The Function of Securities

Governments and corporations need money in order to operate. Governments get money in two ways: through taxation and through borrowing. When governments borrow, they issue bonds, or certificates of debt. These certificates pay interest to the people or institutions that buy them. Thus, a person who buys a bond expects, over a specific period of time, to recover the principal — the amount of the loan — plus the interest — the fee the government pays the lender for the use of the money. Corporations likewise have two means of raising money (apart from their own profits). They may borrow it, and in doing so they may also issue certificates of debt. These certificates are called debentures, or, more commonly, bonds. Like government bonds, they pay interest to the buyers.

The second way for companies to raise money is to issue stocks, which represent ownership in a corporation. A company is literally selling part of itself to raise money. (The terminology varies between Great Britain and the United States. In Great Britain a company is said to issue shares, while in the United States a company issues stock. In the United States stock is divided into shares — 100 shares of IBM stock, for example; in Great Britain “stock” has the same meaning as “bond” does in the United States. Here we use the American terminology.) Bonds and stocks are together called securities. The term stock market, though somewhat imprecise, is used to name the industry in which stocks and bonds are bought and sold.

Just as governments must weigh the merits of higher taxes versus the merits of borrowing, so corporations must decide whether to raise money by borrowing or by issuing stocks. There is a greater risk in borrowing because the company puts itself in debt to someone else. If the debt cannot be repaid, bankruptcy may result. By borrowing, however, management has more control over the operations of the company, whereas when a corporation offers stock to the public, a degree of control is lost. Management becomes responsible to the ownership — those who hold the stock. Stock issues also decrease company income because dividends must be paid out to stockholders from company profits. New companies are quite likely to issue stock, since they are seeking venture capital, or start-up money.

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Merchant Banks

Merchant banks are institutions that carry out a variety of financial services, including the acceptance of bills of exchange, the issue and placing of loans and securities, portfolio and unit trust management and some banking services. Several houses, often through subsidiaries, also provide risk capital for small firms, deal in gold bullion, insurance banking and hire purchase and are active in the market for Eurocurrency. Historically, the merchant bankers were merchants dealing in overseas trade who used their knowledge of traders to accept bills of exchange and who developed other banking services connected with foreign trade, e.g., dealing in gold and foreign currency and assisting foreign borrowers to raise money in London. Their most prominent function has been that of advising the government on privatization and the private finance initiative and firms on mergers and take-overs and other financial matters.

Many merchant banks are well known, e.g., Rothschilds, Barclays de Zoete Wedd (BZW). Lazards and Schroders. Merchant banks are also referred to as issuing houses, accepting houses or investment trusts in exercising particular functions. The merchant banks are relatively small institutions which pride themselves on their personal, flexible management. There has been a recent trend, especially following the Big Bang, for merchant banks to join financial conglomerates, so as to be able to offer a full range of financial services, including retail services, and many of these banks in London are foreign-owned.

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