Depositary receipt
Not to be confused with synthetic equity derivatives. Or a GDR for that matter.
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Synthetic Prime Brokerage Anatomy™
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An American depositary receipt, or “ADR”, is a way of getting synthetic exposure to securities in hard-to-access markets. They were introduced in 1927[1] as an easier way for U.S. investors to buy foreign stock. Before ADRs came along, US persons wanting to buy non-U.S. listed shares had to buy the shares on international exchanges in the local currency, with all the FX and regulatory hair that entails.
ADRs are issued by a US custodian bank evidencing an entitlement to the stock purchased by the bank which the bank has bought through a broker in the open local market in the local currency are deposited in a foreign depositary bank. ADR holders realise any dividends and capital gains in U.S. dollars converted from their local currency net of conversion expenses and foreign taxes. They can be listed or unlisted.
Sponsorship
ADRs can be “sponsored” — where the underlying issuer lined up the custodian directly — or “unsponsored” where it didn’t, and the custodian set it up off its own bat without the issuer’s help.
Levels
The SEC applies different scrutiny to different “levels” of ADRs.
- Level 1 ADRs: trade over the counter (not on American exchanges) and are the only level of ADR that can be unsponsored. Level 1 ADRs have minimal SEC reporting requirements, and they're not required to file quarterly or annual reports in compliance with U.S. generally accepted accounting principles (GAAP), which means less information is available on these securities, and it's more difficult to compare their financial metrics to those of U.S. companies that comply with GAAP.
The lower amount of reliable information makes level 1 ADRs riskier for investors. Level 2 and level 3 ADRs, meanwhile, require the issuer to register and file annual reports with the SEC. Level 3 ADRs have stricter reporting requirements than level 2 ADRs. Level 3 ADRs represent an initial public offering (IPO) on U.S. exchanges. An "IPO" is when a company's stock first becomes available to be purchased on major U.S. stock exchanges. Level 3 ADRs therefore have the added ability to raise capital through a public offering on U.S. exchanges. In order to register the public offering, the ADR is required to file a Form F-1 with the SEC, which entails additional transparency and regulation. For more information, read this page on the SEC website.
Conversion of real underliers into ADRs and back again: A hobbit’s tale
Holders of the underlying ordinary shares may ask the custodian to “convert” these shares into an ADR, by delivering them to the custodian in exchange for an ADR certificate. Similarly, holders of an ADR may request to convert to the underlying ordinary shares if they want to take the shares back out of the American market.
Depositary receipts and hostile governmental action
Now imagine that rather than nationalizing, a national government announced some draconian law preventing corporations in its jurisdiction from accessing the international capital markets even through depositary receipt programmes — you know, something crazy like that.[2] So say, ooh: the DRs must be converted into underlying shares within a stipulated period, failing which the underlying shares lose their dividend and voting rights[3]
The common sense (and economically correct) answer is “however it shakes out, this is all the customer’s risk” — remember the synthetic equity mantra: this is just equity brokerage done with swaps. Imagine what would happen, dear customer, had your broker sold you the ADR outright, a year ago, and now it has been unwound by wartime governmental manoeuvre. Whose problem would that be? Not your equity broker’s, for sure.
That said, the 2002 ISDA Equity Derivatives Definitions don’t do a magnificent job of specifically dealing with what is undoubtedly an extremely far-fetched situation. For once, we should not be too exacting on ISDA’s crack drafting squad™. I mean, who ever heard of a government forcing local issuers to unwind their GDRs just to spite hostile foreign investors?
So, anyway, you are a swap dealer, everything is messy as hell, tanks are unexpectedly rolling across foreign lands somewhere, and now your customer is on the horn asking what the hell is going on. You, naturally, will be as accommodating and constructive as you can in looking for outcomes for your client in such devilish times, but would still like the peace of mind of knowing, should everything go titten hoch, you can cancel the swap and walk away, paying a nugatory Cancellation Amount based on the worthlessness of the underliers. How can you?
- Nationalization, Insolvency and Delisting: this probably:
- Isn’t a nationalization
- Isn’t an insolvency
- It isn’t *inherently* a delisting (though de facto almost certainly will be as the international (...er hostile?...) Exchanges will most likely delist the DRs, but they don’t have to)
- It isn’t a Change in Law as that refers to laws impacting the counterparties to the trade, not the Issuer;
- It isn’t an Increased Cost of Hedging. well — it just isn’t, is it?
- It may be a Hedging Disruption – I mean it is hard to hedge an instrument that has just been compusorily dissolved, right? — though is disappearance of an instrument altogether so that there is nothing to replicate the return of at all really just a hedge disruption?
Also useful at least by way of analogy is “Tender Offer”. It’s not quite on point – but close, and perhaps useful by way of analogy should you have counterparties that are in denial about the fact that, from a very basic standpoint, they are the ones that are long local “craziest regulator in the room” risk, and not their long-suffering swap dealer.
See also
- GDR - former communist East Germany - or - a global depositary receipt.
- Alternative dispute resolution
References
- ↑ Fun fact: The first ADR was introduced by J.P. Morgan on fusty British haberdasher Selfridges.
- ↑ Attentive readers may wonder whether this is really a figment of the JC’s imagination, or something the Russian State Duma actually did, in April 2022.
- ↑ And therefore become largely worthless: they entitle a holder to a pro-rata share of the Issuer’s assets on a non-insolvent winding up or something like that — but who ever wound up a non-insolvent company?