This can represent ownership in a company in the form of stock, a creditor relationship with a government body or a corporation represented by owning that entity's bond, or rights to ownership as represented by an option.
Types of Securities
Equity securities - ownership in a company, partnership, or other business endeavor. An investment of this nature generally conveys some type of control over the direction since there are voting rights.
Securities are regulated by governments.
In the United States, this started at the federal level with the passage of the Securities Act of 1933. This provided powers to write regulation, something that previously operated at the state level. Anyone who wishes to sell investment contracts to the public must publish certain information regarding the proposed offering, the company making it, and the principals in the company.
Ensuing legislation created the Securities and Exchange Commission (SEC) which became the main regulatory agencies in the U.S. Anyone who fails to adhere to the securities laws can be sued by the SEC. If there is criminal action, the case can be referred to the Department of Justice.
The regulation was intended to protect the investing public from deceptive or misleading marketing practices. The company and its principals are strictly liable for any inaccuracy in its financial statements.
One of the most common action taken by the SEC is to go after companies that fail to register the sale of securities. Recent cases against cryptocurrency companies such as Block.one was based upon the selling of an unregistered security.
Securities first applied to stocks and bonds. This changed in 1946 when the Supreme Court expanded the scope.
It was the introduction of the Howey Test.
The name of the test refers to the U.S. Supreme Court case SEC v. W.J. Howey Co., which was heard by the Supreme Court in 1946. It involved the Howey Company, which sold tracts of orange groves to buyers in Florida, which the buyers leased back to Howey. Company staff would tend to the groves and sell the fruit for the owners, with Howey and the land owners sharing the revenue.
Because the Howey Company didn’t register the transactions as securities in an investment contract, the SEC got involved. In SEC vs. Howey, the Supreme Court ruling determined that the leaseback arrangements qualified as investment contracts, and as such were subject to U.S. securities laws.
From this, there were 4 criteria established:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
Anything that meets the Howey Test must register with the SEC.
There are a number of securities:
- commodity contracts
- partnership agreements
- interest rate swaps
- exchange traded funds
- certificates of deposit
There are two areas of focus when it comes to return on a security.
- Speculation - this comes from appreciation in the price of the asset
- Yield - this is a percentage return based upon a direct payout. This could be in the form of interest or through dividends.
Bonds market participants focus upon yield, which is common in the debt markets. Since people are typical acting as lenders to the government or company, the rate is important. This could either be the coupon or yield rate.
Some question whether cryptocurrencies are actually securities. The SEC under Chair Gary Gensler took the stance they are. With the exception of Bitcoin, Gensler proclaimed cryptocurrency as securities, thus requiring registration.
The fact the United States has not adopted specific regulation has put things in a gray area.
Cryptocurrency could pose a difficult situation for regulators and applying securities laws. The decentralized nature of these assets could make the application of the Howey Test invalid.
So far the sale of digital assets has been sold with little oversight. That is likely to change as governments around the world implement laws to regulate them.
Another issue arises with the different forms of crypto assets. Not all cryptocurrency is identical.
View a fungible token like a security is the approach the SEC took. How does this apply to non-fungible tokens which are individual assets that can apply to a variety of things. This can be both in the digital and physical realms.
Brokerage firms connect into the exchanges, allowing for the merging of buyers and sellers. All aspects of the securities industry are run by financial institutions. For many securities, larger investment banks will operate as market makers to ensure liquidity on the exchange.