Haircuts and Collateral
A collateral haircut discounts the value of pledged securities below their market price, so the lender is still covered even if the collateral loses value or becomes hard to sell before the loan can be closed out.
Prerequisites: Initial Margin vs Variation Margin
Lending against collateral sounds safe until you ask the follow-up question: safe against what, and for how long? If a borrower defaults, the lender doesn't get to sell the pledged securities instantly at today's marked price — there's a gap of days during which the market can move against them. A haircut is the lender's way of pricing in that gap before it happens, by simply accepting the collateral at less than its current market value.
A haircut is the percentage discount applied to a security's market value when it is posted as collateral. Riskier, less liquid, more volatile collateral gets a bigger haircut, because there's more room for its value to fall — or for it to be hard to sell — before the lender can act.
The mechanics
In words: the amount a lender will actually advance against a security equals its market price scaled down by the haircut . A 2% haircut on a Treasury bond means a lender will advance $98 for every $100 of bonds posted; a 25% haircut on a volatile equity means only $75.
Worked example
A hedge fund wants to borrow cash and posts $10 million market value of a corporate bond as collateral, with a 5% haircut applied by the lender.
That is, $10m × (1 − 0.05) = $9.5m. The fund can borrow at most $9.5 million against that bond — the remaining $500,000 of value is the lender's buffer. If the bond's price falls 3% before the fund posts more collateral or the position is unwound, the loan is still fully covered by the bond's now-$9.7 million market value. If instead the fund had posted a volatile small-cap stock worth $10 million at a 30% haircut, it could only borrow $7 million — far less credit for the same headline collateral value, precisely because that stock could plausibly fall much further, much faster.
What this means in practice
Haircuts are set by lenders (and, for cleared trades, by clearinghouses) using historical volatility and liquidity data, and they widen automatically during stress — a security haircut at 10% in calm markets might jump to 25% during a crisis, forcing borrowers to post more collateral or repay debt at the worst possible time. This dynamic, where falling asset prices trigger rising haircuts which force further selling which pushes prices down further, is a core mechanism behind liquidity spirals in leveraged markets.
A haircut protects the lender, not the borrower — a fund that thinks of its collateral as "worth" its market price is ignoring that a meaningful chunk of that value is effectively locked up as the lender's safety margin and unavailable for anything else until the loan is repaid.
Practice in interviews
Further reading
- Committee on the Global Financial System, 'Haircutting'