The Cost of Trading

Anytime we go to a market to buy or sell securities (whether shares or debentures), we suffer certain costs such as brokerage fees, stamp duty, etc. Economists call these costs transactions costs.

Transactions costs are like a tax, on trading. Every time you trade, whether you earn profits or not, you pay these transactions costs. If you have a forecast that a certain price is going to go up, then you suffer transactions costs twice: once on entry, and once on exit. For trading to be profitable, the price change that you forecast has to be larger than this "round-trip transactions cost".

There are five parts to transactions costs:

  1. The first is brokerage, the commission you pay the broker.
  2. The second is "market impact". The buy price will always be a bit high, and the sell price will always be a bit low. E.g. if a security trades at Rs.200 or so, then if the buy price turns out to be Rs.204, then we say that the impact cost is 2%.
  3. The third cost is "counterparty risk". This is the risk that your counterparty reneges on the deal. This can happen at the level of one broker, or sometimes an entire exchange can collapse in a payments crisis.
  4. The fourth cost is the paperwork involved in signing transfer form, courier, etc.
  5. Finally, the fifth cost is the risk of stolen or counterfeit certificates.

As we have all seen in India in the last few years, some of the costs of trading have come down sharply. Earlier, gala was routine -- today, with contract notes on the NSE, it is non-existent. Similarly, brokerage fees have come down sharply.

The third element (counterparty risk) is hard to quantify. As of the middle of 1993, the remaining costs added up to roughly 5%. This was an extremely large number. To buy Rs.100,000 of shares, you would normally suffer Rs.5000 of transactions costs, plus some counterparty risk. In speculation, if you forecasted that a price would go up, then it would have to go up by atleast 10% for your transactions to be profitable (you used to lose 5% on entry, and 5% on exit).

As of today, these costs have come down to roughly 2.5%. Counterparty risk has been eliminated on NSE since the clearing corporation gives a guarantee on every trade (if your counterparty defaults, then the clearing corporation steps in and fulfils his obligations). Brokerage fees have come down, impact cost has come down, but the risk of stolen or counterfeit certificates has actually doubled.

What does the future hold? Once the depository comes in, the paperwork costs will collapse. The risk of stolen or forged certificates will vanish. Once a few thousand more VSATs get installed around the country, impact cost and brokerage fees will drop further. In all, within around 1.5 to 2.5 years, the total trading cost will drop to 0.5% or so.

This is a huge change in India's financial markets: from 5% in the middle of 1993, to 2.5% today, to 0.5% around 2 years from now. What effects will this have upon the market?

One effect is simple and direct. When trading becomes cheaper, people will trade more. As of today, the combined trading volume on BSE and NSE often hits Rs.2000 crore or so -- such volumes were unheard of in 1993. Further, when we look at the trading side, transactions costs have come down sharply (brokerage and impact cost), but post-trade costs have actually worsened because of stolen or forged certificates. This helps explain why we see so little trading that is willing to go to delivery. The five-fold reduction that we are forecasting for the future will generate a further huge increase in trading volumes.

Another implication is that forecasting prices will become harder than it is today. Today, if you have some information or research which forecasts a small movement in prices, you will not bother to trade on it since you know that you lose 2.5% on entry and 2.5% on exit -- a forecasted price movement has to be atleast 5% before you will bother to exploit it. When trading costs go to 0.5%, the forecasted movement has to be only 1% in order for you to exploit it. A lot more people will bring their information and analysis into the market, and thus make market prices more tied to fundamental value than is the case today.

Economists say that markets are "efficient" when prices reflect all information and nothing but information, and we strongly feel that the ultimate objective in a well-functioning market is a high degree of market efficiency. The reduction in trading costs today as compared with mid-1993 has improved market efficiency, and the further five-fold reduction in the future will improve market efficiency further.

Markets ultimately are the new planning commission in the country in the sense that they allocate money between projects, management teams, and industries. With better market efficiency, markets will do this job better, and thus enhance the growth of the country. That is the ultimate reason why reducing transactions costs is of such high importance.

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