Local Authority Derivatives – Regulatory Framework David Blake dblake@arlingclose.com

A recent local authority interest rate swap transaction, developed by Arlingclose and believed to be the first of its kind in over thirty years, has reignited the debate around power to use derivatives. A CIPFA official has caught the attention of media outlets, tweeting in a personal capacity that their individual view is interest rate swaps remain “ultra vires”. This is at odds with prevailing legislation and official CIPFA guidance, in this note we set out the legal and regulatory background to local authority use of derivatives.

Legislative Changes

Following the reckless and speculative use of financial derivatives by Hammersmith and Fulham Council in the late 1980s, the House of Lords subsequently ruled that local authorities had “no power” to enter derivative transactions.

Over two decades later, the Localism Act 2011 granted English local authorities a general power of competence. In simple terms, it gives councils the power to do anything an individual can do provided it is not prohibited by other legislation, and underpins the legal basis for utilising derivatives. Several authorities have now obtained QC opinions supporting the use of interest rate swaps, specifically for the purpose of limiting risk arising from fluctuations in interest rates. However, this needs to be undertaken with reference to relevant legislation, guidance, codes of practice and in the context of financial rationality and proper purpose.

Regulatory Framework

Following the enactment of the Localism Act 2011, CIPFA updated the regulatory framework for local government finance to include derivatives. The Treasury Management Code requires local authorities to only use financial derivatives for risk management purposes, not speculation. The Code’s Guidance Notes for Local Authorities include a checklist before derivatives are used, requiring local authorities to:

  • ensure that they have the legal power to enter into such transactions,
  • define clearly their approach to risk management and the use of such tools in their treasury management strategy,
  • clearly state the instruments that they propose to use and in what circumstances,
  • only use such financial instruments for the prudent management of their financial affairs and never for speculative purposes,
  • seek proper advice and consider that advice when entering into arrangements to use such products to ensure that they fully understand those products, and
  • satisfy themselves that they understand fully how underlying risks are affected and any additional risks that may result.

The September 2013 CIPFA Publication “Practical Considerations in Using Financial Instruments to Manage Risk in the Public Sector” expanded upon these points. CIPFA/LASAAC’s Code of Practice on Local Authority Accounting includes two pages on accounting for derivatives. Hedge accounting is permitted with an adaption for the public sector context.

The authority conducting the recent swap followed the procedure outlined in the CIPFA Treasury Management Code for derivative transactions, including obtaining external legal and financial advice and approval from elected members. The authority will adopt hedge accounting for the swap to ensure that whatever direction interest rates move in, the impact on its revenue account will be smaller than before it agreed the swap. This is the very essence of treasury risk management and explains why derivatives are used by nearly every large organisation in the UK other than local authorities. 

Risk Management

Any authority considering using derivatives, including interest rate swaps, will need to verify the appropriateness of this hedging solution. This will include analysis of the impact on interest rate, refinancing, counterparty, market, regulatory and legal risks, together with an assessment on the effectiveness of the hedge. This should be incorporated within a treasury management strategy that brings a balanced approach to risk management.

Evolution in Local Authority Use of Derivatives

Financial markets, legislation and regulation have all moved a long way over the past thirty years. Combined with advances in technology and risk management techniques, they allow the use of a wider range of appropriate financial instruments, helping authorities reduce risk and costs. In this context, the recent negative commentary on derivatives appears out-of-date and contradicts official CIPFA publications. There is a clear process for establishing the legal power to enter these transactions and CIPFA’s current published guidance provide a prudent framework to operate within.