What is a haircut?

A financial haircut has two meanings. Commonly, a haircut refers to the percentage difference between an asset’s market value and loan collateral. The lender adds market price fluctuations to its valuation and risk mitigation processes; therefore, these numbers fluctuate.

If a person needs a $10,000 loan and wishes to use their $10,000 stock portfolio as security, the bank is more likely to value it at $5,000. The haircut is $5,000 for collateral, or 50% of the asset’s value. The person’s stock holdings may be enough to cover the loan if it drops.

The phrase “haircut” is less prevalent than “market maker’s spread.” Market maker spreads are thin; haircuts Market makers may “trim” a tiny charge from liquidity or trade facilitation earnings.

Understand

A haircut is a devalued asset used as loan security. Haircuts are percentages of markdowns between two values. Using securities as collateral often devalues them, as lending parties need a cushion if the market value drops.

The haircut on collateral depends on the lender’s risk. These risks include characteristics that might impact collateral value if the lender must sell it due to borrower default. Factors affecting haircuts include price, volatility, credit quality of the asset issuer, and collateral liquidity hazards.

Quantity

Price predictability and lesser risks result in shortened haircuts since the lender is confident that the collateral will liquidate to satisfy the loan. Treasury bills serve as collateral for overnight repurchase agreements between government securities dealers. In these arrangements, haircuts are minimal, given the certainty of the security’s value, credit quality, and liquidity.

Securities with high volatility and price uncertainty incur higher collateral haircuts. To borrow funds from a brokerage, investors can only borrow 50% of the value of their stock positions in a margin account owing to uncertain prices, resulting in a 50% haircut.

If the deposited securities offer liquidity or volatility problems, a risk-based haircut might enhance the 50% margin account haircut. A portfolio of leveraged ETFs, which are very volatile, may have a haircut of up to 90%. With price, volatility, and liquidity issues, penny stocks are unsuitable collateral for margin accounts.

Different lenders value haircuts differently. If you’re unhappy with your collateral’s worth, compare terms with different lending institutions.

Haircut Market Maker Spreads

A haircut is also known as the market maker’s spread. Market makers can take minor profits (or losses) throughout the day because of razor-thin spreads and minimal transaction costs.

Due to technology and market efficiency, many asset spreads have shrunk below haircut levels. Retail traders can trade the same spreads as market makers, but their expenses are more significant, making spread trading ineffective.

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

Example of LTCM Failure and Collateral Haircuts

LTCM began as a hedge fund in 1993. By 1998, its staggering losses had nearly brought down the banking system. LTCM’s successful business strategy relied on market inefficiencies to extract tiny gains. It is usually known as arbitrage. The company identified possibilities using historical models and invested resources to capitalize.

Since each opportunity yielded little profit, the corporation used leverage to boost gains. It had $5 billion in assets but over $1 trillion in positions.

To save LTCM, 14 banks and brokerage firms contributed $3.6 billion to the hedge fund in October 2018.1

Banks and other institutions enabled LTCM to borrow so much with minimal collateral because they considered the business and its holdings non-risky. However, the business’s model failed to forecast inefficiencies, and those tremendously large positions lost more money than the firm had—and more than many of the banks and institutions that loaned to them or allowed them to buy assets had.

The LTCM debacle necessitated a financial sector rescue, leading to stricter collateral requirements and steeper haircut restrictions. LTCM had no haircuts, but today, an average investor buying standard equities as collateral for a margin trading account must pay a 50% haircut.

Market Maker Haircut Example

The market maker’s spread is often the same as the retail trader’s, but retail traders’ trading expenses make haircut spreads useless.

Retail traders frequently cannot trade at the same spreads as market makers in the FX market. Forex brokers profit by marking up the spread. In the EUR/USD forex pair, market makers have a 0.00001 spread, whereas retail traders may pay 0.00005 to 0.00015 (or greater), a markup of 5–15 times the raw spread.

Forex companies offering raw spreads impose commissions on each deal. Instead of marking up the spread, they profit from trading fees.

What Is the Difference Between a Haircut and a Margin?

Margin and haircut are similar. Both items influence collateral value, usually less than the loan or collateral amount.

Often, a haircut reduces collateral value. A $10,000 borrower may have had 5% of their collateral reduced. This suggests the borrower’s collateral was merely $9,500.

The margin is also known as the collateral ratio or buying price percentage. Imagine a borrower opening a 60% margin trading account. The borrower must deposit $10,000 to borrow $6,000.

Risk

Risk drives financial haircuts. A lender does not want to offer a loan for the genuine worth of collateral because if the assets decline, they may not recover the net debt value.

A lender will reduce collateral value to reduce risk. The lender can mitigate risk and assure complete recoverability by having the collateral’s genuine value exceed the loan’s issued value.

In debt restructuring, what’s a haircut?

A “haircut” in debt restructuring is another unusual financial word. A haircut reduces interest payments or a bond’s unrepaid component in debt restructuring. A firm may face this situation while restructuring its debt and negotiating new terms with bondholders.

What’s Value?

A loan-collateralized asset’s haircut value is lower than the market. Often, the asset holder has no say in the haircut value.

Conclusion

• When used as loan collateral, an asset receives a haircut.
• The haircut’s magnitude depends on the asset’s risk. Riskier investments get more significant haircuts.
• A haircut is applied to a borrower’s assets to ensure the lender has enough security if their value drops.
• Though worded differently, haircut and margin mean deliberately reducing an asset’s value for risk minimization.
• Market makers can construct or access the sliver- or haircut-like spreads.