Technology has facilitated integration which in turn has increased diversification opportunities for investors.
One barrier to investing in a global context is the restrictions imposed by governments. These restrictions are imposed to:
- prevent control of local companies by foreigners,
- allow local investors to own foreign companies operating in the country, and
- to prevent sudden capital outflows, resultant currency devaluations, and equity market meltdowns.
Studies have shown that reducing restrictions results in improved equity market performance over the long run. It is most important for companies in emerging markets because they no longer must be concerned with a lack of capital.
One of the methods of investing in foreign markets is to invest directly in that market. But this approach is prone to a few problems: cash flows are in foreign currency, hence the foreign exchange risk, non-familiarity with local market clearing processes and regulation which leads to volatility and lack of transparency, potentially less liquidity, etc.
Better modes of investment include depository receipts and global registered shares.
A depository receipt is a security floated/traded on a local exchange which represents a stake in a company listed on a foreign exchange. When a certain number of shares of a foreign company are placed with a depository bank (depository) of the local country, the depository issues depository receipts backed by those shares. The role of the depository bank is that of the custodian and registrar. The value of depository receipts depends on the operating performance and position of the foreign company, market conditions, analysts’ recommendations, currency fluctuations, etc.
Sponsored vs unsponsored depository receipts
If the foreign company itself participates in the process, such depository receipts are called sponsored depository receipts. In the case of unsponsored depositary receipts, a depository institution buys the foreign company shares and issues depository receipts on its own. In case of sponsored depositary receipts, investors have rights identical to that of a common shareholder of the company while in case of unsponsored depositary receipts, the depository institution retains all voting rights. Sponsored depositary receipts are subject to greater reporting requirements.
There are two types of depository receipts: global depository receipts and American depository receipts.
Global depository receipts
Global depository receipts are depository receipts issued outside the US and the home country of the company whose shares back those GDRs. Even though most GDRs are issued in US Dollars, many are issued in Pound Sterling and Euro.
The main advantage of a GDR is that it helps the investors circumvent foreign ownership and capital flow restrictions. The issuing company selects the exchanges it wants to float its GDR on considering factors such as the existence of a large investor base and familiarity with the company.
American depository receipts (ADRs)
American depository receipts (ADRs) are depository receipts denominated in US Dollars and floated on a US exchange. ADRs are a special case of ADRs. American depositary shares are shares of the foreign company which back the ADRs.
There are four types of ADRs: Level I sponsored ADRs which trade in OTC market; Level II and III sponsored ADRs which must meet SEC requirements and are used to raise equity in the US market through public offering; and Rule 144A ADRs (or Regulation S ADRs) which require no registration and can raise capital only from qualified investors.
Global registered share
A global registered share is a common share that is traded on different exchanges in different currencies. Currency conversions are not a concern in the case of global registered shares because a share held in one currency can be sold in another currency on a different exchange. This offers greater flexibility than global depository receipts.
A basket of listed depository receipts is an exchange-traded fund (ETF) which represents a portfolio of depositary receipts that can be traded just like any other security. They are intended to track the performance of the basket of depository receipts.