Citing “people close to the investigation”, the WSJ reported that the US financial watchdog is examining whether the four big depositary banks have broken controls designed to prevent market abuse and tax fraud.
ADRs are a type of security that allows shares of a foreign firm to be traded in USD on US securities markets, and can be thought of as the estranged twin of ordinary shares.
To trade ADRs, a client of a non-US securities firm must first purchase shares of the desired company within the country that it is hosted. Outside of the US, these financial instruments are known as GDRs, or global depositary receipts. According to BNY Mellon’s 2015 market review, there were 160 billion depositary receipts valued at $3.1 trillion traded.
The SEC’s scrutiny has landed on a practice known as “pre-release”, which is when a depositary bank issues ADR/GDRs to borrowing brokers. And bringing the issue to regulators has been a long saga for John Germinario, a whistleblower who has been crying foul over market abuses by depositary banks using ADRs since 2005.
“Working with the SEC”
Commenting on the WSJ report, Germinario said: “It’s long overdue, they’re very close to the end. I am working every day with the SEC on this.”
Germinario explained that the borrowing broker commits to owning the corresponding shares and also provides at least 100% cash collateral of the value of the borrowed shares to the bank. The bank earns revenue by charging an interest rate to the broker on the dollar balance held, and sometimes issuance fees or cancellation fees depending on the results of the trade.
The pre-release position has to be settled by the broker within a reasonable settlement time frame, usually a couple of days from the settlement date in the US.
If the shares remain outstanding, then the depositary bank has the responsibility to call in the shares from the broker, and if the broker does not settle the ADRs then the depositary bank needs to use the broker’s cash collateral to buy those share on the open market, hence forcing the settlement of the pre-release.
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How banks benefit from pre-release
This pre-release settlement stage is not happening, Germinario claimed, calling the way pre-releases are being conducted “the stock loan of least resistance”, “antiquated” and “obsolete”.
The banks benefit by making basis points on cash collateral, plus issuance fees, and or cancellation fees, he added. And the longer the pre-release shares are outstanding the greater the interest revenue for the banks.
the stock loan of least resistance
“Pre-release of ADRs/GDRs/ordinary shares costs global shareholders hundreds of billions of dollars by applying constant phantom share pressure on the share price of the ADRs and the ordinary shares,” Germinario said. “Every pre-release action that the depositary banks implement affects ADR holders and ordinary shareholders that own ordinary shares of ADR programs.”
He added that it’s not the end of allegations yet to be investigated thoroughly. “There’s more coming down the pipe (which are) testimonies that the SEC has that revealed the banks paying government officials for the purposes of an international ADR contract.”
Citigroup and BNY Mellon declined to comment. JP Morgan and Deutsche did not respond at time of publication. Sources cited by the WSJ said the investigation won’t necessarily result in enforcement action.
Other national regulators and agencies have been scrutinising different aspects of the potential abuse of ADRs and GDRs for years now.
The Indian regulator, SEBI, has investigated the use of GDRs in “pump-and-dump” schemes and money laundering.
In Canada, a report that goes as far back as 2012 from the Financial Transactions and Reports Analysis Centre detailed how Colombian drug cartels launder money through US securities markets using ADRs, citing an ACAMS (Association of Certified Anti-Money Laundering Specialists) publication.