Key financial concepts: securities

Securities are a very important and useful piece of financial technology, including bank notes, shares and bonds. They make possible a wide range of financial transactions and provide competition to the other main source of funding, banks.

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A security is a certificate representing a contract between two or more people which promises to pay cashflows under certain defined circumstances. The contract can be entirely flexible, so long as the two parties agree to the terms. The security may give the owner a claim to an asset, which can be real (e.g. a house) or financial (e.g. shares). A security is a way of proving a person’s legal entitlement to an asset or cashflows.

If you completely trust somebody then you might accept an oral agreement (one based just on the spoken word). But usually people want a written certificate, a security, to prove that the contract took place. It can then be enforced in court if necessary.

This definition is close to another financial meaning of “security”, which is an asset pledged as collateral against a loan or other financial contract. A loan may be secured on your house, meaning that if you fail to repay the loan, the lender can take your house and sell it.

These meanings derive from the Latin word securitas which means “free from care” and connects the financial terms to the everyday meaning of security – a feeling of safety, free from risk or harm.

Examples of securities

The US Securities Act of 1933 gives a long but not exhaustive list of types of securities. To make sure it captures any new securities, the definition includes ‘any interest or instrument commonly known as a ‘‘security’’’:

The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing (Source: Section 2).

A security can be made transferable to another person (it is then negotiable) which makes it more valuable. And if there is a market available it may be tradable on that market, which makes it more valuable still, particularly if the market provides a lot of liquidity (meaning it can be easily bought or sold at low cost).

Banknotes as bearer securities

The most common form of security that people come across is physical banknotes. A banknote is a security issued by a central bank (usually – historically notes were also issued by private banks). It is a bearer security, meaning that it belong to whoever “bears” or actually has it in their possession. By contrast most shares and bonds are registered securities, meaning that changes of ownership have to be officially recorded in a register to be legally binding.

Banknotes are very useful. You can pay for something just by producing the money, without any cumbersome need to record the transaction. That also makes payment by cash appealing to those who seek anonymity – possibly to avoid taxes or because the transaction is ethically dubious.

Banknotes represent perfect negotiability – in normal times anybody will accept payment with banknotes, partly because they know that everybody else will accept them in payment. A security that is not negotiable is much less useful. You can’t transfer ownership to somebody else, unless you get permission from the original issuer, who may not give it. If it’s not negotiable then you can’t sell the security and get your money back earlier, nor can you pledge it as collateral for a loan.

So most securities are negotiable, as it makes them far more valuable, which means that the issuer has an incentive to agree to their being negotiable.

If securities are not just negotiable but tradable on a financial market then they become even more useful. Tradability with lots of buyers and sellers brings liquidity – this means the ability to turn an asset into cash quickly, with low transaction costs and at a price close to its fair or market value. Without tradability on a liquid market, I can sell a negotiable security but I might have to accept a big discount (cut in price) to attract a buyer, especially if I’m in a hurry.

Note that negotiability is a legal aspect of the security. Tradability and liquidity are practical benefits that may arise if the securities attract enough interest – you can’t make a security liquid just by legally asserting it so.

Key types of securities: debt, equity and derivatives

The two most basic types of securities are for debt and for equity. Debt securities promise a fixed return for a finite period (usually). Equity securities promise a share of the proceeds of a venture, which may or may not succeed. In exchange for carrying greater risk than debt securities, equity securities usually bring some right to take part in the management of the venture.

Anybody can issue a debt security (more commonly known as a bond). If I can find somebody willing to buy it, I can sell a bond based on my personal promise to pay a future amount of money. A bond can be issued by a person, company, partnership or state. But equity securities (usually known as shares or stocks) can only be issued by a corporation.

Note the word “usually” – there are many variations on the basic themes and in practice a security can bear almost any contractual combination of cashflows, contingencies and rights that two parties find mutually acceptable. That makes securities a very flexible financial tool.

From the basic debt and equity securities we can construct hybrid securities with features of both. The most common form is convertible debt – this is a bond which has an option to convert to equity, providing certain features of both debt and equity which can be useful to relatively new companies for example.

The largest type of securities by value is derivatives, meaning securities whose value is derived from the value of some other underlying asset. For example an option on a share is a derivative security. Derivatives can be traded (usually).

Why securities are useful

Imagine if securities didn’t exist. An ordinary personal saver who currently puts her funds into a bank account might be looking for a higher return than the bank’s meagre interest rate. She realises that the bank lends funds at a much higher rate to a company. So why not try to lend directly to that company too, and get a higher rate? Let’s assume she has $1,000 of savings.

The obstacles soon become apparent.

i) Scale. A large company (large companies are more likely to be creditworthy in the first place) is not interested in a $1,000 loan. The smallest loan that say Apple might be interested in would be nearer $100 million, so our small saver would need to find another 99,999 similar savers, pool the funds somehow and then offer the loan to Apple. This would obviously be a costly and complex process.

ii) Indivisibility – lack of diversification. Let’s assume that our saver somehow persuaded the Chief Financial Officer (CFO) of Apple to accept her $1,000 as a loan. This would mean that she had all her savings tied up in a single corporate loan. While Apple, as a large consumer technology company, might be relatively safe, it’s not risk-free. And one of the most basic principles of finance theory is that diversification gives you a better risk/return trade off, which is not achieved in this case.

iii) Liquidity – getting your money back at short notice. If our saver, having lent her savings to Apple, decided six months later that she needed the funds back, for an emergency or to take advantage of another, better investment opportunity, then she would struggle to get her money back. The Apple CFO might point out that the funds have been invested in developing a new product . The funds will not be available for years.

The invention of the security, particularly combined with a securities market, solves these problems. A security can be arranged to address all three of our saver’s and the corporate borrower’s needs. It can be denominated in any amount, so a $1 billion loan can be divided into one million $1,000 individual securities, or 10 million $100 securities. That means even relatively small savers can buy at least one security.

That means they can also diversify their wealth. Even a small saver with $1,000 can spread it across say ten $100 securities, achieving quite a high degree of diversification. It would be better to have perhaps 15 or 20 securities but most of the diversification benefit comes from the first ten or so securities, assuming the borrowers are from different sectors of the economy or even different countries.

Crucially, a security can be sold to somebody else at short notice. So our saver can recover at least part of her funds. If the security is sold only through private channels, without a market, then it might fetch only say 80-90% of its value, because finding a willing buyer for just the security she is selling might not be easy in a hurry.

But if there is a market and if the security is well known and frequently traded, then it has a high degree of liquidity. In that case the saver might reasonably expect to get the full fair market value of the security, reflecting what a rational person would estimate it’s worth on the basis of expected future cashflows. There would be a transactions fee to the broker who gave our saver access to the market and a cost in the market maker’s bid-offer spread, but these might amount to one percent or less of the value of the security.

So securities allow financial intermediation to take place between borrowers and lenders, providing small enough scale for even ordinary household savers, allowing diversification and giving liquidity, especially where a market for the securities exists.

But it doesn’t solve the problem of knowing which securities to buy. For this, buyers and sellers of securities need some form of advice (known usually as investment research).

Securities markets compete with banks

For companies, securities markets can offer an alternative source of debt funding to banks. Banks are the main source of lending to smaller companies, which are too small and lacking in creditworthiness to be able to issue corporate bonds. For those companies who have the necessary scale and track record, issuing corporate bonds will usually be a cheaper source of borrowing than from banks. Large companies in developed economies rarely ever borrow from banks because those companies have at least as good a credit rating as the banks so they can borrow at a lower rate than any loan made by the banks.

So securities markets offer competition to banks in the supply of loans to companies. Corporate bond markets are largest and most developed in the US, where early legal restrictions in the banking sector made it difficult for many companies to get bank loans. This stimulated the growth of the corporate bond markets as a now flourishing alternative.

In Europe, corporate bond markets are proportionately smaller and it is a goal of the European Commission to make those markets larger. This is partly to provide competition with the banks. But it’s also to provide an alternative supply of funds to companies at a time when many European banks are still unable to operate effectively owing to the burden of former bad debts which have not been fully written off or otherwise dealt with.

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