Asset-based derivatives: a forward contract is a tool that you need to understand

When it comes to cryptocurrency trading and risk hedging, many traders choose between two main types of financial instruments. A forward contract is a derivative financial instrument that appeared centuries ago and remains relevant to this day. Alongside it, there are futures— a more modern version of this mechanism. Both instruments allow speculation on the price movement of the underlying asset without owning it physically, but they operate under fundamentally different rules.

How traders historically protected themselves from risks

A forward contract is a tool born out of practical necessity. When farmers and traders faced uncertainty about future prices for their goods, they devised a simple solution—agree today on the price at which they will trade in the future. For example, an airline and an aviation fuel supplier might agree to purchase a certain volume of fuel in six months at a price of $11 per gallon, while the current spot price is $10 per gallon.

If in six months the fuel price rises to $12 per gallon, the airline benefits—buying at the lower agreed-upon price. If it drops to $9, the airline will incur a loss but will fulfill the contractual obligations. Thus, a forward contract is a mechanism for mutual protection against price fluctuations, though with different outcomes.

What OTC markets offer: flexibility and confidentiality

Forward contracts exist outside exchange platforms—these are over-the-counter (OTC) deals, concluded confidentially between two counterparties. It is this independence from a centralized platform that gives forward contracts their unique characteristics.

Main advantages of forward contracts:

• Complete flexibility in setting terms. Participants determine the contract size, underlying asset, settlement date, and price without restrictions imposed by exchange standards
• No initial margin required. Unlike futures, there is no need to deposit margin to open a position
• High confidentiality due to the absence of a public deal registry

But there are significant disadvantages:

• Counterparty risk. If one party cannot or does not want to fulfill the terms, the other is almost defenseless
• Low liquidity. Finding a buyer or seller to exit an already concluded forward contract is very difficult

Futures: when the exchange becomes a guarantor

Futures are an evolution of forward contracts, adapted for mass trading. A futures contract for Bitcoin or another asset is traded on a centralized exchange, where all conditions are standardized: contract size, minimum price increments, settlement dates.

How interest protection works in the futures market:

A clearinghouse— a financial intermediary—stands between the buyer and seller, guaranteeing the execution of each contract. All operations go through this system, which daily recalculates positions at the current market price (mark-to-market).

Each participant must deposit margin— an initial payment covering potential losses. If the account balance falls below the minimum margin, the trader receives a margin call and must top up funds. If not done, the position is automatically closed. This system completely eliminates counterparty risk— the exchange guarantees the fulfillment of conditions.

Direct comparison: futures vs. forward contracts

When to choose each instrument

A forward contract is the best choice when you need full customization of conditions and actual delivery of the asset in the future. Large companies and institutional investors often use them specifically for hedging real supplies or purchases.

Futures are more suitable for traders who want to quickly enter and exit positions, speculate on price movements, and receive reliable guarantees of contract execution. High liquidity allows closing a position at any moment at a fair market price.

Key differences to know

Regulation: Forward contracts remain outside regulatory control, as they are private agreements. Futures exchanges are subject to strict oversight by financial regulators.

Risk: A forward contract is an agreement with maximum risk for both parties—each depends entirely on the reliability of the other. Futures are protected by the clearinghouse and margin system.

Flexibility: Forward contracts allow maximum flexibility to tailor all conditions to specific needs. Futures are limited to the set of tools offered by the exchange.

Practical conclusion

A forward contract is a classic financial instrument that still makes sense in certain situations, especially for corporate hedging and long-term agreements. However, for most retail traders, cryptocurrency futures are a more convenient and safer choice due to transparency, liquidity, and guarantees of execution.

The choice between these two instruments depends on your goals: whether you need maximum flexibility and confidentiality (forward) or reliability, speed, and simplicity of trading (futures).

Important clarification: Trading cryptocurrency derivatives involves high risks, including the possibility of losing your entire capital. Carefully assess your financial situation before trading and determine whether you are prepared for such risks. Consult with professionals regarding investment decisions.