Visa’s charter documents state that Visa may fix fees payable by members in connection with Visa’s operations. We understand that descriptions of significant pending lawsuits and MasterCard’s and Visa’s positions regarding the potential impact of those lawsuits on members are set forth on MasterCard’s and Visa’s respective websites, as well as in MasterCard’s public filings with the Securities and Exchange Commission. Key is not a party to any significant litigation by third parties against MasterCard or Visa. 

In June 2003, MasterCard and Visa agreed, independently, to settle a class-action lawsuit against them by Wal-Mart Stores Inc. and many other retailers. The lawsuit alleged that MasterCard and Visa violated federal antitrust laws by conspiring to monopolize the debit card services market and by requiring merchants that accept certain of their debit and credit card services to also accept their higher priced “off-line,” signature-verified debit card services. Under the terms of the settlements, which the court approved in December 2003, MasterCard and Visa have agreed to pay a total of approximately $3 billion beginning August 1, 2003, over a 10-year period, to merchants who claim to have been harmed by their actions and to lower the fees they charge merchants for their “off-line” signature-verified debit card services. Also, as of January 1, 2004, such merchants are not required to accept MasterCard or Visa debit card services when they accept MasterCard or Visa credit card services. Accordingly, management believes that the settlements will 

Key, mainly through its lead bank, KBNA, is party to various derivative instruments. These instruments are used for asset and liability management and for trading purposes. Generally, these instruments help Key meet clients’ financing needs and manage exposure to “market risk” — the possibility that economic value or net interest income will be adversely affected by changes in interest rates or other economic factors. However, like other financial instruments, these derivatives contain an element of “credit risk” — the possibility that Key will incur a loss because a counterparty fails to meet its contractual obligations. 

The primary derivatives that Key uses are interest rate swaps, caps and futures, and foreign exchange forward contracts. All foreign exchange forward contracts and interest rate swaps and caps held are over-the-counter instruments. 

At December 31, 2003, Key had $735 million of derivative assets and $117 million of derivative liabilities on its balance sheet that arose from derivatives that were being used for hedging purposes. As of the same date, derivative assets and liabilities classified as trading derivatives totaled $1.2 billion and $1.1 billion, respectively. Derivative assets and liabilities are recorded at fair value in “accrued income and other assets” and “accrued expense and other liabilities,” respectively, on the balance sheet. 

## 19. DERIVATIVES AND HEDGING ACTIVITIES 

reduce fees earned by KBNA and Key Bank USA from off-line debit card transactions. Management estimates that the impact of the settlement on Key will be a reduction to pre-tax net income of less than $25 million in 2004. This estimate is subject to change once management completes its evaluation of alternative actions it may take in response to the settlements and has had an opportunity to observe any post-settlement changes in the marketplace for card services. It is management’s understanding that certain retailers have opted-out of the class-action settlement and that additional suits have been filed against MasterCard and Visa seeking additional damage recovery. Management is unable at this time to estimate the possible impact on Key of any such actions. 

Involvement in the Mutual Fund, Brokerage and Annuity Industry. As previously publicly reported in the media, McDonald Investments Inc. (“McDonald”), a registered broker-dealer subsidiary of KeyCorp, has received subpoenas from the Securities and Exchange Commission and inquiries from the National Association of Securities Dealers and the State of New York Attorney General, seeking documents and information as part of their investigations into trading activity involving the mutual fund, brokerage and annuity businesses. McDonald has responded to the various regulatory authorities and is cooperating fully with their inquiries and investigation. It is not known whether, and then to what extent, McDonald could receive further requests or be required to take action related to this matter in the future. 

## ASSET AND LIABILITY MANAGEMENT 

Fair value hedging strategies. Key uses interest rate swap contracts known as “receive fixed/pay variable” swaps to modify its exposure to interest rate risk. These contracts convert specific fixed-rate deposits, short-term borrowings and long-term debt into variable-rate obligations. As a result, Key receives fixed-rate interest payments in exchange for variable-rate payments over the lives of the contracts without exchanges of the underlying notional amounts. 

Key recognized net gains of approximately $3 million in 2003 and 2002 and a net loss of $1 million in 2001 related to the ineffective portion of its fair value hedging instruments. The ineffective portion recognized is included in “other income” on the income statement. 

Cash flow hedging strategies. Key also enters into “pay fixed/receive variable” interest rate swap contracts that effectively convert a portion of its floating-rate debt into fixed-rate debt to reduce the potential adverse impact of interest rate increases on future interest expense. These contracts allow Key to exchange variable-rate interest payments for fixed-rate payments over the lives of the contracts without exchanges of the underlying notional amounts. Similarly, Key has converted certain floating-rate commercial loans to fixed-rate loans by entering into interest rate swap contracts. 

