Custodian Bank in ADR Programs

A custodian bank in an ADR program is a financial institution in the foreign company’s home market responsible for holding, safeguarding, and book-entering the ordinary shares that underlie a depositary receipt program. While the depositary bank in the US or another international financial centre manages the receipts and serves investors, the local custodian holds the actual shares and executes corporate actions in the home market.

The role of the custodian in the receipt structure

The depositary receipt structure involves at least two banking institutions, each with distinct geographic and legal roles. The depositary bank—typically a global institution like JP Morgan or Bank of New York Mellon—sits in a major financial centre and manages the investor-facing operations. But it does not itself hold the foreign shares. Instead, it appoints a custodian bank in the company’s home country (or a regional hub serving that market) to be the actual custodian of record.

This separation is essential because foreign shares cannot be easily held in New York or London. They must be registered or book-entered in the foreign market’s settlement system, under the jurisdiction and custody rules of that country. The custodian bank, as a regulated institution with memberships in the local clearance system, handles this requirement.

The relationship is contractual. The depositary bank instructs the custodian to receive shares, hold them on deposit, and release them only upon the depositary bank’s instruction. The custodian bank acts as an agent, not as principal; it holds title in a fiduciary capacity, with the underlying beneficial ownership traceable back to the receipt holders via the depositary bank’s books.

Receipt creation and share custody

When a foreign company launches a depositary receipt program, it first selects a custodian bank in its home market. Holders of the company’s ordinary shares can then deposit those shares with the custodian in exchange for receipts issued by the depositary bank.

The mechanics are straightforward in outline but complex in execution. The shareholder delivers ordinary shares to the custodian, which verifies ownership and liquidity. Once cleared and received, the custodian holds the shares and issues a confirmation. The depositary bank receives notice that the shares have been deposited and issues the corresponding number of receipts to the depositor. From that point forward, the custodian holds the shares; the depositor holds the receipt.

The custodian typically imposes no deposit fees for initial receipts, but may charge withdrawal fees—a modest amount, perhaps $0.01 to $0.05 per share—when a receipt holder requests cancellation and withdrawal of the underlying shares. These fees are small but material when millions of shares move through a program over its lifetime.

Handling corporate actions in the home market

Because the custodian bank physically or legally holds the shares in the foreign jurisdiction, it is responsible for executing corporate actions initiated by the company in its home market. These include dividend collections, stock splits, rights offerings, recapitalizations, and unusual events like mergers or delistings.

Dividends are the most routine corporate action. When the company declares a dividend, the custodian’s home-market systems automatically collect it in the local currency. The custodian then remits these funds to the depositary bank, which aggregates them, converts them to the receipt currency (typically US dollars), and distributes them to receipt holders. The custodian’s role is mechanical but essential—without local custody, the dividend would not be collected at all.

Stock splits and bonus issues require the custodian to adjust the quantity of shares held. If the company executes a 2-for-1 split, the custodian’s records automatically reflect this. It notifies the depositary bank, which in turn adjusts the receipt ratio (e.g., two new receipts for one old receipt, or an automatic credit to holders’ accounts).

Rights offerings are more complex. When a company offers existing shareholders the right to purchase additional shares at a discount, the custodian receives and holds these rights in the home market. It must then communicate them to the depositary bank, which faces a decision: should it exercise the rights on behalf of receipt holders, sell them, or allow them to expire? Different programs handle this differently. The custodian’s job is to ensure the rights are not lost and can be exercised if instructed.

Extraordinary events—such as mergers, recapitalisations, or involuntary delistings—can be sources of real disruption. The custodian must interpret the home-market rules governing the event and determine its legal and economic impact on the shares. It then communicates this to the depositary bank and the receipt holders. A poorly handled reorganisation can leave receipt holders confused or financially disadvantaged.

Custody standards and safeguards

Custodian banks in the home market are subject to local regulatory oversight. In most developed markets, this includes capital adequacy requirements, segregation of customer assets, regular audit, and insurance or indemnity arrangements to protect against loss or theft.

The custodian is obligated to keep the shares separate from its own operating assets. In many jurisdictions, this segregation is required by law; in others, it is contractual. Failure to segregate would create counterparty risk: if the custodian bank failed, the shares held for ADR programs could be entangled in its bankruptcy, delaying or preventing their return to receipt holders.

Custody accounts are typically insured or covered by indemnity agreements, protecting against loss due to the custodian’s negligence or fraud. However, receipt holders should be aware that insurance limits exist and that in the event of a major systemic failure (such as a stock exchange collapse or sovereign default), no custodian insurance can fully insulate them.

The relationship between custodian and depositary

The custodian bank and the depositary bank are often separate entities and may be in different countries. They communicate via instruction, confirmation, and regular reporting. The depositary bank instructs the custodian to release shares upon receipt cancellation, and the custodian confirms completion. The depositary bank reports to the company and to regulators on the total number of receipts outstanding; the custodian reports to the depositary bank on the total number of shares in its vault.

Because these are separate institutions and borders, communication delays and reconciliation discrepancies can occur. Most modern programs use standardized settlement systems and real-time messaging, reducing friction. But the separation is also a virtue: it creates checks and balances. Neither the depositary bank nor the custodian can unilaterally manipulate the program, issue receipts without shares, or misappropriate underlying shares.

Fee structure

The custodian bank charges an annual custody fee, typically expressed as a basis points charge on the assets held or as a fixed annual fee per program. Fees vary by country and institution but are generally modest—often $0.01 to $0.05 per share per year, or $500 to $5,000 annually for smaller programs.

Withdrawal fees—charged when receipt holders cancel receipts and withdraw shares—are also common. These are often higher than the annual custody fee, ranging from $0.01 to $0.25 per share, and serve as a disincentive to frequent withdrawals, which create operational work for the custodian.

Some custody programs also impose voting-exercise fees or special charges for extraordinary corporate actions. These should be disclosed in the depositary agreement or fund prospectus, but they are not always transparent to retail investors.

Selecting a custodian

The foreign company and its depositary bank jointly select the custodian. The choice depends on several factors: the custodian’s membership in the local settlement system, its reputation for reliability, its fee structure, and its operational capabilities (particularly its ability to handle special corporate actions efficiently).

A major international company might use a large, multinational custodian such as BNY Mellon or State Street. A smaller company might use a local custodian bank. The depositary agreement specifies the custodian’s duties and can include provisions for replacement if the custodian fails to perform adequately.

Risks and considerations

The custodian represents a concentration of counterparty risk. If the custodian bank fails—due to insolvency, fraud, or operational collapse—the shares held in custody could be at risk, despite insurance and regulatory protections. This is one reason why receipt holders may choose to withdraw their shares and hold them directly, eliminating custodian counterparty risk at the cost of forgoing the convenience of US-market trading.

Currency movements between the home market and the receipt currency can also create complications. If the home currency depreciates sharply, the book value of the shares in home-currency terms may remain constant while their US-dollar equivalent falls. This currency risk attaches to the shares themselves, not the custodian, but it is worth noting.

In some emerging markets, custodian services are less reliable, and the risk of loss due to operational failures, political upheaval, or sanctions is higher. Receipt holders in such programs should be aware of this risk and consider it when evaluating their holdings.

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