We were surprised by the editorial ‘Transaction costs: If the securities transaction tax must stay, it needs to be more broad-based’ (IE, February 25). The editorial advocates that the transaction tax levied on securities needs to be extended to commodities and, to an extent, to currencies , to reduce not only the fiscal deficit, but also the alleged distortions in the economy. The truth is that price discovery takes place not so much in equity derivatives as in commodity derivatives. Equity derivative trading is mostly confined to options in equity indices. The so-called price discovery in these index options is of little use for price risk management to institutional investors, who trade in them. Price discovery in commodity derivatives is vital for effective price risk management in that prices quoted for derivative contracts serve as the base (reference) prices for forward physical purchases and sales in both domestic and overseas markets, and are also the prices at which such purchases and sales can be hedged. Such hedges are absolutely efficient.
The commodity transaction tax (CTT) will drive away day traders, who account for the bulk of the trade volumes in commodity derivatives. They assist in efficient hedging by physical-market functionaries, since they are not only willing to absorb hedges at the prevailing futures prices, but also ensure low bid-ask price spreads, which constitutes an important element of transaction costs for hedging costs. As day traders operate on thin margins, CTT will render their trades uneconomical. They will desert the commodity markets. In their absence, the bid-ask spreads will rise, making hedging of all hues far from cost-effective. Physical-market players will then have little option but to recover the cost of their price risks (risk premium) by paying a lower price to the producer, and charging a higher price from the consumer, leading to higher marketing and processing margins, which, when spread to the entire supply chain, will have a cascading effect on the prevailing inflation in the economy.
Incidentally, the imposition of CTT on gold will make the market, bereft of low-cost risk management for a large number of