A depositary receipt is a security representing an economic interest in a foreign company that trades like a common share on a domestic stock exchange. For investors buying shares of foreign companies, the transaction costs associated with purchasing depositary receipts are significantly lower than the costs of directly purchasing the stock on a foreign country's stock exchange. Depositary receipts are not issued by the company and do not raise capital for the company, but rather, they are issued by financial institutions.
Depositary receipts facilitate trading of a company's stock in countries other than the country where the company is located. Depositary receipts are often referred to as global depositary receipts (GDRs), but may be called by different names in different countries. In the United States, GDRs are known as American Depositary Receipts (ADRs) or American depositary shares. Depositary receipts are generally similar globally but may vary slightly because of different laws.
5.2 Working of a Depository Receipt
Now we will consider how depositary receipts are created and work, using the example of Sony and Mexican investors. Mexican investors may want to invest in the stock of Sony, a Japanese company, but Sony's stock is not listed on the Mexican Stock Exchange. Buying Sony stock on the Tokyo Stock Exchange is expensive and inconvenient for Mexican investors. To make this process easier, a financial institution in Mexico, such as a bank, can buy Sony's stock on the Tokyo Stock Exchange and make it available to Mexican investors. Rather than making the shares directly available for trading on the Mexican Stock Exchange, the bank holds the shares in custody and issues GDRs against the shares held. The Sony GDRs issued by the custodian bank are listed on the Mexican Stock Exchange for trading. In essence, the Sony GDRs trade like the stock of a domestic company on the Mexican Stock Exchange in the local currency (Mexican peso).
Depositary receipts, like the shares they are based on, have no maturity date (i.e., they have an infinite life). Depositary receipts typically do not offer their owners any voting rights even though they essentially represent common stock ownership; the custodian financial institution usually retains the voting rights associated with the stock.
5.3 Two Types of Depository Receipts
A Global Depository Receipt(GDR),
They are also known as international depository receipt (IDR), is a certificate issued by a depository bank, which purchases shares of foreign companies and deposits it on the account.
GDRs represent ownership of an underlying number of shares of a foreign company and are commonly used to invest in companies from developing or emerging markets by investors in developed markets. Prices of global depositary receipt are based on the values of related shares, but they are traded and settled independently of the underlying share. Typically, 1 GDR is equal to 10 underlying shares, but any ratio can be used.
If for example, an Indian company which has issued ADRs in the American market wishes to further extend it to other developed and advanced countries such as in Europe, then they can sell these ADRs to the public of Europe and the same would be named as GDR. GDR can be issued in more than one country and can be denominated in any freely convertible currency.
Know how the Securities and Exchange Board of India facilitates trading in security instruments by visiting the linked article.
What are the Features of a GDR?
The following features best describe a Global Depository Receipt
It is a negotiable instrument that can be traded like any other security instrument freely.
Indian companies that have a solid financial record of about three years are readily allowed access to global financial markets through the use of a GDR. However, clearances are required from the Foreign Investment Promotion Board (FIPB) and the Ministry of Finance.
Since it can be denominated as multiple forms of freely convertible currency, GDRs are issued to investors across the country.
GDR is denominated in any foreign currency but the underlying shares would be denominated in the local currency of the issuer.
The holder is entitled to dividend and bonus on the value of shares underlying the GDR.
The investor can convert GDR into equity shares, and sell the shares mentioned in the GDR through a local custodian. This provision can be used after 45 days from the date of issue.
Under GDR, the issuing company transacts with only one entity for all its transactions.
To know how the Foreign Investment Board facilitates FDI (Foreign Direct Investments) initiatives, visit the linked article.
An American depositary receipt (ADR)
It is a security that represents indirect ownership of shares of a foreign company that isn't directly traded on U.S. exchanges. American banks purchase the shares through their foreign branches. Then, they make them available to investors in the U.S.
Not all foreign companies trade directly on U.S. exchanges. But with American depositary receipts, investors can still own shares of many of these companies. Banks and other financial institutions can purchase shares of foreign companies through their foreign branches. Then, they sell ADRs in the U.S. as a form of indirect ownership. These ADRs entitle the purchaser to the foreign stock they represent, even though the bank still has title to the underlying stock.
The first ADR was created in 1927 by J.P. Morgan. This was to allow Americans to invest in shares of a British department store. Today, there are more than 2,000 ADRs available, representing shares of companies located in more than 70 countries.
The Bank of New York, JPMorgan Chase, Deutsche Bank, and Citigroup are among the leading depositary banks, which create and issue ADRs. The popularity of ADRs has surged over the years. They have a number of distinct advantages that appeal to both small investors and professional money managers alike.
A single ADR may represent one share of a foreign company, or it may be a fraction of a share. It depends on the company and the foreign exchange rate involved. This enables firms to convert prices to amounts more appropriate for American exchanges.
5.4 Differences between ADR and GDR
American Depository Receipt (ADR) is a depository receipt which is issued by a US depository bank against a certain number of shares of non-US company stock. Whereas Global Depository Receipt (GDR) is a depository receipt which is issued by the international depository bank, representing foreign company's stock.
Foreign companies can trade in US stock market, through various bank branches with the help of ADR. Whereas GDR helps foreign companies to trade in any country's stock market other than the US stock market.
ADR is issued in America while GDR can be issued in both America and Europe.
ADR is listed in American Stock Exchange i.e. New York Stock Exchange (NYSE) whereas GDR is listed in non-US stock exchanges like London Stock Exchange or Luxembourg Stock Exchange.
ADR can be traded in America only while GDR can be traded in all around the world.
ADR Market is more liquid as compared to GDR market
Investor's participation is more in ADR as compared to GDR
ADR market is a retail investor market whereas GDR's market is institutional one.
ADR's disclosure agreements are more onerous as compared to GDR.
5.5 Advantages of ADR & GDR
They provide access to investments in the foreign markets, thus becoming a great way to diversify our portfolio.
They are denominated in US Dollars and Euros, both of which are very powerful currencies to hold investments in.
Since they are treated like shares, they can easily be traded in markets. They also offer all shareholder benefits to different investors.
For companies, depository receipts are a great way to attract positive international attention and expand their base of shareholders as well.
Depository receipts are one of the most expensive ways to raise capital for companies.
Since all transactions are happening in foreign currencies, the investments and capital are subject to the volatility of the foreign exchange or forex market.
Depository receipts are only suitable for High Net Individuals as high amounts of capital are needed to trade in them.
There are a limited number of companies which offer their shares in the form of depository receipts, thus leaving lesser choices for interested investors.