A quick look into frictions in finance and economics and a simple analogy to fluid dynamics

On January 31st, the S&P 500 index witnessed a 1.6% sell-off, an event that, when viewed alongside the recent SEC announcement mandating hedge funds to disclose their strategies. This confluence of events triggered a deep dive into the dynamics of market downturns, prompting me to consider not only the underlying mechanisms but also the parties who profit and those who bear the brunt of the losses.

To understand this, let’s establish a framework focusing on the U.S. public equity market. Millions of transactions involving shares and other financial instruments occur at this venue, either through public exchanges or dark pools. Each transaction involves a buyer and a seller. A closer examination of market microstructure reveals how basic supply and demand forces dictate securities’ price movements, leading to realized or unrealized gains or losses. Imagine this as a sophisticated ecosystem, akin to a water tank with inflow and outflow valves, where controlling the inflow rate effectively manages the system’s pressure. This analogy extends to the market, where investor behavior and psychology in behavioral finance influence capital flows, dictating market pressure and steering the market toward higher or lower equilibrium points. This process appears flawless: when the market rises, there’s general contentment, but when it falls, panic ensues, and grievances emerge. Over the long term, public equities generally exhibit an upward trend. The question then arises: where does this consistent influx of capital, which has been propelling the broad equity market upwards since the dawn of capitalism, originate? The answer lies in the relentless technological progress initiated by the Industrial Revolution in the 1800s.

In any economic system, the foundational elements are human capital, natural resources, and land. The synergy between human capital and these resources propels technological innovation, driving economic progress. This growth often exhibits a compounding, and sometimes exponential effect. Consider the internet’s emergence, which has interconnected global economies, enhancing their integration. Currently, we’re witnessing a similar transformative impact with the AI surge. Before the pandemic, the concept of technologies akin to ChatGPT was beyond most people’s imagination. Now, such powerful tools are at our disposal, offering significant potential to expedite development in numerous sectors, thereby continuously elevating the economic equilibrium.

Having outlined the broader economic context, let’s delve into the more granular and transient fluctuations within it. The physics methodologies to simulate particle states’ randomness are frequently adapted to model the unpredictable fluctuations in asset prices. In this scenario, we’re applying basic principles of physics, not quantum mechanics, but rather those taught in high school. According to Newton’s second law, an object will remain in its existing state unless an external force acts upon it, meaning it will stay at rest or continue moving uniformly. Yet, when we introduce the concept of friction, myriad reactions occur simultaneously. Kinetic energy may transform into internal energy, such as heat, altering the object’s consistent motion. Let’s explore the parallels between Newton’s principles and their application in the financial sector.

In the realm of corporate finance, the Modigliani-Miller (MM) theorem stands out as a pivotal theory. It elucidates the workings of a company’s capital structure, considering a spectrum of assumptions, both in the presence and absence of market frictions. In practical scenarios, numerous frictions incessantly interact with the system, giving rise to various challenges that stakeholders and investors must navigate. These frictions often lead to conflicts of interest among stakeholders, inducing inefficiencies within the system. Such inefficiencies catalyze potential gains and losses within this tightly-knit system. Over the long term, these dynamics invariably influence all stakeholders, as the firm’s performance dictates the overarching trend they experience.

Within the banking and buy-side sectors, authorities have established specific regulations to mitigate the risk of significant unforeseen economic downturns, known as black swan events. These regulations mandate buy-side firms to report their quarterly results to their investors and shareholders transparently. Such directives form part of a broader risk management framework imposed by regulatory agencies and adopted by individual firms. For instance, banks must hedge against foreign exchange (FX) risk. In contrast, individual investors with diversified global portfolios might not need to undertake such hedging, avoiding the additional costs associated with FX hedges. A prevalent strategy for funds to safeguard against potential losses involves purchasing VIX futures or other volatility-related products, which typically adopt a contango pricing structure. Regulatory-induced market frictions can lead to short-term volatility spikes, creating trading opportunities that capitalize on the return to the long-term average volatility. The firms and their shareholders ultimately bear the inefficiencies stemming from these frictions. Conversely, astute market participants can exploit these circumstances for profit.

Recently, “ESG investing,” which focuses on environmental, social, and governance factors, has introduced a new kind of market friction. “ESG greenwashing” occurs when companies release extensive ESG data that doesn’t match their ESG performance. This phenomenon, often due to regulatory mandates for funds, creates friction by narrowing the pool of securities managers can select from, thereby reducing opportunities for generating alpha. Moreover, it constrains portfolio diversification capabilities, adversely affecting risk management and investment performance. These constraints challenge conventional investment practices and the pursuit of optimal portfolio outcomes.

Numerous frictions exist in economics, including deadweight loss, a phenomenon where market inefficiencies reduce economic efficiency. This loss can originate from various sources, including taxes, subsidies, and price controls. Additionally, labor markets experience search frictions, a situation where the challenge of matching employers with suitable employees leads to unemployment or underemployment. This is because job seekers and employers must invest time and resources to identify the right job openings and candidates.

In conclusion, revisiting the earlier water tank analogy helps illustrate financial market dynamics through the lens of fluid dynamics. Just as fluids move from areas of high pressure to low pressure, capital in financial markets flows from assets offering lower risk-adjusted returns to those with higher ones. The pump in our analogy, which controls the fluid’s pressure, symbolizes economic incentives like central bank policy rates and profit opportunities. This is mirrored in the financial world, where the increasing number of participants in the $1.7 trillion private credit market recently is a testament to these dynamics. In fluid dynamics, greater viscosity leads to more energy dissipation, which parallels the financial concepts of transaction, hedging, and opportunity costs. Higher viscosity, indicating more friction, results in greater energy loss, akin to how increased transaction and hedging costs can suppress trading activities or diminish investment returns. Nonetheless, a fluid with higher viscosity promotes laminar flow, which, in financial terms, suggests that higher internal friction — comparable to regulatory measures — can mitigate market volatility, leading to more stable and predictable asset price trends. Risk management protocols limit market participants from assuming excessive risk, reducing the likelihood of extreme events while opening up opportunities for profit, particularly for entities like derivatives traders.