Expected outflows from derivatives

Could a designated/purpose-specific transaction structure consisting of two Total Return Swaps (“TRS”) on the same underlying basket of non-HQLA eligible equities with the same non-bank market counterparty where one physically settled TRS delivers the performance of the equity basket to the counterparty until the point in time when the bank elects to early terminate the transaction and the other cash settled TRS delivers the performance of the equity basket to the bank until maturity be treated as a net derivative inflow for the bank, within the LCR according to Article 32(5) of Delegated Regulation (EU) 2015/61?

Usually, banks will borrow money from the market to fund the physical equity inventory used to hedge their ongoing client-facilitation business activities. In a stressed scenario, the bank may be required to sell the physical hedges to raise funding and replace them with synthetic hedges (where available). The purpose of the transaction structure is to ensure that in a time of funding market stress, banks can obtain funding whilst maintaining their hedging for on-going client-facilitation equity business through a two way offsetting TRS structure. The transaction consists of a bank entering into two TRS agreements on the same underlying basket of equities with a non-bank market counterparty. The bank receives the equity performance under one cash settled TRS (“TRS1”) and pays the equity performance under the other physically settled TRS (“TRS2”). Both TRS have the same contractual maturity, however the bank has the right (but not the obligation) to terminate the physically settled TRS at any time subject to a one day notice period. The TRS are documented under standard ISDA documentation, with bilateral netting agreements subject to daily margining. Whilst both TRS exist, their mark-to-market movements offset and hence there is no net transfer of margin until such time as the physically settled TRS is early terminated. Under both TRS, all cash flows (except for the fee payment to the client) only occur at maturity or early termination, i.e. there is no cash flow relating to the performance of the basket of equities during the term of the TRS except (importantly) in case of early termination. The initial value of the equity basket is set at the official closing price of the basket on the trade date. The bank has the right to early terminate TRS2 (with 1 day’s notice) and deliver the physical equity basket in exchange for a cash payment to the bank equal to the initial basket value. TRS1 does not include an early termination provision, i.e. the bank continues to receive the performance of the equity basket from the counterparty until maturity. This structure ensures that even in times of stressed liquidity, the bank has access to funding and can replace physical hedges with an unfunded synthetic hedge. For example, in case of an initial value of the basket of EUR 100, and a basket price decline of 40% in a stressed market scenario, the bank has the ability to early terminate the physically settled TRS. In this case, the bank will receive cash in the amount EUR 100 in return for delivering a basket of equities with a fair value of EUR 60. The cash settled TRS will remain until maturity. At the time of termination, the cash settled TRS has a fair value of -40, which will required a cash variation margin transfer of 40. As such the net cash inflow on termination will equal 60, being the then-market value of the basket of equities. Accordingly this structure improves the liquidity position of the bank. Given that the bank has an early termination right, the bank can ensure a net inflow under the transaction from its market counterparty equal to the fair value of the equity basket at the point in time the early termination right is exercised. As a result, this inflow should be captured as an expected inflow from a type of contract as listed in Annex II CRR (i.e. an equity derivative transaction) in line with Article 32 (5) of the Delegated Regulation.