What is a Depositary Receipt?

A depositary receipt refers to a financial instrument for negotiation issued by a bank that represents the publicly traded shares of a foreign company. The financial certificate gives investors a chance to hold foreign countries equity shares since the shares cant leave their home country. It also gives investors the opportunity to trade on international markets.

How Does a Depositary Receipt Work?

Depositary receipts (DRs) in its original form was a physical certificate. It allows investors to shares inequity in foreign countries. American depositary receipts (ADR) is a type of DRs that trades in the United States. From the 1920s, ADR has been offering investors, companies, and traders opportunities to invest in the global markets. The financial instrument has since spread across the world as global depositary receipts (GDRs). Note that GDRs is another most common type of depositary receipt after the ADRs. ADRs trades in the United States national stock exchange. Examples of such include the New York Stock Exchange (NYSE). The GDRs usually trades on the European stock exchanges. A good example is the London Stock Exchange. The denomination of both the ADRs and GDRs are mostly in U.S. dollars, but euros are also used as a denomination.

How do Depositary Receipts Work

Depositary receipts are widespread across the globe, and the most common is the ADRs. The ADRs trades on either of the following: NYSE, AMEX, or Nasdaq. For instance, any time an investor purchases ADRs, there is a listing of the receipt in U.S. dollars. The U.S. financial institution abroad is the one that takes care of the real underlying security. Depositary receipts are usually issued by investment banks. The process involves, buying of shares from foreign companies and grouping them into packets. One packet usually consists of 10 shares. Each packet is issued as a DR on the local stock exchange. The holders of ADR shares dont have to do the transaction in foreign currencies. The reason is that ADRs trading happens in U.S. dollars. The ADRs clearance is also through the United States settlement system. It is a requirement by the U.S. banks that foreign companies provide them with comprehensive financial information. The process enables investors to easily assess the financial status of the company and compare it with that of the foreign company transacting on international exchanges.

Types of Depositary Receipts

Investors in different regions use different terms to refer to depositary receipts. However, the DRs work the same way. They include the following:

• American Depositary Receipts (ADRs)

Investors in the United States access foreign stocks through ADRs. The ADRs are only issued by the U.S. banks, for those stocks that trade on the U.S. exchanges. Examples of exchanges include NASDAQ and NYSE respectively.

• European Depositary Receipts (EDRs)

European depositary receipt is another type of DRs, which allows European investors to access locally traded shares in foreign companies. Issuing of EDRs is done using any of the European currencies. However, the euro being the most common currency in the region, it dominates the market.

• Global Depositary Receipts (GDRs)

GDRs is a combination of EDRs or ADRs. GDRs represent non-American depositary receipts. Investors in developed markets mostly use GDRs where they invest in either emerging markets or frontier.

Advantages of Depositary Receipts

When it comes to depositary receipts, investors are able to benefit from certain rights. The rights include voting rights as well as opening up global markets to investors, an opportunity that would have been impossible without DRs. A good example is ICICI Bank Limited. The fact that the bank is listed in India, it is not available to foreign investors. Nonetheless, Deutsche Bank, which trades on the NYSE, has issued the bank with ADRs which give U.S. investors access. To be able to navigate regulations when creating DRs, a foreign-listed company will always hire a financial advisor to offer assistance. The company may also approach a domestic bank to act as a broker and custodian in the country of interest. What the domestic bank does is to list the company's shares on an exchange like the NYSE.

Depositary Receipts Pros and Cons

Like any other financial instrument, DRs have pros and cons too. They are as follows: 

Pros

• Companies depositary receipts give investors an easy way of raising capital globally, hence encouraging international investment
• Investors are able to diversify their portfolios
• Investors can purchase shares in foreign companies at a low price. The process is also convenient

Cons

• DRs may not be suitable for investors because sometimes DRs are not listed on the stock exchange. In such cases, only institutional investors trade them.
• Depositary receipts have low liquidity
• DRs are risky because securities do not have any backing from companies
• Withdrawal of DRs is anytime. Also, investors have to wait when it comes to selling shares and distributing proceeds
• DRs sometimes may have high administration charges.