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Arbitrage Margins Compressed by New Tax Rates
The Securities Transaction Tax (STT) changes, implemented on April 1, 2026, have significantly altered high-frequency trading economics in India. Taxes on futures rose from 0.02% to 0.05%, and option premiums from 0.10% to 0.15%. This substantial increase has forced proprietary trading desks, which rely on tiny price differences, to reduce their activity. Data shows proprietary desk turnover in equity futures fell to 28.3% in April from 32.7% in March, as the higher tax made many automated arbitrage strategies unprofitable.
Shifting Market Participation
While proprietary trading has decreased, other market players are stepping in. Foreign portfolio investors (FPIs) increased their share in equity futures to a record 30.8% in April. This is notable because FPIs have been selling cash equities throughout 2026. Their interest in futures suggests a focus on hedging and tactical plays rather than long-term equity investments. Meanwhile, trading volume has shifted towards equity options as index turnover declined. This indicates a move by traders to find opportunities in individual stock contracts, potentially avoiding the higher taxes on index derivatives.
Risk of Illiquidity Amidst Speculation Crackdown
Regulators aimed to curb speculation and reduce individual trading losses with the STT adjustment. However, this move risks creating market illiquidity. Arbitrage funds, which are key providers of market liquidity, now face an annual return reduction of 30 to 50 basis points. By trying to limit retail option trading losses, the government may inadvertently widen the gap between buying and selling prices. This could make the market more expensive for all investors, including those the policy intended to protect. The reduced activity of liquidity providers could also worsen price swings during times of market stress.
Higher Costs Expected Ahead
Market participants should anticipate higher operating costs for the rest of the fiscal year. The era of high-volume, low-cost trading is likely over. Trading desks must either adapt to strategies with lower turnover or accept reduced profit margins. While exchanges still see significant premium turnover, overall activity may remain subdued. Traders are adjusting to a new reality of higher breakeven points, which could limit the speculative trading seen in recent years.