Derivatives

Written by Carrie Hunt

NCUA has announced its agenda for Friday's NCUA Board meeting and front and center is an ANPR on derivatives.  Derivatives are one of those topics of cocktail hour conversations that no one wants to admit that they have no idea what one is.  "So Bob, how about those derivatives traders?  Can you believe they made those swaps?"  "No, I can’t, Carol.  Those deals were crazy."

Hedging.  Counterparties.  Third party transactions.  The fun never stops.

So what does Derivative mean?  Investopedia tells us that it is a "security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage."


Currently, NCUA has a pilot program relative to derivatives and almost all of the derivative action that credit unions participate in is relative to interest rate swaps.  NCUA discussed derivatives in a February 2011 NCUA Report:

"What are swaps and caps, and why use them? Depository institutions rely on both instruments to hedge interest-rate risk - the risk a change in rates will materially impair earnings. In a "vanilla" swap - the type credit unions use - one party makes a fixed payment (equal to an unchanging rate times notional value) and receives a floating payment (equal to a varying short-term rate times notional value). Suppose, for example, the floating rate is one-month LIBOR - currently 30 basis points (or bps, three-tenths of a percentage point) - and the fixed rate is 20 bps.  Further, suppose notional value is $10,000,000; payments are annual; and settlement is due. A credit union committed to receive floating/pay fixed will collect the net amount - $10,000 (the difference in rates, 0.001, x $10,000,000) - from the counterparty. In an interest-rate cap, the buyer pays an upfront premium to receive compensation when a floating short-term rate exceeds a fixed rate (say, a payment if one-month LIBOR exceeds 20 basis points on a certain date, equal to notional value times the spread). Note in both cases receipts rise with LIBOR."

With NCUA reconsidering their entire investment rule, derivatives may be an issue that credit unions will not be able to ignore.  As always, NAFCU will prepare a Regulatory Alert on NCUA’s ANPR, so stay tuned on this issue.