What Is a Security?

What Is a Security?

Let me tell you directly: the term 'security' covers a wide range of investments, including stocks, bonds, investment contracts, notes, and derivatives. As you'll see, a security might represent ownership in a corporation through stock, a creditor relationship with a government or company via a bond, or even rights to ownership like an option.

Key Takeaways

You need to understand that securities are tradable financial instruments available in public and private markets. They primarily fall into three categories: equity, debt, and hybrids. Remember, public sales of these are regulated by the Securities and Exchange Commission (SEC), and self-regulatory organizations like NASD, NFA, and FINRA oversee derivative securities.

How Securities Work

Companies issue securities to raise capital from investors, and I want you to know this started with key regulations. The Securities Act of 1933 was the first federal law to regulate the U.S. stock market, shifting oversight from states. It mandates that anyone selling investment contracts publicly must disclose details about the offering, the company, and its leaders.

These rules exist to shield you, the investor, from deceptive practices. The company and its executives are fully liable for any inaccuracies in financial statements, intentional or not. Later laws established the SEC to handle regulations and enforcement.

You might associate 'securities' with stocks and bonds, but the U.S. Supreme Court interprets it broadly. In the 1946 Howey vs. SEC case, the court ruled that selling land with agricultural services was an 'investment contract,' even without traditional stock or bond elements.

The Howey Test

From that case, the four-prong Howey Test emerged, which I'll explain clearly: an investment qualifies as a security if there's an investment of money into a common enterprise, with investors expecting profits primarily from the efforts of a third party or promoter. Under this test, it doesn't matter if there's no formal contract or certificate—any investment offering can count. Courts have applied this to unusual assets like whiskey, beavers, and chinchillas, and the SEC has targeted cryptocurrencies and NFTs.

Types of Securities

Securities divide broadly into equity and debt, with some hybrids blending both. Equity securities give you ownership in a company, partnership, or trust, often as common or preferred stock. Holders don't get regular payments but can gain from dividends or selling at a higher value, and they have voting rights on a pro-rata basis. In bankruptcy, they claim residual interest after creditors.

Debt securities are borrowed money you must repay, with terms for loan size, interest, and maturity. They provide regular interest and principal repayment, regardless of issuer performance, and include bonds, CDs, and collateralized options like CDOs and CMOs. These can be secured or unsecured, with priority in bankruptcy if secured.

Hybrid securities mix debt and equity features, such as equity warrants allowing stock purchase at a set price, convertible bonds turning into shares, or preference shares with prioritized payments. Preferred stock acts like a bond with fixed dividends, making it a fixed-income choice.

Derivatives are contracts priced by underlying assets like stocks or commodities—calls gain if the asset rises, puts if it falls. Asset-backed securities pool income-generating assets like loans or mortgages, distributing cash flows to investors.

How Securities Trade

Publicly traded securities list on stock exchanges, where issuers ensure liquidity and regulation to attract you as an investor. Over-the-counter trading happens directly between parties, often online or by phone. An IPO is a company's first public equity sale, followed by secondary offerings in the primary market.

Private placements go to qualified groups, avoiding some regulations. In the secondary market, you transfer securities between investors for cash or gains. This market is less liquid for private securities, limited to qualified buyers.

Investing in Securities

The issuer creates securities, and you, the investor, buy them. They help municipalities, companies, and enterprises raise capital—think IPOs generating big funds or municipal bonds for projects. Sometimes, it's better than bank loans based on market demand.

Buying on margin means using borrowed money for securities, a common tactic. Companies might use securities as collateral for debts. I advise you to consider this when planning investments, like for retirement.

Regulation of Securities

The SEC oversees public offers and sales in the U.S., requiring registration and filings. Self-regulatory organizations like NASD and FINRA also regulate, especially in brokerage.

Residual Securities

These are convertibles, like bonds turning into stock or preferred shares with conversion features. Companies use them to attract capital in competitive markets, but conversion dilutes shares and affects metrics like earnings per share. Consolidation reduces outstanding shares to boost value and draw big investors.

Other Types of Securities

Certificated securities come in physical paper, but most are now book-entry via systems like the Depository Trust Company, holding them electronically without differences in rights. Bearer securities are negotiable by delivery, often fungible, but rare in the U.S. due to tax evasion concerns.

Registered securities list the holder's name in a register, with transfers via amendments; they're undivided and fungible. Letter securities aren't SEC-registered, sold privately with an investment letter, requiring forms for transfers. Cabinet securities are listed but inactive, often bonds stored historically in cabinets for limit orders.

Issuing Securities: Examples

Take startup XYZ: it could go public via IPO for more capital but with fees, or use private placement to avoid scrutiny—both dilute founder stakes as equity securities. A government might issue bonds for economic revival, promising payments as debt securities. Startup ABC could offer convertible notes to investors, starting as debt and converting to equity in funding rounds, making it a hybrid.

What's the Difference Between Stocks and Securities?

Stocks are one type of security, representing fractional company ownership with potential voting and profit shares. Securities include more, like bonds and derivatives.

What Are Marketable Securities?

These are easily traded on public exchanges, like stocks or treasury bonds. Non-marketable ones, like private shares, have strict sale limits.

What Are Treasury Securities?

Issued by the U.S. Treasury, these low-risk bonds fund the government and appeal to cautious investors.

The Bottom Line

Securities are key investment contracts, and you likely use them for savings like retirement through equity or debt. They're vital for markets, letting companies raise public capital.