What are depositary receipts?
A depositary receipt is a financial instrument that represents ownership rights to the stocks of a foreign company. In other words, it is a certificate that allows investors to buy stocks of foreign companies without the need to directly invest in these companies’ stocks. Instead, depositary receipts are issued by banks and financial institutions in the investors’ country of residence and represent the underlying stocks of the foreign company owned by the depositary bank.
The depositary bank, also known as the depositary, is responsible for holding the stocks of the foreign company and issuing depositary receipts to investors. These receipts are then traded on the stock exchange of the investor’s country, just like any other stock. The depositary bank also performs all administrative and regulatory requirements related to the stocks, including dividends, voting rights, and corporate actions.
In essence, a depositary receipt is a security that gives its holder ownership rights to the stocks or bonds of a foreign company. It was created to allow investors from one country to purchase securities that are traded on another country’s stock exchange through their local exchange. The main goal of a company issuing depositary receipts is to increase demand for its stocks on the local exchange by attracting foreign investors.
How do depositary receipts work?
To understand how depositary receipts work, let’s consider an example. Imagine an American investor wants to invest in a Chinese company whose shares are listed on the Shanghai Stock Exchange. Instead of dealing with the complexities of investing in the Chinese market, the investor can purchase a depositary receipt issued by an American depositary bank, which represents ownership of the underlying shares of the Chinese company.
The depositary bank will hold the actual shares of the Chinese company and issue depositary receipts to the investor. These depositary receipts can be traded on US stock exchanges, allowing investors to buy and sell shares of the Chinese company without dealing with foreign exchange rates, regulatory requirements, or language barriers.
Types of depositary receipts
There are two main types of depositary receipts: sponsored and unsponsored.
Unsponsored depositary receipts are issued for sale on the over-the-counter market and allow foreign companies to avoid disclosing their financial information. However, such receipts are highly risky and illiquid. Sponsored depositary receipts, on the other hand, have gained greater popularity in the market. Issuing banks issue sponsored depositary receipts on behalf of foreign companies, using their capital as the underlying asset.
Sponsored depositary receipts are issued in collaboration with the company whose shares are represented by the receipts. The company collaborates with the depositary bank to create a depositary receipt program and then provides information about the company to the bank, which then uses that information to issue and administer the depositary receipts. Sponsored depositary receipts are usually more transparent and reliable than unsponsored depositary receipts because the company participates in the process and can provide information to the depositary bank to ensure that the receipts accurately reflect the company’s performance.
In turn, unsponsored depositary receipts are issued without collaboration with the company whose shares are represented. Instead, they are issued by the depositary bank, which has acquired the company’s shares on the open market and uses those shares to create the receipts. Unsponsored depositary receipts are typically less transparent and less reliable than sponsored depositary receipts because the company does not participate in the process and does not control the information provided to investors.
Depositary receipts can also be divided to American depositary receipts (ADRs) and Global depositary receipts (GDRs).