ADRs: Will Blockchain Create a Better Mousetrap?

RISE Financial predicts its new blockchain-based infrastructure, set to go live later this year, will reduce fees for investors by at least 20 percent initially through operational improvements over the legacy process and through unbundled services which will generate competition between the best quality service providers. The institutions– depositary banks– that currently create  the unsponsored ADRs charge quarterly or annual “ADR pass along fees” which consist of service fees and fees for processing dividends and corporate actions. These fees add to the cost of investment for investors. “[Using the blockchain approach] eliminates the potential for duplicative unsponsored ADR programs by multiple depositary banks,” explains Thorsten Peisl, chief executive officer of RISE Financial.

Depositary banks can still participate in the blockchain model, but unlike in today’s business model whereby the depositary selects all of the service providers, such as transfer agents, custodian banks, and paying agents to cover all parts of depositary receipt programs, the blockchain-based network itself will choose all of the service providers for each unsponsored ADR program from among the network of members. The selection will be based on an algorithmic formula whose rules are transparently available to each member. The competition will drive down the servicing fees.

Under the new blockchain model for unsponsored ADRs, US investors can also receive their dividend payments in a matter of days following the payable date of the corporation’s home country rather than the average of about two weeks that it currently takes for a depositary bank to convert foreign currencies into US dollars, says Peisl. The additional upside, he claims, is a more favorable exchange rate for investors. Instead of the depositary bank conducting the foreign exchange transaction as currently occurs, the blockchain model will allow for competition between multiple providers. The one offering the best exchange rate will be selected by the blockchain to do the foreign exchange conversion.

ADRs offer US investors an easier and cheaper way of accessing foreign markets than buying foreign equities. They represent shares of foreign corporations which have been deposited with the depositary’s custodian. ADRs trade and settle in the US markets using the same market infrastructure as US equities. Sponsored ADRs and unsponsored ADRs are now created by one of the four depositary banks in the United States– BNY Mellon, Deutsche Bank, JP Morgan Chase, and Citi. Sponsored ADR programs require the consent and cooperation of the foreign corporate issuer while unsponsored programs do not.

Sponsored ADRs are either registered with the Securities and Exchange Commission under the US Securities Act of 1933 or they are exempt from registration. Created at the request of investors, unsponsored ADRs are not registered and are always issued pursuant to an exemption to registration requirements.  Of the 2,400 depositary receipts issued in the US across all types of programs, about 1,400 are unsponsored. Sponsored ADRs are listed on either the New York Stock Exchange, NASDAQ, or traded in the over-the-counter market. Unsponsored ADRs trade strictly in the over-the-counter market. Filings made by fund managers with the SEC on asset holdings indicate that about 350 fund management firms own unsponsored ADRs, including mutual fund managers and pension plan managers. Among the most popular unsponsored ADRs are those of Tencent, Nintendo, Porsche, Volkswagen, and Softbank. For some funds, the value of sponsored and unsponsored ADRs comes to about 12 percent of the value of the total portfolio.

Established in 2016 with former senior executives from State Street and Deutsche Bank at the helm, RISE Financial claims to be the first technology firm to work on second generation blockchain projects in the cross-border securities space and is best known for its analysis of the use of blockchain for the settlement of equities transactions. In the case of the unsponsored ADR programs, RISE Financial will earn licensing fees from a not-for-profit company incorporated in Delaware. The company governs the blockchain service, based on Hyperledger and its smart contracts. The not-for-profit company, which will work on a cost-recovery basis, will be governed by an operating body of its member service providers. Each member participating in the blockchain platform will be given a seat on the board of the yet-to-be-named company.

Here is how an unsponsored program would occur on a blockchain-based platform, explains Peisl: market makers or service requesters would submit a request with the required details to the blockchain to create a new digital unsponsored ADR program. Those details include the underlying market identifier, the security reference identifier, the issuer ticker identifier, and a proposed ratio of foreign shares for each depositary receipt. The blockchain will identify a permissioned member– a register agent– to process the request by qualifying the eligibility of the proposed program for the required exemption from SEC registration, by filing the appropriate documentation with the SEC, by securing the necessary identifiers for the new digital depositary receipts and by notifying the relevant market infrastructure providers, including the Depository Trust Company, the US’ national securities depository.  The permissioned member will then confirm completion of the unsponsored ADR program to the blockchain network via API which will be visible to the market maker who requested the program.  This confirmation opens the door for the initial issuance of depositary receipts and corresponding establishment of the digital register.  The market maker will initiate an issuance request on the network and, through an existing interface with DTC, request that depositary receipts be credited to its depositary receipt account. The market maker will also arrange for the appropriate number of underlying shares to be delivered to the depositary’s custodian. The transfer agent, upon seeing the custodian’s confirmation of the underlying share deposit in the network, will credit the depositary receipts to the market maker’s depositary receipt account using the same existing interface.

The resulting depositary receipts will trade in the over-the-counter market and settle in DTC on a T+2 basis — a two day cycle– the same as what occurs for US equities. Investors will also hold depositary receipts in their accounts with financial intermediaries which have accounts with DTC as participants of the depository. “Our goal isn’t to change the current ownership structure for investors, but to make it more cost-effective and efficient to issue and service unsponsored ADRs,” says Peter Jacaruso, director of strategy and development for RISE Financial. Allowing the current ownership and settlement structure to remain intact lets the blockchain-based service operate with minimal changes to tried and tested ADR structures in place since 1927.

Transfer agents will earn fees for maintaining shareholder records, while custodian banks in overseas countries will earn fees for safekeeping underlying shares in the foreign issuers. Paying agents will earn fees from making cash payments.  The new blockchain-based system will also benefit market makers in unsponsored depositary receipts by making it easier for them to cancel unsponsored ADRs and to exploit more arbitrage activities than through the current system, says Peisl. By creating a single depositary structure, the workflow for cancelling ADRs is streamlined to more efficiently cancel ADRs for market makers.

It remains to be seen how successful RISE Financial will be in attracting investor interest, but so far it seems to have generated plenty of support from critical players in the financial services industry. RISE Financial has already engaged a few custodian banks, transfer agents, and paying agents to help implement the first wave of unsponsored ADRs. The platform can also easily be tested by market makers active in the ADR industry.  Although Rise Financial has a sufficient number of participants for its unsponsored ADR blockchain platform to get started, it is hopeful more will join. “The greater the number of participants the greater the potential for even lower fees and more cost savings for investors as larger volumes generate greater efficiencies from scale and competition,” says Peisl.