Derivatives are instruments financial institutions use to manage interest-rate risk by decreasing risk exposure.
Today’s derivatives market is huge—$342 trillion for interest-rate swaps alone (in “notional” value). Banks have used derivatives extensively for many years. Approximately 28% of banks with assets between $250 million and $1 billion, and 57% of banks with assets between $1 billion and $5 billion use derivatives to guard against interest-rate risk. Essentially, derivatives have become standard practice for many banks.
NCUA has approved its final rule on the use of simple derivatives. This gives credit unions direct access to these risk management tools (albeit at a much simpler level than their banking counterparts). NCUA’s ruling makes about 400 credit unions eligible to apply for the authority to engage in derivatives. The agency estimates 30 to 60 credit unions will apply for the authority within two years.SIDEBAR:
Derivatives can be complex, but they’re basically financial contracts between two parties that derive their value from an underlying asset, commodity, index, or currency. Interest-rate derivatives are used to customize cash flow needs, such as turning a fixed-rate asset into a floating-rate asset, or vice versa. Most credit unions engage in derivatives that gain value when rates rise. This can reduce fair-value losses on a credit union’s longer-term assets, such as mortgage loans.
To understand how derivatives work, consider a futures contract. For example, a producer of wheat might be trying to secure a price at which to sell next season’s crop, while a bread maker might be trying to lock in a price today to buy the wheat to estimate future costs and profits.SIDEBAR:
The farmer and the bread maker would then enter into a futures contract requiring the delivery of 1,000 bushels of grain to the buyer in September 2014 at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in September. This contract can then be bought and sold in the futures market. Misconceptions
The primary misconception of derivatives is that they’re all risky. Derivatives, like most financial instruments, can be risky when viewed in isolation. Homeowners insurance never looks like a reasonable investment until you attach it to a house. Then the combination looks great.
The same goes for derivatives. They hardly ever look good by themselves, but they can look great as part of a portfolio or balance sheet. All derivatives contain some level of risk, but they can have strong risk-reducing characteristics at the portfolio level.
Another misconception is that the demise of some corporate credit unions was due solely to derivatives, which isn’t true. Credit losses on nonconforming securities, not basic derivatives, caused corporate failures.
When using derivatives as defined by NCUA’s ruling, credit risk is minimal due to the requirement of collateral postings. International Securities Dealers Association (ISDA) agreements state that collateral is supported by 100% of the market value gains with daily pricing.
From the credit union’s perspective, a market value gain will be covered by the posting of collateral from the dealer. A market value loss will require the credit union to post collateral to the dealer. The minimum transfer amount is $250,000, which means any movement over that amount will trigger movement of collateral. Exposure to the counterparty is limited to this $250,000 and any further daily market movement.
NEXT: Interest-rate swaps