Why Community Banks Have Been Locked Out of Derivatives and Interest Rate Risk Hedging
The most prominent promise of fintech was that technology would “democratize” finance. While this concept typically centers around empowering consumers, it applies equally to the bank incumbents in the equation. And one of the areas where the democratizing power of financial technology for banks is most clearly on display is in the derivatives market.
Derivatives are contracts that allow parties to trade on the underlying value of an asset, like interest rates or currencies. They have been important risk management tools since the first interest rate swap was executed in 1982. Yet for decades, community banks have watched from the sidelines as their larger competitors wielded these tools to manage interest rate risk. Adoption has been waylaid by operational complexity, regulatory caution, and a broader cultural mistrust of the instrument.
For many community banks, the real barrier has been finding accessible, transparent, and cost-effective ways to participate in interest rate risk hedging without the operational burden of traditional derivatives.
But the dramatic shift in the technology of the derivatives market — bolstered by a more affirming regulatory environment — is causing more banks to take a fresh look at this strategy for managing interest rate risk.
The Long Shadow of Derivative-Phobia: Why Community Banks Avoided Interest Rate Risk Hedging
Some of the wariness around derivatives can be traced back to a string of spectacular, widely publicized disasters in the mid-1990s. In December 1994, Orange County, California declared bankruptcy after its treasurer lost $1.7 billion on leveraged interest rate bets. It was the largest municipal failure in U.S. history at the time. Months later, Barings Bank collapsed when a rogue trader in Singapore ran up more than $1 billion in losses on futures contracts, bringing down an institution that had helped finance the Louisiana Purchase. Around the same time, Procter & Gamble and Gibson Greetings sued Bankers Trust over complex swap products that generated massive losses and made the front page of the Washington Post business section.
The lesson community bankers took from these disasters wasn’t nuanced; it was visceral: derivatives are dangerous.
Regulatory guidance reinforced this perception. The 2010 Interagency Advisory on Interest Rate Risk Management required institutions using derivatives to bring on senior talent who fully understood the instruments and implement in-depth training programs. The risk and investment didn’t seem to justify the reward for smaller banks.
The SVB Wake-Up Call
Thirteen years later, the failure of Silicon Valley Bank (SVB) shifted the industry’s perspective on derivatives and provided a clear illustration of the costs of not hedging.
As rates rose in March of 2023, SVB’s held-to-maturity securities portfolio suffered $15.2 billion in unrealized losses — nearly equivalent to the bank’s entire $16 billion equity base. The Federal Reserve’s post-mortem found that SVB management had actively removed interest rate hedges in 2022, projecting rates would reverse course. When rates didn’t come down, the bank announced a $1.8 billion realized loss. Within 48 hours of the announcement, depositors withdrew $42 billion and had requested an additional $100 billion in withdrawals (totaling $142 billion, or 81% of the prior year’s deposits) before regulators seized the bank.
SVB became the second-largest bank failure in U.S. history at the time, and it countered old narratives about derivatives only making sense for the biggest banks. “Interest rate risk is not a big bank problem,” says Craig Haymaker, who leads bank sector business development at Eris Innovations, IP licensor for Eris SOFR Swap futures. “It’s an every bank problem.”
Breaking Down the Barriers to Derivatives and Interest Rate Risk Hedging for Community Banks
In recent years, regulatory and accounting environments have become more hospitable to hedging.
FASB’s ASU 2017-12 dramatically simplified hedge accounting and reduced the risk of unexpected earnings volatility that had previously kept community banks at bay. The National Credit Union Administration (NCUA) has been actively encouraging credit unions to hedge in recent years through deregulatory measures including a 2020 rule that removed the requirement to be preapproved before participating for institutions over $500 million in assets. Banking regulators are increasingly emphasizing actual financial risk over procedural box-checking — a meaningful shift for community banks that fear examiner criticism more than interest rate risk exposure.
But even as the regulatory climate has warmed, operational barriers remain formidable for banks looking to participate through traditional over-the-counter (OTC) methods. OTC swaps require negotiating ISDA Master Agreements, a process that can take up to a year. Dealers conduct credit reviews, evaluate loan concentrations, and often impose minimum transaction sizes of $10 million or more.
“You have risk exposures on the balance sheet, you’re trying to get an ISDA off the ground,”Haymaker explains. “That negotiation process, nose to tail, can take anywhere from three weeks to a year … And then some of these dealers will say, ‘We’re not going to service banks less than $1 billion in assets.”
Beyond access, there’s the challenge of valuation. OTC swaps are model-priced instrument —banks either blindly accept the dealer’s valuation or spend handsomely hiring staff and systems to support internal modeling capabilities.
These barriers have left many community banks effectively locked out of modern interest rate risk hedging tools, despite having clear exposure that needs managing.
The Exchange-Traded Alternative
Eris Innovations emerged from the 2008 financial crisis with a simple premise: the complexity of OTC swaps was a solvable problem. The company developed exchange-traded swap futures that offer the cash flows and functionality of traditional interest rate swaps, but trade on exchanges like CME Group with the simplicity of standard futures contracts.
Geoffrey Sharp, who joined Eris after two decades on Wall Street including stints at Credit Suisse, Lehman Brothers, and Nomura, describes the transformation: “Swaps are very messy … Every single contract was different. They eventually became traded on a master agreement called an ISDA, which was fairly complex and expensive to negotiate, but more importantly, understand.”
The contrast with exchange-traded swap futures is stark. “The beauty of swap futures is you don’t need anything except a brokerage account to do it,” Sharp explains. “You don’t need risk management systems or valuation engines … It takes a lot of the operational lift out of hedging.”
How Swap Futures Reduce Operational and Valuation Burdens
With Eris SOFR swaps, minimum trade sizes start at $100,000 notional — a fraction of the $10 million minimums common in dealer markets. Pricing is transparent, published daily by CME Group. Initial margin requirements run approximately 0.3% to 1.7% of notional value for 1-year to 10-year tenors, respectively, up to 60% lower than comparable cleared swaps. And for the back office, they qualify for FASB hedge accounting treatment as well.
“The beauty of Eris is you can trade in sizes as low as 100,000 notional,” says Haymaker. “If you wanted to hedge a $500,000 portfolio of loans, you can trade five contracts. That’s fine, and you’ll be treated the same way as somebody who’s hedging a $5 billion position, or trading 50,000 contracts.”
For community banks evaluating hedging strategies today, exchange-traded swap futures offer a more standardized, transparent, and operationally lightweight entry point into interest rate risk management.
Looking Forward: The Growing Role of Swap Futures in Community Bank Risk Management
Today, 97.7% of all derivatives use among US banks occurs at institutions with more than $250 billion in assets. But the regulatory environment continues to shift in ways that may encourage more participation from community banks. Recent proposals would limit supervisors’ ability to issue criticisms for procedural matters, focusing instead on actual financial risk.
From the perspective of Eris, swaps are inherently meant for managing financial risk, not increasing it. “We’re pursuing risk reduction … It’s about achieving a degree of neutrality that allows them [banks] to work within their risk limits.”
Haymaker points to a community bank in West Texas that used Eris swap futures to hedge its mortgage portfolio during the rate increases of 2022. “It turned out to be a very, very successful hedge,” he says. “My estimation is the amount of money that hedge generated was about 25% of the capital base of the bank. Without those hedges, you were seeing 20 to 30% enterprise value impairment.”
For community banks watching interest rate volatility whipsaw their earnings, the opportunity to reconsider derivatives is ripe.
This article is brought to you in partnership with Eris Innovations, LLC. To learn more, visit https://www.erisfutures.com/.
