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 options and interest-rate contracts. 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 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 we manage by performing credit reviews, maintaining individual counterparty limits, entering into netting arrangements and requiring the receipt of collateral. 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, 2017 and 2016, we had recorded approximately $2.55 billion and $1.99 billion, respectively, of cash collateral received from counterparties and approximately $869 million and $4.39 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, 2017 and 2016 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, 2017 totaled approximately $1.13 billion, against which we provided no 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, assuming no change in fair value, as of December 31, 2017 was approximately $1.13 billion. 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.

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 NII. 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.

The entire change in the fair value of the derivatives utilized in our trading activities are recorded in trading services revenue, and the entire change in fair value of derivatives utilized in our asset-and-liability management activities are recorded in processing fees and other revenue.

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.

We grant 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. Interest rate swap agreements alter the interest-rate characteristics of specific balance sheet assets or liabilities. 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, cash flow or net investment hedges.

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.

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 the hedging derivative and the gains and losses on the hedged 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 income from certain AFS 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 4.6 years as of December 31, 2017, compared to 4.5 years as of December 31, 2016. 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 income 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 eight senior notes and one subordinated note from fixed rates to floating rates. The senior and subordinated notes are hedged with interest rate swap contracts with notional amounts, maturities and fixed-rate coupon terms that effectively hedge the fixed-rate 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. The table below summarizes the maturities and the paid fixed interest rates for the hedged senior and subordinated notes:



December 31, 2017	Maturity	Paid Fixed Interest Rate
Senior Notes
	2020	2.55%
	2021	4.38
	2021	1.95
	2022	2.65
	2023	3.70
	2024	3.30
	2025	3.55
	2026	2.65

Subordinated Notes
	2023	3.10

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 NII. 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 in processing fees and other 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 the derivative that are highly effective, and that are designated and qualify as a foreign currency hedge, are recorded in other comprehensive income.

We have entered into an interest rate swap agreement to hedge the forecasted cash flows associated with LIBOR-indexed floating-rate loans. The interest rate swaps synthetically convert the loan interest receipts from a variable-rate to a fixed-rate, thereby mitigating the risk attributable to changes in the LIBOR benchmark rate. As of December 31, 2017, the maximum maturity date of the underlying loans is approximately 4.9 years.

Net Investment Hedges

We have entered into foreign exchange contracts to protect the net investment in our foreign operations against adverse changes in exchange rates. These forward contracts convert the foreign currency risk to U.S. dollars, thereby mitigating our exposure to fluctuations in the fair value of our net investments in our foreign operations attributable to changes in foreign exchange rates. The changes in fair value of the foreign exchange forward contracts are recorded, net of taxes, in the foreign currency translation component of other comprehensive income. Effectiveness of net investment hedges is based on the overall changes in the fair value of the forward contracts and we measure the ineffectiveness of net investment hedge based on changes in forward foreign currency rates. There was no ineffectiveness for our net investment hedge during 2017.

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, 2017	December 31, 2016
Derivatives not designated as hedging instruments:
Interest-rate contracts:
Futures	2,392	13,455
Foreign exchange contracts:
Forward, swap and spot	1,679,976	1,414,765
Options purchased	350	337
Options written	302	202
Futures	50	—
Commodity and equity contracts:
Commodity⁽¹⁾	16	—
Equity⁽¹⁾	50	—
Other:
Stable value contracts	26,653	27,182
Deferred value awards⁽²⁾⁽³⁾	473	409
Derivatives designated as hedging instruments:
Interest-rate contracts:
Swap agreements	11,047	10,169
Foreign exchange contracts:
Forward and swap	28,913	8,564

⁽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."

⁽³⁾ Amount as of December 31, 2016 reflects $249 million related to the acceleration of expense associated with certain cash settled deferred incentive compensation awards.

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 tables present the aggregate notional amounts of these interest rate contracts and the related assets or liabilities being hedged as of the dates indicated:



	December 31, 2017
(In millions)	Fair Value Hedges		Cash Flow Hedges⁽¹⁾		Total
Investment securities available for sale	$	1,254	$	—	$	1,254
Long-term debt⁽²⁾	8,493		—		8,493
Floating rate loans	—		1,300		1,300
Total	$	9,747	$	1,300	$	11,047



	December 31, 2016
(In millions)	Fair Value Hedges		Cash Flow Hedges		Total
Investment securities available for sale	$	1,444	$	—	$	1,444
Long-term debt⁽²⁾	8,725		—		8,725
Floating rate loans	—		—		—
Total	$	10,169	$	—	$	10,169

⁽¹⁾In 2017, we entered into interest-rate contracts designated as cash flow hedges for floating rate loans.

⁽²⁾As of December 31, 2017 and December 31, 2016 , these fair value hedges decreased the carrying value of long-term debt presented in our consolidated statement of condition by $87 million and $15 million, respectively.

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 table presents 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,
	2017				2016
	Contractual Rates		Rate Including Impact of Hedges		Contractual Rates		Rate Including Impact of Hedges
Long-term debt	3.34	%	2.66	%	3.40	%	2.29	%

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 provided in Note 11 to the consolidated financial statements in this Form 10-K.



	Derivative Assets⁽¹⁾
	Fair Value
(In millions)	December 31, 2017		December 31, 2016
Derivatives not designated as hedging instruments:
Foreign exchange contracts	$	11,477	$	15,982
Other derivative contracts	1		—
Total	$	11,478	$	15,982

Derivatives designated as hedging instruments:
Foreign exchange contracts	$	120	$	502
Interest-rate contracts	8		68
Total	$	128	$	570

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



	Derivative Liabilities⁽¹⁾
	Fair Value
(In millions)	December 31, 2017		December 31, 2016
Derivatives not designated as hedging instruments:
Foreign exchange contracts	$	11,361	$	15,881
Other derivative contracts	284		380
Total	$	11,645	$	16,261

Derivatives designated as hedging instruments:
Foreign exchange contracts	$	107	$	75
Interest-rate contracts	100		348
Total	$	207	$	423

⁽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)		2017			2016			2015
Derivatives not designated as hedging instruments:
Foreign exchange contracts	Trading services revenue	$	632		$	662		$	686
Interest-rate contracts	Processing fees and other revenue	—			1			—
Foreign exchange contracts	Processing fees and other revenue	(23		)	—			—
Interest-rate contracts	Trading services revenue	8			(7		)	(2		)
Credit derivative contracts	Trading services revenue	—			(1		)	(1		)
Other derivative contracts	Trading services revenue	—			(2		)	8
Other derivative contracts	Compensation and employee benefits	(143		)	(448		)	(149		)
Total		$	474		$	205		$	542



	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)		2017			2016			2015					2017			2016			2015
Derivatives designated as fair value hedges:
Foreign exchange contracts	Processing fees and other revenue	$	18		$	(6	)	$	(101	)	Investment securities	Processing fees and other revenue	$	(18	)	$	6		$	101
Foreign exchange contracts	Processing fees and other revenue	626			221			(241		)	FX deposit	Processing fees and other revenue	(626		)	(221		)	241
Interest-rate contracts	Processing fees and other revenue	39			43			16			Available-for-sale securities	Processing fees and other revenue⁽¹⁾	(37		)	(40		)	(17		)
Interest-rate contracts	Processing fees and other revenue	(38		)	(98		)	61			Long-term debt	Processing fees and other revenue	39			100			(54		)
Total		$	645		$	160		$	(265	)			$	(642	)	$	(155	)	$	271

⁽¹⁾ In 2017, 2016 and 2015, $22 million, $23 million and $12 million, respectively, of net unrealized gains 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 NII, 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)	2017			2016			2015			2017		2016		2015				2017		2016		2015
Derivatives designated as cash flow hedges:
Interest-rate contracts	$	(14	)	$	—		$	—	Net interest income	$	—	$	—	$	(4	)	Net interest income	$	2	$	—	$	—
Foreign exchange contracts	(104		)	(39		)	55		Net interest income	—		—		—			Net interest income	24		24		10
Total	$	(118	)	$	(39	)	$	55		$	—	$	—	$	(4	)		$	26	$	24	$	10

Derivatives designated as net investment hedges:
Foreign exchange contracts	$	(160	)	$	109		$	—	Gains (Losses) related to investment securities, net	$	—	$	—	$	—		Gains (Losses) related to investment securities, net	$	—	$	—	$	—
Total	$	(160	)	$	109		$	—		$	—	$	—	$	—			$	—	$	—	$	—