What are Financial Securities? Examples, Types, Regulation, and Importance
What is security in the context of finance?
To better understand the term financial security, first, it is important to know what security means. Security is a financial instrument that could be fungible or negotiable and is used to raise capital in different markets like private or public markets.
There are three types of securities, such as equity, debt and hybrids. Equity refers to a kind of security that is used to represent the ownership rights of the security holders. Debt is a kind of security that mainly represents loans, which are paid periodically. However, hybrid security is a mixture of both equity and debt security. We will discuss each in detail later in this article.
SEC (Securities and Exchange Commission, U.S.) is the regulator of the public sales of securities. In regulating derivative securities, many existing organizations are operating as self-regulatory, like NASD, NFA, and FINRA, which play a very important role.
Emergence of Securities
The first federal regulation brought to regulate the stock market of the U.S. was the securities Act of 1933. According to this law, the seller selling the investment contracts to the public must provide information about the offering, the company making the offering, and information about the principal figures of that company. The requirements mentioned in the act are necessary as they protect the public who is investing from any kind of misleading or deceptive practices.
If there is any inaccuracy in the financial statements of any company, whether intentional or not, then the company will be held liable for such inaccuracies.
The term securities have not been defined anywhere. Still, in a case named Howey vs SEC, the U.S. Supreme Court laid down some criteria to determine when any investment should be considered a security. The following are the criteria that need to be fulfilled to consider an investment as securities:
According to this rule, securities should necessarily be in the form of any legal contract, but any investment offering can also be called a security under this rule.
The securities provisions have also been enforced upon unconventional assets, including whiskey or beavers. Recently issuers of cryptocurrencies or fungible tokens have also been brought in under the act.
Types of Securities
As we discussed at the start, securities can be of three types: Equity securities, Debt securities, and third, i.e., a mixture of both securities, called hybrid security.
Let's discuss these securities one by one.
The first security type is equity security. Equity security is represented by the shares and number of capital stocks an individual owns in any company, partnership, or trust. It includes both of the stocks, i.e., common and preferred.
Equity holders are not required to pay regularly, and the securities are used to pay a dividend. But the equity holders can sell the equities they are holding when the price is higher, and they can make a profit.
Having equity shares in any company also gives the holder voting rights in such a company, which means that equity shareholders get some control over the management of the company, but only to the extent that since they hold equity shares, they deserve to vote.
If the company goes bankrupt, all the obligations to the creditors are first paid off, and the equity shareholders shall have the remaining interest.
It is used to represent a loan that a person has borrowed, and the money has not yet been repaid. It must represent the size of the loan, the interest rate on which the loan was taken, and even the renewal or maturity period, if any.
There are mainly two types of debt securities, the first one is "secured debt" and the second one is "unsecured debt".
Secured debts are those debts that are given in exchange for some collateral, and it is important to note that secured debt is the one that is prioritized between unsecured and secured debt.
Unsecured debts are those debts that are not backed up by any collateral and are not contractually prioritized.
An equity warrant is one example of a hybrid security. As the name suggests, it is a mixture of both debt and equity securities as it has characteristics of both these two securities. Equity warrants are an option for the shareholders to buy their shares in a particular time period at a specific price, and the company itself issues these warrants.
The second example of hybrid security is a convertible bond. These are the bonds that can be easily converted into shares of common stock in the company issuing such bonds.
Another perfect example of hybrid security is preference bonds. It is important to note that preferred stock is also an example of equity security but is often considered debt security as it behaves like a bond. For income-seeking investors, preferred shares are the best option for them to choose as they offer a fixed dividend rate which assures the investors a sure income.
Some other Types of Securities
It is a type of financial contract whose price is based on the value of the underlying assets. The assets under this derivative security typically include commodities, bonds, or stock.
Call options and put options are the two derivatives that are most traded. A call option permits the holder the right to buy a stock, whereas a put option gives the holder the right to sell a stock. Simply put, both options are just the opposite.
The term asset-backed securities represent all the assets that are of the same kitties. Similar assets mean credit card debts, mortgages, leases or loans, or any other asset from which income is generated by the associated financial institute.
Over time, whatever cash flow is pooled from such assets is distributed among the different investors.
It is a kind of convertible security which means that it can be converted into some other form like common stock. One of the best examples of a convertible security is a convertible bond, as it can be easily converted into common shares by the bondholder.
Preferred stock is another example of convertible security as it may also be converted.
When high competition is seen in the market for funds, corporations often offer residual securities to attract investment investors. The current outstanding shares can be increased by converting the residual securities or exercising themes.
Securities in physical or paper form are often called certified securities. Securities can also be in the form of a book entry and be held in the direct registration system. In simple terms, it means that an agent on behalf of a company may also maintain the shares of any company without the need for any physical certificates.
Advancement in technology has now made it unnecessary to a complete security register by the issuer, and technology has eliminated the need for certificates in physical form.
A depository Trust company is a system where the issuers just have to submit a single certificate for all the outstanding securities. The trade of securities in DTC (Depository Trust Company) is made in electronic form.
Bearer securities are negotiable securities and can be transferred from investor to investor by delivery or endorsement. It can even be used to evade tax, and the issuers, shareholders, and fiscal regulatory bodies negatively view it.
Each bearer's security consists of a separate asset and also is legally distinct from each other in the same respect.
Registered securities are undivided securities, as each is considered a part of the whole asset, meaning that one single asset is made up of the entire issue. Registered securities commonly contain the name of the holder, and the issuer maintains all the other necessary details in a register. If there is a need to transfer such registered securities, then it can be made only by making necessary amendments in the register.
The nature of the undivided securities is fungible, and secondary market shares are always in the form of undivided securities.
Letter securities are also known as restricted securities. These kinds of securities are not listed under SEC and, therefore, cannot be sold in the marketplace publically. The issuer issues this kind of security to the investor.
The term letter securities are derived from a rule of SEC only, which says that the issuer must submit form 4 with a letter stating that the purchase of the share is just for investment purpose and not for resale.
Cabinet securities are listed under the NYSE (New York Stock Exchange), a major financial exchange, and people holding such securities are often passive (inactive) investors.
Here, the term "cabinet" refers to where all bond orders were stored in earlier times.
Trade of Securities
The stock exchange is where publicly traded securities are listed, and the investors who wish to buy those securities can buy them from there. For trading, a liquid and regulated market must be ensured for the investors. Another way that is becoming very common to make a trade is electronic trading systems, because of which it is now possible to trade securities over a phone, online, or from a counter.
When any company offers to sell its major equity shares for the first time to the public, then it is called an initial public offering (IPO). After the offering of the IPO, the next new stock, which the same company offers, is known as a secondary offering.
In some cases, securities are not offered to the public but privately or to any group; then it is called a private placement. Some companies also offer their stock both ways, i.e., for public and private persons or groups.
In the case of secondary markets, the shareholders often sell their holdings or securities to any other investor in exchange for cash or capital gain. Securities in the secondary market are shared like an asset from one investor to another.
The privately-place securities are more difficult to share as they can only be transferred to any qualified group, not the public.
Investing in Securities
The one who offers its securities for sale is called the issuer, whereas the one who buys such securities is called an investor. The sale of securities is a way to earn capital for municipalities, companies, and commercial enterprises.
Whenever a company offers its securities to the public, they earn a lot of capital. The best example is IPO. Rather than raising capital from financial loans from any bank, if the company's demand is good in the market and other factors are also satisfactory, then the company can issue its stocks as IPO and raise funds for its growing operations.
The purchase of securities from the money borrowed is also considered a good investment, and it is called as buying on-margin technique. However, when any company fails to pay its debt, it usually has to give some property rights, which can be in the form of cash or securities, to another entity from which the debt was borrowed.
Regulation of Securities
Any kind of public offering or selling of securities is regulated by the commission named U.S. Securities and Exchange Commission (SEC) in the United States. In India, the Securities and Exchange Board of India (SEBI) is the regulatory authority. It was established under the SEBI Act 1992. The filing and registration of public offerings, sales, or trading of securities must be made in the state securities department of the regulating authority of the respective nation.
In the brokerage industry, the rules and regulations are often laid down by Self-Regulatory organizations. Some examples of such self-regulatory organizations are the Financial Industry Regulation Authority and the National Association of Securities dealers.
The Supreme Court of the U.S. defined the word security offering in the year 1946 in a case. It laid down four criteria to define security offering:
Example: Issuing Securities
Suppose there is a company named ABC Ltd, and the company is in need of raising capital for its further growth. The company can raise capital by two methods; the first one is by issuing IPO and the second one is by offering a share of the company to private investors in a private placement.
By conducting an IPO, the chances of raising more capital are higher than by offering the shares to the investors privately, but in the case of conducting an IPO, the problem is that it requires high fees and other disclosures to be made public. But in the second option, the shares of the company will be traded in secondary markets, and it will also be out of public scrutiny.
Suppose any country's government wants its economy to get on track and therefore requires raising capital. The government, in this case, can raise capital by selling bonds and debt security and can promise the holder of such bonds or security to pay regularly.
Let's look into the final case and suppose there is a new startup that requires funding in the initial stage, and they raise this capital from their friend and family. In return for that, they issue a convertible note to the person who has invested in the startup. These convertible notes can be converted into the shares of that startup after some time.
Such kinds of notes will fall into the type of debt security as the investment the investors have made a kind of loan.