A depositary receipt is a negotiable instrument issued by a bank to represent shares in a foreign public company, which allows investors to trade in the global markets.
Understanding Depositary Receipts
Depositary receipts allow investors to invest in companies in foreign countries while trading in a local stock exchange in the investor’s home country. It is advantageous to investors since shares are not allowed to leave the home country that they trade in.
Depositary receipts were created to minimize the complications of investing in foreign securities.
Previously, if investors wanted to buy shares in a foreign company, they would need to exchange their money into foreign currency and open a foreign brokerage account. Then, they would be able to purchase shares through the brokerage account on a foreign stock exchange.
The creation of depositary receipts eliminates the entire process and makes it simpler and more convenient for investors to invest in international companies.
How are Depositary Receipts Issued?
An investor needs to contact a broker in a local bank if he/she is interested in purchasing depositary receipts. The local bank in the investor’s home country, which is called the depositary bank, will assess the foreign security before making a decision to purchase shares.
The broker in the depositary bank will purchase the shares either on the local stock exchange that it trades in or purchase the shares in the foreign stock exchange by using another broker in a foreign bank, which is also known as the custodian bank.
After purchasing the shares, the depositary bank will request the shares to be delivered to the custodian bank.
After the custodian bank receives the shares, they will group the shares into packets, each consisting of 10 shares. Each packet will be issued to the depositary bank as a depositary receipt that is traded on the bank’s local stock exchange.
When the depositary bank receives the depositary receipts from the custodian bank, it notifies the broker, who will deliver it to the investor and debits fees from the investor’s account.
Types of Depositary Receipts
1. American Depositary Receipt (ADR)
It is listed only on American stock exchanges (i.e., NYSE, AMEX, NASDAQ) and can only be traded in the U.S. They pay investors dividends in U.S. dollars and are issued by a bank in the U.S.
ADRs are categorized into sponsored and unsponsored, which are then grouped into one of three levels.
2. European Depositary Receipt (EDR)
It is the European equivalent of ADRs. Similarly, EDRs are only listed on European stock exchanges and can only be traded in Europe. It pays dividends in euros and can be traded like a regular stock.
3. Global Depositary Receipt (GDR)
It is a general term for a depositary receipt that consists of shares from a foreign company. Therefore, any depositary receipt that did not originate from your home country is called a GDR.
Many other countries around the world, such as India, Russia, the Philippines, and Singapore also offer depositary receipts.
Advantages of DRs
1. Exposure to international securities
Investors can diversify their investment portfolio by gaining exposure to international securities, in addition to stocks offered by local companies.
2. Additional sources of capital
Depositary receipts provide international companies a way to raise more capital by tapping into the global markets and attracting foreign investors around the world.
3. Less international regulation
Since it is traded on a local stock exchange, investors do not need to worry about international trading policies and global laws.
Although investors will be investing in a company that is in a foreign country, they can still enjoy the same corporate rights, such as being able to vote for the board of directors.
Disadvantages of DRs
1. Higher administrative and processing fees, and taxes
There may be higher administrative and processing fees because you need to compensate for custodial services from the custodian bank. There may also be higher taxes.
For example, ADRs receive the same capital gains and dividend taxes as other stocks in the U.S. However, the investor is subject to the foreign country’s taxes and regulations aside from regular taxes in the U.S.
2. Greater risk from forex exchange rate fluctuations
There is a higher risk due to volatility in foreign currency exchange rates. For example, if an investor purchases a depositary receipt that represents shares in a British company, its value will be affected by the exchange rate between the British pound and the currency in the buyer’s home country.
3. Limited access for most investors
Sometimes, depositary receipts may not be listed on stock exchanges. Therefore, only institutional investors, which are companies or organizations that execute trades on behalf of clients, can invest in them.