What are financial securities?
Security is a type of financial instrument that holds value and can be traded between two parties. We will look into the financial securities definition in more detail and give some security examples, too.
Key takeaways
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Securities are financial instruments that hold value and can be traded between two parties.
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There are many kinds of securities, with equity, debt and hybrid among the most common.
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Stocks are a form of security, but there are many other types of security.
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Trading with and investing in securities carries a level of risk.
Types of securities
There are several different kinds of securities in finance.
Equity securities
Equity securities represent ownership of a company in the form of shares of capital stock. People who hold equity securities do not get a regular payout, although in the case of some shares they may be entitled to dividends, but they are able to be sold for a capital gain if their value has increased over time. Equity securities often entitle their holders to have voting rights in a company.
Debt securities
Debt securities, meanwhile, are borrowed money which must be paid back at the end of a fixed term. Examples of debt securities are corporate and government bonds, collateralised debt obligations and certificates of deposit. Holders are usually entitled to regular interest payments and repayment of principal, though not to voting rights. Debt securities can be secured or unsecured.
Hybrid securities
Hybrid securities are, as their name suggests, something of a cross between equity and debt securities. An example of a hybrid security would be convertible bonds – bonds that can be converted into shares of common stock in the issuing company. Equity warrants are also hybrid securities – these are options issued by a company giving shareholders the right to buy stock within a specific period at a particular price.
Derivatives
Derivatives are financial instruments which are not an underlying asset but something based on the performance of that asset, such as options, futures, and contracts for difference (CFDs) are also forms of security.
Other forms of securities
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Bearer securities: Entitle the shareholder to certain rights under the security.
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Cabinet securities: Listed by a major financial exchange, but aren’t actively traded.
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Certificated securities: Appear in physical paper form. Technology and policy change has done away with the need for certificates in many cases, and it’s important to note that certificated and uncertificated securities don’t confer different rights or privileges to either the holder or the issuer.
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Letter securities: Sold directly to the investor by the issuer. The term stems from the US Securities and Exchange Commission’s (SEC) requirement for an ‘investment letter’ from the purchaser, stating that the purchase is for investment purposes and isn’t intended for resale.
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Mortgage-backed securities (MBS): Allow a smaller bank to lend mortgages to its customers without worrying whether they have the assets to cover the loan. The bank acts as a middleman between the homebuyer and the investor. Mortgage-backed securities played a key role in the 2007-08 financial crisis, and some of the legal cases arising from their improper use were only recently settled.
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Registered securities: Carry the holder’s name and other details maintained in a register by the issuer. Transfers of registered securities are executed through amendments to the register.
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Residual securities: A type of convertible security, meaning they can be changed into another form, usually into common stock.
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Security baskets: Exchange traded funds (ETFs) and mutual funds are examples of security baskets that hold many different securities (or security types).
It is worth noting that marketable securities cover any form of security that can be turned into cash relatively quickly and cheaply while, in the US, treasury securities are backed by the federal government and include treasury bills, bonds and notes, which are issued to help raise funds for projects.
How securities are traded
To understand the meaning of securities in finance, let’s take a look at how different types of securities are traded in the markets.
Stock exchanges
Some equity securities are listed on stock exchanges. The people behind the securities, called issuers, seek listings. When an equity security is new, it is offered to people on an initial public offering (IPO) basis. After this, any other newly issued stock is called a secondary offering.
Private placements
Securities can also be offered privately to a restricted group – this is termed a private placement. Companies sometimes sell stock in a combination of public and private placement. Other securities can be traded privately.
Derivative exchanges and trading platforms
Derivatives are something of a special case, as they can be traded on derivatives exchanges. For instance, futures contracts are often traded on futures exchanges, while CFDs have a range of specialist CFD platforms where people can often use leverage, or borrow money in order to trade with it, to access the market. Note that leverage magnifies both profits and losses. Some derivatives also allow traders to short-sell, speculating on an asset’s price to fall.
Over-the-counter (OTC) market
Bonds, as well as some stocks and shares, can be traded on the over-the-counter (OTC) markets, meaning that they can be bought and sold directly, rather than having to go through a broker.
How to invest in securities
How to invest in a security would largely depend on the type of security you want to buy.
For example, equity securities can be sold on stock exchanges or over-the-counter (OTC).
Things can be different with other types of security, though. For instance, in some jurisdictions, local governments can raise funds through issuing municipal bonds.
Here is a step-by-step guide on how to invest in securities:
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Choose a security that you want to invest in. This would depend on your portfolio needs and overall trading strategy.
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Research how the security is traded. This could be on a stock exchange, a trading platform, in the over-the-counter (OTC) market, or other ways.
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Be aware of regulations and tax implications. Any regulations or tax requirements would depend on your jurisdiction. Refer to government websites or consult a professional.
Remember, though, that investing can be risky, so you should do your own research. Note that markets can move against your position, and never invest more money than you can afford to lose.
Regulation of securities
How securities are regulated, and who by, varies from jurisdiction to jurisdiction.
In the UK, the Financial Conduct Authority (FCA) is responsible for the regulation of securities. The FCA says it strives to make securities markets work well by:
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Monitoring market disclosures by issuers and others and enforcing compliance.
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Reviewing and approving prospectuses published by issuers and offerors.
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Operating the UK listing regime, which requires listed issuers to comply with the Listing Rules.
In the US, the Securities and Exchange Commission (SEC) is in charge of regulating securities.
In the European Union, the European Securities and Markets Authority (ESMA) fulfils that role, while Australia’s securities are regulated by the Australian Securities and Investments Commission (ASIC).
Other jurisdictions have other authorities in charge of regulating securities.
Role of securities in finance
Securities play an important role in global financial markets in the following ways.
Diversification of investment portfolios
Investors use securities as a way to diversify their investment portfolios. The idea is that having a diversified portfolio can potentially help mitigate against risk as well as guard against market volatility with some assets. There are various asset allocation methods that involve diversification.
Risk management
Various types of securities can be used against each other as a way of hedging against risk. For example, short positions in stock derivatives can be used to hedge long equity holdings.
Raising funds for corporations and governments
Securities can help raise funds for companies. In many cases, making an initial public offering (IPO) of stock can be more effective than getting a loan to finance a new company or project. Likewise, governments can sell various kinds of bonds in a bid to generate revenue which otherwise might have to be made via lending or unpopular tax rises or spending cuts in other areas.
Facilitating market liquidity
Securities are able to facilitate market liquidity. Compared to, for instance, property, it is relatively easy to convert a security into cash, meaning that people can do so, adding more money to the market and making it more liquid.
Link to the economy
Securities can reflect the state of the economy. If stocks and shares, for instance, are doing well, then the companies linked to them are probably performing well too. Likewise, a growing market can help bring more money into the overall economy and boost consumer confidence.
Conclusion
In conclusion, securities are tradable financial instruments. There are different types of securities and it’s up to an investor to decide what allocation method suits their portfolio. The way a security is traded would depend on the type of security and can range from a stock exchange to OTC market. The regulation around securities would also vary based on jurisdiction. Finally, securities are an important part of financial markets as they facilitate liquidity, can be used in hedging strategies, for diversification and have a significant impact on the wider economy.
As with all parts of the financial market, the future of the securities market is unknown, which is why you will have to do your own research, remember that markets can move in a direction that can damage your position, and never trade with more money than you can afford to lose.