Most countries have regulations that limit the circulation of foreign securities on the national exchange and limit the ability of foreign residents to purchase domestic securities. This was done in order to exclude the possibility of significant influence on the national exchange market by large foreign corporations and to reduce the influence of foreign capital. For example, large Russian companies have been listed not only on the Moscow Exchange, but also on foreign exchanges. But if their shares are traded on the Moscow Exchange, then on foreign exchanges their papers are presented in the form of ADRs and GDRs.
In order for the national investor to be able to buy foreign stock assets without facing legal restrictions, the following mechanism was invented:
- The issuer issues shares.
- One part of the shares goes to the national exchange. Here securities are freely available, investors buy shares with a corresponding entry in the register of shareholders.
- The second part of the shares is sent to the custodian bank. The bank is in national jurisdiction, the shares transferred by the issuer are stored here.
- In a foreign jurisdiction, the depositary bank issues depositary receipts (DR) in accordance with the number of shares held by the custodian bank.
- Depositary receipts are entered on the stock exchange of foreign jurisdiction.
A depositary receipt is a tool that makes it possible to invest money in foreign securities while remaining on the national exchange. ADR (American DR) and GDR (global DR) have the same essence. The only difference is that ADRs are issued only in the USA.
The depositary receipt is actually secured by shares that remain in the country of the issuer as collateral with the custodian bank. They also allow you to receive dividends on them, are freely placed on the stock exchange in another country, but there may be nuances related to local legislation.
Differences between ADRs and GDRs from shares:
- Denomination. The total nominal amount of depositary receipts corresponds to the total nominal amount of shares. But not necessarily 1 DR = 1 share.
- Ownership. The legislation of some countries prohibits individual investors from investing in foreign assets. For example, government officials.
- Taxation. Since shares and receipts are traded in different jurisdictions, there is a difference in the taxation of both trading profits and dividends.
- Liquidity. It is less for depositary receipts. The reason is lesser interest in foreign securities compared to national ones. For example, Gazprom shares will have a larger trading volume in Russia with local investors than LSE receipts with UK investors.
- Currency of circulation. The shares are denominated in the currency of the country in which they are placed. Receipts are similar. Therefore, Gazprom’s shares will be nominated in rubles, depository receipts in the US – in USD. Investors use this moment to insure risks – buying DR in foreign currency can protect against inflation (depreciation of the ruble relative to freely convertible currencies). But the question is in what currency the issuer receives income. If in rubles, then the assessment of the value of shares in national currency will be a key parameter.
- Pricing and spread. The price is determined by liquidity – trading volumes and investor interest. The exchange rate is on average the same, taking into account the adjustment for the exchange rate. The spread is already in the shares.
What to choose for an investor. Previously, when the CIS stock market was less regulated and more in line with a market economy, Russian issuers sought to gain access to foreign capital. Therefore, depository receipts were issued on the NYSE or LSE exchanges. Investors prefer stocks in their home country. If you have been living in the issuer’s country for a long time, you are familiar with local legislation and have a close understanding of how the local financial market works. But if ordinary shares of a local company are not available on the local market, you can replace them with depositary receipts. The purchase of Russian DR companies on foreign exchanges is advisable when an investor works exclusively with foreign assets in the US and European markets, and it makes no sense for him to register on the CIS markets in order to purchase a security of one Russian issuer.