What is Depository Receipt – Mechanism, ADR, GDR and Benefits

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Depository Receipt definition, types of DRs, DRs issuance stepwise process and what are the benefits of Depository Receipts for Company and Investors. Depository Receipt is a negotiable financial instrument issued by a bank to represent a foreign company’s publicly traded debt or equity in domestic exchanges. Depository Receipt (DR) is a physical certificate which facilitates investors to hold shares in equity of other countries.

Types of Depository Receipts are –

  1. American Depository Receipt (ADR)
  2. Global Depository Receipt (GDR)
  3. European Depository Receipt
  4. Luxembourg Depository Receipt
  5. Indian Depository Receipt

ADRs are typically traded on a US national stock exchange such as New York Stock Exchange (NYSE) or the American Stock Exchange. GDRs are commonly listed on European stock exchange such as London Stock Exchange. Both ADRs and GDRs are usually denominated in US dollars, but can also be denominated in Euros.

What is Depository Receipt Mechanism, ADR GDR Benefits
What is Depository Receipt Mechanism, ADR GDR Benefits

How Depository Receipt (DR) works – Mechanism

Depository Receipt is created when a foreign company wishes to list its already publicly traded shares or debt securities on a foreign stock exchange. The company will have to meet stock exchange’s specific set of rules or requirements before listing for sale on stock exchange. Depository receipts can be traded publicly or over the counter (OTC).

Let us understand the depository receipt mechanism with an example.

Depository Receipt Mechanism - How it works
Depository Receipt Mechanism – How it works, Credit : efinancemanagement.com

Say, an Indian Software company raises funds from the American capital market by publicly trading shares on NYSE.

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There are following parties involved in Depository Receipt Mechanism –

  • Depository Bank – It is located in America that issues the Depository receipt in America.
  • Domestic Custodian – It is the local custodian bank in India chosen by depository bank. It verifies the delievery of shares by informing the depositoy bank that shares can now be issued in America.
  • Broker – Located in India having branch in America, purchases the domestic shares from the Indian market.
  • Foreign Stock Exchange – The exchange where DRs are listed.

DRs Issuance Stepwise Process

Step 1 : US broker, through an international office or a local brokerage house in India, purchases the shares of Indian Software Company and deliver to the domestic custodian (India) of the depository bank.

Step 2 : Domestic custodian bank verifies the delivery /receipt of shares by informing the depository bank that the shares can now be issued in US.

Step 3 : Based on a determined ADR ratio, each ADR may be issued as representing one or more of the Indian local shares and price of each ADR would be stated in US dollars converted from the equivalent Indian price of the shares held by the depository bank.

Step 4 : US Broker receives so formulated ADRs and proceeds for the process of listing of ADRs on stock exchange.

Thus, ADRs of the Indian software company is issued. ADRs can be traded freely among the investors and transferred from the buyer to seller on the NYSE through a procedure known as intra-market trading. All ADR transactions of the Indian software company will now take place in US dollars and are settled like any other US transaction on the NYSE.

The ADR investor hold privileges like those granted to shareholders of the ordinary shares, such as voting rights and cash dividends. The rights of the ADR holder are stated on the ADR certificate.

Benefits of Depository 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.

For 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”). Depository 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.

For 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.

More importantly, 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.

Conclusion –

Issue of ADR/GDR by a company in an overseas market gives people the opportunity to add the benefits of foreign investment while bypassing the unnecessary risks of investing outside your own borders, you may want to consider adding these securities to your portfolio. As with any security, however, investing in DRs requires an understanding of why they are used, and how they are issued and traded.

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