Security

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DEFINITION of 'Security'

A security is a financial instrument that represents an ownership position in a publicly-traded corporation (stock), a creditor relationship with governmental body or a corporation (bond), or rights to ownership as represented by an option. A security is a fungible, negotiable financial instrument that represents some type of financial value. The company or entity that issues the security is known as the issuer.

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BREAKING DOWN 'Security'

Securities are typically divided into debts and equities. A debt security represents money that is borrowed and must be repaid, with terms that define the amount borrowed, interest rate and maturity/renewal date. Debt securities include government and corporate bonds, certificates of deposit (CDs), preferred stock and collateralized securities (such as CDOs​ and CMOs​).

Equities represent ownership interest held by shareholders in a corporation, such as a stock. Unlike holders of debt securities who generally receive only interest and the repayment of the principal, holders of equity securities are able to profit from capital gains.

In the United States, the U.S. Securities and Exchange Commission (SEC) and other self-regulatory organizations (such as the Financial Industry Regulatory Authority (FINRA)) regulate the public offer and sale of securities.

The entity (usually a company) that issues securities is known as the issuer. For example, the issuer of a bond issue may be a municipal government raising funds for a particular project. Investors of securities may be retail investors–those who buy and sell securities on their own behalf and not for an organization–and wholesale investors–financial institutions acting on behalf of clients or acting on their own account. Institutional investors include investment banks, pension funds, managed funds and insurance companies.

Security Functions

Generally, securities represent an investment and a means by which companies and other commercial enterprises can raise new capital. Companies can generate capital through investors who purchase securities upon initial issuance. Depending on an institution's market demand or pricing structure, raising capital through securities can be a preferred alternative to financing through a bank loan.

On the other hand, purchasing securities with borrowed money, an act known as buying on a margin, is a popular investment technique. In essence, a company may deliver property rights, in the form of cash or other securities, either at inception or in default, to pay its debt or other obligation to another entity. These collateral arrangements have seen growth especially among institutional investors.

Debts and Equities

Securities can be broadly categorized into two distinct types – debts and equities – although hybrid securities exist as well. Debt securities generally entitle their holder to the payment of principal and interest, along with other contractual rights under the terms of the issue. They are typically issued for a fixed term, at the end of which, they can be redeemed by the issuer. Debt securities only receive principal repayment and interest, regardless of the issuer's performance. They can be protected by collateral or unsecured, and, if unsecured, may be contractually prioritized over other unsecured, subordinated debt in the case of a bankruptcy of the issuer, but do not have voting rights otherwise.

Equity securities refer to a share of equity interest in an entity. This can include the capital stock of a company, partnership or trust. Common stock is a form of equity interest, and capital stock is considered preferred equity as well. Equity securities do not require any payments, unlike debt securities which are typically entitled to regular payments in the form of interest. Equity securities do entitle the holder to some control of the company on a pro rata basis, as well as right to capital gain and profits. This is to say that equity holders maintain voting rights and, thus, some control of the business. In the case of bankruptcy, they share only in residual interest after all obligations have been paid out to creditors.

Hybrid securities, as the name suggests, combine some of the characteristics of both debt and equity securities. Examples of hybrid securities include equity warrants (options issued by the company itself that give holders the right to purchase stock within a certain timeframe and at a specific price), convertibles (bonds that can be converted into shares of common stock in the issuing company) and preference shares (company stocks whose payments of interest, dividends or other returns of capital can be prioritized over those of other shareholders).

Market Placement

Money for securities in the primary market is typically received from investors during an initial public offering (IPO) by the issuer of the securities. Following an IPO, any newly issued stock, while still sold in the primary market, is referred to as a secondary offering. Alternatively, securities may be offered privately to a restricted and qualified group in what is known as a private placement–an important distinction in terms of both company law and securities regulation. Sometimes a combination of public and private placement is used.

In the secondary market, securities are simply transferred as assets from one investor to another. In this aftermarket, shareholders can sell their securities to other investors for cash or other profit. The secondary market thus supplements the primary by allowing the purchase of primary market securities to result in profits and capital gains at a later time. It is important to note, however, that as private securities are not publicly tradable and can only be transferred among qualified investors, the secondary market is less liquid for privately placed securities.

Securities are often listed on stock exchanges, where issuers can seek security listings and attract investors by ensuring a liquid and regulated market in which to trade. Informal electronic trading systems have become more common in recent years, and securities are now often traded "over the counter," or directly among investors either online or over the phone. The increased transparency and accessibility of stock prices and other financial data have opened up the markets to these alternative buying and selling options.

Classifications

Certificated securities are those that are represented in physical, paper form. Securities may also be held in the direct registration system, which records shares of stock in book-entry form. In other words, a transfer agent maintains the shares on the company's behalf without the need for physical certificates. Modern technologies and policies have, in some cases, eliminated the need for certificates and for the issuer to maintain a complete security register. A system has developed wherein issuers can deposit a single global certificate representing all outstanding securities into a universal depository known as the Depository Trust Company (DTC). All securities traded through DTC are held in electronic form. It is important to note that certificated and un-certificated securities do not differ in terms of the rights or privileges of the shareholder or issuer.

Bearer securities are those that are negotiable and entitle the shareholder to the rights under the security. They are transferred from investor to investor, in certain cases by endorsement and delivery. In terms of proprietary nature, pre-electronic bearer securities were always divided, meaning each security constituted a separate asset, legally distinct from others in the same issue. Depending on market practice, divided security assets can be fungible or non-fungible, meaning that upon lending, the borrower can return assets equivalent either to the original asset or to a specific identical asset at the end of the loan, though fungible arrangements are certainly more common. In some cases, bearer securities may be used to aid regulation and tax evasion, and thus can sometimes be viewed negatively by issuers, shareholders and fiscal regulatory bodies alike. They are therefore rare in the United States.

Registered securities bear the name of the holder, and the issuer maintains a register of necessary details. Transfers of registered securities occur through amendments to the register. Registered debt securities are always undivided, meaning the entire issue makes up one single asset, with each security being a part of the whole. Undivided securities are fungible by nature. Secondary market shares are also always undivided. 

Regulation

Public offerings, sales and trades of securities in the United States must be registered and filed with the SEC state securities departments. Self Regulatory Organizations (SROs) within the brokerage industry are meant to take on regulatory positions as well. Examples of SROs include the National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority (FINRA).

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