Look-alike contracts, or cash-settled derivatives, are contracts that have similar specifications to a standard physically settled futures contract, but also differs in one key characteristic: It's a cash-settled instrument. That is, the swap takes place solely between the two counterparties involved in the contract, and does not necessarily involve the exchange of any physical asset.

Traders who enter into a look-alike contract have the ability to craft their own payments and performance rules without the worry of having to close out an open position to avoid taking delivery of a physical asset. As a result, the contract is commonly used across myriad asset classes and markets from currencies to commodities. Despite its popularity, however, look-alike contracts come with certain risks.

Critics argue that the relative ease with which traders can enter into these contracts fuels speculation in the markets and makes them susceptible to price inefficiency. Many of the same rules applicable to physically settled futures contracts, such as minimum margin requirements, do not typically apply to look-alike contracts, making them more accessible to a greater number of traders and thereby leading to increased speculation.

In addition, due to the lack of physical delivery, look-alike contracts provide traders with a degree of price separation from the underlying asset the contract is tracking. This can lead to the price of the underlying asset deviating from a more “proper” price, creating an illusory view of the real market. Speculators may not recognize these artificially inflated prices and may enter positions mistakenly believing them to be real.

Look-alike contracts are an incredibly popular financial instrument, but come with a number of risks that must be recognized. Counterparties must exercise due diligence to understand the contract before entering into it and be aware of the potential impacts it may have on the markets. While look-alike contracts are an attractive offering for traders, it is important to ensure that these instruments are used responsibly.