Market friction

What Is Market Friction?

Market friction refers to any cost or impediment that hinders the smooth and efficient operation of financial markets. These impediments can be explicit, such as brokerage fees and taxes, or implicit, like the bid-ask spread and information asymmetry. In the broader field of financial markets and economics, market friction accounts for the real-world costs and complexities that theoretical models often simplify or ignore, departing from the concept of a frictionless market. It impacts aspects such as price discovery and the ease with which assets can be bought and sold.

History and Origin

The concept of market friction, while not having a single point of origin, gained significant prominence as financial markets evolved from open outcry systems to electronic trading platforms. Early economic models often assumed "frictionless" markets to simplify analysis, where trades could be executed instantly and without cost. However, real-world events consistently demonstrated that such assumptions were impractical.

The recognition of market imperfections and their macroeconomic consequences has been a subject of ongoing discussion among economists. For instance, the Federal Reserve Bank of San Francisco hosted a conference in 2010 focused on "Financial Market Imperfections and Macroeconomics," highlighting the importance of incorporating these realities into economic analysis, particularly in the wake of financial crises.¹¹, ¹², ¹³

Major market events, such as the 2010 Flash Crash, further underscored the impact of market friction and its underlying components. On May 6, 2010, the U.S. stock market experienced an extraordinarily rapid decline and recovery, which regulators later investigated to identify contributing factors like high-frequency trading behaviors and order imbalances.⁹, ¹⁰ This incident led to discussions and implementation of new trading curbs, or "circuit breakers," to mitigate extreme volatility, illustrating regulatory responses to reduce market friction.⁸ Similarly, regulatory initiatives like the Markets in Financial Instruments Directive II (MiFID II) in Europe, which came into effect in 2018, aimed to increase transparency and address issues like execution risk and market fragmentation, thereby attempting to reduce certain types of market friction in European financial markets.⁵, ⁶, ⁷

Key Takeaways

• Market friction encompasses any cost or impediment that obstructs the smooth functioning of financial markets.
• It includes explicit costs like brokerage fees and taxes, and implicit costs such as bid-ask spreads and liquidity constraints.
• Understanding market friction is crucial for investors and policymakers to assess true returns and design effective market regulations.
• Technological advancements, while reducing some forms of friction (e.g., transaction speed), can introduce new ones (e.g., algorithmic complexity).
• Market friction contributes to the departure from the theoretical ideal of efficient market hypothesis.

Interpreting Market Friction

Interpreting market friction involves recognizing its pervasive presence and quantifying its impact on investment returns and market operations. While often discussed qualitatively, its effects are felt in tangible terms. For investors, higher market friction means lower net returns. For instance, frequent trading in a taxable account can lead to substantial costs from taxes and commissions, eroding potential gains over time.

From a broader market perspective, significant market friction can reduce liquidity and increase volatility, making it harder for participants to execute trades at desired prices. Regulators and market participants often analyze components of market friction to identify areas for improvement, such as developing more robust trading protocols or simplifying regulatory frameworks to enhance overall market efficiency.

Hypothetical Example

Consider an investor, Sarah, who wishes to buy 100 shares of Company A, which is currently trading at a quoted price of $50 per share.

1. Brokerage Commission: Sarah's brokerage charges a flat fee of $7 per trade. This is an explicit market friction.
2. Bid-Ask Spread: The current bid price (what buyers are willing to pay) is $49.95, and the ask price (what sellers are willing to accept) is $50.05. If Sarah places a market order, she will likely pay the ask price. The difference of $0.10 per share ($50.05 - $49.95) represents an implicit cost or market friction.
3. Impact Cost: If Sarah's order is large relative to the market's depth, her purchase might push the price up slightly as she consumes available liquidity at the current best ask. Let's say her 100 shares are executed at an average of $50.07 due to this. This extra $0.02 per share beyond the initial ask is another form of implicit market friction, often referred to as market impact.

In this scenario, the actual cost per share to Sarah is $50.07. For 100 shares, that's $5,007. Adding the $7 commission, her total outlay is $5,014. If the theoretical frictionless price was exactly $50.00, the market friction cost her $14 ($0.07 per share in spread/impact plus $7 commission). This example highlights how various forms of market friction directly affect an investor's total cost of a security acquisition.

Practical Applications

Market friction manifests in various practical aspects across financial markets, influencing investment strategies, regulatory policies, and market design.

In investing, market friction directly impacts portfolio returns. Investors employing high-frequency trading strategies or engaging in frequent portfolio rebalancing must account for the cumulative effect of transaction costs, including brokerage fees, exchange fees, and the bid-ask spread. Even long-term investors are affected by expense ratios in mutual funds and exchange-traded funds (ETFs), which are a form of ongoing market friction. The Bogleheads investment philosophy, for instance, heavily emphasizes minimizing investment costs, recognizing that high fees significantly erode long-term returns through the power of compounding.³, ⁴

From a regulatory standpoint, understanding market friction is critical for ensuring fair and orderly markets. Regulators often implement rules to mitigate excessive friction, such as mandating best execution practices, establishing trading halts (circuit breakers), or increasing market transparency. The goal is to reduce opportunities for market manipulation and ensure that prices accurately reflect supply and demand, rather than artificial barriers. Regulatory changes like MiFID II, for example, aimed to improve transparency in European markets by requiring more detailed reporting and promoting competition among trading venues.¹, ²

In market analysis, friction is a key consideration when evaluating arbitrage opportunities. True arbitrage, which involves profiting from price discrepancies, can only occur if the potential profit exceeds all associated market frictions, including trading costs and the speed of execution. Market microstructure, an area of financial economics, specifically studies how trading mechanisms and market friction affect price formation and the trading process.

Limitations and Criticisms

While essential for understanding real-world markets, the concept of market friction also faces certain limitations and criticisms, primarily concerning its measurement and the potential for unintended consequences when attempting to reduce it.

One challenge is that market friction is not a single, easily quantifiable metric but a composite of many different costs and impediments. Isolating and measuring the exact impact of each component, such as implicit execution costs or the psychological costs associated with behavioral finance biases, can be complex. This can make it difficult to precisely determine the "true" cost of trading or the exact degree of market inefficiency attributed to friction.

Furthermore, efforts to reduce one form of market friction might inadvertently introduce another. For example, the rise of high-frequency trading (HFT), while theoretically reducing bid-ask spreads and increasing liquidity in some cases, has also introduced concerns about market stability, fairness, and potential for "flash crashes." Critics argue that the hyper-speed of HFT can create new forms of friction related to information disadvantage for slower participants or systemic risks due to algorithmic errors. The pursuit of perfect "frictionless" markets could also lead to over-financialization or a lack of necessary safeguards.

Some forms of friction, like certain regulatory costs, are often seen as necessary to ensure market integrity and investor protection. Removing all friction, even if possible, could lead to markets that are highly efficient but also prone to instability or fraud. Therefore, the goal is often to optimize, rather than eliminate, market friction, balancing efficiency with stability and fairness, a central dilemma in financial regulation.

Market Friction vs. Transaction Costs

Market friction and transaction costs are closely related, but market friction is a broader concept that encompasses more than just the direct costs of executing a trade.

Transaction costs specifically refer to the direct and indirect expenses incurred when buying or selling an asset. Direct transaction costs include explicit fees such as brokerage commissions, exchange fees, and regulatory fees. Indirect transaction costs, often harder to quantify, include the bid-ask spread and market impact, which is the adverse price movement caused by the size of an order. These costs are a concrete, measurable component of the overall process of exchanging assets.

Market friction, on the other hand, is a more encompassing term that describes any factor, explicit or implicit, that impedes the smooth and efficient functioning of a market. While transaction costs are a major component of market friction, friction also includes other elements such as information asymmetry (where one party has more or better information than another), regulatory costs (the burden of complying with rules), search costs (finding a counterparty), and even psychological biases that prevent rational decision-making. Therefore, all transaction costs are a form of market friction, but not all market friction is strictly a transaction cost. Market friction represents a broader theoretical concept that helps explain why real-world markets deviate from idealized, perfectly efficient models.

FAQs

What causes market friction?

Market friction arises from various factors, including explicit costs like brokerage commissions, taxes, and exchange fees, as well as implicit costs such as the bid-ask spread and market impact. Other causes include regulatory compliance burdens, information disparities among participants (information costs), and limitations in market liquidity.

How does market friction affect investors?

Market friction directly reduces an investor's net returns. Every fee, spread, or tax paid diminishes the profit from an investment. For example, high trading volumes can lead to significant cumulative transaction costs, even if individual fees seem small. Understanding and minimizing these frictions is key to maximizing long-term investment performance.

Can market friction be eliminated?

No, market friction cannot be entirely eliminated. While technological advancements and regulatory changes can reduce certain aspects of friction (e.g., lower commissions, faster trade execution), some level of cost and impedance will always exist in real-world markets. Factors like taxes, the need for market makers to earn a living (contributing to the bid-ask spread), and regulatory oversight inherently introduce friction, some of which is necessary for market integrity.

Is market friction good or bad?

Market friction is generally considered "bad" in the sense that it reduces market efficiency and investor returns. However, some forms of friction are necessary or even beneficial. For example, certain regulatory costs can protect investors and prevent fraud, contributing to market stability and trust. The challenge lies in identifying and mitigating unnecessary friction while retaining beneficial impediments.

How does technology impact market friction?

Technology has a dual impact on market friction. On one hand, it has drastically reduced some explicit costs, like commissions, and increased the speed of trade execution, lowering certain aspects of friction. On the other hand, complex technological advancements, such as high-frequency trading algorithms, can introduce new forms of implicit friction related to market complexity, fairness concerns, and potential for rapid price dislocations.