An Introduction To Depositary Receipts

A depositary receipt (DR) is a type of negotiable financial security that allows investors to hold shares in a foreign public company. They are represented by a physical certificate and trade on national stock exchanges.

The most common example of a depositary receipt is the American depositary receipt (ADR). Other examples include the global depositary receipt (GDR) and international depositary receipt (IDR). ADRs typically trade on a U.S. national stock exchange, such as the New York Stock Exchange, while GDRs are commonly listed on the London Stock Exchange.

How Does a Depositary Receipt Work?

The DR is created when a foreign company wishes to list its already publicly traded shares or debt securities on a foreign stock exchange. Before it can be listed on a particular stock exchange, the company in question must first meet requirements put forth by the exchange.

DRs can also be issued as part of an initial public offering. They may also trade over-the-counter.

Depositary Receipts Example

Let's look at how an ADR is created and traded. Say, for example, a gas company in Russia has met the requirements of the New York Stock Exchange and now wants to list its publicly traded shares in the form of an ADR.

A U.S. broker, through an international office or Russian brokerage house, would purchase the domestic shares of the company and deliver them to a Russian custodian bank of the depository bank. The depository bank is the U.S. institution that issues the ADRs. In this example, we will say the depository bank is the Bank of New York.

Once the Bank of New York's local custodian bank in Russia receives the shares, the custodian bank verifies delivery by informing the Bank of New York that the ADRs can now be issued in the U.S. The Bank of New York then delivers the ADRs to the broker who initially purchased them.

Based on a determined ratio, each ADR would be issued as representing one or more of the Russian shares, and the price of each ADR would be issued in a U.S. dollar amount converted from the ruble equivalent of the shares held by the depository bank. The ADRs now represent the local Russian shares held by the depository and can be freely traded on the NYSE and settled like any other transaction.

The ADR investor holds privileges like those granted to shareholders of ordinary shares, such as voting rights and cash dividends. The rights of the ADR holder are stated on the ADR certificate.

Depositary Receipt Pricing and Cross-Trading

When any DR is traded, the broker will aim to find the best available price. They will therefore compare the U.S. dollar price of the ADR with the U.S. dollar equivalent price of the local share on the domestic market.

If the ADR of the Russian gas company trades at US$12 per share, and the shares trade on the Russian market at the equivalent of $11 (converted from rubles to USD), a broker would aim to buy more domestic shares in Russia and issue ADRs in the U.S. market. This action causes the domestic Russian price and ADR price to reach parity. Continual buying and selling in both markets usually keeps ADR and domestic prices in close range.

A U.S. broker may also sell ADRs back onto the Russian market. This is known as cross-border trading. When this happens, an amount of ADRs is canceled by the depository and the local shares are released from the custodian bank and delivered to the Russian broker who bought them.

The Benefits of Depositary Receipts

Depositary receipts function as a means to increase global trade, which in turn can help increase not only volumes on local and foreign markets but also the exchange of information, technology, regulatory procedures as well as market transparency.

Thus, instead of being faced with impediments to foreign investment, as is often the case in many emerging markets, the DR investor and company can both benefit from investment abroad. Let's take a closer a look at the benefits:

For the Company

A company may opt to issue a DR to obtain greater exposure and raise capital in the world market. Issuing DRs has the added benefit of increasing the share's liquidity while boosting the company's prestige on its local market ("the company is traded internationally").

Depositary receipts encourage an international shareholder base, and provide expatriates living abroad with an easier opportunity to invest in their home countries. Moreover, in many countries, especially those with emerging markets, obstacles often prevent foreign investors from entering the local market. By issuing a DR, a company can still encourage investment from abroad without having to worry about barriers to entry that a foreign investor might face.

For the Investor

Buying into a DR immediately turns an investor's portfolio into a global one. Investors gain the benefits of diversification while trading in their own market under familiar settlement and clearance conditions.

More importantly, DR investors will be able to reap the benefits of these usually higher risk, higher return equities, without having to endure the added risks of going directly into foreign markets, which may pose lack of transparency or instability resulting from changing regulatory procedures.

It is important to remember that an investor will still bear some foreign-exchange risk, stemming from uncertainties in emerging economies and societies. On the other hand, the investor can also benefit from competitive rates the U.S. dollar and euro have to most foreign currencies.

The Bottom Line

Depositary receipts give you the opportunity to add the benefits of foreign investment while bypassing the unnecessary risks of investing outside your own borders. As with any security, however, investing in DRs requires an understanding of why they are used, and how they are issued and traded.