Trading in Securities for Sophisticated or Professional Investors

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Trading in Securities

Engaging in securities trading signifies the act of purchasing and selling diverse financial instruments. These instruments are customarily issued by corporations or governmental entities to gather funds for various undertakings. The financial market landscape is populated by a vast array of securities, with stocks and bonds standing out as the most ubiquitous. However, the sheer variety of these instruments ensures that there is a suitable option to cater to every investor's unique preferences and financial objectives.

Here is a more comprehensive breakdown of the different categories of tradable securities:

  1. Equity Securities: Representing an ownership stake in a company, equity securities are typically associated with a high-risk, high-reward investment paradigm. Shareholders of equity securities, or stocks, are entitled to a proportionate share of the company's residual profits after all other obligations have been met.
  2. Debt Securities: Essentially loans made to corporations or governments, debt securities offer lower risk but also lower potential returns. Holders of these securities, or bonds, function as creditors and are paid interest on the loaned amount.
  3. Hybrid Securities: Offering a fusion of the features of both equity and debt securities, hybrid securities present a balanced risk-reward profile. They offer investors an opportunity for potential profits via ownership stakes while also providing interest income.
  4. Derivative Securities: These are complex financial contracts whose value is derived from an underlying asset, such as stocks, bonds, commodities, or currencies. Common forms of derivative securities include options, futures, and swaps, which can be used for hedging risk or for speculative purposes.

Securities trading transpires across various platforms, including exchanges and Alternative Trading Systems (ATS). An ATS, as the name implies, offers an alternative venue to traditional exchanges for matching buyers and sellers of securities. They are often employed for executing large volume trades among their subscribers, thereby reducing market impact.

A prevalent form of ATS in the United States is the Electronic Communication Network (ECN), a sophisticated, computerized system designed to automatically match buy and sell orders for securities in the market.

While the specifics of securities trading can vary from region to region, the broad principles remain the same across Europe and other parts of the world. European markets, for example, utilize Multilateral Trading Facilities (MTFs), which operate similarly to American ATSs. Moreover, diverse categories of securities, such as equities, debt, hybrid, and derivative instruments, are traded globally, with the specific types and structures of these instruments varying based on local market conditions and regulations.

In essence, securities trading forms the backbone of the global financial system, providing companies and governments with essential capital, while offering investors a range of opportunities to grow their wealth and manage their risk exposure.

Equity Securities

Equity securities, often referred to as stocks or shares, come in a variety of forms. The different types of equity securities represent different types of ownership in a company and can carry different rights and privileges. Here are some of the most common types:

  1. Common Stocks: This is the most prevalent type of equity security. Common stockholders have a claim on a portion of the company's assets and earnings. They also have voting rights, usually one vote per share owned, and may receive dividends, which are a portion of the company's earnings distributed to shareholders.
  2. Preferred Stocks: Preferred stockholders have a higher claim on the company's assets and earnings than common stockholders. This means they receive dividends before common stockholders and have a higher claim in case of liquidation. However, preferred stock usually does not come with voting rights.
  3. Convertible Stocks: These are a type of preferred stock that can be converted into a certain number of common shares. This gives investors the safety of a preferred stock with the potential upside of a common stock if the company performs well.
  4. Restricted Stocks: These are shares given to company insiders, such as employees and directors, that cannot be sold until certain conditions are met, usually a specific date or performance goal.
  5. Stock Options: These are contracts that give the holder the right, but not the obligation, to buy or sell a stock at a specific price within a certain time period. They are often used as part of employee compensation packages.
  6. Class A, B, C Stocks: Some companies have different classes of stock that carry different voting rights. For example, Class A shares might carry 10 votes per share, while Class B shares carry one vote per share. This allows certain groups of shareholders, often company founders or executives, to maintain control over the company.

Debt Securities

Debt securities represent loans made by investors to a corporation, government, or other entity. In exchange for the loan, the borrower promises to repay the principal amount along with interest by a specified date. Here are some of the most common types of debt securities:

  1. Corporate Bonds: These are debt securities issued by corporations to finance business operations or expansions. They typically have a fixed interest rate and are repaid after a specific period, known as the bond's maturity date.
  2. Government Bonds: These are debt securities issued by governments to fund public projects or government operations. They are usually considered low-risk investments because they are backed by the credit of the government. Examples include U.S. Treasury bonds, UK Gilts, and German Bunds.
  3. Municipal Bonds: Issued by states, cities, or other local governments, these bonds fund public projects like schools, highways, and bridges. In the United States, the interest earned on these bonds is often tax-free.
  4. Agency Bonds: These are issued by government-sponsored entities (GSEs) or federal agencies. While they are not directly issued by the government, they have a high level of creditworthiness due to their close relationship with the government.
  5. Sovereign Bonds: These are issued by national governments in foreign currencies to attract foreign investors. The creditworthiness of these bonds depends on the issuing country.
  6. Convertible Bonds: These are a special type of bond that can be converted into shares of the issuing company’s stock at certain times during its life, usually at the discretion of the bondholder.
  7. Zero-Coupon Bonds: Unlike most bonds, which pay interest throughout their term, zero-coupon bonds do not pay interest at regular intervals. Instead, they are issued at a discount to their face value and repay the full face value at maturity.
  8. Secured and Unsecured Bonds: Secured bonds are backed by a specific asset or collateral. If the issuer defaults, the bondholders may have a claim on those assets. Unsecured bonds are not backed by specific assets and are instead backed by the general creditworthiness of the issuer.
  9. Junk Bonds: Also known as high-yield bonds, these are issued by companies with a higher risk of default. To compensate for this risk, they offer higher interest rates.

Hybrid Securities

Hybrid securities are unique financial instruments that combine features of both equity and debt securities. They typically offer a potential fixed or floating rate return until a certain date, and then convert into another type of security, often equity. Here are some of the most common types of hybrid securities:

  1. Convertible Bonds: These are bonds that can be converted into a specified number of shares of the issuing company's common stock. Convertible bonds combine the potential upside of equity ownership with the fixed returns of a bond.
  2. Convertible Preferred Shares: These are preferred shares that can be converted into a specified number of common shares. Like convertible bonds, they offer the fixed returns of preferred stock with the potential upside of common stock.
  3. Mezzanine Financing: This is a hybrid of debt and equity financing. It is essentially a debt instrument that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full.
  4. Structured Products: These are complex financial products that are derived from and depend on the value of an underlying asset or group of assets. Structured products often combine bonds with derivatives to tailor the risk-return profile of the security.
  5. Preferred Stock with Warrants: This is a type of preferred stock that comes with warrants attached, giving the holder the right to purchase common shares at a specific price.
  6. Participating Convertible Preferred Shares: These are preferred shares that, in addition to their stated dividends, are entitled to participate in any remaining dividends after all other classes of securities have been paid.
  7. Capital Notes: These are subordinated debt securities that have the potential to convert into equity if a specified event occurs. They are riskier than typical debt because they are only repaid after all other corporate debts have been settled in the event of liquidation.

Derivative Securities

Derivative securities are financial contracts whose value is derived from an underlying asset, such as stocks, bonds, commodities, currencies, interest rates, or market indices. They are primarily used for hedging risk or for speculative purposes. Here are some of the most common types of derivative securities:

  1. Options: These are contracts that give the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specific price within a certain time period.
  2. Futures: These are contracts to buy or sell an asset at a specified future date at a price agreed upon today. Unlike options, futures contracts obligate the buyer to purchase the asset (and the seller to sell the asset) at the specified date and price.
  3. Forwards: Similar to futures, these are contracts to buy or sell an asset at a specified future date at a price agreed upon today. However, forward contracts are typically traded over-the-counter (OTC), meaning they are traded between two parties directly, rather than on an exchange.
  4. Swaps: These are agreements between two parties to exchange sequences of cash flows for a set period of time. The most common type is an interest rate swap, where one party agrees to pay a fixed interest rate in return for receiving a variable interest rate.
  5. Credit Derivatives: These are contracts that transfer credit risk from one party to another. The most common type is a credit default swap, where the seller will compensate the buyer in the event of a loan default or other credit event.
  6. Collateralized Debt Obligations (CDOs): These are a type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets and are sliced into different sections, or tranches, each with a different level of risk and return.
  7. Exotic Derivatives: These include more complex instruments such as weather derivatives, barrier options, Asian options, binary options, and others. These derivatives often have unique features or stipulations not found in more traditional derivatives.
  • Weather Derivatives: These are financial instruments used by companies or individuals to hedge against the risk of weather-related losses. The underlying asset of a weather derivative is a weather index. These indices are typically made up of weather data collected and aggregated by weather stations. The indices track various aspects of weather, such as temperature, rainfall, snowfall, or even hurricanes. If a particular weather event occurs (or doesn't occur), the derivative pays out.
  • Barrier Options: A barrier option is a type of option contract where the payoff depends on whether or not the underlying asset reaches a predetermined price level. There are two types of barrier options: 'knock-in' and 'knock-out'. A 'knock-in' option begins to function as a normal option ("knocks in") only once a certain price level is reached prior to expiration. Conversely, a 'knock-out' option ceases to function ("knocks out") if the underlying asset reaches a certain barrier during its life.
  • Asian Options: These options, also known as average price options, are a type of derivative where the payoff is determined by the average price of the underlying asset over a certain period of time as opposed to the price at a specific time (like at maturity). Because of the averaging feature, Asian options reduce the risk of market manipulation of the underlying instrument at maturity.
  • Binary Options: Also known as digital options, binary options are a type of option where the payoff is either some fixed amount of some asset or nothing at all. The two main types of binary options are the cash-or-nothing binary option and the asset-or-nothing binary option. The former pays a fixed amount of cash if the option expires in-the-money, while the latter pays the value of the underlying security.

Financial Instruments that cannot be traded 

Financial institutions, including banks, engage with a wide array of financial instruments, some of which are held for investment or hedging purposes rather than for trading. Certain financial instruments cannot be traded by banks due to regulatory constraints, their purpose within the bank's operations, or their inherent non-tradable nature. 

  1. Loans and Advances: Banks originate loans to individuals and businesses, which constitute a significant portion of their assets. While secondary markets for loans exist, many loans, especially those with specific or customized terms, are not readily tradable due to their unique risk profiles and the complexity of the underlying agreements.
  2. Letters of Credit (LCs): Although LCs are crucial for facilitating international trade by providing payment guarantees, they are not tradable instruments. An LC is a commitment by a bank on behalf of its client, ensuring payment to a seller under specified conditions.
  3. Deposits: Customer deposits at banks are liabilities on the bank's balance sheet and represent the bank's obligation to return funds to depositors. These are not tradable assets but are fundamental to the bank's liquidity management.
  4. Bank-Issued Certificates of Deposit (CDs): While CDs are time deposits that customers can buy, the issuing bank itself cannot trade these instruments. CDs are commitments by the bank to pay back the principal along with interest.
  5. Reserve Requirements: Banks are required to hold a certain amount of funds in reserve at a central bank or in the vault as cash. These reserves are not tradable assets; they are regulatory requirements to ensure liquidity and stability in the banking system.
  6. Collateral Held against Loans: The collateral securing loans, while it may be liquidated in the event of a default, is not a tradable asset by the bank under normal circumstances. The bank holds the collateral for security purposes, not for trading.
  7. Bank-Owned Life Insurance (BOLI): This is a form of life insurance purchased by banks on the lives of certain employees, with the bank as the beneficiary. BOLI is used primarily as a tax-efficient method to fund employee benefits and is not a tradable asset.
  8. Derivatives Used for Hedging Purposes: While derivatives can be traded, those used by banks for hedging exposure to interest rates, currency risks, or other financial metrics are intended to mitigate risk rather than for speculative trading.
  9. Retained Earnings: As a component of a bank's equity, retained earnings represent the cumulative net income not distributed to shareholders as dividends. Retained earnings are crucial for a bank's capital adequacy but are not a tradable instrument.
  10. Goodwill and Intangible Assets: These assets arise from acquisitions where the purchase price exceeds the fair value of the net identifiable assets. Goodwill and other intangibles like brand value or customer relationships are crucial for a bank’s balance sheet but are not tradable assets.

These instruments illustrate the multifaceted nature of banking operations, where not all assets and liabilities are intended for trading. Instead, many serve operational, regulatory, and strategic purposes, underpinning the bank's financial health and stability rather than contributing directly to trading profits.

Insurance-Based Financial Instruments that can be traded

In the realm of finance, certain insurance-based financial instruments have been designed for trading in the markets. These instruments often serve dual purposes: providing risk management solutions and offering investment opportunities.

  1. Credit Default Swaps (CDS): A CDS is a financial derivative that allows an investor to "swap" or offset their credit risk with that of another investor. Essentially, it's a form of insurance against the default of a borrower. The buyer of a CDS pays a premium to a seller in exchange for compensation should a specified credit instrument, such as a bond or loan, default.
  2. Collateralized Debt Obligations (CDO):CDOs are structured financial products that pool together cash flow-generating assets and repackages this asset pool into tranches that can be sold to investors. The tranches are differentiated by their risk profile and expected returns. While not strictly an insurance instrument, CDOs often contain CDS and other derivatives to manage and redistribute risk.
  3. Mortgage-Backed Securities (MBS): Similar in structure to CDOs, MBS are securities backed by mortgage loans. They allow investors to benefit from the mortgage business without directly issuing loans. MBS can be further wrapped with credit enhancement techniques, such as mortgage insurance or a pool insurance policy, to make them more attractive to investors.
  4. Asset-Backed Securities (ABS): ABS are bonds or notes backed by financial assets, typically those that are not mortgage loans. Like CDOs, these can include a variety of assets, such as auto loans, credit card debt, or student loans, and may be enhanced by forms of credit insurance to mitigate the risk of default.
  5. Catastrophe Bonds (Cat Bonds): Cat bonds are a type of insurance-linked security designed to raise money for insurance companies in the event of a natural disaster. Investors receive a high yield, but risk losing their principal if a specified catastrophe (like a hurricane or earthquake) occurs. They represent a direct trade of insurance risk in the financial markets.
  6. Insurance-Linked Securities (ILS): ILS are financial instruments whose values are influenced by insurance loss events. Besides catastrophe bonds, ILS can include other forms of risk transfer instruments that allow insurance risk to be sold to investors in the capital markets.
  7. Longevity Swaps: These are derivative contracts that allow pension plans and insurance companies to hedge longevity risk, the risk of beneficiaries living longer than expected. In a longevity swap, the risk of pensioners or insured parties living longer and hence receiving more payments than anticipated is transferred to investors, who receive regular premiums in exchange.
  8. Weather Derivatives: Unlike traditional insurance products that require proof of loss, weather derivatives pay out based on the occurrence of specific weather events (temperature, rainfall, wind speed, etc.) that can affect businesses and profits. They are used by farmers, energy companies, and other entities to hedge against the financial impact of weather variability.
  9. Credit-Linked Notes (CLN): CLNs are a form of structured financial product that combines a bond with a credit default swap, allowing the issuer to transfer a specific credit risk to credit investors. The return on a CLN is linked to the performance of a credit asset or a basket of assets, making it an investment vehicle as well as a risk management tool.
  10. Viatical Settlements and Life Settlements: While not traded in the traditional sense, these settlements involve the sale of a life insurance policy by the policyholder (who is usually chronically or terminally ill in the case of viatical settlements) to a third party for more than the cash surrender value but less than the death benefit. The third party continues to pay the premiums and eventually collects the death benefit.
  11. Reinsurance Sidecars: Sidecars are financial vehicles used by reinsurance companies to allow investors to take on some of the risks and rewards of underwriting insurance policies. They are typically short-term arrangements that provide additional capacity for insurers, especially in high-risk areas like natural disasters.
  12. Structured Insurance Products: These are bespoke financial instruments created to meet specific investor or issuer needs that traditional insurance products cannot fulfill. They often involve the packaging of insurance risk with financial derivatives or other securities to create tailored risk-return profiles.

These instruments exhibit a blend of insurance principles with capital market innovations, allowing for the transfer, diversification, and management of risk across a wider spectrum of investors. By trading these instruments, market participants can hedge against diverse forms of financial and operational risks, while also accessing investment opportunities not directly available through traditional securities.

Insurance-Based Financial Instruments that cannot be traded 

Below is an elucidation of various insurance instruments, that are not tradable by banks due to their inherent nature and regulatory constraints:

  1. Surety Bonds (Security Bonds): These are contractual agreements involving three parties—the principal, the obligee, and the surety—where the surety guarantees the obligee that the principal will fulfill an obligation or series of obligations. Surety bonds are commonly used in construction contracts, judicial proceedings, and as compliance tools in various industries.
  2. Letter of Credit Guarantees: While not an insurance product per se, letters of credit function similarly to surety bonds in commercial transactions, especially in international trade, offering a guarantee of payment from a bank to a seller on behalf of the buyer. However, unlike tradable letters of credit, guarantees are non-tradable commitments by banks to cover losses if a client fails to fulfill a contractual obligation.
  3. Performance Bonds: These are specific types of surety bonds that ensure the completion of a project by a contractor according to contractual terms. If the contractor fails to complete the project as agreed, the bond covers the cost for completion or compensation.
  4. Payment Bonds: Serving as a companion to performance bonds, payment bonds guarantee that subcontractors and suppliers will be paid for their services and materials in a construction project.
  5. Maintenance Bonds: These bonds guarantee that a contractor will maintain a project in accordance with the contract's standards for a certain period after completion.
  6. Fidelity Bonds: Also known as employee dishonesty coverage, these bonds protect a business from losses caused by fraudulent acts of its employees.
  7. Bid Bonds: These ensure that a contractor bidding on a project will enter into the contract at the bid price if they are awarded the project and will also provide the requisite performance and payment bonds.
  8. Workers' Compensation Insurance: This insurance covers employees' medical expenses and a portion of their lost wages if they get injured on the job. It's mandated by law in most jurisdictions but is not a tradable instrument.
  9. Liability Insurance: General liability insurance provides coverage against claims of property damage or bodily injury. Professional liability insurance, including errors and omissions (E&O) insurance, protects professionals against claims of negligence or harm from services provided.
  10. Property and Casualty Insurance: This broad category includes various types of insurance policies that provide either property protection coverage or liability coverage for property owners.
  11. Credit Insurance: Protects businesses against commercial and political risks that might prevent their customers from paying for goods or services delivered to them.
  12. Trade Credit Insurance: Specifically protects sellers from non-payment by their buyers, a crucial tool in managing accounts receivable risks in both domestic and international trade.

These instruments primarily serve the purpose of risk management and financial protection rather than investment or trading. The regulatory environment surrounding these products ensures that they are utilized appropriately within their respective contexts, emphasizing their role in stabilizing and securing financial and contractual commitments rather than generating trading profits.

The main Financial Securities Markets

  1. Stock Markets: The largest stock market by market capitalization is the New York Stock Exchange (NYSE), followed by the NASDAQ, both based in the United States. As of 2020, the NYSE had a market capitalization of approximately $25.6 trillion USD, while the NASDAQ had a market capitalization of around $19.5 trillion USD​.
  2. Bond Markets: The bond market is also a major financial securities market. The bond market is larger than the stock market globally, with an estimated size of over $100 trillion USD as of 2020. U.S. bonds, both governmental and corporate, make up a significant portion of this market​.
  3. Over the Counter  (OTC): As of 2019, the Bank for International Settlements reported that the notional amount outstanding for all types of over-the-counter (OTC) derivatives, including CDS, was around $640 trillion USD. But the data specifically for CDS was not found in my search. It's worth noting that the CDS market has decreased in size since the 2008 financial crisis, when it played a significant role.

Investor Categories

Investors can be categorized in various ways based on factors such as their income, net worth, investment goals, risk tolerance, and the level of investment knowledge and experience. Here are some broad categories:

  1. Retail (or Individual) Investors: These are individuals who invest on their own behalf, using their personal money. They usually have less access to complex investments and less negotiating power compared to institutional investors. Retail investors are subject to fewer regulations but also have fewer protections.
  2. Institutional Investors: These are organizations that invest on behalf of members or clients. They include pension funds, mutual funds, insurance companies, banks, endowments, and hedge funds. Institutional investors typically have access to a wider range of investment opportunities, can negotiate better terms, and have more regulatory requirements.
  3. Accredited Investors: This category includes individuals or entities that meet certain income, net worth, asset size, governance status, or professional experience thresholds. For example, in the United States, as of my knowledge cutoff in 2021, accredited individual investors are those with a net worth of over $1 million (excluding their primary residence) or an income of over $200,000 in the last two years (or $300,000 combined with a spouse). Accredited investors have access to investment opportunities (such as certain private offerings) that are not available to retail investors.
  4. Sophisticated Investors: The term "sophisticated investor" can vary in meaning depending on the jurisdiction. Generally, it refers to an investor with a high level of knowledge and experience in financial matters, capable of evaluating the risks and merits of an investment independently. In some jurisdictions, sophisticated investors must also meet certain wealth or income criteria, similar to accredited investors. Being classified as a sophisticated investor can provide access to investment opportunities not available to the general public, such as private placements or certain high-risk investments

It's important to note that these categories are not mutually exclusive. For instance, an individual can be both a retail investor and an accredited investor. The specific criteria and definitions for these categories can vary by country and regulatory authority.

The categorization of investors serves an important role in investor protection. More sophisticated, accredited, or institutional investors are assumed to be more capable of understanding and bearing investment risks, and thus they have access to a broader range of investment opportunities. However, they also might face fewer protections under securities laws compared to retail investors.

In the European Union, investor categories are defined under the Markets in Financial Instruments Directive (MiFID II), which is the framework of European Union (EU) legislation for investment intermediaries and markets. Here are the categories as per MiFID II:

  1. Retail Investors: These are individual investors who do not meet the criteria to be considered professional investors. They receive the highest level of protection under MiFID II, which means that financial services providers are required to provide them with more detailed information and cannot assume they possess a certain level of knowledge or experience.
  2. Professional Investors: These are investors who are considered to have the experience, knowledge, and expertise to make their own investment decisions and accurately assess the risk that they incur. This category includes entities such as credit institutions, investment firms, insurance companies, and other authorized or regulated financial institutions. It can also include large corporations and institutional investors.
  3. Eligible Counterparties: This category includes investment firms, credit institutions, insurance companies, and other regulated financial institutions, as well as governments and central banks. When dealing with an eligible counterparty, a firm is exempt from many of the conduct of business rules that would otherwise apply under MiFID II.

An individual can also be considered a professional investor on request, subject to certain conditions and tests regarding their knowledge, experience, and financial capability (the so-called "opt-up" procedure). This is probably the closest concept to the "accredited investor" or "sophisticated investor" in U.S. regulations.

It's crucial to note that different levels of protection and requirements apply to each category, with retail investors receiving the highest level of protection due to typically having less experience and knowledge in financial markets compared to professional investors and eligible counterparties. As always, definitions and regulations may vary from one jurisdiction to another, so it's important to understand the specifics in your own location.