What are the problems of forward markets?
Forward markets worldwide are afflicted by several problems: (a) lack of centralisation of trading, (b) illiquidity, and (c) counterparty risk. In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like the real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradeable. Also the \phone market” here is unlike the centralisation of price discovery that is obtained on an exchange. 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 property: 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 counterparty risk. Even when forward markets trade standa
