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21. What is a haircut?
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A haircut is the difference between the market value of an asset and the purchase price paid at the start of a repo. An initial margin is an alternative to a haircut. A haircut is expressed as the percentage deduction from the market value of collateral (eg 2%), while an initial margin is the market value of collateral expressed as a percentage of the purchase price (eg 105%) or as a simple ratio (eg 105:100).

Ideally, collateral should be free of credit and liquidity risks. The market value of such perfect collateral would be certain, meaning that it would be easy to sell for a predicatable value in the event of default by the collateral-giver. The type of asset that comes closest to this paradigm, and is in fact the most commonly-used type of collateral in the repo market, is a bond issued by a creditworthy central government.

Assets that pose material credit and/or liquidity risks can be used as collateral but not for their full market value. Instead, a risk-adjusted value is calculated, which is less than the market value. Either a haircut is deducted from the market value of collateral or the purchase price is multipied by an initial margin.

The haircut or initial margin represents the potential loss of value due to (1) price volatility between regular margining dates (in case there is a default between a calculation of a margin call and the payment or transfer of margin in response to that margin call) and (2) the probable cost of liquidating collateral following an event of default, as well as (3) inconsistencies between the valuation methodologies used in margining and for a default. There are three broad issues: delays in liquidation, price volatility and the potential price impact of a default by the issuer of the collateral asset. Time delays include: how long it takes to respond to a margin call (operational risk); the likelihood of a delay in liquidation due to a legal challenge to the non-defaulting party’s title to the collateral asset or his right to net (legal risk); and how quickly the entire holding of a collateral asset could be liquidated without a significant market impact or how far might the price fall or be forced down by faster selling (liquidity risk). If the cash and collateral are denominated in different currencies, price volatility must include the effect of exchange rate fluctuations. It is arguable as to whether the credit risk of the repo counterparty should affect the size of a haircut or initial margin, given that the risk of loss by a non-defaulting party is a function of the collateral and collateral management rather than the credit of the counterparty (ie a matter of loss-given-default rather than probability of default). However, it is appropriate to take account of any significant correlation between the credit risks of the repo counterparty and the issuer of the collateral (so-called ‘wrong-way risk’), as this will diminish the effectiveness of the collateral. Nevertheless, in practice, many parties do factor in the credit risk of their repo counterparties.

The use of haircuts and initial margins is explained in the guidance on efficient margining set out in the Guide to Best Practice in the European Repo Market published by the European Repo and Collateral Council (ERCC) of the ICMA.

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