In economics there is a concept known as “friction cost”. Friction costs are fees, commissions, markups, taxes, surcharges or any other expense that may reduce the attractiveness of a transaction. Economists are obsessed with friction costs because they theoretically make economies less efficient.
But economists aren’t the only ones who should pay attention to this key concept. Investors should be concerned with friction costs, too. Now this might seem like a strange assertion because modern capital markets have turned reducing friction costs into a veritable crusade over the last few decades.
And they’ve been largely successful, too. Stocks trades are often ridiculously cheap these days. Anybody can open an online brokerage account where it costs less than $10 for an equity trade. However, while friction costs for paper assets – stocks, bonds, option and futures – are about as low as they can possibly go, friction costs are often still quite substantial for many alternative investments.
For example, early in 2017 I briefly looked into investing a small amount of money in an up and coming crypto-currency ecosystem called Ethereum. Now there are a couple different ways to acquire Ether – the technical name of the Ethereum platform’s currency. You can either buy it from an online exchange or mine it.
Mining Ethereum tokens, while intriguing, didn’t seem very viable for my situation. It requires a computer with a powerful GPU (graphics processing unit) that has a micro-architecture amenable to running complex mining calculations. Not all modern GPUs, even very powerful ones, are efficient at these calculations. But all GPUs that are good at Ethereum mining are relatively expensive – yet more friction costs.
Even if you do happen to have an appropriate GPU, any computer you dedicate to Ethereum mining needs to effectively run 24 hours a day, 7 days a week in order to be worthwhile. And any computer mining Ethereum will consume large amounts of electricity. If the machine is running 24/7, which it should be, you will end up with a large power bill at the end of the month. You just have to hope that the value of the Ethereum you’ve mined is greater than the value of the electricity you’ve used.
Then there is the decision of whether you want to mine Ethereum independently or join a mining pool. A mining pool makes the process somewhat less technically challenging and also makes the pay-outs more predictable. But a mining pool also increases frictions costs; they generally charge a fee totaling between 1% and 4% of the amount mined. The alternative, mining Ethereum independently, not only makes payouts extremely unpredictable, but also turns you into your own technical support desk if something goes wrong.
As you can see, friction costs come in all different shapes and sizes. Sometimes they are very straightforward, as in the case of fees and commissions. But sometimes friction costs do not come in the form of money. Instead, they show up in the guise of time or technical expertise. This is often the case with alternative investments like crypto-currencies (or other alternative investments for that matter). In light of these friction costs, I opted to pass on Ethereum mining.
The alternative to Ethereum mining is purchasing the crypto-currency outright. Surely the friction costs of buying Ether must be lower than with mining it! Sadly, this is not necessarily the case.
In order to buy Ethereum you must open an account with an online crypto-currency exchange like Coinbase. But there are a plethora of fees associated with these accounts. First there is a commission for purchasing the crypto-currency itself. This can vary from 0.2% all the way up to 3%. But there is also often a surcharge on deposits to fund your account – anywhere from 0% to 5%, depending on the funding method used. Withdrawals also face similar fees. Some crypto-currency exchanges even charge a fee for an in-kind withdrawal, when you withdraw your own Ethereum without selling it first!
Now personally, I don’t like the idea of holding crypto-currencies at online exchanges for any length of time. Any funds, including crypto-currencies, held “on deposit” at an online crypto-currency exchange is technically the property of that online exchange. Depositors are merely unsecured creditors in the event of a bankruptcy.
This might seem like legal hair-splitting, but I assure you it is extremely relevant for alternative asset investors. In fact, in February 2017, the world’s leading Bitcoin exchange at the time, Mt. Gox, which handled over 70% of all Bitcoin transactions, suddenly and unexpectedly suspended trading and declared bankruptcy. A large amount of their Bitcoin inventory had been stolen, leaving depositors with little legal recourse to recover their funds.
I considered avoiding this problem by purchasing Ethereum at an online exchange and then moving it to a segregated “wallet”. A wallet is just software that is meant to store your crypto-currency in a secure, offline way. Sounds great, right?
But first you have to choose one. There are dozens of wallets out there and even though most of them are free they all have different features. I discovered that when it comes to crypto-currencies, choosing the right wallet is of paramount importance. You want to make certain that the wallet you choose stores the private key for your Ethereum locally, on your own computer, and not on an external server. However, your friction costs don’t stop once you’ve chosen a wallet for your Ethereum.
Instead, you now have the conundrum of where to store the wallet. If you keep your wallet on your local computer hard drive and it crashes, becomes corrupted, catches a virus or otherwise malfunctions, then there is a good chance your Ethereum is gone forever. So I thought about transferring my wallet to a USB thumb drive. Then I could unplug it from my computer and stash it somewhere safe in my house.
But even that raised more questions (and associated friction costs). I have a couple old USB thumb drives floating around, but do I trust any of them to store hundreds or thousands of dollars worth of crypto-currencies? Probably not. So I really should go buy a new one. In fact, it would probably be wise to invest in a dedicated, high-security crypto-currency hardware wallet (like the Ledger Nano S – Cryptocurrency hardware wallet
But where would I put this new flash drive with my Ethereum investment? If the thumb drive with my Ethereum’s private key is lost, stolen or destroyed, there is usually no way to recover the crypto-currency that was stored on it. A fire, flood or burglary would be devastating under these circumstances. A good home burglary safe would be a perfect solution for this situation, but they aren’t cheap.
In the end, because of all of these friction costs, I didn’t follow through with my plans to purchase Ethereum. Much to my chagrin, within a few months the price of Ethereum skyrocketed, moving from around $10 per Ether in January 2017 to a peak of over $400 in June 2017. I couldn’t believe how bad my luck was, missing out on this tremendous appreciation.
But there are valuable lessons to be learned from my experience. First, friction costs can come in a variety of forms – everything from fees, to wide bid-ask spreads, to specialized knowledge. And, as unpleasant as friction costs can be, they aren’t universally negative. For example, illiquidity has undoubtedly been a powerful factor in keeping the price of many alternative investments, including fine art and antiques, relatively reasonable.
I think the moral of the story here is that alternative investments have a steep learning curve in addition to other friction costs. But you shouldn’t let that deter you. Instead, start learning what you need to know now. The better educated you are about alternative investments like bullion, antiques, gemstones, fine art and yes, crypto-currencies, the greater the chances you will find a gem in the rough. More importantly, knowledge will give you the confidence needed to add these often overlooked alternative assets to your investment portfolio now, before prices rise out of reach.
