Collateral Haircut

A collateral haircut is the percentage by which the market value of an asset is reduced before it is counted toward a margin or borrowing requirement. If a bond is worth 100 in the market but carries a 5 percent haircut, it is credited as only 95 of collateral value, even though its full market price is used for every other purpose. The discount exists because collateral is only useful to the party holding it if that party can sell it quickly, for close to its current price, if the posting party defaults; the haircut builds in a cushion against the asset losing value, or being harder to sell, between the last valuation and the moment it actually needs to be liquidated.

Haircuts are set out in the eligible collateral schedule attached to a trade, repo, or securities-lending agreement, and they vary by asset type, credit quality, maturity, and currency. They are closely related to, but distinct from, the margin amount itself: the haircut adjusts the value of what is posted, while margin determines how much adjusted value is required. Haircuts are used across repo markets, derivatives margining, and prime brokerage lending, and are shaped by both private negotiation and regulatory minimums.

Picture a secondhand car being used as security for a loan. The car is listed for sale at a certain price, but the lender will not count the full sticker price toward the loan, because the car could need repairs, the market for used cars could soften, or it might simply take time to find a buyer. So the lender discounts the car's stated value by a fixed percentage before deciding how much credit it is worth.

A collateral haircut works the same way for financial assets. Even a government bond or a block of shares, is given a value lower than its current market price when used as security, specifically to absorb the possibility that its price falls, or that selling it takes longer than expected, in the time between posting and any eventual sale.

The haircut converts an asset's market value into its collateral value using a single, simple relationship:

Here $V_{adj}$ is the adjusted collateral value credited toward the requirement, $V_{m}$ is the asset's current market value, and $h$ is the haircut, expressed as a decimal. For example, a government bond with a market value of 1,000,000 and a haircut of 2 percent is credited as:

If the same amount of collateral were instead a block of equities with a haircut of 15 percent, it would be credited only as 850,000, meaning a party posting equities has to deliver a larger pool of assets than one posting government bonds to satisfy the same requirement.

• Price volatility: assets whose prices swing more sharply, measured using tools such as Value at Risk (VaR), are given larger haircuts.
• Liquidity: thinly traded assets that are hard to sell without moving the price receive bigger discounts than deeply traded instruments such as Treasury securities.
• Maturity: longer-dated bonds are typically haircut more than short-dated ones, since their prices are more sensitive to interest-rate moves.
• Currency mismatch: collateral posted in a currency different from the exposure it covers carries an additional haircut to cover FX risk.

Haircuts are deliberately sized to cover the price move that could plausibly occur during the margin period of risk, the gap between the last exchange of collateral and the point at which a defaulting counterparty's position is closed out. A longer margin period of risk, or a more volatile asset, generally results in a larger haircut, since there is more time, and more potential price movement, for the collateral's value to erode before it can be sold.

Following the 2008 financial crisis, regulators introduced standardized minimum haircut schedules for securities financing and uncleared derivatives margin, developed by the Basel Committee on Banking Supervision and reflected in reforms under the Dodd-Frank Act in the United States and MiFID II in Europe. These rules set floors below which a haircut cannot fall for regulatory purposes, even if two counterparties might privately agree to a smaller discount. Supervisors periodically revisit these floors after periods of market stress, when haircuts that looked adequate in calm conditions can prove too small once an asset's price swings far more sharply than historical data had suggested.

• Basel Committee on Banking Supervision
• International Swaps and Derivatives Association (ISDA)