Concept of "security"

The legal term "security" still means the legal right of the secured party (usually a lender) to take the asset that backed the loan to satisfy the debt. An example would be a home loan which is secured by the house which was purchased with the loan proceeds. Because the original loan contract gave as part of consideration to the lender the security interest in the form of mortgage, the lender can take possession of the house if the borrower goes broke and cannot repay. If the right to repossess the house moved with the loan should the loan be transferred, then the loan secured by the mortgage claim is protected and would have a ready secondary market. It is in this light that the securitization of loans enables a secondary market. And these secured loans could perform the functions of money that modern securities do today. They can be a store of value. For large denomination transactions, Treasury securities are so sound that they can be the basis of the medium of exchange. In Early modern Europe, companies and government agencies began to raise capital from the public using secured debt obligations, which came to be known as "securities". As shares became more readily transferable from the Victorian era, their functional similarity to debt securities became clearer, and both forms of investment became known as "securities". More recently, the term has also been extended to include units in investment funds and other forms of readily transferable investment.

The concept of "securities" should be distinguished from "interests in securities". The latter are the assets of a client from whom an intermediary holds securities on an unallocated basis, commingled with the interests in securities of other clients. The distinction between securities and interests in securities is often overlooked in practice, although it is a source of legal risk.

Classification

Securities are classified according to the following categories:

• Issuer
• Currency of denomination
• Ownership rights
• Term to maturity
• Degree of liquidity
• Income payments
• Tax treatment

Uses of securities

For the issuer

Issuers of securities include commercial companies, government agencies, local authorities and international and supranational organizations (such as the World Bank). Debt securities issued by the government (called government bonds or sovereign bonds) generally carry a lower interest rate than corporate debt issued by commercial companies. Repackaged securities are usually issued by a company established for the purpose of the repackaging - called a special purpose vehicle (SPV).

New capital: Commercial enterprises have traditionally used securities as a means of raising new capital. Securities are an attractive option relative to bank loans, which tend to be relatively expensive and short term. Another disadvantage of bank loans as a source of financing is that the bank may seek a measure of control over the business of the borrower via financial covenants. Through securities, capital is provided by investors who purchase the securities. In a similar way, government will raise capital from securities (see government debt) if taxation and other income are insufficient to meet public expenditure. This will result in a budget deficit.

Repackaging: In recent decades securities have been issued to repackage existing assets. In a traditional securitisation, a financial institution may wish to remove assets from its balance sheet in order to achieve regulatory capital efficiencies or to accelerate its receipt of cash flow from the original assets. Alternatively, an intermediary may wish to make a profit by acquiring financial assets and repackaging them in a way which makes them more attractive to investors.

For the holder

Investors in securities may be retail, i.e. members of the public investing other than by way of business. The greatest part in terms of volume of investment is wholesale, i.e. by financial institutions acting on their own account, or on behalf of clients. Important institutional investors include investment banks, insurance companies, pension funds and other managed funds.

Investment: The traditional economic function of the purchase of securities is investment, with the view to receiving income and/or achieving capital gain. Debt securities generally offer a higher rate of interest than bank deposits, and equities may offer the prospect of capital growth. Equity investment may also offer control of the business of the issuer. Debt holdings may also offer some measure of control to the investor if the company is a fledgling start-up or an old giant undergoing 'restructuring'. In these cases, if interest payments are missed, the creditors may take control of the company and liquidate it to recover some of their investment.

Collateral:Security Finance The last decade has seen an enormous growth in the use of securities as collateral. Where A is owed a debt or other obligation by B, A may require B to deliver property rights in securities to A. These property rights enable A to satisfy its claims in the event that B becomes insolvent. Collateral arrangements are divided into two broad categories, namely security interests and outright collateral transfers. Commonly, commercial banks, investment banks and government agencies are significant collateral takers.

Debt and equity

Securities are traditionally divided into debt securities and equities.

Debt

The holder of a debt security, typically a bond, is owed a debt by the issuer and is entitled to the payment of principal and interest, together with other personal rights under the terms of the issue, such as the right to receive certain information. Debt securities are generally issued for a fixed term and redeemable by the issuer at the end of that term.

Government bonds are medium or long term debt securities issued by sovereign governments or their agencies. Typically they carry a lower rate of interest than corporate bonds. In addition to serving as a source of finance for governments, treasuries are used to manage the money supply in the open market operations of central banks.

Sub-sovereign government bonds, known in the U.S. as municipal bonds, represent the debt of state, provincial, territorial, municipal or other governmental units other than sovereign governments.

Supranational bonds represent the debt of international organizations such as the World Bank, the International Monetary Fund, regional multilateral development banks and others.

Corporate bonds represent the debt of commercial or industrial entities.

Money market instruments are short term debt instruments, such as certificates of deposit, commercial paper and certain bills of exchange. They are highly liquid and are sometimes referred to as "near cash".

Eurosecurities are securities issued internationally outside their domestic market. They include eurobonds and euronotes. Eurobonds are characteristically underwritten, and not secured, and interest is paid gross. A euronote may take the form of euro-commercial paper (ECP) or euro-certificates of deposit.

Equity

An equity is an ordinary share in a company. The holder of an equity is a shareholder, owning a share, or fractional part of the issuer.

• Stock

Hybrid

Hybrid securities combine some of the characteristics of both debt and equity securities.

Preference shares form an intermediate class of security between equities and debt. If the issuer is liquidated, they carry the right to receive interest and/or a return of capital in priority to ordinary shareholders.

Convertibles are bonds which can be converted, at the election of the bondholder, into another sort of security such as equities.

Equity warrants are contractual entitlements to purchase shares on pre-determined terms. They are often issued together with bonds or existing equities, but are detachable from them and separately tradable.

Securities markets

Primary and secondary markets

The securities markets can be divided into the primary markets and the secondary markets. Primary markets (also known as capital markets) comprise of new securities to their first holders. The issue of new equity securities is commonly known as an Initial Public Offering (IPO). Issuers usually retain investment banks to assist them in finding buyers for these issues, and in many cases, to buy any remaining interests themselves. This arrangement is known as underwriting.

Transferability is an essential characteristic of securities. This trading is called the aftermarket or secondary market. Secondary markets often consist of what is called an exchange to facilitate the meeting of buyers and sellers. They are often referred to as stock exchanges, even though there are exchanges such as the Chicago Board of Options Exchange, where no stocks are traded. Many securities, including the majority of debt securities, do not trade on exchanges at all, even though they may be listed on exchanges. Rather, most debt securities trade in decentralized, dealer-based over-the-counter markets.

In Europe, the principal trade organization for securities dealers is the International Capital Market Association. In the U.S., the principal organization for securities dealers is the Securities Industry Association. The Bond Market Association represents bond dealers globally.

Public offers and private placements

In the primary markets, securities may be offered to the public in a public offer. Alternatively, they may be offered privately to a limited number of qualified persons in a private placement. Often a combination of the two is used. The distinction between the two is important to securities regulation and company law.

Another category, sovereign debt, is generally sold by auction to a specialised class of dealers.

Listing and OTC dealing

Securities are often listed in a stock exchange, an organised and officially recognised market on which securities can be bought and sold. Issuers may seek listings for their securities in order to attract investors, by ensuring that there is a liquid and regulated market in which investors will be able to buy and sell securities.

Growth in informal electronic trading systems has challenged the traditional business of stock exchanges. Large volumes of securities are also bought and sold "over the counter" (OTC). OTC dealing involves buyers and sellers dealing with each other by telephone or electronically on the basis of prices that are displayed electronically, usually by commercial information vendors such as Reuters and Bloomberg.

There are also eurosecurities, which are securities that are issued outside their domestic market into more than one jurisdiction. They are generally listed on the Luxembourg Stock Exchange or admitted to listing in London. The reasons for listing eurobonds include regulatory and tax considerations, as well as the investment restrictions.

International debt markets

London is the centre of the eurosecurities markets. There was a huge rise in the eurosecurities market in London in the early 1980s. Settlement of trades in eurosecurities is currently effected through two European computerised systems called Euroclear (in Belgium) and Clearstream (formerly Cedelbank in Luxembourg).

Legal nature of securities

Bearer and registered securities

Bearer securities

Bearer securities are issued in the form of a paper instrument. On the face of the instrument is written the promise of the issuer to pay the bearer of the instrument. By a legal fiction, the instrument is deemed to constitute the debt of the issuer, and not merely to represent them. In the absence of computerisation, bearer securities constitute tangible assets (or chose in possession). They are transferred by delivering the instrument from person to person. In some cases, transfer is by endorsement, or signing the back of the instrument, and delivery.

Regulatory and fiscal authorities sometimes regard bearer securities negatively, as they may be used to facilitate the evasion of regulatory restrictions and tax. In the United Kingdom, for example, the issue of bearer securities was heavily restricted firstly by the Exchange Control Act 1947 until 1963.

Registered securities

In the case of registered securities, certificates bearing the name of the holder are issued, but these merely represent the securities. A person does not automatically acquire legal ownership by having possession of the certificate. The issuer maintains a register (usually maintained by an appointed registrar) in which details of the holder of the securities are entered and updated as appropriate. In recent years, registers have generally become computerised. Unlike bearer securities, registered securities comprise of a bundle of intangible rights (chose in action) including the right of the shareholder to share in all the assets of a company, subject to all the liabilities of the company. A transfer of registered securities is effected by amending the register.

Traditionally, the delivery of bearer instruments by way of pledge has been widely used in the securities markets to collaterise financial exposures. The delivery of certificates to registered securities has also been widely used in collateral arrangements. However, because registered securities are not tangible assets, the legal effect of such a delivery is generally characterised not as pledge, but rather equitable mortgage.

Divided and undivided securities

The terms "divided" and "undivided" relate to the proprietary nature of a security.

Each divided security constitutes a separate asset, which is legally distinct from each other security in the same issue. Pre-electronic bearer securities were divided. Each instrument constitutes the separate covenant of the issuer and is a separate debt.

With undivided securities, the entire issue makes up one single asset, with each of the securities being a fractional part of this undivided whole. Shares in the secondary markets are always undivided. The issuer owes only one set of obligations to shareholders under its memorandum, articles of association and company law. A share represents an undivided fractional part of the issuing company. Registered debt securities also have this undivided nature.

Fungible and non-fungible securities

The terms "fungible" and "non-fungible" relate to the way in which securities are held.

If an asset is fungible, this means that when such an asset is lent, or placed with a custodian, it is customary for the borrower or custodian to be obliged at the end of the loan or custody arrangement to return assets equivalent to the original asset, rather than the identical asset. In other words, the redelivery of fungibles is equivalent and not in specie (identical).

Undivided securities are always fungible by logical necessity. Divided securities may or may not be fungible, depending on market practice. The clear trend is towards fungible arrangements.

Regulation

In the offer and sale of securities is either registered pursuant to a registration statement that is filed with the U.S. Securities and Exchange Commission (SEC) or are offered and sold pursuant to an exemption therefrom. Dealing in securities is heavily regulated by both the federal authorities (SEC) and state authorities. In addition the industry is heavily self policed by Self Regulatory Organizations (SROs), such as the NASD or the MSRB.

Due to the difficulty of creating a general definition that covers all securities, the SEC attempts to define "securities" exhaustively (and not very precisely) as: "any note, stock, treasury stock, security future, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, 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 instrument commonly known as a 'security'; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or bankers' acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited." - Section 3a item 10 of the 1934 Act.

The US Courts have developed a broad definition for securities that must then be registered with the SEC. There is an investment of money, a common enterprise and expectation of profits to come primarily from the efforts of others.