In this article, we’ll discuss a popular financial instrument, depositary receipts. We’ll learn how they are used, what types of DRs there are, and talk about their advantages and disadvantages.
What a depositary receipt is
A depositary receipt (DR) is a security (certificate) that represents shares or bonds in a foreign company traded on a local stock exchange.
In fact, it’s a derivative security that removes any limitations or restrictions on investments is shares and bonds of foreign companies. These certificates have all rights of base assets being a domestic security.
Depositary receipts are bought by investors (DR holders) in accordance with a deposit agreement. A depository is an issuer’s agent and acts as a link between investors and an issuer.
Using depository receipts, investor can own shares of foreign companies without having to trade directly in foreign markets. Market players acquire depositary receipts the same way as stocks – directly, if they have access to stock exchanges, or via brokerage companies.
How depositary receipts work
Before describing all the nuances, we’ll tell you what is hiding behind such terms as “depository” and “custodian bank”.
A depository is a professional participant in the security market and its major function is registration of titles to assets. In other words, a depository keeps your securities.
A custodian bank both keeps and manages the securities or other financial assets of its clients. In addition, it can offer other financial services; for example, clearing, transaction settlement, or exchange operations.
Now let’s get back to how depositary receipts work.
They are issued when a foreign company wants to trade publicly on a stock exchange of some other country. To do this, a company has to meet all listing criteria for the chosen country. To issue depositary receipts, shares of a foreign company are transferred and deposited in a depository’s custodian bank.
After a custodian bank receives shares, a depository issues depositary receipts available to investors, which are later traded on local stock exchanges.
For example, a Japanese car manufacturing company wants to attract money in the US market. For this purpose, it has to initiate the issuing of American depositary receipts for being listed on the NYSE. This procedure will be as follows:
- A broker from the US buys shares of a Japanese company via its international branch in Japan and then forwards them to a local custodian bank.
- A depository bank (the US) confirms that it received and deposited base shares in a custodian bank. Now, instead of them, a bank can issue depositary certificates.
- A specific number of base shares are consolidated into a single DR. This number is defined after considering different economic factors, including the exchange rate of the Japanese Yen against the American dollar.
- A broker that acts as an intermediary between an issuing company and the US stock exchange receives American depository receipts and lists them on the NYSE — now American investors can invest their money in shares of a Japanese company.
What types of depositary receipts there are
As a rule, they are classified in terms of the market where they are traded.
- Global depositary receipts (GDR) are traded on several international markets at once. The more stock exchanges quote global depositary receipts of a specific foreign company, the more investors have a chance to invest in its shares.
- American depositary receipts (ADR) are traded only on the US exchanges, such as NYSE, AMEX, and NASDAQ. Dividends are paid in US dollars.
- Canadian depositary receipts (CDR) are derivatives that are traded on the Canadian stock exchange. CDRs are voting securities and imply dividend payouts.
- Brazilian depositary receipts (BDR) are certificates on foreign stocks available on the Brazilian stock exchange. They are backed by shares or other securities kept in a foreign custodian bank.
- In addition, global and American depositary receipts are divided into sponsored and unsponsored.
1. Sponsored depositary receipts are issued on the initiative of a company that issued base shares. This company enters into an agreement with a depository, according to which it takes the responsibility to unveil financial information.
A depository is an intermediary between an issuer and investors. Such securities are also considered voting securities, just like ordinary shares.
2. Unsponsored depositary receipts are issued by one or several depositories without any official agreement with a foreign company. These certificates are issued on already floating securities.
However, since they do not imply a company’s involvement, they are mostly traded on over-the-counter markets and are not considered voting securities.
Advantages of depositary receipts
- They offer investors access to foreign securities and, therefore, opportunities to diversify their investment portfolios
- Companies can consider them an additional source of income. For example, using global depositary receipts they can attract money from foreign investors from all over the world
- Local regulation. Since they are traded on local exchanges, investors don’t have to worry about international politics and global regulations
Disadvantages of depositary receipts
- Higher administrative fees and charges, commissions, and taxes if the countries of an issuing company and a depository have no agreement on the avoidance of double taxation
- Risks of exchange rate fluctuations. For example, if an investor acquires global depositary receipts on shares of a British company, they will be influenced by exchange rates of the Pound Sterling and the currency of the investor’s country
- Limited availability. Some derivatives are traded on over-the-counter markets, that’s why they are available only to institutional investors, companies or organisations performing transactions on behalf of their clients
Summary
Depositary receipts are a popular financial instrument on the stock markets. Using them, investors have a chance to invest their money in shares of foreign companies on local exchanges without undue effort. At the same time, issuing companies have an opportunity to attract more investments and list their shares on global stock exchanges.
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