Financial Market Frictions

Abstract

Defined simply as anything that interferes with trade, financial market frictions can exist even in efficient markets. Understanding financial market frictions is important, this article argues, because they generate real costs to investors, because they generate business opportunities, and because they change over time. Financial market frictions depend in part on market structure. Market structure tends to evolve over time, as trading volume increases, from low fixed costs and high marginal costs to high fixed costs and low marginal costs. To help identify the best means of reducing market frictions costs, the authors classify and discuss five primary categories of frictions: transactions costs, taxes and regulations, asset indivisibility, nontraded assets, and agency and information problems. Looking for evidence of how frictions influence market participants behavior, the authors not only review the economic literature but also conduct an empirical exercise to illustrate and quantify frictions impact on investors risk-return trade-off. Their results show that market frictions impose utility costs on investors by making preferable investment portfolios unattainable. Their findings and other academic studies also suggest that investors who ignore market frictions compound the harm done by the frictions themselves.