When I first came across this term last year, I couldn’t even spell it, let alone tell you what it meant, but in today’s complex world of regulatory change and OTC swap reform it’s kind of important to understand.
So what’s it all about?
If you look it up in the dictionary, you get “the right or privilege of a state to exercise authority in certain circumstances beyond the limits of its territory”.
And that pretty much sums it up.
In the context of financial regulations, it means that if a country thinks that your firm or business should fall in-scope of a particular regulation, even though your firm or business may not be based in that country, then the regulatory scope to comply will be extended to include you.
The basis behind extraterritoriality is straightforward – if it wasn’t applied, the entire global financial services sector would simply relocate to a jurisdiction that didn’t bother with regulations.
Think Cayman Islands, but on a bigger scale!
Perhaps an easier way to understand this, is by way of example. Consider JP Morgan, based in New York. JP Morgan also has a branch in London and without extraterritoriality, JP Morgan could avoid the application of US regulations, such as Dodd Frank, by simply executing all of its business out of its London branch.
Simple. But also too obvious. Hence extraterritoriality.
Extraterritoriality closes this gap and extends the obligation to comply with US regulations, such as Dodd Frank, to all of JP Morgan’s non-US, overseas branches. And there’s probably quite a lot of them.
Now, you’re possibly thinking that doesn’t this mean that an awful lot of folks are going to ‘have to do things twice’? It’s a good question because European regulators are certainly going to paint JP Morgan’s London branch as being in-scope of European regulations, such as EMIR, and so doesn’t that mean that JP Morgan’s London branch will have to comply with both Dodd Frank and EMIR when looking at OTC swap reform?
In theory, the answer is yes but in practice, thankfully, the answer is no. This is all down to – deep breath! – “substituted compliance”, which is largely the other piece in the puzzle that helps explain exactly how the ‘global’ part of all this OTC swap reform is eventually going to play out.
So what is ‘substituted compliance’?
In summary, where one country’s “regulatory regime and level of supervision and enforcement” is deemed to be equivalent to that of another country, the two countries may allow substituted compliance of their respective regulations.
In plainer English(!), continuing with the example above, this would mean that should Dodd Frank be deemed equivalent by ESMA and should EMIR be deemed equivalent by both the CFTC and SEC, then JP Morgan’s London branch, from a US perspective, would be allowed to comply with EMIR instead of Dodd Frank and hence only one piece of regulation overall.
I said should because this process is far from guaranteed as both regulatory authorities need to agree on equivalence and the early global probing that we are currently seeing into each other’s regulations is suggesting that not all regulations are equal!
It took me a while to get my head around this one, but you can now see just how complex the cross-border application of OTC swap reform has become.
Swap futures anyone?! lol