Oftentimes, when we hear the word “financial securities” we tend to associate that with shares, but the list goes on and includes several additional financial instruments. Financial security, in basic terms, can be any financial instrument that has a monetary value such as stocks, bonds, mutual funds, options, etc. Basically, in the financial world, security is an instrument that is either equity, debt or derivatives. Equity refers to the ownership stake in a company, debt is the obligation to pay a definite amount of money and derivatives are securities derived from other securities. This article serves as a guide to help you understand financial securities and their types.
Financial securities can be considered as financial assets possessing monetary value, which can be bought and sold. But, what are the features of financial securities? Well, they are financial products that can reflect stock ownership in a corporation, a creditor relationship with a bank or a security for a loan or ownership rights represented by an option. In some cases, the term financial securities can be used interchangeably with the term financial instruments.
Based on the structure, purpose and other attributes, financial securities can be categorized into equity, debt and derivatives. Likewise, a few examples for each class of security are stock, bonds and options respectively. As a result, financial securities lay the foundation of any business, financial market, or country’s economy.
What is security?
The word “security” in financial terminology means a wide range of financial instruments. In essence, it can be defined as any financial instrument that is considered a medium of exchange, store of value, credit instrument, contract, financial obligation, a right to ownership, or any other financial asset or obligation that serves a particular purpose.
All in all, security can be defined as a financial asset that holds a monetary value, which can be transferred or sold between parties for a specific purpose. Thus, security is an umbrella term used to refer to any type of instrument that has a monetary value and is issued, held and traded by companies, investors or other parties.
History of financial securities
The U.S. stock market was previously governed at the state level until the Securities Act of 1933, which was introduced by the U.S. Congress and served as the first federal law attempting to regulate the financial securities industry. The reason for introducing this legislation was to make the financial industry more transparent and ensure fair trading practices. To put it simply, the Securities Act of 1933 became the U.S. federal legislation that protects investors.
The Securities and Exchange Commission (SEC), which is in charge of rules and enforcement, was established by later legislation. As per the law, any type of investment proposal can be a security; it makes no difference if it is formalized with a written agreement or stock certificates. Therefore, any offering of financial securities held in the U.S. is governed by the SEC under the Securities Act of 1933.
Types of financial securities
There are various kinds of financial securities and all of these financial securities are categorized into basic classes – equity securities, debt securities and derivatives securities. The following are the types of financial securities, along with their pros and cons:
An equity security is a share of capital stock, which includes both common and preferred stock, that represents the ownership stake that shareholders have in a legal body such as a corporation, partnership, or trust. In simple words, equity security represents ownership in a company.
- Pros – With the use of equity securities, companies can raise capital, which can be used to finance the company’s development and growth. In addition, equity securities provide a form of financial benefit for the company’s shareholders, which is known as dividends.
- Cons – By issuing equity securities, the level of dilution (reduction in the ownership) may increase which can affect the company’s value. When additional shares are issued, the ownership percentage of existing shareholders decreases.
Debt securities are financial instruments that are used to raise capital by borrowing money. In other words, a debt security is a contract that specifies the amount of borrowed money, the interest rate, and the maturity or repayment period of the loan. This kind of security is used to obtain funds for various business activities.
- Pros – Debt securities can be used to borrow money and get financial help. It serves as an alternative to equity securities, which means that by issuing debt securities, companies can quickly raise capital without reducing their ownership stake in the company.
- Cons – Debt securities are associated with regular interest payments, strict terms and conditions, and repayment obligations. As a result, it can increase the company’s debt levels and negatively affect the corporation’s financial management.
Hybrid securities are a combination of debt and equity securities. This type of security is used to achieve the benefits of both debt and equity securities, which are known as hybrid securities. Equity warrants, convertible bonds, and preference shares are some examples of hybrid securities.
- Pros – Hybrid securities can serve as an attractive instrument for companies to raise capital. It can accommodate the risk preferences of the companies by offering more flexibility in terms of financial instruments.
- Cons – Hybrid securities are associated with certain disadvantages, such as financing costs, complicated structure, and other issues that can impact the company’s overall performance.
Derivatives securities are financial securities that are based on the value of another financial asset or an index known as the underlying asset. In private companies, for instance, stock options are a common type of derivatives security which are used as a way to reward and incentives employees.
- Pros – Derivatives securities are associated with flexible terms, which makes it easier for companies to issue these securities. In addition to this, derivatives securities can be used in a variety of financial instruments, including futures, options, and swaps.
- Cons – It is a common misconception that derivatives securities are risk-free. However, the risk of misuse and under-management of derivatives securities can cause greater risks and losses for the company.
Asset-backed securities are financial instruments that are created by pooling assets such as loans, leasing, credit card debts, or mortgage. The cash flow from such assets is accumulated over time and allocated among the various investors. In this way, the pooled assets can be sold to investors.
- Pros – Companies can obtain additional sources of funding that can be used as a way to issue more loans or borrow money to finance the company’s growth by selling their assets through asset-backed securities.
- Cons – The process involved in asset-backed securities issuance is complex, which can result in additional fees and higher costs. As such, the process of securitization i.e. pooling assets into asset-backed securities can be complicated.
Certificated securities are based on a security that is represented by a paper certificate, which is issued and registered by the issuer. It is essentially a written document in the form of a financial instrument that contains specific details regarding the securities. However, the rights, benefits, or privilege remains the same regardless of whether the securities are represented by a paper certificate or in the form of electronic.
- Pros – Certified securities are considered to be more valuable because financial intuitions often regard certificates as authentic and reliable forms of proof. As a result, companies can use certificates to comply with both legal and regulatory requirements.
- Cons – With the advent of technology and the rise of electronic forms of security, managing and procuring certificates can become a hassle. In addition, the cost of printing certificates, which are used for these securities can be expensive for companies.
A bearer security is a fixed-income instrument in which the purchaser receives the security in physical form and no ownership is recorded. They are often transferred through endorsement and delivery when the transfers take place from one investor to another.
- Pros – A holder of bearer shares maintains the highest level of anonymity concerning their ownership in a corporation. In this way, the primary benefit of bearer securities is that it provides complete privacy.
- Cons – It is nearly impossible to retrieve bearer security that has been lost due to theft, damage, etc. because there is no record of ownership. As such, the absence of a record of ownership makes it difficult to recover the ownership of these securities.
In contrast to bearer securities, registered securities are issued and registered by the issuer. In other words, securities whose ownership is recorded with the issuing company are considered to be registered securities. As a result, every transaction involving registered securities is recorded and registered by the company.
- Pros – Registered securities are easier to retrieve than bearer securities in case it is lost, damaged or stolen. In addition to this, registered securities are useful because they serve as a record of ownership and can be used to comply with regulatory requirements.
- Cons – The process involved in issuing registered securities can be time-consuming and may result in additional costs for the issuing corporation as a result of additional legal and registration fees.
Letter securities cannot be offered openly in the market since they are not registered with the U.S. Securities and Exchange Commission (SEC). The issuer issues letter securities, often referred to as restricted securities, letter stocks, or letter bonds, directly to the investor. Therefore, these securities can not be listed on any stock exchange.
- Pros – Since there is no market for letter securities, clearing and settlement of their transactions is widely regarded as efficient because it does not require a third party to facilitate the transaction.
- Cons – Letter securities do not provide any type of liquidity and are not readily transferable. These securities are distributed in the form of private placements, and as such can only be issued to a limited number of investors.
Cabinet securities are not actively traded, despite being listed on a major stock exchange like the NYSE. Cabinet securities are more likely to be bonds or stocks because they are held by inactive investors. Hence, on the trading floor, cabinet securities are held until they are required.
- Pros – The inactivity status of cabinet securities makes it easier for companies to appeal to investors by issuing bonds and stocks with higher yields, which offers investors a greater revenue stream.
- Cons – Since these securities are listed on stock exchanges like the NYSE, the external market can affect the value, although, these securities are issued to small batches of investors and remain inactive for a considerable time.
Pros and cons of financial securities
Now that the various types of financial securities have been listed along with their advantages and disadvantages, the question remains, what are the pros and cons of financial securities as a whole? Below are the pros and cons of financial securities:
Widespread ownership, ease of transfer, wealth distribution among investments, usage of professional management, and accessibility to more diverse sources of capital makes financial securities an attractive tool for businesses, financial institutes, and investors. In addition to this, you might have noticed, there are several types of financial securities, and depending upon the requirement, purpose, and investment objectives, it is possible to choose one that best fits the need. Overall, the pros of financial securities make them very attractive in today’s financial marketplace.
Unfortunately, financial securities also have their share of disadvantages. From legal frameworks and reporting requirements to taxation and accounting, financial securities may present a myriad of issues and complications. While these issues can be overcome through proper planning and the use of professional assistance, it is important to keep in mind that the underlying financial principles of financial securities remain unchanged. As a result, the pros and cons of financial securities will ultimately depend on the specific nature and characteristics of a particular financial security.
Trade in financial securities
You might be wondering how to trade in financial securities. Well, trading in financial securities is usually done through the stock exchange in the case of public companies. Trades in security are agreed upon through an exchange which is recorded, monitored and tracked electronically. On the other hand, in the case of private or unlisted companies, trading of financial securities is restricted to a certain limit. As such, private companies generally issue financial securities to raise funds or to issue equity compensation to employees.
Rules and regulations of financial securities
The Securities and Exchange Commission (SEC) governs the public offering and sale of securities in the US. U.S. securities must be issued, sold, and traded publicly after being registered and reported to the state securities departments by the SEC. Within the brokerage sector, Self Regulatory Organizations (SROs) frequently fill regulatory roles as well. The National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority are two examples of SROs (FINRA). Thus, securities need to be traded in compliance with all applicable laws and regulations of financial securities in the case of publicly listed companies.
How to invest in financial securities?
An entity that issues securities for sale is referred to as the issuer, and investors are essentially those who purchase them. In general, securities serve as a kind of investment and a way for businesses, governments, and other commercial entities to raise additional funds. In layman’s terms, securities are a part of the capital markets and are designed to enable investors to allocate their money to investment opportunities that they believe will provide them with financial returns. The specific benefits, however, will vary depending on the type of security being considered.
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