What is a Haircut?

A Haircut in the financial market refers to the reduction in the value of an asset when used as collateral for a loan or during debt restructuring. This adjustment accounts for potential risks, ensuring lenders are protected from market volatility or asset devaluation. In the Indian share market, haircuts are a common practice in margin trading, securities lending, and during insolvency resolution.

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Why is a Haircut Applied?

Haircuts are implemented to mitigate risks associated with:

1. Market Volatility: To cover potential price fluctuations in the collateral.
2. Credit Risk: To account for the borrower’s ability to repay.
3. Liquidity Concerns: To address difficulties in selling the collateral quickly.

For example, if an investor uses shares worth ₹1,00,000 as collateral and the lender applies a 20% haircut, the loan will be limited to ₹80,000.

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Types of Haircuts

1. Collateral Haircut

Occurs when the value of an asset used as collateral is reduced to safeguard lenders against risks.

2. Debt Haircut

Happens during debt restructuring or insolvency proceedings, where creditors agree to accept a reduced repayment amount.

3. Market Haircut

Used in margin trading to determine the permissible borrowing limit against securities.

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How is Haircut Calculated?

The haircut is usually expressed as a percentage of the asset’s market value:

Haircut Formula:
Haircut=(1−Loan Value/Asset Value​)×100

For instance:

• Asset Value: ₹1,00,000
• Loan Value: ₹80,000
  Haircut=(1−80,000/1,00,000​)×100=20%

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Haircuts in Margin Trading

In margin trading, a haircut determines the maximum leverage an investor can obtain. Securities with high volatility are assigned larger haircuts.

Stock	Market Price (₹)	Haircut (%)	Margin Available (₹)
Reliance Industries	2,500	25	1,875
Infosys	1,200	20	960
Tata Motors	600	30	420

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Haircut in Insolvency and Bankruptcy

Haircuts are crucial in insolvency proceedings under the Insolvency and Bankruptcy Code (IBC), where creditors accept a reduced payment to settle debts. Historical cases in India:

Company	Debt (₹ Crores)	Haircut (%)	Recovery (%)
Essar Steel	49,000	58	42
Bhushan Steel	56,000	37	63
Alok Industries	29,500	83	17

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Advantages and Disadvantages of Haircuts

Advantages:

1. Risk Mitigation: Protects lenders from market fluctuations.
2. Encourages Responsible Borrowing: Ensures loans are backed by reliable collateral.
3. Facilitates Debt Resolution: Enables faster settlement of insolvency cases.

Disadvantages:

1. Lower Loan Amounts: Borrowers receive less than the asset’s market value.
2. Market Impact: High haircuts may reduce investor confidence.
3. Negotiation Challenges: Disputes over haircut percentages can delay insolvency resolution.

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Historical Perspective: Haircuts in the Indian Market

Haircuts have played a pivotal role in resolving high-profile debt cases in India. The table below illustrates significant cases:

Year	Event	Impact
2016	Implementation of IBC	Streamlined insolvency resolution with structured haircuts.
2020	COVID-19 Pandemic	Increased haircuts as companies struggled with cash flow.
2021	DHFL Insolvency	Creditors took a 60% haircut, recovering ₹37,000 crores.

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Factors Influencing Haircuts

1. Asset Volatility: Highly volatile assets attract larger haircuts.
2. Liquidity: Illiquid assets often face higher haircuts.
3. Creditworthiness: The borrower’s financial health influences haircut levels.
4. Regulatory Policies: Guidelines by SEBI and RBI impact haircut practices.

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Haircuts in International Context

Haircuts are a global phenomenon, used to safeguard financial systems. Notable examples:

• 2008 Global Financial Crisis: Haircuts were applied to mortgage-backed securities, ensuring stability.
• Greek Debt Crisis (2012): Creditors agreed to significant haircuts to prevent economic collapse.

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Strategies for Investors

How to Handle Haircuts:

1. Diversify Collateral: Reduce exposure to high-volatility assets.
2. Understand Terms: Check haircut percentages before leveraging securities.
3. Opt for Stable Stocks: Use low-volatility shares to minimize haircut impact.

When to Avoid:

• Assets with excessive haircuts may indicate high risk and low returns.

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Conclusion

Haircuts are a vital mechanism in the Indian share market, balancing risks for lenders and opportunities for borrowers. Whether in margin trading or insolvency cases, understanding haircuts helps investors make informed decisions. By analyzing historical data and market trends, stakeholders can navigate the complexities of haircuts effectively, ensuring financial stability and growth.