A negotiable instrument that is issued by a bank to act like shares in a foreign public company and allows investors to trade in the global markets is known as a depositary receipt.
It is a type of physical certificate through which investors can hold shares in the equity of other countries.
The American depositary receipt (ADR) is one of the most common types of DRs, which has been offering investors, companies, and traders an opportunity for global investment since the 1920s.
They were basically created to reduce the complexities of investing in foreign securities.
In old times when investors wanted to purchase shares in a foreign company what they need to do was to exchange their money into foreign currency and then opening a foreign brokerage account. This would enable them to buy shares via the brokerage account on a foreign stock exchange.
The introduction of depositary receipts obviates the entire process and makes it less complicated, simpler, and more convenient for the investors to invest in foreign companies.
The process for the issuance of depository receipts is as follows;
- Firstly, an investor is required to communicate with a broker in a local bank if he/she is interested in purchasing depositary receipts.
- Before making a decision to buy shares, the local bank (which is called the depositary bank) in the investor’s home country will make an assessment of foreign security.
- The broker in the depositary bank will procure the shares either on the local stock exchange or in the foreign stock exchange by using another broker in a foreign bank (custodian bank).
- After the procurement of the shares, the depositary bank will ask the shares to be delivered to the custodian bank.
- After receiving the shares by the custodian bank it will be issued to the depositary bank as a depositary receipt that is traded on the bank’s local stock exchange.
- A notification is sent to the broker, who will deliver it to the investor and debit the fees from the investor’s account when the depositary bank receives the depositary receipts from the custodian bank.
Depositary Receipts are of the following types:
1) American Depositary Receipt (ADR)
This depositary receipt is listed only on American stock exchanges and can only be traded in the U.S. Dividends are paid to the investors in U.S. dollars.
2) European Depositary Receipt (EDR)
EDRs are only listed on European stock exchanges and can only be sold and bought in Europe. It pays dividends in euros. It can be said that these depositary receipts are the European equivalent of ADRs.
3) Global Depositary Receipt (GDR)
Any depositary receipt that is not generated from your home country is called a global depositary receipt.
Advantages of depository receipts (DRs)
The following are some of the advantages of depository receipts;
1) Less international regulation
Investors are not required to worry about international trading policies and global laws since these DRs are traded on a local stock exchange.
2) Exposure to international securities
Through depositary receipts, investors can diversify their investment portfolios. They do so by gaining exposure to international securities in addition to securities offered by local companies.
3) Additional sources of capital
It provides the companies with a way to raise more capital by tapping into the international markets and attract more foreign investors around the world.
Limitations of DRs
The following are some limitations of DRs;
1) Limited access for most investors
Sometimes, depositary receipts may not be listed on stock exchanges, and for this reason only institutional investors can invest in them which might be the companies or organizations that execute trades on behalf of the clients.
2) Higher risk from forex exchange rate fluctuations
There is a greater risk owing to volatility in foreign currency exchange rates as if an investor buys a depositary receipt that represents shares in a British company so its value will be impacted by the difference in the exchange rate between the British pound and the currency in the buyer’s home country.
3) More administrative and processing fees, and taxes
Administrative and processing fees might be higher in this whole process of depositary receipts because one needs to compensate for custodial services from the custodian bank and also there would be high taxes that are to be paid.
For instance, ADRs get the same dividend taxes and capital gains as like other stocks in the U.S. However, the investor is required to pay the foreign country’s taxes and regulations in addition to regular taxes in the U.S.