3. Financial Instruments Classified as Securities
- Jose Cartas, and Qi He
- Published Date:
- June 2015
3.1 This chapter describes the different financial instruments that are classified as debt and equity securities, respectively. It also considers borderline cases and lists the financial instruments that are not classified as securities.
3.2 The most common types of debt security include bills, bonds, notes, negotiable certificates of deposit, commercial paper, debentures, asset-backed securities, and similar instruments normally traded in the financial markets that serve as evidence of a debt.
3.3 Common types of debt security are those sold on:
A coupon basis, stipulating that periodic interest, or coupon payments will be made during the life of the instrument and that the principal will be repaid at maturity.
An amortized basis, stipulating that interest and principal payments will be made in installments during the life of the instrument.
A discount, or zero coupon basis, whereby a debt security is issued at a price that is less than its face (or par) value, and the interest and principal are paid at maturity.
A deep discount basis, whereby a debt security is issued at a price that is less than face value, and the principal and a substantial part of the interest are paid at maturity.
An indexed basis, which ties the amount of interest and/or principal payment to a reference index, such as a price index or an exchange rate index, or to the price of a commodity (e.g., gold).
3.4 Bills are debt securities that give the holders the unconditional right to receive stated fixed sums on a specified date. Bills are generally issued with short-term maturities at discounts to face value that depend on the rate of interest and the time to maturity, and are usually traded in organized markets. Examples of such short-term securities are treasury bills, negotiable certificates of deposit, promissory notes, bankers’ acceptances, and commercial paper.
3.5 Bonds and debentures are long-term debt securities that give the holders the unconditional right to fixed payments or contractually determined variable payments on a specified date or dates, that is, the earning of interest is not dependent on earnings of the debtors. Bonds and debentures also give holders the unconditional right to fixed sums as payments to the creditor on a specified date or dates.
3.6 Asset-backed securities (ABSs) are created through the securitization of various categories of loan. Income payments and repayment of the principal are derived from and collateralized by a specified pool of underlying assets. ABSs are classified as debt securities because the security issuers have an obligation to make payments, while the holders do not have a residual claim on the underlying assets. The process of securitization is explained in Chapter 6 of this Handbook.
3.7 Equity securities are commonly called shares. Shares (or “stocks,” the meaning is identical) are claims on the residual value of a corporation after the claims of all creditors have been met. Shares may be listed (F511) or unlisted (F512), and may be ordinary shares or preferred shares.
Listed and Unlisted Shares
3.8 Listed shares are listed (or registered) on a stock exchange, which can be a recognized stock exchange or any other form of organized secondary market. Listed shares are also referred to as “quoted shares.” The existence of quoted prices for shares listed on an exchange usually means that current market prices are readily available.
3.9 A share may be listed, but traded only very infrequently, or not at all (e.g., in the case of closely held corporations1). Stock exchanges are often divided into market segments (e.g., an official market, a second regulated market, and a third market), with shares in some of these segments (usually third markets) traded less frequently. Consequently, prices may not be available on a daily basis but only at certain points in time, for example, when transactions take place or when positions are valued (which may occur at specific intervals, such as at the end of each month).2
3.10 In addition to paying regular listing fees, a corporation must fulfill certain requirements, such as having a minimum asset base and publishing specific financial information, both at the time of listing and periodically thereafter.
3.11 Unlisted shares are not listed (or registered) on a stock exchange. They are also referred to as “unquoted shares” and sometimes “private equity.” Venture capital usually takes this form. Because prices may not be observable for unlisted shares, other valuation methods may have to be applied (see Annex 8).
3.12 Holders of unlisted shares do not enjoy the protection that the stock exchange offers holders of listed shares. Trading unlisted shares can also be difficult.
3.13 Unlisted shares are issued by limited liability companies as follows:
Capital shares give holders the status of joint owners of the company and entitle them to a share in the total distributed profits, as well as a share in the company’s net assets in the event of liquidation.
Redeemed shares are shares whose capital has been repaid, but are retained by holders who continue to be joint owners and remain entitled to a share in the profits left after dividends have been paid on the remaining registered capital, as well as a share in any surplus in the event of liquidation (i.e., net assets minus the remaining registered capital).
Dividend shares (sometimes also called “founders’ shares” or “profit shares”) are not part of the registered capital and do not give holders the status of joint owners. Consequently, holders do not have the right to a share in the repayment of registered capital, nor do they have the right to a return on this capital, or vote at shareholders’ meetings, and so on. Nevertheless, holders are entitled to a share of any profits remaining after dividends have been paid on the registered capital and a share in any surplus remaining in the event of liquidation.
Participating preferred shares or stocks give holders the right to participate in the distribution of the residual value of the company on dissolution. Holders also have the right to participate in, or receive, additional dividends over and above the fixed percentage dividend (see paragraph 3.25 below). Additional dividends are usually paid in proportion to any ordinary dividends declared. In the event of liquidation, participating preferred shareholders have the right to a share in any surplus, as well as receiving back whatever they paid for their shares.
Ordinary and Preferred Shares
3.14 Ordinary shares (or “common” shares) usually give holders the right to the following:
Holders are generally entitled to participate in the corporation’s general policymaking and have the right to attend, speak, and vote (in the case of voting shares) at general meetings. Holders of ordinary shares can vote on corporate objectives and matters of policy, on stock splits, and to elect the corporation’s board of directors.
Holders are usually entitled to a preferential subscription in the event of a capital increase. Some holders of ordinary shares also receive preemptive rights (a rights issue), which enables them to retain their proportional share in the ownership of a corporation should it issue more stock.
Holders generally have the right to a share in the corporation’s profits. However, no fixed dividends are paid out to ordinary shareholders. Ordinary shareholders’ returns are therefore uncertain and dependent on earnings, corporate reinvestment, and the market’s ability to value and sell stock efficiently.
3.15 The difference between ordinary shares and preferred shares can be seen in terms of the rights holders enjoy and the terms and conditions under which the shares are issued. Holders of preferred shares have priority over holders of ordinary shares when it comes to laying claim to a corporation’s assets. However, while preferred shares may have priority over ordinary shares in the payment of dividends and in the event of liquidation, they are subordinated to debt securities.
3.16 Ordinary shares (and their certificates)3 may be “bearer” shares. Holders of bearer shares remain anonymous, even to the issuer. Holders of other registered shares are recorded in the corporation’s share register.
3.17 Priority shares are registered shares that give the holder specific powers, such as the power to nominate candidates for the board of directors. They often also give the holder special rights with regard to amending the corporation’s statute.
3.18 Occasionally, nonvoting shares are issued. These have a marginally higher dividend, but may be less liquid.
3.19 Deferred shares have fewer or no voting rights and, in the event of bankruptcy, holders are not entitled to a share in the corporation’s assets until all ordinary and preferred shareholders have been paid in full as per the nominal (par) value of their shares. Deferred shareholders then receive a share of any surplus remaining.
3.20 In the event of bankruptcy, holders of ordinary shares receive their funds after preferred shareholders, bondholders, creditors, etc.
3.21 Preferred shares (or “preference shares,” “preferred stocks,” or “participating preferred shares”) typically rank higher than ordinary shares. They may carry superior voting rights relative to ordinary shares (sometimes up to two votes per share), or no voting rights at all.
3.22 Where the preferred shares do not carry voting rights, shareholders do not have the right to vote at shareholders’ meetings. This is usually offset by higher dividends, or the right to a larger share in the distribution of the residual value of a corporation on dissolution.
3.23 Preferred shares may entitle their holders to a preferential dividend, which may, at times, be higher than the dividends paid to ordinary shareholders. They may also be convertible into ordinary shares, or they may entail preferential rights in the event of liquidation. Preferred shares may carry the right to a specific dividend, paid ahead of dividends to holders of ordinary shares, and take precedence over ordinary shares in the event of liquidation.
3.24 Like ordinary shares, preferred shares represent partial ownership of a corporation. Unlike ordinary shares, however, preferred shares often pay a fixed dividend (although the corporation does not have to pay this dividend if it lacks the financial means to do so).
3.25Table 3.1 provides an overview of various types of preferred shares. In general, preferred shares comprise the following:
|Cumulative preferred shares||Holders are entitled to receive a fixed dividend ahead of ordinary shares and retain the right to any accumulated preferred dividends that may have built up.||Equity securities|
|Noncumulative preferred shares||Holders are not entitled to accumulate preferred dividends.||Equity securities|
|Participating preferred shares||Holders are entitled to participate in the profits of a corporation over and above fixed dividends by means of an additional fluctuating dividend. They also participate in the distribution of the residual value of a corporation on dissolution.||Equity securities (regardless of whether income is fixed or determined according to a formula)|
|Participating convertible preferred shares||Holders are entitled to receive the dividends that holders of preferred shares are eligible to receive. Holders are also allowed to convert preferred shares into ordinary shares in order to claim excess earnings.||Equity securities|
|Nonparticipating preferred shares||Holders are entitled to receive a fixed dividend, but do not participate in the distribution of the residual value of a corporation on dissolution.||Debt securities (with income from nonparticipating preferred shares treated as interest income, rather than dividends)|
|Redeemable preferred shares||These can be redeemed at the request of either the corporation or the shareholder (at a fixed price on a specified date or during a specified period of time). Strict conditions apply to the issuance of redeemable shares and their redemption. Instead of cancelling shares on redemption, a corporation may continue to hold such shares as treasury shares, but no voting rights may be exercised and no dividends are payable.||Equity securities|
|Retractable preferred shares||These include features that allow holders to demand that the corporation redeem the share on a specific date.||Equity securities|
|Straight perpetual preferred shares||These have no maturity date and pay fixed dividends for as long as they remain outstanding.||Equity securities|
|Rate reset or fixed floating rate preferred shares||These pay fixed dividends until the reset date, which is typically also the call date.||Equity securities|
|Floating rate preferred shares||These pay dividends on a quarterly (or in some cases monthly) basis. Dividends fluctuate in relation to a reference rate, usually a prime rate, although some may have a “floor,” or minimum dividend.||Equity securities|
|Structured preferred shares||These are synthetic preferred shares based on an underlying portfolio of ordinary shares or a portfolio created from diverse or complex financial instruments, including financial derivatives.||Equity securities or financial derivatives|
Cumulative or noncumulative preferred shares, depending on whether dividends payable are accumulated or not.
Participating or nonparticipating preferred shares, depending on whether they confer the right to a share in the residual value of the corporation on dissolution (with participating preferred shares treated as equity securities, regardless of whether the income is fixed or determined according to a formula, while non-participating preferred shares are classified as debt securities).
Convertible or exchangeable preferred shares, depending on whether they can be converted into a specified amount of ordinary shares or bonds.
Redeemable or retractable preferred shares, which are redeemed or retracted at a fixed price on a specified date or during a specified period of time at the request of either the corporation or the holder.
Straight perpetual preferred shares, rate reset preferred shares, fixed floating rate preferred shares, and floating rate preferred shares, all of which have different dividend payment patterns.
Split and structured preferred shares, which are based on an underlying portfolio of ordinary shares or other financial instruments.
3.26 Depository receipts represent ownership of securities issued in other economies. Ownership of the receipts is treated as direct ownership of the underlying financial instrument backing them (i.e., the relevant debt or equity security).4 A resident deposit-taking corporation will purchase the underlying securities and then issue receipts in a currency more acceptable to the investor.
3.27 Depository receipts allow a nonresident institutional unit to introduce its debt or equity securities on another market in a form more readily acceptable to the investors in that market. Financial investors frequently prefer to acquire securities in financial markets where the payments and settlement systems, registration procedures, and other arrangements are familiar, rather than in the home market of the issuer. The depository issues receipts listed on one exchange representing ownership of securities listed on another exchange.
3.28 For instance, American depository receipts (ADR) are liabilities of the non-U.S. institutional units whose securities underlie the ADR, not of the U.S. financial institutions issuing the ADR. Depository receipts have spread to other countries in the form of global depository receipts (GDR), European depository receipts (EDR), and international depository receipts (IDR).
3.29 GDR are securities available in one or more markets outside the corporation’s country of residence. The primary advantage of GDR, compared with ADR, is that they allow the issuer to raise capital on two or more markets simultaneously, increasing its shareholder base. They have also gained in popularity owing to the flexibility of their structure. A GDR represents one or more shares (or a fraction of a share) in a corporation. The depository bank in the country of residence holds the shares. A GDR investor has the same rights as holders of ordinary shares, but does not typically have voting rights. Sometimes the depository bank can vote on behalf of GDR holders. GDR are commonly listed on European stock exchanges (e.g., the London Stock Exchange). Both ADR and GDR are usually denominated in U.S. dollars, but they can also be denominated in other currencies, such as the euro. Corporations have a choice of four types of depository receipt: unsponsored depository receipts and three levels of sponsored depository receipts.
Some depositories issue unsponsored depository receipts in response to market demand, but without a formal agreement with the corporation in question. Unsponsored depository receipts are considered to be obsolete and do not tend to be issued owing to the corporation’s lack of control and hidden costs.
Alternatively, a depository (appointed by the relevant corporation under a deposit agreement or service contract) may issue sponsored depository receipts. Sponsored depository receipts offer the corporation control over the facility, the flexibility to list on other exchanges, and the ability to raise capital.
A sponsored level I depository receipt program is the simplest way for corporations to access capital markets. Level I depository receipts are traded in the U.S. over-the-counter (OTC) market and on some exchanges outside the United States. The corporation does not have to comply with the U.S. Generally Accepted Accounting Principles (GAAP) or full U.S. Securities and Exchange Commission (SEC) disclosure. Essentially, a sponsored level I depository receipt program allows a corporation to enjoy the benefits of a publicly traded security without changing its reporting process.
Corporations that wish to either list their securities on an exchange in the U.S. or raise capital use sponsored level II or III depository receipts, respectively. These types of depository receipt can also be listed on some exchanges outside the United States. There are different SEC registration and reporting requirements for each level, in addition to adherence to the U.S. GAAP. The corporations must also meet the listing requirements of the U.S. exchanges that they choose. Generally, the higher the level of the depository receipt program, the greater the visibility and attractiveness of the depository receipt.
3.30 In addition to the three levels of publicly traded sponsored depository receipt programs, a corporation can also access the U.S. and other markets through the private placement of sponsored depository receipts. This allows a corporation to raise capital by placing depository receipts with large institutional investors in the U.S., avoiding SEC registration.
3.31 Where possible, depository receipts should be recorded in such a way that “looks through” the depository issuing the receipts, that is, the holder of the receipts should be considered to have a claim on the issuer of the underlying securities. Depository receipts should be allocated to the country of residence of the issuer of the original (or underlying) security, not the country of residence of the depository issuing the receipts.
3.32 The potential for double counting lies in the existence of both the underlying security, held by the depository, and the associated depository receipts. To avoid double counting, financial intermediaries should not report holdings of securities issued by nonresidents against which depository receipts have been issued and sold. If a depository receipt has been issued before the financial corporation arranging the issue has acquired the original (or underlying) securities, that financial corporation should report negative holdings of the original (or underlying) securities.
3.33 Debt securities may include loans that have become negotiable de facto, but only if there is evidence of secondary market trading, including the existence of market makers, and frequent quotations of the instrument, such as provided by bid-offer spreads (2008 SNA, paragraph 11.65). The conversion of a loan into a debt security should be recorded as two flows, that is, a decrease in the loan and an increase in debt securities arising from the statistical reclassification of the loan.
3.34 Debt securities can also be issued as private placements. Private placements involve the issuer selling debt securities directly to a small number of investors. The creditworthiness of private placements is usually not assessed by credit rating agencies and, as the securities are generally not resold or repriced, their secondary market is shallow. However, to the extent that some private placements can be traded among investors—and so ownership is readily capable of being transferred—the main negotiability criterion for securities is met.
Structured Debt Securities
3.35 Debt securities that combine different features of financial instruments are more challenging to classify. This is particularly the case for so-called structured debt securities, which are a subset of structured securities.
3.36 A structured debt security typically combines a debt security, or a basket of debt securities, with a financial derivative, or a basket of financial derivatives. This financial derivative, or the basket, is typically embedded in and therefore inseparable from the debt security. When the debt security and financial derivative components of a financial instrument are separable from each other they should be classified accordingly. If they cannot be separated, however, the instrument should be valued and classified according to its primary characteristics (BPM6, paragraph 5.83 (d)), either as a debt security or a financial derivative. For further details on structured debt securities, see Annex 2.
Islamic Debt Securities
3.37 Debt securities also encompass financial instruments governed by Islamic rules and principles (Sharī’ah). Islamic finance uses financial instruments that are backed by returns from a nonfinancial asset and earn a variable rate of return tied to the performance of the asset, or returns that are not specified before the investment is made, but shared on the basis of a pre-agreed ratio of actual earnings. Islamic debt securities are distinguished from equity securities by two categories of criteria. The first category comprises criteria used to differentiate conventional debt securities from equity securities. The second category comprises additional criteria used to distinguish Islamic debt securities from equity securities. These criteria and other details concerning Islamic securities are outlined in Annex 3.
3.38 Convertible bonds are debt securities that can be converted into equity securities (although some are included in capital under the Basel III definition). From the time they are converted, they are classified as equity securities.
3.39 When the option to convert the bonds into shares is exercised, two entries must be made showing the redemption of the bonds and the issuance/acquisition of the shares.
Securities Repurchase Agreements
3.40 A securities repurchase agreement is an arrangement involving the provision of securities in exchange for cash with a commitment to repurchase the same or similar securities at a fixed price either on a specified future date, or with an “open” maturity. Securities lending with cash collateral and sell/buybacks are terms for different arrangements having the same economic effect as a securities repurchase agreement. Economic ownership of the securities provided as collateral under such agreements is considered not to have been transferred because the cash recipient (the seller of the securities) remains subject to all market risks and continues to receive any benefits. Therefore, transactions involving securities repurchase agreements and securities lending do not entail a new issuance of debt securities, but rather the incurrence of collateralized loans. These transactions are therefore excluded from debt securities statistics.
3.41 Equity certificates (or “primary capital certificates”) are shares issued by savings banks and other financial institutions that are not limited liability companies or public limited companies. These can be either listed (mainly equity certificates issued by savings banks), or unlisted.
3.42 Equity-linked notes (ELN)—a type of equity-linked instrument (ELI)—are debt securities that differ from fixed interest rate debt securities in that their coupons or redemption values are based on the return for a single share, a basket of shares (whether listed or unlisted), or an equity index (the “underlying equity”). This means that ELNs are generally designed to return the principal of the original investment at maturity, but, unlike fixed interest rate debt securities, their coupons are determined by changes in the value of the underlying equity. Moreover, unlike structured warrants, the principal is usually protected.
3.43 An ELN can be constructed by packaging a call option and a zero-coupon bond. The call option provides the note buyer with exposure to the underlying equity. The zero-coupon bond provides the note buyer with principal protection. A zero-coupon bond allows for principal protection because it moves from its discount value to its par value over a specified period of time without the periodic payment of interest. The discount from the par value of the zero-coupon bond can be used to purchase the call option on the underlying equity.
Dividend Reinvestment Plans/Programs
3.44 Dividend reinvestment plans/programs (DRIPs) and direct investment plans enable shareholders to reinvest variable amounts in a corporation. DRIPs are offered by corporations and allow investors to reinvest their dividends by purchasing additional shares or fractions of shares from the corporation on the dividend payment date.
3.45 Participation certificates grant their holders participation rights. Participation rights may take various forms, both for equity securities and for debt securities. In many countries, almost no legal restrictions are placed on this type of financial instrument.
3.46 Depending on their specific features, participation certificates are considered to be either equity securities or debt securities. They are treated as equity securities if the following criteria are met:
The holder’s claims are subordinated.
The holder’s remuneration is performance related.
Capital is provided for an unlimited period, or at least on a long-term basis.
In light of these criteria, most participation certificates are considered to be equity securities.
3.47 “Genußscheine” (or “Genußrechte”) are a type of participation certificate. These are issued mainly in European countries such as Germany, Austria, and Switzerland. “Genußscheine” sometimes have a stated maturity.
3.48 Private equity is corporate equity (such as venture capital) that is not traded publicly on a stock exchange. Private equity is classified as either unlisted shares (F512) or other equity (F519).
Development Capital Certificates
3.49 Development capital certificates (“certificados de capital de desarrollo” or “CCDs”) are securities issued by trusts in order to channel investment resources to equity securities relating to sectors and activities with the potential for long-term growth. The yield for these instruments depends on the results of each project. Neither interest nor the repayment of principal is guaranteed.
3.50 CCDs have a defined settlement period. Once the deadline has been reached, the issuing trust administrator must liquidate all of the assets and distribute the proceeds among investors.
3.51 CCDs give their holders the right to collect dividends and participate in capital reductions and share redemptions, as well as the right to sell or otherwise dispose of shares.
3.52 CCDs are similar to financial instruments issued by special-purpose acquisition companies (SPAC) in the United States, income trusts in Canada, and infrastructure funds in Australia.
Shares in Cooperative Entities and Credit Unions
3.53 Shares in cooperative entities are usually non-negotiable financial instruments and should be classified as “other equity.” However, there may also be situations where credit unions issue equity certificates, which are classified as listed or unlisted shares.
3.54 If the holder of shares in a cooperative entity has the right to request redemption without restrictions, the shares should be classified as equity securities. However, they should be classified as “other equity” if:
The entity has an unconditional right to refuse redemption.
Local legislation, regulations, or the entity’s statute limits redemption.
3.55 Credit unions are cooperative financial institutions owned and operated by their customer-owners; the shareholders constitute both customers and owners of the credit union. Each customer-owner has one vote at the annual general meeting. A voluntary board of directors is nominated and elected by the shareholders.
3.56 Ownership is usually open to any resident organization or corporation and is based on a common share account. Shares are refundable on cancellation of ownership. They also carry the right to dividends, which may be based on the credit union’s earnings and are determined by the board of directors.
3.57 Members of a credit union can hold their savings in either deposit or share accounts. Accordingly, as a rule, shares in credit unions should be treated as deposits, or as “other equity” if they are not redeemable immediately or on short notice.
Other Financial Instruments Not Classified as Securities
Investment Fund Shares or Units
3.58 Investment funds are collective investment undertakings through which investors pool funds in order to acquire financial or nonfinancial assets. Shares or units in these funds (F52) may be categorized, depending on the variability of the capital base, as open-ended or closed-ended investment fund shares or units.
Open-ended investment funds can issue and redeem shares on a continuous basis or at certain predefined (short-term) intervals. The most popular types of open-ended investment fund are index funds and money market funds (MMFs). Index funds track the performance of particular stock or bond indices.5 MMFs invest in short-term, low-risk financial instruments. An open-ended investment fund is divided equally into shares or units, which vary in price in direct proportion to the variation in the fund’s net asset value (NAV).6
Closed-ended investment funds issue a limited number of shares or units. These sometimes have a specified maturity, such as five to seven years. New shares or units are rarely issued once the fund has been launched, and shares or units are not usually redeemable until the fund is liquidated.
3.59 Open-ended investment fund shares or units are not usually negotiable and are not, therefore, equity securities. However, closed-ended investment fund shares or units are typically negotiable and therefore constitute equity securities. Open-ended investment fund shares or units are not covered in the Handbook.
3.60 Other equity (F519) is equity that is not in the form of securities.7 Other equity includes equity in quasi-corporations (such as branches, trusts, and partnerships), as well as notional units representing ownership of real estate.
3.61 Equity of partners with unlimited liability in incorporated partnerships is classified as other equity.
3.62 Participation in (i.e., ownership of) many international organizations is not in the form of shares and therefore is classified as other equity. However, equity in the Bank for International Settlements (BIS) does take the form of (unlisted) shares (BPM6, paragraph 5.26).
3.63 The financial instruments listed below are also typically regarded as other equity.
All equity in corporations that is not in the form of shares:
Equity in incorporated partnerships that is subscribed by unlimited partners
Equity in limited liability companies whose owners are partners and not shareholders
Capital invested in ordinary or limited partnerships recognized as independent legal entities
Capital invested in cooperative societies recognized as independent legal entities.
Investment by general government in the capital of public corporations whose capital is not divided into shares and that are recognized as independent legal entities under special legislation.
Investment by general government and nongovernment units in the capital of the central bank.8
Investment by general government and central banks in the capital of international and supranational organizations (with the exception of the IMF), even if these are legally constituted financial resources of a currency union central bank (CUCB) (e.g., the European Central Bank) contributed by national central banks.
Capital invested in financial and nonfinancial quasi-corporations (corresponding to new investment—whether in cash or in kind—minus any capital withdrawals).
Any financial claims of nonresident units against notional resident units, and vice versa.
Shares Offered for Sale
3.64 Equity securities offered for sale, but not taken up on issue, are not recorded.
3.65 Loan stocks are classified as loans. Loan stocks are loans secured using ordinary or preferred shares as collateral. The loan will earn a fixed rate of interest, much like a standard loan.
3.66 Secured loan stocks are called “convertible loan stocks” if they can be converted directly into shares, subject to specific conditions being met, with a predetermined conversion rate, as with irredeemable convertible secured loan stocks.
3.67 Warrants are options and should be classified as financial derivatives.9 Warrants are tradable financial instruments giving the holder the right to buy or sell, subject to specific conditions and for a specified period of time, a certain number of shares or debt securities from or to the issuer of the warrant (usually a corporation; 2008 SNA, paragraph 11.119). The instruments described below are all classified as warrants:
Call or put warrants are issued on the basis of an underlying financial instrument or an index.
Basket warrants are issued as call or put warrants based on a basket of two or more underlying shares.
Bull equity-linked instruments give investors the right to buy the underlying shares at a discounted rate vis-à-vis the underlying share price at the time of issuance. If the underlying share price exceeds the exercise price, investors are entitled to a cash settlement on expiration of the warrant (i.e., the par value of the instrument plus interest).
Bear equity-linked instruments essentially function in the opposite way to bull instruments. If the prevailing price of the underlying share (the closing price) is below the exercise price, investors receive the par value of the instrument plus interest as a cash settlement.
Range equity-linked securities give the investor the par value plus interest where the prevailing price of the underlying share is within a range demarcated by two exercise prices.
Callable bull or bear certificates track the performance of an underlying stock without requiring investors to pay the full price required in order to own the actual stock.
3.68 A stock option (or “share option”) represents a contract sold by one party to another that entitles (but does not oblige) the buyer to buy (call) or sell (put) a stock at an agreed price within a certain period or on a specific date. Stock options are financial derivatives and are not, therefore, classified as securities.
3.69 Employee stock options are agreements under which employees have the right to purchase a given number of shares in their employer’s firm at a stated price, either on a specified date (the “vesting” date) or within a specific period of time immediately following the vesting date.
Closely held corporations are corporations that are owned by a small number of shareholders. Their shares are usually traded less frequently.
There are other types of trading platform, such as over-the-counter (OTC) exchanges. Large numbers of shares are traded on these exchanges, but they may not be liquid enough to be officially listed.
Ordinary share certificates often carry limited voting rights.
This treatment is justified because the “issuer” (the deposit-taking corporation) does not take the underlying securities on to its balance sheet, but rather acts as a facilitator (External Debt Statistics Guide, Appendix I).
Exchange-traded funds are a subset of index funds that can be traded on an exchange during the day, just like common stocks.
The classification of financial instruments (CFI) standard defines open-ended funds as those that “permanently sell new units to the public and redeem outstanding units on demand, resulting in an increase or decrease of outstanding capital.”
With security-by-security (SBS) databases, it may be that financial instruments are reported using the International Securities Identification Number (ISIN) code for other equity (F519). These should be classified as unlisted shares (F512).
From a legal perspective, central banks may resemble corporations issuing shares, but central bank equity is treated as other equity (AF519) by convention.
Listed financial derivatives, such as warrants, are sometimes considered to be securities (BPM6, paragraph 5.15).