Transaction cost for a market is important for several reasons. It is a key parameter to measure the impact of modernization of market infrastructure, institutionalization of the market and market regulation. Transaction costs can be classified into two categories viz.,
- Explicit costs are observable and measurable. They can be easily measured and are directly borne by the investors. These costs include:
- Brokerage commission Stamp duty
- Service tax Custody charges
- Regulatory charges etc.
Some of these charges, such as stamp duty and service tax are also levied in few other markets also.
- The Implicit costs include:
- Bid-ask spreads
- Realised spreads
Opportunity cost of delayed execution (timing costs) or non-execution.
Like implicit costs, certain additional explicit costs also arise from the nature of the trading and settlement systems, existence of physical paper and the registration process. The transaction costs are influenced by the following important factors:
- Trading, Clearance and Settlement
- Systems Physical and
- Dematerialised Shares Investor
- Profile
- After- Trade Practices Margins
- Rolling Settlement
In the Indian capital market, transaction costs in respect of most of the components especially brokerage, are charges as a “percentage of the value of trade” (ad valorem) as is the practice in several other markets, viz. Hong Kong, Australia, Singapore, UK and not on “per transaction “basis as in the US markets. Both principles of charging are valid and have their own logic and merit.
The components of explicit transaction costs for institutional investors include brokerage, stamp duty, safe keeping which includes custody charges for physical stock and charges for dematerialization. Each of these components vary depending on whether:
- The stock which is traded is in compulsory dematerialization list, which implies that trading and safe keeping have necessarily to be in the dematerialized form or,
- The stock which is traded is in the physical segment, in which case both trading/delivery will be in physical form while safe keeping may be in the physical or dematerialized form or,
- The existing stock has not been fully dematerialized and hence is still being held in the physical form..
The transaction cost is different for each of the above situations. Variations on account of squaring off or carry forward of transactions do not occur for institutional investors as they have to operate on delivery basis.
Financial intermediaries make profits by reducing transactions costs (search costs).
Debt Transaction Costs
The issuance of bonds and the use of other debt instruments usually carry a cost for listing the security in capital markets. For small businesses, the process of obtaining financing, such as hard money loans, may also require upfront costs and origination fees. These fees impact the decision on whether to obtain debt financing instead of equity financing. With debt obligations, however, ownership interests are not diluted or sold to obtain financing. Avoiding that requirement can be beneficial, especially for small companies.
Equity Transaction Costs
Traditionally, raising equity financing in the capital markets has been more costly than raising debt financing. Companies require large issuers to meet strict requirements for listing securities on national exchanges. For small companies whose shares are not publicly traded, transaction costs may end up being less. However, they still face the costs of updating financial records, operating agreements and other documentation for the addition of new owners.
