1. For a contract between bank A and B as set out in the background that is a forward sell (physical delivery), can Bank A deduct from its own funds the net position on FSE?
2. For a contract between bank A and B as set out in the background that is cash-settled (TRS, future, options), can Bank A deduct from its own funds the net position on FSE?
In the case at hand:
• Bank “A” holds an equity position of financial sector entity “FSE”.
• Bank A covers its position with another Bank, Bank “B”.
• The contract between Banks A and B is of maturity lower than a year
• All positions are within the trading book.
• Bank A’s delta hedge is perfect: there is no residual delta position within Bank A’s book. In other words, the net exposure of Bank A to FSE equity in 0.
All the questions are related to the application of Articles 36, 45(a) of Regulation (EU) No 575/2013 (CRR), more precisely whether Bank “A” should deduct from its own funds the gross exposure to FSE.
In both cases, bank B will need to deduct from its own funds the delta position induced by its contract with bank A. Therefore, if Bank A couldn’t use the net delta exposure, the equity position in FSE would have to be deducted twice, once from Bank A own funds and once from Bank B own funds.
In http://www.bis.org/publ/bcbs211.pdf, the Basel Committee has concluded that, “for positions in the trading book, if the bank has a contractual right/obligation to sell a long position at a specific point in time and the counterparty in the contract has an obligation to purchase the long position if the bank exercises its right to sell, this point in time may be treated as the maturity of the long position. Therefore, if these conditions are met, the maturity of the long position and the short position are deemed to be matched even if the maturity of the short position is within one year."
There is little difference between question 1 and 2, as long as the equity position FSE is liquid and listed with regular quotations. In Q&A 2014_1658, related to the same article, EBA indicated that the form of the settlement did not matter
Article 45(a) does not precise what is the maturity of an equity position. EBA already indicated that if the short position is longer than the long position, the net position could be used. Hence, if liquid equity positions of the trading book could be considered of short maturity the net position could be used for own funds deduction.
Moreover, maturity mismatch of long/short positions of the trading book are captured within the capital requirements of trading book (either within the VaR, or with the compensation mechanism).
For the deduction required by points (h) and (i) of Article 36 (1) CRR, institutions may calculate direct, indirect or synthetic holdings of Common Equity Tier 1 instruments of financial sector entities only on the basis of net long positions in the same underlying exposure if the requirements of Article 45(a) CRR are met. Referring to the example given, the requirements are deemed to be met if both positions are in the trading book, and if the institution (Bank A) has a contractual right/obligation to sell a long position at a specific point in time and the counterparty (Bank B) in the contract has an obligation to purchase the long position if the bank exercises its right to sell. In that case,
f these conditions are met, the maturity of the forward sell can be treated as the maturity of the hedged equity position, and therefore the condition (i) of Article 45(a) CRR maturity of the long position and the short position are is deemed to be matched for the application of met Article 45(a) CRR even if the residual maturity of the short position is less lower than one year.
Regarding the relevance of the form of settlement, Q&A 2014_1658 (part 2) states explicitly that the form of settlement (delivery or cash) does not matter for the requirements of Article 45(a) CRR.
Update 26.03.2021: This Q&A has been updated in the light of the changes introduced to Regulation (EU) No 575/2013 (CRR).