Dealers said the sell-off was initially sparked by a slump in NSE index futures listed on the Singapore exchange, which are now trading at a discount to domestic NSE index futures.
The heavy selling in shares also hit bond markets, with the 10-year bond yield rising as much as 6 basis points to 7.92 per cent, the highest since December 29, 2014, according to Thomson Reuters data.
The sell-off signals the sudden bout of uncertainty gripping markets since April over the so-called minimum alternative tax (MAT) that is being demanded from some foreign investors.
After rallying since early 2014, both bonds and share indices have wiped out their 2015 gains.
"Nifty was already below 200-day average and today it also broke Tuesday's low which generated strong selling on algo platforms," said Nilesh Dedhia, founder of NTD Trading, which specialises in providing algorithm-based trading platforms.
The Sensex fell up to 2.6 per cent, marking its lowest intraday level since December 17, 2014, while the broader Nifty lost as much as 2.8 per cent marking its lowest intraday level since January 7.
Traders attributed the initial falls to heavy selling in Singapore which was later followed by over Rs 900 crore ($141.7 million) worth of Nifty May futures being sold in three minutes from 9.39 a.m.
That has sparked some heavy selling in domestic shares, especially by algorithmic trades, which accounts for a third of the total volume on cash shares and almost half of the volume in the derivatives segment, analysts said.
Bonds were also impacted in line with other global debt markets. The benchmark 10-year bond yield was up 4 basis points on the day at 7.89 per cent.
Uncertainty is expected to continue given lingering concerns over MAT. Overseas investors have offloaded shares worth a net of more than $1.7 billion in the last 13 sessions excluding the amount raised from Daiichi Sankyo's stake sale in Sun Pharmaceutical Industries.
Minister of State for Finance Jayant Sinha last month said notices had been issued in 68 cases, with a total tax demand of Rs 602 crore ($94.6 million). But Finance Minister Arun Jaitley has estimated claims could eventually stand at as much as Rs 40,000 crore.
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