11. Derivative Financial Instruments

In the normal course of business, we enter into derivative contracts for trading, market making and risk management purposes. For financial reporting purposes, a derivative instrument is designated in one of the following categories: (a) financial instruments held for trading, (b) hedging instruments designated as a qualifying hedge under derivative accounting principles or (c) a non-qualifying economic hedge. The derivative instruments held are predominantly swaps, futures, options and forward contracts. All freestanding derivatives, including bifurcated embedded derivatives, are stated at fair value. Where we enter into enforceable master netting arrangements with counterparties, the master netting arrangements permit us to net those derivative asset and liability positions and to offset cash collateral held and posted with the same counterparty.

Derivatives Held for Risk Management Purposes Our risk management policy requires us to identify, analyze and manage risks arising from the activities conducted during the normal course of business. We use derivative instruments as an asset and liability management tool to manage our exposures to interest rate, foreign currency and credit risks in existing assets and liabilities, commitments and forecasted transactions. The accounting for changes in fair value of a derivative instrument will depend on whether the derivative has been designated and qualifies for hedge accounting under derivative accounting principles.

Accounting principles for qualifying hedges require detailed documentation that describes the relationship between the hedging instrument and the hedged item, including, but not limited to, the risk management objectives and hedging strategy and the methods to assess the effectiveness of the hedging relationship. We designate derivative instruments to offset the fair value risk and cash flow risk arising from fixed-rate and floating-rate assets and liabilities as well as forecasted transactions. We assess the hedging relationships, both at the inception of the hedge and on an ongoing basis, using a regression approach to determine whether the designated hedging instrument is highly effective in offsetting changes in the fair value or cash flows of the hedged item. We discontinue hedge accounting when we determine that a derivative is not expected to be highly effective going forward or has ceased to be highly effective as a hedge, the hedging instrument is terminated, or when the designation is removed by us.

In the tables that follow below, the fair value disclosed does not include swap collateral that we either receive or deposit with our interest rate swap counterparties. Such swap collateral is recorded on our balance sheet at an amount which approximates fair value.

Fair Value Hedges In the normal course of business, we hold fixed-rate loans and securities and issue fixed-rate senior and subordinated debt obligations. The fair value of fixed-rate (USD and non-USD denominated) assets and liabilities fluctuates in response to changes in interest rates or foreign currency exchange rates. We utilize interest rate swaps, interest rate forward and futures contracts and foreign currency swaps to minimize the effect on earnings caused by interest rate and foreign currency volatility.

The changes in fair value of a derivative designated in a qualifying fair value hedge, along with the effective portion of the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings. We recognized a net gain of $17 million and a loss of $3 million during the three and nine months ended September 30, 2012, respectively, compared to net losses of $45 million and $46 million during the three and nine months ended September 30, 2011, respectively, which are reported in other income in the consolidated statement of income (loss) which represents the ineffective portion of all fair value hedges. The interest accrual related to the derivative contract is recognized in interest income.

The changes in fair value of the hedged item designated in a qualifying hedge are captured as an adjustment to the carrying amount of the hedged item (basis adjustment). If the hedging relationship is terminated and the hedged item continues to exist, the basis adjustment is amortized over the remaining life of the hedged item. We recorded basis adjustments for active fair value hedges which decreased the carrying amount of our debt by $3 million and $9 million during the three and nine months ended September 30, 2012, respectively, compared to $1 million and $6 million during the three and nine months ended September 30, 2011, respectively. We amortized $3 million and $9 million of basis adjustments related to terminated and/or re-designated fair value hedge relationships during the three and nine months ended September 30, 2012, respectively, compared to $3 million and $8 million during the three and nine months ended September 30, 2011, respectively. The total accumulated unamortized basis adjustment amounted to an increase in the carrying amount of our debt of $53 million as of both September 30, 2012 and December 31, 2011. Basis adjustments for active fair value hedges of available-for-sale securities increased the carrying amount of the securities by $44 million and $231 million during the three and nine months ended September 30, 2012, respectively, compared to an increase in carrying amount of $1.2 billion and $1.3 billion during the three and nine months ended September 30, 2011, respectively. Total accumulated unamortized basis adjustments for active fair value hedges of available-for-sale securities amounted to an increase in carrying amount of $937 million and $1.1 billion as of September 30, 2012 and December 31, 2011, respectively.

The following table presents the fair value of derivative instruments that are designated and qualifying as fair value hedges and their location on the balance sheet.

Derivative Assets⁽¹⁾

Derivative Liabilities⁽¹⁾

Balance Sheet

Location

Fair Value as of

Balance Sheet

Location

Fair Value as of

September 30,

2012

December 31,

2011

September 30,

2012

December 31,

2011

(in millions)

Interest rate contracts

Other assets

Interest, taxes and
other liabilities

933

1,134

⁽¹⁾	The derivative asset and derivative liabilities presented above may be eligible for netting. Balance sheet categories in the above table represent the location of the assets and liabilities absent the netting of the balances.

The following table presents information on gains and losses on derivative instruments designated and qualifying as hedging instruments in fair value hedges and the hedged items in fair value hedges and their location on the consolidated statement of income (loss).


	Gain (Loss) on Derivative						Gain (Loss) on Hedged Items						Gain (Loss) on Derivative						Gain (Loss) on Hedged Items
	Interest Income (Expense)			Other Income			Interest Income (Expense)			Other Income			Interest Income (Expense)			Other Income			Interest Income (Expense)			Other Income
	2012												2011
	(in millions)
Three Months Ended September 30,
Interest rate contracts/AFS securities	$	(33	)	$	(41	)	$	141		$	58		$	4		$	(1,322	)	$	187		$	1,278
Interest rate contracts/commercial loans		-			-			-			-			(6	)		1			-			(1	)
Interest rate contracts/subordinated debt		3			3			(15	)		(3	)		14			10			(32	)		(11	)

Total	$	(30	)	$	(38	)	$	126		$	55		$	12		$	(1,311	)	$	155		$	1,266

Nine Months Ended September 30,
Interest rate contracts/AFS securities	$	(117	)	$	(326	)	$	482		$	323		$	(18	)	$	(1,640	)	$	506		$	1,598
Interest rate contracts/commercial loans		-			-			-			-			(17	)		1			-			(3	)
Interest rate contracts/subordinated debt		10			9			(46	)		(9	)		38			4			(70	)		(6	)

Total	$	(107	)	$	(317	)	$	436		$	314		$	3		$	(1,635	)	$	436		$	1,589

Cash Flow Hedges We own or issue floating rate financial instruments and enter into forecasted transactions that give rise to cash flow risk exposure. As a part of our risk management strategy, we use interest rate swaps, currency swaps and futures contracts to mitigate risk associated with variability in the cash flows. We also hedge the variability in interest cash flows arising from on-line savings deposits and certain commercial loans.

Changes in fair value associated with the effective portion of a derivative instrument designated as a qualifying cash flow hedge are recognized initially in other comprehensive income (loss). When the hedged cash flows affect earnings, the associated gain or loss from the hedging derivative previously recognized in accumulated other comprehensive income (loss) is reclassified to earnings. If a cash flow hedge of a forecasted transaction is de-designated because it is no longer highly effective, or if the hedge relationship is terminated, the cumulative gain or loss on the hedging derivative to that date will continue to be reported in accumulated other comprehensive income (loss) unless it is probable that the hedged forecasted transaction will not occur by the end of the of the specified periods forecasted at inception, at which time the cumulative gain or loss is released into earnings. As of September 30, 2012 and December 31, 2011, active cash flow hedge relationships extend or mature through July 2036. During the three and nine months ended September 30, 2012, $4 million and $12 million, respectively, of losses related to terminated and/or re-designated cash flow hedge relationships were reclassified to earnings from accumulated other comprehensive income (loss). During the next twelve months, we expect to reclassify $14 million of remaining losses in accumulated other comprehensive income to earnings resulting from these terminated and/or re-designated cash flow hedges. During the three and nine months ended September 30, 2011, $4 million and $9 million, respectively, of losses related to terminated and/or re-designated cash flow hedge relationships were amortized to earnings from accumulated other comprehensive income (loss). The interest accrual related to the derivative contract is recognized in interest income.

The following table presents the fair value of derivative instruments that are designated and qualifying as cash flow hedges and their location on the consolidated balance sheet.

Derivative Assets⁽¹⁾

Derivative Liabilities⁽¹⁾

Balance Sheet
Location

Fair Value as of

Balance Sheet
Location

Fair Value as of

September 30,

2012

December 31,

2011

September 30,

2012

December 31,

2011

(in millions)

Interest rate contracts

Other assets

Interest, taxes &
other liabilities

274

248

⁽¹⁾	The derivative assets and derivative liabilities presented above may be eligible for netting. Balance sheet categories in the above table represent the location of the assets and liabilities absent the netting of the balances.

The following table presents information on gains and losses on derivative instruments designated and qualifying as hedging instruments in cash flow hedges (including amounts recognized in AOCI from all terminated cash flow hedges) and their locations in the consolidated statement of income (loss).


	Gain (Loss) Recognized in AOCI on Derivative (Effective Portion)					Location of Gain (Loss) Reclassified from AOCI into Income (Effective Portion)		Loss Reclassified From AOCI into Income (Effective Portion)						Location of Loss Recognized in Income on the Derivative (Ineffective Portion and Amount Excluded from Effectiveness Testing)		Loss Recognized in Income on the Derivative (Ineffective Portion and Amount Excluded from Effectiveness Testing)
	2012		2011					2012			2011					2012		2011
	(in millions)
Three Months Ended September 30,
Interest rate contracts	$	14	$	(205	)		Other income	$	(4	)	$	(4	)		Other income	$	-	$	(6	)
Nine Months Ended September 30,
Interest rate contracts	$	4	$	(219	)		Other income	$	(12	)	$	(9	)		Other income	$	-	$	(7	)

Trading and Other Derivatives In addition to risk management, we enter into derivative instruments for trading and market making purposes, to repackage risks and structure trades to facilitate clients’ needs for various risk taking and risk modification purposes. We manage our risk exposure by entering into offsetting derivatives with other financial institutions to mitigate the market risks, in part or in full, arising from our trading activities with our clients. In addition, we also enter into buy protection credit derivatives with other market participants to manage our counterparty credit risk exposure. Where we enter into derivatives for trading purposes, realized and unrealized gains and losses are recognized in trading revenue or residential mortgage banking revenue. Credit losses arising from counterparty risk on over-the-counter derivative instruments are recognized as an adjustment to the fair value of the derivatives and are recorded in trading revenue.

Derivative instruments designated as economic hedges that do not qualify for hedge accounting are recorded at fair value through earnings. Realized and unrealized gains and losses are recognized in other income or residential mortgage banking revenue while the derivative asset or liability positions are reflected as other assets or other liabilities. As of September 30, 2012, we have entered into credit default swaps which are designated as economic hedges against the credit risks within our loan portfolio. In the event of an impairment loss occurring in a loan that is economically hedged, the impairment loss is recognized as provision for credit losses while the gain on the credit default swap is recorded as other income (loss). In addition, we also from time to time have designated certain forward purchase or sale of to-be-announced (“TBA”) securities to economically hedge mortgage servicing rights. Changes in the fair value of TBA positions, which are considered derivatives, are recorded in residential mortgage banking revenue.

The following table presents the fair value of derivative instruments held for trading purposes and their location on the consolidated balance sheet.

Derivative Assets⁽¹⁾

Derivative Liabilities⁽¹⁾

Fair Value as of

Balance Sheet
Location

September 30,

2012

December 31,

2011

Balance Sheet

Location

September 30,

2012

December 31,

2011

(in millions)

Interest rate contracts

Trading assets

74,031

60,719

Trading liabilities

74,065

61,280

Foreign exchange contracts

Trading assets

14,147

15,654

Trading liabilities

13,677

15,413

Equity contracts

Trading assets

1,070

1,165

Trading liabilities

1,067

1,164

Precious Metals contracts

Trading assets

771

1,842

Trading liabilities

1,910

1,248

Credit contracts

Trading assets

8,218

14,388

Trading liabilities

8,486

14,285

Total

98,237

93,768

99,205

93,390

⁽¹⁾	The derivative assets and derivative liabilities presented above may be eligible for netting. Balance sheet categories in the above table represent the location of the assets and liabilities absent the netting of the balances.

The following table presents the fair value of derivative instruments held for other purposes and their location on the balance sheet.


	Derivative Assets⁽¹⁾					Derivative Liabilities⁽¹⁾
		Fair Value as of					Fair Value as of
	Balance Sheet Location	September 30, 2012		December 31, 2011		Balance Sheet Location	September 30, 2012		December 31, 2011
	(in millions)
Interest rate contracts	Other assets	$	986	$	957	Interest, taxes and other liabilities	$	113	$	106
Foreign exchange contracts	Other assets		33		11	Interest, taxes and other liabilities		31		13
Equity contracts	Other assets		546		51	Interest, taxes and other liabilities		107		87
Credit contracts	Other assets		1		2	Interest, taxes and other liabilities		5		8

Total		$	1,566	$	1,021		$	256	$	214

⁽¹⁾

The derivative assets and derivative liabilities presented above may be eligible for netting and consequently may be shown net against a different line item on the consolidated balance sheet. Balance sheet categories in the above table represent the location of the assets and liabilities absent the netting of the balances.

The following table presents information on gains and losses on derivative instruments held for trading purposes and their locations on the statement of income.


	Location of Gain (Loss) Recognized in Income on Derivatives	Amount of Gain (Loss) Recognized in Income on Derivatives
		Three Months Ended September 30,						Nine Months Ended September 30,
		2012			2011			2012			2011
		(in millions)
Interest rate contracts	Trading revenue	$	(24	)	$	(87	)	$	(8	)	$	(206	)
Interest rate contracts	Residential mortgage banking revenue		7			120			28			118
Foreign exchange contracts	Trading revenue		3			(246	)		648			131
Equity contracts	Trading revenue		2			101			62			105
Precious Metals contracts	Trading revenue		44			175			96			97
Credit contracts	Trading revenue		(27	)		(176	)		(1,695	)		(86	)

Total		$	5		$	(113	)	$	(869	)	$	159

The following table presents information on gains and losses on derivative instruments held for other purposes and their locations on the statement of income.


	Location of Gain (Loss) Recognized in Income on Derivatives	Amount of Gain (Loss) Recognized in Income on Derivatives
		Three Months Ended September 30,						Nine Months Ended September 30,
		2012			2011			2012			2011
		(in millions)
Interest rate contracts	Other income	$	15		$	494		$	120		$	628
Interest rate contracts	Residential mortgage banking revenue		(5	)		3			-			(8	)
Foreign exchange contracts	Other income		23			23			73			22
Equity contracts	Other income		351			(508	)		597			(316	)
Credit contracts	Other income		-			5			(3	)		2

Total		$	384		$	17		$	787		$	328

Credit-Risk Related Contingent Features We enter into total return swap, interest rate swap, cross-currency swap and credit default swap contracts, which contain provisions that require us to maintain a specific credit rating from each of the major credit rating agencies. Sometimes the derivative instrument transactions are a part of broader structured product transactions. If HSBC Bank USA’s credit ratings were to fall below the current ratings, the counterparties to our derivative instruments could demand additional collateral to be posted with them. The amount of additional collateral required to be posted will depend on whether HSBC Bank USA is downgraded by one or more notches as well as whether the downgrade is in relation to long-term or short-term ratings. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a liability position as of September 30, 2012, is $10.0 billion for which we have posted collateral of $10.3 billion. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a liability position as of December 31, 2011, is $10.3 billion for which we have posted collateral of $8.5 billion. Substantially all of the collateral posted is in the form of cash which is reflected in either interest bearing deposits with banks or other assets. See Note 20, “Guarantee Arrangements and Pledged Assets” for further details.

In the event of a credit downgrade, we do not expect HSBC Bank USA’s long-term ratings to go below A2 and A or the short-term ratings to go below P-2 and A-1 by Moody’s and S&P, respectively. The following tables summarize our obligation to post additional collateral (relative to the current collateral level) in certain hypothetical commercially reasonable downgrade scenarios. It is not appropriate to accumulate or extrapolate information presented in the tables below to determine our total obligation because the information presented to determine the obligation in hypothetical rating scenarios is not mutually exclusive.


Moody’s	Long-Term Ratings
Short-Term Ratings	A1		A2		A3
	(in millions)
P-1	$	-	$	71	$	230
P-2		2		6		230


S&P	Long-Term Ratings
Short-Term Ratings	AA-		A+		A
	(in millions)
A-1+	$	-	$	-	$	65
A-1		35		100		259

We would be required to post $41 million of additional collateral on total return swaps and certain other transactions if HSBC Bank USA is downgraded by S&P and Moody’s by two notches on our long term rating accompanied by one notch downgrade in our short term rating.

Notional Value of Derivative Contracts The following table summarizes the notional values of derivative contracts.


	September 30, 2012		December 31, 2011
	(in billions)
Interest rate:
Futures and forwards	$	389.3	$	320.3
Swaps		2,657.0		2,325.1
Options written		64.9		69.9
Options purchased		65.0		67.3

		3,176.2		2,782.6

Foreign Exchange:
Swaps, futures and forwards		820.4		725.0
Options written		51.9		39.7
Options purchased		53.0		40.4
Spot		77.3		60.1

		1,002.6		865.2

Commodities, equities and precious metals:
Swaps, futures and forwards		54.1		50.2
Options written		9.5		8.2
Options purchased		20.4		17.1

		84.0		75.5

Credit derivatives		526.0		657.3

Total	$	4,788.8	$	4,380.6