Incremental depository receipt: Meaning, Criticisms & Real-World Uses

What Is Incremental Depository Receipt?

An Incremental Depository Receipt refers to the process by which new depositary receipts are issued to increase the available supply in a market. This process is a fundamental operational aspect within the broader category of financial instruments, specifically those related to international investment. It allows a foreign company to expand its presence in a foreign market, such as the United States, by making more of its underlying shares accessible to local investors. When demand for existing depository receipts rises, a depositary bank facilitates the creation of these incremental depository receipts by acquiring additional shares from the foreign company's home market and issuing new receipts against them. This mechanism is crucial for maintaining liquidity and meeting investor interest in cross-border equity investments.

History and Origin

The concept underlying incremental depository receipts is as old as depositary receipts themselves, evolving from the initial establishment of American Depositary Receipts (ADRs) in 1927. The first ADR program was created by J.P. Morgan to enable American investors to buy shares of the British retail company Selfridges.⁴ This innovation sought to bridge the gap between foreign securities and the U.S. market, simplifying cross-border transactions. As international trade and capital markets expanded, the need for mechanisms to efficiently increase the supply of these instruments became evident. The ability to issue incremental depository receipts ensures that as investor interest in a particular foreign company grows, the market can readily supply more of its shares in the form of receipts without disrupting market dynamics significantly. The ongoing liberalization of capital movements, as supported by frameworks like the OECD Code of Liberalisation of Capital Movements, has further facilitated the seamless flow of funds necessary for the creation of incremental depository receipts.³

Key Takeaways

Incremental Depository Receipt refers to the operational process of issuing new depositary receipts to meet market demand.
This process allows foreign companies to expand their investor base in foreign markets, such as the U.S.
Depositary banks facilitate the creation of incremental depository receipts by acquiring underlying shares.
The mechanism helps maintain liquidity and efficiency in the trading of international securities.
It is a continuous process driven by investor demand and the mechanics of the depositary receipt program.

Interpreting the Incremental Depository Receipt

Interpreting the issuance of incremental depository receipts involves understanding market dynamics and a foreign company's strategic objectives. An increase in outstanding incremental depository receipts typically signals growing investor interest in the underlying foreign equity. This could be due to positive financial performance, favorable economic conditions in the company's home country, or broader trends in international investment.

For investors, the availability of more incremental depository receipts means enhanced liquidity and easier access to the foreign company's shares. It reflects the depositary bank's active role in managing the supply of these instruments to match demand, thereby maintaining a healthy trading environment on local exchanges, whether a major stock exchange or the over-the-counter market.

Hypothetical Example

Consider "GlobalTech Inc.," a fictional technology company based in Germany, whose shares trade on the Frankfurt Stock Exchange. U.S. investors are increasingly interested in GlobalTech due to its innovative products and strong earnings reports. Initially, its American Depository Receipts (ADRs) are trading on an over-the-counter market in the U.S., with 10 million ADRs outstanding.

As U.S. investor demand for GlobalTech's ADRs surges, the trading volume increases, and the price of the ADRs starts to diverge from the underlying shares in Frankfurt, indicating scarcity. To address this, "Transatlantic Trust Bank," the depositary bank for GlobalTech's ADR program, recognizes the need to issue incremental depository receipts.

Here's how the process would unfold:

Demand Signal: Broker-dealers in the U.S. identify strong buy orders for GlobalTech ADRs that cannot be fully met by the existing supply in the secondary market.
Share Acquisition: Transatlantic Trust Bank, or its custodian in Germany, acquires additional GlobalTech ordinary shares directly from the Frankfurt market. Let's say it acquires 1 million shares.
Deposit and Issuance: These 1 million shares are deposited with the custodian. In return, Transatlantic Trust Bank issues an equivalent number of new ADRs (assuming a 1:1 ADR-to-share ratio) in the U.S. These 1 million new ADRs represent the incremental depository receipts.
Market Adjustment: The new ADRs enter the U.S. market, increasing the total outstanding ADRs to 11 million. This additional supply helps to meet investor demand, potentially narrowing any premium that the ADRs might have developed over the underlying shares and improving overall market liquidity for GlobalTech.

This ongoing cycle of issuing incremental depository receipts ensures that the U.S. market accurately reflects the demand for GlobalTech's shares without significant friction due to limited supply.

Practical Applications

The process of issuing incremental depository receipts is vital in several areas of finance:

Market Liquidity and Price Efficiency: The continuous creation of incremental depository receipts helps ensure sufficient supply to meet demand, which contributes to robust market liquidity and helps keep the price of the depositary receipt closely aligned with its underlying shares in the home market. This prevents significant premiums or discounts that could arise from supply constraints.
International Capital Formation: For foreign companies, the ability to have incremental depository receipts issued means they can effectively tap into broader global capital markets for future capital raising activities, such as a public offering or a private placement. This access to diverse investor bases can be crucial for growth and expansion.
Arbitrage Opportunities: The seamless process of creating and canceling depositary receipts facilitates arbitrage. When the price of the depositary receipt deviates from its underlying shares, professional traders can profit by simultaneously buying the cheaper asset and selling the more expensive one, thereby helping to bring prices back into equilibrium.
Regulatory Oversight: Regulatory bodies, such as the Securities and Exchange Commission (SEC) in the U.S., oversee the issuance and trading of depositary receipts to prevent abusive practices. For instance, the SEC has taken action against financial institutions for improper "pre-release" practices, where depositary receipts were issued without the corresponding foreign shares being held in custody, disrupting the integrity of the incremental issuance process.²

Limitations and Criticisms

While essential for market functionality, the process of incremental depository receipts does have limitations and areas of criticism. One significant concern relates to potential for misuse, as highlighted by regulatory actions against certain depositary bank entities. For example, some banks have been penalized by the SEC for improper "pre-release" practices, where depositary receipts were issued without the underlying foreign shares being deposited.¹ This allowed for an artificial increase in the supply of receipts, which could facilitate abusive practices like inappropriate short selling and dividend arbitrage, distorting market dynamics and harming legitimate investors.

Another limitation stems from the inherent complexities of cross-border transactions, including fluctuating foreign exchange rates and varying settlement systems, which can add costs and risks to the incremental issuance process. While a depositary receipt aims to simplify foreign investment, the underlying process still involves navigating these international financial landscapes. Additionally, the liquidity and ease of creating incremental depository receipts are dependent on the liquidity of the underlying shares in the home market. If the home market for the foreign company's shares is illiquid, the ability to issue new incremental depository receipts to meet demand may be constrained, affecting price efficiency and investor access.

Incremental Depository Receipt vs. American Depository Receipt

The term "Incremental Depository Receipt" is not a distinct type of financial instrument in the same way an American Depository Receipt (ADR) is. Rather, it describes the process of increasing the number of existing depositary receipts, often ADRs, available in the market.

An American Depository Receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank that represents a specified number of shares of a foreign company's stock. ADRs trade on U.S. stock exchanges or over-the-counter markets, providing U.S. investors with a way to invest in foreign companies without directly trading in foreign markets or currencies.
Incremental Depository Receipt refers to the ongoing operational activity where the depositary bank issues new ADRs (or other types of depositary receipts) by acquiring additional underlying shares from the foreign company's home market and depositing them. This process is triggered by demand from investors and brokers to increase the supply of the existing ADRs in the secondary market. Essentially, an incremental depository receipt is an addition to the outstanding pool of a specific type of depositary receipt, like an ADR.

The confusion arises because the term "incremental" suggests a separate category. However, it's a descriptor for the routine issuance process that expands the total number of circulating depositary receipts, ensuring that the market for these instruments remains fluid and responsive to investor interest.

FAQs

What is the primary purpose of issuing incremental depository receipts?

The primary purpose of issuing incremental depository receipts is to meet increasing investor demand for a foreign company's shares in a foreign market, such as the U.S. It ensures sufficient supply of the depositary receipt to maintain liquidity and facilitate trading.

Who issues incremental depository receipts?

Incremental depository receipts are issued by a depositary bank, which is a financial institution that acts as an intermediary between the foreign company and the local market investors.

Are incremental depository receipts a different type of investment?

No, "incremental depository receipt" is not a different type of investment instrument. It refers to the process by which new units of an existing depositary receipt (like an American Depository Receipt) are created and introduced into the market to satisfy demand. The investment itself remains the original type of depositary receipt.

How does the issuance of incremental depository receipts impact investors?

For investors, the issuance of incremental depository receipts generally improves market liquidity for the foreign company's shares. It makes it easier to buy and sell the depositary receipts and helps keep their prices in line with the underlying shares in the foreign company's home market.