commodity futures contracts from the national bourses, it ended with the allowing of FDI/FII investment in the commodities sector and the amendment of the archaic Forward Contracts Regulation Act.

Proactive measures were also undertaken by the government to give autonomy to the Forward Markets Commission and to institutionalise the development of a market mechanism, support institutions, capacity building and the development of strong forward and backward linkages between markets, producers, traders and consumers.

The Union Budget for the financial year 2008-09 also commenced on the right spirit of focused social development. Emphasis has been laid on the development of education and health for delivering services at the rural areas, particularly to deprived classes and to make economic growth an all-inclusive process.

As expected, the agriculture sector attracted the most intense thrust along with a large debt relief package, that is, the single largest scheme-based expenditure announced by the finance minister in his budget. While this measure is good, we wish there was additional market-based and institutional intervention so as to provide the benefits to the farmers on a sustainable basis.

However, while bringing the commodity derivatives market into the tax net, the finance minister made three observations. The observations, which would be enacted from the new financial year are a hike in short-term capital gains, commodity transactions tax and non-availability of the benefit of treating profit or loss from futures as normal business income or loss.

Perhaps, the measures were taken to bring the commodity and securities markets at par. But we must understand that securities derivatives and commodity derivatives have different genes and perform different economic utility functions.

In India, the commodity derivatives market is at an embryonic stage. It has been operational on an institutional level for only five years now. We have restricted participation in the market and no participation at all from banks, mutual funds,
financial institutions and FIIs.

We have not introduced options contracts, index futures and futures based on intangibles. Therefore, the appropriate approach would be to let the market flourish, enabling all types of instruments and participants and then bring it under a higher tax regime. When the Securities Transaction Tax was imposed in the equity markets, it was already mature, all types of contracts were available on its platform and there was wider participation by various classes of investors.

Rationalisation measures such as increasing short-term capital gains tax from 10 per cent to 15 per cent will eventually make some risk management transactions costlier for groups of assets from which returns are already low in a differential interest rate and currency regime currently existing in India vis-à-vis global markets.

Particularly, the trading class in the commodity exchanges would find it less attractive to manage their risks through domestic comexes, especially at this stage of the market (compared to the large size of the physical market).

Again, commodity markets are global in nature and are comparable with currency markets, where transaction cost-sensitivity is severe. Considering this fact, a sudden increase in transaction cost will make commodity markets highly inefficient, dormant and illiquid.

For instance, gold, soya, crude oil, sugar, cotton and so on, are traded on various global exchanges. Any cost increase in India will induce hedgers to shift their hedging activity to overseas exchanges or parallel markets over which the government will have no control (which was the status before the ban was lifted in 2003).

Without liquidity, market prices can be influenced relatively easily with a single transaction, thus leaving it exposed to potential manipulation.

Further, without liquidity, market participants would not get an incentive to participate in the market. In such conditions, participants may have to accept highly unfavourable prices in order to take positions in the market.

Finally, liquidity is a prerequisite for effective hedging. Without liquidity, the futures prices of a commodity will not correlate with the underlying cash markets, and in these circumstances, hedging would become a futile and perhaps expensive waste of resources.

The impact of the CTT can be calculated per Rs 100,000 transaction as shown in Table 1.

An increase of cost from Rs 2.00 per lakh to Rs 19.25 per lakh implies an escalation of more than 800 per cent. The incident of higher transaction cost can be compared with other more mature markets.

In Table 2, a comparative analysis has been made indicating the transaction costs across various markets. It is evident from Table 2 that the cost of transaction will increase almost by 800 per cent.

Out of the total transaction cost, 85 per cent will be towards CTT and the balance will be towards exchange transaction fee, service tax, stamp duty, and so on. Indian exchanges will become costlier to participate and thus, will lose their global competitive edge.

This action of the government will create a regulatory arbitrage between national electronic commodity exchanges and regional ring-based exchanges, and may lead to under-reporting of transactions. The "futures" market has recently seen an increase in participation by corporates, who have seen a definite advantage in hedging their price risk in accordance with global best practices.

A move like this is going to see an exodus of the same corporates and, in its wake, would leave us with a structurally weak market system.

In a groundbreaking research, Euna Shim (2006) provides a thorough investigation of the conditions necessary for the success of derivatives exchanges across seven countries, her conclusions worth quoting here:

". macroeconomic stability and government regulations that are favourable to futures trading were almost prerequisites for successful local futures exchanges. Meeting these preconditions, a contract that is significantly different from existing ones or with a large basis risk backed by a large physical market was an essential element for a new exchange to attract a viable level of liquidity.

"Even with all these set and subset of conditions, a market could fail if well-developed financial intermediaries were not present. Financial intermediaries are the distribution channels of futures markets, and when these channels are blocked, the market extension was hard to accomplish..."

Considering the critical macroeconomic functions that commodity derivative exchanges play in terms of providing price signals for allocating resources efficiently and helping participants manage their risks, it is worrisome to note that unless reconsidered, the triple whammy of service tax, CTT and non-availability of the benefit of treating profit or loss from futures as normal business income or loss (as in the securities market), will make the exchanges unviable in terms of providing risk management and price discovery.

Before trying to regulate commodity derivatives markets, governments should realise the role such markets play in the transferring of price risk, and therefore, their developmental role in the economy.

The authors are with PricewaterhouseCoopers India. The views expressed are personal. They can be reached at chiragra.chakrabarty@in.pwc.com and ankan.mondal@in.pwc.com