What is a Security?
The term “security” encompasses a wide range of investments, including stocks, bonds, investment contracts, notes, and derivatives. For instance, a security can signify ownership in a company through stock, a creditor relationship with a corporation or government via a bond, or ownership rights via an option.
Key Takeaways
- Securities are fungible and tradable financial instruments used to raise capital in both public and private markets.
- The three main types of securities are: equity (provides ownership rights), debt (loans repaid with regular payments), and hybrid (combines aspects of both equity and debt).
- Public security sales are regulated by the SEC.
- Self-regulatory organizations such as NASD, NFA, and FINRA also play key roles in regulating derivative securities.
Understanding Securities
The Securities Act of 1933 marked the first federal regulation of the U.S. stock market, introducing requirements that companies must publish detailed information about financial offerings. This regulatory framework aims to protect investors from deceptive practices by holding companies accountable for accuracy in their financial disclosures.
The term “securities” broadly includes stocks, bonds, and similar instruments. The U.S. Supreme Court, in the landmark case Howey vs. SEC (1946), broadened this definition to encompass investment contracts, even those without traditional stock or bonds. According to the Howey Test, an investment qualifies as a security if:
- Money is invested.
- The investment is in a common enterprise.
- Investors expect to make a profit.
- Expected profits come from the efforts of a third party.
Types of Securities
Equity Securities
Equity securities represent shares of ownership in a company, partnership, or trust, usually in the form of common or preferred stock. Shareholders profit from capital gains (value appreciation) and may have voting rights to influence company decisions.
Debt Securities
Debt securities are essentially loans that must be repaid with specified interest rates and maturity dates. These include government and corporate bonds and certificates of deposit (CDs).
Hybrid Securities
Hybrid securities combine elements of both equity and debt. Examples include convertible bonds and preferred shares, which act like bonds but offer a fixed dividend rate.
Derivative Securities
Derivatives are financial contracts based on the value of an underlying asset, such as stock or commodities. Common derivatives include call options, which profit from the asset’s appreciation, and put options that gain value as the asset loses value.
Asset-Backed Securities
Asset-backed securities represent operations of a basket of similar assets like loans or mortgages. The income from these assets is pooled and distributed among investors.
How Securities Trade
Publicly traded securities are listed on stock exchanges, fostering a liquid and regulated environment for trade. Alternative trading methods include electronic systems and over-the-counter (OTC) trades. An initial public offering (IPO) introduces a company’s stock to the public, while private placements offer stocks to select, qualified investors.
Investing in Securities
Securities provide entities with ways to raise capital. Companies can go public through IPOs, and governments may issue bonds to fund projects. Investors can also buy securities on margin, where purchased securities themselves act as collateral for loans.
Regulation of Securities
In the United States, the SEC regulates securities offerings and trading, in collaboration with self-regulatory organizations (SROs) like FINRA. These regulations aim to protect investors and ensure market integrity.
Residual Securities
Residual securities, like convertible bonds, can be converted into stock. Companies may issue these to attract investment during competitive markets. However, converting these securities enlarges the pool of available shares, potentially diluting share value and affecting financial metrics like earnings per share (EPS).
Other Types of Securities
Certificated and Non-Certificated Securities
Certificated securities exist in paper form, while non-certificated are recorded electronically.
Bearer Securities
Bearer securities are transferrable and grant ownership without needing to register the transfer formally. They are rare in the U.S. due to tax evasion risks.
Registered Securities
Registered securities require recording the holder’s details in a registry.
Letter Securities
Not publicly traded, letter securities are sold directly by the issuer with restrictions.
Example of Issuing Securities
Consider XYZ, a successful startup looking for growth capital. It can issue shares via an IPO or opt for private placement to raise funds. Another example is a government issuing bonds to finance public projects. In some cases, startups issue convertible notes to initial investors, turning these loans into shares once certain conditions are met.
Difference Between Stocks and Securities
Stocks represent one type of security focused on ownership in a corporation whereas securities can further include bonds, derivatives, and other financial instruments.
Marketable Securities
Marketable securities, like public company stocks, can easily be traded. Non-marketable securities, like shares in non-public companies, have restricted trade abilities.
Treasury Securities
Treasury securities, issued by the U.S. government, are highly secure debt instruments suitable for risk-averse investors.
The Bottom Line
Securities are vital tools for raising capital and investing. Equity and debt securities, among other types, are foundational for both personal investments and the broader market landscape.
Related Terms: equity securities, debt securities, hybrid securities, derivative securities, asset-backed securities.
References
- CaseText. “Continental Marketing Corp. v. SEC”.
- Open Jurist. “Miller v. Central Chinchilla Group”.
- CaseText. “Securities and Exchange Commission vs. Haffenden-Rimdar”.
- FINRA. “Money Market Securities and More”.
