A:

A haircut rate is a measure that reduces the value of any collateral used in a loan to ensure that when the effects of volatility and adverse price changes are taken into consideration, the collateral will still have enough value so that the lender does not realize any loss.

Haircut rates are imposed by clearing corporations to ensure adequate capital requirements, margin and collateral levels. Broker-dealers are required by law to meet capital requirements. The net capital requirements required by various institutions are stated under SEC Rule 15c3-1.

Haircut rates will vary depending on the instrument and the length, type or riskiness of the transaction. Under the SEC rule, the haircut rate for an exchange-traded fund (ETF) such as a Spider is 10%, compared to a 2% haircut for a money market fund. Notice how a higher rate is imposed on assets that are riskier.

As another example, a 30% haircut rate may be imposed when an investor wishes to use shares which she already holds in her account as collateral for margin required for a separate transaction. The market value of the shares is devalued by 30% to give the lending institution a cushion in case the value of the collateral experiences a sharp decline.

For information on the effects of these margin requirements on the average investor, check out our Margin Trading Tutorial.

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