Depository receipt

A depositary receipt (DR) is a type of negotiable (transferable) financial security that is traded on a local stock exchange but represents a security, usually in the form of equity, that is issued by a foreign publicly-listed company. The DR, which is a physical certificate, allows investors to hold shares in equity of other countries. One of the most common types of DRs is the American depositary receipt (ADR), which has been offering companies, investors and traders global investment opportunities since the 1920s. DRs have spread to other parts of the globe in the form of global depositary receipts (GDRs) European DRs and International DRs. ADRs are typically traded on a U.S. national stock exchange, such as the New York Stock Exchange (NYSE) or the American Stock Exchange, while GDRs are commonly listed on European stock exchanges such as the London Stock Exchange. Both ADRs and GDRs are usually denominated in U.S. dollars, but can also be denominated in euros.

How Does the DR Work?

The DR is created when a foreign company wishes to list its already publicly-traded shares or debt securities on a foreign stock exchange. Before it can be listed to a particular stock exchange, the company in question will first have to meet certain requirements put forth by the exchange. Initial public offerings, however, can also issue a DR. DRs can be traded publicly or over-the-counter. Example
Say a gas company in Russia has fulfilled the requirements for DR listing and now wants to list its publicly-traded shares on the NYSE in the form of an ADR. Before the gas company's shares are traded freely on the exchange, a U.S. broker, through an international office or a local brokerage house in Russia, would purchase the domestic shares from the Russian market and then have them delivered to the local (Russian) custodian bank of the depository bank. The depository bank is the American institution that issues the ADRs in America. In this example, the depository bank is the Bank of New York. Once the Bank of New York's local custodian bank in Russia receives the shares, this custodian bank verifies the delivery of the shares by informing the Bank of New York that the shares can now be issued in the United States.
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Example (contd.)
The Bank of New York then delivers the ADRs to the broker who initially purchased them. Based on a determined ADR ratio, each ADR may be issued as representing one or more of the Russian local shares, and the price of each ADR would be issued in U.S. dollars converted from the equivalent Russian price of the shares being held by the depository bank. The ADRs now represent the local Russian shares held by the depository, and can now be freely traded equity on the NYSE. After the process whereby the new ADR of the Russian gas company is issued, the ADR can be traded freely among investors and transferred from the buyer to the seller on the NYSE, through a procedure known as intra-market trading. All ADR transactions of the Russian gas company will now take place in U.S. dollars and are settled like any other U.S. transaction on the NYSE. The ADR investor holds privileges like those granted to shareholders of ordinary shares, such as voting rights and cash dividends. The rights of the ADR holder are stated on the ADR certificate.

Pricing and Cross-Trading

When any DR is traded, the broker will aim to find the best price of the share in question. He or she will therefore compare the U.S. dollar price of the ADR with the U.S. dollar equivalent price of the local share on the domestic market. If the ADR of the Russian gas company is trading at US$12 per share and the share trading on the Russian market is trading at $11 per share (converted from roubles to dollars), a broker would aim to buy more local shares from Russia and issue ADRs on the U.S. market. This action then causes the local Russian price and the price of the ADR to reach parity. The continual buying and selling in both markets, however, usually keeps the prices of the ADR and the security on the home market in close range of one another. Because of this minimal price differential, most ADRs are traded by means of intra-market trading. A U.S. broker may also sell ADRs back into the local Russian market. This is known as cross-border trading. When this happens, an amount of ADRs is canceled by the depository and the local shares are released from the custodian bank and delivered back to the Russian broker who bought them. The Russian broker pays for them in roubles, which are converted into dollars by the U.S. broker.
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The Benefits of Depositary Receipts

The DR functions as a means to increase global trade, which in turn can help increase not only volumes on local and foreign markets but also the exchange of information, technology, regulatory procedures as well as market transparency. Thus, instead of being faced with impediments to foreign investment, as is often the case in many emerging markets, the DR investor and company can both benefit from investment abroad. For the Company A company may opt to issue a DR to obtain greater exposure and raise capital in the world market. Issuing DRs has the added benefit of increasing the share's liquidity while boosting the company's prestige on its local market ("the company is traded internationally"). Depositary receipts encourage an international shareholder base, and provide expatriates living abroad with an easier opportunity to invest in their home countries. Moreover, in many countries, especially those with emerging markets, obstacles often prevent foreign investors from entering the local market. By issuing a DR, a company can still encourage investment from abroad without having to worry about barriers to entry that a foreign investor might face.

Benefits for the Investor

Buying into a DR immediately turns an investors' portfolio into a global one. Investors gain the benefits of diversification, while trading in their own market under familiar settlement and clearance conditions. DR investors will be able to reap the benefits of these usually higher-risk, higher-return equities, without having to endure the added risks of going directly into foreign markets, which may pose lack of transparency or instability resulting from changing regulatory procedures. It is important to remember that an investor will still bear some foreign-exchange risk, stemming from uncertainties in emerging economies and societies. On the other hand, the investor can also benefit from competitive rates the U.S. dollar and euro have to most foreign currencies.
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Definition of Important Terms

Domestic Custodian Bank
means a banking company which acts as a custodian for the ordinary shares or foreign currency convertible bonds of an Indian Company which are issued by it against global depositary receipts or certificates;

Foreign Currency Convertible Bonds

means bonds issued in accordance with this scheme and subscribed by a non- resident in foreign currency and convertible into ordinary shares of the issuing company in any manner, either in whole, or in part, on the basis of any equity related warrants attached to debt instruments;

Global Depositary Receipts

means any instrument in the form of a depositary receipt or certificate (by whatever name it is called) created by the Overseas Depositary Bank outside India and issued to non- resident investors against the issue of ordinary shares or Foreign Currency Convertible Bonds of issuing company;

Issuing Company
means an Indian company permitted to issue Foreign Currency Convertible Bonds or ordinary shares of that company against Global Depositary Receipts;

Overseas Depositary Bank

means a bank authorised by the issuing company to issue global depositary receipts against issue of Foreign Currency Convertible Bonds or ordinary shares of the issuing company;
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What Is An ADR?
Introduced to the financial markets in 1927, an American depositary receipt (ADR) is a stock that trades in the United States but represents a specified number of shares in a foreign corporation. ADRs are bought and sold on American markets just like regular stocks, and are issued/sponsored in the U.S. by a bank or brokerage. ADRs were introduced as a result of the complexities involved in buying shares in foreign countries and the difficulties associated with trading at different prices and currency values. For this reason, U.S. banks simply purchase a bulk lot of shares from the company, bundle the shares into groups, and reissues them on either the New York Stock Exchange (NYSE), American Stock Exchange (AMEX) or the Nasdaq. In return, the foreign company must provide detailed financial information to the sponsor bank. The depositary bank sets the ratio of U.S. ADRs per homecountry share. This ratio can be anything less than or greater than 1. This is done because the banks wish to price an ADR high enough to show substantial value, yet low enough to make it affordable for individual investors. Most investors try to avoid investing in penny stocks, and many would shy away from a company trading for 50 Russian roubles per share, which equates to US$1.50 per share. As a result, the majority of ADRs range between $10 and $100 per share. If, in the home country, the shares were worth considerably less, then each ADR would represent several real shares.
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Types of ADR issues

There are three different types of ADR issues: Level 1 - This is the most basic type of ADR where foreign companies either don't qualify or don't wish to have their ADR listed on an exchange. Level 1 ADRs are found on the over-the-counter market and are an easy and inexpensive way to gauge interest for its securities in North America. Level 1 ADRs also have the loosest requirements from the Securities and Exchange Commission (SEC). Level 2 - This type of ADR is listed on an exchange or quoted on Nasdaq. Level 2 ADRs have slightly more requirements from the SEC, but they also get higher visibility trading volume. Level 3 - The most prestigious of the three, this is when an issuer floats a public offering of ADRs on a U.S. exchange. Level 3 ADRs are able to raise capital and gain substantial visibility in the U.S. financial markets. American Depository Share - ADS A share issued under deposit agreement that represents an underlying security in the issuer's home country. The term ADR and ADS are often thought to be the same. Technically, an ADS is the actual share trading, while an ADR represents a bundle of ADS's.

ADR Risks
There are several factors that determine the value of the ADR beyond the performance of the company. Analyzing these foreign companies involves further scrutiny than merely looking at the fundamentals. Here are some other risks that investors should consider: Political Risk - Ask yourself if you think the government in the home country of the ADR is stable? For example, you might be wary of Russian Vodka Inc. because of the characteristic instability of the Russian government. Exchange Rate Risk - Is the currency of the home country stable? Remember the ADR shares track the shares in the home country. If a country's currency is devalued, it will trickle down to your ADR. This can result in a big loss, even if the company had been performing well. Inflationary Risk - This is an extension of the exchange rate risk. Inflation is the rate at which the general level of prices for goods and services is rising and, subsequently, purchasing power is falling. Inflation can be a big blow to business because the currency of a country with high inflation becomes less and less valuable each day.

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The Process
The process of issuing an ADR usually starts by seeking a financial advisor, an international investment bank, or may be initiated by a foreign investment bank that recognizes the attraction to a company for its money management clients (and of course the fees generated for its own bottomline). The advisor would then contact commercial banks that can act as a depository in the foreign market and as a custodian in the domestic market and form the depository trust against shares held in the domestic market. The depository bank also carries out all the necessary corporate actions like dividend payments and voting procedures etc. The issuing company decides on the number of shares to be sold in the foreign market. After delivering these shares to the custodian bank, the custodian registers them in the depository banks name. The depository bank then issues the required number of receipts. The ratio of receipts issued to shares deposited varies from company to company. In the case of Infosys, each ADR is one half of the domestic share whereas in the case of TSP, a Brazilian telephone company, each ADR represents 1,000 preferred shares of the underlying shares.

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The Process (contd.)

To set the price of the ADR, the advisor goes through a price discovery process as dictated by the markets, participants, and the supply-demand considerations. The advisor might invite other investment banks to join it to form a syndicate. The syndicate should have more financial muscle and bigger client base to place the issue in the market. A foreign investor may find it beneficial to invest in an ADR as opposed to a domestic share, for a variety of reasons lack of custody or safekeeping agent in the foreign market, difficult settlement procedures for share purchase and transaction costs associated with foreign currencies. The ADRs, from the perspective of a foreign buyer, may be more liquid as they trade among large institutional investors and can be sold in bulk. The liquidity makes for quicker execution and less transaction costs. The issuing process usually goes smoothly, but at times hits snags or is cancelled or postponed. Unfavorable market conditions like the global crisis in 1997 and 1998 or the issuing companys reluctance to accept a market determined price for its G/ADR can upset the cart.

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Global Depository Receipt - GDR

A bank certificate issued in more than one country for shares in a foreign company. The shares are held by a foreign branch of an international bank. The shares trade as domestic shares, but are offered for sale globally through the various bank branches. A financial instrument used by private markets to raise capital denominated in either U.S. dollars or euros. A GDR is very similar to an American Depository Receipt These instruments are called EDRs when private markets are attempting to obtain euros.
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