A claim you can hand to someone else
Strip away the jargon and a security is a piece of paper (today, an electronic entry) that records one of two things. Either someone owes you: a company, a financial institution or the government has promised to pay you back with a return. Or you own a slice: a fraction of an incorporated business, with the rewards and the risks that come with ownership. Equity shares, preference shares, debentures and bonds all fit one of those two descriptions.
The word that does the work is transferable. A bank fixed deposit is a claim too, but you cannot sell it to your neighbour. A security you can. The industry calls the same objects instruments or products, and the syllabus treats the three words as interchangeable.
The investor has money and wants it to earn something. The issuer needs money and is willing to pay for it. A security is the contract that satisfies both at a price they negotiate: the investor turns savings into a financial asset that returns, and the issuer raises capital at a cost.
Why transferability changes everything
Suppose a company borrows for ten years by issuing a bond. Without a secondary market, whoever lends the money is locked in for ten years. With one, the lender can sell the bond to another investor next month, and the company never notices: it still has its ten-year money. The syllabus puts it neatly: a long-term security effectively becomes a short-term security because a secondary market exists.
That is the whole social function of the securities market. It brings together many buyers and sellers, which creates liquidity, the ability to buy or sell at close to the going price. And it channels idle savings toward people who can put them to productive use. Issuers get access to a broad universe of savers; savers get a wide menu of things to hold.
A retiree holds shares in a listed cement company. She needs cash for a medical bill on Tuesday. She sells on the exchange on Tuesday morning and the money reaches her within the settlement cycle. The cement company did not repay her; another investor bought her slice. The company's capital stayed with the company. That handover, repeated millions of times a day, is what the market is for.
The four kinds of participant
The syllabus describes the financial market as four groups:
What the law calls a security
The definition that the exam draws on sits in Section 2(h) of the Securities Contracts (Regulation) Act, 1956. The list is long, and questions like to test whether an item is in it.
- Shares, scrips, stocks, bonds, debentures, debenture stock and other marketable securities of a like nature, of any incorporated company, pooled investment vehicle or body corporate
- Derivatives
- Units or other instruments issued by a collective investment scheme to its investors
- Security receipts as defined in the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002
- Units or other instruments issued under a mutual fund scheme
- Units or other instruments issued by a pooled investment vehicle
- Certificates issued by a special purpose distinct entity that holds debt or receivables (including mortgage debt) and acknowledges the investor's beneficial interest in them
- Government securities
- Any other securities the Central Government declares to be securities, and rights or interests in securities
Unit-linked insurance policies are expressly not securities, even though they carry an investment component. The Act spells out that a policy combining life cover with investment, issued by an insurer under the Insurance Act, sits outside the definition. An option that lists a ULIP among securities is wrong.
The declaration power has been used. Electronic Gold Receipts, receipts issued against physical gold deposited under SEBI's regulations, were declared securities by a gazette notification dated 24 December 2021. It is a favourite recent-update question.
Three families
Whatever the legal list says, the syllabus sorts every security into three families by its risk and return character: equity, debt and derivatives. The next four topics walk through the actual products in each family.
- A security is a transferable financial claim: either a promise by an issuer to pay the holder (debt) or an ownership interest in an incorporated entity (equity). Instruments and products are the same thing.
- The market matches savers who have surplus with issuers who need capital, and because holders can sell to other investors, a long-term security becomes a short-term holding for anyone who wants out.
- Four kinds of participant: providers of funds, seekers of funds, intermediaries, and regulators.
- Section 2(h) of the SCRA 1956 lists securities: shares and bonds of companies and pooled vehicles, derivatives, collective investment scheme units, security receipts, mutual fund units, securitised debt certificates, government securities, and whatever the Central Government declares (Electronic Gold Receipts since 24 December 2021). Unit-linked insurance policies are excluded.