Look-alike contracts are fascinating and complex financial instruments, characterized as cash-settled products anchored in the settlement prices of similar exchange-traded, physically settled futures contracts. Traded over the counter, look-alike contracts entirely eliminate the risk of actual physical delivery, distinguishing them sharply from their futures counterparts.
Key Takeaways
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Definition: Look-alike contracts are OTC derivatives that are cash-settled and mirror the specifications of physically settled futures contracts.
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Benefit: Traders engaging with look-alike contracts are not concerned with closing positions to avoid physical deliveries, simplifying transaction clauses.
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Criticisms: Skeptics argue that these contracts promote speculative behaviors and lead to market inefficiencies, as they disconnect from the tangible assets they represent.
Gaining Insight Into Look-Alike Contracts
Fundamentally, look-alike contracts operate similarly to options, with their underlying being a futures contract scheduled for a specific settlement date. For instance, ICE’s Brent Crude American-style Options draw upon ICE Brent Crude Futures Contracts as their underlying benchmark. These contracts align closely with futures contract terms, and they can be structured in American or European options styles.
Look-Alike Contracts and Their Impact on Position Limits
One intriguing aspect of look-alike contracts arises when these instruments involve contracts traded on disparate exchanges. This allows exchanges to tap into trading activities related to commodities even when they don’t traditionally handle the physical trades of such commodities. Consequently, some speculative activities can transpire outside the purview of actual futures contracts. Moreover, the exclusion of physical commodities in look-alike contracts means that existing position limits—which aim to control commodity speculation—can be circumvented.
Evaluating Criticisms of Look-Alike Contracts
As with many derivative products, look-alike contracts are subject to criticisms. The traditional role of futures markets is fundamentally tied to price discovery and enabling entities to manage supply and demand risks through effective hedging. However, look-alike contracts, as derivatives of derivatives, deviate by neglecting the core physical commodity.
Critics argue that rather than influencing asset prices directly (like the price of oil, for example), these contracts allow market participants to speculate without contributing to genuine market signals or price formation. However, supporters counter that participation in these contracts brings additional volume and open interest, thereby reflecting market views and indirectly informing the underlying futures prices.
In the realm of competitive exchanges, sentiments can be rather vocal. For instance, in 2011, former CME Group CEO Craig Donohue referred to look-alike contracts as
Related Terms: Futures Contracts, OTC Derivatives, Commodity Trading, Position Limits, Price Discovery.
References
- Intercontinental Exchange. “Option on Brent Crude Futures Weekly”.
- The Financial Times. “CME Takes Aim at ‘Parasitic’ Derivatives”.
