Transaction costs have long been the subject of rigorous scrutiny, particularly by FPIs, who have historically lamented the high cost of entering and operating in Indian markets. These costs are multifaceted, often categorized as one-time fees for setup and registration, assets-under-custody (AuC)-based charges and transaction-based fees. However, lurking beneath these enumerated fees is a less transparent cost known as ‘float’.
The hidden cost
Banks earn a net interest margin by lending money deposited by investors in current, savings and fixed deposit accounts. However, when these funds are idle, typically due to procedural constraints, and cannot earn any interest, the benefit accruing to the bank is called float income.
This cost is elusive, often escaping the transparency expected in fee structures. The root causes of float are diverse, ranging from regulatory constraints, such as the prohibition on interest for current accounts, to procedural inefficiencies that decelerate the transfer of funds. Float, therefore, has thrived in a domain where sluggishness and opacity are inadvertently incentivized.
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History of float in India
India’s financial market has evolved from ambiguous settlement dates to highly efficient T+0 (same-day) settlements. However, this has not been accompanied by a reduction in the float.
From the pre-clearing corporation era, which saw significant float due to DVP/RVP (delivery versus payment/receive versus payment) settlements, to partial standardization with the emergence of the Clearing Corporation and STP Gate, the float has remained present at varying degrees despite advances in the market, including the Reserve Bank of India’s emphasis on custodians recognizing trade confirmation risks.
On the buy side, this has moved in tandem with the shortening of the trade cycle, but it has unfortunately persisted on the sell side.
The sell-side dilemma
Sell-side float is particularly problematic because of the intricate web of tax liabilities and regulations that dictate the flow of funds from a foreign investor’s account. Key among these is the requirement to appoint a tax representative, a complex necessity given India’s intricate tax laws and the enduring liability even after an investor exits the market.
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Additionally, tax regulations necessitate the deduction of tax before any remittance, which requires a handoff between custodians and tax consultants. This is the primary reason why the sell-side float has remained stubbornly immune to efficiency improvements. In the developing T+0 cycle, the tax liability crystallization is further delayed, occurring only after the sale transaction contract note is issued, effectively sustaining the sell-side float.
Envisioning a solution
It’s important to note that there are other developing markets in Asia (such as Indonesia) where the onus of tax computation lies on the custodians, and the same set of banks do this willingly. But as they say, turkeys don’t vote for Christmas. The path forward lies outside the current frameworks and conventional thinking.
Capital gains on equity is a simple calculation based on the tenure of holding, the purchase price and the amount sold, using the first-in-first-out (FIFO) method. FPI holdings are bought and sold in demat form, so a simple solution would be to allow Securities and Exchange Board of India-registered depositories to issue certificates that could be recognized by the authorized dealer banks for remittances, eliminating the need for a separate certificate from a tax consultant. After all, depositories have robust, regulated IT platforms. This reform could be integrated into the upcoming money bill for a timely, reliable and efficient solution.
The two depositories in India boast advanced technology, making generating capital gains tax liability a trivial concern. This change would not only streamline processes but also lower transaction costs, since obtaining tax certificates is costly.
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Yes, there are further nuances for those availing of benefits under specific tax treaties, clubbing multiple transactions, and in the realm of debt, so sceptics will point out the partial nature of this solution. But to start with, let’s follow the KISS principle—keep it simple and straight—and deliver the cost benefits to the bulk of FPIs.
There is ample collateral upside to T+0. Eliminating the hidden cost of float could make investing in India more economical and allow service providers to reprice at an accurate market value, absent any covert subsidy.
The T+0 revolution has the potential to be transformative, marking not just a numerical shift but a paradigm shift in trading. It’s a unique, once-in-a-lifetime opportunity, and the time to act is now.
Mrugank Paranjape is a managing partner at MCQube, and an independent non-executive director at SBI and Oracle Financial Services Software Ltd.