Security (finance)

• 1. Introduction

  ›

  A security is a tradable financial asset, and that deceptively simple definition sits at the foundation of the entire global economy. Every time a company raises money from investors, every time a government borrows to fund public spending, every time a pension fund holds wealth on behalf of millions of workers, the instrument at the center of the transaction is almost certainly a security. Yet the word itself is slippery. Ask a regulator in London, a banker in New York, and a trader in Mumbai what a security is, and you may get three meaningfully different answers. The legal definition varies by jurisdiction, and in some countries the term covers almost every form of financial instrument imaginable, while in others it applies only to equities and fixed income. What makes a security a security? Who holds them, who issues them, and who controls the vast machinery that keeps them moving? Those are the questions this documentary will answer.

• 2. Debt Securities

  ›

  Corporate bonds represent the debt of commercial or industrial entities, and they come in a striking variety of forms: mortgage bonds, collateral trust bonds, equipment trust certificates, debenture bonds, convertible debentures, and guaranteed bonds. The maturity of a debt security is one of its most defining characteristics. Debentures carry a long maturity, typically at least ten years, while notes have a shorter lifespan. At the very short end of the spectrum sits commercial paper, a simple instrument that essentially functions as a post-dated cheque with a maturity of no more than 270 days. Money market instruments are even more closely related to everyday deposit accounts. Certificates of deposit and Accelerated Return Notes are so liquid they are sometimes called near cash. Beyond domestic markets, euro debt securities are issued internationally outside their home market in a currency different from the issuer's own. Eurobonds are characteristically underwritten and not secured, and interest on them is paid gross. U.S. federal government bonds, called treasuries, carry a perceived low risk so strong that non-U.S. central banks rely on them to manage their own money supplies through open market operations. Below the sovereign level, municipal bonds in the United States represent the debt of state, provincial, territorial, and other governmental units. At the international level, supranational bonds represent the debt of bodies such as the World Bank, the International Monetary Fund, the African Development Bank, and the Asian Development Bank.

• 3. Equity and Hybrid Forms

  ›

  Common stock is the most familiar form of equity interest, but it sits within a broader family of instruments that blend ownership with obligation in different ways. Unlike debt holders, equity holders receive no guaranteed payments. In a bankruptcy, they share only in whatever is left after every creditor has been paid out in full. What equity provides in exchange is control: a holder of a majority of a company's equity is usually entitled to direct the issuer's affairs. Equity also carries the right to profits and capital gain, a prospect unavailable to debt holders who receive only interest and principal repayment no matter how well the company performs. Preference shares occupy a middle ground between pure debt and pure equity. If an issuer is liquidated, preference shareholders have the right to receive interest or a return of capital before ordinary shareholders do. Convertibles add another layer of flexibility: these are bonds or preferred stocks that can be converted, at the election of the holder, into ordinary shares of the issuing company. That conversion can, however, be forced. When a convertible is also a callable bond and the issuer calls it, the bondholder has about one month to convert or the company will pay the call price, which may be less than the value of the converted stock. Equity warrants work differently. Issued by the company itself, they allow the holder to purchase a specific number of shares at a specified price within a specified time. When a holder exercises a warrant, the money goes directly to the company, which then issues new shares. Because warrants increase the total number of shares outstanding, financial reports must always account for them as fully diluted earnings per share.

• 4. Primary and Secondary Markets

  ›

  In the primary market, money flows from investors directly to the issuer, most visibly in an initial public offering, or IPO. A company can later issue additional shares through a process known as a shelf registration, and those later issues are sold in the primary market as well, though they are not considered an IPO and are typically called a secondary offering. Investment banks play a central role in administering these transactions. When a bank buys an entire new issue from the issuer at a discount and resells it at a markup, that arrangement is called firm commitment underwriting. If the bank judges the risk too high to guarantee the purchase, it may instead agree only to a best effort arrangement, simply doing its best to sell the issue without any guarantee of proceeds. Secondary markets exist to provide liquidity once those initial sales are done. Without a functioning aftermarket where investors can sell holdings to other investors for cash, few buyers would participate in primary offerings, and companies and governments would struggle to raise equity capital. Organized exchanges constitute the main secondary markets, while smaller issues and most debt securities trade in the decentralized, dealer-based over-the-counter markets. Growth in informal electronic trading systems has challenged traditional stock exchanges. Over-the-counter dealing connects buyers and sellers by telephone or electronically, with prices displayed by financial data vendors such as SuperDerivatives, Reuters, Investing.com, and Bloomberg. In Europe, the principal trade organization for securities dealers is the International Capital Market Association. In the United States, the Securities Industry and Financial Markets Association performs that role, itself the product of a merger between the Securities Industry Association and the Bond Market Association. In India, the equivalent body is the Securities Exchange Board of India.

• 5. Securities as Collateral

  ›

  The last decade has seen an enormous growth in the use of securities as collateral, reshaping how institutions and individuals borrow against financial assets. Purchasing securities with borrowed money secured by other securities or cash is called buying on margin. At the consumer level, three distinct groups of loans against securities have emerged. Standard institutional loans generally offer low loan-to-value ratios with strict call and coverage requirements, similar to standard margin loans. Transfer-of-title loans, typically provided by private parties, completely extinguish the borrower's ownership except for rights written into the loan contract. Non-transfer-of-title credit line facilities allow shares to remain in the borrower's name, serving as assets in a lien-type cash credit line. Of the three, transfer-of-title loans have fallen into the very high-risk category. The number of providers has dwindled as regulators launched an industry-wide crackdown on structures where a private lender may sell or sell short the securities to fund the loan. By contrast, institutionally managed consumer securities-based loans draw their funds from the lending institution's own resources, not from selling the collateral. The nature of acceptable collateral has also shifted over time. In 2012, gold became a more acceptable form of collateral. By 2015, exchange-traded funds, previously seen by many as unpromising candidates for collateral, had started to become more readily available and acceptable in that role.

• 6. Physical Form and Settlement

  ›

  Securities that exist in paper form are called certificated securities. Bearer securities among these are fully negotiable: whoever physically holds the instrument is entitled to the rights it carries, whether that means receiving interest payments or casting a vote. Transfer happens simply by passing the document from person to person, sometimes with an endorsement on the back. Regulatory and fiscal authorities have long viewed bearer securities with suspicion because they can facilitate tax evasion and circumvent regulatory restrictions. In the United Kingdom, the Exchange Control Act 1947 heavily restricted bearer securities until 1953. In Luxembourg, a law of the 28th of July 2014 mandated the compulsory deposit and immobilization of bearer shares and units with a depositary, enabling identification of holders. In the United States, bearer securities are very rare because of the negative tax implications they carry for both issuer and holder. Registered securities work differently: the issuer or its agent maintains a register, and legal ownership transfers only when that register is amended, not merely when a certificate changes hands. Modern practice has largely moved to eliminate certificates entirely. In the United States, the Depository Trust Company, known as DTC, holds a single global certificate representing all outstanding securities of a class on behalf of roughly thirty of the largest Wall Street firms. These thirty firms are the DTC participants. DTC's parent, the Depository Trust and Clearing Corporation, is a non-profit cooperative owned by those same participants. A retail investor's shares pass through multiple layers: the investor's broker, the broker's account at a DTC participant, and ultimately DTC itself. Ownership held in this layered fashion is called beneficial ownership, sometimes described as owning in street name. The National Securities Clearing Corp., a subsidiary of DTCC, clears most mutual fund share transactions among intermediaries electronically.

• 7. Regulation and Classification

  ›

  In the United States, public offers and sales of securities must either be registered with the Securities and Exchange Commission or fall under a recognized exemption. Brokerage firms are subject to both federal oversight by the SEC and state-level securities departments. Self-regulatory organizations add another layer: the Financial Industry Regulatory Authority, known as FINRA and formerly the National Association of Securities Dealers, polices the brokerage industry alongside the Municipal Securities Rulemaking Board. When investment schemes do not fit neatly within the traditional categories listed in the Securities Act of 1933 and the Securities Exchange Act of 1934, U.S. courts have developed a broader test for what must be registered. Courts look for an investment of money, a common enterprise, and an expectation of profits derived primarily from the efforts of others. That framework comes from the case SEC v. W.J. Howey Co. Beyond legal classification, securities can also be sorted along many practical dimensions: currency of denomination, ownership rights, maturity terms, degree of liquidity, income payments, tax treatment, credit rating, industrial sector, region or country, market capitalization, and type of holder. Holders themselves are broadly divided between retail investors, who are members of the public investing personally, and wholesale investors, meaning financial institutions acting on their own account or on behalf of clients. The wholesaler is typically an underwriter or broker-dealer trading with other broker-dealers rather than with the public. In the United Kingdom, the Financial Conduct Authority defines security narrowly, covering equities, debentures, government and public securities, warrants, and related instruments eligible for the Official List, while excluding much of what other jurisdictions would include under the same word.