In the modern globalized economy, companies often operate in multiple countries, trading their stocks on various stock exchanges around the world. This has led to an increase in demand for financial instruments that allow investors to invest in foreign companies without facing currency and regulatory system complexities. One such instrument is a depositary receipt.
Today, many investors are interested in the opportunity to invest in the stocks of foreign companies, but such stocks may not be available for trading on stock exchanges of their home country. One solution to this problem is the purchase of depositary receipts, which allow investors to invest in the stocks of foreign companies that are not listed on their local stock exchange.
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).
American depositary receipts (ADRs)
ADRs are issued by American depositary banks and represent ownership of foreign shares held in custody by the depositary bank. They are designed to facilitate trading and investment in foreign securities by US investors. GDRs are similar to ADRs but are issued outside of the United States and are denominated in a foreign currency.
Sponsored ADRs can be divided into three levels depending on their compliance with SEC requirements:
- Level 1 ADRs: These are the simplest and most basic type of ADR. They are not required to comply with SEC reporting requirements and therefore have limited information for investors.
- Level 2 ADRs: These ADRs are required to comply with SEC reporting requirements and provide investors with more information than Level 1 ADRs.
- Level 3 ADRs: These ADRs are the most complete type of ADR. They require full compliance with SEC reporting requirements and provide investors with the most detailed information.
There are also Rule 144A ADRs and “Regulation S” ADRs.
- Rule 144A ADRs represent a closed category of US securities that are only available to a limited group of qualified investors. This is essentially a private placement that allows companies to avoid registering the issuance of securities with the SEC and providing financial reporting.
- “Regulation S” ADRs are offshore depositary receipts whose issuance is not registered with the SEC. They are only available to non-US residents and can be converted into Level 1 ADRs after the expiration of their term.
Global Depositary Receipts (GDRs)
They are similar to ADRs but are issued by depositary banks outside the United States and represent shares of non-US companies. They are traded on stock exchanges worldwide and denominated in different currencies depending on the location of the depositary bank.
GDRs include:
Russian Depositary Receipts. Russian Depositary Receipts (RDRs) are derivative securities based on shares of foreign companies traded on the Russian stock market. The first RDR was issued on the Moscow Exchange in 2010 by RUSAL, a British company that traded its shares on the Hong Kong stock exchange. To buy a share in RUSAL, a Russian investor had to purchase depositary receipts. One RDR corresponded to 10 shares of the company.
European Depositary Receipts. European Depositary Receipts (EDRs) are securities issued on one of the European stock exchanges. EDRs represent the right of ownership of a company’s share traded outside the issuer bank’s country. EDRs can be issued not only in euros but also in US dollars.
In addition to European and Russian depositary receipts, the group of global depositary receipts (GDRs) also includes Japanese (JDRs), Chinese (CDRs), and other depositary receipts, except for American depositary receipts (ADRs).
Why are depositary receipts issued?
Depositary receipts are issued for various reasons, but the most common reason is to provide foreign companies with the opportunity to attract capital from international investors. By issuing depositary receipts, companies can expand their investor base and gain access to new sources of financing. In addition, depositary receipts can provide investors with access to investment opportunities that would otherwise be difficult or impossible to obtain.
Another reason why depositary receipts are issued is to provide investors with access to companies in foreign markets. For example, a US investor interested in investing in a company listed on the Hong Kong Stock Exchange may find it difficult to do so directly. However, by acquiring depositary receipts representing shares of the company, the investor may have the opportunity to familiarize himself with the company’s performance without facing the difficulties of direct investment in a foreign market.
The difference between a depositary receipt and a stock
A depositary receipt and a stock are two different investment instruments, although they are related to each other. The main difference between them is that a stock is a document confirming the owner’s right to a share in the company, while a depositary receipt is a financial instrument that represents the right to own shares of a company located in another country.
When a company wants to attract investments from abroad, it may decide to issue depositary receipts, which are usually traded on international stock exchanges. The depositary receipt can be American, global, or European, depending on the jurisdiction and trading platform on which it is traded.
When an investor purchases a depositary receipt, they obtain the right to own shares of the company that are held in custody in another country. The custodian, in turn, issues depositary receipts based on these shares and provides them to investors for trading.
One of the advantages of depositary receipts is that they give investors the opportunity to invest in shares and companies located outside their country. Additionally, depositary receipts may be more accessible and liquid than shares traded on foreign exchanges, thanks to their wider distribution and convenience of trading on international platforms.
Overall, depositary receipts and shares are two different but related instruments. Depositary receipts represent the right to own shares of a company held in another country and allow investors to invest in shares they may not have been able to acquire otherwise.
Advantages of Depositary Receipts
Depositary receipts are a popular financial instrument worldwide, as they offer numerous advantages. Some of the benefits of depositary receipts include:
- Diversification of investment opportunities: Depositary receipts allow investors to invest in stocks and other assets that are located outside of their country. This means that investors have access to a larger number of companies and markets than if they only invested in their region.
- Liquidity: Depositary receipts can be bought and sold on global exchanges, which increases their liquidity. This allows investors to quickly buy or sell their depositary receipts at market prices.
- Convenience: Investors do not need to have direct access to foreign markets to invest in stocks and other assets located outside of their country. Depositary receipts are a more convenient and straightforward way to invest in foreign assets.
- Lower costs: Investing in depositary receipts can be cheaper than direct investment in foreign stocks and other assets. This is because depositary receipts usually have lower fees and transaction costs than direct investment.
- Protection against currency risks: Investors who invest in depositary receipts protect their investments against currency risks. This is because depositary receipts are traded in the local currency, which means that investors are not exposed to the risk of currency fluctuations.
- Convenient way to receive dividends: Depositary receipts provide investors with a convenient way to receive dividends and other payments related to investing in stocks and other assets. Depositary banks often pay dividends and other payments in the local currency, which is convenient for investors.
However, in addition to the advantages, depositary receipts, like any other financial instrument, have their risks:
- Currency risk: Since depositary receipts are denominated in a currency other than the investor’s country, there is always a risk that currency fluctuations will affect the value of the investment.
- Political risk: Investing in foreign companies through depositary receipts can be risky because investors may be exposed to political risks that they would not encounter when investing domestically.
- Legal risk: Depositary receipts may be subject to a different legal and regulatory framework than underlying stocks, which can make them more complex and difficult to understand.
Conclusion
Depositary receipts are a useful tool for both issuers and investors, providing access to new sources of capital, new markets, and diversification opportunities. Depositary receipts offer investors a convenient and accessible way to invest in stocks and other assets that are outside their country. They have several advantages, such as investment diversification opportunities, liquidity, convenience, lower costs, protection against currency risks, and a convenient way to receive dividends. However, like any investment, depositary receipts are not without risks, and investors should carefully study the potential risks and benefits before investing their funds in them.
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