Haircut (Finance)

What is a haircut?

In finance, a “haircut” is a reduction applied to the value of an asset. It most commonly refers to:
* A reduction in the assessed value of collateral used to secure a loan, intended to protect the lender against declines in market value before the collateral can be sold.
* A markdown in the value of debt during restructurings (e.g., sovereign debt).
* Informally, the small loss a counterparty accepts because of the bid-ask spread when trading (often collected by market makers).

Key takeaways

• Haircuts limit how much a borrower can receive against pledged assets.
• They reflect risks such as price volatility, liquidity, and credit quality.
• Haircuts can both reduce systemic risk and increase borrowing costs or trading frictions.

How a haircut works

When a lender accepts collateral, it typically discounts that collateral’s market value by a haircut. This discount creates a buffer so the lender can recover outstanding exposure if the borrower defaults and asset prices fall. Haircuts are common in wholesale markets—especially in repurchase agreements (repos) where institutions borrow cash overnight and post securities as collateral.

Example: With a 5% haircut on $1,000,000 in bonds, a lender will advance $950,000. To borrow $1,000,000 against that haircut, a borrower must pledge $1,052,632 in bonds (approx.).

Factors that determine haircut size

There’s no single formula; lenders set haircuts based on risk considerations:
* Volatility — More price fluctuation → larger haircut.
Liquidity — Less liquid assets require bigger haircuts because they’re harder to sell quickly.
Credit/price risk — Riskier assets (corporate bonds, distressed securities) get higher haircuts.
* Counterparty risk — Higher borrower default risk leads to larger haircuts.

Market-maker haircut and bid–ask spreads

Market makers provide liquidity by quoting bid (buy) and ask (sell) prices. The difference between ask and bid is the spread. Traders using market orders effectively take a small haircut because they buy at the ask or sell at the bid, giving the market maker the spread as profit.

Example: If a stock’s last trade is $50.00 with a bid of $49.98 and an ask of $50.02:
* Selling 100 shares at market fills at $49.98 → proceeds $4,998.
* Buying back at the ask costs $5,002.
The $4 difference is the cost incurred from the spread — the market-maker haircut.

Case study: Long-Term Capital Management (LTCM)

LTCM, a hedge fund in the 1990s, used heavy leverage to amplify small arbitrage profits. Its repo counterparties imposed minimal haircuts, allowing extreme borrowing relative to capital. In 1998, LTCM suffered large losses; its collateral was insufficient to cover leverage, prompting a private-sector rescue organized with Federal Reserve encouragement. The episode highlights how inadequate haircuts can amplify systemic risk.

Bottom line

A haircut is a practical risk-control tool that reduces lender exposure to collateral value declines and illiquidity. While haircuts increase the collateral required or reduce borrowing capacity, they also help stabilize financial markets by limiting excessive leverage. Traders should also consider haircuts implicitly embedded in bid-ask spreads, since these reduce realized trading returns.