Daily Rules, Proposed Rules, and Notices of the Federal Government
A credit union may enter into a derivatives transaction to protect itself against interest rate risk. For example, a credit union that has invested its deposits in a portfolio of mortgages that pays a fixed rate of interest is exposed to risk of an upward movement in interest rates. On members' variable rate
To offset the impact of rising interest rates, a credit union could enter into an interest rate “swap” in which it exchanges with a counterparty the fixed-rate cash flows it receives from its mortgages for variable-rate cash flows that fluctuate with the yield it must pay on members' deposits. As a result, the credit union's cost of funds remains the same regardless of interest rate movements.
Alternatively, a credit union could purchase an interest rate “cap” that would effectively fix the cost of funds at a pre-agreed ceiling. For a premium paid by the credit union, the counterparty agrees to make payments to the credit union when the referenced variable market rate exceeds the contractual ceiling rate. This payment would occur at the end of each period in which a referenced rate, like LIBOR, exceeds the agreed ceiling rate. The interest rate “cap” acts as insurance against rising interest rates since the credit union's cost of funds on the amount hedged will be offset by counterparty's payments in excess of the interest rate ceiling. The counterparty thus absorbs the risk of significant interest rate increases above the contractual ceiling rate.
To implement the investment authorities of FCUs, part 703 of NCUA's Rules and Regulations, 12 CFR 703, identifies the investments and investment activities authorized by the Act and imposes requirements and restrictions in order to preserve the safety and soundness of the credit unions that hold the investments and engage in the activities.
Part 703 provides for an exemption from the prohibition against derivatives transactions in the form of an investment pilot program (“Pilot Program”) that “permit[s] a limited number of [FCUs] to engage in investment activities prohibited by this part but permitted by the Act.”
A third party seeking to establish a Pilot Program to engage in a prohibited activity on behalf of client FCUs also must obtain NCUA approval.
Since the inception of Pilot Programs allowing investment activities prohibited by part 703, the NCUA Board has generally limited its approval of FCUs seeking to independently engage in derivatives to offset IRR, primarily for two reasons. First, such derivatives present risks that generally are not familiar to FCUs. Second, FCU demand for such instruments has been low. Also for these reasons, the NCUA Board thus far has not reconsidered whether to permit derivatives activities on an elective basis, as other federal financial institution regulators do, instead of only under an approved Pilot Program.
The CFTC recently issued for comment a proposed rule on “End-User Exception to Mandatory Clearing of Swaps.” 75 FR 80747 (December 23, 2010). The proposed rule introduces
In view of the Dodd-Frank clearing mandate, and with the benefit of 12 years' experience with Pilot Programs allowing derivatives activities, it is timely for the NCUA Board to reconsider, and resolve issues related to, whether and under what conditions it should permit natural person FCUs to engage in derivatives transactions for the purpose of offsetting IRR,
NCUA is disinclined to allow FCUs to engage in derivatives activities unconditionally for several reasons. First, NCUA must ensure that FCUs do not use derivatives for the unauthorized purpose of speculation. Second, the value of the cash flow streams from derivative transactions can be unusually volatile because the value is driven by the movement of interest rates and level of volatility in financial markets and this value can therefore itself be volatile. Finally, it is reasonable to condition participation in derivatives activities on the FCU's development of sufficient expertise and infrastructure to manage IRR and credit risks associated with derivatives in financial markets. For these reasons, NCUA is reconsidering permitting FCUs to engage in derivative activity only on the basis of a waiver of the existing regulatory prohibition, subject to compliance with appropriate conditions.
In reconsidering derivatives activity by FCUs for the purpose of offsetting IRR, the NCUA Board seeks public comment—in the form of answers to the specific questions set forth under “Issues for Comment” below—on five different policy alternatives: (A) Whether to discontinue allowing Pilot Programs for FCUs and third parties to engage in derivatives activity to offset IRR and, if so, whether to terminate such existing Pilot Programs; (B) Whether to allow FCUs to engage in such derivatives activities through a third party on a case-by-case basis (
To facilitate consideration of the public's views, please address your comments to the questions set forth below on each issue, and organize and identify them by corresponding question number so that each question is addressed separately. To maximize the value of public input on each issue, it is also important that commenters provide and explain the reasons that support each of their conclusions. There will be a further opportunity to comment on these issues should the NCUA Board issue a proposed rule modifying its present policies on financial derivatives activities to offset IRR.
NCUA believes it is timely to determine whether existing Pilot Programs are either to be terminated or incorporated as a permissible activity.
1. Should existing Pilot Programs for FCUs to engage in derivatives for IRR management be permitted to continue? Explain why or why not.
2. Should such Pilot Programs for FCUs be permitted to continue by “grandfathering” the previous approvals into Part 703? Explain why or why not.
3. If FCUs seek an end-user exception from mandatory clearing as contemplated by the CFTC's proposed rule, they would need to provide items of information to a registered swap data repository. In view of this requirement, should NCUA permit FCUs to seek an end-user exception? Explain why or why not.
In approving third party Pilot Programs, the NCUA Board sought to ensure that FCUs would engage in derivative activities in a safe and sound manner while allowing FCUs that lacked experience in derivatives to gain this experience. 62 FR at 32999. To achieve that goal, NCUA created standards for third party Pilot Programs (
The Pilot Program standards for an FCU engaging in third party derivatives activity are as follows:
• Minimum net worth ratio of 7 percent or more; and
• Positive, stable earnings for preceding 12 months.
• Approve the counterparty or counterparties.
• Update, at least quarterly, the credit rating and analysis of approved counter-parties.
• Approve the proposed types of derivative transactions, the maximum limits for aggregate notional principal amounts permitted for each type of transaction deemed appropriate by the FCU's board of directors. The maximum limit on derivative exposure in notional terms should be stated as a percentage of net worth. The maximum notional limit for swaps plus the value of the underlying securities in option transactions must not exceed 250 percent of net worth.
• Determine hedge objectives and parameters and designate what correlation measures will be utilized. Approve correlation targets and tolerance limits prior to execution of each individual transaction.
• Understand, review and approve each transaction prior to execution and affirm that transactions will be used solely to reduce interest rate risk.
• Ensure management monitors the effectiveness of the hedge on at least a quarterly basis (preferably monthly) and reports this information to the board.
• Require management demonstrate it has adequate knowledge to understand and monitor hedge positions using derivative instruments.
• Commit to an annual independent audit of financial statements. The statements will be prepared in accordance with generally accepted accounting principles, including FASB ASC 815 Derivatives and Hedging. The audits will be performed in accordance with generally accepted auditing standards by a certified public accountant or public accountant licensed by the appropriate state or jurisdiction to perform those services.
• Have external auditors review its accounting policies and procedures prior to the first transaction. The external auditors will opine that the policies are suitable for these transactions.
• Identify the circumstances leading to the decision to hedge; and
• Specify derivative transactions to be employed and definition of:
○ Hedge type (fair value, cash flow, etc); and
○ Analysis to demonstrate effectiveness of hedge.
• Designation of the individual(s) with responsibility for purchasing derivative instruments.
• Designation of the individual(s) or departments that have accounting and risk reporting responsibilities for the derivative instruments and hedge transactions.
• Segregation of duties for the individual(s) obtaining the prices of the derivative instruments, hedged items, and other instruments associated with reporting the hedge transaction and of those that execute the transaction.
• Segregation of duties for the individual(s) with derivative instrument reporting and risk assessment responsibility and of those involved in the hedge execution.
• Requirement for monitoring hedge performance by the asset/liability committee and the board.
• Requirement that the derivative and the hedged item be priced by an independent third party.
• The FCU's legal counsel must opine that the proposed transactions are legal.
• There must be an International Swap and Derivatives Association (ISDA) agreement between the counter-party and the FCU.
• The ISDA agreement must be supplemented by a bilateral collateral agreement between counter-party and the FCU. The bilateral collateral agreements must require the posting of collateral by either party that is in a net deficit position on any derivative that has been transacted. The agreement should further specify that the collateral must be permissible for FCUs to hold and will be held by an independent third party.
1. These third party standards would require replacement of credit quality references by functional equivalents. With this change, are the third party operating standards required in NCUA's Pilot Program generally appropriate to govern the use of derivatives by an FCU approved to engage in these activities through a third party? Explain why or why not.
2. If FCUs lacking prior experience with derivatives were required to spend a period of time within a third party Pilot Program, what period of time and/or number of transactions is reasonable to a safe and sound understanding of derivatives? In your answer explain why this is sufficient minimum time or number of transactions.
Even if the NCUA Board allows FCUs having little or no derivatives exposure to participate in derivatives activities only through a third-party provider, it is anticipated that such FCUs may, after a time, seek to engage in derivative activities independently of a third party. In that event, however, further assessment of the FCU's knowledge, expertise, experience and infrastructure would be necessary, prior to granting such permission, to determine if the FCU is able to perform all aspects of derivatives activity for which the FCU may have previously relied on the third-party provider. The NCUA Board expects that, during any period of time when the FCU was acting with a third-party provider, the FCU would enhance its abilities to address asset liability analysis and modeling, dynamic hedging functionality, the pricing of any derivatives purchased, and the impact of marking-to-market on the value of derivatives and any hedged items. This enhanced expertise would serve as the basis for an application to engage in derivatives activity independently for the purpose of offsetting IRR.
1. Should the NCUA Board consider allowing credit unions to engage in derivatives activity independently? Explain why or why not.
2. What are the attendant criteria, such as, asset size, capital adequacy, the balance sheet composition of a credit union, or risk exposure with and without derivatives, that NCUA should take into consideration in evaluating an FCU's request for approval to engage in derivatives independently? Specify and explain any criteria that are essential.
3. Are there specific actions an FCU should expect to take in preparation for applying to engage in derivatives activities independently? Specify and explain any actions which are needed.
An FCU that seeks to engage in derivatives activity through a third party Pilot Program must request permission from its Regional Office to participate (
1. Should NCUA require an FCU to state a balance sheet management plan to hedge IRR based on risk management objectives as a condition for approval? Explain why or why not.
2. Is it useful for an FCU to rely on the expertise of a third party to assess the effectiveness of derivatives to hedge IRR on an ongoing and dynamic basis or should the FCU be required to demonstrate it has this expertise internally as a condition for approval? In either case explain why or why not.
3. Is it useful for an FCU to rely on the expertise of a third party to assess the credit quality of derivative counterparties? Explain why or why not.
NCUA expects that approving an FCU to independently engage in derivatives activity would require extensive examination of the applicant FCU and also would require enhanced supervision. This approval would be similar to the granting of expanded authority for a corporate credit union under recently revised Part 704, 75 FR 64786 (Oct. 20, 2010) and would require a self-assessment by the FCU to support its request. The NCUA Board would expect an FCU to address the following items prior to granting approval for that FCU to engage in derivatives activities independently:
i. Board of directors' policy identifying the specific purposes of specified derivatives activities and stating limits on maximum exposure in terms of notional principal amounts and mark-to-market values of individual and aggregate swaps;
ii. Ongoing assessment and reporting to the FCU's board of directors of derivative performance in achieving explicit interest rate risk management objectives;
iii. Selection criteria for eligible counterparties that address the process of identification and credit monitoring; posting of bilateral collateral and process for maintenance of available collateral;
iv. Disclosure of derivative price at time of purchase expressed as dollar values of a basis point on each derivative instrument;
v. Disclosure of costs of terminating any derivatives in the course of pursuing any exit strategy.
NCUA would expect the FCU's board of directors to review policy periodically, to review the FCU's derivatives positions on an ongoing basis, and to actively enforce compliance with the stated IRR management purpose of derivative activities.
1. Should approval of an FCU to engage in derivatives activities be in the form of additional authorization similar to the expanded authority available under Appendix B to Part 704—Expanded Authorities and Requirements? Explain why or why not.
2. Should an FCU demonstrate enhanced credit functionality in terms of the experience of the FCU's personnel, credit analysis and reporting infrastructure in order to evaluate the creditworthiness of derivative counterparties? Explain why or why not and describe any minimum expectation.
3. Should an FCU demonstrate enhanced hedging expertise based on the experience of FCU's personnel or on additional derivatives management infrastructure? Explain why or why not, and describe any minimum expectation.
4. Is one year a sufficient amount of time for an FCU to fully prepare a self-assessment and application for approval to independently engage in derivatives to offset IRR? Explain why it is sufficient or why more time may be required.
5. Are there any additional aspects of the FCU besides items (i)-(v) above which NCUA should consider in its approval for the FCU to engage in derivatives activity independently? If so, explain why the item should be considered.