There used to be only one way international portfolio investors felt comfortable about investing into emerging marketing stocks. Opening an account with a local brokerage in some far-flung country could be a hairy experience. So depositary receipts (DRs) were created – a proxy for locally listed shares that could be listed on exchanges in New York or kept with a trusted global custodian in London. DRs give the fund managers all the security of developed market laws, regulations and infrastructure, but exposure to the massive upside most emerging markets (EM) stocks offer.

The downside of DRs is they are very expensive to use and as emerging markets increasingly have emerged, those thousand per cent returns are also a thing of the past. With the increasing sophistication of most EM exchanges, which are being hooked up to the international financial system, the rational for depositary receipts is dying. 

The fact that an investor can make money on transforming their ownership from the DR to holding the underlying shares directly has only catalysed the process. In Russia in 2017 three times more DRs were cancelled than created and the number of new DRs created has fallen by almost a third in the last three years.

The DRs come in two main flavours: American depositary receipts (ADRs), and later global depositary receipts (GDRs), as the instrument spread to other developed world exchanges. But because of those high costs the price of the DRs is unusually a little different to that of the underlying shares so converting them makes money. The spread between the DR price and local share price can be significant.

For example, the spread between Russian supermarket chain Magnit’s local and DR share prices – one of the most widely held Russian stocks – peaked at 25.7% in November 2015, according to MOEX, but never fell below 8.7% in the last three years. At least that was true until February 19 when Magnit's founder and largest shareholder Sergey Galitsky decided to call it a day and sold a 29% stake to Russian state-owned VTB Bank for RUB138bn ($2.4bn). Investors were not happy with his decision and the share price tanked by 10% on the news. Case in point: the GDRs traded in London were a lot more volatile than the locally listed shares. 

“GDRs are more expensive to maintain for both the issuer and the holder,” Max Lapin, the new CFO of the Moscow Exchange (MOEX), told bne IntelliNews in an exclusive interview. “And they are less efficient as things like dividend payments take longer to get to the shareholder.”

Another problem with DRs is that three quarters (77%) of them are never actually listed on an international exchange but kept on accounts with global custodians, according to MOEX. That reduces the liquidity of the stock as all trading in an unlisted share has to be done over-the-counter (OTT), which also reduces price transparency.

The cost of holding a DR can be prohibitively expensive. Typically the custodian takes 7% of a dividend payment as fees and the custody service of Bank of New York Mellon (BONY), one of the biggest custodians in the world, charges between 7% and 84% just to transfer the shareholder their dividends (and BONY has been accused of offering below-market FX rates to boot), according to MOEX. There are no fees to pay at all to collect dividend payments on locally listed shares.

Finally while the DRs mean share ownership is governed by the investor’s home market, the rights associated with DRs are less than with holding normal domestically listed shares. While the owner of DRs has the right to do things such as vote their shares at the company’s AGM and receive dividends, they are not covered by redemption laws, don't have pre-emptive rights if the company issues new shares or makes tender offers, or the right to receive securities in the event of a reorganisation, amongst other things.

The underlying problem here is that the holders of DRs are not formally recognised as the final beneficial owners of the share in many markets. In effect the custodian that holds the shares safely on behalf of the investor is also technically the beneficial owner of the shares – at least as far as the law is concerned. This confusion over ultimate ownership means a shareholder is cut off from bringing a case in the Russian courts if the company abuses their shareholder’s rights.

More recently a new problem has surfaced. DRs expose the investor to the risk their depositary bank may be put under sanctions – and VTB Bank has been sanctioned and is one of the biggest custodians in Russia. That has raised the question of if a bank registered in the EU or US is legally allowed to ask VTB, as the custodian, to vote their shares at an AGM as technically international banks are not allowed to do “business” with sanctioned banks.

Add to this a confusion over converting DRs to local share ownership: does the local share ownership constitute the creation of new shares or the transfer of ownership of existing shares? The US regulator counts the conversion as the creation of new shares, which is banned by sanctions, but the EU says they are existing shares which is not, VTB told bne IntelliNews in an interview. 

In the past all this didn't matter much as the whole point of buying emerging markets stocks was that the potential returns that can be made from a well-timed investment were so big that all the costs were drowned out. Investors didn't invest in emerging markets unless they think they could make a lot of money. For most of the last two decades the Russian equity market always returned at least 20% in any year that was not a crisis year but since 2008 the returns have fallen to single digits. Costs matter more now.

RTS index performance 1996-2017
Year	1996	1997	1998	1999	2000	2001	2002	2003	2004	2005	2006
RTS index (eop)	201	397	59	175	143	257	359	567	614	1126	1922
% change y/y	142	98	-85	197	-18	79	40	58	8	83	71
Year	2007	2008	2009	2010	2011	2012	2013	2014	2015	2016	2017
RTS index (eop)	2291	632	1445	1770	1382	1527	1443	791	757	1152	1124
% change y/y	19	-72	129	23	-22	11	-6	-45	-4	52	-2
source: Aton, Bloomberg

On top of that the reforms to Russia’s capital market in 2012 caused a revolution. The two main exchanges – the dollar denominated Russia Trading System (RTS) and its sister, the ruble-denominated Moscow Interbank Currency Exchange (MICEX) – were merged and a Central Depository (CSD) was set up. The final piece was to sign the new system up to the Euroclear and Clearstream international settlement systems, which plugged Russia directly into the international financial system.

Now a London-based trader can buy and sell stocks and bonds listed in Moscow from the comfort of their own chair. There is no more need for costly intermediaries and most of the Russia-based investment banks have closed or been consumed by the big state-owned banks. 

A third force driving the death of the DRs is the growing preference by Russian companies to list at home. 

“In the 90s it was popular amongst Russian companies to list in London,” says Lapin, “that added to the value of the company’s brand.”

The Kremlin has been on a campaign to “de-offshore” the Russian economy, by encouraging companies to register themselves at home instead of using shell companies registered in some tax haven.

“Since 2014 nearly all the Russian companies that listed have chosen to list in Moscow,” says Lapin. “It used to be 50/50.” While the indices were more or less flat in 2017 after a stellar 2016 50%-plus gain, last year saw a string of IPOs and SPOs as investors' interest picked up again thanks to the end of Russia's recession. Even more stock placements are expected this year, according to the experts at BSC Global Markets.

And MOEX has been working hard to make the system even easier to use. Since December MOEX has set up the Sponsored Market Access (SMA) system, which directly connects the Russian exchange's infrastructure to clients' systems abroad to make transactions easier and faster. 

Sponsored access provides clients of MOEX member firms with direct technical access to the Moscow Exchange trading system using the member firm's trading code. A client is able to give instructions to a member firm to be executed on the market directly through the trading system. To avoid erroneous orders in the trading system, the Moscow Exchange provides sponsoring firms with risk management tools, the exchange explains on its website.