Lower haircuts allow for more leverage. Haircuts play an important role in many types of transactions, such as.B. repurchase agreements (called « reverse repurchase agreements » in debt financing, but not to be confused with the concept of repossession, which is referred to by this term in consumer finance) and reverse repurchase agreements (« reverse reverse repurchase agreements » in debt financing). When you make short sales, you must provide the security you sold to the buyer. But you don`t have it! So you have to borrow it. This means becoming a buyer in a pension business. (Technically, this is called a reverse deposit). The deposit means that you can temporarily borrow the title and use it for delivery (see Figure 3). If traders or portfolio managers own bonds, they can use them as collateral to borrow money (such as a secured loan). The repo rate may well be a few basis points lower than the standard money market rate. Sometimes it is much lower. Repo can therefore be a useful tool for liquidity management.
The reverse repurchase agreement rate is usually negotiated closely with money market rates. This is sometimes referred to as the general interest rate of the guarantee. But sometimes a particular title is in demand for credit purposes. This is because there are many traders who do not have this security. Buy/resell transactions are identical to repurchase transactions in terms of collateral movements and cash flow. Special reverse repurchase rates mean that the individual security is expensive to borrow for traders who are shorted. But for those who are long, there is a lucky victory. You can borrow money at interest rates well below money market interest rates and make a simple profit by redirecting it to prevailing money market rates.
For example, U.S. Treasuries, which are relatively safe and highly liquid assets, have little or no haircut, while more volatile or less tradable assets can have discounts of up to 50%. When used in exchange-traded products such as stocks, options or futures, the discount is used interchangeably with the term margin. This is the amount of capital a broker needs to maintain positions in a trading account. If the discount exceeds the capital of the account, the broker may either require additional capital (for example, margin call. B), liquidate positions until the discount no longer exceeds the available capital. In this situation, the cost of borrowing the guarantee increases and, depending on the conditions of supply and demand, the repo rate can fall significantly. It can end up being several percentage points lower than the rates prevailing in the money market.
And in extreme situations, there may be a negative repo set. In general, price predictability and the associated lower risks lead to compressed haircuts because the lender has a high level of security that the total amount of the loan can be covered if the collateral is to be liquidated. For example, treasury bills are often used as collateral for overnight loan agreements between government securities dealers called repurchase agreements (rest). In these agreements, discounts are negligible due to the high level of certainty about the value, credit quality and liquidity of the security. When traders enter into a repo transaction, they accept the terms of the agreement. These include the collateral involved, the maturity of the transaction (usually these transactions are short-term from 1 day to 3 months), the cash amount and the reverse repurchase agreement rate. Why are there haircuts? Because some bonds are riskier than others. The buyer will claim the money back guarantee in case the seller is in default. If the stock has a volatile price history, the buyer is at risk. The price of security can fall exactly the moment it relies on it.
To reduce this risk, a haircut is imposed. For the duration of the transaction, the market risk and the credit risk of the guarantee remain the responsibility of the seller. (Because he agreed to buy back the asset for an amount of money agreed at maturity). If the transaction is properly documented, if the guarantee has a coupon payment during the duration of the repo, the buyer is obliged to pay it to the seller. In the media[1],[2][3] as well as in economic texts[4],[5][6], especially after the 2007-2008 financial crisis[7], the term « haircut » was mainly used to refer to a reduction in the amount repaid to creditors[3], or, in other words, a reduction in the nominal value of the debts of a borrower in difficulty [2], [Note 1] as in « take a discount »: accept or receive less than what is due. [8] In 2012, the global media reported on the « largest debt restructuring operation in history »[9]:1, which included the « very large discount » of about « 70% of the face value » of Greek NPV government bonds. [9]:27 The failure of the MCTA, which necessitated a bailout of the financial system, led to much higher haircut rules regarding what can be accounted for as collateral and the amount of the discount. LTCM basically had no discount, but today, an average investor who buys regular shares is subject to a 50% discount when using those shares as collateral against the amount borrowed in a margin trading account. When calculating « net capital », the rule requires deductions from the « net worth » of certain specific percentages of the market value of marketable securities and future commodity contracts, both long and short, in the capital and equity accounts of the dealer and in the « partners` accounts ». (These impressions are commonly referred to as « haircuts » in the industry.) .
. . The purpose of these « net worth » deductions is to provide a margin of safety against losses incurred by a broker or trader due to market fluctuations in the prices of these securities or future commodity contracts. [10] For the duration of the transaction, the buyer may use the warranty for delivery or repo purposes. And if the seller does not return the money, the buyer can ask for a guarantee for the refund. On the due date, the buyer returns the warranty to the seller. At the same time, the seller reimburses the initial amount in cash to the buyer plus an amount of interest in order to be able to use the money. The interest rate used is called the reverse repurchase rate.
The repo rate is generally calculated on the basis of the money market (is/360) (see Figure 2). While a 50% discount is the norm for margin accounts, a risk-based discount can be increased if the deposited securities carry liquidity or volatility risks. For example, a portfolio of highly volatile leveraged exchange-traded funds (ETFs) can be as much as 90%. Penny stocks, which present potential price, volatility and liquidity risks, generally cannot be used as collateral for margin accounts. They differ in that trading is structured like cash buying and forward selling of collateral. This means that the transaction is not based on an interest rate (the reverse repurchase agreement rate), but on a spot rate at which you buy the guarantee and a forward price at which you sell the guarantee. As advances in technology and markets become more efficient, spreads for many assets have fallen to the level of debt haircuts. Retailers can trade at the same spreads as market makers, although the cost to retailers is even higher, which can make spread trading inefficient. In a stock, retailers and market makers can buy and sell for a spread of $0.01 in an active and liquid stock, but buying and selling 500 shares to earn $5 ($500 * $0.01) when each trade typically costs $5 to $10 (varies by broker) is not a profitable strategy for the retailer. In many markets, the market maker`s spread is the same as the retailer`s, although trading costs make it inefficient for the retailer to try to take advantage of a discount spread. The European Central Bank applies a discount to all securities offered as collateral.
The amount of the discount depends on the risk appetite and liquidity of the security offered as collateral. [11] A haircut has two meanings. The term discount is most often used to refer to the percentage difference between the market value of an asset and the amount that can be used as collateral for a loan. There is a difference between these values because market prices change over time, which the lender must take into account. For example, if a person needs a $10,000 loan and wants to use their $10,000 stock portfolio as collateral, the bank will likely recognize the $10,000 portfolio as collateral worth only $5,000. Reducing the value of the asset by $5,000, or 50% for collateral purposes, is called a discount. A repurchase transaction involves two parties, the buyer and the seller. There are two exchanges taking place. One is at the beginning of trading, the other is at maturity. The haircut agreed by Greek sovereign debt holders was classified as « voluntary » by the banks` chief negotiator, Charles Dallara, although the Greek government, in order to convince national bondholders, « made it clear that the recalcitrant would not get a softer deal, » while declaring that the Greek state would not be able to « continue servicing its debt. » [13] The financial term « haircut » began and continues to be used as a reference to valuation haircuts applied under the U.S. Securities and Exchange Commission`s net capital rule. The net capital rule was adopted to protect public investors by establishing standards of financial accountability for broker-dealers and requires that a dealer has sufficient liquidity at all times to cover its current debt.
The SEC explained the role of haircuts in calculating net capital in 1967: discounts are the way the repo market imposes a margin on the seller of collateral. Here`s a simple example. Suppose a 2% discount is applied to a repurchase agreement with a market value of the collateral of $10 million. . . .