Fair Value Option

9 Months Ended

Sep. 30, 2020

We report our results to HSBC in accordance with HSBC Group accounting and reporting policies ("Group Reporting Basis"), which apply International Financial Reporting Standards ("IFRSs") as issued by the International Accounting Standards Board ("IASB") and endorsed by the European Union ("EU"). We typically have elected to apply fair value option ("FVO") accounting to selected financial instruments to align the measurement attributes of those instruments under U.S. GAAP and the Group Reporting Basis and to simplify the accounting model applied to those financial instruments. We elected to apply FVO accounting to certain commercial loans held for sale, certain securities purchased and sold under resale and repurchase agreements, certain fixed-rate long-term debt issuances, all of our hybrid instruments, including structured notes and deposits, and, beginning January 1, 2020, certain student loans held for investment. Excluding the fair value movement on fair value option liabilities attributable to our own credit spread, which is recorded in other comprehensive income, changes in the fair value of fair value option assets and liabilities as well as the mark-to-market adjustment on the related derivatives and the net realized gains or losses on these derivatives are reported in gain (loss) on instruments designated at fair value and related derivatives in the consolidated statement of income (loss).

Loans and Loans Held For Sale We elected to apply FVO accounting to certain commercial syndicated loans which are originated with the intent to sell and certain commercial loans that we purchased from the secondary market and hold as hedges against our exposure to certain total return swaps and include these loans as loans held for sale in the consolidated balance sheet. Beginning January 1, 2020, we also elected to apply FVO accounting to certain student loans held for investment. These elections allow us to account for these loans at fair value which is consistent with the manner in which the instruments are managed. Where available, fair value is based on observable market pricing obtained from independent sources, relevant broker quotes or observed market prices of instruments with similar characteristics. Where observable market parameters are not available, fair value is determined based on contractual cash flows adjusted for estimates of prepayment rates, expected default rates and loss severity discounted at management's estimate of the expected rate of return required by market participants. We also consider loan-specific risk mitigating factors such as collateral arrangements in determining the fair value estimate. Interest from these loans is recorded as interest income in the consolidated statement of income (loss). Because a substantial majority of the loans elected for the fair value option are floating rate commercial loans, changes in their fair value are primarily attributable to changes in loan-specific credit risk factors. The components of gain (loss) related to loans designated at fair value are summarized in the table below. At September 30, 2020 and December 31, 2019, no loans for which the fair value option has been elected were 90 days or more past due or in nonaccrual status.

Resale and Repurchase Agreements We elected to apply FVO accounting to certain securities purchased and sold under resale and repurchase agreements which are trading in nature. The election allows us to account for these resale and repurchase agreements at fair value which is consistent with the manner in which the instruments are managed. The fair value of the resale and repurchase agreements is determined using market rates currently offered on comparable transactions with similar underlying collateral and maturities. Interest on these resale and repurchase agreements is recorded as interest income or expense in the consolidated statement of income (loss). The components of gain (loss) related to these resale and repurchase agreements designated at fair value are summarized in the table below.

Long-Term Debt (Own Debt Issuances) We elected to apply FVO accounting for certain fixed-rate long-term debt for which we had applied or otherwise would elect to apply fair value hedge accounting. The election allows us to achieve a similar accounting effect without having to meet the hedge accounting requirements. The own debt issuances elected under FVO are traded in secondary markets and, as such, the fair value is determined based on observed prices for the specific instruments. The observed market price of these instruments reflects the effect of changes to our own credit spreads and interest rates. Interest on the fixed-rate debt accounted for under FVO is recorded as interest expense in the consolidated statement of income (loss). Excluding the fair value movement attributable to our own credit spread, the components of gain (loss) in the consolidated statement of income (loss) related to long-term debt designated at fair value are summarized in the table below.

Hybrid Instruments We elected to apply FVO accounting to all of our hybrid instruments issued, including structured notes and deposits. The valuation of the hybrid instruments is predominantly driven by the derivative features embedded within the instruments and our own credit risk. Cash flows of the hybrid instruments in their entirety, including the embedded derivatives, are discounted at an appropriate rate for the applicable duration of the instrument adjusted for our own credit spreads. The credit spreads applied to structured notes are determined with reference to our own debt issuance rates observed in the primary and secondary markets, internal funding rates, and structured note rates in recent executions while the credit spreads applied to structured deposits are determined using market rates currently offered on comparable deposits with similar characteristics and maturities. Interest on this debt is recorded as interest expense in the consolidated statement of income (loss). Excluding the fair value movement attributable to our own credit spread, the components of gain (loss) in the consolidated statement of income (loss) related to hybrid instruments designated at fair value are summarized in the table below.

The following table summarizes the fair value and unpaid principal balance for items we account for under FVO:


	Fair Value		Unpaid Principal Balance		Fair Value Over (Under) Unpaid Principal Balance
	(in millions)
At September 30, 2020
Student loans held for investment	$	34	$	36	$	(2)
Commercial loans held for sale	41		48		(7)


Fixed rate long-term debt	995		741		254
Hybrid instruments:
Structured deposits	4,723		4,471		252
Structured notes	8,793		8,147		646
At December 31, 2019
Commercial loans held for sale	$	178	$	189	$	(11)

Securities sold under repurchase agreements	373		373		—
Fixed rate long-term debt	959		741		218
Hybrid instruments:
Structured deposits	7,209		7,491		(282)
Structured notes	9,388		8,187		1,201

Components of Gain (Loss) on Instruments Designated at Fair Value and Related Derivatives The following table summarizes the components of gain (loss) on instruments designated at fair value and related derivatives reflected in the consolidated statement of income (loss) for the three and nine months ended September 30, 2020 and 2019:


	Loans and Loans Held for Sale		Long-Term Debt		Hybrid Instruments		Total
	(in millions)
Three Months Ended September 30, 2020
Interest rate and other components⁽¹⁾	$	—	$	18	$	(292)	$	(274)
Credit risk component⁽²⁾	(4)		—		—		(4)
Total mark-to-market on financial instruments designated at fair value	(4)		18		(292)		(278)
Mark-to-market on related derivatives	—		(24)		307		283
Net realized gain on related long-term debt derivatives	—		10		—		10
Gain (loss) on instruments designated at fair value and related derivatives	$	(4)	$	4	$	15	$	15

Three Months Ended September 30, 2019
Interest rate and other components⁽¹⁾	$	—	$	(115)	$	(98)	$	(213)
Credit risk component⁽²⁾	(1)		—		—		(1)
Total mark-to-market on financial instruments designated at fair value	(1)		(115)		(98)		(214)
Mark-to-market on related derivatives	—		89		95		184
Net realized gain on related long-term debt derivatives	—		11		—		11
Gain (loss) on instruments designated at fair value and related derivatives	$	(1)	$	(15)	$	(3)	$	(19)

Nine Months Ended September 30, 2020
Interest rate and other components⁽¹⁾	$	—	$	(114)	$	198	$	84
Credit risk component⁽²⁾⁽³⁾	(53)		—		—		(53)
Total mark-to-market on financial instruments designated at fair value	(53)		(114)		198		31
Mark-to-market on related derivatives	37		126		(203)		(40)
Net realized gain on related long-term debt derivatives	—		24		—		24
Gain (loss) on instruments designated at fair value and related derivatives	$	(16)	$	36	$	(5)	$	15

Nine Months Ended September 30, 2019
Interest rate and other components⁽¹⁾	$	—	$	(284)	$	(1,532)	$	(1,816)
Credit risk component⁽²⁾	2		—		—		2
Total mark-to-market on financial instruments designated at fair value	2		(284)		(1,532)		(1,814)
Mark-to-market on related derivatives	—		225		1,514		1,739
Net realized gain on related long-term debt derivatives	—		30		—		30
Gain (loss) on instruments designated at fair value and related derivatives	$	2	$	(29)	$	(18)	$	(45)

⁽¹⁾As it relates to hybrid instruments, interest rate and other components primarily includes interest rate, foreign exchange and equity contract risks.

⁽²⁾The fair value movement on fair value option liabilities attributable to our own credit spread is recorded in other comprehensive income.

⁽³⁾During the nine months ended September 30, 2020, the loss in the credit risk component for loans and loans held for sale was attributable to the widening of credit spreads associated with certain commercial loans held for sale which were impacted by the COVID-19 pandemic.

- Definition

The entire disclosure for a company's election to apply the fair value option for measurement and reporting of eligible financial assets and liabilities (as defined), as well as certain other eligible items (as defined) included in the statement of financial position, whether such option is elected for a single eligible item or a group of similar eligible items and is in addition to other disclosures concerning fair value which the company may be required to provide. Such disclosure might be expected to include: (1) for items included in the statement of financial position: (a) the reasons for electing a fair value option for each eligible item or group of similar eligible items; (b) if the fair value option is elected for some but not all eligible items within a group of similar eligible items: (i) a description of those similar items and the reasons for partial election and (ii) information of how the group of similar items relates to individual balance sheet line items; (c) for each line item in the statement of financial position that includes an item or items for which the fair value option has been elected: (i) information of how each line item in the statement of financial position relates to major categories of assets and liabilities presented in accordance with other fair value disclosures and (ii) the aggregate carrying amount of ineligible items included in each line item in the balance sheet, if any; (d) the difference between the aggregate fair value and the aggregate unpaid principal balance (assuming contractual principal amounts and fair value option elected) of: (i) loans and long-term receivables (other than securities otherwise reported at fair value) and (ii) long-term debt instruments; (e) for loans held as assets for which the fair value option has been elected: (i) the aggregate fair value of loans that are 90 days or more past due, (ii) if the policy is to recognize interest income separately from other changes in fair value, the aggregate fair value of loans in nonaccrual status, and (iii) the difference between the aggregate fair value and the aggregate unpaid principal balance for loans that are 90 days or more past due, in nonaccrual status, or both; (f) for investments that would have been accounted for under the equity method if the entity had not chosen to apply the fair value option, the information required for such investments, if material either individually or in the aggregate; (2) for items included in the income statement: (a) the amounts of gains and losses from fair value changes included in earnings and in which line in the income statement those gains and losses are reported whether or not combined with gains and losses from items required to be accounted for at fair value; (b) a description of how interest and dividends are measured and where they are reported in the income statement; (c) for loans and other receivables held as assets: (i) the estimated amount of gains or losses included in earnings attributable to changes in instrument-specific credit risk and (ii) how the gains or losses attributable to changes in instrument-specific credit risk were determined; (d) for liabilities with fair values that have been significantly affected during the reporting period by changes in the instrument-specific credit risk: (i) the estimated amount of gains and losses from fair value changes included in earnings that are attributable to changes in the instrument-specific credit risk, (ii) qualitative information about the reasons for those changes, and (iii) how the gains and losses attributable to changes in instrument-specific credit risk were determined; and (3) certain other disclosures as required or determined to be provided.

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