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 recognise 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.
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 characterised 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.
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 x $ 0.01) when each trade typically costs $ 5 to $ 10 (varies by broker) is not a profitable strategy for the retail trader.
LTCM’s failure and collateral haircuts example
Long-Term Capital Management (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 utilised 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.
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.
Haircut and 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.
(Source: Investopedia)