Derivative Financial Instruments

Our business activities involve analysis, evaluation, acceptance and management of some degree of risk or combination of risks. Accordingly, we have comprehensive risk management policies to address potential financial risks, which include credit risk, liquidity risk, market risk, and operational risks. Our risk management policy is designed to identify and analyze these risks, to set appropriate limits and controls, and to monitor the risks and limits continually by means of reliable and up-to-date administrative and information systems. Our risk management policies are primarily carried out in accordance with practice and limits set by the HSBC Group Management Board. The HSBC North America Asset Liability Committee (“HSBC North America ALCO”) meets regularly to review risks and approve appropriate risk management strategies within the limits established by the HSBC Group Management Board. Additionally, our Risk Management Committee receives regular reports on our interest rate and liquidity risk positions in relation to the established limits. In accordance with the policies and strategies established by HSBC North America ALCO, in the normal course of business, we enter into various transactions involving derivative financial instruments. These derivative financial instruments primarily are used as economic hedges to manage risk.

Objectives for Holding Derivative Financial Instruments Market risk (which includes interest rate and foreign currency exchange risks) is the possibility that a change in underlying market rate inputs will cause a financial instrument to decrease in value or become more costly to settle. Prior to our ceasing originations in our Consumer Lending business and ceasing loan purchase activities in our Mortgage Services business, customer demand for our loan products shifted between fixed rate and floating rate products, based on market conditions and preferences. These shifts in loan products resulted in different funding strategies and produced different interest rate risk exposures. Additionally, the mix of receivables on our balance sheet and the corresponding market risk is changing as we manage the liquidation of all of our receivable portfolios. We maintain an overall risk management strategy that utilizes interest rate and currency derivative financial instruments to mitigate our exposure to fluctuations caused by changes in interest rates and currency exchange rates related to our debt liabilities. We manage our exposure to interest rate risk primarily through the use of interest rate swaps with the main objective of managing the interest rate volatility due to a mismatch in the duration of our assets and liabilities. We manage our exposure to foreign currency exchange risk primarily through the use of cross currency interest rate swaps.

Interest rate swaps are contractual agreements between two counterparties for the exchange of periodic interest payments generally based on a notional principal amount and agreed-upon fixed or floating rates. The majority of our interest rate swaps are used to manage our exposure to changes in interest rates by converting floating rate debt to fixed rate or by converting fixed rate debt to floating rate. We have also entered into currency swaps to convert both principal and interest payments on debt issued in one currency to the appropriate functional currency.

To manage our exposure to changes in interest rates, we entered into interest rate swap agreements and currency swaps which have been designated as cash flow hedges under derivative accounting principles, or are treated as non-qualifying hedges. We currently utilize the long-haul method to assess effectiveness of all derivatives designated as hedges.

We do not manage credit risk or the changes in fair value due to the changes in credit risk by entering into derivative financial instruments such as credit derivatives or credit default swaps.

Control Over Valuation Process and Procedures A control framework has been established which is designed to ensure that fair values are validated by a function independent of the risk-taker. To that end, the ultimate responsibility for the measurement of fair values rests with the HSBC U.S. Valuation Committee. The HSBC U.S. Valuation Committee establishes policies and procedures to ensure appropriate valuations. Fair values for derivatives are measured by management using valuation techniques, valuation models and inputs that are developed, reviewed, validated and approved by the Markets Independent Model Review Team of an HSBC affiliate. These valuation models utilize discounted cash flows or an option pricing model adjusted for counterparty credit risk and market liquidity. The models used apply appropriate control processes and procedures to ensure that the derived inputs are used to value only those instruments that share similar risk to the relevant benchmark indices and therefore demonstrate a similar response to market factors.

Credit Risk of Derivatives By utilizing derivative financial instruments, we are exposed to counterparty credit risk. Counterparty credit risk is the risk that the counterparty to a transaction fails to perform according to the terms of the contract. We manage the counterparty credit (or repayment) risk in derivative instruments through established credit approvals, risk control limits, collateral, and ongoing monitoring procedures. We utilize an affiliate, HSBC Bank USA, National Association ("HSBC Bank USA") as the primary provider of derivatives. We have never suffered a loss due to counterparty failure.

At both June 30, 2015 and December 31, 2014, all of our existing derivative contracts are with HSBC Bank USA, making them our sole counterparty in derivative transactions. Derivative agreements require that payments be made to, or received from, the counterparty when the fair value of the agreement reaches a certain level. When the fair value of our agreements with the affiliate counterparty requires the posting of collateral, it is provided in either the form of cash and recorded on the balance sheet, consistent with third party arrangements, or in the form of securities which are not recorded on our balance sheet. The fair value of our agreements with the affiliate counterparty required us to provide collateral to the affiliate of $543 million at June 30, 2015 and $213 million at December 31, 2014, all of which was provided in cash. These amounts are offset against the fair value amount recognized for derivative instruments that have been offset under the same master netting arrangement and recorded in our balance sheet as derivative financial assets or derivative related liabilities which are included as a component of other assets and other liabilities, respectively. At June 30, 2015 and December 31, 2014, we had derivative contracts with a notional amount of $12.2 billion and $14.0 billion, respectively, all of which is outstanding with HSBC Bank USA. Derivative financial instruments are generally expressed in terms of notional principal or contract amounts which are much larger than the amounts potentially at risk for nonpayment by counterparties.

The following table presents the fair value of derivative contracts by major product type on a gross basis. Gross fair values exclude the effects of both counterparty netting and collateral, and therefore are not representative of our exposure. The table below presents the amounts of counterparty netting and cash collateral that have been offset in the consolidated balance sheet.



	June 30, 2015					December 31, 2014
	Derivative Financial Assets		Derivative Financial Liabilities			Derivative Financial Assets		Derivative Financial Liabilities
	(in millions)
Derivatives⁽¹⁾
Derivatives accounted for as cash flow hedges associated with debt:
Interest rate swaps	$	2	$	(45	)	$	7	$	(74	)
Currency swaps	136		(208		)	97		(133		)
Cash flow hedges	138		(253		)	104		(207		)

Non-qualifying hedge activities:
Derivatives not designated as hedging instruments:
Interest rate swaps	20		(340		)	20		(379		)
Derivatives not designated as hedging instruments	20		(340		)	20		(379		)

Derivatives associated with debt carried at fair value:
Interest rate swaps	46		—			117		—
Currency swaps	11		(228		)	50		—
Derivatives associated with debt carried at fair value	57		(228		)	167		—
Total derivatives	215		(821		)	291		(586		)
Less: Gross amounts offset in the balance sheet⁽²⁾	215		(758		)	291		(504		)
Net amounts of derivative financial assets and liabilities presented in the balance sheet⁽³⁾	$	—	$	(63	)	$	—	$	(82	)


⁽¹⁾	All of our derivatives are bilateral over-the-counter ("OTC") derivatives.


⁽²⁾	Represents the netting of derivative receivable and payable balances for the same counterparty under an enforceable netting agreement. Gross amounts offset in the balance sheet includes cash collateral paid of $543 million at June 30, 2015 and $213 million at December 31, 2014. At June 30, 2015 and December 31, 2014, we did not have any financial instrument collateral received/posted.


⁽³⁾	At June 30, 2015 and December 31, 2014, we had not received any cash or financial instruments not subject to an enforceable master netting agreement.

Fair Value Hedges At June 30, 2015 and December 31, 2014 we do not have any active fair value hedges. We recorded fair value adjustments to the carrying value of our debt for terminated fair value hedges which decreased the debt balance by $14 million at June 30, 2015 and $8 million at December 31, 2014.

Cash Flow Hedges Cash flow hedges include interest rate swaps to convert our variable rate debt to fixed rate debt by fixing future interest rate resets of floating rate debt as well as currency swaps to convert debt issued from one currency into U.S. dollar fixed rate debt. Gains and losses on derivative instruments designated as cash flow hedges are reported in other comprehensive income (loss) net of tax and totaled losses of $32 million and $52 million at June 30, 2015 and December 31, 2014, respectively. We expect $37 million ($23 million after-tax) of currently unrealized net losses will be reclassified to earnings within one year. However, these reclassified unrealized losses will be offset by decreased interest expense associated with the variable cash flows of the hedged items and will result in no significant impact to our earnings.

The following table provides the gain or loss recorded on our cash flow hedging relationships.



	Gain (Loss) Recognized in AOCI on Derivative (Effective Portion)				Location of Gain (Loss) Reclassified from AOCI into Income (Effective Portion)	Gain (Loss) Reclassed From AOCI into Income (Effective Portion)						Location of Gain (Loss) Recognized in Income on the Derivative(Ineffective Portion)	Gain (Loss) Recognized In Income on Derivative (Ineffective Portion)
	2015		2014			2015			2014				2015		2014
	(in millions)
Three Months Ended June 30,
Interest rate swaps	$	11	$	8	Interest expense	$	—		$	1		Derivative related income (expense)	$	—	$	—
Currency swaps	1		3		Interest expense	(3		)	(4		)	Derivative related income (expense)	9		3
Total	$	12	$	11		$	(3	)	$	(3	)		$	9	$	3

Six Months Ended June 30,
Interest rate swaps	$	20	$	21	Interest expense	$	—		$	1		Derivative related income (expense)	$	—	$	—
Currency swaps	6		7		Interest expense	(6		)	(7		)	Derivative related income (expense)	7		8
Total	$	26	$	28		$	(6	)	$	(6	)		$	7	$	8

Non-Qualifying Hedging Activities We have entered into interest rate swaps which are not designated as hedges under derivative accounting principles. These financial instruments are economic hedges but do not qualify for hedge accounting and are primarily used to minimize our exposure to changes in interest rates through more closely matching both the structure and duration of our liabilities to the structure and duration of our assets.

The following table provides detail of the realized and unrealized gain or loss recorded on our non-qualifying hedges:



	Location of Gain (Loss) Recognized in Income on Derivative	Amount of Gain (Loss) Recognized in Derivative Related Income (Expense)
		Three Months Ended June 30,					Six Months Ended June 30,
		2015		2014			2015			2014
		(in millions)
Interest rate contracts	Derivative related income (expense)	$	81	$	(93	)	$	(14	)	$	(188	)
Total		$	81	$	(93	)	$	(14	)	$	(188	)

We have elected the fair value option for certain issuances of our fixed rate debt and have entered into interest rate and currency swaps related to debt carried at fair value. The interest rate and currency swaps associated with this debt are non-qualifying hedges but are considered economic hedges and realized gains and losses are reported as “Gain on debt designated at fair value and related derivatives” within other revenues. The derivatives related to fair value option debt are included in the tables below.

The following table provides the gain or loss recorded on the derivatives related to fair value option debt. See Note 6, “Fair Value Option,” for further discussion.



	Location of Gain (Loss) Recognized in Income on Derivative	Amount of Gain (Loss) Recognized in Derivative Related Income (Expense)
		Three Months Ended June 30,				Six Months Ended June 30,
		2015		2014		2015			2014
		(in millions)
Interest rate contracts	Gain on debt designated at fair value and related derivatives	$	1	$	5	$	3		$	8
Currency contracts	Gain (loss) on debt designated at fair value and related derivatives	1		18		(17		)	26
Total		$	2	$	23	$	(14	)	$	34

Notional Amount of Derivative Contracts The following table provides the notional amounts of derivative contracts.



	June 30, 2015		December 31, 2014
	(in millions)
Derivatives designated as hedging instruments:
Interest rate swaps	$	1,959	$	1,959
Currency swaps	2,248		2,248
	4,207		4,207
Non-qualifying hedges:
Derivatives not designated as hedging instruments:
Interest rate swaps	3,199		3,199
	3,199		3,199
Derivatives associated with debt carried at fair value:
Interest rate swaps	1,859		3,682
Currency swaps	2,892		2,892
	4,751		6,574
Total	$	12,157	$	13,980