What is a look-alike contract?
Similar contracts are a cash-settled financial product based on the settlement price of a similar exchange-traded, physically-settled contract future contracts. Similar contracts are negotiated over-the-counter and carry no risk of physical delivery regardless of the terms of the underlying futures contract.
Similar futures contracts are regulated by the Commodity Futures Trading Commission (CFTC).
Key points to remember
- A similar contract is a OTC cash-settled derivative contract that otherwise has similar characteristics to a physically settled futures contract.
- Since physical settlement is not an issue, traders do not have to worry about closing open positions to avoid making or taking delivery.
- Critics argue that similar contracts fuel speculation and generate market inefficiencies since they are taken out of the underlying asset they are tracking.
Understanding Similar Contracts
Similar contracts are essentially options where the underlying is a futures contract with a specific settlement date. For example, the ICE Crude Brent American-style Option The product has an ICE Crude Brent Futures contract as the underlying. The contractual terms of a similar contract closely match the contractual terms of the futures contract. Similar contracts may be offered both in the United States and European fashions.
Similar contracts and position limits
Where similar contracts become attractive is when they cover contracts traded on other exchanges, allowing the exchange to capture some of the trading activity in a commodity for which they are not known. This allows some of the pure risk speculation to take place away from the actual numbers of the underlying futures contracts.
Additionally, since none of the physical commodities are involved in trading similar contracts, position limits intended to temper commodity speculation can be circumvented.
Criticisms of similar contracts
Like many derivatives, similar contracts have their share of detractors. The primary purpose of the futures market has traditionally been to aid in price discovery and to hedge supply and demand risks or offload them to parties better prepared to manage them.
Similar contracts leave the physical commodity behind by being a derivative of a derivative. Instead of influencing the price of oil, for example, similar contracts allow traders to bet against each other while arguably providing no new market price signals. Traders of similar contracts make this last point because they are market participants, so the volume and open interest of their speculation gives market information about their opinions on the price performance of the futures contract. underlying.
Ancient CME Group CEO Craig Donohue called similar contracts “second-order parasitic derivatives” in 2011.At the time, of course, ICE was aggressively creating similar contracts using futures contracts traded on CME as a benchmark. The rivalry between the two exchanges has no doubt colored his opinions. Overall, similar contracts are no different from other OTC products in that they allow high-level market participants to place bets with money they are willing to risk. a very specific way.