If you’ve ever invested in stocks, bonds, or certificates of deposit (CDs), you’ve owned financial securities. Most -- but not all -- investment instruments count as financial securities. Keep reading to learn how a financial security is defined as well as what types of investments don’t meet the criteria.
What are financial securities?
What are financial securities?
A financial security is a tradeable asset that holds monetary value. There are many types of financial securities, often just referred to as “securities,” which range from somewhat risky to nearly sure deals. They usually have profit potentials to match the risk involved.
For example, a tech stock for a start-up is a financial security that has massive upside potential, but a large risk is involved. As a rule, a certificate of deposit has a much lower return rate, but there is almost no risk to your money.
There are three main kinds of securities:
- Equity securities
- Debt securities
- Hybrid securities
Equity securities represent ownership in a company, partnership, or other business endeavor. As an investor, you generally will have some control over the company’s direction via voting rights.
Debt securities represent money you’ve essentially loaned toward a project or entity. You’re entitled to regular interest and principal payments. Debt securities might include bonds, CDs, or other collateralized securities.
Bonds
Hybrid securities combine features of both equity and debt securities. Convertible bonds and preferred stock are examples of hybrid securities. Some people also include derivative securities and asset-backed securities as their own categories.
What counts as a security?
What counts as a security?
The question of what a security is has come up a lot since cryptocurrencies have gained popularity. Whether or not these assets count as securities matters a lot to crypto investors.
If an asset isn’t a security, it generally isn’t regulated by the U.S. Securities and Exchange Commission (SEC). That can leave investors vulnerable. Crypto investors currently have very little protection provided by the SEC because the world of crypto remains largely unregulated.
SEC (Securities and Exchange Commission)
The Securities Act of 1933 was created specifically to protect investors and increase transparency in financial disclosures for securities being offered for public sale. Consequently, investors understand the way the security works and whether that security is a partial ownership in a business or a loan to the government.
How are securities defined?
How are securities defined?
The Howey Test is a precedent established by the U.S. Supreme Court in 1946. It established that for an investment to be a security, it had to meet a four-part definition:
- There’s an investment of money involved.
- The investment is part of a common enterprise with other investors.
- There’s an expectation that the enterprise will profit.
- The enterprise and its profit is derived through the efforts of others.
These very specific characteristics helped define what a security was so that future investors had an expectation of what their investment would look like over time. It also gave investors increased access to information about the enterprise since all securities must be registered with the SEC.
Cryptocurrencies and financial securities
Cryptocurrencies and financial securities
Many people think of cryptocurrencies as being similar to stocks, and, in some cases, some crypto assets do behave like stocks. Companies can offer shares of their projects, as in the case of a tokenized real estate investment, as a crypto asset. However, in other cases, cryptocurrencies are just that -- a type of digital currency that can be used to buy and sell things both digital and physical.
Although crypto assets haven’t been cleanly defined or regulated, the SEC is working toward doing just that. For now, it’s best to assume that crypto assets are unregulated and not treated as financial securities until you know for sure. The SEC’s former chairman, Jay Clayton, attempted to clarify this in 2018, but giant loopholes remain.
“Cryptocurrencies: These are replacements for sovereign currencies, replace the dollar, the euro, the yen with bitcoin," Clayton said in a 2018 interview with CNBC. "That type of currency is not a security."
On the other hand, he noted, "A token, a digital asset, where I give you my money and you go off and make a venture, and in return for giving you my money I say 'you can get a return' that is a security and we regulate that. We regulate the offering of that security and regulate the trading of that security."
However, this leaves a gaping hole when it comes to trade among cryptocurrency and non-fungible token (NFT) investors. They may be buying into something considered a component of a software ecosystem (and widely regarded as an investment among crypto enthusiasts) but without the official “expectation of profit” given by the developer. In addition, the level of decentralization of any given blockchain can also play a part in determining if a crypto asset is a security.
Cryptocurrencies are typically considered in the same class as other types of currency for the SEC’s purposes. Crypto assets may look and feel like securities, but they often fail the Howey Test.
