What Is a Haircut?

What Is a Haircut?

Let me explain what a haircut means in finance—it's basically a reduction or trim in the value of an asset, and you'll see it in a few key contexts.

Most commonly, it refers to cutting the value of collateral used to secure a loan, which helps offset the risk that the collateral might drop in market value if the borrower defaults and it needs to be sold. You might also hear it in relation to debt markdowns, like during a sovereign debt crisis.

Another way it's used, though less often, is with market makers and their bid-ask spreads. When you buy or sell stocks, you're essentially taking a small haircut because the market maker profits by dealing slightly off the market price.

Key Takeaways

In finance, haircuts apply to situations like reducing collateral value or the cut taken by market makers. They directly impact how much you can borrow against assets in a secured loan. Often, they reflect the volatility of the underlying asset, which can make its value unpredictable.

How a Haircut Works

To get how a haircut functions, you need to start with collateral— that's the assets you pledge when borrowing money. If you can't repay, the lender sells them to cover losses, like with a home equity loan where your house is the collateral.

Haircuts aren't something most individual borrowers deal with often; they're more common in deals between financial institutions, such as repurchase agreements (repos). In a repo, you borrow cash short-term, say overnight, and pledge assets like government bonds.

The lender applies a haircut because asset values can change. For instance, with a 5% haircut on $1 million in bonds, you could only borrow $950,000. If you pledge $1,050,000 instead, you'd get the full $1 million.

How Is a Haircut Calculated?

There's no single formula for haircuts since they vary by lender, but they generally consider volatility—assets that swing in price a lot need bigger haircuts. Liquidity matters too; if it's hard to sell quickly without losing value, expect a larger trim.

Price and credit risks play in—if an asset like a corporate bond is risky and could default, the haircut grows. Your own borrower risk factors in as well; if you're seen as likely to default, the lender will demand more protection through a higher haircut.

How a Haircut Works for Market Makers

When you look at a stock quote, that's usually the last traded price, often midway between bids and asks in a fast market. Sellers set asks, buyers set bids, and the gap is the spread.

Market makers provide liquidity by trading on both sides and profit from the spread—buying at the bid and selling at the ask. As a trader, you take a small haircut by paying a bit more or selling for a bit less than the true market price.

Example of a Market Maker Haircut

Say you own 100 shares of Company XYZ quoted at $50, but the bid is $49.98 and ask is $50.02. Selling at market gets you $49.98 per share, so $4,998 total, not $5,000.

If you buy back at $50.02, that's $5,002, meaning you lost $4 to the spread—that's the haircut the market maker pockets by buying low and selling high.

Case Study: Long-Term Capital Management (LTCM)

LTCM was a hedge fund from 1994 that focused on arbitrage, profiting from small price differences in similar securities. They borrowed heavily, with $30 debt per $1 capital and over $1 trillion in derivatives.

Lenders gave them almost no haircuts on repos, letting them borrow a ton without much buffer. In 1998, an economic downturn caused huge losses, risking default.

To avoid a crisis, the New York Fed organized $3.6 billion from 14 firms to bail them out. This showed the risks of low haircuts, though similar issues persisted into 2008.

The Bottom Line

In finance, a haircut is a value reduction on assets, whether for collateral or trading spreads. It protects lenders by cutting risk and can keep you from overleveraging, like when borrowing against stocks.

It might eat into your trading profits, so watch the size—if it's too big, you might skip the trade altogether.