GOVERNMENT FINANCE OFFICERS ASSOCIATION
Recommended Practice
Use of Derivatives by State and Local Governments
A derivative is a financial instrument created from or whose value depends on (is derived from) the value of one or more underlying assets or indexes of asset values. The term “derivative products” refers to instruments or features such as collateralized mortgage obligations (CMO’s), interest-only (IOs) and principal-only (POs), forwards, futures, currency and interest swaps, options, floaters/inverse floaters and caps/floors/collars. State and local governments are potential users of derivatives in their roles as debt, cash and pension fund managers.
The Government Finance Officers Association (GFOA) urges government finance officers to exercise extreme caution in the use of derivative instruments and to consider their use only when they have developed a sufficient understanding of the products and the expertise to manage them. Because new derivative products are increasingly complex, state and local governments considering derivatives should use these instruments only if they can evaluate the following factors, among others, to determine the appropriateness of derivative use for their jurisdiction:
1. Government entities must observe the objectives of sound asset and liability management policies that ensure safety, liquidity and yield. Because of the risks involved, the use of derivatives by government entities should receive particular scrutiny. Certain derivative products may not be appropriate for all government investors. Characteristics of such products can include:
• High price volatility;
• Illiquid markets;
• Products that are not market-tested;
• Highly leveraged products;
• Products requiring a high degree of sophistication to manage; and
• Products that are difficult to value.
2. Government entities should understand that state and local laws may not specifically address the use of derivatives. Therefore, analysis should include an examination of considerations, such as:
• The constitutional and statutory authority of the governmental entity to execute derivative contracts;
• The potential for violating constitutional or statutory provisions limiting the entity’s authority to incur debt resulting from the transaction; and
• The application of the government entity’s procurement statutes to derivative transactions.
3. Government entities should be aware of the risks incurred as a result of use of derivatives. These include, in addition to legal risk, counter party credit risk, custodial risk, market risk, settlement risk and operating risk.
4. Government entities should establish internal controls for each type of derivative in use to ensure that these risks are adequately managed. Examples include:
• The entity should provide a written statement of purpose and objectives for derivative use.
• Written procedures should be established that provide for periodic monitoring of derivative instruments.
• Managers should have sufficient expertise and technical resources to oversee derivative programs. Periodic training should be provided.
• Recordkeeping systems should be sufficiently detailed to allow governing bodies, auditors and examiners to determine if the program is functioning in accordance with established objectives.
• Managers should report regularly on the use of derivatives to their governing body, and appropriate disclosure should be made in official statements and other disclosure documents.
• Reporting on derivative use should be in accordance with generally accepted accounting principals. Because use of these instruments is a complex matter, early discussion with public accountants is essential. Specialized reporting may be required.
5. Government entities should be aware if the broker or dealer with whom they are dealing is merely acting as an agent or intermediary in a derivative transaction or is taking a proprietary position. Any possible conflict of interest should be taken into consideration before entering into a transaction.
6. Government entities should be aware that there may be little or no pricing information or standardization for some derivatives. Competitive price comparisons are recommended before entering into a transaction.
7. Government entities should exercise caution in their selection of brokers, dealers or investment managers and ensure that these agents are knowledgeable about, understand and provide disclosure regarding the use of derivatives, including benefits and risks. The entity should secure written acknowledgment from the
broker or dealer that they have received, read and understood the entity’s debt and investment policies, including whether derivatives are currently authorized under the entity’s investment policy, and that the broker, dealer or investment manager has ascertained that the recommended product is suitable for the government entity.
8. Government entities are responsible for ensuring this same level of safeguards when derivative transactions are conducted by a third party acting on behalf of the governmental entity.
(Prior Code, Ch. 38, App. B) (Ord. 99-286, passed 12-14-1999)