India’s Markets Should Make Ownership Cheaper Than Speculation

There is a curious imbalance in India’s capital markets. The country has built one of the world’s largest equity derivatives markets, yet its underlying cash market remains surprisingly shallow beyond a relatively small universe of stocks. More troublingly, the tax system can make it cheaper to speculate than to own.

Consider the Securities Transaction Tax.

A delivery-based equity investor pays STT of 0.1% on purchase and another 0.1% on sale. An intraday equity trader pays 0.025% on the sell side. A futures contract attracts STT of just 0.02% on the sell side, while options are taxed at 0.1% only on the premium—not on the value of the underlying shares.

Because the option premium is only a fraction of a contract’s notional value, leveraged exposure can carry a far lower effective tax burden than buying shares outright.

The policy signal is perverse: leverage is relatively inexpensive, while ownership is comparatively costly.

India now accounts for an overwhelming share of global listed equity derivatives trading by contract volume. Weekly options have become a phenomenon in themselves. Meanwhile, cash-market liquidity remains concentrated in a limited number of stocks. Beyond the large-cap universe, trading volumes fall, bid-ask spreads widen, and institutional investors often struggle to execute sizeable transactions without moving prices.

A market can therefore appear extraordinarily active at the derivatives level while remaining thin where ownership of the underlying companies actually changes hands.

This divergence should concern regulators, not because derivatives are undesirable, but because a healthy derivatives market ultimately depends on a healthy underlying market.

Every futures contract and every option derive their value from an underlying security. Efficient hedging, reliable price discovery and orderly settlement all assume that the cash market is sufficiently liquid. When it lacks depth, hedging and arbitrage flows generated in the derivatives market can exert disproportionate influence on cash prices.

Prices may converge at expiry, but during much of a contract’s life, they risk being driven more by leveraged trading flows than by transactions in the underlying asset. The tail begins to wag the dog.

In engineering, no structure can remain stronger than its foundation. Financial markets are no different. The cash market is the foundation; derivatives are the superstructure. Strengthening the upper floors while neglecting the base eventually makes the entire structure less resilient.

This is not merely an academic concern.

Indian mutual funds continue to receive large and regular inflows from retail investors. As they accumulate larger stakes in listed companies, the proportion of shares actively available for trading can decline, particularly outside the largest and most widely held stocks. Unless participation from pension funds, insurance companies and other long-term domestic institutions broadens alongside these inflows, liquidity is likely to become more concentrated rather than more widely distributed.

The market may look busy because derivatives volumes are soaring, even as the underlying cash market becomes progressively less resilient.

None of this diminishes the importance of derivatives. Futures and options are indispensable for hedging risk, facilitating arbitrage and improving market efficiency. Modern financial markets cannot function effectively without them. Speculators, too, perform a legitimate role by assuming risk and supplying liquidity.

But tax policy should not distort the balance between the underlying market and the derivatives built upon it.

A sensible reform would begin by reducing STT on delivery-based equity transactions. Lower transaction costs would encourage greater participation in the cash market, improve liquidity, narrow bid-ask spreads and make portfolio rebalancing less expensive for long-term investors.

Conversely, STT could be increased selectively on products where speculative activity is most intense, particularly ultra-short-expiry options. Such an increase should be calibrated rather than punitive and designed to avoid burdening longer-dated contracts used for genuine risk management.

The aim would not be to eliminate speculation—nor should it be. It would be to ensure that taxation does not unintentionally favour leveraged, short-term trading over direct ownership.

The objective is not to punish derivatives. It is to restore equilibrium.

Markets are ecosystems, and every ecosystem depends on balance. When one segment grows disproportionately because policy makes it artificially attractive, stresses inevitably emerge elsewhere. A derivatives market many times larger than its underlying cash market is sustainable only if the underlying market continues to deepen alongside it.

India has every reason to celebrate the sophistication of its exchanges, the speed of settlement and the democratisation of investing. Yet policymakers should not confuse trading activity with market quality. A billion derivatives contracts cannot compensate for a shallow underlying market.

The next phase of market reform should therefore ask a simple question: should public policy strengthen the market’s foundation, or continue rewarding its fastest-growing superstructure?

The answer will determine not only how much India trades, but how well its capital markets function.