Meaning
Total loss of capital efficiency resulting from transaction costs and market inefficiencies measures the resistance to investment flow. Financial friction drag represents the difference between a theoretical market price and the actual execution cost. It includes the fees paid to brokers and the impact of the bid ask spread.
This cumulative expense reduces the total return on an investment over time.
Capital Leakage
Funds that could have been reinvested are instead consumed by the process of trading. The financial friction drag is often higher in illiquid markets where the cost of finding a counterparty is high. If the friction is not managed, it can erode the gains from a successful strategy.
Market Liquidity
Ease of entering or exiting a position influences the total cost of a transaction. Within the context of financial friction drag, a high volume of participants helps to narrow the spread and lower the per trade expense. A supplier’s forecast of liquidity must be tested against the demonstrated rate of execution in a real environment.
Transaction Cost
Hidden expenses such as slippage and opportunity cost contribute to the overall burden. When the financial friction drag is high, the cost of calling a market entry early is a measurable loss of principal. Reducing these barriers is a priority for organizations that manage large pools of capital.
The efficiency of a market is measured against the ideal of zero friction trading.
