Transaction costs can actually be a huge problem in the financial markets as they can cut down on a person’s profit, and many other problems that could reduce interest in financial markets, and more. The most typical and obvious example of transaction costs, and how they affect every day people is with stock trading.
For example, if you want to trade stocks, and you only have $10,000, you can only buy a set amount of shares of a particular stock. This by itself seems normal, but even if you use a cheap online broker, because the investment is relatively small, you have a good chance of getting charged extra commission and more fees by the broker. This will eat up a fairly significant percentage of your share earnings. Even if you buy a bond instead of stocks, sometimes the minimum denomination on a good bond can be quite high, around your full $10,000.
Also, because of transaction costs, you’re likely to limit the amount of trades you make, how often you add or subtract money from your account, and how often you buy new market instruments. This unfortunately can discourage many people from taking part in the various financial markets, and actually loses them money, as they’re most likely earning much less interest in their bank’s savings account, than they would in the various financial markets. There are however, ways that financial intermediaries can help reduce these transaction costs.
The first solution of high transaction costs would be to bundle the funds of many investors together so that they can take advantage of what is called, economies of scale. Because you are sharing the investment with multiple people, you are splitting the transaction cost by the amount of people you have investing total. This of course results in a much smaller transaction cost per person for the transaction. Also, as the size of the investment increases, typically certain fees may be waived since you are such a good customer to the brokerage.
Another solution that financial intermediaries have come up with in order to transaction costs include being able to better develop enterprise to lower transaction costs. Their ability to set up toll free hotlines, websites, etc for their customers allowing them to check up on their balances of their accounts, etc. It also allows them to do transactions online, which greatly lowers broker fees, as it doesn’t necessarily take an individual to do the work.
Overall, transaction fees can sometimes be pretty high, especially if you’re not a big time investor, but there are ways to avoid these fees. Despite this, there are several fees that are unavoidable, but are usually worth the cost for the particular return of the financial market asset.