A Quick Primer on ADRs and SKHY

I started my career as a foreign equity arbitrageur.  In those dark ages, when trading was done over the phone and brokerage firms rarely offered direct access to international markets, an institutional trader could seek opportunities where there was a minor mispricing between ordinary shares traded in local markets and their ADR counterparts in the US.  Even then, those divergences were fleeting, and more efficient markets made them even rarer. Yet one giant exception is occurring in plain sight: SK Hynix ADRs (SKHY) are trading at a significant premium to local shares.

Let’s start with a primer on ADRs themselves.  ADR is an acronym for American Depository Receipt.  As the name suggests, these are not a company’s actual shares.  Instead, they are notes issued by a bank that holds shares on deposit, and those notes become negotiable securities traded on US exchanges.  They can be “sponsored,” meaning that the company has arranged with a custodial bank to issue the ADRs on its own behalf, or “unsponsored,” meaning that the bank has done this on their own behalf without the company’s involvement.  There is functionally no difference for holders – the bank manages the custody, currency, dividends, and tax issues.  The key difference is that only Level 2 and Level 3 sponsored ADRs – those where the company follows US listing, disclosure, and accounting requirements – trade on exchanges.  Unsponsored ADRs only trade over-the-counter, as do Level 1 sponsored ADRs, where the company has an arrangement with an ADR custodian but chooses not to follow US listing requirements.  The latter two types are far more common than Level 2 sponsored, but exchange-traded ADRs tend to be much more liquid.

ADRs are fungible with ordinary shares.  As with the much newer ETFs (ADRs were first introduced in 1927; SPY, the first US-listed ETF arrived in 1993, though the first ETF was listed in Canada in 1990), ADRs can be exchanged for their underlying shares and vice versa.  Banks charge a fee for that service of course; it generally ranges between 1 and 5 cents per ADR.  Banks also pass along any necessary taxes, such as withholding a percentage of foreign dividends or local transaction taxes.

To make them more marketable to US investors, ADRs sometimes trade with a ratio.  For example, the new SKHY ADRs represent 1/10 of an ordinary Korean share (symbol 000660), while Shell PLC ADRs (SHEL) represent 2 ordinary shares (also SHEL).  This, along with the relevant currency conversion rate, must be taken into account when comparing the two.

(There is one major exception to consider when trading foreign shares: Canadian shares traded in the US are NOT ADRs.  Those are actually the same shares, equally deliverable to clearing houses in either the US or Canada.  The settlement currencies of course differ, but there is no intervening custodial bank.)

Thus, because there is a straightforward relationship between ADRs and ordinary shares, it is not difficult for traders to keep them in line with each other, subject to fees, particularly when both markets are open.  It’s really a matter of simple arithmetic.   Here is the most basic example, noting of course that these are not ADRs:

Let’s see if there is an arbitrage opportunity in BCE.  I took this snapshot shortly after noon ET.  If I buy BCE in Canada at C$30.93 and buy Canadian dollars at 1.40409 to pay for those shares, that equates to $22.0285 US.  That is inside the spread of the US listed shares, and thus the markets are demonstrating efficiency.

Source: Interactive Brokers

Now, let’s do the same exercise for SKHY, bearing in mind that the South Korean market is closed during US hours. 

SKHY shares are trading at $160.69 right now, there are 1480 Korean Won (KRW) to the USD, and as noted above, 1 ADR represents 1/10 of an ordinary share.  When we calculate the implied price of an equivalent ordinary share, we get

              160.69 * 1,480 * 10 = 2,378,212 KRW

The problem for ADR investors is that the 000660 shares closed at 1,830,000 overnight.  Thus, US investors are paying roughly a 30% premium for the ADRs!

As we noted above, there can be reasons why US investors might pay a premium for the ADRs, such as more affordable pricing and convenience.  In this case, however, that is a huge premium for the convenience of transacting in the US.  For customers of other brokerage firms, this may be the only way that they can access SK Hynix shares.

But for many IBKR customers, that is an unnecessary premium.  Many of you can access South Korean markets directly.  If you want to buy shares in SK Hynix, you can do that via your IB account.  Yes, the trades will need to be done during local market hours, but they will save investors significant amounts of money for as long as the ADRs trade at a substantial premium.  Traders, of course, can trade the large intraday swings in the ADR market during regular US hours.  But anyone going home with a position should keep the differential between ADRs and ordinary shares in mind.