What Are Look-Alike Contracts?
Let me explain look-alike contracts directly: they're cash-settled financial products tied to the settlement price of a similar exchange-traded futures contract that's physically settled. You trade them over the counter, and there's zero risk of actual physical delivery, no matter what the underlying futures say.
These futures look-alike contracts fall under the regulation of the Commodity Futures Trading Commission (CFTC), so you know they're operating within official guidelines.
Key Takeaways
A look-alike contract is essentially an OTC derivative that's cash-settled and mirrors the specs of a physically settled futures contract. Since physical settlement isn't a factor, you don't have to stress about closing positions to dodge delivery obligations.
That said, critics point out that these contracts can amp up speculation and create market inefficiencies because they're detached from the actual underlying asset they're tracking.
Understanding Look-Alike Contracts
Think of look-alike contracts as options where the underlying is a futures contract with a set settlement date. For instance, the ICE Brent Crude American-style Option uses the ICE Brent Crude Futures as its base. The terms match closely with the futures contract, and you can find them in American or European styles.
Look-Alike Contracts and Position Limits
Things get intriguing when look-alike contracts cover futures from other exchanges, letting one exchange snag trading activity on commodities they're not typically associated with. This shifts pure speculation away from the actual underlying futures.
Plus, since no physical commodities are involved, you can often sidestep the position limits designed to curb excessive speculation in commodities.
Criticisms of Look-Alike Contracts
Like plenty of derivatives, look-alike contracts draw criticism. Traditionally, futures markets help with price discovery and let parties hedge or offload supply and demand risks to those equipped to handle them.
But look-alikes are derivatives of derivatives, leaving the physical commodity out entirely. Instead of affecting something like oil prices, they let traders bet against each other without adding real market signals. Traders do counter that their volume and open interest provide insights into market opinions on the underlying futures' price.
Back in 2011, former CME Group CEO Craig Donohue dubbed them 'parasitic, second-order' derivatives, especially as ICE was pushing look-alikes based on CME futures. Rivalry aside, they're just like other OTC products—tools for sophisticated players to place targeted bets with capital they're willing to risk.
What Are Futures Contracts?
Futures contracts are straightforward agreements to buy a commodity at a set price on a future date. You use them to secure income ahead of time and cut down on volatility exposure.
What Are Index Futures?
Index futures let you buy or sell contracts tied to a stock market index's value at a future date. They're tools for speculating on where market indexes might head.
What Is an Inverted Futures Market?
An inverted futures market happens when near-maturity contracts price higher than those further out. Normally, farther-out contracts cost more, but supply disruptions in the underlying commodity can flip this.
The Bottom Line
In summary, look-alike contracts derive from exchange-traded futures but trade OTC without delivery risks. They've faced flak as speculative tools that skip out on aiding price discovery.
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