Why are forwards less liquid?

The Paradox of Forwards: Why Larger Trades Mean Less Liquidity

The world of financial derivatives often presents counterintuitive relationships. One such example is the apparent paradox of liquidity in the forwards market, specifically in currency forwards. While futures contracts, traded on centralized exchanges, are often cited as the epitome of liquidity, the reality for large-scale currency transactions is more nuanced. In fact, despite the significantly larger trade sizes facilitated by over-the-counter (OTC) currency forwards, they are generally considered less liquid than their exchange-traded counterparts. This seemingly contradictory situation demands a closer examination.

The commonly held belief that higher volume equals higher liquidity holds true for standardized instruments traded on exchanges. The high trading frequency and readily available order book on platforms like the CME Group provide unparalleled price transparency and ease of execution. A buyer can quickly find a seller, and vice versa, ensuring swift and efficient transactions, regardless of the size (within reasonable limits). This is the hallmark of a liquid market.

However, the OTC market for currency forwards operates differently. While it handles vastly larger trades than the futures market, these trades are bespoke, negotiated directly between two parties. This lack of a centralized, transparent order book is a key factor in reducing liquidity. Finding a counterparty willing and able to accommodate a massive, non-standardized forward contract can be challenging, time-consuming, and potentially costly.

Several factors contribute to this decreased liquidity in the OTC forward market:

• Counterparty Risk: The larger the transaction, the greater the risk of default by one of the counterparties. This necessitates extensive due diligence, credit checks, and potentially collateralization agreements, adding friction to the process and making it less efficient than a simple exchange trade.

• Price Discovery: In the absence of a centralized order book, price discovery is less efficient. Negotiating the exact terms, including the forward rate, requires significant back-and-forth communication, potentially leading to delays and less favourable pricing compared to the readily available prices on a futures exchange.

• Market Depth: While the overall volume in the OTC forward market is substantial, the market depth for any specific currency pair and maturity date may be surprisingly shallow. This means that even if a counterparty is found, a large trade might significantly move the market price, leading to unfavorable execution for one or both parties.

• Settlement Risk: Settlement in the OTC market adds another layer of complexity. The process is typically more protracted and carries a greater risk of failure compared to the standardized and highly regulated settlement procedures of exchanges.

In conclusion, while OTC currency forwards handle significantly larger transaction sizes, their inherent characteristics – bilateral negotiation, higher counterparty risk, less efficient price discovery, and limited market depth – contribute to lower liquidity compared to exchange-traded futures contracts. The seemingly paradoxical relationship highlights the crucial difference between volume and liquidity: a high volume of large, bespoke transactions does not automatically translate to a liquid market. Liquidity relies fundamentally on the ease and efficiency of execution, a factor significantly hindered in the OTC forward market.