What Are Look-Alike Contracts?
Look-alike contracts are a cash-settled financial product based on the settlement price of a similar, exchange-traded physically-settled futures contract. Look-alike contracts are traded over the counter and they carry no risk of actual physical delivery regardless of the terms of the underlying futures contract.
Futures look-alike contracts are regulated by the Commodity Futures Trading Commission (CFTC).
- A look-alike contract is an OTC derivatives contract that is cash-settled that has otherwise similar specifications to a physically-settled futures contract.
- Because physical settlement is not an issue, traders do not have to worry about closing out open positions to avoid making or taking delivery.
- Critics argue that look-alike contracts fuel speculation and generate market inefficiencies since they are removed from the underlying asset that they track.
Understanding Look-Alike Contracts
Look-alike contracts are essentially options where the underlying is a futures contract with a specific settlement date. For example, the ICE Brent Crude American-style Option Product has an ICE Brent Crude Future Contract as its underlying. The contract terms of a look-alike contract closely correspond with the contract terms of the futures contract. Look-alike contracts may be offered in both American and European styles.
Look-Alike Contracts and Position Limits
Where look-alike contracts get interesting is when they cover contracts traded on other exchanges, allowing the exchange to capture some of the trading activity on a commodity they are not known for. This allows some of the pure risk speculation to take place away from the actuals in the underlying futures contracts.
Moreover, since none of the physical commodities are involved with the look-alike contract trading, the position limits meant to temper commodity speculation can be skirted.
Criticisms of Look-Alike Contracts
Like many derivative products, look-alike contracts have their share of detractors. The main purpose of the futures market is traditionally to aid in price discovery and allow supply and demand risks to be hedged or offloaded on to parties better prepared to handle them.
Look-alike contracts leave the physical commodity behind by being a derivative of a derivative. Instead of influencing the price of oil, for example, look-alike contracts allow traders to bet against one another while arguably providing no new market price signals. Traders of look-alike contracts do argue that last point, as they are market participants so the volume and open interest of their speculation gives market information on their opinions on the price performance of the underlying futures contract.
Former CME Group CEO, Craig Donohue called look-alike contracts “parasitic, second-order” derivatives in 2011. At the time, of course, ICE was aggressively creating look-alike contracts using CME traded futures as a benchmark. The rivalry between the two exchanges no doubt colored his opinions. All in all, look-alike contracts are no different than other over-the-counter products in that they allow high-level market participants to make bets with money they are prepared to risk in a very specific way. Regardless of your opinion on the wisdom of such a practice, it is their money to play with.