Derivative Financial Instruments

Northern Trust is a party to various derivative financial instruments that are used in the normal course of business to meet the needs of its clients, as part of its trading activity for its own account and as part of its risk management activities. These instruments include foreign exchange contracts, interest rate contracts, total return swap contracts, credit default swap contracts, and swaps related to the sale of certain Visa Class B common shares.

Northern Trust’s primary risks associated with these instruments are the possibility that interest rates, foreign exchange rates, equity prices, or credit spreads could change in an unanticipated manner, resulting in higher costs or a loss in the underlying value of the instrument. These risks are mitigated by establishing limits, monitoring the level of actual positions taken against such established limits and monitoring the level of any interest rate sensitivity gaps created by such positions. When establishing position limits, market liquidity and volatility, as well as experience in each market, are taken into account.

Credit risk associated with derivative instruments relates to the failure of the counterparty and the failure of Northern Trust to pay based on the contractual terms of the agreement, and is generally limited to the unrealized fair value gains and losses on these instruments, net of any collateral received or deposited. The amount of credit risk will increase or decrease during the lives of the instruments as interest rates, foreign exchange rates, equity prices or other underlying exposures fluctuate. Northern Trust’s risk is controlled by limiting such activity to an approved list of counterparties and by subjecting such activity to the same credit and quality controls as are followed in lending and investment activities. Credit Support Annexes and other similar agreements are currently in place with a number of Northern Trust’s counterparties which mitigate the aforementioned credit risk associated with derivative activity conducted with those counterparties by requiring that significant net unrealized fair value gains be supported by collateral placed with Northern Trust.

All derivative financial instruments, whether designated as hedges or not, are recorded in the consolidated balance sheets at fair value within other assets or other liabilities. As noted in the discussions below, the manner in which changes in the fair value of a derivative is accounted for in the consolidated statements of income depends on whether the contract has been designated as a hedge and qualifies for hedge accounting under GAAP. Northern Trust has elected to net derivative assets and liabilities when legally enforceable master netting arrangements or similar agreements exist between Northern Trust and the counterparty. Derivative assets and liabilities recorded in the consolidated balance sheets were each reduced by $1.8 billion and $1.7 billion as of September 30, 2017 and December 31, 2016, respectively, as a result of master netting arrangements and similar agreements in place. Derivative assets and liabilities recorded at September 30, 2017, also reflect reductions of $617.9 million and $334.3 million, respectively, as a result of cash collateral received from and deposited with derivative counterparties, respectively. This compares with reductions of derivative assets and liabilities of $461.3 million and $722.1 million, respectively, at December 31, 2016. Additional cash collateral received from and deposited with derivative counterparties totaling $235.5 million and $405.0 million, respectively, as of September 30, 2017, and $70.8 million and $324.5 million, respectively, as of December 31, 2016, was not offset against derivative assets and liabilities in the consolidated balance sheets as the amounts exceeded the net derivative positions with those counterparties. Northern Trust centrally clears eligible interest rate derivative instruments as required under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The following table presents the fair value of securities that have been either pledged to or accepted from counterparties for these derivative transactions.

Table 59: Fair Value of Securities Collateral for Derivative Transactions



(in Millions)	September 30, 2017		December 31, 2016
Pledged to others:
Not permitted by contract or custom to sell or repledge	$	43.0	$	70.8
Permitted by contract or custom to sell or repledge	—		—
Accepted from others:
Not permitted by contract or custom to sell or repledge	—		—
Permitted by contract or custom to sell or repledge	4.5		—

Securities pledged or accepted as collateral are not offset against derivative assets and liabilities in the consolidated balance sheets. There was no repledged or sold collateral at September 30, 2017 or December 31, 2016.

Certain master netting arrangements Northern Trust enters into with derivative counterparties contain credit-risk-related contingent features in which the counterparty has the option to declare Northern Trust in default and accelerate cash settlement of net derivative liabilities with the counterparty in the event Northern Trust’s credit rating falls below specified levels. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that were in a liability position was $240.4 million and $358.2 million at September 30, 2017 and December 31, 2016, respectively. Cash collateral amounts deposited with derivative counterparties on those dates included $190.1 million and $317.5 million, respectively, posted against these liabilities, resulting in a net maximum amount of termination payments that could have been required at September 30, 2017 and December 31, 2016, of $50.3 million and $40.7 million, respectively. Accelerated settlement of these liabilities would not have a material effect on the consolidated financial position or liquidity of Northern Trust.

Foreign exchange contracts are agreements to exchange specific amounts of currencies at a future date, at a specified rate of exchange. Foreign exchange contracts are entered into primarily to meet the foreign exchange needs of clients. Foreign exchange contracts are also used for trading purposes and risk management. For risk management purposes, Northern Trust uses foreign exchange contracts to reduce its exposure to changes in foreign exchange rates relating to certain forecasted non-functional-currency-denominated revenue and expenditure transactions, foreign-currency-denominated assets and liabilities, including investment securities and net investments in non-U.S. affiliates.

Interest rate contracts include swap and option contracts. Interest rate swap contracts involve the exchange of fixed and floating rate interest payment obligations without the exchange of the underlying principal amounts. Northern Trust enters into interest rate swap contracts with its clients and also may utilize such contracts to reduce or eliminate the exposure to changes in the cash flows or fair value of hedged assets or liabilities due to changes in interest rates. Interest rate option contracts may include caps, floors, collars and swaptions, and provide for the transfer or reduction of interest rate risk, typically in exchange for a fee. Northern Trust enters into option contracts primarily as a seller of interest rate protection to clients. Northern Trust receives a fee at the outset of the agreement for the assumption of the risk of an unfavorable change in interest rates. This assumed interest rate risk is then mitigated by entering into an offsetting position with an outside counterparty. Northern Trust may also purchase or enter into option contracts for risk management purposes including to reduce the exposure to changes in the cash flows of hedged assets due to changes in interest rates.

Client-Related and Trading Derivative Instruments. Approximately 96% of Northern Trust’s derivatives outstanding at September 30, 2017 and December 31, 2016, measured on a notional value basis, relate to client-related and trading activities. These activities consist principally of providing foreign exchange services to clients in connection with Northern Trust’s global custody business. However, in the normal course of business, Northern Trust also engages in trading of currencies for its own account.

The following table shows the notional and fair values of client-related and trading derivative financial instruments. Notional amounts of derivative financial instruments do not represent credit risk, and are not recorded in the consolidated balance sheets. They are used merely to express the volume of this activity. Northern Trust’s credit-related risk of loss is limited to the positive fair value of the derivative instrument, which is significantly less than the notional amount.

Table 60: Notional and Fair Values of Client-Related and Trading Derivative Financial Instruments



	September 30, 2017						December 31, 2016
	Notional Value		Fair Value				Notional Value		Fair Value
(In Millions)	Notional Value		Asset		Liability		Notional Value		Asset		Liability
Foreign Exchange Contracts	$	323,057.7	$	3,047.4	$	3,002.2	$	273,213.1	$	3,274.2	$	3,221.7
Interest Rate Contracts	7,384.0		81.5		67.3		6,968.3		87.0		85.2
Total	$	330,441.7	$	3,128.9	$	3,069.5	$	280,181.4	$	3,361.2	$	3,306.9

Changes in the fair value of client-related and trading derivative instruments are recognized currently in income. The following table shows the location and amount of gains and losses recorded in the consolidated statements of income for the three and nine months ended September 30, 2017 and 2016.

Table 61: Location and Amount of Client-Related and Trading Derivative Gains and Losses Recorded in Income



		Amount of Derivative Gain Recognized in Income
	Location of Derivative Gain Recognized in Income	Three Months Ended September 30,				Nine Months Ended September 30,
(In Millions)	Location of Derivative Gain Recognized in Income	2017		2016		2017		2016
Foreign Exchange Contracts	Foreign Exchange Trading Income	$	49.1	$	53.6	$	147.1	$	178.5
Interest Rate Contracts	Security Commissions and Trading Income	2.7		2.6		8.3		9.7
Total		$	51.8	$	56.2	$	155.4	$	188.2

Risk Management Instruments. Northern Trust uses derivative instruments to hedge its exposure to foreign currency, interest rate, equity price, and credit risk. Certain hedging relationships are formally designated and qualify for hedge accounting under GAAP as fair value, cash flow or net investment hedges. Other derivatives that are entered into for risk management purposes as economic hedges are not formally designated as hedges and changes in fair value are recognized currently in other operating income.

In order to qualify for hedge accounting, a formal assessment is performed on a calendar-quarter basis to verify that derivatives used in designated hedging transactions continue to be highly effective in offsetting the changes in fair value or cash flows of the hedged item. If a derivative ceases to be highly effective, matures, is sold or is terminated, or if a hedged forecasted transaction is no longer probable of occurring, hedge accounting is terminated and the derivative is treated as if it were a trading instrument.

The following table identifies the types and classifications of derivative instruments formally designated as hedges under GAAP and used by Northern Trust to manage risk, their notional and fair values, and the respective risks addressed.

Table 62: Notional and Fair Value of Designated Risk Management Derivative Financial Instruments



			September 30, 2017						December 31, 2016
	Derivative Instrument	Risk Classification	Notional Value		Fair Value				Notional Value		Fair Value
(In Millions)	Derivative Instrument	Risk Classification	Notional Value		Asset		Liability		Notional Value		Asset		Liability
Fair Value Hedges
Available for Sale Investment Securities	Interest Rate Swap Contracts	Interest Rate	$	3,430.1	$	17.4	$	11.0	$	3,873.4	$	88.3	$	16.8
Senior Notes and Long-Term Subordinated Debt	Interest Rate Swap Contracts	Interest Rate	1,250.0		18.0		4.1		1,250.0		71.8		3.3
Cash Flow Hedges
Forecasted Foreign Currency Denominated Transactions	Foreign Exchange Contracts	Foreign Currency	431.2		11.7		8.5		329.3		8.5		7.8
Foreign Currency Denominated Investment Securities	Foreign Exchange Contracts	Foreign Currency	1,439.8		27.4		—		1,431.6		151.5		0.8
Available for Sale Investment Securities	Interest Rate Contracts	Interest Rate	1,025.0		0.2		1.7		975.0		0.1		2.7
Net Investment Hedges
Net Investments in Non-U.S. Affiliates	Foreign Exchange Contracts	Foreign Currency	2,855.4		5.0		154.9		2,083.6		174.6		10.8
Total			$	10,431.5	$	79.7	$	180.2	$	9,942.9	$	494.8	$	42.2

Derivatives are designated as fair value hedges to limit Northern Trust’s exposure to changes in the fair value of assets and liabilities due to movements in interest rates. For a fair value hedge, changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability attributable to the hedged risk are recorded currently in income. The following table shows the location and amount of derivative gains and losses recognized in the consolidated statements of income related to fair value hedges for the three and nine months ended September 30, 2017 and 2016.

Table 63: Location and Amount of Fair Value Hedge Derivative Gains and Losses Recorded in Income



		Location of Derivative Gain/(Loss) Recognized in Income	Amount of Derivative Gain/(Loss) Recognized in Income
	Derivative Instrument		Three Months Ended September 30,					Nine Months Ended September 30,
(In Millions)	Derivative Instrument		2017		2016			2017			2016
Available for Sale Investment Securities	Interest Rate Swap Contracts	Interest Income	$	1.1	$	15.5		$	(24.5	)	$	(44.3	)
Senior Notes and Long-Term Subordinated Debt	Interest Rate Swap Contracts	Interest Expense	1.2		(7.3		)	14.3			63.7
Total			$	2.3	$	8.2		$	(10.2	)	$	19.4

Northern Trust applies the “shortcut” method of accounting, available under GAAP, to substantially all of its fair value hedges, which assumes there is no ineffectiveness in a hedge. For fair value hedges that do not qualify for the “shortcut” method of accounting, Northern Trust utilizes regression analysis, the “long-haul” method of accounting, in assessing whether the hedging relationships are highly effective at inception and quarterly thereafter. There was no ineffectiveness or changes in the fair value of hedged items recognized in income for fair value hedges accounted for under the “long-haul” method of accounting during the three- and nine- month periods ended September 30, 2017 and 2016.

Derivatives are also designated as cash flow hedges in order to minimize the variability in cash flows of earning assets or forecasted transactions caused by movements in interest or foreign exchange rates. There was no ineffectiveness recognized in income for cash flow hedges during the three and nine months ended September 30, 2017 and 2016. As of September 30, 2017, 23 months was the maximum length of time over which the exposure to variability in future cash flows of forecasted foreign-currency-denominated transactions was being hedged.

The following table provides cash flow hedge derivative gains and losses recognized in AOCI and the amounts reclassified to income during the three and nine months ended September 30, 2017 and 2016.

Table 64: Cash Flow Hedge Derivative Gains and Losses Recognized in AOCI and Reclassified to Income



(In Millions)	Foreign Exchange Contracts (Before Tax)					Interest Rate Contracts (Before Tax)
Three Months Ended September 30,	2017		2016			2017			2016
Net Gain/(Loss) Recognized in AOCI	$	3.1	$	(0.5	)	$	(0.2	)	$	(5.9	)
Net Gain/(Loss) Reclassified from AOCI to Net Income
Other Operating Income	1.7		(6.8		)	—			—
Interest Income	4.2		1.6			0.1			0.7
Other Operating Expense	0.1		(0.2		)	—			—
Total	$	6.0	$	(5.4	)	$	0.1		$	0.7



(In Millions)	Foreign Exchange Contracts (Before Tax)						Interest Rate Contracts (Before Tax)
Nine Months Ended September 30,	2017			2016			2017		2016
Net Gain/(Loss) Recognized in AOCI	$	19.4		$	1.7		$	1.2	$	1.9
Net Gain/(Loss) Reclassified from AOCI to Net Income
Other Operating Income	4.2			(8.5		)	—		—
Interest Income	12.1			1.6			0.2		2.5
Other Operating Expense	(0.1		)	(0.7		)	—		—
Total	$	16.2		$	(7.6	)	$	0.2	$	2.5

There were no material gains or losses reclassified into earnings during the three and nine months ended September 30, 2017 and 2016, as a result of the discontinuance of forecasted transactions that were no longer probable of occurring. It is estimated that a net gain of $2.8 million and a net gain of $0.2 million will be reclassified into net income within the next twelve months relating to cash flow hedges of foreign currency denominated transactions and cash flow hedges of foreign currency denominated investment securities, respectively. It is estimated that a net gain of $0.1 million will be reclassified into net income upon the receipt of interest payments on earning assets within the next twelve months relating to cash flow hedges of available for sale investment securities.

Certain foreign exchange contracts and qualifying nonderivative instruments are designated as net investment hedges to minimize Northern Trust’s exposure to variability in the foreign currency translation of net investments in non-U.S. branches and subsidiaries. There was no ineffectiveness recorded during the three and nine months ended September 30, 2017 and 2016. Amounts recorded in AOCI are reclassified to net income only upon the sale or liquidation of an investment in a non-U.S. branch or subsidiary.

The following table provides net investment hedge gains and losses recognized in AOCI during the three and nine months ended September 30, 2017 and 2016.

Table 65: Net Investment Hedge Gains and Losses Recognized in AOCI



	Hedging Gain / (Loss) Recognized in OCI (Before Tax)
	Three Months Ended September 30,					Nine Months Ended September 30,
(In Millions)	2017			2016		2017			2016
Foreign Exchange Contracts	$	(62.3	)	$	4.1	$	(194.7	)	$	87.6
Total	$	(62.3	)	$	4.1	$	(194.7	)	$	87.6

Derivatives that are not formally designated as a hedge under GAAP are entered into for risk management purposes. Foreign exchange contracts are entered into to manage the foreign currency risk of non-U.S.-dollar-denominated assets and liabilities, the net investment in certain non-U.S. affiliates, commercial loans and forecasted foreign-currency-denominated transactions. Swaps related to sales of certain Visa Class B common shares were entered into which retains the risks associated with the ultimate conversion of the Visa Class B common shares into Visa Class A common shares. Credit default swaps were entered into to manage credit risk associated with certain loans and loan commitments. Total return swaps are entered into to manage the equity price risk associated with certain investments. The following table identifies the types of risk management derivative instruments not formally designated as hedges and their notional amounts and fair values.

Table 66: Notional and Fair Values of Non-Designated Risk Management Derivative Instruments



	September 30, 2017						December 31, 2016
(In Millions)	Notional Value		Fair Value				Notional Value		Fair Value
(In Millions)	Notional Value		Asset		Liability		Notional Value		Asset		Liability
Foreign Exchange Contracts	$	996.4	$	8.7	$	2.9	$	289.6	$	0.8	$	1.8
Other Financial Derivatives ⁽¹⁾	364.3		—		27.7		270.0		—		25.2
Total	$	1,360.7	$	8.7	$	30.6	$	559.6	$	0.8	$	27.0


⁽¹⁾	This line includes swaps related to sales of certain Visa Class B common shares.

Changes in the fair value of derivative instruments not formally designated as hedges are recognized currently in income. The following table provides the location and amount of gains and losses recorded in the consolidated statements of income for the three and nine months ended September 30, 2017 and 2016.

Table 67: Location and Amount of Gains and Losses Recorded in Income for Non-Designated Risk Management Derivative Instruments



(In Millions)	Location of Derivative Gain / (Loss) Recognized in Income	Amount of Derivative Gain / (Loss) Recognized in Income
		Three Months Ended September 30,						Nine Months Ended September 30,
		2017			2016			2017			2016
Foreign Exchange Contracts	Other Operating Income	$	(5.9	)	$	(1.2	)	$	2.2		$	(0.2	)
Other Financial Derivatives ⁽¹⁾	Other Operating Income	(4.0		)	(2.3		)	(8.4		)	(8.6		)
Total		$	(9.9	)	$	(3.5	)	$	(6.2	)	$	(8.8	)


⁽¹⁾	This line includes swaps related to sales of certain Visa Class B common shares, total return swap contracts, and credit default swap contracts.