What are Depositary Receipts?
Depositary Receipt is a financial instrument that gives the investors an opportunity to invest in equity of the foreign companies, and these depositary receipts can be traded on stock exchange representing the underlying equity shares of the foreign companies. It helps companies to raise capital from the international market, financial intermediaries such as domestic custodian banks and overseas depositary banks help the domestic company to raise funds from foreign investors.
How does a company raise the capital via Depositary Receipts?
Let’s say an Indian firm – Infosys, which is listed on the Bombay Stock Exchange wanted to raise more funds to expand its business but from the foreign investors in Japan. So, Infosys will first go to the depositary bank in Japan & ask them to help in raising funds from the Japanese investors. Infosys has to provide the depositary bank the detailed financial reports, which make it easier for the depositary bank to assess the financial health of the issuing company.
Depositary Bank will purchase the shares, or it can contact it business counterpart in India to purchase the specified number of shares and offer an Infosys’s depositary receipt to the Japanese investors, and these depositaries receipt can be listed on the Tokyo stock exchange & also it can be traded on Over the counter market. Usually, one unit of depositary receipts holds around 10 shares of underlying companies.
Types of Depositary Receipt
There are two most common types which are known to the people in the world i.e., American Depositary receipts & Global Depositary receipts. Let’s discuss this in more detail.
#1 – ADR- American Depositary Receipts
An American Depositary ReceiptsAmerican Depositary ReceiptsAmerican Depositary Receipts (ADR) refer to negotiable certificate released by the US depository bank and comprise a certain number of stocks with atleast one foreign company's shares. It is freely traded on the US stock markets, just like the other domestic stocks. is a financial instrument that represents a certain number of shares in the company situated outside the United States. ADR is issued by the United States depositary bank to the investors. This ADR gets listed on the stock exchange in the United States & trades like the other shares on the exchange. ADR benefits the foreign firm to attract & raise the fund from the investor without listing its equity shares in the united states at a lower expense compared to if the firm chooses to list its shares in the United States.
Depositary Bank holds the underlying security of the foreign firm, which is offered to the investor as ‘ADR’ which is denominated in U.S. Dollar & get listed on the recognized stock exchanges in the United States for e.g., NYSE, NASDAQ, etc. or also get traded on over the counter market. American investors who hold ADRADRADR (American Depository Receipts) is a financial instrument traded in US markets and are issued by US banks. ADRs are listed on the stock exchange and can trade like other stocks. realize any dividend or capital gain in USD but after net of foreign exchange expense and taxes.
As by this time, you understand that an ADR represents the underlying foreign security in some ratios, such as one ADR consist of 10 shares or maybe one share. The depositary bank ensures the value or price of the ADR is in line with this conversion ratio.
- Unsponsored ADR: Investment BankInvestment BankInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc. or Brokers, with the help of depositary banks, create & issue unsponsored ADR to the investor by holding shares in the foreign company. Unsponsored ADR cannot be listed on the American stock exchange as this ADR has not registered with the regulator and also has no involvement of the foreign company. Unsponsored ADR only trades on Over the counterOver The CounterOver the counter (OTC) is the process of stock trading for the companies that don't hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments..
- Sponsored ADR: Under this ADR, Foreign firms, with the help of depositary banks, create & issue ADR to the investor which is registered with the regulators & can be traded on the stock exchange.
Further, ADR’s are categorized into 3 levels when it comes to fulfilling the requirement to list its shares on the stock exchange.
- Level 1: This type of ADR is usually traded on Over the counter market as this firm does not meet the criteria to the reporting standard (US GAAP) or register with the regulator (SEC) to get its share listed on the stock exchange. This ADR is considered to be risky among investors.
- Level 2 & 3: The firm must register its ADR with the regulator (SEC) & also submit the financial reports of the firm, which should be U.S GAAP compliance. Level 2 registered ADR can’t be used to raise funds in the market. But Level 3 ADR is considered one of the most efficient ADRs among all levels and can be used to raise funds for the firm. Level 3 ADR can be listed on the American stock exchange, such as NYSE or NASDAQ.
#2 – GDR – Global Depositary Receipts
GDRGDRGlobal Depository Receipt is a receipt in which a security certificate is issued by financial intermediaries such as a depository bank, which purchases foreign securities, creates a bank certificate consisting of such shares, and then sells them on the stock exchange. is another type of depositary receipt that can be issued to investors in most of the foreign countries in the world. By issuing GDR, the Firm can raise funds from the financial marketFinancial MarketThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces. of more than one country and can be traded in multiple stock exchanges at the same time. A GDR also serves the same purpose as ADR, but by issuing GDR, the firm has certain benefits as compared to ADR.
The following are the advantages of Depositary Receipt.
- Lower Expenses: Raising funds through depositary receipts in the foreign market can lower expenses for the firm as compared to raising funds by issuing directly equity shares in the primary marketPrimary MarketThe primary market is where debt-based, equity-based or any other asset-based securities are created, underwritten and sold off to investors. It is a part of the capital market where new securities are created and directly purchased by the issuer. of the foreign country.
- Liquidity for Investors: As this Depositary Receipt traded on the stock exchange can provide liquidity to the foreign investor.
Below are the disadvantages of Depositary Receipt.
- Risk of Foreign Exchange Rate: As you know, depositary receipts are exposed to currency foreign exchange riskForeign Exchange RiskForeign exchange risk is an unfavourable change in the settlement value of a transaction entered in a currency other than the base currency (domestic currency), also referred to as currency risk or exchange rate risk. to the investor who wants to invest in foreign companies.
- Regulatory Risk: Firm who raise fund by issuing the depositary receipt in the foreign market has to adhere to the regulation of multiple countries;
Depositary Receipts is the financial instrument which serves the purposes for both investors and issuing firm. This provides a platform where a firm can raise funds from a foreign country, and the investor gets the opportunity to diversify his portfolio by investing in these depositary receipts of foreign companies.
Important Point to Remember
American Depositary Receipts are issued only to the investor in the United States & Global depositary receipts are issued to all investors in the world except to the investors in the United States.
This has been a guide to what are Depositary Receipts. Here we discuss how does a company raise the capital via depositary receipts along with its types, advantages, and disadvantages. You can learn more about financing from the following articles –