Forward contracts and futures: What’s the difference?
Understanding crypto derivatives 🤝
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Forward contracts are private, flexible agreements to buy or sell cryptocurrency at a future date but carry higher counterparty risk due to no intermediary.
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Futures contracts are standardized, regulated, and traded on exchanges with margin requirements, offering more liquidity and lower default risk.
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Key differences include settlement methods, risk, and exchange adoption, with futures providing daily settlements and less counterparty risk.
Forward contracts are a type of financial derivative instrument that allows crypto traders to bet on the prices of underlying asset prices at future dates.
These contracts serve as agreements between two private parties to buy or sell an amount of cryptocurrency, at a predetermined price on a specified future date.
The foundational principle of a forward contract is that a private agreement inked today materializes into a transaction at a future date, executing at a pre-agreed price, known as the forward price. This establishes a commitment between the buyer and seller, providing a degree of certainty amid market volatility.
These contracts often come with varying durations, with common timelines spanning 3 months, 6 months, or extending up to a year. Longer durations tend to involve heightened risks (prices have longer to rise or fall) and typically incur a higher forward price.
A forward contract trade example
To better understand how forward contracts work the crypto markets, imagine a trader entering into a private contract to purchase 10 Bitcoin in 3 months at a fixed rate of $60,000 per Bitcoin. Upon the contract's expiration date in 3 months, the trader is obligated to purchase 10 bitcoins at the pre-arranged price, regardless of the market rate at that time.
If the current price of bitcoin is $65,000 at the delivery date, the seller must sell bitcoin at a loss to the buyer. In this example, the buyer would make a $50,000 profit (10 bitcoins x $5,000 profit per coin).
Conversely, if the current market price of bitcoin is lower, say, $50,000, the buyer must purchase the pre-agreed 10 bitcoin at the higher price of $60,000 per coin. This would result in a $100,000 profit for the seller.
One important consideration to note when dealing with forward contracts is counterparty risk. Unlike other derivatives, forward contracts do not involve trusted intermediaries like exchanges to ensure both parties honor the terms of the contract
What are futures contracts? 📆
Crypto futures contracts represent another type of derivative contract that involves agreements to buy or sell an amount of the underlying crypto asset, or the cash equivalent at a later date, based on a preset price.
In the futures market, traders essentially speculate on the future price fluctuations of the cryptocurrency and agree to settle at the point of the contract's maturity — that is, when the conditions of the contract must be settled.
Futures represent standardized contracts, whereby the underlying exchange sets conditions such as the type of delivery and the number of units within each contract.
If a person believes the price of the underlying asset of a futures contract might rise by a predetermined date, they might decide to purchase a futures contract. This is known as going long.
If a person believes the price of the underlying asset will fall by a predetermined date, they might decide to sell a futures contract. This is known as going short.
Understanding leverage and margin
Leverage is typically built into these contracts, meaning a person can buy a futures contract with a notional value many times greater than the cost of the contract itself.
For example, a trader who purchases a Bitcoin futures contract with a notional value of 5 BTC may only need to pay around 10% to take that position. This effectively increases their equivalent trade size by ten times.
Exchanges that provide crypto futures trading require traders to deposit an amount of collateral margin to open these types of trades. Additionally, a secondary pot of capital (called maintenance margin) is needed to keep the trade open if the markets move against a trader's position.
Should a trader's maintenance margin capital run low, the exchange will issue a margin call. This notification urges the trader to deposit more funds to keep their trade open. If the markets move sharply against the trader, or they fail to top up their maintenance margin, the exchange may automatically close the trade and liquidate the position (confiscate the initial margin).
Key differences between forward and futures contracts 🤔
Forward contracts
- Traded privately over-the-counter.
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Flexible terms and conditions based on private negotiation.
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Only has one settlement date when both parties must fulfill the forward contract obligations.
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No initial margin or maintenance margin required to open forward contract trade.
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Forward contracts are not officially regulated derivatives contracts.
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No middleman fees involved.
Futures contracts
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Crypto futures contracts are traded publicly on futures exchanges.
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Futures contracts have fixed conditions regarding delivery and contract sizes.
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Crypto futures have daily settlements.
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Initial margin and maintenance margin requirements to open and maintain open futures trades.
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Futures contracts are highly regulated derivative products.
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Futures trades incur exchange fees.
Forward contracts v fixed maturity futures 🧐
Fixed maturity futures are a type of futures contract that expire on a specified future date (note the difference here from perpetual futures contracts, which have no expiry).
When they mature, the underlying asset must be delivered or the contract must be settled, returning the cash value to the trader. The benefit of such an instrument is that traders can hedge their exposure and lock in a future price.
Fixed maturity contract example
A trader elects to buy 1 BTC quarterly futures contract at a price of $50.000 (with a notional value of 1 Bitcoin), which expires at the end of year.
On December 31st, Bitcoin (BTC) is trading at $60.000 and the contract is settled. As the contract is settled by “physical” delivery, rather than pocketing the difference between the purchase and settlement price, the trader simply receives 1 Bitcoin at the price he initially bought the contract for (they are obliged to do so as per the terms of the contract). The trader can sell the 1 Bitcoin on the spot market for cash if they wish to realize their profit.
Key differences
Here are the key differences between forward contracts and fixed maturity futures Contracts:
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Standardization: While forward contracts are fully customized to the parties’ needs, fixed maturity futures are standardized by their contract size, maturity and the asset in question. This makes the process of exchanging fixed contracts much easier, because of the general familiarity and transferability of the product.
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Settlement: Forward contracts are settled only at contract maturity whereas futures are settled on a daily basis through something called ‘mark-to-market’ (the value of the contract is updated based on the current market price, rather than the price it was initially agreed upon)
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Risk: Futures contracts attract less counterparty risk because they are traded on regulated futures exchanges or clearing houses, which guarantees that both parties will fulfill their obligations. The risk of default with forward contracts is therefore much higher.
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Exchange Adoption: One crucial benefit that fixed futures have over forwards is that there are more ways to trade them. Fixed contracts can easily be traded at the click of a button on an exchange, whereas Forwards are traded OTC in private, meaning a buyer or seller has to be sourced before the transaction can take place.
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Liquidity: Forward contracts are generally illiquid, owing their bespoke, specialist nature - there are simply far less market participants prepared to trade them. However, fixed contracts are highly liquid because of their standardization and the greater ease in which they can be traded through regulated exchanges.
To summarize, fixed maturity contracts offer a host of benefits in comparison to forward contracts, particularly with respect to risk and position management. Using a highly standardized and regulated product, traders can easily enter and exit a position - something that is much more challenging with fixed contracts.
Fixed contracts may be more flexible than forward contracts (in terms of the nature of the agreement), but it’s their bespoke nature that also makes them illiquid and a riskier prospect overall, as holders are dependent on the counterparty delivering on the terms of agreement.
For traders interested in trading these types of derivatives, Kraken Pro offers fixed contracts for a range of leading cryptocurrency pairs, including Bitcoin (BTC), Solana (SOL) and Ethereum (ETH).
Popular forward contract trading strategies 👨💻
Going long or short are two popular forward contract trading strategies. Going long means that the trader may profit if the underlying crypto asset's price goes up over time, while going short means that a trader may profit if the price goes down.
Hedging is another popular strategy that involves taking an opposite position in a forward contract trade to reduce the risk of spot market trades or other open positions.
Forward contracts offer a means to profit from the future movements of cryptocurrency assets, as well as hedge against potential market fluctuations. These agreements represent a useful tool for managing risk and planning in the volatile world of cryptocurrency trading.
Pros and cons of forward contract trading 🎭
Pros
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Forward contracts are highly flexible.
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Incur no middleman fees.
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No initial margin or collateral required to open trades.
Cons
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The lack of a trusted intermediary creates higher counterparty/ default risk.
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Lack of regulatory clarity.
Get started with Kraken
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Disclaimer
These materials are for general information purposes only and are not investment advice or a recommendation or solicitation to buy, sell, stake, or hold any cryptoasset or to engage in any specific trading strategy. Kraken makes no representation or warranty of any kind, express or implied, as to the accuracy, completeness, timeliness, suitability or validity of any such information and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Kraken does not and will not work to increase or decrease the price of any particular cryptoasset it makes available. Some crypto products and markets are unregulated, and you may not be protected by government compensation and/or regulatory protection schemes. The unpredictable nature of the cryptoasset markets can lead to loss of funds. Tax may be payable on any return and/or on any increase in the value of your cryptoassets and you should seek independent advice on your taxation position. Geographic restrictions may apply.