10 Questions a CU Board Should Ask When Establishing a Derivatives Program
Credit unions are increasingly utilizing derivatives to manage risk, with industry interest and adoption growing since the NCUA streamlined rules surrounding their regulation in June of 2021. The current NCUA derivative rules, found in Part 703 Subpart B, established a principles-based approach to hedging with derivatives. Changes served to exempt certain FCUs from the application process and remove regulatory limits on both the amount and types of derivatives. A renewed focus on risk management has led many credit unions to seek guidance on establishing derivatives programs. Below are 10 questions a credit union board of directors should ask during the derivative establishment process and after exposure to the fundamental mechanics of derivatives.
1. What regulatory applications are necessary prior to engaging in our first derivative transaction?
According to NCUA regulation Part 703.108, an FCU is exempt from the application process so long as it has both:
· A Management CAMEL component of 1 or 2
· At least $500 million of assets
If your credit union is exempt from the application process, the only regulatory requirement is notifying the applicable regional director via email or in writing within five business days after the first transaction. Otherwise, prior written approval must be obtained. This is done via an application, which would, amongst other things, document plans regarding interest rate risk (IRR), derivative products intended to be used, policy drafts, and operational support. For state-chartered credit unions, most state laws offer parity to the federal rules found above, but some states do have differences. If your cooperative is state chartered, it’s important to become familiar with your state’s requirements and consult with qualified legal counsel.
2. How do derivatives benefit members of the Credit Union?
Derivatives are used across the globe by entities seeking to manage risk. Most financial intermediaries face interest rate risk (IRR) exposure from lending and funding activities. Specifically, credit unions face IRR that can be managed using derivatives. Sometimes phrased as, “don’t manage your interest rate risk using your membership”, derivatives can benefit cooperatives by allowing lending and funding activities to go on-balance sheet while simultaneously mitigating the institution’s interest rate risk footprint. Specifically, if the institution is concerned with market value losses of mortgage loans given upward rate movements, instead of ceasing issuance, derivatives can be used to offset losses in market value. If concern is margin compression in a falling rate environment, derivatives can be used to stabilize margins. The result is a centralized IRR management function that can allow for greater product flexibility. Who regulates the derivatives markets?
The Commodity Futures Trading Commission (CFTC) is the primary regulator of the U.S. derivatives market. Created in 1974, it is an independent federal agency responsible for regulating, amongst other things, futures exchanges, clearing organizations (clearinghouses), and the swap market. After the 2007-2008 financial crisis its jurisdiction was expanded to include the swap market, and many of the financial innovations around credit risk, such as margining and central clearing, from the exchange-traded markets were applied to the swap market.
3. What are some risks and red flags to keep in mind?
The use of complex or illiquid derivatives is a red flag. For the most part, interest rate risk hedging can be accomplished with simple, plain-vanilla swap instruments which can be more easily unwound if necessary. Conventional swaps are tied to the Secured Overnight Financing Rate (SOFR) or the Overnight Federal Funds Rate. Furthermore, participation in transactions without appropriate knowledge or experience in the markets can indicate a red flag. Derivatives, while highly useful for risk management, can generate undue losses if not used appropriately. Along these lines, a large ratio of derivatives notional to total assets can be something to keep in mind. While a high ratio can be justifiable if used in a hedging relationship, the greater the notional relative to assets, the greater the materiality to the institution. As that number becomes larger it becomes even more critical to understand the hedging implications. Drawing numbers from the bank industry, commercial banks under $10B hold a median of 10% swap notional to total assets, with 25% being the 90th percentile. Lastly, a rapid growth in derivative use without appropriate hedge relationship documentation is a red flag. It should be very clear what the hedged risk is and how the hedges mitigate this risk. Institutions should understand the interest rate risk and liquidity impacts of using derivatives to prevent financial surprises.
4. Who is on the other side of the transaction and how do we manage the risk of this counterparty?
Most of the time it’s a market maker (dealer) in derivatives. For cleared transactions, the central clearing firm (clearinghouse) acts as the ultimate counterparty and surety guarantee, becoming the buyer to all sellers and seller to all buyers. For non-cleared transactions, sometimes called bilateral transactions, NCUA regulation Part 703.104 requires these be done with a registered swap dealer with the CFTC. It also requires the credit union to have in place a margining process. Counterparty risk is a commonly cited risk of derivatives, particularly for bilateral transactions, and is mitigated through the margining process. For example, if an institution has an open derivative position with a gain, then the margin process entails requesting cash to be held to protect the credit union against a counterparty default. Often there is a minimum transfer threshold to prevent the inconvenience of small denominations from being transferred. The transfer amount should represent the current value of the position if it were to be closed out at that time. For exchange-traded derivatives, such as futures contracts, any payments due to the credit union are guaranteed by a clearinghouse, and these transactions are generally seen as safer than bilateral transactions from a counterparty risk perspective.
5. How much is being hedged and how is this amount determined?
The quantity of derivatives should be directly related to the item being hedged—the hedged item. As stated earlier, the primary source of interest rate risk on the balance sheet stems from lending and funding activities and the interest rate risk mismatch therein. While all credit union balance sheets are different, they all should have a sensitivity profile that can be modeled with a degree of reasonableness. You can’t manage what you can’t quantify. Institutions should be confident in their quantification of interest rate risk and have sophisticated models that can support hedgeable analytics.
6. How do we ensure we have the expertise to manage a derivatives program?
NCUA regulation Part 703.106 outlines four areas of expertise: asset/liability management (ALM), accounting and financial reporting, derivative execution and oversight, and lastly counterparty, collateral, and margin management. Understanding and ensuring expertise in these areas will help promote a successful derivatives program, as success is contingent on multiple departments working together in concert. The NCUA defines an External Service Provider (ESP) as an “entity that provides services to assist in carrying out its Derivatives program.” Part 703.107 also outlines what an ESP may or may not do. A derivative advisor is a professional financial services firm providing support in derivative program implementation, thus helping institutions accomplish their risk management goals given their financial situation. Overall, a derivative advisory firm can be valuable as an objective sounding board, providing context with the broader industry, and bolstering internal capabilities. If a derivative advisor and/or an ESP are utilized, it is still important for internal management to have an understanding of that process.
7. What internal controls are common for larger institutions?
Internal controls should center around the ALM, accounting, capital markets, and counterparty management. There should be a separation between the party responsible for measuring risk and the party responsible for overseeing the hedges. Common practice amongst credit unions with hedging programs is the review of monthly derivative exposure reports. While a full ALM report run every month isn’t required, understanding the impact of hedges on the ALM profile isn’t a bad idea, either, especially for those utilizing NEV metrics as rebalance thresholds. For accounting, internal controls usually involve the auditing staff, which will look to ensure all elements of GAAP are met, along with appropriate records and financial documents. Thus, as part of internal controls, an accounting report is usually produced that shows a monthly snapshot of all cash received/paid, accruals, and valuations so that financial statement entries can be reconciled properly. Controls on capital markets execution are usually in place as well in the form of required trade approvals and board resolutions that document who is allowed to place trades. Lastly, an important area of internal control is daily price monitoring for margining. While the dealer typically sets the value for margining (for bilateral transactions), having an additional source to model the derivative price is an internal control recommendation. While the dealer will be quick to request margin if the price moves in their favor, it is important to remember they will be less inclined to return it to you if the opposite occurs!
8. What is the financial statement impact of using derivatives?
Accounting standards for derivatives are provided in FASB ASC 815. These standards dictate that any contract meeting the definition of a derivative should be reported at fair value with changes in fair value reported through earnings unless designated in a hedge accounting relationship. If hedge accounting is designated the derivative change in fair value can be offset by the hedged item such that its change is not reported in current earnings. If the accounting relationship becomes ineffective, then the total or a residual amount of the derivative P&L may be reported through earnings and could cause income volatility.
9. Do we need to use hedge accounting?
A hedge accounting relationship need not be used for all hedging transactions. For example, if the hedged item is already accounted for under the fair value option (FVO) this means the changes in fair value of the asset/liability already flow through earnings. Thus, paired with a hedge, the income effect would be naturally offsetting. This is sometimes called a natural hedge and is commonly the case in mortgage servicing rights (MSR) hedging (since institutions often elect FVO for MSR assets). Also, held for sale (HFS) loan pipelines are typically not hedged using a hedge accounting relationship, as this process involves daily and intraday rebalances and an FVO election is usually made as well. However, for assets/liabilities that stay on the balance sheet for their life (held for investment) hedge accounting is virtually always used to prevent a volatile income statement from the P&L impact of the derivative.
With the growing use of derivatives in the credit union industry, more financial professionals are looking for the necessary expertise to ensure a successful derivative program implementation.
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