Reverse ADRs hot in Chile

A twist on an the concept of American Depository Receipts is attracting greater trading to emerging market exchanges, generating more income for local brokers and more choice for investors as well as helping large companies diversify their investor base and tap into vital new pools of liquidity.

Blue chip companies based in illiquid emerging markets have long cross-listed shares on the world’s leading exchanges as a means to tap into the most liquid markets. In recent years, service providers have turned that idea on its head, extending the reach of the crème de la crème of the developed world by selling shares and funds through emerging market exchanges, providing welcome diversification for both sides. As the assets of emerging market investors are set to grow fast, use of the instruments is likely to grow rapidly.

Last December, the Chilean equities market got a welcome shot of liquidity thanks to the listing of 25 i-Shares on the Valores Extranjeros para Chilenos (VECH). An i-Share is an Exchange Traded Funds (ETFs), an index fund that is traded on stock markets, and the registered trade mark of asset management giant BlackRock.

The Chilean programme represents the third Transferable Custody Receipts (TCR) programme in Latin America to be supported by Deutsche Bank, notes Dirk Reinicke, director at the Trust & Securities Services.

The move enables Chilean institutional and retail investors to gain access to blue chip US and, albeit in a more limited way, European stocks. The instruments are also attractive for the local exchange and brokers, providing extra income for both.

In the trade, Deutsche Trust & Securities Services holds the underlying assets in custody in New York before a certificate is issued in the local market with a one-to-one relationship between the two securities and with the assets held for the buyer in segregated accounts, explains Reinicke. The buyer of the certificate enjoys all the same voting rights and entitlements as any other shareholder and can buy the securities in local currency through a local broker, he notes.

Access and ability to move in and out of these shares as well as the competitive cost is of the essence in making these programmes attractive, says Reinicke. There are also advantages in having an ETF format which allows funds to short baskets of securities. In the deal, the company is not offering new shares, but a product that facilitates access to foreign securities by local investors, he emphasizes.

Deutsche Bank’s Trust & Securities Services recognised the possibilities of these instruments over 10 years ago and decided to use its clout as one of the world’s largest and most experienced providers of administrative services for capital market instruments to set them in action. The division provides custody, clearing and related services in more than 30 securities markets worldwide with more than 30 offices and already has deep experience in depositary services, acting in both American and Global Depositary Receipt programmes, and offering registrar, paying agent and related services for German equities.

History

The first roll out of TCRs took place in Argentina in 1997 and the choice of that country as the launching pad for the product was in large part opportunistic, notes Reinicke. Deutsche was present in what was at the time the most liquid South American market and found a willing regulator and exchange, who were ready to explore the idea jointly with Deutsche.

The German bank brought with it parts of the infrastructure. “You need a custody unit that holds and services securities and a local branch with a custody unit,” notes Reinicke. Deutsche had both and in 1997 saw the opportunity to exploit this.

The new instrument provided a liquid and diverse new market segment to the local exchange. In Argentina, there are 198 individual equities and 21 bonds listed through the programme, including such heavyweights as Microsoft and Cisco, points out Reinicke. Today, they account for some 15-20% of the volumes seen on the Bolsa de Comercio de Buenos Aires.

The development of the instruments in Argentina has not all been smooth sailing and volumes have fluctuated according to the times. Repeated crises in Argentina and changes in regulations in foreign exchange markets made progress difficult enough. More recently, the 2008 nationalisation of pension funds: “had a very strong impact on volumes as pension funds had been holding a significant amount in TDRs and, as they exited, volumes went down,” admits Reinicke.

However, other players have stepped in to fill the pension funds’ shoes and today interest from mutual funds is offsetting their withdrawal, he says. One of the lessons to be drawn from the Argentine experience is that regulations can play as great a role in the development of the instruments as supply and demand factors.

The development of a framework that would allow TCR investments in Mexico led Deutsche Bank to work closely with the Bolsa Mexicana de Valores, the local exchange, as well as the regulator to list a range of instruments on the Mercado Global. Both sides recognised the value in generating more liquidity for the exchange and investors, Reinicke notes. This time, a greater array of instruments was allowed, including access to indexes through the rapidly-growing ETF market and today there are some 513 instruments including 273 equities, 202 ETFs and 38 debt securities, says Reinicke. The individual equities include issues from blue chip companies such as Johnson & Johnson, Coca-Cola, IBM and Boeing.

Mexico has developed a different profile to Argentina. Investors have proved particularly keen on the ETF segment. Investing in these diversified instruments makes sense if you have little or no experience in managing portfolios outside your home market and one of your motivators for overseas investments is diversification, reckons Reinicke. Today, ETFs account for around 38-40% of the trading of foreign securities with 34% in equities and the rest in Real Estate Investment Trusts and debt securities, he notes.

Mexico was very successful because of the diversity of programmes and because the market has proven flexible and adaptable, says Reinicke. “The exchange fully embraced the project and promoted it with its partners,” he said. Today, foreign instruments account for some one third of the total volumes traded on the exchange.

At the beginning of the marketing campaign in Mexico, Deutsche and its partners started with high net worth individuals and then mutual funds, which were specially designated to hold foreign shares (akin to the Qualified Institutional Buyer system in the US). As volume grew, domestic pension funds were attracted in and gave a huge boost to liquidity, he notes. With full transparency and as exchange traded instruments, arbitrage opportunities for brokers were created helping to ensure competitive pricing. “That’s when volume really boomed,” notes Reinicke. The Mexican market, however, has also seen uneven progress with pension funds tending to limit foreign purchases from about a year and a half ago.

The latest venture in Chile takes these instruments to a more open market than Mexico or Argentina. Chile has raised its limits on foreign exposure dramatically over the years just as Argentine limits have been drastically reduced.

Indeed, Chilean legislation was already in place and the market open for foreign transactions. In the country, the marketing pitch emphasizes access for investors that do not have the size to justify opening and maintaining a foreign account, says Reinicke. Volumes have started off promisingly, but it is only after the end of the southern hemisphere summer in March that a significant marketing drive will begin, he notes.

Marketing
A willingness to listen to market participants is fundamental in getting the right blend of securities launched on each exchange, believes Reinicke. “We learn from market players what they want. Before we list securities, we talk to private banks, brokers, mutual and pension funds and ask them what they and their clients want,” says Reinicke. It is doubly important to keep up with what the market says as certain stocks and sectors move in and out of favour and there are opportunistic buyers.

“We constantly adjust to the market and stay very focused and vigilant,” says Reinicke. The bank scrutinizes its range of offerings once or twice per year and removes those securities that have not garnered liquidity from the market. At the same time, the bank introduces new products according to investor demand.

The marketing of these instruments relies heavily on the education of investors and brokers and involves significant research. Deutsche needs to show local brokers how to transact these instruments efficiently and sell them correctly to different kind of funds. “We need to pay attention to both the market and the client. Your success depends on how well you have researched the market,” he notes.

A support in its drive to extend the reach of the instruments has been an alliance with BlackRock, one of the largest providers of ETFs since its take-over of Barclays Global Investors last year for $13.5 billion. “We have been very successful in Mexico with them and the partnership has prospered. We have extended that partnership in Chile,” notes Reinicke. The trading of TCRs has to grow for people to have confidence in investing in these international securities through the local market and BlackRock was willing to rise to the challenge, Reinicke says.

BlackRock has marketing teams in the countries where it offers TCRs, which promote the product and actively markets funds while Deutsche helps explain how the product works to brokers and investors. The agreement is not exclusive and Deutsche works with a number of other ETF providers, Reinicke says.

It’s not only educating the brokers and investors in local markets, but explaining the instruments to issuers back in developed markets. A prime difference between a TCR and an ADR is that the issuer sponsors an ADR listing and the company clearly selects in which market the stock will be listed as it is expensive to maintain ADR programmes.

By contrast, in the case of a TCR, Deutsche uses existing listed securities to create the local market product. “At the start, we had a couple of calls from issuing companies, who were concerned. We explained that we were not claiming to issue stock or launch an IPO but that through this instrument they would have a broader investor base at no risk for company. They understood that idea and were more than happy with the arrangement,” he says.

Deutsche Bank is working to bring these instruments to a wide variety of new countries although it is not always easy admits Reinicke. “We are looking at another couple of countries in Latin America, up to three in eastern Europe and as many as six in Asia,” he notes.

The launch of the products depends on appropriate legislation being in place, a willing stock exchange management and sufficient robustness of systems. Altogether, the process is very time consuming, he notes. The German bank has been working to introduce the products in Brazil and is confident that they will become available there although Reinicke admits that it has been a difficult process. He declined to mention the other countries pointing to competitive and regulatory issues.

The arrival of blue chip names in emerging markets should be a win-win situation as both sides gain from the transaction and brokers and the exchange get their cut of fees. It remains difficult however to navigate the complex regulations prevalent in each jurisdiction, making the roll out of TCR programmes a slow and protracted process. That’s a shame for all the players in the markets involved.

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