What are securities, and why are they important in financial markets?

Securities refer to any tradable financial asset. The exact definition of a security can vary depending on the jurisdiction where it’s being traded. In the United States, the term ‘security’ covers a wide range of financial instruments that can be grouped into three main categories:

• Equity securities (e.g. stocks)
• Debt securities (e.g. government and corporate bonds)
• Derivatives (e.g. options and futures).

Types of securities

The primary types of securities are equity, debt, hybrid and derivatives.

Equity securities

Equity securities, commonly known as stocks, represent partial ownership in a company. When an investor purchases equity securities, they acquire a share of the company and may receive dividends, which are distributions of the company’s profits. The value of these securities can fluctuate based on the company’s performance and market conditions.

Although equity securities don’t guarantee regular payments, investors can potentially earn returns through capital gains if the stock’s value increases. In the event of bankruptcy, shareholders are paid only after all debts have been settled, which can make them a riskier investment compared to debt securities.

Debt securities

Debt securities involve lending money to a company, government, or other entity in exchange for regular interest payments and the return of the principal amount by a set date (the maturity date). Common examples of debt securities include bonds and Treasury notes.

Unlike equities, debt securities don’t grant ownership or voting rights, and investors are repaid regardless of the issuer’s performance. Debt securities may be secured (backed by collateral) or unsecured, with secured debt having priority in case of bankruptcy.

Hybrid securities

Hybrid securities combine elements of both debt and equity securities. These include:

• Equity warrants: Options issued by a company giving shareholders the right to buy the stock at a set price on a specified date.
• Convertible bonds: Bonds that can be converted into shares of stock under predefined conditions.
• Preferred stock: Stocks which allow shareholders to receive interest, dividend, and other capital returns before other stockholders.

Hybrid securities combine features of both equities and debt securities, such as income payments (like bonds) and the potential for price appreciation (like stocks).

Derivatives

Derivatives are financial contracts whose value is derived from the price of an underlying asset, which may be a commodity (e.g. gas, gold, or coffee), currency, bond, or stock. Options and futures contracts are two examples of derivatives that allow investors to speculate on price movements without directly owning the underlying asset.

Companies and institutional investors often use derivatives to hedge against price fluctuations in underlying assets. They can be traded over-the-counter (OTC) or on exchanges.

Example of issuing securities

ABCTECH is a growing tech company looking to raise capital for its next phase of expansion. Up to this point, ownership has been split between its three co-founders. To secure additional funding, ABCTECH has two main options:

• It can go public through an IPO, raising capital by selling shares on the stock exchange. This option allows for significant fundraising but comes with regulatory requirements and disclosure obligations.
• It can conduct a private placement by selling shares to select investors without making them publicly available. This avoids the complexities of an IPO but limits the pool of potential investors.

Both methods involve issuing equity securities, where new shares dilute the founders’ ownership while granting investors a stake in the company.

Now, consider a municipal government looking to fund infrastructure projects. It issues bonds to investors, agreeing to pay periodic interest and return the principal at maturity. This is an example of a debt security, allowing the government to raise funds while offering periodic interest payments to investors.

How are securities traded?

Securities are traded in both public and private markets. The first time a company issues equity securities is through an initial public offering (IPO). After that, any newly issued shares are considered secondary offerings, although they’re still sold in the primary market – the market where securities are first created and issued.

Publicly traded securities are listed on stock exchanges, where issuers can attract investors by offering a liquid and regulated market for buying and selling shares. They can also be traded over-the-counter (OTC), where transactions take place between buyers and sellers rather than on a centralized exchange.

Securities can also be sold privately through private placements, where they’re offered to a select and qualified group of investors rather than the general public. Some companies choose a combination of both public and private placements when raising capital.

Once securities have been issued, they can be resold in the secondary market, also known as the aftermarket. This is where investors trade securities with each other, buying and selling shares for cash or capital gains.

What are the key differences between public and privately traded securities?

Publicly traded securities tend to have higher liquidity as they can be easily exchanged on the open market. Privately placed securities are subject to more restrictions and can only be transferred amongst qualified investors, making them less liquid.

What is the role of securities in raising capital for businesses?

Companies can issue securities to secure funding from investors. The capital raised can then be used to finance expansion projects, operations, research & development, and other strategic initiatives.

When companies issue equity securities, like stocks, they can raise capital without having to take on any debt. This can potentially be beneficial for long-term financial stability as it avoids the need for interest payments and repayment obligations.

On the other hand, issuing debt securities, like bonds, means companies can raise capital without having to dilute ownership. This can sometimes be a more attractive alternative to bank loans, depending on borrowing costs and market conditions.

How are securities regulated?

In the United States, the Securities and Exchange Commission (SEC) regulates the issuance, trading, and sale of securities. The goal of the SEC is to enhance transparency, protect investors, and prevent fraud in the financial markets. Public offerings and sales must be registered with the SEC and comply with disclosure requirements.

Additionally, self-regulatory organizations (SROs), such as the Financial Industry Regulatory Authority (FINRA) help oversee brokerage firms and trading practices.

Other countries have their own regulatory bodies, including the Financial Conduct Authority (FCA) in the United Kingdom and the European Securities and Markets Association (ESMA) in Europe. There are also global regulatory organizations, such as the International Organization of Securities Commissions (IOSCO), which sets international standards for consistency across markets.

What are the benefits and risks of investing in securities for businesses?

Investing in securities offers companies a way to generate additional income, diversify their financial holdings, and create a buffer against economic downturns. At the same time, these investments can come with risks that must be carefully considered.

Let’s take a look at the benefits and risks of investing in securities for businesses:

Benefits of investing in securities

Businesses can potentially benefit from investing in securities by:

Earning additional revenue

Purchasing securities may provide businesses with an additional source of income beyond their core operations. Companies can even explore securities lending services, which involve temporarily transferring securities to a borrower in exchange for collateral and potential compensation.

Gaining financial stability & risk management

Holding financial securities may potentially provide a buffer for businesses navigating periods of uncertainty. Just as banks and insurance companies invest to maintain liquidity, companies can use securities to maintain a steady cash flow and mitigate financial risk.

Protecting against seasonal or economic fluctuations

Companies that experience seasonal demand fluctuations sometimes use a diversified investment portfolio to manage cash flow variability. During off-peak periods, income from securities can help stabilize cash flow. At the same time, investments in industries that perform differently from the company’s core business may act as a hedge against revenue losses during economic downturns.

Liquidity for short-term operations

Investing in money market instruments and other liquid securities can provide companies with quick access to funds when needed. This may be a better alternative to holding excess cash in low-interest savings accounts that might not keep up with inflation.

Exploring new markets and industries

Investing in securities can serve as a form of research and development. For example, a company considering expansion into a new industry can first invest in publicly traded businesses within that sector to analyse growth potential and market trends before making a direct entry.

Potential for more borrowing power

Companies with a well-managed securities portfolio may appear more financially stable, which can potentially improve creditworthiness. As a result, it may potentially be easier to secure loans or attract investors.

Risks of investing in securities

Like any investment, there are also certain risks associated with investing in securities. These include:

Market volatility

Securities may experience price fluctuations depending on economic conditions and company performance. A decline in market value can lead to investment losses and affect overall portfolio performance.

Credit & default risk

Debt securities carry the risk that issuers may default on payments, which may impact repayment obligations to investors. Businesses investing in bonds or other registered debt securities must assess the creditworthiness of issuers before committing capital.

Liquidity constraints

Many securities are highly liquid, but some may be difficult to sell quickly without incurring losses – particularly those in private placements or less active markets.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.