The primary objective of margins and haircuts is to cover for risks related to counterparty creditworthiness or to the use of collateral, stemming from different trading activities. As a result, the terms are sometimes used interchangeably. To avoid confusion, and given the different meanings of margins based on the context (e.g., CCPs, derivatives or securities lending), the report differentiates between margins and haircuts: margins refer to the collateralisation of counterparty exposures, and haircuts to the discount applied on securities used as collateral.
Margins can be considered a form of insurance that involve a transfer of cash or securities to collateralise exposures (Gregory, 2014). They are usually designed to cover for counterparty credit risk. In the EU margins are required by central counterparties (CCPs) for all centrally cleared transactions, including SFTs. In the future, non-centrally cleared derivatives transactions will also require the use of margins. In case of counterparty default(s), the surviving party (i.e. a CCP in the context of centrally cleared transactions), can make use of the margin to cover the losses.
A haircut is a discount applied to the value of collateral provided, in order to account for market risk. The market value of collateral typically fluctuates over time. If the market value of the collateral falls, the collateral taker is exposed to market risk, i.e. the risk that proceeds from the sale of the collateral in case of counterparty default will be insufficient to cover for the losses incurred. Similarly, market participants tend to take into account the credit risk of their counterparties, or counterparty creditworthiness, which tends to be correlated with changes in market risk. To mitigate these risks, a discount is applied so that the market value of collateral exceeds the price of the collateral used in the transaction. This discount to the market value of collateral is referred to as a haircut.
Haircut % = Market value of collateral − Discounted price of collateral / Market value of collateral
There are important differences between haircuts in a centrally cleared and in a non- centrally cleared context. In non-centrally cleared SFTs, the haircut is a discount applied to the value of the collateral exchanged as part of the transaction. SFTs are fully or over- collateralised transactions, which means that the discounted value of the collateral received (after haircut) should at least cover for the value of the nominal exposure. For example, a 10% haircut corresponds to financing of EUR 9mn obtained through a repo transaction, against collateral worth EUR 10mn in cash markets.
In centrally cleared transactions, CCPs require their Clearing Members (CM) to post margins to collateralise net exposures. These net exposures are calculated on the basis of multiple transactions that may include derivatives, SFTs, and other types of trades. Margins can be posted by CMs either in cash or securities. When securities (or cash in non-base currency) are posted, a haircut applies. For example, a long SFT position of 200 netted with a short derivative position of 100 results in net exposure and CCP margin requirement of 100. The CM may post e.g. 100 in cash, or 110 in securities which would correspond to a 10% haircut.
Therefore, in centrally cleared transactions, haircuts may either refer to CCP haircuts on the collateral posted for margining purposes across multiple transactions, or to haircuts on the collateral exchanged between SFT counterparties. Whereas in non-centrally cleared SFTs, haircuts always apply to the collateral exchanged between counterparties. In practice, this implies that haircuts may be difficult to compare across market segments.
In the context of margin lending, the set-up is very different. In a typical margin lending scenario, prime brokers offer margin loans to their clients, which are usually funds, against a portfolio of securities held in a margin account (ESMA, 2016). Prime brokers calculate on a daily basis their clients' margin requirements, together with the amount of margin financing available to their clients, based on this portfolio. Margin loans are extended against this collateral portfolio without requiring clients to post additional cash or securities. Therefore, haircuts are not used in margin loans since there is no new collateral received, and margin requirements are not influenced by margin loans.
Report on securities financing transactions and leverage in the EU Report prepared under the mandate in Article 29(3) SFTR, 4 October 2016, ESMA/2016/1415, p. 12 - 14