Haircut

What Is a Haircut?

In finance, a haircut is a difference in the current market value of a particular asset compared to its value as loan collateral. This difference results from fluctuations in market prices, and the lender accounts for this in valuing the asset when constructing the loan. 

The greater an asset's volatility, the larger the difference. This holds for various financial instruments, including stocks, bonds, and other financial securities. 

The level of risk is assessed by considering all risks that may cause the security's market value to drop, such as interest rates, credit, liquidity, market conditions, and more.

It can also be considered the inverse of the loan-to-value ratio, which, when summed with the markdown, equals 100%. The loan-to-value ratio is the loan balance divided by the asset's market value, and the collateral is the margin divided by the market value.

For example, suppose someone needs a $50,000 loan and pledges $50,000 worth of small-cap stock as collateral. Since these are volatile and unpredictable stocks, the lender may only evaluate them as worth $20,000 in collateral. 

Thus, this is a 60% haircut, as 60% of the market value was reduced. This protects the lender in case the market cap of the small-cap stocks declines rapidly; there will be sufficient collateral since the lender reduced their risk exposure through a lesser valuation.

Other definitions of a Haircut

The term can be used in numerous situations, such as:

• Loan collateral: The most common use of the term in a financial sense is when a borrower is posting an asset as collateral for a loan, in which the lender will reduce the value of the asset by a percentage below market value for purposes of the loan to reduce the amount of risk they are exposed to.
• Investing: It can also refer to the difference between the prices paid and received for buying and selling stocks, bonds, option contracts, and more. These typically include fees and are used as a jargon word to describe a lesser deal experienced by a trader.
• Debt restructuring: When restructuring debt, the term can be used to describe the reduction in the outstanding interest payments or bond principal. This happens when companies restructure their debt.

Collateral haircuts

The term haircut refers to the lower market value that an asset will be assessed when pledged as collateral for a loan. This value is expressed as a markdown of the asset's market value. This creates a buffer for the lender in the case of a steep market decline in value. 

The degree of the reduction depends on the level of assessed risk that the lender is willing to bear if the market conditions or the lender's conditions sour. 

In this case, the lender will liquidate the pledged assets at a lower price than market value, but hopefully at a greater price than was assessed by the lender after the reduction.

By accounting for variables such as the asset's price, volatility, the lendee's credit quality, the investment's liquidity, and more, the lender reduces its risk by assessing the asset as having less than its market value.

Determining Haircut Amount

Numerous factors determine the haircut amount. It more commonly depends on the predictability of the pledged asset's price and the other assessed risks. If more risk and uncertainty are involved, the haircut’s significance is directly correlated and will increase.  

Suppose the price is predictable and the asset is associated with fewer extraneous risks. In that case, the reduction will likely be small since the lender is expected to cover the total loan amount if it liquidates the asset.

For example, liquid assets such as treasury bills, commercial paper, or other easily liquidated money market instruments would not receive a significant discount. This is because the asset is liquid and can reasonably be sold by the lender for near full market value if needed. 

In contrast, securities with high market volatility will experience a much more significant decline in value for the loan due to the uncertainty surrounding the value the asset will bring if it needs to be liquidated. This is true of most stock securities due to their unpredictability and risk.

The risk that the borrower defaults on the loan is also present. If the borrower is more likely to be unable to meet specific requirements, the discount will be more significant. Furthermore, the amount will be determined by how easily the lender can liquidate the collateral if the borrower defaults. 

However, haircuts on exchange-traded funds may be more negligible due to their lower risk from built-in diversification than a single security. This will receive a more minor discount than a micro-cap tech stock, and stocks like penny stocks with low liquidity are unlikely to be accepted as collateral.

The reduction will be lower if the lender can sell the collateral reasonably at a predictable price. However, if liquidating the position is difficult and not at a fair price, the amount will be more significant. 

When valuing a risk-based markdown, the Options Clearing Corporation (OCC) provides information on the liquidating price calculations of certain options contracts. 

The Cox-Ross-Rubinstein binomial option pricing model is used to find the liquidating price of American-style options. Likewise, the Black-Scholes model projects the liquidating price of European-style options.

How is the Haircut Expressed?

They can be expressed in numerous ways, but typically on a per-share or per-security basis. For example, a stock trading for $20 per share might be given a 20% haircut and valued by a lender at $16 per share.

So, if a borrower posted 1,000 shares of this stock, the market value would be $20,000, but the reduction in market value would result in the loan being valued at $16,000, protecting the lender.

Haircut risk

Haircuts are directly tied to the risk surrounding an investor's collateral. A lender will not post a full valuation for an asset likely to decline, making it “more risky.”

Instead, a lender will impose a more substantial discount for risky securities. Thus, the more risky a collateral posted is, the more significant the markdown. 

By applying a haircut and valuing the collateral at less than its market worth, the lender mitigates risk rather than assuming less risk.

Lenders assess the probability that an asset will decline in value and create a barrier to protect their loan. By artificially lowering the securities' market value, the collateral's value has enough leeway to decrease and not pose as significant a loss to the lender.

For example, if the borrower posted $50,000 worth of securities for $20,000, with a 60% haircut, the collateral value would be $20,000. If the securities declined to $20,000 in value, the lender could liquidate them for the same amount they initially received, avoiding any loss.

The reduction in the collateral's value also protects the borrower from potential margin calls. In this sense, margin calls are when the borrower must deposit more money into the margin account when the account's value falls too low.

Haircut Market Maker Spreads

When trading stocks, a haircut can also be referred to as a market maker’s spread. The spread is the difference between the bid and ask price. This is a difference in the prices the market maker buys and sells securities for, buying them for a little less than they sell them for.

The difference in these prices allows them to profit off the securities they transact and represent said markdown. 

Like before, the difference in the bid and ask price, or “the spread,” depends on liquidity. A more liquid security will have a much smaller spread, as many people trading it will push these prices closer together. This will lead to less risk for the market maker, resulting in a lesser discount.

However, the bid-ask spread widens as the security becomes more illiquid. This can be thought of as the market maker taking a more significant reduction when there is more liquidity risk in the security, creating a bid price (the price at which the market maker will buy a stock) much lower than the ask.

Market maker haircut example

In many cases, the market maker and the retail investor trade the same margins, making it difficult for retail investors to profit from such spreads.

Retail investors can’t trade the same spreads as market makers on the forex market, a global marketplace. Brokers often mark up the default spread of 0.00001 default EUR/USD forex to 0.00005 - 0.00015, allowing them to profit from haircuts and commissions. 

In the real world, central banks, such as the European Central Bank, can also use markdowns when making loans. 

They will lend to borrowers with posted collateral valued at less than market value and sell the collateral if the borrower cannot pay the bank back, necessitating the bank to sell at a price that will sufficiently cover the loaned amount.

Haircut Vs. Margin

The difference between haircuts and margins lies in their purposes and calculations. Haircuts reduce the collateral value to mitigate risks, while margins represent the percentage of the loan amount that must be provided as collateral.

For example, if an investor seeks a $50,000 loan and pledges 40% of the loan amount as margin collateral, the amount of collateral posted will be $20,000. This essentially means the investor will post $20,000 in collateral, or “margin,” in this case, to borrow $30,000.

In parallel, if an investor is seeking a similar loan for $50,000 and pledges risky securities as collateral, a lender may impose a 60% markdown, in which the collateral posted by the investor will be valued at a 60% reduction in the loan amount, or $20,000.

In both cases, the investor posted $20,000 in collateral, but the margin was framed as 40% posted, and the markdown was framed as a 60% reduction, essentially an inverse that arrives at the same answer.

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