What are the pros and cons of using market-based vs. model-based haircuts?

1 What is a haircut?

A haircut is the difference between the market value of a collateral asset and the amount that a lender is willing to lend against it. It represents a safety margin that protects the lender from potential losses in case of default or market fluctuations. For example, if a borrower pledges a $100 bond as collateral for a $90 loan, the haircut is 10%. The higher the haircut, the lower the loan-to-value ratio and the higher the collateralization ratio.

2 How are haircuts calculated?

There are two main methods for calculating haircuts: market-based and model-based. Market-based haircuts are derived from observed market prices and volatility of the collateral assets. They reflect the current market conditions and the liquidity and credit risk of the assets. Model-based haircuts are based on theoretical models and assumptions that estimate the future value and risk of the collateral assets. They rely on historical data, statistical analysis, and expert judgment.

3 What are the advantages of market-based haircuts?

Market-based haircuts have the advantage of being more transparent, objective, and responsive to market changes. They can capture the real-time market sentiment and risk appetite, and adjust the haircuts accordingly. They can also reduce the valuation disputes and margin calls between counterparties, as they use a common reference price. Market-based haircuts are widely used in standardized and liquid markets, such as exchange-traded derivatives and securities lending.

4 What are the disadvantages of market-based haircuts?

Market-based haircuts have the disadvantage of being more volatile, procyclical, and subject to market distortions. They can amplify the market fluctuations and create feedback loops that exacerbate the liquidity and credit crises. They can also be influenced by market manipulation, speculation, and arbitrage, which can create artificial price movements and mispricing. Market-based haircuts are less suitable for illiquid and complex markets, such as over-the-counter derivatives and structured products.

5 What are the advantages of model-based haircuts?

Model-based haircuts have the advantage of being more stable, countercyclical, and customized. They can smooth out the market noise and provide a long-term perspective on the collateral value and risk. They can also account for the specific characteristics and constraints of the counterparties, such as their risk profiles, preferences, and regulatory requirements. Model-based haircuts are widely used in bespoke and illiquid markets, such as repo transactions and collateral swaps.

6 What are the disadvantages of model-based haircuts?

Model-based haircuts have the disadvantage of being more opaque, subjective, and inconsistent. They depend on the quality and reliability of the models and data used, which can be flawed, outdated, or inaccurate. They also introduce the model risk, which is the risk of errors or discrepancies in the model design, implementation, or validation. Model-based haircuts can create valuation gaps and disputes between counterparties, as they may use different models or assumptions.