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 is 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 credit spreads 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.

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 $1.4 billion and $1.7 billion as of December 31, 2017 and 2016, respectively, as a result of master netting arrangements and similar agreements in place. Derivative assets and liabilities recorded at December 31, 2017 also reflect reductions of $427.6 million and $189.0 million, respectively, as a result of cash collateral received from and deposited with derivative counterparties. 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 $67.0 million and $143.1 million, respectively, as of December 31, 2017, and $70.8 million and $324.5 million, respectively, as of December 31, 2016, was not offset against derivative assets and liabilities on the consolidated balance sheets as the amounts exceeded the net derivative positions with those counterparties. Northern Trust centrally clears certain 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 113: FAIR VALUE OF SECURITIES COLLATERAL FOR DERIVATIVE TRANSACTIONS



	DECEMBER 31,
(in Millions)	2017		2016
Pledged to others:
Not permitted by contract or custom to sell or repledge	$	39.9	$	70.7
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	4.6		—

Securities pledged or accepted as collateral are not offset against derivative assets or liabilities in the consolidated balance sheets. There was no repledged or sold collateral at December 31, 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 $223.7 million and $358.2 million at December 31, 2017 and 2016, respectively. Cash collateral amounts deposited with derivative counterparties on those dates included $35.8 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 December 31, 2017 and 2016 of $187.9 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 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 December 31, 2017 and 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, net of any collateral received, which is significantly less than the notional amount.

TABLE 114: NOTIONAL AND FAIR VALUES OF CLIENT-RELATED AND TRADING DERIVATIVE FINANCIAL INSTRUMENTS



	DECEMBER 31, 2017						DECEMBER 31, 2016
			FAIR VALUE						FAIR VALUE
(In Millions)	NOTIONAL VALUE		ASSET		LIABILITY		NOTIONAL VALUE		ASSET		LIABILITY
Foreign Exchange Contracts	$	317,882.5	$	2,527.0	$	2,522.5	$	273,213.1	$	3,274.2	$	3,221.7
Interest Rate Contracts	7,418.0		65.1		64.1		6,968.3		87.0		85.2

Total	$	325,300.5	$	2,592.1	$	2,586.6	$	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 years ended December 31, 2017, 2016, and 2015.

TABLE 115: LOCATION AND AMOUNT OF CLIENT-RELATED AND TRADING DERIVATIVE GAINS AND LOSSES RECORDED IN INCOME



(In Millions)	LOCATION OF DERIVATIVE GAIN RECOGNIZED IN INCOME	AMOUNT OF DERIVATIVE GAIN RECOGNIZED IN INCOME DECEMBER 31,
(In Millions)	LOCATION OF DERIVATIVE GAIN RECOGNIZED IN INCOME	2017		2016		2015
Foreign Exchange Contracts	Foreign Exchange Trading Income	$	209.9	$	236.6	$	261.8
Interest Rate Contracts	Security Commissions and Trading Income	10.7		11.4		17.5

Total		$	220.6	$	248.0	$	279.3

Risk Management Instruments. Northern Trust uses derivative instruments to hedge its exposure to foreign currency, interest rate, equity price, and credit risk.

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 116: NOTIONAL AND FAIR VALUES OF DESIGNATED RISK MANAGEMENT DERIVATIVE FINANCIAL INSTRUMENTS



			December 31, 2017						December 31, 2016
					FAIR 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	$	3,423.1	$	15.7	$	14.5	$	3,873.4	$	88.3	$	16.8
Senior Notes and Long-Term Subordinated Debt	Interest Rate Swap Contracts	Interest Rate	1,050.0		16.0		3.7		1,250.0		71.8		3.3
CASH FLOW HEDGES
Forecasted Foreign Currency Denominated Transactions	Foreign Exchange Contracts	Foreign Currency	436.2		13.5		6.4		329.3		8.5		7.8
Foreign Currency Denominated Investment Securities	Foreign Exchange Contracts	Foreign Currency	2,852.8		14.9		6.6		1,431.6		151.5		0.8
Available for Sale Investment Securities	Interest Rate Contracts	Interest Rate	$	925.0	$	0.2	$	1.2	$	975.0	$	0.1	$	2.7
NET INVESTMENT HEDGES
Net Investments in Non-U.S. Affiliates	Foreign Exchange Contracts	Foreign Currency	3,011.3		0.6		179.6		2,083.6		174.6		10.8

Total			$	11,698.4	$	60.9	$	212.0	$	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. 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 years ended December 31, 2017, 2016, and 2015.

TABLE 117: LOCATION AND AMOUNT OF FAIR VALUE HEDGE DERIVATIVE GAINS AND LOSSES RECORDED IN INCOME



	DERIVATIVE INSTRUMENT	LOCATION OF DERIVATIVE GAIN/(LOSS) RECOGNIZED IN INCOME	AMOUNT OF DERIVATIVE GAIN/ (LOSS) RECOGNIZED IN INCOME DECEMBER 31,
(In Millions)			2017			2016		2015
Available for Sale Investment Securities	Interest Rate Swap Contracts	Interest Income	$	(0.8	)	$	63.4	$	(21.1	)
Senior Notes and Long-Term Subordinated Debt	Interest Rate Swap Contracts	Interest Expense	3.4			5.0		34.7

Total			$	2.6		$	68.4	$	13.6

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 earnings for cash flow hedges during the years ended December 31, 2017, 2016, or 2015. As of December 31, 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 that were recognized in AOCI and the amounts reclassified to earnings during the years ended December 31, 2017, 2016 and 2015.

TABLE 118: CASH FLOW HEDGE DERIVATIVE GAINS AND LOSSES RECOGNIZED IN AOCI AND RECLASSIFIED TO INCOME



	FOREIGN EXCHANGE CONTRACTS (BEFORE TAX)									INTEREST RATE CONTRACTS (BEFORE TAX)
(In Millions)	2017			2016			2015			2017		2016			2015
Net Gain/(Loss) Recognized in AOCI	$	32.5		$	7.9		$	(1.2	)	$	1.3	$	(3.4	)	$	—

Net Gain/(Loss) Reclassified from AOCI to Earnings
Other Operating Income	5.0			(6.4		)	(8.0		)	—		—			—
Interest Income	19.3			6.4			—			0.3		2.8			5.2
Other Operating Expense	(0.1		)	(0.9		)	(1.9		)	—		—			—

Total	$	24.2		$	(0.9	)	$	(9.9	)	$	0.3	$	2.8		$	5.2

There were no material gains or losses reclassified during the years ended December 31, 2017, 2016, and 2015 as a result of the discontinuance of forecasted transactions that were no longer probable of occurring. It is estimated that a net gain of $6.2 million and $1.6 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 loss of $0.1 million will be reclassified into earnings 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. For net investment hedges, there was no ineffectiveness recorded for these hedges during the years ended December 31, 2017, 2016, and 2015. Net investment hedge losses recognized in AOCI related to foreign exchange contracts were $223.2 million for the year ended December 31, 2017. Net investment hedge gains recognized in AOCI related to foreign exchange contracts were $212.4 million for the year ended December 31, 2016.

Derivatives that are not formally designated as hedges 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 the sale of certain Visa Class B common shares were entered into which retain the risks associated with the ultimate conversion of the Visa Class B common shares into shares of Visa Class A common shares. Credit default swaps were entered into to manage the 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 119: NOTIONAL AND FAIR VALUES OF NON-DESIGNATED RISK MANAGEMENT DERIVATIVE INSTRUMENTS



	DECEMBER 31, 2017						DECEMBER 31, 2016
			FAIR VALUE						FAIR VALUE
(In Millions)	NOTIONAL VALUE		ASSET		LIABILITY		NOTIONAL VALUE		ASSET		LIABILITY
Foreign Exchange Contracts	$	214.1	$	1.1	$	0.1	$	289.6	$	0.8	$	1.8
Other Financial Derivatives ⁽¹⁾	404.7		—		30.4		270.0		—		25.2

Total	$	618.8	$	1.1	$	30.5	$	559.6	$	0.8	$	27.0

(1) This line consists of swaps related to the sale of certain Visa Class B common shares and total return swap contracts.

The following table provides the location and amount of gains and losses recorded in the consolidated statements of income for the years ended December 31, 2017, 2016, and 2015 for derivative instruments not formally designated as hedges under GAAP.

TABLE 120: LOCATION AND AMOUNT OF GAINS AND LOSSES RECORDED IN INCOME FOR NON-DESIGNATED RISK MANAGEMENT DERIVATIVE INSTRUMENTS



	LOCATION OF DERIVATIVE GAIN/ (LOSS) RECOGNIZED IN INCOME	AMOUNT RECOGNIZED IN INCOME
(In Millions)	LOCATION OF DERIVATIVE GAIN/ (LOSS) RECOGNIZED IN INCOME	2017			2016			2015
Foreign Exchange Contracts	Other Operating Income	$	8.2		$	(6.7	)	$	(10.9	)
Other Financial Derivatives ⁽¹⁾	Other Operating Income	(13.3		)	(6.1		)	(1.0		)

Total		$	(5.1	)	$	(12.8	)	$	(11.9	)

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