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Language is unclear in the law regulating credit unions investing in derivatives. Will NCUA’s new effort to revisit the rule help?

 
 

Credit Unions have long been prohibited from investing in derivatives, a risky but possibly rewarding investment that can help financial institutions hedge a portfolio. Recently, the NCUA has been mulling loosening the restriction, asking credit unions and CUSOs for comments on the topic. Whatever the outcome, I hope any new language on investing in derivatives will be crystal clear because, in my opinion, previous attempts to loosen it have been a little confusing.

The NCUA released an Advance Notice of Proposed Rulemaking (ANPR) on June 17 regarding financial derivatives transactions. Derivatives have periodically received a bad rap, most recently following the financial crisis of 2008. However, when used properly, derivatives such as interest-rate swaps can hedge an investment portfolio’s interest rate risk. The new rulemaking could modify the ban on derivatives investment and determine whether exceptions under ‘pilot programs’ created in the late 1990s – which I think are hazy exemptions – will continue.  

In general, NCUA’s effort is a welcomed attempt at regulatory easing. But this new prerogative doesn’t fix the fact that NCUA just might be unnecessarily requiring credit unions to obtain NCUA approval before joining a third party’s investment pilot program. The pilot programs were created in the late 1990s as the NCUA Board acknowledged that, while many credit unions didn’t understand derivatives and were taking great risks, derivatives could be a powerful portfolio tool when used by experienced investors.

To balance the risk and benefit, the NCUA created exemptions in the form of two types of investment pilot programs: one for credit unions to invest themselves and one for credit unions to use a third party to help invest. These investment pilot programs are the core focus of the proposed rule making today.

Here’s where it gets a little odd. Credit unions are required to submit a slew of documents to the NCUA and must get its approval before joining pilot investment programs, either individual or third-party. That’s because the NCUA wants to ensure that a credit union can skillfully deal with potentially complex derivatives. This approval process seems logical for individual credit union pilot programs that will be managing their own derivates. But doesn’t it seem burdensome for credit unions to obtain NCUA approval and to “demonstrate adequate experience and infrastructure” to join a third party’s investment pilot program? Why?

I mean, the whole purpose of setting up third-party investment pilots was to allow inexperienced credit unions to benefit from derivatives and to gain the experience they need from a more experienced investor’s services.

How does it make sense to limit participation in third-party pilot investment program to those credit unions that need it least – those with enough experience to operate independently – while barring those credit unions that arguably need it most – those that are so inexperienced that they need an expert, third-party investment program?  

Even more confusing, it looks like the approval requirement is in direct contradiction to the original law which says, “credit unions need not obtain individual written approval to engage in investment activities prohibited by this part but permitted by statute where the activities are part of a third-party investment program that NCUA has approved under this section.” At the time the rule was revised, NCUA recognized that any third-party’s pilot investment program would have already been thoroughly vetted and NCUA-approved by the time a credit union participated in it.

The way I’m reading it, the NCUA created a classic chicken-and-the-egg scenario for small, inexperienced credit unions: you can’t easily get the help you need because you’re inexperienced, and you’re inexperienced because you can’t easily get the help you need. I hope any new regulations or modifications to the rule on derivates will make a little more sense.