What Are Financial Securities?

Both Apple stock and the most complex financial instruments in the world fall under the same umbrella term — securities. The term is used in the finance sector to refer to many different financial instruments. Because of this, it is important to understand the different types of securities, the definition of a security and the current issues surrounding the definition.

What Are Securities?

Securities are financial assets that hold value and can be traded between parties. Securities can be in the form of debt, equity, contracts or a mixture of all. From a regulatory perspective, the Howey test can be used to determine if something is a security:

1. An investment of money
2. In a common enterprise
3. With the expectation of profit
4. To be derived from the efforts of others

The test is based on a 1946 Supreme Court ruling in the case of SEC v. W.J. Howey Co. While the test leaves room for interpretation, it provides a solid framework for the definition of securities.  

How Do Financial Securities Work?

Financial securities can be sold to the public in an offering or distributed privately under the expectation of making a profit. Public offerings are typically under more scrutiny than private. 

The Securities Act of 1933 established a set of rules surrounding the sale of securities to the public. It required those who wish to sell securities to the public to publicly disclose information about the security and the offering, such as financial statements and leadership. The act laid the foundation for the U.S. Securities and Exchange Commission (SEC) to begin regulating the industry. 

Types of Financial Securities

Let’s take a look at a few examples.

Debt Securities

Debt securities are a type of financial asset that offer interest payments to the owner. It typically involves the owner giving an amount of money to the borrower in exchange for interest payments and the principal back. The notional amount of the interest payments is often influenced by the credit rating and trustworthiness of the borrower. 

Some examples are certificates of deposit (CDs) and government bonds. In the case of the CD, you can allow banks to borrow some of your money in return for interest payments. Government bonds are similar, but instead of a bank borrowing your money, the U.S. government is the borrower. 

Equity Securities

Equities are perhaps the most well-known of all securities. Equities make up the stock market, one of the largest and most diverse markets available to investors. Equities are financial instruments that are representative of ownership in a corporation. This ownership also gives the rights to earnings and voting rights. There are several types of equities, such as common stock, preferred stock and warrants.

An example of an equity security is Apple stock. If you own Apple stock, you own an asset that represents ownership in Apple. You are entitled to a share of Apple’s earnings through dividends and voting rights. 

Hybrid Securities

Hybrid securities are often much more complex than plain debt or equity securities. Instead, they combine aspects of both to form a new type of security. They can give investors fixed or floating returns and payments in interest or dividends. These securities are often far less liquid than others and usually used by sophisticated investors. 

The most common type of hybrid security is a convertible bond. It is structured like a debt security, with interest payments and borrowed money but can be converted into equity as shares of stock. Investors gain exposure to fixed income through interest payments but also tap into equities as the price of the convertible bond is closely tied to the price of the stock. 

Other examples of hybrid securities include preferred shares and structured notes.

Derivative Securities

A derivative security is a financial contract whose price is derived from an underlying asset. It is structured as an agreement between two or more parties and can trade on an exchange or over the counter (OTC). These contracts often provide leverage, which increases the profits and losses from moves in the underlying. They can provide more cost-effective exposure to the underlying asset, whether for speculative purposes or for hedging activities.

The most common example of a derivative is an option, which is a contract whose price is derived from the underlying stock. It gives the owner of the option the right, but not the obligation, to purchase a set amount of shares for a set price before or on a set date. 

Asset-Backed Securities

Asset-backed securities are well known because of their link to the 2008 financial crisis, but not many people know what they are and the purpose they serve. Asset-backed securities are financial instruments that are collateralized by an underlying pool of assets. The underlying assets can range from mortgages and loans to credit cards and collateralized debt obligations (CDOs). The issuer collects these assets and packages them into an asset-backed security, which it can then sell to the public. This offering provides investors with access to a diverse pool of the underlying assets without having to directly involve themselves with the origination process.

The most famous example of an asset-backed security is a mortgage-backed security (MBS). For this security, an investment bank purchases a large amount of mortgages from a mortgage originator, providing the investment bank with cash flow from the mortgages. The investment bank packages these into an MBS and distributes them to investors.

Importance of Financial Securities

Financial securities have played an important role in the economy for centuries. They can provide mutual benefits to investors and businesses, which in turn can help the overall economy. The main benefit of securities is that they allow individuals to invest and diversify their portfolios across assets. Since securities hold value and often expect to generate a profit, it allows investors to grow their wealth and preserve its value. 

How Financial Securities Are Traded

Financial securities can be traded in multiple ways and places. The most common is on an exchange and with a broker. An exchange is a collective place where securities are traded, and a broker is the one who facilitates those trades to make sure the process runs smoothly. 

Another way securities can be traded is over-the-counter (OTC), which is done directly between two parties with a broker-dealer as the intermediary and allows for more customization and flexibility while being less liquid. 

Role of Financial Securities in Cryptocurrency

While the definition of security was not debated and generally understood for decades, a recent debate has come about with the rise of cryptocurrency. When applying the Howey test to crypto, the main points of contention are whether or not it is a “common enterprise” and if the profits are derived from the efforts of others.”

Many are trying to determine whether or not cryptocurrencies are securities, as it has regulatory implications. The main implication is that many people used initial coin offerings (ICOs) to raise capital, but they did not register with the SEC. Additionally, firms that offer cryptocurrency trading may not be registered with the SEC. In either case, they could be dealing with securities without registration, which is illegal.

The Exact Definition of a Security is a Hot Topic

Many types of financial securities exist, but they are all financial assets that hold value and can be traded between parties. Examples include debt, equity, hybrid, derivative and asset-backed securities. The specifics of the definition are under debate as it relates to crypto, but the general idea has remained the same since the 1940s. 

Frequently Asked Questions