WTF are CDRs? (other than a potential trillion dollar market)

Over the past few days, the Chinese government announced the potential creation of a new trillion dollar investment market, and it isn’t an April Fools joke.

China’s tech giants like Alibaba and Tencent are some of the most valuable in the world, and upcoming potential IPOs by the next generation of startups like Xiaomi are causes for celebration. Most Chinese citizens would be thrilled, however, there is a deep irony behind their success. These Chinese tech companies can actually not be purchased on a Chinese stock exchange, nor can Chinese retail investors buy a share in them.

Chinese workers build these companies up, and the value accretes to American capitalists (“Socialism with Chinese Characteristics,” I guess?)

Now, the central government is proposing new rules that would allow these companies to come back to the mainland through the use of Chinese Depositary Receipts, or CDRs. That’s big news, and could completely transform not only the market caps of some of the largest tech companies in the world, but also increase competition between trading houses like the New York Stock Exchange and Chinese stock exchanges in Hong Kong, Shanghai, and Shenzhen.

WTF is a CDR then? Before we get to that, we first need to understand why they are needed in the first place.

Domestic buyers buying domestic stocks is really, really hard in China

In economics theory, stock exchanges are epitomized as a shining exemplar of the notions of free trade and efficient markets. Each company is selling a standard unit (a share), prices are transparently disclosed, and buyers and sellers can connect in a central market (an exchange) to buy and sell their securities at voluntary prices.

In reality of course, governments strongly regulate financial securities to ensure that those exchanges are well-ordered. The Securities and Exchange Commission in the United States is just one of several public and private bodies that regulate the conduct and operation of the nation’s exchanges.

Now up that regulation by 100x when you enter China. Listing on a stock exchange must be approved by the central government, and regulators have been aggressive in blocking listings over the past few years. Due to robust capital controls, Chinese citizens may only buy local securities, and can’t invest in companies outside of China through foreign stock exchanges. Likewise, foreign investors face daunting challenges in investing in local companies, even with liberalization programs over the last two decades. The government regularly intervenes in the operation of the Shanghai and Shenzhen stock exchanges through trade freezes and other machinations. Local securities regulations can be highly burdensome, and force companies to engage in “party building” activities.

For Chinese companies looking to raise capital from private investors, there are two paths forward. One is to offer multiple types of shares traded in different places. Classically, this has meant an “A-share” that was traded in say Shanghai and only available for purchase by locals, and a “B-share” that was only available to foreigners. Some companies chose to have an “H-share,” which was listed in Hong Kong, which has none of the securities regulations of domestic Chinese exchanges. These different classes of shares are priced independently, and there can be wide discrepancies between them (A-shares have traditionally had massive premiums compared to other share types, and researchers still don’t know exactly why).

This path is convoluted, so large Chinese companies — including Alibaba and Tencent — are often incorporated in places like the Cayman Islands to avoid domestic securities requirements while also giving them access to foreign capital markets. According to an analysis by offshore incorporation specialist law firm Walkers, nearly half of all Hong Kong-listed stocks are based in the Cayman Islands, with another quarter based in Bermuda. That is financially prudent for executives, but deeply unpopular with Chinese authorities, which both loses corporate control and also loses the future growth that these stocks attain when they list on a foreign exchange.

WTF is a CDR?

That’s where Chinese Depositary Receipts (CDRs) come in. Modeled after American Depositary Receipts, which were invented almost a century ago, CDRs are a way for local buyers to own foreign shares in a way that both fits within local securities regulations and reduces friction in the trading process.

A bank acts as a middleman broker between a foreign issuer and local buyers. This institution, known as the depositary, holds foreign shares of companies in trust, and then offers a new security to the local market linked to those deposited shares by a ratio (say one receipt per six shares). We now have two securities: the receipt, held by a shareholder which is connected to a depositary bank, and then the original foreign share, which is held by the bank on behalf of a foreign issuer.

This is where the “magic” happens: securities regulations apply to the new security targeting local buyers, and not to the shares of the original company (massive asterisk here since the reality is thousands of pages of policies and laws, but this is the general idea). By intermediating the transaction, everyone can win: local buyers get access to foreign investments, while also still coming under the purview of domestic regulations.

It’s important to note that there are a bunch of peculiarities that I don’t want to dive too much into. There are more fees than standard shares in order to pay for custody of the shares and the trading logistics to maintain them. There are tax implications and other accounting issues that can be quite complex depending on the investor.

Despite such complications though, depositary receipts are quite popular in the United States. The market in 2016 was worth an estimated $2.9 trillion, with roughly 3,500 such securities available to be traded, and dozens more launched that year according to BNY Mellon, which is among the largest depositary bank institutions in the country. Given that the Chinese economy is already larger than America’s today by some economic measures, the scale of a CDR market could well pass a trillion dollars.

Share the wealth at home

The concept behind depositary receipts may not be new, but their use in China has not previously been formalized, and that is liable to change now. This past Friday, the central government circulated a draft policy of new securities regulations that would allow for Chinese Depositary Receipts to be issued on local stock exchanges.

According to China Banking News, tech companies look like the major focus here. “The Opinions will allow some tech companies or enterprises in strategic emerging industries to perform listing via the issuance of either shares or depository receipts, with a focus on sectors including big data, cloud computing, artificial intelligence, software, integrated circuits, high-end manufacturing and bio-tech.” That focus on technology would match other initiatives of the Chinese Communist Party, namely the country’s roadmap for technological dominance, known as Made in China 2025.

Once the CDR mechanism is in place, Chinese companies listed overseas are expected to face significant pressure to utilize it and open up their ownership to local buyers. Already, companies like Baidu, Sogou, Alibaba, Tencent, and Xiaomi have said publicly that they are interested in finding a channel to return to the mainland (or in the case of Xiaomi, to potentially launch its initial offering at least partially there). As Bloomberg wrote a month ago, “Enticing mega-corporations to list locally will help burnish the reputation of China’s twin bourses in Shanghai and Shenzhen, notorious for spotty regulation, volatility and periodic government intervention.”

Furthermore, having more domestic Chinese shareholders ensures that corporate control of these local companies stays in Chinese hands. The Chinese Communist Party has been particularly aggressive on this front, proposing taking a point of equity in top firms and potentially installing party cadres on corporate boards. Changing the shareholder structure of these firms then should be seen as an extension of control by the party into the private sector.

While the changes are still being promulgated, we should be prepared for large changes in the ways that companies — particularly those in the technology sector — are capitalized. Alibaba and Tencent’s combined market cap is nearly a trillion dollars. There are dozens of other Chinese stocks listed exclusively in U.S. and Western exchanges, so if CDRs become popular, it could be a massive market. Expect CDRs to be a major news story for the remainder of the year as final regulations are published.