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, and swaps related to the sale of certain Visa Class B common shares.

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 primarily 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.

The following table shows the notional and fair values of all derivative financial instruments as of June 30, 2018 and December 31, 2017.

Table 63: Notional and Fair Values of Derivative Financial Instruments



	June 30, 2018						December 31, 2017
	Notional Value		Fair Value				Notional Value		Fair Value
(In Millions)	Notional Value		Asset ¹		Liability ²		Notional Value		Asset ¹		Liability ²
Derivatives Designated as Hedging under GAAP
Interest Rate Contracts
Fair Value Hedges	$	4,457.4	$	33.3	$	20.7	$	4,473.1	$	31.7	$	18.2
Cash Flow Hedges	925.0		0.2		2.2		925.0		0.2		1.2
Foreign Exchange Contracts
Cash Flow Hedges	3,196.8		60.2		7.5		3,289.0		28.4		13.0
Net Investment Hedges	2,914.2		191.3		0.9		3,011.3		0.6		179.5
Total Derivatives Designated as Hedging under GAAP	$	11,493.4	$	285.0	$	31.3	$	11,698.4	$	60.9	$	211.9

Derivatives Not Designated as Hedging under GAAP
Non-Designated Risk Management Derivatives
Foreign Exchange Contracts	$	139.5	$	0.4	$	0.9	$	214.1	$	1.1	$	0.1
Other Financial Derivatives ³	468.8		—		36.7		404.7		—		30.4
Total Non-Designated Risk Management Derivatives	$	608.3	$	0.4	$	37.6	$	618.8	$	1.1	$	30.5

Client-Related and Trading Derivatives
Foreign Exchange Contracts	$	295,355.2	$	3,056.9	$	3,053.8	$	317,882.5	$	2,527.0	$	2,522.5
Interest Rate Contracts	7,593.0		67.1		90.5		7,418.0		65.1		64.1
Total Client-Related and Trading Derivatives	$	302,948.2	$	3,124.0	$	3,144.3	$	325,300.5	$	2,592.1	$	2,586.6

Total Derivatives Not Designated as Hedging under GAAP	$	303,556.5	$	3,124.4	$	3,181.9	$	325,919.3	$	2,593.2	$	2,617.1

Total Gross Derivatives	$	315,049.9	$	3,409.4	$	3,213.2	$	337,617.7	$	2,654.1	$	2,829.0
Less: Netting ⁴			1,775.8		2,463.3				1,860.0		1,621.4
Total Derivative Financial Instruments			$	1,633.6	$	749.9			$	794.1	$	1,207.6

⁽¹⁾Derivative assets are reported in other assets on the consolidated balance sheets.

⁽²⁾Derivative liabilities are reported in other liabilities on the consolidated balance sheets.

⁽³⁾This line includes swaps related to sales of certain Visa Class B common shares and a total return swap contract.

⁽⁴⁾ See further detail in Note 22 - Offsetting of Assets and Liabilities.

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, which is significantly less than the notional amount.

All derivative financial instruments, whether designated as hedges or not, are recorded on the consolidated balance sheets at fair value within other assets or other liabilities. 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.

Hedging Derivative Instruments Designated under GAAP. Northern Trust uses derivative instruments to hedge its exposure to foreign currency, interest rate, equity price, and credit risk. Certain hedging relationships are formally designated and qualify for hedge accounting under GAAP as fair value, cash flow or net investment hedges. Other derivatives that are entered into for risk management purposes as economic hedges are not formally designated as hedges and changes in fair value are recognized currently in other operating income (see below section “Derivative Instruments Not Designated as Hedging under GAAP”).

In order to qualify for hedge accounting, a formal assessment is performed on a calendar-quarter basis to verify that derivatives used in designated hedging transactions continue to be highly effective in offsetting the changes in fair value or cash flows of the hedged item. If a derivative ceases to be highly effective, matures, is sold or is terminated, or if a hedged forecasted transaction is no longer probable of occurring, hedge accounting is terminated and the derivative is treated as if it were a trading instrument.

Fair Value Hedges. 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. Northern Trust enters into interest rate swaps to hedge changes in fair value of available for sale debt securities and long-term subordinated debt. Northern Trust applied the “shortcut” method of accounting, available under GAAP, which assumes there is perfect effectiveness in a hedge, for all of its fair value hedges during the three- and six-month periods ended June 30, 2018 and 2017. Changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability attributable to the hedged risk are recognized currently in earnings within the same income statement line item.

Cash Flow Hedges. 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. Northern Trust enters into foreign exchange contracts to hedge changes in cash flows due to movements in foreign exchange rates of forecasted foreign- currency-denominated transactions and foreign-currency-denominated debt securities. Northern Trust also enters into interest rate contracts to hedge changes in cash flows due to movements in interest rates of available for sale debt securities. The change in fair value of cash flow hedging derivative instruments are recorded in AOCI and reclassified to earnings when the hedged forecasted transaction impacts earnings within the same income statement line item.

There were no material gains or losses reclassified into earnings during the three and six months ended June 30, 2018 and 2017, as a result of the discontinuance of forecasted transactions that were no longer probable of occurring. It is estimated that net gains of $0.4 million and $0.6 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 debt securities, respectively. It is estimated that a net loss of $0.9 million will be reclassified into net income upon the receipt of interest payments on earning assets within the next twelve months relating to cash flow hedges of available for sale debt securities. As of June 30, 2018, 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. There was no ineffectiveness recognized in earnings for cash flow hedges during the three and six months ended June 30, 2017.

The following tables provide fair value and cash flow hedge derivative gains and losses recognized in income during the three and six months ended June 30, 2018 and 2017.

Table 64: Location and Amount of Fair Value and Cash Flow Hedge Derivative Gains and Losses Recorded in Income



	Location and Amount of Derivative Gain/(Loss) Recognized in Income
(In Millions)	Interest Income						Interest Expense						Other Operating Income				Other Operating Expense
Three Months Ended June 30,	2018			2017			2018			2017			2018		2017		2018		2017
Total amounts on the consolidated statements of income	$	567.7		$	417.2		$	154.4		$	75.7		$	31.4	$	43.0	$	75.3	$	82.3
Gains/(Losses) on fair value hedges recognized on
Interest Rate Contracts
Recognized on derivatives	10.4			(24.6		)	(15.2		)	(5.3		)	—		—		—		—
Recognized on hedged items	(10.4		)	24.6			15.2			5.3			—		—		—		—
Amounts related to interest settlements on derivatives	6.6			1.5			8.3			15.2			—		—		—		—
Total gain/(loss) recognized on fair value hedges	$	6.6		$	1.5		$	8.3		$	15.2		$	—	$	—	$	—	$	—

Gains/(Losses) on cash flow hedges recognized on
Foreign Exchange Contracts
Net gain/(loss) reclassified from AOCI to net income	16.0			3.5			—			—			1.1		1.8		—		—
Interest Rate Contracts
Net gain/(loss) reclassified from AOCI to net income	(0.1		)	0.1			—			—			—		—		—		—
Total gain/(loss) reclassified from AOCI to net income on cash flow hedges	$	15.9		$	3.6		$	—		$	—		$	1.1	$	1.8	$	—	$	—



	Location and Amount of Derivative Gain/(Loss) Recognized in Income
(In Millions)	Interest Income						Interest Expense						Other Operating Income				Other Operating Expense
Six Months Ended June 30,	2018			2017			2018			2017			2018		2017		2018		2017
Total amounts on the consolidated statements of income	$	1,073.6		$	827.5		$	276.3		$	132.5		$	66.2	$	82.7	$	144.3	$	147.4
Gains/(Losses) on fair value hedges recognized on
Interest Rate Contracts
Recognized on derivatives	64.7			(20.8		)	(37.1		)	(4.1		)	—		—		—		—
Recognized on hedged items	(64.7		)	20.8			37.1			4.1			—		—		—		—
Amounts related to interest settlements on derivatives	2.9			(4.8		)	9.7			17.2			—		—		—		—
Total gain/(loss) recognized on fair value hedges	$	2.9		$	(4.8	)	$	9.7		$	17.2		$	—	$	—	$	—	$	—

Gains/(Losses) on cash flow hedges recognized on
Foreign Exchange Contracts
Net gain/(loss) reclassified from AOCI to net income	30.2			7.9			—			—			3.5		2.5		—		(0.1		)
Interest Rate Contracts
Net gain/(loss) reclassified from AOCI to net income	(0.1		)	0.2			—			—			—		—		—		—
Total gain/(loss) reclassified from AOCI to net income on cash flow hedges	$	30.1		$	8.1		$	—		$	—		$	3.5	$	2.5	$	—	$	(0.1	)

The following table provides the impact of fair value hedge accounting on the carrying value of the designated hedged items as of June 30, 2018.

Table 65: Hedged Items in Fair Value Hedges



	June 30, 2018
(In Millions)	Carrying Value of the Hedged Items		Cumulative Hedge Accounting Basis Adjustment ⁽¹⁾
Available for Sale Debt Securities ⁽²⁾	$	4,038.6	$	149.8
Senior Notes and Long-Term Subordinated Debt	1,049.4		1.9

⁽¹⁾ There are no amounts related to discontinued hedging relationships.

⁽²⁾ Carrying value represents amortized cost.

Net Investment Hedges. Certain foreign exchange contracts 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 during the three and six months ended June 30, 2017. Net investment hedge gains of $157.7 million and losses of $102.0 million were recognized in AOCI related to foreign exchange contracts for the three months ended June 30, 2018 and 2017, respectively. Net investment hedge gains of $83.4 million and losses of $132.4 million were recognized in AOCI related to foreign exchange contracts for the six months ended June 30, 2018 and 2017, respectively.

Derivative Instruments Not Designated as Hedging under GAAP. Northern Trust’s derivative instruments that are not designated as hedging under GAAP include derivatives for purposes of client-related and trading activities, as well as other risk management purposes. 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.

Non-designated risk management derivatives include foreign exchange contracts 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 sales of certain Visa Class B common shares were entered into pursuant to which Northern Trust retains the risks associated with the ultimate conversion of the Visa Class B common shares into Visa Class A common shares. Total return swaps are entered into to manage the equity price risk associated with certain investments.

Changes in the fair value of derivative instruments not designated as hedges under GAAP are recognized currently in income. The following table provides the location and amount of gains and losses recorded in the consolidated statements of income for the three and six months ended June 30, 2018 and 2017.

Table 66: Location and Amount of Gains and Losses Recorded in Income for Derivatives Not Designated as Hedging Under GAAP



(In Millions)	Location of Derivative Gain / (Loss) Recognized in Income	Amount of Derivative Gain / (Loss) Recognized in Income
		Three Months Ended June 30,						Six Months Ended June 30,
		2018			2017			2018			2017
Non-designated risk management derivatives
Foreign Exchange Contracts	Other Operating Income	$	(5.4	)	$	6.4		$	(1.3	)	$	8.1
Other Financial Derivatives ⁽¹⁾	Other Operating Income	(7.8		)	(1.4		)	(11.8		)	(4.4		)
Gains/(Losses) from non-designated risk management derivatives		$	(13.2	)	$	5.0		$	(13.1	)	$	3.7

Client-related and trading derivatives
Foreign Exchange Contracts	Foreign Exchange Trading Income	78.9			49.9			157.4			98.0
Interest Rate Contracts	Security Commissions and Trading Income	2.9			4.4			4.6			5.6
Gains/(Losses) from client-related and trading derivatives		$	81.8		$	54.3		$	162.0		$	103.6

Total gains/(losses) from derivatives not designated as hedging under GAAP		$	68.6		$	59.3		$	148.9		$	107.3


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