Forward and futures contracts — understanding the differences

Many participants in the crypto market actively practice trading derivatives to profit from price fluctuations of assets. However, before starting, it is important to understand how these financial instruments work. There are two main types of contracts in the market: forward and futures. Despite their similarities, they differ significantly in mechanics, risks, and regulation.

How the Forward Contract Originated and Why It Is Relevant

A forward contract is one of the oldest derivative instruments in the world of finance. The origins of forward contracts date back several centuries, when farmers and traders sought to minimize losses from sharp price fluctuations of commodities. Such agreements allowed them to lock in the value of assets for the future.

In today’s world, forward contracts are a powerful hedging tool for large corporations. For example, an airline may want to hedge against rising jet fuel prices. The airline and supplier can enter into an agreement: the airline orders fuel six months in advance at a price of $11 per gallon, even though the current market price is $10. If, after six months, the price rises to $12, the airline saves money. If the price drops to $9, the company will still have to purchase fuel at the agreed-upon price.

Features of Trading on the Forward Market

The forward market operates on principles of flexibility and confidentiality. Any two parties can enter into an agreement and independently determine the underlying asset, price level, and settlement date. Such contracts are negotiated over-the-counter (OTC), meaning the deal is private and there is no third-party regulator.

Since a forward contract is a private agreement, it has legal force and obligates both parties. However, this also creates a problem: parties do not make advance payments and exchange funds only at the end of the contract term. This has both advantages and serious disadvantages.

Advantages of Forward Contracts

The main benefits of forward contracts that attract users:

• No upfront requirements. Unlike most other derivatives, forward contracts do not require a initial deposit to enter into the agreement.

• Flexibility of parameters. Participants determine the terms themselves: which asset to trade, at what price, and for what period. This allows tailoring the contract to specific needs.

• Confidentiality. The over-the-counter nature ensures privacy of trading and allows avoiding public disclosure of deal details.

Disadvantages of Forward Contracts

Along with advantages, forward contracts carry significant risks:

• Counterparty risk — the greatest threat. Since the deal is only executed at the end of the term, there is a real possibility that one party will be unable or unwilling to fulfill its obligations. This is especially critical when working with unreliable partners.

• Low liquidity. Very few market participants are willing to buy existing forward contracts. This complicates early exit from positions and can lead to substantial financial losses.

What Is a Futures Contract and How Does It Work

A futures contract is a standardized derivative traded on public exchanges. It represents an agreement to deliver or settle the underlying asset (Bitcoin, Ethereum, etc.) at a specified date for an agreed-upon price. Unlike forwards, futures are marked-to-market daily and regulated by clearinghouses.

The functioning of the futures market is based on standardization. The exchange sets in advance the contract size, underlying asset, price, and settlement date. When a trader opens a position, they must deposit an initial margin — the minimum amount serving as a guarantee. If the position moves against the trader, the clearinghouse requires a margin call (margin-call). If not met, the position is automatically closed by the system.

The Role of the Clearinghouse in Futures Trading

The key difference of futures contracts is the presence of an intermediary in the form of a clearinghouse. It verifies data from both parties, performs daily settlements, and guarantees the fulfillment of the deal’s terms. This almost completely eliminates counterparty risk, as the clearinghouse becomes the final guarantor.

Daily settlement of differences means profits and losses are paid out regularly, not just at the end. Although this increases the number of commission payments, it minimizes the accumulation of large losses.

Advantages of Futures Contracts

• Transparency and standardization. Contract parameters are predetermined and publicly accessible, creating a fair competitive environment.

• Risk minimization. The clearinghouse guarantees the execution of deals and protects participants from unforeseen losses due to counterparty bankruptcy.

• High liquidity. On public exchanges, high trading volumes allow traders to quickly enter and exit positions without significant price losses.

Disadvantages of Futures Contracts

• Cost and commissions. Daily settlements and trading fees can significantly reduce final profit, especially with frequent trading.

• Limited flexibility. The exchange strictly defines the contract size, assets, and trading conditions. Traders cannot adapt the contract to their needs.

Comparison: a forward contract is not the same as a futures contract

Main differences between these two types of derivatives:

Which Contract to Choose?

The choice between a forward and a futures contract depends on your goals:

Forward contracts are better suited if you need physical delivery, are willing to work with private deals, and accept counterparty risk for flexibility and low commissions.

Choose futures contracts if you speculate on price fluctuations, value liquidity and transparency, and are ready to pay higher commissions for risk protection.

Frequently Asked Questions

What is the difference between the forward and futures markets?

The forward market operates over-the-counter — private, unregulated agreements. The futures market functions on public exchanges with a clearinghouse and government regulation.

Why are forward contracts cheaper to service?

They do not require daily settlements, upfront payments, or clearinghouse intermediaries. All costs are minimized and paid only at the end of the term.

How do forward contracts differ from options?

A forward contract is an agreement that obligates the participant to fulfill the terms. An option gives the right, but not the obligation, to execute the deal. This makes options less risky but also more expensive.

Can futures contracts be used on crypto?

Yes, futures contracts are actively traded for assets like Bitcoin and Ethereum. They allow speculation on price fluctuations without direct ownership of the asset.