Haircut: What It Means in Finance, With Examples

What Is a Haircut?

In finance, a haircut has two meanings. A haircut is most commonly used when referencing the percentage difference between an asset's market value and the amount that can be used as collateral for a loan. There is a difference between these values because market prices change over time, and the lender factors this fluctuation into their valuation and analysis for risk mitigation.

For example, if a person needs a $10,000 loan and wants to use their $10,000 stock portfolio as collateral, the bank is more likely to recognize the $10,000 portfolio as worth only $5,000 in collateral. The $5,000 or 50% reduction in the asset's value, for collateral purposes, is called the haircut. Should the person's stock portfolio decline in value, they may still have sufficient collateral for the amount of debt issued.

The term haircut is less commonly used as the market maker's spread. The term haircut is used since the market maker's spreads are so thin. A market maker may "trim" a very small fee off of proceeds collected as part of providing liquidity in markets or facilitating trades.

Key Takeaways

  • A haircut is the lower-than-market value placed on an asset when it is being used as collateral for a loan.
  • The size of the haircut is largely based on the risk of the underlying asset. Riskier assets receive larger haircuts.
  • A haircut is implemented on the value of a borrower's assets to make sure the lender is sufficiently covered with collateral should the value of the assets decline.
  • Haircut and margin both refer to the same concept of an asset's value being arbitrarily reduced for risk mitigation, though they are expressed differently.
  • A haircut also refers to the sliver or haircut-like spreads market makers can create or have access to.
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Haircut

Understanding Collateral Haircut

A haircut refers to the lower-than-market value placed on an asset being used as collateral for a loan. The haircut is expressed as a percentage of the markdown between the two values. When they are used as collateral, securities are generally devalued, since a cushion is required by the lending parties in case the market value falls.

When collateral is being pledged, the degree of the haircut is determined by the amount of associated risk to the lender. These risks include any variables that may affect the value of the collateral in the event that the lender has to sell the security due to a loan default by the borrower. Variables that may influence that amount of a haircut include price, volatility, credit quality of the asset's issuer (if applicable), and liquidity risks of the collateral.

Determining Haircut Amount

Generally speaking, price predictability and lower associated risks result in compressed haircuts, as the lender has a high degree of certainty that the full amount of the loan can be covered if the collateral must be liquidated. For example, Treasury bills are often used as collateral for overnight borrowing arrangements between government securities dealers, which are referred to as repurchase agreements (repos). In these arrangements, haircuts are negligible due to the high degree of certainty on the value, credit quality, and liquidity of the security.

Securities that are characterized by volatility and price uncertainty have larger haircuts when used as collateral. For example, an investor seeking to borrow funds from a brokerage by posting equity positions to a margin account as collateral can only borrow 50% of the value of the account due to the lack of price predictability, which is a haircut of 50%.

While a 50% haircut is standard for margin accounts, a risk-based haircut can be increased if the deposited securities pose liquidity or volatility risks. For example, the haircut on a portfolio of leveraged exchange-traded funds (ETFs), which are highly volatile, may be as high as 90%. Penny stocks, which pose potential price, volatility, and liquidity risks, typically cannot be used as collateral in margin accounts.

Different lenders will have different haircut valuations. If you're not satisfied with how much value your collateral is being assigned, consider evaluating the terms of other financial institutions.

Haircut Market Maker Spreads

A haircut is also sometimes referred to as the market maker's spread. Since market makers can transact with razor-thin spreads and low transaction costs they can take small slivers or haircuts of profits (or losses) constantly throughout the day.

With advances in technology and markets becoming more efficient, spreads in many assets have dropped to haircut levels. Retail traders can transact at the same spreads market makers do, although retail traders' costs are still higher which may make trading the spread ineffective.

In a stock, both retail traders and market makers can buy and sell for a $0.01 spread in an active and liquid stock, but buying and selling 500 shares to make $5 (500 * $0.01) when each trade typically costs $5 to $10 (varies by broker) is not a profitable strategy for the retail trader.

Long-Term Capital Management's (LTCM) Failure and Collateral Haircuts Example

LTCM was a hedge fund started in 1993. By 1998 it had amassed massive losses, nearly resulting in a collapse of the financial system. The basis of LTCM's profit model, which worked very well for a while, was to suck up small profits from market inefficiencies. This is commonly called arbitrage. The firm used historical models to highlight opportunities and then deployed capital to profit from them.

Each opportunity typically only produced a small amount of profit, so the firm utilized leverage—or borrowed money—in order to increase the gains. The firm had $5 billion in assets, yet controlled over $1 trillion worth of positions.

In the fall of 2018, 14 banks and brokerage firms invested $3.6 billion in LTCM to prevent the imminent collapse of the hedge fund.

Banks and other institutions allowed LTCM to borrow or leverage so much, with little collateral, mainly because they viewed the firm and their positions as non-risky. Ultimately, though, the firm's model failed to predict inefficiencies accurately, and those massively sized positions began to lose far more money than the firm actually had—and more money than many of the banks and institutions that lent to them or allow them to purchase assets had.

The failure of LTCM, which required a bailout of the financial system, resulted in much higher haircut rules in terms of what can be posted as collateral, and how much the haircut has to be. LTCM had basically no haircuts, yet today an average investor buying regular stocks is subject to a 50% haircut when using those stocks as collateral against the amount borrowed on a margin trading account.

Market Maker Haircut Example

In many markets, the market maker's spread is the same as the retail trader's spread, although the trading costs for the retail trader make trying to profit from a haircut spread ineffective.

One market where retail traders often cannot trade at the same spreads as the market makers is the forex market. This is because forex brokers often mark up the spread, which is how they make money. In the EUR/USD forex pair the raw spread available to market makers is 0.00001, yet retail traders may be paying a spread of 0.00005 to 0.00015 (or even higher), a mark-up of five to 15 times the raw spread.

Forex brokers that provide raw spreads to their clients charge a commission on each trade. They make their money off of trading fees instead of marking up the spread.

What Is the Difference Between a Haircut and a Margin?

A haircut and a margin are effectively the same things. Both items determine the value of collateral that is often less than the full amount of the collateral or loan.

A haircut is often expressed as a reduction in the value of collateral. For example, a borrower may have received a 5% haircut on their $10,000 collateral. This means the borrower's collateral was only valued at $9,500.

Alternatively, margin is often stated as the collateral ratio or percentage of the purchase price. Imagine a borrower opens up a trading account with a 60% margin. The borrower must deposit $10,000 to borrow $6,000.

What Is Haircut for Risk?

A haircut in finance is directly tied to risk. A lender does not want to issue a loan for the true value of collateral because if the value of the assets decrease, the lender will be at-risk to not recover the net value of their issued debt.

To mitigate risk, a lender will implement a haircut on the value of the collateral. By having the true value of the collateral be higher than what the loan is actually issued for, the lender can build in risk mitigation to ensure full recoverability.

What Is a Haircut in Debt Restructuring?

A haircut in debt restructuring is yet another unique use of the term "haircut" in finance. Specific to debt restructuring, a haircut is the reduction of outstanding interest payments or a portion of a bond payable that will not be repaid. This condition may arise when a company considers restructuring its debt and negotiates new terms with existing bondholders.

What Is Haircut Value?

Haircut value is the lower-than-market valuation placed on an asset when the asset is being used as collateral for a loan. The haircut value is externally determined, and the asset holder often does not have a say in the determination of the haircut value.

Article Sources
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  1. Federal Reserve History. "Near Failure of Long-Term Capital Management."

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