Depository Receipts

What are Depository Receipts?

Depository receipt is a source of raising foreign capital. It enables an already listed company (in most cases) to raise further capital from international markets. Also, the individual investors get an opportunity to invest in foreign markets without hassle. A depository receipt is a negotiable instrument. The local bank of a country issues a depository receipt. The exchange of the issuing country lists the depository receipts. However, it represents shares, usually equity, of a foreign company as its underlying.

The most prevalent depository receipts traded today include ADR’s and GDR’s.

Depository Receipt Issuance: Process

The process of issuance of a depository receipt involves several steps. The following example seeks to clarify and explain the process in a simplified manner.

Say, a Japanese Automobile company wishes to raise funds from the American capital market. It, therefore, proceeds to initiate the issue for ADR’s to be listed on the NYSE. It satisfies the preliminary requirements to qualify for an ADR issue.

Parties Involved

Depository Bank

Located in the country of ADR issuance. (Here, USA). The depository bank is the ultimate issuer of the DR’s on a local exchange.

Custodian Bank

Located in the country from where the shares have originated. (Here, Japan). The depository bank, sitting in the USA chooses the custodian bank.

Broker

A broker undertakes to oversee the entire process from inception to issuance. He is usually located in the country of ADR issuance.

Foreign Stock Exchange

The exchange ultimately listing the ADR’s. (Here, NYSE).

Process

Step 1:

The US broker purchases the shares of the Japanese company through his international branch situated in Japan. He then has these shares delivered to the custodian bank (Japan).

Step 2:

The depository bank (USA) confirms the delivery and receipt of the underlying shares with the custodian bank. Its a signal from Custodian Bank to the depository bank that the shares are deposited with it and ADRs in lieu of them can now be issued.

Step 3:

ADRs are issued upon confirmation. A predetermined number of underlying shares are consolidated to constitute an ADR. The ADR ratio is decided upon after considering several economic factors including the existing exchange rate of the Japanese Yen to USD as on that date.

Step 4:

The broker receives the so formulated ADR’s. The broker is an intermediary between the Japanese company and the American Exchange. He then proceeds to conclude the process of listing of the ADR’s on the NYSE.

Depository Receipts

 

Characteristics of Depository Receipt

Global Accessibility

The first and foremost reason why a company issues depository receipts is global exposure. By issuing DR’s, a company can invite capital from across borders. This is a particularly helpful tool when a business has exhausted equity capital sources from its own country.

Investors too reap great benefits from being able to invest in depository receipts. For an individual investor, wanting to invest in foreign capital markets spells trouble. There are so many countless hurdles of compliances and procedures to cross that the desire to invest abroad is a nip in the bud. With a depository receipt, the investor can successfully take a position in international markets and not worry about multiple compliances.

Diversification

Elaborating on the aforementioned point, depository receipts allow investors to participate in markets beyond their borders. Consequently, investors from the developed economy can participate in the high yielding economies of developing countries. For example, ICICI Bank, India has issued ADR’s listed on the NYSE. Investing in DR’s escalates one’s portfolio to capture global movements. The investor can diversify away the risk specific to his own country by investing into depository receipts.

Foreign Exchange Exposures

The investors are also able to generate foreign exchange income. Dollars or Euros denominate most depository receipts. These are amongst the strongest currencies today. Naturally, apart from the anticipated capital gain income, the investors make a considerable profit while converting their income back to that of the home country. However, like two sides of a coin, this upside can quickly turn to a downside should the foreign currency take any hits owing to economic and other factors. Therefore, an investor of DR’s is equally exposed to positive as well as negative currency fluctuations.

Ease of Operations

A remarkable aspect in the workings of a depository receipt is that they replicate any other existing stock on the exchange. They are denominated in the currency of the country they are issued. For example, ADR’s are listed in dollars and even pay out dividends in dollars. Since they are expected to comply with the statutory requirements of the issuing country, they behave almost identically with shares of that country.
The willing investors are not required to go any extra effort for obtaining depository receipts than they have to for purchasing local shares of that country. And local brokerage or trading account will easily make available the DR’s. This has greatly benefited the individual and small investors who wish to invest in the foreign market but do not possess the extravagant means to do so.

Derived Value

Though the depository receipts are issued in the currency of the country of issuance, that currency has little or no significance in determining its value. This is because the DR’s, in essence, is a consolidated bunch of the underlying shares. These shares continue to be denominated in the currency of its originating country. The underlying shares determine the value of a depository receipt. It is the business performance of parent company and market sentiment for the stock in its country of origin that has a considerable bearing in deciding the price of a depository receipt.

Statutory Compliance

Issuance of a depository receipt requires heavy compliances from the issuing company. It is required to obtain umpteen number of sanctions and approvals before proceeding with a DR issue. It does not end there. After satisfying the legal requirements of own country, the issuer must also ensure that the issue agrees with the compliance requirements of the target country. The issuing company is also subjected to stringent examination of books of accounts and credit evaluations. It is only on “getting an okay” in all respects can the company finally roll out its issue.

Cost of Issue

Owing to its complicated and intermingling nature, depository receipts are undoubtedly a very expensive source of finance. Corporations cannot resort to it as a routine means of raising funds. Issuing depository receipts is not as simple an affair as merely issuing fresh equity shares. In fact, most organizations go a lifetime without having to raise funds through DR’s. Several investment banking professionals and financial service institutions have to be hired who charge a very hefty amount for such an issue. Additionally, government approvals and sanctions also entail a significant amount of fees.

Last updated on : September 28th, 2018

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