What Is a Security?

November 3, 2022

It doesn’t take an avid investor to understand securities. From stocks and bonds to hedge funds, these are all terms you have probably heard before, but what is a security you may ask?

 in this article, we’ll give an overview of what securities are, how they’re regulated, and why it matters. 

What is a Security?

To start to understand securities, we have to ask, “What is a security?”

A security is a financial asset that can be sold or traded in a financial market. The term securities refers to investments that can be exchanged and used to raise capital.

The most common types of securities are stocks, bonds, ETFs (exchange traded funds), options, and mutual funds. However, the rapid adoption of blockchain technology, cryptocurrency, and NFTs has led to many legal gray areas when it comes to securities regulation.

In the United States, financial securities trading is regulated and monitored by the SEC to protect investors. 

Transactions that are considered “investment contracts” (such as trading stocks or shares in a company) must adhere to regulations outlined in the Securities Act of 1933 and the Securities Exchange Act of 1934; otherwise, the company could be the target of SEC enforcement.

Companies engaged in these transactions must provide the SEC with a description of their properties and businesses, a description of the security being offered, and information on the executive management, along with certified financial statements.

What Makes a Security?

The SEC refers to the Howey Test to determine whether an investment contract exists and a security is being sold. According to this test, an investment contract exists if

  1. There’s an investment of money,
  2. In a joint enterprise,
  3. With the expectation of a profit,
  4. Which is obtained through the efforts of others.

The Howey Test plays a vital role in determining whether or not specific digital projects are considered “investment contracts.” While some cryptocurrencies and ICOs pass the Howey Test, that is not the case for every digital token.

4 Types of Securities

Securities are divided into 4 categories: equity, debt, hybrid, and derivative.

  1. Equity Security: An equity security generally refers to stocks or a share of ownership in a company. One of the pros of this type of security is that it provides investors with regular earnings in the form of dividends. Those earnings can fluctuate since they depend solely on the state of the market and company.
  2. Debt Securities: Unlike equity securities, debt securities allow companies to borrow money from investors and repay the loan with interest. This is another option for corporations, banks, and government institutions looking to raise funds without selling equity. Bonds and promissory notes are both examples of debt securities.
  3. Derivative Securities: Derivative securities are contracts between 2 or more parties; they differ from other types of securities since their value depends on the price of an underlying asset (e.g., stocks and bonds). Derivative securities are commonly used to gain access to specific markets and may be traded to hedge against risk. Options, futures contracts, forwards, and swaps are common derivative securities.
  4. Hybrid Securities: Hybrid securities include debt and equity securities characteristics. A typical example of a hybrid security would be a convertible bond, a corporate bond that can be converted into shares of stock for the company providing the bond.

Cryptocurrency, NFTs, and Securities

As the world of cryptocurrency and blockchain continues to grow, investors should be aware that some up-and-coming projects are not adhering to the requirements laid out by the SEC.

Cryptocurrency exchange Ripple raised funds through an ICO (initial coin offering) of its native token XRP. 

It’s now in the midst of a highly publicized lawsuit with the SEC, which claims that Ripple raised funds illegally. But trading platforms aren’t the only ones that could come under fire.

Decentralized Autonomous Organizations, or DAOs, commonly raise funds through similar token sales, but the tokens can be NFTs or utility tokens rather than currencies. 

While the SEC hasn’t issued specific guidance on any of these projects, many of them are likely selling unregistered securities.

The same is true of many other NFT- or blockchain-based projects. Before launching any project that’s selling tokenized assets, founders should be careful to obtain qualified legal guidance to avoid the wrath of the SEC.

How are Securities Regulated?

The Securities and Exchange Commission, or SEC, acts independently of the government, enforces federal securities laws, and regulates the securities industry. 

It regulates the U.S. stock exchange, options markets and exchanges, and other electronic security markets. Companies or individuals who violate SEC regulations can face severe penalties or be forced to repay investors.

If you need help launching a project or handling any disputes with the SEC, reach out to the award-winning attorneys at Gordon Law Group for help! Our attorneys are well versed in cryptocurrency and SEC compliance.

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