Budget 2024: A tax leash on F&O coming up tomorrow? Dalal Street in tense huddle

As the Union Budget 2024 approaches, Dalal Street is gripped with anxiety over potential new regulations that could impact the equity and derivatives markets. Finance Minister Nirmala Sitharaman's budget announcement on July 23 is anticipated to include measures aimed at curbing speculative activities, particularly in the derivatives market.

Speculation suggests possible increases in taxes on short-term gains and heightened scrutiny in areas of unchecked growth. Despite some believing that the government, constrained by a reduced mandate from recent elections, may avoid drastic changes, the tension remains palpable. Jefferies' global equity strategist Chris Wood has noted a reduction in fears of a capital gains tax hike, bringing some relief to market nerves.

Regulatory risks have become a significant concern for investors and equity strategists. The possibility of regulatory actions to moderate market activity is a hot topic, with the government yet to signal any immediate clampdown. However, recent comments from financial regulators have fueled speculation. SEBI chief Madhabi Puri Buch's remarks on the surge in futures and options (F&O) volumes and RBI Governor Shaktikanta Das's warnings about structural liquidity issues have sparked debates about potential government intervention.

SEBI is already taking steps to streamline F&O contracts to slow down speculative trading. Market participants fear the government might take further action to temper market fervor. Historical precedents, such as the 2018 reintroduction of taxes on long-term capital gains that triggered a prolonged slide in mid-cap and small-cap stocks, add to these concerns.

The increase in F&O trading volumes has been dramatic. SEBI data shows a fourfold increase in F&O turnover and a fivefold surge in the number of contracts traded from May 2022 to May 2024. While retail investors often face losses, proprietary and high-frequency traders tend to profit, prompting SEBI to reconsider the role of derivatives trading in the market.

To address these concerns, SEBI has formed a working group under former RBI executive director G Padmanabhan to study the derivatives market and recommend risk management measures. The group is expected to present an interim report soon, which might include raising the minimum value of F&O contracts and increasing margin requirements for investors.

As market participants brace for the budget, the potential for regulatory changes looms large. Whether the government decides to act on these concerns or maintain the status quo will significantly impact the financial landscape. A relief rally in equities could follow if the current capital markets tax structure remains unchanged, but the specter of regulatory risk continues to weigh on investors' minds.

The Economic Survey has expressed strong concerns over the rising participation of retail investors in the F&O market, using the harshest words yet by a government agency. It warns that speculative trading has "no place in a developing country" like India and that a potential market downturn could deter investors from returning to capital markets for a long time, which could be detrimental to the entire economy.

The survey highlights that derivatives trading, with its allure of quick profits, often appeals to the human instinct for gambling, driving significant retail participation. However, the reality is starkly different, with most retail investors facing losses. This underscores the importance of raising investor awareness and continuous financial education to warn them of the low or negative expected returns from derivatives trading.

The risks associated with derivatives trading are not merely theoretical. A significant stock market correction can lead to substantial losses, particularly for retail investors engaged in derivatives. These losses could provoke a strong negative behavioral response, with investors feeling "cheated by unseen more considerable forces."

The Economic Survey also provides a broader context for understanding the potential pitfalls of rapid financialization, pointing to historical precedents like the 2008 global financial crisis and the 1997-98 Asian financial crisis. These examples illustrate the dangers when financial market innovations and growth outpace economic growth.

For India, the survey advocates for a cautious approach, emphasizing the need for an orderly and gradual evolution of the financial market to avoid the destabilizing effects seen in other economies. It calls on all stakeholders, including market participants, market infrastructure institutions, regulators, and the government, to ensure that capital markets fulfill their fundamental role of directing savings to productive investments.