Look-Alike Contracts

Look-Alike Contracts: What They Are and Why They Matter

Key takeaways
* Look-alike contracts are over-the-counter (OTC), cash-settled derivatives whose settlement is tied to the settlement price of a similar, exchange-traded, physically settled futures contract.
* They carry no risk of physical delivery, often mirror the contract terms of the underlying futures, and can be structured in American or European styles.
* Critics say they promote speculative activity and can weaken traditional price-discovery and position-limit regimes; proponents argue they still convey market sentiment through volume and open interest.
* In the U.S., look-alike futures products fall under Commodity Futures Trading Commission (CFTC) oversight.

Definition and basic mechanics

A look-alike contract is a privately negotiated, cash-settled derivative designed to replicate the economic exposure of a specific exchange-traded futures contract without creating any obligation for physical delivery of the underlying commodity. Settlement is tied to the futures contract’s reference price at a specified date.

Typical features:
* OTC trading between counterparties rather than on a central exchange.
* Cash settlement based on the settlement price of the referenced futures contract.
* Contract terms that closely mirror those of the exchange-traded futures (expiry dates, tick sizes, etc.).
* Available in option-like forms and structured in American or European exercise styles.

Example: An option whose underlying reference is an exchange-traded Brent crude futures contract can be structured to mirror that futures contract’s monthly settlement characteristics while remaining cash-settled OTC.

How look-alikes interact with position limits and markets

Because look-alike contracts do not involve physical delivery, participants can take positions without the logistical constraints that apply to actual futures contracts. This can have two practical effects:
* Exchanges and regulators may find it harder to enforce or monitor position limits intended to limit concentrated speculative exposure in the physical market.
* Trading activity can shift to venues or instruments not traditionally associated with a given commodity, allowing speculation to occur away from the exchange that lists the underlying futures.

Regulators, particularly the CFTC in the U.S., monitor these products to address risks related to market integrity and potential circumvention of position-limit regimes.

Criticisms and counterarguments

Main criticisms:
* Detached from the physical market: Because they are derivatives of a derivative, look-alikes do not directly involve the underlying commodity and therefore may not contribute clear new information to price discovery.
* Encourage speculation: They can facilitate speculative positions that bypass exchange-based rules and position limits, potentially increasing volatility or concentration risk in underlying markets.
* Market fragmentation: By allowing similar bets to be taken off-exchange, they can dilute the liquidity and price signals on the primary futures market.

Counterarguments from supporters:
* Market signals: Volume and open interest in look-alike contracts reflect participants’ views and thus can supplement price-discovery information, even if indirectly.
* Risk management and flexibility: They provide a means for sophisticated participants to achieve bespoke risk exposures and hedges when exchange-traded instruments don’t meet specific needs.
* Commonality with other OTC products: Like other OTC derivatives, look-alikes enable tailored risk transfer among parties prepared to manage counterparty risk.

Related concepts (brief)

• Futures contract: An agreement to buy or sell a commodity or financial instrument at a predetermined price on a future date, often used for hedging or speculation.
• Index futures: Futures whose settlement is based on the value of a stock market index rather than a physical commodity.
• Inverted (backwardated) futures market: A market state where near-term futures prices are higher than prices for later delivery, often reflecting short-term supply disruptions or high immediate demand.

Bottom line

Look-alike contracts offer a way to replicate the economic exposure of exchange-traded, physically settled futures without risk of delivery. They expand the toolkit for hedging and speculation but raise regulatory and market-structure questions, particularly around price discovery and position limits. Regulators monitor these products to mitigate risks while market participants weigh their convenience and flexibility against potential market-impact concerns.