What is ADR? | Definition, Types, Working, Pros and Cons

Depository Receipts are an essential mechanism of raising capital for domestic companies from the international equity markets. They are primarily instruments of negotiation through which foreign investors purchase shares in domestic companies enlisted in local markets using local currency.

In exchange for that investment, they issue a claim denominated in a convertible currency; mostly the US dollars. These claims are called depository receipts and are enlisted on the stock exchange.

There are primarily two kinds of depository receipts that are enlisted under the domestic stock exchange but denote the security issues of a foreign public listed enterprise. American Depository Receipt is one of them.

How does American Depository Receipt work?

An ADR or American Depository Receipt is a negotiable instrument or certificate that a US depository bank issues to denote a foreign company’s securities, trading in the US stock market. These are denominated in US dollars and are traded in the US stock markets just like domestic shares.

Foreign companies need to provide all the critical pieces of information regarding their financial status to get their shares converted into ADRs by a US bank.

The bank then purchases those stocks on foreign exchanges and hold them as inventory to issue ADRs for trading in the domestic markets.

A company’s illustrious description of its financial health enables American investors to decide whether they want to invest in that company or not.

ADRs serve as a lucrative opportunity for US investors who want to hold shares in foreign markets, which is otherwise not accessible.

It proves to be profitable for foreign enterprises as well, as they can attract the capital of American investors without undergoing the expense and hassles of getting listed on the US stock markets.

Some of the significant US stock exchanges, where ADRs get listed, include the New York Stock Exchange and the Nasdaq. However, they are also exchanged over-the-counter (OTC).

Types of American Depository Receipt

There are primarily two kinds of ADRs that are listed on the US stock markets:

1. Sponsored: These are the results of an agreement between a US bank and a foreign company. According to the agreement, the expense of issuing ADRs will be borne by the company. In contrast, the bank will deal with transactions with stakeholders.
2. Unsponsored: The US banks issue these without the participation or even permission of the foreign company. Unlike sponsored ADRs, these are traded only over-the-counter. Besides that, investors have no voting rights in case of sponsored ADRs.

Advantages of American Depository Receipt

The following are some significant advantages of an American Depository Receipt:

1. As they are issued in a local currency, both investors and firms find them hassle-free to trade. To investors, they are a rare opportunity to own shares in foreign companies. For the firms, on the other hand, they are a more straightforward way to bring American investors.
2. US banks issue ADRs with the underlying security kept as inventory. Consequently, they are easy to track down.
3. ADRs are denominated in US dollars. Consequently, they can be traded easily in domestic markets.
4. ADRs can be availed from US brokers.
5. They allow investors to diversify their portfolio.

Disadvantages of American Depository Receipt

Despite their several benefits, ADRs have some inherent limitations:

1. They could be subject to double-taxation.
2. The selection of companies under ADRs is relatively limited.
3. There are possibilities of ending up incurring currency conversion fees from the investors’ point of view.
4. Most ADRs are unsponsored which in turn are often non-compliant with SEC regulations.

References

1. https://www.sciencedirect.com/science/article/pii/S1042443117304419
2. https://meridian.allenpress.com/accounting-horizons/article-abstract/28/3/579/52905