NCUA's Derivatives Proposal; Can't Help Myself
Written By JiJi Bahhur, Regulatory Compliance Counsel
Today, the NCUA Board issued a proposed rule to provide qualified credit unions limited authority to engage in derivatives activities for purposes of mitigating against interest rate risk (IRR). But, the proposalÂ establishes a Ã¢ÂÂpay-to-playÃ¢ÂÂ regulatory scheme for credit unions that are permitted to engage in derivatives activities.Â IÃ¢ÂÂll get into that in a moment.Â
First, I should probably give some background on what derivatives are and what NCUA is proposing. NCUA has created a Q&A document addressing this, among other things.Â From the Q&A document:
Ã¢ÂÂQ.1: What are derivatives? What kinds of derivatives is NCUA proposing to allow for credit unions?
The Commodities Futures Trading Commission (CFTC) broadly defines a derivative as: Ã¢ÂÂA financial instrument, traded on or off an exchange, the price of which is directly dependent upon (i.e., Ã¢ÂÂderived fromÃ¢ÂÂ) the value of one or more underlying securities, equity indices, debt instruments, commodities, other derivative instruments, or any agreed upon pricing index or arrangement (e.g., the movement over time of the Consumer Price Index or freight rates). They can be used to hedge risk or to exchange a floating rate of return for fixed rate of return. Derivatives include futures, options, and swaps.Ã¢ÂÂ
While the term Ã¢ÂÂderivativesÃ¢ÂÂ covers a broad spectrum of financial instruments in todayÃ¢ÂÂs market, NCUA is only recommending authorizing the use of plain-vanilla, US Dollar-denominated (USD) interest rate swaps and purchased-only interest rate caps. These instruments are widely transacted in todayÃ¢ÂÂs capital markets, have deep and transparent pricing and afford end users with strong liquidity and execution. The Bank for International Settlements reports that interest rate swaps are the largest component of the global over-the-counter (OTC) derivatives market.
With regard to interest rate swaps, the NCUA Board is proposing to authorize only standard Ã¢ÂÂpay-fixed/receive-floatingÃ¢ÂÂ and Ã¢ÂÂpay-floating/receive-fixedÃ¢ÂÂ interest rate swaps. It is currently anticipated that most interest rate swaps users would enter into Ã¢ÂÂpay-fixed/receive-floatingÃ¢ÂÂ transactions to hedge against rising interest rates. This Ã¢ÂÂplain vanillaÃ¢ÂÂ interest rate swap affords some protection against the most common interest rate exposure experienced by credit unions with material interest-rate risk (IRR) sensitivityÃ¢ÂÂnamely, a balance sheet with an asset portfolio that does not reset to external rate changes as quickly as its liabilities. Most credit unions use non-maturity and other short-term shares to fund longer duration assets, creating an inherent re-pricing mismatch for which pay-fixed/receive-floating interest rate swaps can provide some effective mitigation.Ã¢ÂÂ
Eligible credit unions seeking derivatives authority must submit an application for one of two levels of authority.Â Level I authority contains more stringent limits, including limits to the notional value of interest rate swaps, aggregate book value of interest rate caps, combined limit of interest rate swaps and caps, and the maximum weighted average life of all derivatives transactions cannot exceed 5 years.Â Level II authority has fewer limits, but credit unions that seek Level II authority must show why the Level I limits are not adequate to meet their IRR mitigation needs.
So whatÃ¢ÂÂs the catch?Â You have to Ã¢ÂÂpay-to-play.Ã¢ÂÂÂ The proposed rule calls for application fees and pretty hefty ones at that.Â Level I application processing costs would range from $25,000 to $50,000 and Level II applications would range from $75,000 to $125,000.Â If thatÃ¢ÂÂs not bad enough, there is an associated fee for every year after that.Â
NAFCU has long advocated for expanded investment authorities for credit unions, but the "pay-to-play" proposal raises concerns as this would be the first time Ã¢ÂÂpay-to-playÃ¢ÂÂ will be required in the credit union industry.Â
The proposal can be accessed here.Â NCUAÃ¢ÂÂs Q&A document Ã¢ÂÂ which provides an understanding of the ruleÃ¢ÂÂs intent and the main contents Ã¢ÂÂ can be accessed here.Â Also, NAFCUÃ¢ÂÂs Regulatory Affairs team is in the process of drafting a Regulatory Alert (NAFCU Member Log-In required) on this proposal so keep your eyes peeled for that.Â
I just had to share these pictures with you all.Â Have a great weekend.