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Understanding Depository Receipts

BY: Vivek SHARMA | Category: Finance | Submitted: 2011-01-29 07:37:09
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Article Summary: "The article gives a brief overview of depository receipts and their functioning.."


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Depository receipts (DRs) are financial instruments that have the shares of a foreign company as an underlying, but are traded in an investor's domestic market. This essentially means that an UK share can be traded as ADR in US Markets. These receipts further are traded in investor's domestic currency and also follow the financial regulations operating in the investor's domestic market.

The holder of DR also receives dividends in its own local currency. American Depository Receipts (ADRs) are the most widespread form of DR in circulation. ADRs are issued in the US in US dollars and provide a mechanism through which US investors can reduce the costs and risks associated with investing in non-US companies.

Two types of banks are typically involved in launching an ADR on a US exchange: an investment bank and a depository bank. The investment bank purchases foreign shares in a foreign market and offers them for sale in the US. The depository bank handles the issuance and cancellation of ADR certificates to meet investors' orders, with each ADR commonly backed by the requisite number of underlying shares held in the local Central Securities Depository (CSD).

Let us try to understand the entire process through an example. A US investment bank, ABC, purchases one million shares in UK company XYZ which is listed on the London Stock Exchange. After this as the next step, ABC registers the shares with the US regulator,' Securities and Exchange Commission', which will facilitate issuance and marketing of ADRs in XYZ. After the approval has been received, ABC approaches the New York Stock Exchange for listing and trading of XYZ ADRs on the exchange. Effectively, the XYZ ADR is a repackaged XYZ share, backed by XYZ shares that are owned by NYC.

The valuation of ADRs is in US dollars and these ADRs trade like any other share on the NYSE. ABC will also set up an arrangement with a custodian bank which will act as the depository bank for the ADRs. Once the agreement has been done, the underlying shares are then registered in the depositary's name, which will then handle the day-to-day interaction with ADR holders. The ADR certificate sets out the responsibilities of the depository bank and defines its responsibilities in terms of actions such as payment of dividends, voting at shareholder meetings, and how it should handle rights offers.

It is the job of depository bank to receive dividend distributed by XYZ and distribute it to XYZ ADR holders in US dollars in direct proportion to their ADR holding. If XYZ withholds tax on the dividends before this distribution then the depository bank will withhold a proportional amount before distributing the dividend to ADR holders.

Holders of the XYZ ADR may trade the ADR in the secondary market, or OTC, just like any other US-listed security. The ADR holder is entitled to instruct ABC to cancel the XYZ ADR at any point and to convert this back into the underlying XYZ share. ABC, as investment bank, will typically receive a commission or management fee for overseeing the ADR issuance and marketing process.

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