Arbitrage, often called a free lunch in the financial world, is likely to become less attractive in Indian markets as the proposed commodities transaction tax (CTT) in non-farm derivatives is expected to dent profits.
Though a proposed reduction in securities transaction tax (STT) in equity futures could divert arbitrage trades from commodities, high-frequency trading systems that are quicker than human beings in spotting such opportunities have seen several small-to-medium brokerages shutting their arbitrage trading desks, according to a report.

Arbitrage opportunities arise from minor pricing discrepancies between markets or related instruments. For instance, if a stock is trading higher by Rs.2 in exchange A than it is on exchange B, a quick trade can be executed by buying it from the latter and selling on the former, pocketing the difference. Such trades are generally done in huge quantities to maximize profits as the per-unit price difference is too small.

Similarly, if a stock is quoting at different prices in the same exchange in its cash and derivatives segments, money can be made from the spread or difference through a quick trade. However, since the price difference is generally small, higher transaction costs eat into the potential profits, making the practice less attractive.

“The imposition of the CTT could impact the gross returns of the arbitrageurs by 20-30% and, consequently, significantly impede the growth of the segment, at least over the short term,” credit rating company ICRA Ltd said in a report on Indian brokerage industry.

In India, non-agricultural commodities dominate trading volumes with precious metals, base metals and crude forming the majority.

Among these asset classes, during the first nine months of the current fiscal year, precious metals such as gold and silver contributed nearly 46% to the overall value traded in the commodities market on exchanges. This is followed by energy products (22%). During the same period, farm products contributed to 13% of the overall trade value.

While the imposition of CTT on non-farm products would mean added tax revenue to the government, it could also result in volumes shifting to low-cost agricultural futures, often blamed by opposition parties for high food inflation, a core concern of the United Progressive Alliance government. However, experts think the finance minister has done the right thing by not taxing farm futures.

“Volumes can shift to non-farm products as the cost is lower there. The Indian government has the habit of banning agri futures every time there are allegations that futures trading has led to price rises. But until there is solid evidence of a well-orchestrated market bubble because of futures trading, those allegations fail to convince me,” said Rajesh Chakrabarti, executive director at the Bharti Institute of Public Policy at the Indian School of Business in Hyderabad.

Arbitrage opportunities will come down in commodities as a result of increased costs and that could hit traded volumes, Chakrabarti said.

“There is no doubt arbitraguers will lose out on opportunities. Commodity exchanges are nervous. In the past, mere rumours of CTT introduction has seen volumes plummet,” he said.

Though the finance minister in his budget speech proposed to lower STT in equity futures from 0.17% to 0.01%, growing presence of high frequency trading systems has seen big firms pocketing such free-lunch opportunities ahead of medium-to-small brokerages and retail traders.

“Increasing penetration of high frequency trading has led many medium-to-small sized broking houses to close arbitrage trading operations… The mediocrity of the recent performance in proprietary arbitrage trading is in part the result of massive growth (of high-frequency trading systems). Whereas in the past it was plausible for smart managers to spot market anomalies, several hundred managers in a large industry would be unlikely to earn spectacular returns,” the rating agency said.

Smaller retail brokers continued to close down equity markets proprietary arbitrage operations as increased penetration of algorithmic trading have thinned the spreads and made operations unviable, it added.
Market experts say that the introduction of CTT could see volumes shifting from commodities markets to equities, where STT has been lowered.

“Transaction costs will go up with CTT, margins will be impacted and volumes could shift to equities. In fact, because of CTT, business of commodities could go out of India altogether,” said V.K. Sharma, head, private broking and wealth management, HDFC