The National Credit Union Administration (NCUA) issued a proposed rule last month to lift a federal ban on derivatives trading by credit unions. The proposal would allow qualified credit unions limited authority to engage in derivatives activities for purposes of mitigating against interest rate risk (IRR) under a pay-to-play regulatory scheme.
Along with its proposed rule, the NCUA released a Q&A document. One of the issues addressed in the Q&A is the NCUA’s definition of derivatives:
Q.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: “A financial instrument, traded on or off an exchange, the price of which is directly dependent upon (i.e., “derived from”) 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.”
While the term “derivatives” covers a broad spectrum of financial instruments in today’s 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 today’s 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 “pay-fixed/receive-floating” and “pay-floating/receive-fixed” interest rate swaps. It is currently anticipated that most interest rate swaps users would enter into “pay-fixed/receive-floating” transactions to hedge against rising interest rates. This “plain vanilla” interest rate swap affords some protection against the most common interest rate exposure experienced by credit unions with material interest-rate risk (IRR) sensitivity—namely, 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.”
To participate in derivatives trading under the proposed rule, credit unions must submit an application for one of two levels of authority with the applicable application fee of $25,000 to $125,000. Once approved for derivative trading, credit unions must pay an annual fee to stay in the program.
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