In order to understand depository receipts, one needs to clearly understand their intricacies. You may have heard someone refer to ‘depositary receipts’ as American depositary receipts (ADRs) and global depositary receipts (GDRs); thus, understanding these concepts is crucial.
In this article, we explore the meaning of depository receipts and understand the differences between ADR and GDR to help you make informed decisions and enhance your financial portfolio.
What is a Depositary Receipt?
A Depositary Receipt (DR) is a negotiable certificate issued by a bank. It represents shares in a foreign company that are traded on a local stock exchange. DRs provide investors with the opportunity to hold shares in foreign companies without needing to trade on international markets.
Historically, DRs were physical certificates. Today, one of the most common types of DRs is the American Depositary Receipt (ADR), which has been facilitating global investment opportunities since the 1920s.
Understanding depository receipts
Depositary receipts (DRs) enable investors to purchase shares in foreign companies on their local stock exchange, without the need to invest directly in a foreign market. This eliminates the complexities of foreign currency exchange and international brokerage accounts.
By investing in DRs, investors can diversify their portfolios and gain exposure to global markets. This makes international investing more accessible and convenient.
Types of depository receipts
Overall, DRs can be categorised into three different types: American depositary receipts (ADRs), global depositary receipts (GDRs), and sponsored or unsponsored depositary receipts. We will mainly focus on the differences between ADR and GDR, as both make it easy to access growth stocks across different markets.
1. American Depositary Receipts (ADRs)
By utilising ADRs, it becomes fairly convenient for investors to access foreign stocks. Only U.S. banks can issue ADRs for foreign stocks traded on a U.S. exchange. Moreover, if you purchase an ADR, the receipt will be listed in U.S. Dollars. The actual underlying security is held by a U.S. financial institution instead of a global institution. In addition, ADRs are an excellent way of purchasing shares in a foreign company while being paid dividends stocks and earning capital gains.
If you own an ADR, you are not required to transact in foreign currencies since ADRs trade in U.S. Dollars. An ADR gets cleared via the U.S. settlement systems. Additionally, foreign companies must provide U.S. banks with comprehensive financial information. This is done to ensure that investors can easily calculate the business’s financial health compared with a foreign company, which only transacts on international exchanges.
For example, a bank that is only listed in India and is usually unavailable to foreign investors can have an ADR issued by a foreign bank that trades on the New York Stock Exchange (NYSE), which is accessible to most U.S-based investors.
2. Global Depositary Receipts (GDRs)
The difference between ADR and GDR is that in today’s financial landscape, DRs have reached other parts of the world and are known as GDRs. These are also referred to as European and international DRs. Unlike ADRs, GDRs are generally registered on European stock exchanges. Typically, both GDRs and ADRs are denominated in U.S. Dollars; however, GDRs can also be denominated in Euros.
One should note that a GDR operates like an ADR, albeit in reverse. Moreover, if a company based in the U.S. wishes to list its stock on the London Stock Exchange, it can do so using a GDR. The said company can enter into a DR agreement with the depository bank in London. In exchange, the bank can issue shares in England depending on the regulatory compliance of both countries.
3. European Depositary Receipt (EDR)
EDRs are the European equivalent of American Depositary Receipts (ADRs). They are listed on European stock exchanges and can only be traded within Europe. EDRs pay dividends in euros and trade like ordinary shares.
How are Depositary Receipts issued?
To purchase Depositary Receipts (DRs), an investor should contact a broker at a local bank. The local bank, known as the depositary bank, assesses the foreign security before purchasing shares.
The bank's broker acquires the shares either on a local stock exchange or through a foreign broker, known as the custodian bank. Once purchased, the shares are delivered to the custodian bank.
The custodian bank then groups the shares into packets of 10 and issues Depositary Receipts to the depositary bank. These DRs are then traded on the local stock exchange.
The depositary bank notifies the broker, who delivers the DRs to the investor and charges a fee
Advantages and disadvantages of depository receipts
To help understand DRs better, we have listed down the advantages and disadvantages of DRs in the following table:
We can infer from the above table that DRs offer investors a range of advantages, including portfolio diversification, cost savings compared to direct trading, and access to foreign markets. However, they come with certain restrictions, such as limited listing on exchanges, currency risks, and liquidity issues.
Final thoughts
Upon exploring DRs, including ADRs and GDRs, it becomes evident that these financial instruments offer a pathway to diversification, cost efficiency, and access to foreign markets, particularly in acquiring foreign stocks. However, challenges such as limited exchange listings, currency risks, and liquidity concerns underscore the need for cautious consideration. By weighing these factors, investors can harness the benefits of DRs while mitigating potential drawbacks, fostering informed decision-making, and enhancing their global investment strategies.
