Haircut (Collateral)
A haircut is the percentage reduction applied to the market value of collateral when calculating how much credit or margin it provides, reflecting the risk that the collateral could decline in value during the time it takes to liquidate it if the borrower defaults.
When financial institutions post collateral to secure borrowings, margin obligations, or derivatives exposures, the recipient does not accept the collateral at 100 cents on the dollar. Instead, a haircut is applied: if a bond has a 5% haircut, $100 million of bonds provides only $95 million of credit. The haircut compensates for market risk, liquidity risk, and operational risk associated with the collateral.
Haircuts vary significantly by collateral type. The most pristine collateral — on-the-run US Treasury bills — typically carries a haircut of zero or near-zero in overnight repo transactions because they are the most liquid instruments in the world and their prices are extremely stable over short periods. Investment-grade corporate bonds might carry haircuts of 3-8%. High-yield bonds and equities carry larger haircuts of 10-25% or more, reflecting their greater price volatility. Illiquid or structured products — subordinated tranches of mortgage-backed securities, for example — might face haircuts of 30-50% or be rejected as collateral entirely.
In the repurchase agreement (repo) market — the primary short-term funding market for US financial institutions, dealers, and money market funds — the Federal Reserve Bank of New York and the DTCC publish standard haircut schedules for the tri-party repo market. These schedules are recalibrated periodically based on market conditions. During the 2008 financial crisis, haircuts on mortgage-backed securities and other structured products increased dramatically and in some cases collateral became entirely unacceptable, forcing sudden deleveraging — the mechanism Gary Gorton described as a run on the repo market.
Clearinghouses apply haircuts to non-cash collateral accepted as initial margin. The OCC and CME publish their collateral eligibility schedules and associated haircuts, which reflect both the credit quality and liquidity profile of each eligible collateral type. Managing the collateral optimization problem — determining which eligible collateral to post where across multiple margin accounts and counterparties to minimize overall funding cost — has become a specialized function at large broker-dealers and asset managers.
Haircut procyclicality is a recognized systemic risk. During crises, haircut increases force institutions to find additional collateral or unwind positions, amplifying deleveraging pressure at precisely the moment when markets are most stressed. Post-crisis regulatory reforms, including recommendations from the Financial Stability Board, have focused on reducing haircut volatility through more conservative baseline calibrations.