What is a Haircut
A haircut is the difference between prices at which a market maker can buy and sell a security. The term comes from the fact that market makers can trade at such a thin spread. The term may also refer to the percentage by which an asset's market value is reduced for the purpose of calculating capital requirement, margin, and collateral levels.
BREAKING DOWN Haircut
A haircut refers to a negative spread between either the buying and selling prices of a security, or the lower-than-market value placed on a security being used as collateral. 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 default by the borrower. Variables that may influence that amount of a haircut include price, credit and liquidity risks of the collateral.
What Determines a Haircut?
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, especially over a short time frame.
Securities that are characterized by volatility and price uncertainty, on the other hand, have steep 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 price, volatility and liquidity risks, cannot be used as collateral in margin accounts.