Two-way fungibility unraveled

Finance Minister in the budget this year gave into the long-standing demand of the industry for two-way fungibility. What does it mean? And what are the benefits? Read on. Fungibility means to serve in place of (i.e. interchangeability). Applying this definition to the capital markets. The term fungibility means interchangeability of any securities of a class.

Two-way fungibility means investors can freely convert ADRs (American Depository Receipts) /GDRs (Global Depository Receipts) into underlying domestic shares and vice versa. Previously only one-way fungibility was allowed. The ADRs/GDRs could be converted into local shares but could not be converted back into ADRs/GDRs. This effectively meant that once a conversion was done the number of ADRs/GDRs would decrease and could only be replenished by fresh issue of ADRs/GDRs. In effect, this would lead to lower liquidity in the ADR/GDR markets.

The benefits of two-way fungibility would be two fold:

• Better liquidity in the ADR/GDR market.
• Reduction of price differential between the domestic and ADR/GDR markets

The primary reason for low-liquidity in the Indian ADRs/GDRs is due to the fact that the companies have had very small ADR/GDR issue sizes. For example Wipro listed on the NYSE with 2.3 m shares, which accounts for less than 2% of its equity capital. The small number of shares leads to lower volumes. Ideally, by allowing two-way fungibility, the trading volumes would improve. However, the fungibility is limited to local shares that arise due to ADR/GDR conversions. This implies that a share issued in the domestic market cannot be converted into ADR/GDR (unless it arises due to a previous ADR/GDR conversion).

Given that most Indian ADRs have historically traded at a premium to the underlying local stocks, converting into domestic shares would not have made sense. Thus, the current impact may be negligible. The impact could be more on the GDR market, which has a longer history and has seen conversions into local stocks in the past. There might be a few takers who would like to re-convert for various reasons. Forex fluctuations could be one of the reasons to convert back to GDR.

Infosys has always traded at a premium on the NASDAQ compared to the price at the local exchanges. However, once the ADR was converted to domestic shares it was not allowed to reconvert. Now with the two-way fungibility being allowed, players will be able take positions according to their convenience. This would probably help in removing the price differential between the local and the ADR/GDR markets.

The government has taken a right step, which would significantly help improve the liquidity of Indian ADRs/GDRs, thus, inviting more global interest in the Indian companies.