Definition of The Depository Receipts Mechanism and Depository Receipts

The Depository Receipts Mechanism

The volume of new equity issues in the international markets increased dramatically between 1983 and 1987 and again after 1989. The ‘90s saw a growing interest in the emerging markets. From the side of the issuers, the driving force was the desire to tap low-cost sources of financing, broaden the shareholder base, acquire a spring board for international activities such as acquisitions and generally improve access to long-term funding. From the point of view of investors, the primary motive has been diversification. Some of these markets may not be readily accessible except to very high quality issuers.

When the issue size is large the issuer may consider a simultaneous offering in two or more markets. Such issues are known as Euroequities.

Issue costs are an important consideration. In addition to the underwriting fees (which may be in the 3 – 5% range), there are substantial costs involved in preparing for an equity issue particularly for developing country issuers unknown to developed country investors. Generally speaking, issue costs tend to be lower in large domestic markets such as the US and Japan.

Depository Receipts

(ADRs, EDRs, and GDRs)

During the late ‘80s, a number of European and Japanese companies have got themselves listed on foreign stock exchanges such as New York and London. Shares of many firms are traded indirectly in the form of depository receipts. In this mechanism, the shares issued by a firm are held by a depository, usually a large international bank, which receives dividends, reports etc. and issues claims against these shares. These claims are called “depository receipts” with each receipt being a claim on a specified number of shares. The depository receipts are denominated in a convertible currency, usually US dollars. The depository receipts may be listed and traded on major stock exchanges or may trade in the OTC market. The issuer firm pays dividends in its home currency. This is converted into dollars by the depository and distributed to the holders of depository receipts. This way the issuing firm avoids listing fees and onerous disclosure and reporting requirements which would be obligatory if it were to be directly listed on the stock exchange. This mechanism originated in the US, the so-called American Depository Receipts or ADRs. Recent years have seen the emergence of European Depository Receipts (EDRs) and Global Depository Receipts (GDRs) which can be used to tap multiple markets with a single instrument. Transactions in depository receipts are settled by means of computerized book transfers in international clearing systems such as Euroclear and Cedel.

In 1992 following the experience of the first ever GDR issue by an Indian corporate, a fairly large number of Indian companies took advantage of the improved market outlook to raise equity capital in international markets. During the period April 1992 to 1994, almost 30 companies are estimated to have raised a total of nearly US$3 billion through GDR issues.

From the point of view of the issuer, GDRs represent non-voting stock with a distinct identity which do not exhibit in its books. There is no exchange risk since dividends are paid by the issuer in its home currency. The device allows the issuer to broaden its capital base by tapping large foreign equity markets. The risk is that the price of GDRs may drop sharply after issue due to problems in the local markets and damage the issuer’s reputation which may harm future issues.

From the investors’ point of view, they achieve portfolio diversification while acquiring an instrument which is denominated in a convertible currency and is traded on developed stock markets. The investors bear exchange risk and all the other risks borne by an equity holder. There are also taxes such as withholding taxes on dividends and taxes on capital gains.

A major problem and concern with international equity issues is that of flowback, i.e. the investors will sell the shares back in the home stock market of issuing firm. Authorities of some countries have imposed a minimum lock-in period during which foreign investors cannot unload the shares in the domestic market.

Withholding taxes on dividends paid to non-residents reduces the attractiveness of the asset to foreign shareholders and consequently raises the cost to the issuer.

During 1993-94, GDR issues were a very popular device for many large Indian companies. Yields in developing country markets were rather low and many Indian issues offered attractive returns along with diversification benefits. The economic liberalization policy of the government made Indian issues an attractive investment vehicle for foreign investors. In subsequent years, a variety of problems with the workings of the Indian capital markets – lack of adequate custodial and depository services, long settlement periods, delivery and payment delays, suspicions of price rigging etc. – led to the wearing off of investor enthusiasm.

The world market capitalization of bonds is larger than that of equity. The international market for bonds comprises three major categories: domestic bonds, foreign bonds and Eurobonds.

Domestic bonds are issued by a domestic borrower in the domestic market, usually in domestic currency.

Foreign bonds are issued on the domestic market by a foreign borrower, usually in domestic currency. The rules and regulations governing issuing and trading procedures are under the control of the domestic authorities.

Eurobonds are issued in countries other than the one in whose currency they are denominated. They are not traded on a particular national bond market and, therefore, are not regulated by any domestic authority.

Financing and investing in the international bond markets is both technical and difficult. This stems from the vast diversity in regulation, instruments, terminology and techniques.

The Major Domestic Bond Markets

The globalization of the world’s capital markets has introduced an element of competition among the different markets and has enabled borrowers to diversify their financing sources. The World Bank’s “global bonds” issued simultaneously in September 1989 on the Eurobond market and the US domestic market are a good example.

Investors also benefit from globalization. The different domestic bond market can offer attractive diversification opportunities. They are also a source of products with unique characteristics arising from the different legal, fiscal and economic systems of the countries where they are issued.

For a firm raising funds in the international capital markets or for an investor managing an international bond portfolio, thorough technical knowledge of each domestic market is a fundamental requirement. This is an especially difficult proposition because there is a wide variety of instruments available. They range from classic fixed interest bonds, through FRNs, zero coupons, convertibles and bonds with warrants attached to the more exotic varieties with simultaneous call and put options or links to an index such as a stock market or gold. Trading and quotation practices concerning the various instruments can vary from market to market. In Europe, dealing and quotations are usually handled by brokers on the exchanges, although Germany. The Netherlands, Switzerland and the United Kingdom do some over-the-counter trading of non-government issues. In the United States most trading in domestic bonds is handled over the counter, while in Japan bond trading takes place over the counter and on the exchanges. When trading is handled over the counter, it is difficult to estimate costs which are hidden in the bid-ask spread. Even when commissions are charged by brokers on the organized exchanges, the fact that they are negotiable makes it hard to come up with an average figure.

Price and yield quotations also differ from market and it is important to know and understand these differences when comparing the relative merits of different domestics bonds.

Asian Currency Market

Asian dollars are the same current account surpluses in dollars used in the Asian continent. Singapore has developed as the centre for this market, particularly after 1968. This market facilities the use of dollar balances in the Asian continent for balance of payments purposes as well as for investment in development projects. It has imparted greater liquidity to the Asian economies whereby larger trade and larger investment became possible in this region. There was also greater co-operation in economic and financial matters as a result of the Asian dollar market in many centres in the region such as Hongkong, Sydney and Manila.

Source and Uses

The main sources of funds for the market came from varied groups individuals, corporations, commercial banks, international institutions, multinationals, the central banks, the governments etc. Thus, a part of the dollar deposits is owned by the US banks and US nationals. Originally, the market had grown without any official favour and as an off-shoot of pure private enterprise. Subsequently, when it reached a state of significant dimensions which no single nation could control, all governments and international institutions began to consider it respectable and partake in its operations. Borrowers and lenders in the market are only banks insofar as the inter-bank segment is concerned. Among the non-bank public, companies in export and import business or in investment business or multinationals in need of funds and governments or central banks for balance of payments purposes figure prominently in the non-bank markets. Among borrowings, bulk of it is for commercial operations by non-bank public and business corporations.

The Euro-currency market has no geographical limits or a common market place. Business is done by telex, telephone and other communication systems. Internationally- reputed brokers put through the transactions for the banks. Deposits are secured for the banks operating in the market by the general guarantee of its parent or holding company and in some cases, by its central bank and /or the government of the concerned country. Similarly, loans to commercial parties are guaranteed by their respective governments. Deposits and loans to banks are, however, not guaranteed except by the banks parent companies or their exchange control authorities.

The amounts of loans and the periods of maturity vary over a wide range from a few thousands to millions of dollars and from call loans to maturities extending up to 10-15 years. Some of the loans may be syndicated and jointly sponsored by a number of banks. There are also varied interest rates of floating rate notes.