In this article, we will discuss a popular financial instrument – depository receipts. We will learn how they are applied, what are the DRs, and also tell about their advantages and disadvantages.
What is a depository receipt
Depository Receipt (DR) is a security (certificate) representing actions or bonds of a foreign company traded on a local stock exchange.
In essence, this is a derivative security that removes any restrictions on investments – these are shares and bonds of foreign companies. These certificates have all the rights of the underlying assets, which are domestic securities.
Depositary receipts are purchased by investors (DR holders) in accordance with the deposit agreement. The depositary is the agent of the issuer and acts as a link between investors and the issuer.
Using depositary receipts, an investor can own shares of foreign companies without having to trade directly in foreign markets. Market players purchase depository receipts in the same way as stocks – either directly if they have access to an exchange or through brokerage companies.
How depository receipts work
Before describing all the nuances, let us tell you what is hidden behind such concepts as “depository” and “custodian bank”.
The depository is a professional participant in the securities market and its main function is to register ownership of assets. In other words, the depository holds your securities.
A custodian bank simultaneously holds and manages the securities or other financial assets of its clients. In addition, it may offer other financial services; for example, clearing, settlement or exchange transactions.
Now let’s go back to how depository receipts work.
They are issued when a foreign company wants to publicly trade on another country’s stock exchange. For this, the company must meet all the listing criteria for the selected country. For the issuance of depository receipts, the shares of a foreign company are transferred and stored in a depository bank.
After the custodian bank receives the shares, the depository issues depositary receipts available to investors, which are later traded on local stock exchanges.
For example, a Japanese car manufacturing company wants to raise money in the US market. To do this, it must initiate the issue of American depositary receipts for listing on the NYSE. This procedure will look like this:
- A US broker buys shares of a Japanese company through its international office in Japan and then sends them to a local custodian bank.
- The Depositary Bank (US) confirms that it has received and deposited the underlying shares with the Custodian Bank. Now, instead of them, the bank can issue depository certificates.
- A certain number of underlying shares are combined into one DR. This figure is determined after considering various economic factors, including the exchange rate Japanese yen against the US dollar.
- The broker, which is an intermediary between the issuing company and the US exchange, receives American depositary receipts and places them on the NYSE – now American investors can invest their money in the shares of the Japanese company.
What are the types of depository receipts
They are generally classified according to the market in which they are traded.
- Global Depositary Receipts (GDRs) traded at once on several international markets. The more global depositary receipts of a particular foreign company are quoted on stock exchanges, the more chances investors have to invest in its shares.
- American Depositary Receipts (ADRs) traded only on US stock exchanges such as the NYSE, AMEX and NASDAQ. Dividends payable in US dollars.
- Canadian Depository Receipts (CDRs) are derivatives traded on a Canadian stock exchange. CDRs are voting securities and provide for the payment of dividends.
- Brazilian Depository Receipts (BDRs) are foreign share certificates available on the Brazilian stock exchange. They are secured by shares or other securities held in a foreign custodian bank.
- In addition, global and American depository receipts are divided into sponsored and non-sponsored.
1. Sponsored depositary receipts are issued at the initiative of the company that issued the basic shares. This company enters into an agreement with the depository, according to which it undertakes the obligation to disclose financial information.
The depositary is an intermediary between the issuer and investors. Such securities are also considered voting securities in the same way as common stock.
2. Unsponsored depository receipts are issued by one or more depositories without official agreement with a foreign company. These certificates are issued for securities already in circulation.
However, since they do not represent a company’s participation, they are mainly traded in over-the-counter markets and are not considered securities with voting rights.
Advantages of depository receipts
- They offer investors access to foreign securities and thus opportunities to diversify their investment portfolios
- Companies can consider them as an additional source of income. For example, with the help of 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 do not need to worry about international politics and global regulations
Disadvantages of depository receipts
- Higher administrative fees and charges, commissions and taxes if the countries of the issuing company and the depositary do not have a double taxation agreement
- Risks of exchange rate fluctuations. For example, if an investor buys global depositary receipts for the shares of a UK company, they will be affected by exchange rates A pound sterling and the currency of the investor’s country
- Limited availability. Some derivatives are traded on over-the-counter markets, so they are only available to institutional investors, companies or organizations that transact on behalf of their clients.
Summary
Depository receipts are a popular financial instrument in the stock markets. Using them, investors have the opportunity to invest money in shares of foreign companies on local exchanges without any extra effort. At the same time, issuing companies have the opportunity to attract more investment and place their shares on world exchanges.
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