Using derivatives to hedgeagainst interest rate risk is not a strategy that looms large onmany credit unions' horizons. However, those that pursue it mayfind significant advantages, according to Emily Hollis, a partner with ALM First, a Dallas consulting firm.

“Derivatives can serve as a valuable tool for some creditunions, offsetting the interest rate risk inherent in today'sfinancial environment,” Hollis said. “When used properly,derivatives allow eligible credit unions to compete moreeffectively, but their restrictions and guidelines must beunderstood and followed.”

Understanding and applying the newly available hedging tools wasthe focus of ALM First's Feb. 20 webinar “The Use of Derivatives.”Hollis led 95 participants through the strategies of hedgingbalance sheet risk with various kinds of derivatives in compliancewith the NCUA's newly released guidelines.

ALM First is currently the only organization that has approvedderivative credit union clients, according to an earlier releasefrom the firm. NCUA's new ruling limits derivative use to federallyregulated credit unions with assets of more than $250 million, aCAMEL rating of 1, 2 or 3 and a management rating of 1 or2.

The final rule differs significantly from the earlier Notice ofProposal Rule, Hollis told webinar participants. The final rulecontains added interest rate swaps, purchased interest rate caps,purchased interest rate floors and Treasury note futures toinvestment authorities for qualified credit unions, sheexplained.

Many credit unions need stable, long-duration funding, Hollistold webinar participants. Deposits and borrowed funds are, atbest, average hedging sources. Interest rates swaps and capscan be great interest rate management tools for credit unionsprepared and authorized to use them, she said.

The use of derivatives originally was not condoned by the NCUAexcept under very limited circumstances. The regulator approved amuch broader use of derivatives within its revised guidelines onJan. 23.

In order to be approved to use derivatives, credit unions mustpresent the NCUA with an interest rate risk mitigation plan thatdemonstrates the role derivatives will play and how credit unionswill acquire the necessary resources to use them.

The agency will then evaluate the credit union on its readinessto engage in derivative transactions based on its personnel,control mechanisms and systems in place to manage the program. Thisreadiness includes understanding and approval by the credit union'sboard, Hollis told webinar attendees.

“The board will have to approve the credit union's entry intothe derivatives market before NCUA will undertake the finalapproval process,” Hollis said. “The regulator doesn't want to gothrough the efforts if the board is likely to say 'no' toderivatives later on.”

The NCUA's goal is to respond within 120 days of the initialapplication with final approval for the program, she added