What are the problems of forward markets?

Forward markets worldwide are affl icted by several problems:

(a) lack of centralisation of trading,

(b) illiquidity, and

(c) counterparty risk.

In the fi rst two of these, the basic problem is that of too much fl exibility and generality. The forward market is like the real estate market in that any two persons can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specifi c situation for the specifi c parties, but makes the contracts nontradeable if more participants are involved. Also the “phone market” here is unlike the centralisation of price discovery that is obtained on an exchange, resulting in an illiquid market place for forward markets. Counterparty risk in forward markets is a simple idea: when one of the two sides of the transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic issue: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counter- party risk. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, the counterparty risk remains a very real problem.

 

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