Derivative Financial Instruments

A derivative financial instrument is a financial instrument or other contract which has one or more referenced indices and one or more notional amounts, either no initial net investment or a smaller initial net investment than would be expected for similar types of contracts, and which requires or permits net settlement.

We use derivative financial instruments to support our clients' needs and to manage our interest-rate and currency risk. In undertaking these activities, we assume positions in both the foreign exchange and interest-rate markets by buying and selling cash instruments and using derivative financial instruments, including foreign exchange forward contracts, foreign exchange and interest-rate options and interest-rate swaps, interest-rate forward contracts and interest-rate futures. Our derivative positions include derivative contracts held by a consolidated sponsored investment fund (refer to Note 14). We record derivatives in our consolidated statement of condition at their fair value on a recurring basis.

Interest-rate contracts involve an agreement with a counterparty to exchange cash flows based on the movement of an underlying interest-rate index. An interest-rate swap agreement involves the exchange of a series of interest payments, at either a fixed or variable rate, based on the notional amount without the exchange of the underlying principal amount. An interest-rate option contract provides the purchaser, for a premium, the right, but not the obligation, to receive an interest rate based upon a predetermined notional amount during a specified period. An interest-rate futures contract is a commitment to buy or sell, at a future date, a financial instrument at a contracted price; it may be settled in cash or through the delivery of the contracted instrument.

Foreign exchange contracts involve an agreement to exchange one currency for another currency at an agreed-upon rate and settlement date. Foreign exchange contracts generally consist of foreign exchange forward and spot contracts, option contracts and cross-currency swaps. Future cash requirements, if any, related to foreign exchange contracts are represented by the gross amount of currencies to be exchanged under each contract unless we and the counterparty have agreed to pay or to receive the net contractual settlement amount on the settlement date.

Derivative financial instruments involve the management of interest-rate and foreign currency risk, and involve, to varying degrees, market risk and credit and counterparty risk (risk related to repayment). Market risk is defined by U.S. banking regulators as the risk of loss that could result from broad market movements, such as changes in the general level of interest rates, credit spreads, foreign exchange rates or commodity prices. We use a variety of risk management tools and methodologies to measure, monitor and manage the market risk associated with our trading activities, which include our use of derivative financial instruments. One such risk-management measure is Value-at-Risk, or VaR. VaR is an estimate of potential loss for a given period within a stated statistical confidence interval. We use a risk-measurement system to measure VaR daily. We have adopted standards for measuring VaR, and we maintain regulatory capital for market risk in accordance with currently applicable regulatory market risk requirements.

Derivative financial instruments are also subject to credit and counterparty risk, which is defined as the risk of financial loss if a borrower or counterparty is either unable or unwilling to repay borrowings or settle a transaction in accordance with the underlying contractual terms. We manage credit and counterparty risk by performing credit reviews, maintaining individual counterparty limits, entering into netting arrangements and requiring the receipt of collateral. Collateral requirements are determined after a review of the creditworthiness of each counterparty, and these requirements are monitored and adjusted daily. Collateral is generally held in the form of cash or highly liquid U.S. government securities. We may be required to provide collateral to the counterparty in connection with our entry into derivative financial instruments. Cash collateral received from and provided to counterparties in connection with derivative financial instruments is recorded in accrued expenses and other liabilities and other assets, respectively, in our consolidated statement of condition. As of December 31, 2015 and 2014, we had recorded approximately $1.40 billion and $1.79 billion, respectively, of cash collateral received from counterparties and approximately $1.65 billion and $4.79 billion, respectively, of cash collateral provided to counterparties in connection with derivative financial instruments in our consolidated statement of condition.

Certain of our derivative assets and liabilities as of December 31, 2015 and 2014 are subject to master netting agreements with our derivative counterparties. Certain of these agreements contain credit risk-related contingent features in which the counterparty has the right to declare us in default and accelerate cash settlement of our net derivative liabilities with the counterparty in the event that our credit rating falls below specified levels. The aggregate fair value of all derivative instruments with credit risk-related contingent features that were in a net liability position as of December 31, 2015 and 2014 totaled approximately $1.05 billion and $2.54 billion, respectively, against which we provided $32 million and $105 million, respectively, of underlying collateral. If our credit rating were downgraded below levels specified in the agreements, the maximum additional amount of payments related to termination events that could have been required pursuant to these contingent features as of December 31, 2015 and 2014 was approximately $1.02 billion and $2.43 billion, respectively. Such accelerated settlement would be at fair value and therefore not affect our consolidated results of operations.

On the date a derivative contract is entered into, we designate the derivative as: (1) a hedge of the fair value of a recognized fixed-rate asset or liability or of an unrecognized firm commitment (a “fair-value” hedge); (2) a hedge of a forecast transaction or of the variability of cash flows to be received or paid related to a recognized variable-rate asset or liability (a “cash-flow” hedge); (3) a foreign currency fair value or cash flow hedge (a “foreign currency” hedge); (4) a hedge of a net investment in a non-U.S. operation; or (5) a derivative utilized in either our trading activities or in our asset-and-liability management activities that is not designated as a hedge of an asset or liability.

At both the inception of the hedge and on an ongoing basis, we formally assess and document the effectiveness of a derivative designated in a hedging relationship and the likelihood that the derivative will be an effective hedge in future periods. We discontinue hedge accounting prospectively when we determine that the derivative is no longer highly effective in offsetting changes in fair value or cash flows of the underlying risk being hedged, the derivative expires, terminates or is sold, or management discontinues the hedge designation.

Unrealized gains and losses on foreign exchange and interest-rate contracts are reported at fair value in our consolidated statement of condition as a component of other assets and accrued expenses and other liabilities, respectively, on a gross basis, except where such gains and losses arise from contracts covered by qualifying master netting agreements.

Derivatives Not Designated as Hedging Instruments:

In connection with our trading activities, we use derivative financial instruments in our role as a financial intermediary and as both a manager and servicer of financial assets, in order to accommodate our clients' investment and risk management needs. In addition, we use derivative financial instruments for risk management purposes as economic hedges, which are not formally designated as accounting hedges, in order to contribute to our overall corporate earnings and liquidity. These activities are designed to generate trading services revenue and to manage volatility in our net interest revenue. The level of market risk that we assume is a function of our overall objectives and liquidity needs, our clients' requirements and market volatility.

With respect to cross-border investing, our clients often enter into foreign exchange forward contracts to convert currency for international investments and to manage the currency risk in their international investment portfolios. As an active participant in the foreign exchange markets, we provide foreign exchange forward contracts and options in support of these client needs, and also act as a dealer in the currency markets. As part of our trading activities, we assume positions in both the foreign exchange and interest-rate markets by buying and selling cash instruments and using derivative financial instruments, including foreign exchange forward contracts, foreign exchange and interest-rate options and interest-rate swaps, interest-rate forward contracts, and interest-rate futures. In the aggregate, we seek to match positions closely with the objective of minimizing related currency and interest-rate risk. We also use foreign currency swap contracts to manage the foreign exchange risk associated with certain foreign currency-denominated liabilities. The foreign exchange swap contracts are entered into for periods generally consistent with foreign currency exposure of the underlying transactions.

We offer products that provide book-value protection primarily to plan participants in stable value funds managed by non-affiliated investment managers of post-retirement defined contribution benefit plans, particularly 401(k) plans. We account for the associated contingencies, more fully described in Note 12, individually as derivative financial instruments. These contracts are valued quarterly and unrealized losses, if any, are recorded in other expenses in our consolidated statement of income.

In 2014 and 2015, we granted deferred cash awards to certain of our employees as part of our employee incentive compensation plans. We account for these awards as derivative financial instruments, as the underlying referenced shares are not equity instruments of State Street. The fair value of these derivatives is referenced to the value of units in State Street-sponsored investment funds or funds sponsored by other unrelated entities. We re-measure these derivatives to fair value quarterly, and record the change in value in compensation and employee benefits expenses in our consolidated statement of income.

Derivatives Designated as Hedging Instruments:

In connection with our asset-and-liability management activities, we use derivative financial instruments to manage our interest-rate risk and foreign currency risk. Interest-rate risk, defined as the sensitivity of income or financial condition to variations in interest rates, is a significant non-trading market risk to which our assets and liabilities are exposed. We manage our interest-rate risk by identifying, quantifying and hedging our exposures, using fixed-rate portfolio securities and a variety of derivative financial instruments, most frequently interest-rate swaps and options (for example, interest-rate caps and floors). Interest-rate swap agreements alter the interest-rate characteristics of specific balance sheet assets or liabilities. When appropriate, forward-rate agreements, options on swaps, and exchange-traded futures and options are also used. We use foreign exchange forward and swap contracts to hedge foreign exchange exposure to various foreign currencies with respect to certain assets and liabilities. Our hedging relationships are formally designated, and qualify for hedge accounting, as fair value or cash flow hedges.

Fair Value Hedges

Derivatives designated as fair value hedges are utilized to mitigate the risk of changes in the fair values of recognized assets and liabilities. Differences between the gains and losses on fair value hedges and the gains and losses on the asset or liability attributable to the hedged risk represent hedge ineffectiveness. We use interest-rate or foreign exchange contracts in this manner to manage our exposure to changes in the fair value of hedged items caused by changes in interest rates or foreign exchange rates. Changes in the fair value of a derivative that is highly effective, and that is designated and qualifies as a fair-value hedge, are recorded in processing fees and other revenue, along with the changes in fair value of the hedged asset or liability attributable to the hedged risk.

We have entered into interest-rate swap agreements to modify our interest revenue from certain available-for-sale investment securities from a fixed rate to a floating rate. The hedged AFS investment securities included hedged trusts that had a weighted-average life of approximately 5.4 years as of December 31, 2015, compared to 5.9 years as of December 31, 2014. These trusts are hedged with interest-rate swap contracts of similar maturity, repricing frequency and fixed-rate coupons. The interest-rate swap contracts convert the interest revenue from a fixed rate to a floating rate indexed to LIBOR, thereby mitigating our exposure to fluctuations in the fair value of the securities attributable to changes in the benchmark interest rate.

We have entered into interest-rate swap agreements to modify our interest expense on seven senior notes and two subordinated notes from fixed rates to floating rates. The senior notes mature in 2017, 2018, 2020, 2021, 2023, 2024 and 2025 and pay fixed interest at annual rates of 5.38%, 1.35%, 2.55%, 4.38%, 3.70%, 3.30% and 3.55%, respectively. The subordinated notes mature in 2018 and 2023 and pay fixed interest at annual rates of 4.96% and 3.10%, respectively. The senior and subordinated notes are hedged with interest-rate swap contracts with notional amounts, maturities and fixed-rate coupon terms that align with the hedged notes. The interest-rate swap contracts convert the fixed-rate coupons to floating rates indexed to LIBOR, thereby mitigating our exposure to fluctuations in the fair values of the senior and subordinated notes stemming from changes in the benchmark interest rates.

We have entered into foreign exchange swap contracts to hedge the change in fair value attributable to foreign exchange movements in our foreign currency denominated investment securities and deposits. These forward contracts convert the foreign currency risk to U.S. dollars, thereby mitigating our exposure to fluctuations in the fair value of the securities and deposits attributable to changes in foreign exchange rates. Generally, no ineffectiveness is recorded in earnings, since the notional amount of the hedging instruments is aligned with the carrying value of the hedged securities and deposits. The forward points on the hedging instruments are considered to be a hedging cost, and accordingly are excluded from the evaluation of hedge effectiveness and recorded in net interest revenue.

Cash Flow Hedges

Derivatives categorized as cash flow hedges are utilized to offset the variability of cash flows to be received from or paid on a floating-rate asset or liability. Ineffectiveness of cash flow hedges is defined as the extent to which the changes in fair value of the derivative exceed the changes in the present value of the forecasted cash flows attributable to the forecasted transaction.

We have entered into foreign exchange contracts to hedge the change in cash flows attributable to foreign exchange movements in foreign currency denominated investment securities. These foreign exchange contracts convert the foreign currency risk to U.S. dollars, thereby mitigating our exposure to fluctuations in the cash flows of the securities attributable to changes in foreign exchange rates. Generally, no ineffectiveness is recorded in earnings, since the critical terms of the hedging instruments and the hedged securities are aligned.

Changes in the fair value of a derivative that are highly effective, and that are designated and qualify as a foreign currency hedge, are recorded either in processing fees and other revenue or in other comprehensive income, net of taxes, depending on whether the hedge transaction meets the criteria for a fair-value or a cash-flow hedge. If, however, a derivative is used as a hedge of a net investment in a non-U.S. operation, its changes in fair value, to the extent effective as a hedge, are recorded, net of taxes, in the foreign currency translation component of other comprehensive income. Lastly, entire changes in the fair value of derivatives utilized in our trading activities are recorded in trading services revenue, and entire changes in the fair value of derivatives utilized in our asset-and-liability management activities are recorded in processing fees and other revenue.

The following table presents the aggregate contractual, or notional, amounts of derivative financial instruments entered into in connection with our trading and asset-and-liability management activities as of the dates indicated:



(In millions)	December 31, 2015		December 31, 2014
Derivatives not designated as hedging instruments:
Interest-rate contracts:
Swap agreements and forwards	$	336	$	645
Options and caps purchased	—		7
Options and caps written	—		7
Futures	2,621		3,939
Foreign exchange contracts:
Forward, swap and spot	1,274,277		1,231,344
Options purchased	403		2,767
Options written	404		2,404
Credit derivative contracts:
Credit swap agreements	141		191
Commodity and equity contracts:
Commodity⁽¹⁾	113		26
Equity⁽¹⁾	87		2
Other:
Stable value contracts	24,583		23,409
Deferred value awards⁽²⁾	320		210
Derivatives designated as hedging instruments:
Interest-rate contracts:
Swap agreements	9,398		6,077
Foreign exchange contracts:
Forward and swap	4,515		2,705

⁽¹⁾Primarily composed of positions held by a consolidated sponsored investment fund, more fully described in Note 14.

⁽²⁾Represents grants of deferred value awards to employees; refer to discussion in this note under "Derivatives Not Designated as Hedging Instruments."

In connection with our asset-and-liability management activities, we have entered into interest-rate contracts designated as fair value and cash flow hedges to manage our interest-rate risk. The following table presents the aggregate notional amounts of these interest-rate contracts and the related assets or liabilities being hedged as of the dates indicated:



	December 31, 2015⁽¹⁾
(In millions)	Fair Value Hedges
Investment securities available for sale	$	1,698
Long-term debt⁽²⁾	7,700
Total	$	9,398



	December 31, 2014⁽¹⁾
(In millions)	Fair Value Hedges
Investment securities available for sale	$	2,577
Long-term debt⁽²⁾	3,500
Total	$	6,077

⁽¹⁾ As of December 31, 2015 and December 31, 2014 there were no interest-rate contracts designated as cash flow hedges.

⁽²⁾As of December 31, 2015, these fair value hedges increased the carrying value of long-term debt presented in our consolidated statement of condition by $105 million. As of December 31, 2014, these fair value hedges decreased the carrying value of long-term debt presented in our consolidated statement of condition by $76 million.

Notional amounts of derivative financial instruments are not recorded in the consolidated statement of condition. They are provided here as an indication of the volume of our derivative activity and do not represent a measure of our potential gains or losses. The notional amounts are not required to be exchanged for most of our derivative contracts and they generally serve as a reference to calculate the fair values of the derivatives.

The following tables present the contractual and weighted-average interest rates for long-term debt, which include the effects of the fair value hedges presented in the table above, for the periods indicated:



	Years Ended December 31,
	2015				2014
	Contractual Rates		Rate Including Impact of Hedges		Contractual Rates		Rate Including Impact of Hedges
Long-term debt	3.57	%	2.42	%	3.44	%	2.63	%

The following tables present the fair value of derivative financial instruments, excluding the impact of master netting agreements, recorded in our consolidated statement of condition as of the dates indicated. The impact of master netting agreements is disclosed in Note 2.



Derivative Assets⁽¹⁾
	Fair Value
(In millions)	December 31, 2015		December 31, 2014
Derivatives not designated as hedging instruments:
Foreign exchange contracts	$	10,799	$	14,626
Interest-rate contracts	2		15
Other derivative contracts	5		2
Total	$	10,806	$	14,643
Derivatives designated as hedging instruments:
Foreign exchange contracts	$	517	$	509
Interest-rate contracts	133		62
Total	$	650	$	571

⁽¹⁾ Derivative assets are included within other assets in our consolidated statement of condition.



Derivative Liabilities⁽¹⁾
	Fair Value
(In millions)	December 31, 2015		December 31, 2014
Derivatives not designated as hedging instruments:
Foreign exchange contracts	$	10,795	$	14,922
Other derivative contracts	103		70
Interest-rate contracts	2		16
Total	$	10,900	$	15,008
Derivatives designated as hedging instruments:
Interest-rate contracts	$	180	$	223
Foreign exchange contracts	73		3
Total	$	253	$	226

⁽¹⁾ Derivative liabilities are included within other liabilities in our consolidated statement of condition.

The following tables present the impact of our use of derivative financial instruments on our consolidated statement of income for the periods indicated:



	Location of Gain (Loss) on Derivative in Consolidated Statement of Income	Amount of Gain (Loss) on Derivative Recognized in Consolidated Statement of Income
			Years Ended December 31,
(In millions)			2015			2014			2013
Derivatives not designated as hedging instruments:
Foreign exchange contracts	Trading services revenue		$	686		$	612		$	586
Interest-rate contracts	Trading services revenue		(2		)	1			2
Credit derivative contracts	Trading services revenue		(1		)	1			—
Credit derivative contracts	Processing fees and other revenue		—			(1		)	1
Other derivative contracts	Trading services revenue		8			(2		)	—
Total			$	691		$	611		$	589



	Location of (Gain) Loss on Derivative in Consolidated Statement of Income	Amount of (Gain) Loss on Derivative Recognized in Consolidated Statement of Income
			Years Ended December 31,
(In millions)			2015		2014		2013
Derivatives not designated as hedging instruments:
Other derivative contracts	Compensation and employee benefits		$	149	$	106	14
Total			$	149	$	106	$	14



	Location of Gain (Loss) on Derivative in Consolidated Statement of Income	Amount of Gain (Loss) on Derivative Recognized in Consolidated Statement of Income									Hedged Item in Fair Value Hedging Relationship	Location of Gain (Loss) on Hedged Item in Consolidated Statement of Income	Amount of Gain (Loss) on Hedged Item Recognized in Consolidated Statement of Income
		Years Ended December 31,											Years Ended December 31,
(In millions)		2015			2014			2013					2015			2014			2013
Derivatives designated as fair value hedges:
Foreign exchange contracts	Processing fees and other revenue	$	(101	)	$	(92	)	(183		)	Investment securities	Processing fees and other revenue	$	101		$	92		$	183
Foreign exchange contracts	Processing fees and other revenue	(241		)	—			—			FX deposit	Processing fees and other revenue	241			—			—
Interest-rate contracts	Processing fees and other revenue	16			(44		)	32			Available-for-sale securities	Processing fees and other revenue⁽¹⁾	(17		)	39			(30		)
Interest-rate contracts	Processing fees and other revenue	61			150			(192		)	Long-term debt	Processing fees and other revenue	(54		)	(138		)	175
Total		$	(265	)	$	14		$	(343	)			$	271		$	(7	)	$	328

⁽¹⁾Represents amounts reclassified out of or into OCI. For the year ended December 31, 2015, $12 million of unrealized gains on AFS investment securities designated in fair value hedges were recognized in OCI. For the years ended December 31, 2014 and 2013, $24 million and $86 million, respectively, of unrealized losses and gains, respectively, on AFS investment securities designated in fair value hedges were recognized in OCI.

Differences between the gains (losses) on the derivative and the gains (losses) on the hedged item, excluding any amounts recorded in net interest revenue, represent hedge ineffectiveness.



	Amount of Gain (Loss) on Derivative Recognized in Other Comprehensive Income							Location of Gain (Loss) Reclassified from OCI to Consolidated Statement of Income	Amount of Gain (Loss) Reclassified from OCI to Consolidated Statement of Income									Location of Gain (Loss) on Derivative Recognized in Consolidated Statement of Income	Amount of Gain (Loss) on Derivative Recognized in Consolidated Statement of Income
	Years Ended December 31,								Years Ended December 31,										Years Ended December 31,
(In millions)	2015		2014			2013			2015			2014			2013				2015		2014		2013
Derivatives designated as cash flow hedges:
Interest-rate contracts	$	—	$	(2	)	$	9	Net interest revenue	$	(4	)	$	(4	)	$	(4	)	Net interest revenue	$	—	$	3	$	3
Foreign exchange contracts	55		126			153		Net interest revenue	—			—			—			Net interest revenue	10		6		6
Total	$	55	$	124		$	162		$	(4	)	$	(4	)	$	(4	)		$	10	$	9	$	9