[Federal Register Volume 79, Number 21 (Friday, January 31, 2014)]
[Rules and Regulations]
[Pages 5228-5247]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-01703]


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NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Parts 703, 715, and 741

RIN 3133-AD90


Derivatives

AGENCY: National Credit Union Administration (NCUA).

ACTION: Final rule.

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SUMMARY: This final rule permits credit unions to engage in limited 
derivatives activities for the purpose of mitigating interest rate 
risk. This rule applies only to Federal credit unions. The final rule 
addresses permissible derivatives and

[[Page 5229]]

characteristics, limits on derivatives, operational requirements, 
counterparty and margining requirements, and the procedures a credit 
union must follow to apply for derivatives authority.

DATES: This final rule is effective March 3, 2014.

FOR FURTHER INFORMATION CONTACT: Justin M. Anderson, Staff Attorney, 
Office of General Counsel, at the above address or telephone (703) 518-
6540; or Tom Fay, Senior Capital Markets Specialist, Office of 
Examination and Insurance, at the above address or telephone (703) 518-
1179.

SUPPLEMENTARY INFORMATION:

I. Notice of Proposed Rule Making
II. Summary of Comments
III. Section-by-Section Analysis of the Final Rule
IV. Regulatory Procedures

I. Notice of Proposed Rule Making

    In May 2013 the NCUA Board (Board) issued a proposed rule to permit 
Federal credit unions (FCUs or credit unions) to engage in derivatives 
transactions for the purpose of mitigating interest rate risk (IRR). 
The proposal also required federally insured, state-chartered credit 
unions (FISCUs) permitted by state law to engage in derivatives to 
follow the requirements of NCUA's rule. The proposed rule required a 
credit union seeking derivatives authority to meet minimum eligibility 
criteria and included two levels of authority, Level I and Level II. 
The two levels had different permissible limits of derivatives and 
regulatory requirements. To obtain Level I or Level II authority, the 
proposed rule required a credit union to apply to NCUA or, in the case 
of a FISCU, its state supervisory authority (SSA). In addition, the 
proposed rule described requirements on derivatives processes, systems, 
and personnel; experience requirements; and restrictions on the use of 
external service providers (ESPs). The proposed rule also addressed 
credit unions in NCUA's pilot program and regulatory violations. 
Finally, the Board specifically requested comment on the possibility of 
requiring credit unions that apply for derivatives authority to pay an 
application and/or supervision fee. The Board issued the proposed rule 
with a 60-day comment period.

II. Summary of Comments

    The Board received 75 comments on the proposed rule: 28 from FCUs; 
16 from FISCUs; 13 from state credit union leagues; 9 from credit union 
service organizations or third-party vendors, including investment 
advisors and brokers; 3 from trade associations; 3 from SSAs; 2 from 
law firms; and 1 from a Federal Home Loan Bank.
    In general, commenters supported permitting credit unions to engage 
in derivatives transactions. However, all commenters opposed at least 
one aspect of the proposed rule. While most provisions of the rule 
elicited comments, commenters focused on fees, permissible derivatives, 
limits, processes, and experience requirements.
    Most commenters believed the proposed requirements imposed high 
costs and regulatory burdens on credit unions. Virtually all of the 
commenters, however, believed that credit unions would be able to use 
derivatives as a meaningful IRR mitigation tool if the Board did not 
include application or supervisory fees and reduced the regulatory 
requirements. The Board addresses comments on the proposed rule in more 
detail in the following section.

III. Section-by-Section Analysis of the Final Rule

(a) General

    The Board has made several changes in the final rule based on 
public comments. Most notably, the Board has condensed and simplified 
the rule and reduced the overall regulatory burden. The Board also 
decided not to include, in this final rule, fees associated with using 
derivatives. The final rule also addresses swap clearing regulations 
issued in early 2013 by the Commodities and Futures Trading Commission 
(CFTC). The following is a brief summary of the final rule:
     The rule allows limited derivatives authority comprising 
of plain vanilla interest rate derivatives for balance sheet management 
and risk reduction.
     Derivatives exposure is limited by two related measures, a 
measure of notional amount of derivatives outstanding and a fair value 
loss limit. The limits are designed to work in tandem, with the 
notional limit a prospective limit on a credit union's derivatives 
activity and the fair value loss limit based on the actual performance 
of the derivatives held by a credit union.
    [cir] The limit on notional amount of derivatives outstanding takes 
into account the type of derivative and the time to maturity, two key 
components that determine an instrument's sensitivity to interest rate 
changes. This innovation provides significant flexibility under the 
rule and improves the relationship between the notional limit and the 
fair value limit.
    [cir] The fair value threshold, if breached, will require a 
participating credit union to cease new derivative investments, provide 
notification and develop a corrective action plan.
     Credit unions are required to apply for derivatives 
authority. Generally the application process will be conducted in two-
stages. In the first stage, the credit union will present to NCUA an 
IRR mitigation plan, which demonstrates how derivatives fit within that 
plan and how it will acquire the appropriate resources, controls and 
systems to implement a sound derivatives program. In the second stage 
of the approval process, NCUA will evaluate the credit union on its 
actual readiness to engage in derivatives transactions based on the 
personnel, controls, and systems it has put in place. Credit unions new 
to derivatives authority must operate safely for one year under limited 
authorities before moving to full authority.
     The rule outlines the appropriate resources, controls and 
systems required for an effective derivatives program.
    The Board believes the changes between the proposed and final rules 
will significantly lower the cost and burden for credit unions to use 
derivatives as part of their IRR mitigation strategy.

(b) Changes to Part 703

    The proposed rule divided part 703 into two subparts, subpart A and 
subpart B. Subpart A consisted of the current part 703, with minor 
modifications, and subpart B consisted of rules and requirements 
related the use of derivatives. The Board did not receive any comments 
on the changes to Part 703, but is amending the definition of 
``derivative'' in both subparts for accuracy. The Board has not made 
any other changes to the structure of Part 703.
    In addition, the Board notes that the requirements of new subpart B 
do not apply to derivatives transactions that are permitted under Sec.  
703.14, which include European call options, interest rate lock 
commitments, certain embedded options, and certain options associated 
with the sale of loans on the secondary market.

(c) Purpose and Scope (Sec.  703.100)

    The purpose and scope section of the proposed rule indicated that 
the rule applied to FISCUs that are permitted to engage in derivatives 
by state law. The purpose and scope section also outlined which 
sections of the rule applied specifically to the different levels of 
derivatives authority (Level I or Level II, as defined in the proposed 
rule). Based on public comment and other changes

[[Page 5230]]

to the rule, the Board has significantly revised this section.
(1) Applicability to FISCUs (Sec.  703.100)
    The proposed rule required any FISCU permitted by state law to 
engage in derivatives to follow NCUA's rule, including the application 
process and regulatory limits. Approximately one-quarter of the 
commenters addressed this requirement. All but one commenter argued 
that NCUA is encroaching on states' rights and should not regulate 
FISCUs' derivatives use. Commenters maintained that such regulation is 
the province of the states, and that NCUA did not provide sufficient 
support for Federal regulation of derivatives transactions.
    After consideration of the comments, the Board has removed this 
requirement from the rule. Given the absence to date of any problems 
specific to FISCUs' derivatives use, FISCUs may follow applicable state 
law (including a state parity provision) or other SSA authorization, 
rather than this final rule.
    NCUA will closely supervise all federally insured credit unions 
that engage in derivatives, and will address any safety and soundness 
concerns through use of applicable enforcement actions. Given the 
complexity of, and risks associated with, derivatives activity, NCUA 
will be publishing supervisory guidance in this area. This guidance 
will address standards for the safe and sound operations of a 
derivatives program, including expectations for comprehensive policies 
and procedures, counterparty and collateral management practices, 
internal control, accounting, and reporting systems, personnel with 
appropriate levels of expertise, and asset-liability management 
modeling capabilities. As insurer, NCUA's supervisory guidance will 
apply to all federally insured credit unions. The final rule also 
requires that a FISCU engaging in derivatives--whether pursuant to 
authority granted under state law (including a state parity provision) 
or other SSA authorization--must notify the applicable field director 
in writing at least 30 days before it begins engaging in such 
transactions. This provision will open a dialog between the FISCU and 
NCUA about the objectives of each new derivatives program. It will also 
facilitate efforts between NCUA and SSAs to coordinate off-site 
monitoring and on-site supervision.
(2) Registered Investment Companies
    The Board also wants to clarify application of this rule to Sec.  
703.14(c), which reads as follows:
    (c) Registered investment company. A Federal credit union may 
invest in a registered investment company or collective investment 
fund, as long as the prospectus of the company or fund restricts the 
investment portfolio to investments and investment transactions that 
are permissible for Federal credit unions.
    The Board notes that this final rule will not allow FCUs that are 
approved for derivatives to invest in a registered investment company 
or collective investment fund that has derivatives. The Board does not 
believe it is appropriate for FCUs to invest in entities that may use 
derivatives for non-hedging purposes. The Board notes that derivatives 
are complex instruments that can pose significant risk.
    The Board has taken steps to mitigate that risk for credit unions 
using derivatives, but does not have authority to do the same with 
respect to registered investment companies and collective investment 
funds. The Board is concerned that such entities using derivatives may 
put credit unions, and therefore the NCUSIF, at risk. Thus, NCUA has 
included a clarifying provision in the final rule stating that FCUs are 
not permitted to invest in registered investment companies or 
collective investment funds that allow derivatives to be in their 
investment portfolios. The Board also notes that the purpose of this 
rule is to permit credit unions to use derivatives for the very limited 
purpose of mitigating IRR. It never intended for this rule to be a 
vehicle for credit unions to take on additional risks through a 
registered investment company or a collective investment fund.

(d) Definitions (Sec.  703.101)

    The proposed rule included several new definitions. The Board 
received three comments asking for clearer definitions of ``plain 
vanilla derivatives,'' ``leveraged derivative,'' and ``weighted average 
life.'' In addition to clarifying several of the definitions, the Board 
has added new definitions to correspond with other changes in the rule. 
The Board has also deleted definitions of terms that are no longer used 
in the rule.

(e) Permissible Derivatives and Characteristics (Sec.  703.102)

    The proposed rule permitted credit unions that have derivatives 
authority to use interest rate swaps and interest rate caps. The 
proposal further limited the use of interest rate swaps and interest 
rate caps to those that are non-leveraged, based on domestic rates, 
denominated in U.S. dollars, are not used to create structured 
liability offerings, and settled within three days. The proposal 
further limited the use of interest rate swaps to those that did not 
have a fluctuating notional amount.
    More than half of the commenters maintained that the list of 
permissible derivatives was too restrictive to allow credit unions to 
adequately hedge against IRR. Many of these commenters believed NCUA 
should allow interest rate floors as a means of hedging against falling 
rates. Other commenters suggested the list of permissible derivatives 
should include swaptions, basis swaps, forward settling swaps, swaps 
with amortizing features, interest rate collars, and interest rate 
futures. These commenters cited IRR mitigation and low levels of 
complexity as reasons for permitting these additional derivatives and 
characteristics.
    The Board has considered all of the derivatives and characteristics 
suggested by commenters, and has expanded the list of permissible 
derivatives and characteristics in the final rule. In reviewing each 
suggested derivative, the Board compared the product's utility in 
mitigating IRR to the derivative's overall complexity and risk. After 
careful deliberation, the Board is permitting credit unions to apply 
for the following derivatives and characteristics:

----------------------------------------------------------------------------------------------------------------
             Derivatives                                      Derivative characteristics
----------------------------------------------------------------------------------------------------------------
 Interest rate swaps........   Amortizing notional amounts for swaps, caps, and floors.
 Interest rate caps.........
 Interest rate floors.......   Forward start date for swaps (90-day maximum).
 Basis swaps.
 Treasury futures.
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[[Page 5231]]

    The following is a description of each new derivative or 
characteristic that the Board has included in this final rule. The 
following discussion does not include plain vanilla interest rate swaps 
and interest rate caps, which the Board discussed in the proposed rule:
    (1) Interest Rate Floors. An interest rate floor requires payment 
to the holder when an underlying interest rate (the ``index'' or 
``reference'' interest rate) falls below a specified contract rate (the 
``floor rate'').
    (2) Basis Swaps. A basis swap is an interest rate swap in which the 
parties exchange two floating rate indices. For example, Party A enters 
into a five-year agreement with Party B in which Party A makes 
quarterly payments to Party B of the U.S. dollar Prime rate multiplied 
by $10,000,000 (the notional amount), and Party B makes quarterly 
payments to Party A of the Three-Month U.S. dollar LIBOR rate times 
$10,000,000. The Board believes that basis swaps can be a useful 
hedging tool and are commonly used when one party is active in two 
money markets and wishes to limit the exposure to the risk that the 
spread between the two interest rates fluctuates.
    (3) Amortizing Notional Amounts. An amortizing notional amount is a 
characteristic of an interest rate cap, interest rate floor, or 
interest rate swap where the notional amount of the derivative 
decreases over time according to a predetermined, fixed schedule. The 
Board agrees the use of amortizing derivatives can potentially enhance 
hedge effectiveness, provided the amortizing schedule is set at the 
time of the derivative transaction. For example, a $5 million five-year 
interest rate swap where the notional amount is reduced $1 million each 
year after year one. However, the Board is not permitting derivatives 
with amortizing notional amounts in which the notional amount is 
indexed to another financial instrument. For example, a credit union 
cannot enter into an interest rate swap where the notional amount 
declines based on the amount and frequency of repayments of a reference 
mortgage pool or portfolio. In such circumstances, the reference index 
is known but the amounts are unknown and can vary throughout the term 
of the contract. This adds significant uncertainty to the performance 
of the derivative, resulting in modeling and pricing complexity that is 
inconsistent with the objectives of this final rule.
    (4) Treasury Futures. A Treasury future is an IRR management tool 
and a contractual obligation to either buy (take delivery of) or sell 
(make delivery of) U.S. Treasury notes on a specified date in the 
future. The final rule restricts permissible Treasury futures to those 
that deliver Treasury notes (Treasury notes with maturities of up to 10 
years, as compared to Treasury bonds which have maturities greater than 
ten years).
    (5) Forward Starting. A forward start date is a characteristic of 
an interest rate swap that allows the start date of the exchange of 
interest rate payments to begin at some date in the future. The Board 
is permitting forward start dates of up to 90 days from the date the 
credit union executes the transaction. The Board believes that longer 
forward start dates can impose undue risk on a credit union.
    As discussed in more detail below in the section on applications, a 
credit union must demonstrate that it has the need for, and capacity to 
manage, the type of derivatives and associated characteristics it is 
seeking. Accordingly, in its application for derivatives authority, a 
credit union must specify which type(s) of derivative(s) it is 
requesting, include a description of each type of derivative it seeks 
to use, a discussion of how the type of derivative(s) fits within its 
IRR mitigation plan, and a justification and statement of use for each 
type of derivative.
    The Board notes that this requirement is different from the 
proposed rule, which permitted any approved credit union to use 
interest rate swaps or interest rate caps without specifically applying 
for these types of derivatives. With an expanded list of permissible 
derivatives and characteristics in the final rule, the Board believes 
it is necessary and prudent for credit unions to specify how each 
requested type of derivative fits in the credit union's unique asset-
liability structure and IRR mitigation plan. The Board believes this 
system in the final rule appropriately balances an expanded list of 
permissible derivatives and safety and soundness.
    The Board notes that a credit union may subsequently apply for 
additional types of derivatives or characteristics that it does not 
seek in its original derivatives authority application. The final rule 
includes procedures for applying for authority to use additional types 
of derivatives.
    The Board believes the types of derivatives and characteristics in 
this final rule will provide credit unions with effective tools to 
hedge IRR. NCUA's analysis of other derivatives and characteristics 
suggested by commenters, in particular swaptions and interest rate 
collars, did not warrant inclusion of these derivatives transaction 
types at this time. The Board determined that the other types of 
derivatives suggested by commenters added higher levels of complexity 
and risk without adding to a credit union's IRR mitigation strategy. 
The Board believes the expanded list of derivatives it has included in 
the final rule will allow a credit union to successfully use 
derivatives as part of its IRR mitigation strategy.
    The Board reiterates that derivatives are only one tool for credit 
unions to mitigate IRR and are not the only way credit unions should be 
managing this risk. The Board believes that the expanded list of 
derivatives and characteristics in the final rule will provide credit 
unions with additional, meaningful tools to mitigate IRR. The Board 
notes that as part of its annual review of one-third of all 
regulations, it will reconsider the requirements of this rule within 36 
months from its effective date.
    Finally, the Board notes that all derivatives under this final rule 
must have the characteristics adopted in this final rule, unless a 
credit union receives NCUA's approval for a differing characteristic.
    In addition to the characteristics in the proposed rule, the Board 
is also including one new item and revising another. First, the final 
rule includes a requirement that all derivatives used by credit unions 
meet the definition of a derivative under generally accepted accounting 
principles (GAAP). This requirement will ensure that credit unions are 
using derivatives in such a way to be recognized as such under GAAP, 
and preclude transactions that result in a form of lending or 
borrowing.
    Second, the Board is increasing the maximum maturity to 15 years. 
In the proposed rule, the Board set a maximum maturity limit for Level 
I authority of seven years and at ten years for Level II. The Board 
believes this change will allow credit unions to effectively hedge 
various points on the yield curve and allow for longer-term assets, 
like mortgages, while at the same time preventing an excessive exposure 
to very long maturities. As discussed below, the Board has imposed a 
new maturity weighted notional limit on the aggregate derivative 
portfolio, which will account for the risk of derivatives with longer 
maturities.

(f) Derivatives Authority (Sec.  703.103 and Appendix A)

(1) Structure
    The final rule reflects the Board's determination that all credit 
unions using derivatives should adhere to one set of regulatory 
requirements. In the final rule, the Board has eliminated the

[[Page 5232]]

``Level I'' and ``Level II'' derivatives authority structure in the 
proposed rule. This structure permitted eligible credit unions to apply 
for either Level I or Level II authority; each level had different 
permissible limits and regulatory requirements. Many commenters 
believed that some of the regulatory requirements outlined in the 
proposed rule were overly burdensome and could restrict credit unions 
from effectively using derivatives.
    Based on these comments, the Board determined that this structure 
does not efficiently administer a derivatives regulatory framework. 
Therefore, the Board has eliminated the two level authority structure 
and has adjusted many of the regulatory requirements. The Board 
believes the final rule is less prescriptive and more efficient for 
credit unions, but also retains the necessary safety and soundness 
provisions.
    The final rule introduces ``entry'' and ``standard'' limit 
authorities. The two authorities differ only by the permissible limits 
under which a credit union must operate. The limits are as follows:

------------------------------------------------------------------------
                                  Entry limits (% of  Standard limits (%
                                      net worth)         of net worth)
------------------------------------------------------------------------
Total fair value loss...........                  15                  25
Weighted Average Remaining                        65                 100
 Maturity Notional (WARMN)......
------------------------------------------------------------------------

    When initially granted its authority, a credit union must first 
operate under the entry limits for one year before it can increase the 
volume of its activities under the standard limits. A credit union that 
has engaged in derivatives for a continuous period of one year 
(beginning on the trade date of its first derivatives transaction) will 
automatically progress from the entry limit to the standard limit, 
unless it has received written notice from NCUA of relevant safety and 
soundness concerns. It is not necessary for a credit union to submit an 
additional application to progress from the entry limits to the 
standard limits. The Board notes that relevant safety and soundness 
concerns are ones that undermine the credibility of the credit union's 
management of its derivatives program or expose the credit union to 
undue risk. NCUA will make this determination on a case-by-case basis, 
taking into account the overall condition of the credit union and the 
severity of the safety and soundness concerns.
    The Board believes the one-year entry period will allow credit 
unions to obtain experience with derivatives to ensure their programs 
are safe and sound. This period also provides NCUA with an opportunity 
to examine a credit union's actual use of derivatives before that 
credit union begins using the higher limits in the standard limit 
authority. While credit unions in NCUA's derivatives pilot program must 
apply to maintain their derivatives authority under this final rule, 
most of them will meet the one year of activity threshold and may 
immediately use standard limit authority after they are approved. The 
following discussion provides a description of the fair value and 
notional limits.
(2) Description of Fair Value Loss and Notional Limits (Sec.  703.103 
and Appendix A)
    The proposed rule included a notional limit for interest rate 
swaps, a book value limit for interest rate caps, and a combined 
notional and book value for all derivatives positions. In addition, the 
Board also proposed a fair value loss limit for interest rate swaps and 
a maturity limit based on weighted average positions for all 
derivatives.
    Approximately half of the commenters suggested ways the Board could 
improve the limit structure. Commenters focused on the measurements for 
interest rate swaps and interest rate caps, and on the problematic 
aspects of a mixed attribute limit methodology that combines a notional 
limit for interest rate swaps with a book value for interest rate caps.
    Some commenters suggested using total assets as a notional limit 
versus a net worth percentage and recommended increasing the maximum 
maturity limits to account for longer duration assets, like mortgages. 
Other commenters suggested adjusting the notional amounts of 
derivatives for time to maturity to account for a lower degree of risk 
for shorter maturity transactions. Finally, with respect to the fair 
value loss limit, commenters requested NCUA include the changes in fair 
value in the underlying hedged item (i.e. the corresponding asset or 
liability) along with the derivative for the regulatory limit.
    First, the Board has eliminated the proposed maximum weighted 
average maturity limits. Instead, it has adopted a single maximum 
maturity limit for all derivatives transactions of 15 years.
    Second, the Board has replaced limits on individual derivative 
instruments with a consolidated fair value loss limit and weighted 
average remaining maturity notional (WARMN) limit for all derivatives 
transactions. The Board believes this approach holds risk exposures at 
a more constant degree regardless of maturity, and is more reasonable 
and effective to implement and monitor.
(i) Considerations for Notional and Fair Value Loss Limits
    The Board recognizes that notional amounts, in and of themselves, 
do not constitute the economic risk exposure of derivatives. Rather, 
they serve as the reference principal amount upon which parties in a 
derivatives transaction calculate periodic payments. The notional 
amount of a derivative contract does not directly represent the actual 
amounts exchanged or the overall exposure to credit and market risk. In 
addition, the Board is aware that not all derivatives have the same 
price sensitivity to changes in interest rates and using a simple gross 
notional limit could be unduly restrictive.
    The Board faced a similar challenge in determining how to implement 
a fair value loss limit for transactions that are presumed to be used 
as IRR hedges, where the change in the fair value of the hedged item 
(asset or liability) could potentially offset the change in the value 
of the derivative, which is not considered in the fair value loss 
limit.
    However, derivatives can create incremental financial and operation 
risk. Thus, at this time, the Board believes that a well-constructed 
limit on total derivatives activity is a critical piece of an effective 
regulatory framework for derivatives.
    The Board seeks a limit framework that is as simple as possible, 
while providing sufficient authority for credit unions to achieve 
meaningful reductions in their IRR and recognizing derivatives should 
not be the sole mitigation strategy for extraordinary levels of IRR. 
Therefore, the final rule limits derivatives exposure with two related 
measures, a measure of the notional amount of derivatives outstanding 
and a fair value loss limit.

[[Page 5233]]

The limits are designed to work in tandem, with the notional limit a 
prospective limit on a credit union's derivatives activity and the fair 
value loss limit based on the actual performance of the derivatives 
held by the credit union.
     Fair Value limit. The fair value loss limit for 
derivatives transactions in the final rule is 15 percent of net worth 
for ``entry'' authority, and 25 percent of net worth for ``standard'' 
authority. These limits are for all derivatives positions outstanding 
on the date a credit union reports its transactions. The fair value 
limit, if breached, requires a participating credit union to cease new 
derivatives transactions, provide written notification to NCUA, and 
develop and submit a corrective action plan to NCUA.
    The proposed rule had established fair value loss limits for swaps 
only while limits for cap premiums were considered as part of the 
notional limit. The Board believes that simplifying the framework to 
have one fair value limit for all derivatives positions is an effective 
approach in governing credit union's derivatives activity.
    Many of the commenters suggested that the Board consider a 
methodology that takes into account the offsetting effect of the hedged 
item. Commenters maintained that this approach would better align with 
the strategy of using derivatives for risk mitigation where the 
associated gain (loss) from the hedged item would have an offsetting 
gain (loss) to the derivative. The Board considered this approach and 
has concluded that doing so would add too much complexity. As such, the 
limit methodology is based upon the derivatives positions only. The 
Board believes this approach is more transparent and more 
straightforward to monitor, measure, and control.
    Credit unions calculate the fair value loss by totaling the fair 
value gains and losses on all of its outstanding derivatives positions. 
If this sum results in an aggregate net loss, the credit union must 
compare the loss amount, expressed as a percentage of net worth, to the 
applicable fair value loss limit. Appendix A of the final rule defines 
what constitutes a gain or a loss and provides an example of how the 
fair value loss amount should be reported for each of the permissible 
derivative types (swaps, options, and futures).
    Unlike the proposed rule, the final rule requires credit unions to 
calculate the aggregate gain (loss) for options. As noted above, the 
proposed rule only required this calculation for swaps. An option's 
gain or loss is the difference between the option's fair value and its 
corresponding unamortized premium on the date the credit union reports 
its transactions. The Board recognizes that credit unions may amortize 
the upfront premium paid to purchase a cap or floor over the life of 
the option. In order to determine a gain or loss on an option, credit 
unions should use the unamortized balance on an option at the reporting 
date to determine the gain (loss) amount.
     Weighted Average Remaining Maturity Notional (WARMN) 
limit. This limit on the notional amount of derivatives outstanding 
takes into account the type of derivative and time to maturity, two key 
components that determine an instrument's sensitivity to interest rate 
changes. This innovation provides significant flexibility under the 
rule and improves the relationship between the notional limit and the 
fair value limit. The WARMN calculation is designed to correspond to 
the net worth at risk (15% and 25% for entry and standard limits) in an 
interest rate shift of 300 basis points. While the WARMN limit 
corresponds to a fixed percentage of net worth (65% and 100% of net 
worth for entry and standard limits), the maturity weighting method 
provides for higher gross notional amounts for shorter duration 
derivatives portfolios, but lower gross notional amounts for longer 
duration derivatives portfolios.
    The Board received several comments on the effectiveness of 
applying a notional limit to a derivatives program. Commenters 
expressed concern that a simple notional limit does not represent the 
true economic risk of a transaction, and requested that if it proceeded 
with this type of limit the Board consider weighting the notional 
exposure by time (maturity) and its respective price sensitivity. By 
doing so, it would make a notional limit more consistent with the 
actual price risk of the underlying transaction (shorter maturity 
derivatives could have higher permissible notional amounts than longer 
maturity ones).
    The Board acknowledges that the notional amount of a derivatives 
contract does not directly represent the amount of risk in a 
transaction and other factors, such as the derivative type and its 
tenor, are key risk drivers. For example, interest rate floors and 
interest rate caps will have lower sensitivity to interest rate 
movements given the inherent structure of the instruments. To better 
account for the varying price sensitivities between interest rate 
options and interest rate swaps, the Board incorporated adjustment 
factors into the limit calculation methodology that keep these 
different product types roughly comparable from a risk exposure 
standpoint.
    The notional limit methodology has been adjusted to take into 
account the impact of average life and maturity on a transaction's 
price sensitivity (its risk). The methodology scales exposure limits 
based on years and uses a ten-year maturity as the basis for assigning 
relative weights. The notional limit in the final rule has been 
designed to provide credit unions with a constant level of total risk 
assumption capacity. This allows for increased notional capacity for 
derivatives that have shorter terms and as they approach maturity by 
weighting notional amounts based on the underlying derivatives' 
remaining time to maturity. This better accounts for the risk and 
permits greater flexibility to replace maturing hedges. NCUA 
established the maximum transaction limits after taking into account 
the projected price sensitivity of options and swaps in the current 
market and stressed for an instantaneous, parallel, and sustained shock 
in the yield curve of 300 basis points. This allows for significant 
price moves over time and creates room within which credit unions can 
actively manage exposures.
    The Board has adopted a conservative approach for calculating the 
WARMN by prohibiting the netting of offsetting transactions for limit 
measurement purposes (i.e. pay-fixed swap transactions which were 
offset with receive-fixed swap transactions must show the total 
notional amount of both transactions). Rather than netting offsetting 
transactions, the rule requires all transactions to be cumulatively 
aggregated. The notional limit in the final rule applies to all 
derivative transactions. Credit unions must calculate the WARMN limit 
to determine compliance as detailed in Appendix A of the final rule.
    The following are definitions and a calculation example as follows:
    (A) Interest rate swaps--The total of all notional amounts 
regardless of whether a pay fixed, receive fixed, or basis transaction 
are used. Netting or offsetting of transactions when done for risk 
reducing purposes are to be reported gross for the calculation of 
adjusted notional for limit purposes. Transactions with amortizing 
notional amounts must use the current notional amount as per the 
amortization schedule at the reporting date.
    (B) Interest rate options--The total of all notional amounts for 
caps and floors are reduced by two-thirds (factored down to 33 percent 
of the total). Reducing the gross notional amounts for caps and floors 
by two-thirds approximates the reduced price

[[Page 5234]]

sensitivity of options compared to interest rate swaps.
    (C) Futures--U.S. Treasury note futures will use the underlying 
contract size for notional limits. For example, a 5-year Treasury note 
futures contract with an underlying contract size of $100,000 will use 
$100,000 of notional as a five-year maturity.
    An illustration with definitions and calculations is included in 
Appendix A of the rule.
    The Board believes the limit structure described above balances 
ease of calculation for credit unions with a meaningful and accurate 
measure of risk associated with using derivatives.

(g) Collateral, Margining, and Counterparty Management (Sec.  703.104)

    Two sections in the proposed rule addressed collateral and 
counterparty requirements for credit unions operating a derivatives 
program. The collateral requirements in the proposed rule specified the 
permissible types of collateral, the respective margining, and the 
minimum transfer requirements. In the section addressing 
counterparties, the proposed rule included requirements on who is a 
permissible counterparty and the requirements for the credit union to 
manage the counterparty credit risk.
    Approximately half of the commenters addressed either or both of 
the proposed requirements for collateral or counterparties. All of the 
commenters that addressed the collateral requirements suggested a more 
expansive list of permissible collateral types. Some commenters 
suggested permissible collateral include agency pass-through 
residential mortgage-backed securities, callable agency debentures from 
government sponsored enterprises (GSEs), and collateralized mortgage 
obligations. Other commenters suggested that NCUA's collateral 
requirements align with the Chicago Mercantile Exchange's eligible 
collateral requirements for cleared swaps.
    For collateral requirements, some commenters believed the 
requirement to support pricing collateral daily would be too costly and 
unnecessary and should be less stringent. Others urged NCUA not to 
impose margining rules at this point, but rather wait until relevant 
rules required by the Dodd-Frank Wall Street Reform and Consumer 
Protection Act (Dodd-Frank Act) http://www.hblr.org/2013/04/margin-costs-of-otc-swap-clearing-rules/_ftn11 are promulgated.
    Only a few commenters addressed the issue of counterparties. These 
commenters believed the rule should be expanded to include additional 
counterparties, like Federal Home Loan Banks.
    Based on comments and the implementation of CFTC swap clearing 
regulations, the Board has amended the sections on collateral and 
counterparties to address swap clearing, expansion of the permissible 
types of collateral, and streamlining the requirements for credit 
unions.
(1) CFTC Swap Clearing
    Since the promulgation of the proposed rule, the CFTC finalized 
rules that provide credit unions with an End-User Exception or 
Cooperative Exemption from swap clearing. The CFTC's final rules on 
derivatives clearing requirements were required by the Dodd-Frank Act. 
Title VII of the Dodd-Frank Act imposes comprehensive changes in the 
regulatory framework for derivatives and includes amendments to the 
Commodity Exchange Act (CEA) and the Securities Exchange Act of 1934. 
This new section makes it unlawful for any person (including financial 
institutions) to engage in a swap that the CFTC has determined requires 
clearing unless the person submits the swap for clearing to a 
derivatives clearing organization (DCO) or an exception applies. 
Clearing changes the traditional relationship between counterparties by 
placing a clearinghouse intermediary between counterparties.
    The two CTFC exceptions are the End-User Exception, which applies 
to small financial institutions with total assets of $10 billion or 
less and the Cooperative Exemption, which applies to entities with 
assets greater than $10 billion where the entity is a cooperative. The 
CFTC's definition scope includes credit unions. Therefore, all credit 
unions have the exceptional right, as cooperatives, to elect to either 
clear swaps or engage in a traditional bilateral agreement. The Board 
notes that the clearing structure only applies to swaps as of the date 
of this rule.
    For cleared derivatives transactions, each party to the swap 
submits the transaction to a DCO for clearing. This reduces 
counterparty risk for the original swap participants in that they each 
bear the same risk attributable to facing the intermediary DCO as their 
counterparty. In addition, DCOs exist for the primary purpose of 
managing credit exposure from the swaps being cleared and therefore 
DCOs are effective at standardizing transactions and mitigating 
counterparty risk through the use of exchange-based risk management 
frameworks.
    Finally, swap clearing requires both counterparties to post 
collateral (i.e. initial margin) with the clearinghouse when they enter 
into a swap. The clearinghouse can use the posted collateral to cover 
defaults in the swap. As the valuation of the swap changes, the 
clearinghouse determines the fair market value of the swap and may 
collect additional collateral (i.e. variation margin) from the 
counterparties in response to fluctuations in market values. The 
clearinghouse can apply this collateral to cover defaults in payments 
under the swap.
(2) Changes in the Final Rule
    The Board has merged the two proposed sections addressing 
collateral and counterparties and made conforming changes in the final 
rule. First, the Board has included in the final rule that any credit 
union using exchange traded or cleared derivatives must comply with the 
applicable exchange or DCO regulations on these types of derivatives. 
Second, for non-centrally cleared derivatives, the Board has retained 
many of the requirements in the proposed rule, but has also made 
several changes to address comments it received.
(i) Collateral and Margining
    Exchange traded or cleared swap transactions are subject to the 
clearing member's requirements, which is regulated by the respective 
exchange or DCO's eligible collateral requirements. The current 
eligible collateral by these exchanges are within the investment 
authority granted under the Federal Credit Union Act for credit unions. 
Margining requirements are also promulgated by the exchanges and DCO's, 
and would be consistent with an initial margin and daily variation 
margining with no minimum transfer amounts.
    For non-centrally cleared transactions, the Board has retained all 
of the proposed requirements. However, the Board has expanded the list 
of permissible collateral types to include GSE issued agency 
residential mortgage-backed securities and GSE debentures. The Board 
agrees with commenters that these types of collateral may be useful for 
credit unions and do not pose significant liquidity risks when used for 
this purpose. The Board recognizes, however, that the counterparty may 
limit the eligible collateral list to less than the permissible 
authority. Margining for non-cleared transactions as part of a 
bilateral credit support annex must still have a minimum transfer 
amount of $250,000.

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(ii) Counterparties
    With respect to counterparties, the Board addresses the different 
arrangements a credit union may have given clearing requirements, the 
ability of credit unions to use exchange-traded derivatives, and 
applicable exemptions that credit unions can use for non-centrally 
cleared derivatives. The Board included in the final rule that credit 
unions must use CFTC registrant swap dealers, introducing brokers, and 
futures commission merchants whether using cleared or non-cleared 
derivatives clearing or non-clearing. However, the Board has eliminated 
major swap participants (MSP) as permissible counterparties. The Board 
notes that MSPs are substantial holders of derivatives positions and 
may not be in the market of dealing derivatives to other parties. Swap 
dealers and introducing brokers, however, regularly act as 
counterparties in the ordinary course of business as dealers to 
derivatives transactions. The Board believes swap dealers and 
introducing brokers are a sufficient universe of counterparties for 
credit unions to execute transactions, consistent with the safe and 
sound operation of a derivatives program.

(h) Reporting Requirements (Sec.  703.105)

    The proposed rule required senior executive officers of a credit 
union with Level I or Level II authority to report to the credit 
union's board of directors at least monthly on the following topics: 
Noncompliance, utilization of limits, itemization of the credit union's 
positions, the credit union's financial condition, and the cost of 
executing new transactions. Less than a quarter of the commenters 
addressed the issue of reporting requirements. All of these commenters 
disagreed with the requirement of monthly reporting, instead favoring 
quarterly reporting.
    After further evaluation, the Board is amending this section by 
requiring that senior executive officers, and, if applicable, the 
credit union's asset liability committee, receive derivatives reports 
from credit union staff on a monthly basis and the credit union's board 
of directors receive derivatives reporting from the credit union's 
senior executive officers at least quarterly. The Board is retaining 
the requirements of what must be included in these reports from the 
proposed rule, with a few minor technical amendments. The technical 
amendments conform to the other changes the Board has made throughout 
the rule. The Board believes these changes are less burdensome, while 
ensuring the proper credit union officials receive the reports that are 
necessary to oversee the credit union's derivatives program.

(i) Operational Requirements (Sec.  703.106)

    The proposed rule contained requirements relating to a credit 
union's personnel, internal controls structure, transaction management, 
and asset liability management (ALM). The Board has made several 
changes to this section to simplify and consolidate the requirements, 
and make this section of the rule less burdensome while retaining 
elements necessary to ensure a safe and sound derivatives program.
(1) Personnel
(a) Board of Directors and Senior Management
    The proposed rule set minimum knowledge and experience requirements 
for a credit union's board of directors and senior management. 
Specifically, the rule required that a credit union's board of 
directors complete derivatives training before a credit union could 
begin a derivatives program and annually thereafter. The proposed rule 
also required that senior executive officers have sufficient experience 
and knowledge to oversee the credit union's derivatives program.
    Most commenters did not address the experience requirements for a 
credit union's board of directors and senior executive officers. 
However, a few commenters felt the training and experience requirements 
for credit union board members are excessive and unwarranted. These 
commenters requested that the Board eliminate this requirement, arguing 
that the board members do not need annual training on this topic.
    The Board believes that a credit union's board of directors and 
senior executive officers need to have sufficient experience and 
knowledge to effectively oversee and effectuate a derivatives program. 
Therefore, the Board is retaining the proposed requirements. However, 
the Board is deleting the provision that requires a credit union to 
provide notification to NCUA when positions become vacant and 
documentation evidencing knowledge and experience for any new senior 
executive officer. This deletion is a reduction in regulatory burden 
that the Board believes will help credit unions administer a 
derivatives program more efficiently, without sacrificing safety and 
soundness.
(b) Qualified Derivatives Personnel
    The proposal also required a credit union to have qualified 
derivatives personnel. The rule required the qualified derivatives 
personnel to have three or five years of direct transactional 
experience with derivatives based on the level of authority for which a 
credit union was approved. The qualified derivatives personnel are 
responsible for ALM, accounting and reporting, trade execution, and 
credit and collateral management.
    The majority of the commenters that addressed the qualified 
derivatives personnel requirement argued against the proposed 
experience requirements. Commenters believed the proposed experience 
requirements would result in large expenses to a credit union in its 
attempt to attract and retain qualified individuals. Some commenters 
argued that the experience requirements were arbitrary, unrealistic, 
and unattainable. As alternatives, commenters suggested shorter 
experience requirements or allowing credit unions to substitute capital 
markets experience in place of derivatives experience. Some commenters 
also suggested that the final rule allow greater use of external 
service providers as an alternative to having qualified derivatives 
personnel (relaying on external service providers is addressed in 
additional detail in the section on ESPs).
    After careful consideration, the final rule does not require a 
credit union to have one or more employees with a specific number of 
years of experience. Rather, the final rule addresses the overall 
experience of the credit union staff overseeing the credit union's 
derivatives program. To that end, the Board has replaced the specific 
years of experience requirement with a general requirement that a 
credit union have staff with commensurate experience in the following 
areas: ALM; accounting and financial reporting; derivatives trade 
execution and oversight; and counterparty, collateral, and margining.
    With respect to the qualified derivatives personnel having 
experience with ALM and transaction management, the Board has retained 
the requirements on these topics from the proposed rule. The Board 
believes that the addition of an effective derivatives program should 
include enhanced capacity by the credit union staff to analyze and 
understand the credit union's IRR.
    In particular, a derivatives program will require enhanced capacity 
to estimate the credit union's earnings and economic value based on the 
market's expectation of future interest rates and any potential changes 
from these expectations. While a projection of income over a short 
period of time is customarily used by credit unions for financial 
planning, the Board believes that the longer maturity and increased

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complexity of permissible derivatives contracts will require credit 
unions to project their earnings over longer periods of time. In 
addition, because interest rate derivatives are priced using the 
forward interest rate curve, and the value of these contracts changes 
when there is a shift in the market's expectation of future interest 
rates, credit unions need to incorporate the forward interest rate 
curve into their baseline assumptions. It is important for the credit 
union to consider its earnings and economic value in the context of 
these forward rates, and how changes from these forward rates would 
affect the institution's projected financial performance. Moreover, 
analyses of the effects of changing interest rates should include both 
parallel and non-parallel changes in rates over the maturity spectrum 
(both a flattening and steepening of the yield curve).
    The Board believes these changes reduce the overall expense and 
burden on the credit union, while ensuring that credit unions have 
adequate experience to manage a derivatives program. As discussed 
below, before a credit union can begin using derivatives, NCUA will 
ensure that the credit union has staff with the experience necessary to 
comply with this section. While credit unions are not required to 
obtain staff with a specific length of experience, the Board notes that 
it may be necessary for a credit union to hire outside staff to comply 
with this section of the rule.
(2) Internal Controls Structure
    The proposed rule required credit unions engaging in derivatives to 
maintain adequate internal controls, including proper separation of 
duties, a written and schematic description of the derivatives decision 
process, an internal controls review, a financial statement audit, 
legal review, and a hedge review.
    Few commenters addressed the internal controls structure 
requirements. However, the comments the Board did received argued that 
experience requirements for attorneys to conduct a legal review and the 
requirement for an internal controls review conducted by an external 
auditor were overly burdensome, costly, and unnecessary.
    Based on comments and a reevaluation of the rule, the Board has 
significantly condensed and simplified the internal controls structure 
requirements. The Board has retained the requirement for a credit union 
to maintain a process and responsibility framework that visually 
demonstrates the derivatives decision process. The Board has also 
retained the required separation of duties without amendment.
    In response to commenters, however, the Board is amending the 
section on internal controls review to indicate that a credit union 
must only obtain this review for the first two years of its derivatives 
program. The Board believes that an internal controls review is only 
needed for the first two years of a derivatives program, as that will 
be the time when the credit union is implementing and expanding its 
internal controls.
    The final rule also provides that this review may be conducted by a 
credit union's internal auditor, if it has one. The Board believes that 
if credit union has an independent auditor on staff, it is not 
necessary for the credit union to bear additional expense to produce 
this review.
    The Board has also moved the requirement for a legal review to the 
section addressing collateral and counterparties. The proposed rule 
required a credit union to obtain counsel with at least five years of 
experience with derivatives transactions. Based on public comment, the 
Board is not including this experience requirement in the final rule.
    Finally, the Board is retaining the proposed requirements for a 
financial statement audit and a hedge review. However, the Board is 
eliminating the requirement that the person conducting the financial 
statement audit have at least two years of experience with derivatives. 
The Board has reconsidered this requirement and does not believe it is 
necessary for a financial statement auditor to have a specific number 
of years of experience with derivatives. However, the Board believes a 
credit union should use a person or persons that have relevant 
experience accounting for these instruments.
(3) Policies and Procedures
    The proposed rule required credit unions to maintain and operate 
according to written, comprehensive policies and procedures. The 
proposal required that these policies and procedures cover the 
following topics: The scope of activities; risk management; accounting 
and reporting; limits; and oversight and responsibilities. In addition, 
the proposed rule required a credit union's board of directors to 
review the policies annually and update them when necessary.
    One commenter maintained that credit union board members should not 
be required to review the policies and procedures for a derivatives 
program. This commenter did not provide a justification for the 
comment. The Board continues to believe that a credit union should 
operate according to written policies to govern the credit union's 
staff operations of the derivatives program. However, the Board does 
not believe the final rule needs to be as prescriptive as the proposed 
rule. The Board, therefore, has eliminated the list of specific items a 
credit union must have in its policies and procedures and moved this 
section to the section addressing operational requirements.
    In the final rule, the Board requires credit unions to have 
policies and procedures that address everything in the rule, except for 
sections relating to applications, pilot program credit unions, 
regulatory violation, and eligibility. In addition, the Board is 
retaining the requirement that a credit union's board of directors 
reviews these policies at least annually, and updates them when 
necessary. The Board continues to believe that it is important for a 
credit union's board of directors to update the credit union's policies 
and procedures as the condition of the credit union and its market 
position change.

(j) External Service Providers (ESPs) (Sec.  703.107)

    The proposed rule restricted who a credit union could use as an ESP 
and indicated what activities an ESP could conduct or support for the 
credit union. The proposal defined ``support'' as having the credit 
union conduct the function with assistance from an ESP and ``conduct'' 
as allowing an ESP to conduct a function with the credit union's 
oversight. Credit unions approved for Level I derivatives authority 
were permitted to have ESPs conduct more activities than credit unions 
approved for Level II derivatives authority. The proposed rule 
contemplated that credit unions with Level II authority would have less 
reliance on ESPs and be able to conduct more activities independently, 
in-house.
    Several commenters argued that the restrictions on the use of ESPs 
were too great. These commenters argued that ESPs are an efficient and 
inexpensive means to safely and soundly conduct a derivatives program. 
These commenters sought to use ESPs for most of the functions needed to 
successfully carry out a derivatives program, as opposed to employing 
high cost internal derivatives personnel.
    The Board agrees that, if properly managed, ESPs can be an 
efficient and cost effective way to carry out many of the functions of 
a derivatives program. Based on the comments and NCUA's staff 
evaluation, the Board is amending the section of the rule addressing 
ESPs.
    Most notably, the Board is eliminating a majority of the provisions 
that

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describe the activities an ESP can conduct and support. The final rule 
permits a credit union to use ESPs for most functions, provided the 
credit union complies with the other requirements related to ESPs. 
However, the Board is retaining the requirement that a credit union 
must internally and independently conduct ALM and liquidity risk 
management. The Board believes these two functions are fundamental to a 
credit union's understanding of derivatives and how they fit into its 
IRR mitigation strategy. The Board notes that while a credit union must 
conduct these functions internally it may obtain assistance from ESPs, 
for example use of ESP produced software and modeling tools. The Board 
believes this change makes the final rule clearer and easier for credit 
unions to follow, and also makes it less burdensome and costly for 
credit unions to administer a derivatives program.
    The Board is also retaining the restrictions on who cannot be an 
ESP. The Board believes these restrictions are necessary to preclude 
conflicts of interest. The Board is also retaining requirements that a 
credit union have the internal capacity and experience to oversee and 
manage any ESP and that the credit union documents the specific use of 
ESPs in its process and responsibility framework. While the Board 
believes ESPs can be a safe and sound way to conduct many functions, 
the Board reiterates that NCUA considers anything produced by an ESP as 
the product of the credit union. Therefore, it is necessary that the 
credit union have the internal capacity and expertise to ensure the 
work done by ESPs is accurate and sufficient for its purposes. Also, 
NCUA staff will use the process and responsibility framework in 
conjunction with a credit union's application to determine if the use 
of ESPs is proper and if the credit union can effectively manage the 
use of ESPs.

(k) Credit Union Eligibility (Sec.  703.108)

    The proposed rule required a credit union applying for either Level 
I or Level II authority to provide an IRR mitigation plan; have a CAMEL 
rating of 1, 2, or 3, with a management component of 1 or 2; and have 
assets of at least $250 million. In addition, any credit union applying 
for Level II had to demonstrate why the limits under Level I are 
insufficient.
    As noted above, the eligibility requirements were one of the most 
commented on topics. Approximately half of the commenters addressed 
this issue. All but one commenter argued that the Board should reduce 
or eliminate the asset threshold in the proposed rule. These commenters 
argued that an asset threshold of $250 million is arbitrary and would 
exclude credit unions that need, and are capable of engaging in, 
derivatives transactions. Also, one commenter did not believe that the 
rule should contain a restriction on credit union participation based 
on CAMEL ratings. This commenter argued that some lower CAMEL rated 
credit unions may need, and be able to successfully manage, a 
derivatives program.
    The Board continues to believe that a $250 million asset threshold 
and a CAMEL rating based eligibility requirement will ensure that well-
managed credit unions that need derivatives to mitigate IRR are able to 
obtain this authority. However, the Board recognizes that there may be 
some credit unions with assets under $250 million that need and are 
capable of effectively managing a derivatives program.
    The Board, therefore, is retaining the eligibility requirements in 
the proposed rule, but is including a provision in the final rule that 
provides an NCUA field director with the authority to permit a credit 
union that has assets under $250 million to apply for derivatives 
authority. The field director will only permit a credit union that does 
not meet the asset threshold to apply if he or she concludes that the 
credit union needs derivatives to manage its IRR and can effectively 
manage a derivatives program. Further, a field director may set 
additional stipulations or conditions related to the application of a 
credit union that is below the $250 million asset threshold. The Board 
believes this provision gives field directors flexibility to determine 
if a credit union that does not meet the asset threshold can benefit 
from and effectively manage derivatives. A field director may not, 
however, permit a credit union that does not meet the CAMEL code 
eligibility requirements to apply for derivatives authority. The Board 
believes it is crucial for a credit union to be well run and in sound 
financial condition to take on the additional complexity of 
derivatives.

(l) Application Process, Content, and Review (Sec.  703.109-Sec.  
703.111)

    The proposed rule included a detailed procedure for credit unions 
to apply for one of the two levels of authority. The proposed 
application process required credit unions to submit an IRR mitigation 
plan. In addition, credit unions were required to obtain all necessary 
personnel, systems, and infrastructure before the credit union could 
apply for Level II authority.
    Approximately ten percent of the commenters addressed the 
application process. The majority argued against the upfront costs 
associated with applying for Level II derivatives authority. These 
commenters believed that a requirement to have systems, processes, and 
personnel in place before receiving approval was inefficient and could 
lead to a waste of institution resources. Several other commenters were 
in favor of a more streamlined application process. These commenters 
believed that the propensity for rising interest rates in the near term 
warrants a quicker application process.
    In response to commenters, the Board has replaced the requirement 
that credit unions obtain all necessary personnel and infrastructure 
before NCUA grants approval with a more streamlined application 
process. The changes are highlighted below.
(1) Applying for Derivatives Authority
    The Board is retaining the requirement that a credit union seeking 
derivatives authority must submit a detailed application to the 
appropriate field director.
(2) Application Content
    The Board is retaining the required application content items, but 
has expanded on each to ensure clarity in the final rule. The Board has 
also included a requirement that the credit union include a list of the 
types of derivatives and characteristics it is applying for and a 
business justification for each. The Board believes the clarifying 
changes it made in this section will make it easier for credit unions 
to submit a complete and accurate application, which will help NCUA 
expedite its review.
(3) NCUA Approval
    Consistent with amendments to the section on derivatives authority, 
the Board is amending this section to increase the efficiency of NCUA's 
application review process, as well as allow credit unions to receive 
an approved application before procuring all necessary resources.
    In lieu of requiring a credit union to obtain all necessary 
personnel and systems before receiving final approval, the Board is 
amending the application review process. This process is made up of the 
following steps:
(i) Interim Approval
    First, a credit union must submit a detailed application to NCUA. 
This application must include all of the information in the application 
content section, which NCUA may further

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clarify through guidance. While the Board has eliminated a deadline for 
NCUA to review and approve or deny an application, the Board notes that 
NCUA's goal is to respond to every application within 60 days.
(ii) Acquisition of Infrastructure To Comply With the Rule
    A credit union that receives approval of its application must then 
acquire all of the personnel and systems that are necessary to comply 
with this final rule. The Board recognizes that each credit union will 
have its own approach to establishing its infrastructure and that this 
acquisition period may vary from credit union to credit union.
(iii) Notice of Readiness
    Once a credit union has acquired and implemented all of the 
necessary elements to comply with this rule, it must notify NCUA that 
it is ready to begin using derivatives.
(iv) Final Approval
    After NCUA receives a notice of readiness, it will review the 
credit union's derivatives program to ensure the credit union is in 
compliance with this final rule. The Board notes that a credit union 
may not begin using derivatives until it receives this final approval. 
NCUA's goal is to provide approval or denial within 60 days from the 
date it receives the notice of readiness. In rendering a decision, NCUA 
may conduct an onsite review to verify the credit union is ready and 
able to start using derivatives. In addition, NCUA may permit a credit 
union it denies to remedy any deficiencies in its program and reapply. 
However, reapplication is solely at the discretion of the applicable 
field director and reapplication efforts do not ensure that a denied 
credit union will receive authority if deficiencies persist.
    Finally, the Board notes that a credit union may choose to submit 
an application after acquiring all of the necessary resources. In this 
situation, it is not necessary for the credit union to submit a 
separate notice of readiness. NCUA's goal is to approve or deny these 
applications within 120 days from the date it receives the credit 
union's complete application and request for final approval. Again, the 
Board notes that this process will only apply to a credit union that 
has acquired all of the necessary resources and is ready to begin using 
derivatives when it applies.
    The Board believes this new application structure is more efficient 
and streamlined and allows a credit union to receive interim approval 
of its application before expending resources to acquire the 
infrastructure necessary to operate a derivatives program in compliance 
with this final rule.

(m) Application for Additional Derivatives and Characteristics (Sec.  
703.112)

    Consistent with changes made to the permissible derivatives 
section, the Board has included in the final rule a description of how 
a credit union applies for additional derivatives and characteristics 
which it did not request in its initial application. This section 
requires that a credit union seeking an additional derivative type or 
characteristic submit an application to the applicable field director. 
The application must include a list of the additional derivatives and 
characteristics that the credit union is applying for, and 
justification and explanation of the need for each of the additional 
derivatives and/or characteristics. NCUA's goal is to issue a decision 
on a credit union's application for additional derivatives or 
characteristics within 60 days from date of receipt of the credit 
union's request. The Board believes this application system will allow 
NCUA to grant authority for additional derivatives only to credit 
unions that need and can manage these additional derivatives and 
characteristics, while providing credit unions with additional 
variations of derivatives transactions to mitigate their IRR. Similar 
to appeal rights granted in the final rule relative to entry level 
applications, if NCUA denies an application for additional derivatives 
and characteristics, a credit union may appeal any denial to the Board 
within 60 days of the denial from the field director.

(n) Pilot Program Participants (Sec.  703.113)

    The proposed rule required that any credit union in NCUA's 
derivatives pilot program comply with the requirements of the rule 
within 12 months from its effective date. Any credit union that fails 
to comply within 12 months must stop entering into new derivatives 
transactions and, within 30 days, present a corrective action plan to 
the appropriate field director, explaining how it will come into 
compliance or safely unwind its program.
    Several commenters addressed the issue of pilot program 
participants being required to apply for derivatives authority. All of 
these commenters argued that pilot program participants should be 
grandfathered into the rule without going through the application 
process. Commenters maintained that NCUA has been evaluating these 
credit unions for a considerable amount of time and, therefore, a 
separate application review process is not needed.
    The Board believes the requirement for a pilot program credit union 
to apply for authority helps to ensure a continued safe and sound 
program in compliance with the final rule. Therefore, the Board is 
adopting the proposed section on pilot program credit unions without 
amendment.

(o) Regulatory Violation (Sec.  703.114)

    The Board included a section in the proposed rule that provided a 
system of corrective action for a credit union with derivatives 
authority that fails to comply with the rule or has safety and 
soundness concerns. This corrective action system included a cessation 
of new transactions and a corrective action plan from the credit union 
to the applicable field director. The Board did not receive any 
comments on this section of the rule. However, the Board is amending 
this section to further explain the steps that a credit union must take 
if it fails to meet the requirements of this final rule or its approved 
strategy.
(1) Suspension
    A credit union that no longer complies with the requirements of the 
final rule must immediately suspend all new derivatives activities. 
However, a credit union may terminate existing transactions. In 
addition, NCUA may permit a credit union to enter into new offsetting 
transactions if part of a corrective action strategy. The Board 
recognizes that it may be necessary for a credit union to terminate 
existing positions as a way to immediately come into compliance with 
the limits in the rule. Further, the Board believes that offsetting 
transactions are another means of coming into compliance with the 
limits in the rule. Offsetting transactions involve entering into 
another derivatives transaction that operates in the opposite way as a 
current position. For example, if a credit union has a pay-fixed swap, 
the offsetting position would be a receive-fixed swap with similar 
terms. These transactions essentially offset the risk of each other if 
constructed effectively. However, because this strategy involves 
entering into new transactions for credit unions that are already 
exceeding one of the rule's limits, the Board believes it is important 
for NCUA to approve these actions.
    A credit union seeking to use offsetting transactions must make 
this request in its notice to the appropriate field director. As 
explained in the final

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rule, a credit union must notify NCUA within three days from the date 
of the regulatory violation. In addition to including a request for 
offsetting transactions, if applicable, the notice must also provide a 
description of the violation and the immediate steps the credit union 
is taking. This notice will allow NCUA to begin working with the credit 
union to develop a corrective action plan for remedying the violation.
    Within 15 days from the date the credit union provides a notice of 
violation, it must submit a corrective action plan to NCUA. This 
corrective action plan, to which NCUA must agree, must describe in 
detail how the credit union will remedy the violation. A credit union 
that submits a satisfactory corrective action plan must comply with 
that plan until it has remedied its violation. A credit union may enter 
into any new derivatives transactions while it is under a corrective 
action plan. The Board believes this structure will help to protect the 
NCUSIF and the credit union from continuing and compounding violations.
(2) Revocation
    In addition to a suspension of activities, NCUA may also revoke a 
credit union's authority granted under this final rule. Revocation will 
require the credit union to immediately cease any new derivatives 
transactions and may require the termination of existing positions. The 
Board notes that NCUA will only require the termination of existing 
positions if it determines that doing so would not pose a safety and 
soundness concern. The Board believes it is necessary for NCUA to have 
the power to revoke authority for credit unions that demonstrate that 
they are not capable of successfully managing a derivatives program 
safely and soundly.
(3) Appeals
    A credit union may appeal NCUA's revocation of its authority or 
NCUA's determination to require the termination of existing positions. 
The Board believes the finality of both of these actions and the impact 
they will have on the credit union and its members warrants additional 
scrutiny through an appeals process to the Board. Further, as a credit 
union may not enter into any new derivatives transactions during the 
pendency of an appeal, the Board does not believe the time associated 
with the appeals process will raise any additional safety and soundness 
concerns.

(p) Fees

    In the proposed rule the Board specifically requested comment on 
including a fee structure for those credit unions that apply for 
derivatives. The Board considered having a fee structure that included 
an application and/or a supervision fee just for those credit unions 
utilizing derivatives.
    Most of the commenters addressed the imposition of application and/
or supervision fees. All of these commenters argued that NCUA should 
not charge a separate fee, in any form, for derivatives authority. Some 
commenters questioned the actual agency costs associated with 
derivatives, while other commenters believed the suggested fees would 
establish a negative precedent. All of the commenters on this subject 
argued that the fees suggested by the Board would make derivatives cost 
prohibitive, and that, by reducing risk to the share insurance fund, 
credit unions with derivatives would actually be saving the agency and 
the industry money.
    In response to those comments, the Board is not instituting a fee 
structure for derivatives. While the Board notes that derivatives 
authority is cost and labor intensive for the agency, it does not 
believe singling out derivatives for an authority-based fee is 
appropriate at this time.

(q) Changes to Part 715

    The proposed rule included an amendment to part 715, which 
clarifies that all credit unions engaging in derivatives must have a 
financial statement audit, regardless of asset size. As noted above, 
the Board is retaining this requirement in the final rule. Therefore, 
the Board is also adopting the proposed changes to part 715 without 
amendment.

(r) Changes to Part 741

    The proposed rule contained changes to Part 741 to reflect 
application of the rule to FISCUs. The final rule will not apply to 
FISCUs, so the Board is only amending this section to require that any 
FISCU engaging in derivatives provide NCUA with written notice at least 
30 days before it begins engaging in derivatives transactions.

IV. Regulatory Procedures

a. Regulatory Flexibility Act

    The Regulatory Flexibility Act requires NCUA to prepare an analysis 
of any significant economic impact any proposed regulation may have on 
a substantial number of small entities (primarily those under $50 
million in assets).\1\ The final rule allows credit unions to enter 
into certain derivatives transactions to reduce IRR. Since the final 
rule requires credit unions seeking derivatives authority to have at 
least $250 million in assets, it will not have a significant economic 
impact on a substantial number of small credit unions.
---------------------------------------------------------------------------

    \1\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

b. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (PRA) applies to rulemakings in 
which an agency by rule creates a new paperwork burden on regulated 
entities or increases an existing burden.\2\ For purposes of the PRA, a 
paperwork burden may take the form of a reporting or recordkeeping 
requirement, both referred to as information collections. The proposed 
changes to part 703 impose new information collection requirements. As 
required by the PRA, NCUA is submitting a copy of this final rule to 
OMB for its review and approval. NCUA also submitted a copy of the 
proposed rule to OMB for review.
---------------------------------------------------------------------------

    \2\ 44 U.S.C. 3507(d); 5 CFR part 1320.
---------------------------------------------------------------------------

1. Estimated PRA Burden
    For the purposes of calculating the PRA burden, NCUA estimates that 
43 credit unions will apply for and be granted derivatives authority. 
NCUA estimates for the final rule were modified from the proposed 
rule's estimates based on rule changes and feedback received during the 
comment period.
    NCUA will grant entry limit authority to qualifying credit unions 
that NCUA recognizes meet the requirements of this rule. After a one 
year period of continuous risk mitigation with interest rate 
derivatives and no safety and soundness issues related to the activity, 
the credit union will be considered to have standard limit authority. 
Certain credit unions with experience mitigating risk with interest 
rate derivatives may be granted standard limit authority at the time of 
application. NCUA estimates that:
     10 credit unions will qualify for and be granted standard 
limit authority;
     33 credit unions will apply for and be granted entry limit 
authority;
    Section 703.106(d) of the rule requires a credit union to operate 
according to written, comprehensive policies and procedures for 
control, measurement, and management of derivatives transactions. To do 
so, a credit union must first develop such policies and procedures. 
NCUA estimates that on average it will take a credit union seeking 
derivatives authority an average of 50 hours to develop appropriate 
policies and procedures. This is a one-time recordkeeping burden.

[[Page 5240]]

    Section 703.106(d) of the rule requires a credit union's board of 
directors to review the derivatives policies and procedures annually 
and update them when necessary. NCUA estimates this ongoing 
recordkeeping burden will take an average of 10 hours per year per 
respondent.
    Section 703.105(a) of the rule requires a credit union's senior 
executive officers to provide a quarterly, comprehensive derivatives 
report to the credit union's board of directors. Section 703.105(b) 
requires that at least monthly, credit union staff must deliver a 
comprehensive derivatives report to the credit union's senior executive 
officers. NCUA estimates this ongoing recordkeeping burden will take an 
average of 2 hours per respective reporting cycle (total of 8 hours per 
year for board reporting and 24 hours per year for senior management 
reporting).
    Section 703.106(a)(1) of the rule requires that a credit union 
retain evidence of annual derivatives training for its board of 
directors. NCUA estimates this ongoing recordkeeping requirement will 
take an average of 4 hours per year per respondent.
    Section 703.106(b)(1) of the rule requires that a credit union 
maintain a written and schematic description of the derivatives 
decision process. NCUA estimates that the one-time recordkeeping burden 
of creating the description will take 12.5 hours on average. The 
ongoing burden of maintaining the description will take 2 hours per 
year per respondent.
    Section 703.106(b)(2) requires that for the first two years after 
commencement of its derivatives program, a credit union must have an 
internal controls review focused on the integration and introduction of 
derivatives functions. This review must be performed by an independent 
external unit or, if applicable, the credit union's internal auditor. 
NCUA estimates that an internal controls review for a credit union's 
derivatives program will cost approximately $50,000 each year for the 
first two years.
    Section 703.106(b)(3) of the rule requires a credit union engaging 
in derivatives transactions to obtain an annual financial statement 
audit by a certified public accountant. Section 715.5(a) of NCUA's 
Regulations already requires FCUs with assets of $500 million or 
greater to obtain an annual financial statement audit. Currently, 
approximately 60 credit unions with assets between $250 million and 
$500 million that meet the proposed CAMEL ratings requirements do not 
obtain annual financial statement audits. Due to the overhead costs 
associated with derivatives activity, NCUA estimates that ten percent, 
or six, of these credit unions will apply for and be granted 
derivatives authority. NCUA further estimates that a financial 
statement audit for a credit union of this size would cost 
approximately $50,000.
    Section 703.106(b)(4) of the rule requires a credit union, before 
executing any derivatives transaction, to identify and document the 
circumstances leading to the decision to hedge, specify the derivatives 
strategy the credit union will employ, and demonstrate the economic 
effectiveness of the hedge. NCUA estimates a credit union will execute 
an average of 2 transactions per year and that it will take an average 
of 2 hours per transaction to complete the pre-execution analysis. This 
results in an ongoing recordkeeping burden of 4 hours per year per 
respondent.
    Sections 703.109, 703.110 and of the rule require a credit union 
seeking derivatives authority to submit a detailed application to NCUA. 
NCUA estimates that this one-time recordkeeping burden will take an 
average of 50 hours per respondent to prepare. This estimate does not 
include developing policies and procedures for operating a derivatives 
program and creating and maintaining a written and schematic 
description of the derivatives decision process, as those recordkeeping 
requirements are already accounted for above.
    Section 703.114 of the proposed rule requires a credit union that 
no longer meets the requirements of subpart B of part 703 to submit a 
corrective action plan to NCUA. NCUA estimates that 3 credit unions may 
have to submit an action plan each year and that a plan will take an 
average of 10 hours to prepare.
    Section 741.219 requires a FISCU to notify NCUA in writing at least 
30 days before it begins engaging in derivatives. This notice will be a 
one-time burden. NCUA estimates that 30 FISCUs will have to prepare 
this notice, and that the notice will take an average of 0.5 hours to 
prepare.

Summary of Collection Burden

    Written policies and procedures: 43 credit unions x 50 hours = 
2,150 hours (one-time burden).
    Board review of policies and procedures: 43 credit unions x 10 
hours = 430 hours.
    Derivatives reporting: 43 credit unions x 32 hours = 1,376 hours.
    Evidence of board training: 43 credit unions x 4 hours = 172 hours.
    Derivatives process description: 43 credit unions x 12.5 hours = 
537.5 hours (one-time burden).
    43 credit unions x 2 hours = 86 hours.
    Independent internal controls review: 43 credit unions x $50,000/
year for 2 years $4,300,000 (one-time burden).
    Financial statement audit: 6 credit unions x $50,000 = $300,000.
    Pre-execution analysis: 43 credit unions x 4 hours = 172 hours.
    Application: 43 credit unions x 50 hours = 2,150 hours (one-time 
burden).
    Corrective action plan: 3 credit unions x 10 hours = 30 hours.
    FISCU notice: 30 credit unions x 0.5 hours = 15 hours (one-time 
burden).
    Total Annual Hours Burden: 7,118.5 (4,852.5 one-time only).
    Total Annual Cost Burden: $4,600,000 ($4,300,000 one-time only).

(c) Executive Order 13132

    Executive Order 13132 encourages independent regulatory agencies to 
consider the impact of their actions on state and local interests. 
NCUA, an independent regulatory agency as defined in 44 U.S.C. 3502(5), 
voluntarily complies with the executive order to adhere to fundamental 
federalism principles. This final rule applies only to FCUs, and only 
requires a FISCU to notify NCUA in writing at least 30 days before it 
begins engaging in derivatives transactions. Accordingly, the rule will 
not have substantial direct effects on the States, on the relationship 
between the national government and the States, or on the distribution 
of power and responsibilities among the various levels of government. 
NCUA has, therefore, determined that this proposal does not constitute 
a policy that has federalism implications for purposes of the executive 
order.

(d) Assessment of Federal Regulations and Policies on Families

    NCUA has determined that this final rule will not affect family 
well-being within the meaning of Sec.  654 of the Treasury and General 
Government Appropriations Act, 1999, Pub. L. 105-277, 112 Stat. 2681 
(1998).

List of Subjects

12 CFR Part 703

    Credit unions, Investments.

12 CFR Part 715

    Audits, Credit unions, Supervisory committees.

12 CFR Part 741

    Credit, Credit Unions, Reporting and recordkeeping requirements, 
Share insurance.


[[Page 5241]]


    By the National Credit Union Administration Board, on January 
23, 2014.
Gerard Poliquin,
Secretary of the Board.

    For the reasons discussed above, the National Credit Union 
Administration is amending parts 703, 715, and 741 as follows:

PART 703--INVESTMENT AND DEPOSIT ACTIVITIES

0
1. The authority citation for part 703 continues to read as follows:

    Authority:  12 U.S.C. 1757(7), 1757(8), 1757 (15).


0
2. In part 703, designate Sec. Sec.  703.1 through 703.20 as subpart A 
under the following heading:

Subpart A--General Investment and Deposit Activities

* * * * *


0
3. Amend Sec.  703.2 by revising the definitions of ``derivative'' and 
``fair value'' and adding definitions of ``forward sales commitment'' 
and ``interest rate lock commitment'' to read as follows:


Sec.  703.2  Definitions.

* * * * *
    Derivative means a financial contract which derives its value from 
the value and performance of some other underlying financial instrument 
or variable, such as an index or interest rate.
* * * * *
    Fair value means the price that would be received to sell an asset, 
or paid to transfer a liability, in an orderly transaction between 
market participants at the measurement date, as defined by GAAP.
* * * * *
    Forward sales commitment means an agreement to sell an asset at a 
price and future date specified in the agreement.
* * * * *
    Interest rate lock commitment means an agreement by a credit union 
to hold a certain interest rate and points for a specified amount of 
time while a prospective borrower's application is processed.
* * * * *

0
4. In Sec.  703.14, add paragraph (k) to read as follows:


Sec.  703.14  Permissible investments.

* * * * *
    (k) Derivatives. A Federal credit union may only enter into in the 
following derivatives transactions:
    (1) Any derivatives permitted under Sec.  701.21(i) of this 
chapter, Sec.  703.14(g), or subpart B of this part;
    (2) Embedded options not required under generally accepted 
accounting principles (GAAP) adopted in the United States to be 
accounted for separately from the host contract; and
    (3) Interest rate lock commitments or forward sales commitments 
made in connection with a loan originated by a Federal credit union.


Sec.  703.16  [Amended]

0
5. In Sec.  703.16, remove paragraph (a) of and redesignate paragraphs 
(b) through (d) as (a) through (c), respectively.

0
6. Add subpart B to read as follows:

Subpart B--Derivatives Authority

Sec.
703.100 Purpose and scope.
703.101 Definitions.
703.102 Permissible derivatives.
703.103 Derivative authority.
703.104 Requirements for derivative counterparty agreements, 
collateral and margining.
703.105 Reporting requirements.
703.106 Operational support requirements.
703.107 External service providers.
703.108 Eligibility.
703.109 Applying for derivatives authority.
703.110 Application content.
703.111 NCUA approval.
703.112 Applying for additional products or characteristics.
703.113 Pilot program participants with active derivatives 
positions.
703.114 Regulatory violation.


Sec.  703.100  Purpose and scope.

    (a) Purpose. This subpart allows Federal credit unions to enter 
into certain derivatives transactions exclusively for the purpose of 
reducing interest rate risk exposure.
    (b) Scope. (1) This subpart applies to all Federal credit unions. 
Except as provided in Sec.  741.219, this rule does not apply to 
federally insured, state-chartered credit unions.
    (2) Mutual funds. This subpart does not permit a Federal credit 
union to invest in registered investment companies or collective 
investment funds under Sec.  703.14(c) of this part, where the 
prospectus of the company or fund permit the investment portfolio to 
contain derivatives.


Sec.  703.101  Definitions.

    For purposes of this subpart:
    Amortizing notional amount means a characteristic of a derivative, 
in which the notional amount declines on a predetermined fixed basis 
over the term of the contract, according to an amortization schedule to 
which the parties agree when executing the contract;
    Basis swap means an agreement between two parties in which the 
parties make periodic payments to each other based on floating rate 
indices multiplied by a notional amount;
    Cleared swap has the meaning as defined by the Commodity Futures 
Trading Commission in 17 CFR 22.1;
    Counterparty means a swap dealer, derivatives clearing 
organization, or exchange that participates as the other party in a 
derivatives transaction with a Federal credit union;
    Credit support annex means the terms or rules under which 
collateral is posted or transferred between a Federal credit union and 
a counterparty to mitigate credit risk that may result from changes in 
the fair value of derivatives positions;
    Derivative means a financial contract which derives its value from 
the value and performance of some other underlying financial instrument 
or variable, such as an index or interest rate;
    Derivatives clearing organization has the meaning as defined by the 
Commodity Futures Trading Commission in 17 CFR 1.3(d);
    Economic effectiveness means the extent to which a derivatives 
transaction results in offsetting changes in the interest rate risk 
that the transaction was, and is, intended to provide;
    Exchange means a central financial clearing market where end users 
can trade futures, as defined in this section of this subpart;
    External service provider means any entity that provides services 
to assist a Federal credit union in carrying out its derivatives 
program and the requirements of this subpart;
    Fair value has the meaning specified in Sec.  703.2 of subpart A of 
this part;
    Field director means an NCUA Regional Director or the Director of 
the Office of National Examinations and Supervision;
    Forward start date means an agreement that delays the settlement 
date of a derivatives transaction for a specified period of time;
    Futures commission merchant (FCM) has the meaning as defined by the 
Commodity Futures Trading Commission in 17 CFR 1.3(p);
    Futures means a U.S. Treasury note financial contract that 
obligates the buyer to take delivery of Treasury notes (or the seller 
to deliver Treasury notes) at a predetermined future date and price. 
Futures contracts are standardized to facilitate trading on an 
exchange;
    Hedge means to enter into a derivatives transaction to mitigate 
interest rate risk;

[[Page 5242]]

    Interest rate cap means a contract, based on a reference interest 
rate, for payment to the purchaser when the reference interest rate 
rises above the level specified in the contract;
    Interest rate floor means a contract, based on a reference interest 
rate, for payment to the purchaser when the reference interest rate 
falls below the level specified in the contract;
    Interest rate risk means the vulnerability of a Federal credit 
union's earnings or economic value to movements in market interest 
rates;
    Interest rate swap means an agreement to exchange future payments 
of interest on a notional amount at specific times and for a specified 
time period;
    Introducing broker means a futures brokerage firm that deals 
directly with the client, while the trade execution is done by a 
futures commission merchant;
    ISDA protocol means a multilateral contractual amendment mechanism 
that has been used to address changes to International Swap and 
Derivatives Association (ISDA) standard contracts since 1998;
    Leveraged derivative means a derivative where the value of the 
transaction does not change in a one to one proportion with the 
contractual rate or index;
    (x) Margin means the minimum amount of funds that must be deposited 
between parties to a derivatives transaction, as detailed in a credit 
support annex or clearing arrangement;
    Master service agreement means a document agreed upon between two 
parties that sets out standard terms that apply to all derivatives 
transactions entered into between those parties. Each time the same two 
parties enter into a transaction, the terms of the master service 
agreement apply automatically and do not need to be re-negotiated. The 
most common form of a master service agreement is a master ISDA 
agreement;
    Minimum transfer amount means the minimum amount of collateral that 
a party to a derivatives transaction will require, per transfer, to 
cover exposure in excess of the collateral threshold;
    Net economic value means the economic value of assets minus the 
economic value of liabilities;
    Net worth has the meaning specified in Sec.  702.2 of this chapter;
    Non-cleared means transactions that do not go through a derivatives 
clearing organization;
    Notional amount means the contracted amount of a derivatives 
contract for swaps and options on which interest payments or other 
payments are based. For futures contracts, the notional amount is 
represented by the contract size;
    Novation means the substitution of an old obligation with a new one 
that either replaces an existing obligation with a new obligation or 
replaces an original party with a new party;
    Reference interest rate means the index or rate to be used as the 
variable rate for resetting derivatives transactions;
    Reporting date means the end of the business day on the date used 
to report positions and fair values for limit compliance (e.g., daily, 
month-end, quarter-end and fiscal year-end);
    Senior executive officer has the meaning specified in Sec.  701.14 
of this chapter and any other similar employee that is directly within 
the chain of command for the oversight of a Federal credit union's 
derivatives program, as identified in a Federal credit union's process 
and responsibility framework, as discussed in Sec.  703.106(b)(1) of 
this subpart;
    Structured liability offering means a share product created by a 
Federal credit union with contractual option features, such as periodic 
caps and calls, similar to those found in structured securities or 
structured notes;
    Swap dealer has the meaning as defined by the Commodity Futures 
Trading Commission in 17 CFR 1.3(ggg);
    Swap execution facility means a Commodities and Futures Trading 
Commission-registered facility that provides a system or platform for 
participants to execute cleared derivatives transactions;
    Threshold amount means an unsecured credit exposure that a party to 
a derivatives transaction is prepared to accept before requesting 
additional collateral from the other party;
    Trade date means the date that a derivatives order (new 
transactions, terminations, or assignments) is executed in the market; 
and
    Unamortized premium means the balance of the upfront premium 
payment that has not been amortized.


Sec.  703.102  Permissible derivatives.

    (a) Products and characteristics. A Federal credit union with 
derivatives authority may apply to use each of the following products 
and characteristics, subject to the limits in Sec.  703.103 of this 
subpart:
    (1) Interest rate swaps with the following characteristics:
    (i) Settle within three business days, unless the Federal credit 
union is approved for a forward start date of no more than 90 days from 
the trade date; and
    (ii) Do not have fluctuating notional amounts, unless the Federal 
credit union is approved to use derivatives with amortizing notional 
amounts.
    (2) Basis swaps with the following characteristics:
    (i) Settle within three business days, unless the Federal credit 
union is approved for a forward start date of no more than 90 days from 
the trade date; and
    (ii) Do not have fluctuating notional amounts, unless the Federal 
credit union is approved to use derivatives with amortizing notional 
amounts.
    (3) Purchased interest rate caps with no fluctuating notional 
amounts, unless the Federal credit union is approved to use derivatives 
with amortizing notional amounts.
    (4) Purchased interest rate floors with no fluctuating notional 
amounts, unless the Federal credit union is approved to use derivatives 
with amortizing notional amounts.
    (5) U.S. Treasury note futures (2-, 3-, 5-, and 10-year contracts).
    (b) Overall program characteristics. A Federal credit union may 
only enter into derivatives, as identified and described in paragraph 
(a) of this section, that have the following characteristics:
    (1) Not leveraged;
    (2) Based on domestic rates, as defined in Sec.  703.14(a) of 
subpart A of this part;
    (3) Denominated in U.S. dollars;
    (4) Except as provided in Sec.  703.14(g) of subpart A of this 
part, not used to create structured liability offerings for members or 
nonmembers;
    (5) Have contract maturity terms of equal to or less than 15 years, 
at the trade date; and
    (6) Meet the definition of a derivative under GAAP.


Sec.  703.103  Derivative authority.

    (a) General authority. A Federal credit union that is approved for 
derivatives authority under Sec.  703.111 of this subpart may use any 
of the products and characteristics, described in Sec.  703.102(a), 
subject to the following limits, which are described in more detail in 
Appendix A to this subpart:
     (1) Entry limits authority. Unless a Federal credit union is 
permitted to use standard limits authority under this subpart, the 
aggregate fair value loss (as defined in Appendix A) on all of a 
Federal credit union's derivatives positions may not exceed 15 percent 
of net worth, and a Federal credit union's weighted average remaining 
maturity notional (as defined in Appendix A), may not exceed 65 percent 
of net worth.
     (2) Standard limits authority. A Federal credit union that is 
permitted to use standard limits authority may not exceed an aggregate 
fair value loss on all

[[Page 5243]]

of the Federal credit union's derivatives positions of 25 percent of 
net worth, and a weighted average remaining maturity notional of 100 
percent of net worth, provided:
     (i) The Federal credit union has engaged in derivatives at the 
entry limits authority for a continuous period of one year (beginning 
on the trade date of its first derivatives transaction); and
     (ii) The Federal credit union has not been notified in writing by 
NCUA of any relevant safety and soundness concerns while engaged in 
derivatives at the entry limits authority.
    (b) Limit description--(1) Fair value limit. The fair value limit 
is calculated by aggregating the fair values for all derivatives 
positions at the reporting date. If an aggregate loss exists, it must 
be less than the limit set forth in this subpart. A further description 
of this limit and example calculations are detailed in Appendix A to 
this subpart.
    (2) Weighted average remaining maturity notional limit. The 
weighted average remaining maturity notional limit is calculated by 
aggregating the notional amount for all derivatives positions based on 
each derivative's pricing sensitivity and maturity. A further 
description of this limit and example calculations are detailed in 
Appendix A to this subpart.


Sec.  703.104  Requirements for derivative counterparty agreements, 
collateral and margining.

    (a) A Federal credit union may have exchange-traded, centrally 
cleared, or non-cleared derivatives, in accordance with the following:
     (1) Exchange-traded and cleared derivatives. A Federal credit 
union with derivatives that are exchange-traded or centrally cleared 
must:
     (i) Comply with the Commodity Futures Trading Commission's rules;
     (ii) Use only swap dealers, introducing brokers, and/or futures 
commission merchants that are current registrants of the Commodity 
Futures Trading Commission; and
     (iii) Comply with the margining requirements required by the 
futures commission merchant.
    (2) Non-cleared derivative transactions. A Federal credit union 
with derivatives that are non-cleared must:
     (i) Have a master service agreement and credit support annex with 
a registered swap dealer that are in accordance with ISDA protocol for 
standard bilateral agreements;
     (ii) Utilize margining requirements contracted through a credit 
support annex and have a minimum transfer amount of $250,000 for daily 
margining requirements; and
     (iii) Accept as collateral, for margin requirements, only cash 
(U.S. dollars), U.S. Treasuries, government-sponsored enterprise debt, 
and government-sponsored enterprise residential mortgage-backed 
security pass-through securities.
    (b) Counterparty, collateral, and margining management. A Federal 
credit union must:
     (1) Have systems in place to effectively manage collateral and 
margining requirements;
     (2) Have a collateral management process that monitors the Federal 
credit union's collateral and margining requirements daily and ensures 
that its derivatives positions are collateralized at all times and in 
accordance with the collateral requirements of this subpart and the 
Federal credit union's agreement with its counterparty. This includes 
the posting, tracking, valuation, and reporting of collateral using 
fair value; and
    (3) Analyze and measure potential liquidity needs related to its 
derivatives program and stemming from additional collateral 
requirements due to changes in interest rates. The Federal credit union 
must calculate and track contingent liquidity needs in the event a 
derivatives transaction needs to be novated or terminated, and must 
establish effective controls for liquidity exposures arising from both 
market or product liquidity and instrument cash flows.


Sec.  703.105  Reporting requirements.

    (a) Board reporting. At least quarterly, a Federal credit union's 
senior executive officers must deliver a comprehensive derivatives 
report to the Federal credit union's board of directors. The report may 
be delivered separately or as part of the standard funds management or 
asset/liability report.
    (b) Senior executive officer and asset liability committee. At 
least monthly, Federal credit union staff must deliver a comprehensive 
derivatives report to the Federal credit union's senior executive 
officers and, if applicable, the Federal credit union's asset liability 
committee.
    (c) Comprehensive derivatives report. At a minimum, the reports 
required in paragraphs (a) and (b) of this section must include:
     (1) Identification of any areas of noncompliance with any 
provision of this subpart or the Federal credit union's policies;
     (2) Utilization of the limits in Sec.  703.103 and any additional 
limits in the Federal credit union's policies;
     (3) An itemization of the Federal credit union's individual 
positions and aggregate current fair values, and a comparison with the 
Federal credit union's fair value loss and notional limit authority, as 
described in Appendix A to this subpart;
     (4) A comprehensive view of the Federal credit union's statement 
of financial condition, including, but not limited to, net economic 
value calculations for the Federal credit union's statement of 
financial condition done with derivatives included and excluded;
     (5) An evaluation of the effectiveness of the derivatives 
transactions in mitigating interest rate risk; and
     (6) An evaluation of effectiveness of the hedge relationship and 
reporting for derivatives in compliance with GAAP.


Sec.  703.106  Operational support requirements.

    (a) Required experience and competencies. A Federal credit union 
operating with derivatives authority must internally possess the 
following experience and competencies:
     (1) Board. Before entering into any derivatives transactions, and 
annually thereafter, a Federal credit union's board members must 
receive training that provides a general understanding of derivatives 
and the knowledge required to provide strategic oversight of the 
Federal credit union's derivatives program. This requirement includes 
understanding how derivatives fit into the Federal credit union's 
business model and risk management process. The Federal credit union 
must maintain evidence of this training, in accordance with its 
document retention policy, until its next NCUA examination.
     (2) Senior executive officers. A Federal credit union's senior 
executive officers must be able to understand, approve, and provide 
oversight for the derivatives activities. These individuals must have a 
comprehensive understanding of how derivatives fit into the Federal 
credit union's business model and risk management process.
     (3) Qualified derivatives personnel. To engage in derivatives 
transactions, a Federal credit union must employ staff with experience 
in the following areas:
     (i) Asset/liability risk management. Staff must be qualified to 
understand and oversee asset/liability risk management, including the 
appropriate role of derivatives. This requirement includes identifying 
and assessing risk in transactions, developing asset/liability risk 
management strategies, testing the effectiveness of asset/liability 
risk management, determining the effectiveness of managing interest 
rate risk under a range of stressed rates and statement of financial 
condition

[[Page 5244]]

scenarios, and evaluating the relative effectiveness of alternative 
strategies. Staff must also be qualified to understand and undertake or 
oversee the appropriate modeling and analytics related to scope of risk 
to earnings and economic value over the expected maturity of 
derivatives positions;
     (ii) Accounting and financial reporting. Staff must be qualified 
to understand and oversee appropriate accounting and financial 
reporting for derivatives transactions in accordance with GAAP;
     (iii) Derivatives execution and oversight. Staff must be qualified 
to undertake or oversee trade executions; and
     (iv) Counterparty, collateral, and margining management. Staff 
must be qualified to evaluate counterparty, collateral, and margining 
risk as described in Sec.  703.104 of this subpart.
    (b) Required management and internal controls structure. To 
effectively manage its derivatives activities, a Federal credit union 
must assess the effectiveness of its management and internal controls 
structure. At a minimum, the internal controls structure must include:
     (1) Transaction support. Before executing any derivatives 
transaction, a Federal credit union must identify and document the 
circumstances that lead to the decision to hedge, specify the 
derivatives strategy the Federal credit union will employ, and 
demonstrate the economic effectiveness of the hedge;
     (2) Internal controls review. For the first two years after 
commencing its derivatives program, a Federal credit union must have an 
internal controls review that is focused on the integration and 
introduction of derivatives functions. This review must be performed by 
an independent external unit or, if applicable, the Federal credit 
union's internal auditor. The review must ensure the timely 
identification of weaknesses in internal controls, modeling 
methodologies, risk, and all operational and oversight processes;
     (3) Financial statement audit. Any Federal credit union engaging 
in derivatives transactions pursuant to this subpart must obtain an 
annual financial statement audit, as defined in Sec.  715.2(d) of this 
chapter, and be compliant with GAAP for all derivatives-related 
accounting and reporting;
     (4) Process and responsibility framework. A Federal credit union 
must maintain a written and schematic description (e.g., flow chart or 
organizational chart) of the derivatives management process in its 
derivatives policies and procedures. The description must include the 
roles of staff, qualified personnel, external service providers, senior 
executive officers, the board of directors, and any others involved in 
the derivatives program;
     (5) Separation of duties. A Federal credit union's process, 
whether conducted internally or by an external service provider, must 
have appropriate separation of duties for the following functions 
defined in paragraph (a)(3) of this section:
     (i) Asset/liability risk management;
     (ii) Accounting and financial reporting;
     (iii) Derivatives execution and oversight; and
     (iv) Collateral, counterparty, and margining management.
    (c) Legal review. A Federal credit union with derivatives authority 
must hire or engage legal counsel to reasonably ensure that all 
derivatives contracts adequately protect the legal and business 
interests of the Federal credit union. The Federal credit union's 
counsel must have legal expertise with derivatives contracts and 
related matters.
    (d) Policies and procedures. A Federal credit union with 
derivatives authority must operate according to comprehensive written 
policies and procedures for control, measurement, and management of 
derivatives transactions. At a minimum, the policies and procedures 
must address the requirements of this subpart, except for those in 
Sec. Sec.  703.108 through 703.114, and any additional limitations 
imposed by the Federal credit union's board of directors. A Federal 
credit union's board of directors must review the policies and 
procedures described in this section annually and update them when 
necessary.


Sec.  703.107  External service providers.

    (a) General. A Federal credit union with derivatives authority may 
use external service providers to support or conduct aspects of its 
derivatives program, provided:
     (1) The external service provider, including affiliates, does not:
     (i) Act as a counterparty to any derivatives transactions that 
involve the Federal credit union;
     (ii) Act as a principal or agent in any derivatives transactions 
that involve the Federal credit union; or
     (iii) Have discretionary authority to execute any of the Federal 
credit union's derivatives transactions.
    (2) The Federal credit union has the internal capacity, experience, 
and skills to oversee and manage any external service providers it 
uses; and
    (3) The Federal credit union documents the specific uses of 
external service providers in its process and responsibility framework, 
as described in Sec.  703.106(b)(1) of this subpart and the 
application.
    (b) Support functions. A Federal credit union must perform the 
following functions internally and independently. A Federal credit 
union may have assistance and input from an external service provider, 
provided the external service provider does not conduct the following 
functions in lieu of the Federal credit union:
     (1) Asset/liability risk management; and
     (2) Liquidity risk management.


Sec.  703.108  Eligibility.

    (a) A Federal credit union may apply for derivatives authority 
under this subpart if it meets the following criteria:
    (1) The Federal credit union's most recent NCUA-assigned composite 
CAMEL code rating is 1, 2, or 3, with a management component of 1 or 2; 
and
    (2) The Federal credit union has assets of at least $250 million as 
of its most recent call report.
    (b) Notwithstanding paragraph (a)(2) of this section, a Federal 
credit union may request permission from the appropriate field director 
to apply for derivatives authority, subject to requirements imposed by 
the field director. If the field director grants such permission, the 
application will be subject to Sec. Sec.  703.109 through 703.111.


Sec.  703.109  Applying for derivatives authority.

    An eligible Federal credit union must receive written approval to 
use derivatives by submitting a detailed application, consistent with 
this subpart and any guidance issued by NCUA. A Federal credit union 
must submit its application to the applicable field director.


Sec.  703.110  Application content.

    A Federal credit union applying for derivatives authority must 
document how it will comply with the requirements of this subpart and 
any guidance issued by NCUA, and must include all of the following in 
its application:
    (a) An interest rate risk mitigation plan that shows how 
derivatives are one aspect of the Federal credit union's overall 
interest rate risk mitigation strategy, and an analysis showing how the 
Federal credit union will use derivatives in conjunction with other on-
balance sheet instruments and strategies to effectively manage its 
interest rate risk;
    (b) A list of the products and characteristics the Federal credit 
union

[[Page 5245]]

is seeking approval to use, a description of how it intends to use the 
products and characteristics listed, an analysis of how the products 
and characteristics fit within its interest rate risk mitigation plan, 
and a justification for each product and characteristic listed;
    (c) Draft policies and procedures that the Federal credit union has 
prepared in accordance with Sec.  703.106(d) of this subpart;
    (d) How the Federal credit union plans to acquire, employ, and/or 
create the resources, policies, processes, systems, internal controls, 
modeling, experience, and competencies to meet the requirements of this 
subpart. This includes a description of how the Federal credit union 
will ensure that senior executive officers, board of directors, and 
personnel have the knowledge and experience in accordance with the 
requirements of this subpart;
    (e) A description of how the Federal credit union intends to use 
external service providers as part of its derivatives program, and a 
list of the name(s) of and service(s) provided by the external service 
providers it intends to use;
    (f) A description of how the Federal credit union will support the 
operations of margining and collateral; and
    (g) A description of how the Federal credit union will comply with 
GAAP.


Sec.  703.111  NCUA approval.

    (a) Interim approval. The field director will notify the Federal 
credit union in writing if the field director has approved or denied 
its application and, if applicable, the reason(s) for any denial. A 
Federal credit union approved for derivatives authority may not enter 
into any derivatives transactions until it receives final approval from 
NCUA under paragraph (c) of this section.
    (b) Notice of readiness. A Federal credit union approved under 
paragraph (a) of this section must provide written notification to NCUA 
when it is ready to begin using derivatives.
    (c) Final approval. NCUA will review every approved Federal credit 
union's derivatives program to ensure compliance with this subpart and 
evaluate the Federal credit union's implementation of the items in its 
application. This supervisory review may be conducted on site. After 
NCUA has completed its review, the field director will notify the 
Federal credit union in writing if the field director has granted final 
approval and the Federal credit union may begin entering into 
derivatives transactions. If applicable, the notification will include 
the reason(s) for any denial. A Federal credit union may not enter into 
any derivatives transactions under this subpart until it receives this 
determination from the applicable field director. At a field director's 
discretion, a Federal credit union may reapply under this subsection if 
the field director has determined that the Federal credit union has 
demonstrated compliance with this subpart and its application.
    (d) Right to appeal. A Federal credit union may submit a written 
appeal to the NCUA Board within 60 days from the date of denial by NCUA 
under paragraph (b) or (c) of this section.


Sec.  703.112  Applying for additional products or characteristics.

    (a) A Federal credit union with derivatives authority may 
subsequently apply for approval to use additional products and 
characteristics, described in Sec.  703.102 of this subpart, that it 
did not request in its initial application, subject to the following:
    (1) A Federal credit union must submit an application to NCUA;
    (2) A Federal credit union's application must include a list of the 
products and/or characteristics for which it is applying; and
    (3) A Federal credit union must include a justification for each 
product and/or characteristic requested in the application and an 
explanation of how the Federal credit union will use each product and/
or characteristic requested.
    (b) The field director will notify the Federal credit union in 
writing if the field director has approved or denied its application 
for additional products or characteristics. If applicable, the 
notification will include the reason(s) for denial.
    (c) A Federal credit union may appeal any denial of an application 
for additional products and/or characteristics in accordance with Sec.  
703.111(d).


Sec.  703.113  Pilot program participants with active derivatives 
positions.

    (a) A Federal credit union with outstanding derivatives positions 
under NCUA's derivatives pilot program as of January 1, 2013, must 
comply with the requirements of this subpart within 12 months of the 
effective date of this subpart, including the requirement to submit an 
application for derivatives authority. During the 12-month interim 
period, the Federal credit union may continue to operate its 
derivatives program in accordance with its pilot program terms and 
conditions.
    (b) A Federal credit union with outstanding derivatives positions 
under NCUA's derivatives pilot program as of January 1, 2013, that does 
not comply with the requirements of this subpart within 12 months of 
the effective date of this subpart, or does not want to continue 
engaging in derivatives transactions, must:
    (1) Stop entering into new derivatives transactions; and
    (2) Within 30 days, present a corrective action plan to NCUA 
describing how the Federal credit union will cure any deficiencies or 
wind down its derivatives program.


Sec.  703.114  Regulatory violation.

    (a) A Federal credit union with derivatives authority that no 
longer meets the requirements of this subpart or fails to comply with 
its approved strategy (including employing the resources, policies, 
procedures, accounting, and competencies that formed the basis for the 
approval) must:
    (1) Immediately stop entering into any new derivatives transactions 
until the Federal credit union is in compliance with this subpart. 
During this period, however, the Federal credit union may terminate 
existing derivatives transactions. NCUA may permit a Federal credit 
union to enter into offsetting transactions if NCUA determines these 
transactions are part of a corrective action strategy.
    (2) Within three business days from the regulatory violation, 
provide the appropriate field director notification of the regulatory 
violation, which must include a description of the violation and the 
immediate corrective action the Federal credit union is taking; and
    (3) Within 15 business days after notifying the appropriate field 
director, submit a written corrective action plan to the appropriate 
field director.
    (b) NCUA may revoke a Federal credit union's derivatives authority 
at any time if a Federal credit union fails to comply with the 
requirements of this subpart. Revocation will prohibit a Federal credit 
union from executing any new derivatives transactions under this 
subpart, and may require the Federal credit union to terminate existing 
derivatives transactions if, in the discretion of the applicable field 
director, doing so would not pose a safety and soundness concern.
    (c) Within 60 days from the date of the related field director's 
action, a Federal credit union may appeal the following to the NCUA 
Board:
    (1) NCUA's revocation of a Federal credit union's derivatives 
authority; and
    (2) NCUA's order that a Federal credit union terminate existing 
derivatives positions.
    (d) With respect to an appeal regarding revocation of a Federal 
credit

[[Page 5246]]

union's derivatives authority, the Federal credit union may not enter 
into any new derivatives transactions until the NCUA Board renders a 
final decision on the appeal. The Federal credit union may, however, 
elect to terminate existing derivatives positions. With respect to an 
appeal regarding an order to terminate a Federal credit union's 
existing derivatives positions, the Federal credit union is not 
required to terminate any existing positions until the NCUA Board 
renders a final decision on the appeal.

Appendix to Subpart B--Examples of Derivative Limit Authority 
Calculations

    Limit authority. A Federal credit union that is approved for 
derivatives authority under Sec.  703.111 may use any of the 
products and characteristics described in Sec.  703.102(a), subject 
to the following position and risk limits:

                                            Table 1--Authority Limits
----------------------------------------------------------------------------------------------------------------
                                               Entry limits (first 12
              Limit authority                  months of transactions)                Standard limits
----------------------------------------------------------------------------------------------------------------
Fair Value Loss (See (a) below)...........  15% of net worth............  25% of net worth.
Weighted Average Remaining Maturity         65% of net worth............  100% of net worth.
 Notional (WARMN) (See (b) below).
----------------------------------------------------------------------------------------------------------------

    (a) Calculating the fair value loss limit for compliance with 
this subpart. To demonstrate compliance with the fair value loss 
limit authority of this subpart, a Federal credit union must combine 
the total fair value (as defined by product group below) of all 
derivatives transactions. The fair value loss limit is exclusive to 
the derivatives positions (not net of offsetting gains and losses in 
the hedged item).
    (1) The resulting figure, if a loss, must not exceed the Federal 
credit union's authorized fair value loss limit:
    (i) Options--the gain or loss is the difference between the fair 
value and the unamortized premium at the reporting date;
    (ii) Swaps--the gain or loss is the fair value at the reporting 
date; and
    (iii) Futures--the gain or loss is the difference between the 
exchange closing price at the reporting date and the purchase or 
sales price.
    (2) Example calculations for compliance with this subpart: fair 
value loss limit. The table below provides an example of the fair 
value loss limit calculations for a sample Federal credit union that 
has entry level authority. The sample Federal credit union has a net 
worth of $100 million and total assets of $1 billion; its fair value 
loss limit is -$15 million (15 percent of net worth).

                                                      Table 2--Example Fair Value Loss Calculations
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                Fair value gains (losses)                           % of Net
                                        ------------------------------------------------------------------------      worth          Limit  violation
                                              Options            Swaps            Futures            Total          (percent)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Scenario A.............................        $1,000,000        $2,000,000          $200,000        $3,200,000               3  No.
Scenario B.............................         5,000,000        10,000,000         2,000,000        17,000,000              17  No.
Scenario C.............................         1,000,000       (3,000,000)           250,000       (1,750,000)             (2)  No.
Scenario D.............................         1,000,000      (20,000,000)       (2,000,000)      (21,000,000)            (21)  Yes.
Scenario E.............................       (2,000,000)      (10,000,000)         1,000,000      (11,000,000)            (11)  No.
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (b) Calculating the WARMN exposure for compliance with this 
subpart. The WARMN calculation adjusts the gross notional of a 
derivative to take into account its price sensitivity and remaining 
maturity. The WARMN limit is correlated to the fair value loss 
limit, as described in paragraph (a) of this appendix, for a 300 
basis point parallel shift in interest rates. To demonstrate 
compliance with the WARMN limit authority of this subpart, a Federal 
credit union must calculate the WARMN using the following reference 
table, definitions, and calculation steps:

                                      Table 3--Summary of WARMN Calculation
----------------------------------------------------------------------------------------------------------------
                                  Step 1 gross        factor        Step 2      Step 3  WARM
                                    notional        (percent)     adjusted notional
----------------------------------------------------------------------------------------------------------------
Options (Caps).................         Current              33  33% of current      Time remaining to maturity.
                                       notional                   notional.
Options (Floors)...............         Current              33  33% of current      Time remaining to maturity.
                                       notional                   notional.
Swaps..........................         Current             100  100% of current     Time remaining to maturity.
                                       notional                   notional.
Futures........................   Contract size             100  100% of contract    Underlying contract.
                                                                  size.
                                 ..............  ..............  Sum = Total         Sum = Overall WARM
                                                                  Adjusted Notional.
----------------------------------------------------------------------------------------------------------------
Step 4 WARMN = Adjusted Notional x (WARM/10)
----------------------------------------------------------------------------------------------------------------

    (1) Step #1--Calculate the gross notional of all outstanding 
derivative transactions. (i) For options and swaps, all gross 
notional amounts must be absolute, with no netting (i.e., offsetting 
a pay-fixed transaction with a receive-fixed transaction). The gross 
notional for derivatives transactions with amortizing notional 
amounts is the current contracted notional amount, in accordance 
with the amortization schedule.
    (ii) For futures, the gross notional is the underlying contract 
size as designated by the Chicago Mercantile Exchange (CME) product 
specifications (e.g., a five-year Treasury note futures contract 
will use $100,000 for each contract purchased or sold and reported 
here on a gross basis for limit purposes.)

[[Page 5247]]

    (2) Step #2--Convert each gross notional by its derivative 
adjustment factor to produce an adjusted gross notional. The 
derivative adjustment factor approximates the price sensitivity for 
each of the product groups in order to weight the notional amount by 
sensitivity before weighting for maturity.
    (i) For cap and floor options, the derivative adjustment factor 
is 33 percent. For example, an interest rate cap with a $1 million 
notional amount has an adjusted gross notional of $330,000 
($1,000,000 x 0.33 + $330,000).
    (ii) For interest rate swaps and Treasury futures, the 
derivative adjustment factor is 100 percent. For example, an 
interest rate swap with a $1 million notional amount has an adjusted 
gross notional of $1,000,000 ($1,000,000 x 1.00 = $1,000,000).
    (iii) The total adjusted notional for all derivatives positions 
is the sum of (i) and (ii) above.
    (3) Step #3--Produce the weighted average remaining time to 
maturity (WARM) for all derivatives positions. (i) For interest rate 
caps, interest rate floors, and interest rate swaps, the remaining 
maturity is the time left between the reporting date and the 
contracted maturity date, expressed in years (round up to two 
decimals);
    (ii) For Treasury futures, the remaining maturity is the 
underlying deliverable Treasury note's maximum maturity (e.g., a 
five-year Treasury note future has a five-year remaining maturity); 
and
    (iii) Determine the WARM using the adjusted gross notional, as 
set forth in subsection (2) of this section, and the remaining time 
to maturity as defined for each product group above in paragraphs 
(b)(3)(i) and (ii) of this appendix.
    (4) Step #4--Produce the WARMN by converting the WARM to a 
percentage and then multiplying the percentage by the total adjusted 
gross notional. (i) Divide the WARM, as calculated in paragraph 
(b)(3) of this appendix, by ten to convert it to a percentage (e.g., 
7.75 WARMN is translated to 77.5 percent); and
    (ii) Multiply the WARM converted to a percentage, as described 
in paragraph (c)(4)(i) of this appendix, by total adjusted gross 
notional, described in paragraph (c)(2) of this appendix.
    (5) Compare WARMN calculation to the WARNM limit for compliance. 
The total in step four (4) must be less than the limit in paragraph 
(a)(1)(ii) or (a)(2)(ii) of this appendix, as applicable.
    (6) Example calculations for compliance with this subpart: 
WARMN. The table below provides an illustrative example of the WARMN 
limit calculations for a sample Federal credit union that has entry 
level authority. The sample Federal credit union has a net worth of 
$100 million and total assets of $1 billion; its notional limit 
authority is $65 million (65 percent of net worth).

                                    Table 4--Example WARMN Limit Calculation
----------------------------------------------------------------------------------------------------------------
                                               Options            Swaps            Futures            Total
----------------------------------------------------------------------------------------------------------------
Gross Notional (Step 1)........      $100,000,000       $50,000,000        $5,000,000      $155,000,000
Adjustment Factor.......................               33%              100%              100%  ................
Adjusted Notional (Step 2).....       $33,000,000       $50,000,000        $5,000,000       $88,000,000
Weighted Average Remaining Maturity                   7.00              8.50              5.00              7.74
 (WARM) (Step 3)...............
----------------------------------------------------------------------------------------------------------------
                                                                Weighted Average Remaining       \1\ $68,100,000
                                                              Maturity Notional (WARMN) (Step
                                                                       4):
                                                             Notional Limit Authority (65% of        $65,000,000
                                                                        net worth)
                                                                Under/(Over) Notional Limit         ($3,100,000)
                                                                         Authority
----------------------------------------------------------------------------------------------------------------
\1\ (77.4% of Step 3.)

PART 715--SUPERVISORY COMMITTEE AUDITS AND VERIFICATIONS

0
7. The authority citation for part 715 continues to read as follows:

    Authority:  12 U.S.C. 1757, 1766(a), and 1781-1790; 31 U.S.C. 
3717.

0
8. In Sec.  715.5, revise paragraph (a) to read as follows:


Sec.  715.5  Audit of Federal Credit Unions.

    (a) Total assets of $500 million or greater. To fulfill its 
Supervisory Committee audit responsibility, a Federal credit union 
having total assets of $500 million or greater, except as provided in 
Sec.  703.106(b)(3) of this chapter, must obtain an annual audit of its 
financial statements performed in accordance with Generally Accepted 
Auditing Standards by an independent person who is licensed to do so by 
the State or jurisdiction in which the credit union is principally 
located.
* * * * *

PART 741--REQUIREMENTS FOR INSURANCE

0
9. The authority citation for part 741 is revised to read as follows:

    Authority:  12 U.S.C. 1757, 1766(a), 1781-1790, and 1790d; 31 
U.S.C. 3717.


0
10. Revise Sec.  741.219 to read as follows:


Sec.  741.219  Investment requirements.

    (a) Any credit union which is insured pursuant to Title II of the 
Act must adhere to the requirements stated in part 703 of this chapter 
concerning transacting business with corporate credit unions.
    (b) Any credit union which is insured pursuant to Title II of the 
Act must notify the applicable NCUA Regional Director or the Director 
of the Office of National Examinations and Supervision in writing at 
least 30 days before it begins engaging in derivatives.
[FR Doc. 2014-01703 Filed 1-30-14; 8:45 am]
BILLING CODE 7535-01-P