What Are Depositary Receipts?
Depositary receipts are negotiable securities issued by a depositary bank that represent shares of a foreign company's stock. They enable investors to gain investment exposure to international companies without directly trading on foreign stock exchanges. These instruments fall under the broader category of International Finance, facilitating cross-border capital flows. By holding a depositary receipt, investors effectively own shares in a foreign company, with the depositary bank managing the underlying foreign equity securities and handling aspects like dividends and corporate actions. This structure simplifies the process for domestic investors to access foreign markets, which would otherwise involve complexities such as foreign exchange conversions and differing settlement procedures.
History and Origin
The concept of depositary receipts emerged from the practical challenges faced by investors seeking to own shares in foreign companies. Before their introduction, acquiring foreign stocks often involved cumbersome processes, including navigating different legal systems, varying trading hours, and complex currency conversions. In response to these difficulties, J.P. Morgan pioneered the first American Depositary Receipt (ADR) in 1927 for the British retailer Selfridges. This innovative financial instrument was listed on the New York Curb Exchange, the predecessor to the American Stock Exchange, allowing U.S. investors a more accessible way to invest in international businesses.4 This development marked a significant step in democratizing international investment, paving the way for easier access to global capital markets.
Key Takeaways
- Depositary receipts allow investors to own shares in foreign companies indirectly through a domestic financial instrument.
- They simplify international investing by mitigating issues related to foreign exchange, foreign settlement, and different market regulations.
- The underlying shares represented by depositary receipts are held in custody by a depositary bank.
- They are denominated in the local currency of the market where they trade, and typically pay dividends in that currency.
- Depositary receipts enhance portfolio diversification by providing access to a wider range of global companies.
Interpreting the Depositary Receipts
Depositary receipts are interpreted as proxies for direct ownership of foreign shares. An investor holding a depositary receipt effectively holds a claim on the underlying asset—the foreign company's shares—which are held by a depositary bank. The ratio of depositary receipts to underlying shares can vary, impacting how the price of the depositary receipt reflects the foreign stock. For example, one depositary receipt might represent multiple foreign shares, or vice versa, depending on the desired trading price and liquidity in the host market. These instruments are traded on domestic stock exchanges, making their pricing and liquidity easily observable through standard market data, similar to domestic equities. The transparency and ease of trading offered by depositary receipts make them a popular vehicle for investors seeking international exposure without the complexities of direct cross-border transactions.
Hypothetical Example
Consider an investor in the United States who wishes to invest in a growing technology company based in Japan. Instead of directly purchasing shares on the Tokyo Stock Exchange, which would involve opening an account with an international broker-dealer, dealing with yen currency conversion, and understanding Japanese market conventions, the investor can purchase depositary receipts for the Japanese company's equity securities.
Suppose one depositary receipt represents one share of the Japanese company. If the Japanese share trades at ¥10,000 and the exchange rate is ¥150 to $1, then the theoretical value of one depositary receipt would be approximately $66.67. The investor can buy and sell these depositary receipts on a U.S. stock exchange using their regular brokerage account, with transactions denominated in U.S. dollars. The depositary bank holds the actual Japanese shares in custody, ensuring that the investor's interest in the underlying asset is maintained, and facilitates the payment of any dividends in U.S. dollars.
Practical Applications
Depositary receipts are widely used in global financial markets, serving several key purposes for both companies and investors. For companies, issuing depositary receipts provides a mechanism to raise capital from a broader base of institutional investors and retail investors in foreign markets without the full administrative burden of a direct listing. This allows foreign companies to tap into new pools of capital and increase their visibility and market capitalization globally.
For investors, depositary receipts offer a convenient way to achieve portfolio diversification by adding international stocks to their holdings. They streamline the process of international investment by consolidating foreign exchange conversions, dividend payments, and shareholder communications. The Federal Reserve System, alongside the Department of the Treasury, plays a role in measuring U.S. cross-border securities flows, which include transactions involving depositary receipts.
L3imitations and Criticisms
While depositary receipts offer significant advantages, they also come with certain limitations and criticisms. Investors holding depositary receipts are still exposed to the same risks as the underlying foreign shares, including political, economic, and foreign exchange risks in the home country of the issuing company. Furthermore, changes in regulatory compliance can pose significant challenges.
A notable concern has been the delisting risk, particularly for depositary receipts of companies from certain jurisdictions. For instance, Chinese American Depositary Receipts (ADRs) have faced ongoing threats of delisting from U.S. exchanges due to disputes over auditing oversight, where U.S. regulators have demanded full access to audit papers that Beijing has historically denied. This 2situation highlights how geopolitical tensions and differing regulatory compliance standards can impact the availability and stability of depositary receipts. Such delistings can create uncertainty for institutional investors and may force them to convert their holdings to local shares, which can be less liquid or more cumbersome to trade.
Depositary Receipts vs. Global Depositary Receipts (GDRs)
Depositary receipts is an umbrella term encompassing various types, including American Depositary Receipts (ADRs) and Global Depositary Receipts (GDRs). The key distinction between depositary receipts generally and Global Depositary Receipts (GDRs) lies primarily in the markets where they are issued and traded.
ADRs are specific to the United States market, allowing non-U.S. companies to list their shares on U.S. stock exchanges or trade over-the-counter. They are denominated in U.S. dollars and designed for U.S. investors. In contrast, GDRs are typically issued in two or more markets simultaneously, often in Europe (such as London or Luxembourg) and sometimes in conjunction with a U.S. listing. They are designed to attract a broader, international base of institutional investors and are typically denominated in U.S. dollars or euros. While both types facilitate foreign investment, GDRs offer a wider global reach, making them suitable for companies seeking to raise capital from diverse international capital markets beyond just the U.S.
FAQs
What is the primary purpose of depositary receipts?
The primary purpose of depositary receipts is to simplify the process of investing in foreign companies for domestic investors. They eliminate many of the complexities associated with cross-border trading, such as foreign exchange conversions, differing settlement systems, and foreign legal frameworks.
How do depositary receipts differ from direct stock ownership?
When an investor buys a depositary receipt, they own a certificate that represents shares of a foreign company, rather than directly owning the shares themselves. The actual foreign shares are held in custody by a depositary bank, which handles the administrative tasks. This indirect ownership simplifies trading and record-keeping for the investor.
Are all depositary receipts traded on major stock exchanges?
No, not all depositary receipts trade on major stock exchanges. Some depositary receipts, particularly those that do not meet stringent listing requirements or those from companies not actively seeking a major listing, may trade on over-the-counter (OTC) markets. The U.S. Securities and Exchange Commission (SEC) has frameworks, such as the Foreign Private Issuer (FPI) definition, that determine the reporting and listing requirements for foreign companies, which in turn affects where their depositary receipts can trade.
1Can depositary receipts be converted into the underlying foreign shares?
Yes, typically, depositary receipts can be converted into the underlying asset—the foreign shares they represent—through the depositary bank. However, this process may involve fees, and the investor would then be responsible for managing direct ownership of foreign shares, including navigating foreign broker-dealer accounts, foreign custody fees, and compliance with foreign regulations.
Do depositary receipts pay dividends?
Yes, depositary receipts generally pass on the dividends declared by the foreign company to the holders of the receipts. The depositary bank collects the dividends in the foreign currency, converts them into the local currency of the depositary receipt (e.g., U.S. dollars for ADRs), and then distributes them to the receipt holders, usually after deducting any relevant fees and taxes.