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Global Depositary Receipts

Date 29/10/2008

Chris Prior-Willeard, Bank of New York

Global Depository Receipts (GDRs) have come into prominence recently as being the favoured instrument by which companies from emerging markets such as Russia, India and China raise capital on western stock exchanges. Yet GDRs are rarely fully understood by the people that use them, either because they appear ‘complicated’ (they are not) or because they are thought to be something to do with the ‘back office’ (this is only true of the settlement of GDRs). This article is intended to explain more about these instruments and to provide some commentary about their role in the wider marketplace.

Until now, the restricted circulation of knowledge about GSRs has not been a significant problem for the small number of banks with the ability to issue GDRs, since the traders in emerging markets were happy to quote prices for GDRs as much as they would for ordinary shares and in fact pretty much anything else. However, there are now some awesomely large Russian companies which are actively traded outside Russia in GDR form, and a growing host of other companies from emerging markets around the globe. These are attracting the attention of regulators, portfolio strategists, derivative traders and others, and the demand for knowledge about GDRs is therefore increasing.

The objective of a GDR is to enable investors in developed markets, who would not necessarily feel happy buying emerging market securities directly in the securities’ home market, to gain economic exposure to the intended company and, indeed, the overall emerging economy using the procedures with which they are familiar.

Depository Receipts (DRs) have a long and respectable history. These instruments have served for decades to reduce obstacles to investment between one market jurisdiction and another. Putting it more simply they convert, say, a UK share into a US share. And although the same share is governed by two very different regulatory regimes, it trades happily in both regimes without needing any surgery (structuring) whatsoever.

Importantly, the prices of that same share trading in the US and the UK, albeit in different currencies, remain linked.

The history of the GDR began in the late 1920s when Selfridges, the London department store, decided to expand its investor population in the US. The rules in the UK governing the transfer of shares were strict: all transfers were required to pass through the list of registered holders held by the share registrar, who was invariably located in England. In those days it was not felt necessary to specify the geographic scope applying to this rule. Therefore if a US investor in Selfridges wished to sell his shares to another investor via the New York Stock Exchange, the transfer was not considered legal until a two-legged communication had been successfully completed with the UK share registrar.

With the Cunard liners of the day taking four days to cross the Atlantic carrying the mail, the whole process of trading a UK share in New York could take weeks before final settlement was complete.

A US bank, Guaranty Trust, solved the problem by holding the Selfridges shares in London in its own name, which was recorded on the UK register, and then issuing promissory notes representing those shares in New York. Being both denominated in US dollars and issued against a US legal contract with investors, the promissory notes traded as US securities in New York and worked in exactly the same manner as other US securities. Ownership of the promissory notes was recorded in a US-held register.

These promissory notes became known as American Depositary Receipts.

Since then a surprisingly large number of markets have used the DR format to overcome the difficulties of investing across national and economic borders. These include to mention a few:
  • Austrian
  • Australian
  • Belgian
  • Brazilian
  • Canadian
  • Dutch
  • German
  • Indian
  • Japanese
  • Korean
  • Russian
  • South African
  • Swedish
  • Swiss
  • Taiwanese

However, all these DRs share one important characteristic: they can be exchanged for the shares they represent in their home market. In other words, the DRs can be cancelled by the holder surrendering them to the issuing or depository bank, whereupon the shares they represent will be released to the investor in the home market.

This ‘exchange’ facility is important as it ensures a price linkage between the two markets. Clearly, if the price of the DRs began to deviate upwards from a practical price of the home share, there would be economic benefit to DR holders in cancelling DRs and selling underlying shares in the home market.

New sponsored DRs

Source: Bank of New York Mellon

New sponsored DRs by exchange, 2007

Source: Bank of New York Mellon

That is not to say that price aberrations do not occur, and they do – but the ‘exchange’ process provides a channel whereby some price equilibrium can be reintroduced between the two marketplaces.

Where there is market demand for GDRs, the two ways in which this can be satisfied is by a purchase of GDRs in the secondary market, or by using the creation process to increase the GDR market supply.

The creation of GDRs requires that the appropriate number of underlying shares be delivered to the depository bank’s custodian, which verifies the receipt of the shares and holds them on behalf of the depository. The depositor, on being notified of the delivery, issues GDRs to the stipulated amount and updates the register.

In this manner a Russian share can be made to trade as an English security, a US common stock or, for that matter, an Australian share. The depository bank can issue GDRs into any jurisdiction for which there is widespread investor demand and will tailor the terms and conditions of the GDRs to accommodate the legal jurisdiction concerned.

In the recent past, the two stock exchanges most associated with GDRs have been Luxembourg and London. In the early days of GDRs in the late 1980s, Luxembourg was initially seen as the logical listing domicile due to its historic role in the Eurobond market and its direct communications with Euroclear and Clearstream, the prime settlement providers of this market. These organisations are used to handling securities transactions in a variety of foreign securities and in coping with the complexities of corporate actions coming from economies that do not necessarily have the same traditions of corporate reporting and shareholders’ rights.

A few years later, the London Stock Exchange successfully carved a niche in the GDR business by applying a ‘light touch’ regulatory approach to listing and by providing secondary market liquidity through the International Order Book, a trading platform operated by the exchange.

Annual DR trading via the International Order Book

Source: Bank of New York Mellon

As a result, a large proportion of listed GDRs have chosen London as their listing and trading venue, whilst the settlement of bargains in GDRs continues to be directed through Euroclear and Clearstream.

More recently, however, as competition between stock exchanges has ignited into full blazing fury, GDRs have been seen by other stock exchanges as an attractive path towards offering their own trading service and investment opportunities in foreign securities, relying on the standardising effect of GDRs to reduce the complexities of quoting a mix of foreign companies. This standardisation reduces the investment required in specialised skills and systems to an absolute minimum. As a result, GDRs offer stock exchanges a method to grow their activities and reputation outside the confines of their domestic marketplaces.

Total sponsored DRs

Source: Bank of New York Mellon

Total sponsored DRs by country, 2007

Source: Bank of New York Mellon

The result has been an increase in the number of stock exchanges in Europe and the Far East quoting and trading GDRs, and a few also looking to attract GDR listings for initial public offerings from emerging markets.

It is not all one-way, however, because domestic market regulators can view a foreign listing by a large local company as an export of capital and liquidity from their economies, resulting in their own markets missing out in the ‘great capital markets circus’. As a result it is not unknown for these regulators to impose a cap on the proportion of issued share capital that is allowed to be listed abroad, or alternatively to place a restriction on the proportion of foreign shareholders allowed on the register of a domestic company.

The problem in this is that it ignores the reason why domestic issuers look abroad to raise capital and engage with major foreign investors. In markets where there is a plentiful supply of domestic capital, the attractions to issuers of a foreign listing are greatly diminished. And these attractions are a mixture of tax, regulation and a generally helpful approach to investment. For example Benn Steill, in his study of the European equity markets in the mid 1990s, highlighted the practice of a number of European authorities at the time of restricting their government pension funds to investing only in domestic government securities. The effect of this policy was to remove a great deal of potential capital and liquidity from their own securities markets, driving both their own issuers, not to speak of foreign issuers, to look elsewhere to raise equity finance.

This was justified, of course, as being the fault of the rapacious international capitalists, but miraculously when more enlightened governments removed this restriction, not only did the local markets thrive but they began to attract foreign consumers of capital.

Into this situation comes the GDR.

For regulators, unused to dealing with the interface between foreign and domestic regulation and practices, GDRs offer foreign securities in a form that domestic regulators can recognise and treat effectively as domestic securities.

More progressive regulators recognise that there is an essential difference in the investment needs of sophisticated and institutional investors, who have a requirement for foreign securities, and retail investors, who are assumed to want to buy into local companies alone. The result is a differentiation of the listing rules and access to trading platforms, so that professional investors are able to undertake their own due diligence on foreign companies and to trade with their peers on professional trading platforms.

This policy ignores an inconvenient reality: Many foreign companies who might wish to establish a listing have globally recognised brands for the goods and services they sell. As such, it is not just the trade investor, but retail investors as well that, recognising the excellence of a brand, may want to gain investment exposure to it.

Confining foreign share investment to professionals can serve to deny access by investors to companies they would like to own. In turn, it denies companies access to interested investors who can form useful populations of loyal and long-term stock holders.

In this situation a GDR works well. Like its older brother, the American Depositary Receipt, it can perform as an ideal domestic instrument and, with the depository bank’s assistance, may trade, clear and settle in almost any domestic market. Shareholder entitlements in GDRs are laid out contractually within the programme documentation; dividend streams are handled by the depository banks who themselves are some of the biggest players in international cash management and foreign exchange.

Voting and corporate actions of the most complex kinds are processed by the GDR depository bank’s specialists who have many years of experience in handling these. The dominant provider of these services offers an integrated stock transfer and share registrar service, ensuring that GDR holders receive a high quality service, reinforced by in-house call centres, multi-language capabilities and a range of self-help web services.

By opting to use GDRs as the preferred instrument for cross-border investment, a stock exchange is able to import leading edge shareholder administration and servicing on a scale that domestic providers may not be in a position to deliver to investors buying foreign securities. This is the principle function of the ADR, which is very much a retail instrument in the US market.

Currently, however, the majority of GDRs are held in Euroclear and Clearstream within their participants’ accounts. Downstream servicing to a retail level is thereby held in abeyance as professional investors are content to delegate the administration of their foreign holdings to custodian banks, who undertake these administrative services for their customers. However, as more stock exchanges adopt the use of GDRs the capability of the instrument to service retail investors may become more widely appreciated.

On the other hand, of course, much retail investment is now directed toward mutual and investment funds, themselves important users of GDRs. So the results of regulator policies designed to attract and cultivate retail participation in the stock market may often be successful, but through the take-up by retail investors of collective investment schemes rather than trading the shares directly.

The experience of the US suggests that regulators find DRs an effective way to police and monitor foreign investment. Moreover, the DR depository bank acts as a convenient hub for information on DR programmes and an effective method of broadcasting the US listing rules and requirements which apply to companies from foreign markets.

This central role of the depository bank is further underpinned by the concept of sponsorship. In the same manner as companies are required to employ a sponsor when they list on certain markets, sponsorship of a GDR describes the exclusive relationship between a company and its depository bank. This exclusivity ensures that only one bank can issue GDRs for the company. This arrangement, whilst commercially attractive to the bank, also avoids confusion whilst ensuring direct and efficient channels of communication.

Many GDRs may be set up with the additional capability to access US private placements, termed the Rule 144a market. This facility enables GDRs to flow across the Atlantic and into a prescribed population of sophisticated US investors. The attendant trading activity in this market may not compare well with the activity in Europe, but for capital raising it is an important additional attribute of the instrument.

Reflecting both the current investor interest in emerging economies and the logistical advantages of GDRs in facilitating this investment, a number of derivative exchanges in Europe have announced their intention to get involved with GDRs. So far this has translated into the establishment of stock indices based on Russian GDRs and launching traded options and single stock futures on the GDRs and their indices. Whilst this is not a new phenomenon, since the CBOE has for years traded options on listed ADRs in the US, using GDRs in this manner is formal acknowledgement of the role that these instruments play in standardising foreign shares against overseas jurisdictions and practices.

At the same time there are moves to add central counterparty clearing to GDR trades which are expected to offer a number of advantages, including the removal of counterparty risk, reduction of trading costs through netting and increased liquidity resulting from the lower friction on cleared GDRs. Time will tell, although the fact that GDRs will be handled in precisely the same manner as other cleared domestic securities further promotes them as an effective surrogate for foreign securities.

This makes surprising a recent comment from a UK firm of auditors that GDR issuers have effectively avoided many of the standard controls and disclosure requirements which are observed by other issuers listing in London. This has little to do with GDRs as such, and more toward the willingness of UK regulators and exchange operators to introduce special accommodation for issuers from emerging markets in order to compete with other financial centres in attracting these listings.

It is the reduction in standards in order to compete that generates the cause for complaint from investors, who feel that the packaging on the security suggests that they are admitted to the Official List, and therefore a listed security, when the reality is different.

Where foreign issuers decide to list on the main market and therefore undertake to satisfy the most onerous obligations of a London listing, they may use GDRs. The GDR will satisfy the legitimate disclosure requirements of any regime to which it is exposed, whether that be the lightest touch imaginable or the full onus of account reconciliation, language translation and quarterly reporting.

Looking to the future, detractors express their envy of the DR business by forecasting a global market in which there will be one stock exchange, one listing and similarly harmonised treatment of investors and their rights and obligations. They claim that in this totally fungible world there will be little need for GDRs.

But just as the GDR developed from the shortcomings of established markets of the day to handle foreign securities, issuer demand for an efficient means to discharge their obligations to regulators and investors alike across borders is likely to continue, as new markets come on stream and issuers need to raise capital outside their borders. As long as domestic regulators insist on regulating their own markets, and not ceding this function to a neighbour; as long as rules of equity and corporate governance remain a matter of national sovereignty; as long as national capital markets retain their own identity; then a cross-border vehicle like GDRs will be needed to normalise the investment attributes of foreign shares to the domestic practices and preferences of an investor pool.

Over time GDRs will change in character, reflecting the forces of dematerialisation and the forthcoming surveillance and other regulatory treaties between principle regulatory bodies, and above all the demand from the various market participants that benefit from the characteristics of GDRs. As settlement systems link and stock exchanges perform tricks normally attributed to sea lions, the added value of GDRs in delivering information, rights of ownership and alternatives for liquidity will continue to thrive in these new environments.

The world is still a very difficult place for multinational companies to operate in and raise capital. GDRs are a recognised and effective means for these companies to deal with this business environment.