Haircut
A haircut is the percentage by which a lender discounts the market value of collateral when deciding how much to lend against it. A 2 percent haircut means US$100 of securities supports a loan of US$98.
Also called: collateral haircut · margin · initial margin · valuation haircut
The haircut is the lender's cushion. If the borrower defaults, the lender must sell the collateral, and the price may have fallen by then. Safer and more liquid assets get smaller haircuts: short-dated government bonds may be cut by a fraction of a percent, corporate bonds or equities by far more. Central banks publish haircut schedules for the assets they accept.
Haircuts set how much leverage is possible. At 2 percent, US$2 of a borrower's own money carries US$100 of assets. If lenders raise the haircut to 10 percent, the borrower must find five times as much capital overnight or sell. Rising haircuts in the repo market were the mechanism through which funding stress spread in 2008, and they remain the lever that turns falling prices into forced selling in shadow banking.
The same principle appears elsewhere in payments and crypto: the over-collateralisation required for a crypto-backed loan, the discount a regulator applies to certain permissible investments, and the margin a liquidity provider demands before extending a settlement line.
In practice
The word is also used loosely for losses imposed on creditors in a debt restructuring. That is a different meaning: a reduction in what is owed, not a discount on collateral.
See also
- Repurchase AgreementA repurchase agreement, or repo, is a short-term loan structured as a sale: one party sells securities for cash and agrees to buy them back later at a slightly higher price. The securities are the collateral and the price difference is the interest.
- Shadow BankingShadow banking is credit intermediation carried out by institutions and markets outside the regular banking system: money market funds, finance companies, hedge funds, securitisation vehicles and repo markets doing what banks do without bank licences, deposit insurance or central bank backing.
- Money Market FundA money market fund (MMF) is an investment fund that holds short-term, high-quality debt such as Treasury bills, repo and commercial paper, and aims to keep a stable value while offering daily access. Investors use it like a deposit, but it is not one.
- Permissible InvestmentsPermissible investments are the categories of asset a licensed US money transmitter may count against its outstanding money transmission obligations. Under the model law states have been adopting, the licensee must hold permissible investments worth at least the whole of what it owes customers, and the eligible list runs wider than cash and government securities.
- Liquidity ProviderA liquidity provider is a counterparty that quotes both a buy and a sell price in a currency or asset and stands behind those quotes. It lets a customer transact immediately instead of waiting to find someone with the opposite need.