Note 12. Derivative Financial Instruments

We use derivative financial instruments to support our clients' needs, conduct our trading activities, and manage our interest-rate and currency risk.

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.

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, either at 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.

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 as the risk of adverse financial impact due to fluctuations in interest rates, foreign exchange rates and other market-driven factors and prices. We use a variety of risk management tools and methodologies to measure, monitor and manage the market risk associated with our trading activities. 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 estimate VaR daily. We have adopted standards for estimating VaR, and we maintain regulatory capital for market risk in accordance with federal regulatory capital guidelines.

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 comprehensive review of the creditworthiness of each counterparty, and the 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. 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.

We enter into master netting agreements with many of our derivative counterparties. Certain of these agreements contain credit risk-related contingent features in which the counterparty has the option to declare State Street in default and accelerate cash settlement of our net derivative liabilities with the counterparty in the event 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 June 30, 2011 totaled approximately $742 million, against which we had posted aggregate collateral of approximately $366 million. If State Street's credit rating was 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 June 30, 2011 was approximately $376 million. Such accelerated settlement would not affect our consolidated results of operations.

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 revenue and to hedge 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.

Our clients use derivative financial instruments to manage the financial risks associated with their investment goals and business activities. With respect to cross-border investing, clients have a need for foreign exchange forward contracts to convert currency for international investment and to manage the currency risk in their 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. We also participate in the interest-rate markets, and provide interest-rate swaps, interest-rate forward contracts, interest-rate futures and other interest-rate contracts to our clients to enable them to mitigate or modify their interest-rate risk. As part of our trading activities, we may 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, positions are matched closely to minimize currency and interest-rate risk. Gains or losses in the fair values of trading derivatives are recorded in trading services revenue in our consolidated statement of income.

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 8, individually as "derivatives not designated as hedging instruments." These contracts are valued quarterly and unrealized losses, if any, are recorded in other 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 interest-rate 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. These hedging relationships are formally designated, and qualify for hedge accounting, as fair value or cash flow hedges. We manage 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 (e.g., 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.

Fair value hedges

Derivatives designated as fair value hedges are utilized to mitigate the risk of changes in fair value of recognized assets and liabilities. Gains and losses on fair value hedges are recorded in processing fees and other revenue in our consolidated statement of income along with the gain or loss on the asset or liability attributable to the hedged risk. 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, which is recorded in net interest revenue or in processing fees and other revenue. We use interest-rate contracts in this manner to manage our exposure to changes in the fair value of hedged items caused by changes in interest rates.

We have entered into interest rate contracts to hedge fair value changes for certain available-for-sale securities. Under one strategy, we have entered into interest-rate swap agreements to modify our interest revenue from certain available-for-sale securities from a fixed rate to a floating rate. The securities hedged have a weighted-average life of approximately 7.5 years as of June 30, 2011, compared to 7.7 years as of December 31, 2010. These securities are hedged with interest-rate swap contracts of similar maturity, repricing 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. Under a second strategy, we have entered into U.S. Treasury note futures contracts to hedge the risk of changes in fair value for certain fixed-rate available-for-sale U.S. Treasury securities. Those U.S. Treasury securities have terms ranging from two to five years, and are hedged with U.S. Treasury note futures contacts with similar terms.

We have entered into interest-rate swap agreements to modify our interest expense on two subordinated notes from fixed rates to floating rates. The subordinated notes mature in 2018; one pays fixed interest at a 4.956% annual rate and the other pays fixed interest at a 5.25% annual rate. The subordinated notes are hedged with interest-rate swap contracts with notional amounts, maturities and fixed-rate coupon terms that align with the hedged subordinated 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 subordinated notes stemming from changes in the benchmark interest rates.

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. Gains and losses on cash flow hedges that are considered highly effective are recorded in accumulated OCI in our consolidated statement of condition until earnings are affected by the hedged item. When gains or losses are reclassified from accumulated OCI into earnings, they are recorded in net interest revenue in our consolidated statement of income. The ineffectiveness of cash flow hedges, defined as the extent to which the changes in fair value of the derivative exceeded the variability of cash flows of the forecasted transaction, is recorded in processing fees and other revenue.

We have entered into interest-rate swap agreements to modify our interest revenue from certain available-for-sale securities from a floating rate to a fixed rate. The securities hedged have a weighted-average life of approximately 3.3 years as of June 30, 2011, compared to 3.8 years as of December 31, 2010. These securities are hedged with interest-rate swap contracts of similar maturities, repricing and other characteristics. The interest-rate swap contracts convert the interest revenue from a floating rate to a fixed rate, thereby mitigating our exposure to fluctuations in the cash flows of the securities attributable to changes in the benchmark interest rate.

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


(In millions)	June 30, 2011		December 31, 2010
Derivatives not designated as hedging instruments:
Interest-rate contracts:
Swap agreements and forwards	$	192,346	$	52,383
Options and caps purchased		1,156		140
Options and caps written		1,344		130
Futures		126,792		25,253
Foreign exchange contracts:
Forward, swap and spot		1,000,892		637,847
Options purchased		13,228		14,299
Options written		12,943		14,587
Credit derivative contracts:
Credit default swap agreements		155		155
Other:
Stable value contracts		43,150		46,758

Derivatives designated as hedging instruments:
Interest-rate contracts:
Swap agreements		2,265		1,886
Futures		2,383		—

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.


	June 30, 2011						December 31, 2010
(In millions)	Fair Value Hedges		Cash Flow Hedges		Total		Fair Value Hedges		Cash Flow Hedges		Total
Investment securities available for sale	$	3,820	$	128	$	3,948	$	1,561	$	125	$	1,686
Long-term debt⁽¹⁾		700		—		700		200		—		200

Total	$	4,520	$	128	$	4,648	$	1,761	$	125	$	1,886

⁽¹⁾	As of June 30, 2011 and December 31, 2010, fair value hedges of long-term debt increased the carrying value of long-term debt presented in our consolidated statement of condition by $90 million and $81 million, respectively.

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

Three Months Ended June 30,

2011

2010

Contractual
Rates

Rate Including
Impact of Hedges

Contractual
Rates

Rate Including
Impact of Hedges

Long-term debt

3.55

3.16

3.73

3.23

Six Months Ended June 30,

2011

2010

Contractual
Rates

Rate Including
Impact of Hedges

Contractual
Rates

Rate Including
Impact of Hedges

Long-term debt

3.55

3.18

3.74

3.26

For cash flow hedges, any changes in the fair value of the derivative financial instruments remain in accumulated OCI and are generally recorded in our consolidated statement of income in future periods when earnings are affected by the variability of the hedged cash flow.

The following table presents the fair value of the 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 11.

Asset Derivatives

Liability Derivatives

June 30, 2011

(In millions)

Balance Sheet
Location

Fair
Value

Balance Sheet
Location

Fair
Value

Derivatives not designated as hedging instruments:

Interest-rate contracts

Other assets

397

Other liabilities

471

Foreign exchange contracts

Other assets

8,278

Other liabilities

8,312

Credit derivative contracts

Other assets

—

Other liabilities

Equity derivative contracts

Other assets

Other liabilities

—

Total

8,676

8,784

Derivatives designated as hedging instruments:

Interest-rate contracts

Other assets

Other liabilities

230

Total

230


	Asset Derivatives				Liability Derivatives
	December 31, 2010				December 31, 2010
(In millions)	Balance Sheet Location		Fair Value		Balance Sheet Location		Fair Value
Derivatives not designated as hedging instruments:
Interest-rate contracts		Other assets	$	412		Other liabilities	$	423
Foreign exchange contracts		Other assets		7,779		Other liabilities		8,174
Credit derivative contracts		Other assets		1		Other liabilities		1
Equity derivative contracts		Other assets		1		Other liabilities		—

Total			$	8,193			$	8,598

Derivatives designated as hedging instruments:
Interest-rate contracts		Other assets	$	32		Other liabilities	$	228

Total			$	32			$	228

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
(In millions)		Three Months Ended June 30, 2011			Six Months Ended June 30, 2011
Derivatives not designated as hedging instruments:
Interest-rate contracts	Trading services revenue	$	(8	)	$	(18	)
Foreign exchange contracts	Trading services revenue		168			327
Foreign exchange contracts	Processing fees and other revenue		(4	)		1

Total		$	156		$	310


	Location of Gain (Loss) on Derivative in Consolidated Statement of Income	Amount of Gain (Loss) on Derivative Recognized in Consolidated Statement of Income
(In millions)		Three Months Ended June 30, 2010			Six Months Ended June 30, 2010
Derivatives not designated as hedging instruments:
Interest-rate contracts	Trading services revenue	$	(1	)	$	(2	)
Interest-rate contracts	Processing fees and other revenue		3			14
Foreign exchange contracts	Trading services revenue		188			331
Foreign exchange contracts	Processing fees and other revenue		(5	)		(7	)

Total		$	185		$	336


	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
(In millions)		Three Months Ended June 30, 2011			Six Months Ended June 30, 2011				Three Months Ended June 30, 2011			Six Months Ended June 30, 2011
Derivatives designated as fair value hedges:
Interest-rate contracts	Processing fees and other revenue	$	19		$	16	Long- term debt	Processing fees and other revenue	$	(17	)	$	(14	)
Interest-rate contracts	Processing fees and other revenue		(16	)		10	Available- for-sale securities	Processing fees and other revenue		11			(14	)

Total		$	3		$	26			$	(6	)	$	(28	)


	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
(In millions)		Three Months Ended June 30, 2010			Six Months Ended June 30, 2010					Three Months Ended June 30, 2010			Six Months Ended June 30, 2010
Derivatives designated as fair value hedges:
Interest-rate contracts	Processing fees and other revenue	$	38		$	40		Long- term debt	Processing fees and other revenue	$	(36	)	$	(35	)
Interest-rate contracts	Processing fees and other revenue		(81	)		(90	)	Available- for-sale securities	Processing fees and other revenue		81			90

Total		$	(43	)	$	(50	)			$	45		$	55

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
(In millions)	Three Months Ended June 30, 2011		Six Months Ended June 30, 2011			Three Months Ended June 30, 2011			Six Months Ended June 30, 2011				Three Months Ended June 30, 2011		Six Months Ended June 30, 2011
Derivatives designated as cash flow hedges:
Interest-rate contracts	$	4	$	4	Net interest revenue	$	(2	)	$	(4	)	Net interest revenue	$	1	$	2

Total	$	4	$	4		$	(2	)	$	(4	)		$	1	$	2


	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
(In millions)	Three Months Ended June 30, 2010		Six Months Ended June 30, 2010			Three Months Ended June 30, 2010			Six Months Ended June 30, 2010				Three Months Ended June 30, 2010		Six Months Ended June 30, 2010
Derivatives designated as cash flow hedges:
Interest-rate contracts	$	5	$	5	Net interest revenue	$	(2	)	$	(3	)	Net interest revenue		—	$	2

Total	$	5	$	5		$	(2	)	$	(3	)			—	$	2