An American Depositary Receipt (ADR) is what?

A negotiable certificate issued by a U.S. depositary bank that represents a certain number of shares—typically one share—of a foreign firm’s stock is known as an American depositary receipt (ADR). The ADR trades on American stock exchanges like any domestic share.

ADRs allow American investors to buy stock in foreign corporations that they otherwise wouldn’t be able to. Foreign businesses also profit since ADRs allow them to draw in American money and investors without the difficulty and cost of going public on American stock markets.

The Functioning of American Depositary Receipts (ADRs)

The currency of American depositary receipts is the U.S. dollar. The holding company for the underlying securities is a U.S. financial institution, frequently through a branch abroad. These securities are valued, traded, and cleared through American settlement channels in dollars.

A U.S. bank must buy shares on a foreign exchange before offering ADRs. The bank keeps the stock as inventory, and an ADR is issued for domestic trade. ADRs can be purchased over-the-counter (OTC) and listed on the NYSE or Nasdaq.

American banks need comprehensive financial data from overseas businesses. This rule makes it simpler for American investors to evaluate the financial stability of a firm.

American Depositary Receipts: Types

American depositary receipts can be divided into two groups:

Sponsored ADRs

A bank issues a sponsored ADR on behalf of a foreign business. An agreement in writing is made between the bank and the company. Typically, the bank conducts transactions with investors while the foreign firm covers the expenses of issuing the ADR and maintains control over it. The classification of sponsored ADRs is based on how closely the foreign firm adheres to Securities and Exchange Commission (SEC) rules and American accounting practices.

ADRs not sponsored

A bank also releases an unsponsored ADR. However, the foreign company hasn’t had any involvement, participation, or even permission to create this certificate. Theoretically, the possibility of multiple unsponsored ADRs for the same foreign company issued by various U.S. banks exists. The dividends offered by these various offerings could also vary. There is only one ADR issued by the bank that partners with the foreign company in sponsored programs.

Where the two types of ADRs trade is one of their main differences. All sponsored ADRs, except the lowest level, are SEC-registered and traded on significant U.S. stock exchanges. ADRs that are not sponsored will only trade over the counter. Voting rights are never included in unsponsored ADRs.

ADR Grades

ADRs are divided into three levels based on how much foreign companies can access American markets.

Grade I
This is the most basic kind of ADR, where foreign companies either don’t meet the requirements or don’t want their ADR to be listed on an exchange. Although it cannot be used to raise money, this kind of ADR can be used to establish a trading presence.

The Securities and Exchange Commission (SEC) has the laxest requirements for Level I ADRs, which are only available on the over-the-counter market and are frequently very speculative. Despite being riskier for investors than other kinds of ADRs, they are a simple and cost-effective way for a foreign company to determine American investors’ interest level in its securities.

Stage II
Level II ADRs are similar to Level I ADRs in that they can be used to establish a trading presence on a stock exchange but not to raise money. Although Level II ADRs receive higher visibility and trading volume than Level I ADRs, they are subject to a few more SEC requirements.

The most prestigious ADRs are Level III ADRs. An issuer uses them to launch an ADR public offering on a U.S. exchange. The foreign issuer can use them to establish a sizable trading presence in the American financial markets and to raise money. Issuers must file complete reports with the SEC.

Pricing and Costs for American Depositary Receipts

An ADR may represent the underlying shares of the underlying company, one share for one, a portion of a share, or multiple shares.
The depositary bank will choose a price for the ratio of U.S. ADRs to home-country shares that it believes will be attractive to investors. Some investors may become discouraged if an ADR’s value is too high. On the other hand, investors might believe the underlying securities resemble riskier penny stocks if it is too low.

An ADR’s price closely mirrors the price of the company’s stock on its home exchange as a result of arbitrage. Remember that arbitrage involves simultaneously purchasing and selling the same item in multiple marketplaces. This allows traders to gain from variations in the asset’s quoted price.

If you invest in an ADR, you can pay extra costs that don’t apply to domestic stocks. The depositary bank that holds the underlying stock may levy a fee, known as a custody fee, to cover the expense of generating and issuing an ADR.

This cost will be mentioned in the ADR prospectus and normally varies from one to three cents per share. The cost will be withheld from dividends or passed to the investor’s brokerage business.

ADRs and Taxes

Holders of ADRs realize any dividends and capital gains in U.S. dollars. However, dividend payments are net of currency translation expenditures and foreign taxes. Usually, the bank automatically withholds the required amount to pay costs and international taxes.

Since this is the procedure, American investors would need to seek a credit from the IRS or a refund from the foreign government’s taxing body to avoid double taxation on any capital gains achieved. Those interested in learning more about ADRs and other financial issues may consider enrolling in one of the best investing courses available.

Advantages and Disadvantages of American Depositary Receipts

As with every investment, investing in ADRs has specific pros and cons. We’ve included some of the key ones below.

Advantages
As indicated above, ADRs are just like stocks. This implies they trade on a stock market or over the counter, making them reasonably straightforward to obtain and trade. Investors may also track their success by studying market data.

Purchasing ADRs is straightforward because they’re available directly through American brokers. This eliminates the need to go through international procedures to purchase stock in a firm you may be interested in. Since they’re offered locally, shares are denominated in U.S. dollars. But that doesn’t imply you escape any direct dangers linked with currency-value variations.

One of the most apparent benefits of investing in ADRs is that they give investors a method to diversify their portfolios. Investing in overseas securities allows you to expand your investment portfolio up to higher rewards (along with the hazards).

Disadvantages

The primary concerns linked with ADRs are that they may involve double taxation—locally and abroad—and how many firms are listed. Unlike domestic corporations, there are a restricted number of foreign entities whose ADRs are published for the public to trade.
As indicated above, some ADRs may not comply with SEC standards. These are termed unsponsored ADRs, which have no direct engagement by the firm. Some corporations may not even offer authorization to list their shares this way.

Investors who invest in ADRs can avoid direct foreign exchange risks but may be charged currency conversion costs. These charges were implemented to connect international securities and those traded domestically clearly.

American Depositary Receipts’ History

Before American depositary receipts were created in the 1920s, American investors who wanted shares of a firm not listed in the United States had to do so solely on overseas markets, which was an impractical choice for the typical individual then.

Though buying shares on overseas markets is now simpler thanks to technology, there are still disadvantages. The difficulty of currency exchange is one particularly difficult obstacle. The regulatory discrepancies between U.S. and overseas exchanges are another significant negative.

U.S. investors must get familiar with the rules of the various financial authorities before investing in a globally listed firm, or they risk misinterpreting crucial data, such as the company’s financials. Since not all domestic brokers can do overseas business, they might additionally need to open a foreign account.

ADRs were created due to the challenges connected with purchasing shares in foreign jurisdictions and the challenges of trading at various prices and currency values. Guaranty Trust, a J.P. Morgan (JPM) forerunner, invented the ADR idea. It developed and introduced the first ADR in 1927, allowing American investors to purchase shares of renowned British retailer Selfridges and assisting the upscale department store to enter international markets. On the New York Curb Exchange, the ADR had a listing.

The British music label Electrical & Musical Industries (commonly known as EMI), which would eventually become the Beatles’ home, received the first sponsored ADR from the bank a few years later, in 1931. J.P. Morgan and another American bank, BNY Mellon, still actively participate in the ADR markets today.

Real-World Illustration of ADRs

Volkswagen AG, a German automaker, traded OTC in the United States as a sponsored ADR from 1988 to 2018 with the ticker VLKAY. Volkswagen ended its ADR program in August 2018. The next day, J.P. Morgan created an unsponsored ADR for Volkswagen, now quoted as VWAGY.
Investors who owned the previous VLKAY ADRs had the choice of cashing out, exchanging their ADRs for Volkswagen stock that traded on German marketplaces, or swapping them for the new VWAGY ADRs.

Is Owning an ADR Equivalent to Owning Stock in the Company?

Not quite. ADRs are certificates denominated in U.S. dollars that trade on American stock markets and follow the price of domestic shares of a foreign corporation. Although ADRs show the share values, they do not provide you ownership rights as ordinary stock does. ADRs can be issued at different ratios, and some may pay dividends. The most typical ratio is one common corporation share for every ADR.

An ADR can be purchased and sold through your broker just like any other share if listed on an exchange. ADRs allow American investors to diversify their portfolios geographically without having to open foreign accounts or deal with currency conversion and taxes because of this and the fact that they are priced in U.S. dollars.

Why List ADRs by Foreign Companies?

Foreign businesses frequently want to have their shares listed on U.S. exchanges through ADRs to get additional exposure to the global market, access to more investors, and coverage from more equities analysts. Companies that issue ADRs may also discover that when their ADRs are listed in U.S. markets, it is simpler to raise capital in other markets.

How Do Sponsored and Unsponsored ADRs Differ?

A U.S. investment bank must serve as the depositary bank for all ADRs. The organization that issues ADRs keeps track of their holders, records trades made, and delivers dividends or interest on shareholder equity payments in dollars to ADR holders is the depositary bank.

In a sponsored ADR, the depositary bank collaborates to register and issue the ADRs with the foreign firm and their custodian bank in their place of origin. Instead, a depositary bank will issue an unsponsored ADR on its initiative without the participation or approval of the foreign firm whose ownership it denotes. Broker-dealers who possess common stock in overseas corporations and conduct over-the-counter trading issue unsponsored ADRs. On exchanges, sponsored ADRs are increasingly frequent.

What Distinguishes an ADR from a GDR?

ADRs provide foreign shares a listing in a single market. On the other hand, U.S. Global Depositary Receipts (GDRs) offer access to two or more markets (often the U.S. and Euro markets) with a single fungible asset. When the issuer raises funds locally, internationally, and in the U.S. markets, GDRs are most frequently employed. Either a private placement or a public offering might be used for this.

Are American Depositary Shares (ADS) and ADR Equivalent?

The real underlying shares the ADR represents are American depositary shares (ADSs). In other words, the ADR represents the total bundle of issued ADSs, whereas the ADS represents the actual share accessible for trade.

Do ADRs eliminate the risk of exchange rates?

No, and this is a typical misunderstanding. Even though they trade in the United States and U.S. dollars, American Depository Receipts are subject to exchange rate or currency risk. This is a result of the way things are set up. A worldwide bank that owns a significant portion of the local shares of a multinational company issues ADRs. An ADR share is worth a specified number of local shares according to the conversion rate that the bank sets. Changes in the home country’s exchange rate relative to the U.S. dollar must also be reflected in the price of the U.S.-traded ADR in U.S. dollars to maintain this conversion rate over time. Maintaining the bank-set conversion rate would be difficult if this didn’t happen.

The Verdict Americans can invest in overseas corporations using American Depositary Receipts, or ADRs. Even though these firms don’t typically trade on the American stock market, an investor can purchase these equities via an ADR like any other domestic company. Foreign businesses may raise financing from the American market, another advantage of the agreement.

Updated on January 24, 2023: A previous version of this page incorrectly claimed that ADRs do not carry any direct risks related to changes in currency rates. That version has been changed. Changes influence the price of an ADR in the local share price of the firm and the national currency’s exchange rate versus the U.S. dollar.

Conclusion

• A certificate issued by a U.S. bank that represents shares of foreign stock is known as an American depositary receipt.
• On American stock markets, these certificates are traded.
• ADRs are valued in U.S. dollars, as are their dividends.
• ADRs provide American investors with a simple, liquid option to purchase overseas equities.
• Few choices are available, and these investments may subject investors to double taxation.