What Is Haircut And How Does It Work In MTF? 

Before you step into the world of margin trading, it is important to understand how collateral is valued and why brokers apply certain reductions to it. One such crucial concept is the haircut in share market, which safeguards brokers and investors against unexpected price fluctuations. This guide explains every aspect of haircut in detail, from its meaning to how it functions in a Margin Trading Facility (MTF), ensuring you are better equipped to manage risks and make informed decisions.

Introduction to Haircut in Stock Market 

The proportion subtracted from an asset's market value when it is offered as collateral is known as a haircut in the financial markets. The haircut in the share market serves as a safeguard against price fluctuations or liquidity issues. For example, if you pledge shares worth ₹1,00,000 and the haircut is 20%, only ₹80,000 will be considered for lending purposes for margin funding. This approach maintains market stability, especially during uncertain periods, by reducing the exposure of brokers and other lenders.

What is Haircut in Margin Trading? 

Margin trading allows you to buy more securities than your available funds permit by borrowing the balance from your broker. To secure this loan, you pledge your holdings, which the broker values after applying an MTF haircut. This deduction ensures the broker is protected if the pledged securities lose value. Suppose you pledge stocks worth ₹50,000 with a 25% haircut; their collateral value becomes ₹37,500, and your borrowing limit is set accordingly. Understanding this calculation is vital for maintaining adequate funds and avoiding margin calls.

How Does Haircut Work in MTF? 

In an MTF arrangement, you can leverage your holdings to enhance your buying capacity. When you pledge securities, brokers assess their risk and apply a haircut to determine the net collateral value. The process involves:

1. Assessing the market value of pledged securities.
   
    
2. Applying a predetermined haircut in the share market based on volatility, liquidity, and regulatory norms.
   
    
3. Calculating the eligible margin after deducting the haircut.
   
    

For instance, if you hold shares worth ₹2,00,000 and the haircut is 30%, only ₹1,40,000 will be counted as collateral. From this amount, your broker may further subtract applicable MTF charges, leaving you with the final margin available for trading.

Factors That Affect Haircut Percentage 

Haircut percentages are influenced by several variables that brokers carefully evaluate:

Price Volatility 

Brokers are more at risk when dealing with securities that undergo significant price fluctuations on a regular basis. These stocks are given larger haircuts to counteract the risk of unexpected losses, which lowers the collateral value for margin funding.

Liquidity

It is simpler to sell shares that trade in large quantities every day without depressing their price. When calculating collateral value, these stocks typically receive lower discounts because they present less of a challenge during liquidation.

Corporate Stability 

Lenders are more confident in businesses with solid balance sheets, consistent revenue, and good governance. Due to the decreased likelihood of significant value erosion, their securities frequently receive moderate haircuts.

Regulatory Oversight 

A framework for the amount of haircut that can be applied to various asset classes is provided by regulations established by SEBI and stock exchanges. These guidelines guarantee that brokers value pledged securities in a consistent, risk-averse manner.

Market Events 

Market uncertainty may rise as a result of unforeseen events like monetary policy changes, quarterly results, or geopolitical tensions. Brokers may momentarily modify haircut levels during these periods to guard against increased volatility.

Haircut Percentages for Different Securities 

Not all securities are treated equally in terms of haircuts. The discount depends on the type and risk profile of the asset:

Blue-chip stocks 

These stocks are owned by reputable businesses that have a solid track record, high liquidity, and robust earnings. Brokers typically apply a haircut of 10%–20% when valuing them as collateral because they trade frequently and are less likely to see sharp price swings.

Mid-cap and small-cap stocks

Compared to blue-chip companies, shares of medium- and small-sized businesses can exhibit less predictable price movements. Brokers typically apply haircuts of 25%–50% to these securities under margin funding arrangements in order to offset the increased risk.

Exchange-Traded Funds (ETFs) 

ETFs frequently replicate the results of an underlying index or asset basket. Depending on the benchmark being tracked and the state of the market, brokers can apply relatively modest discounts, typically ranging from 5% to 15%, due to their diversified nature and generally high liquidity.

Bonds and other debt instruments 

Debt securities, such as government and corporate bonds, show less volatility than stocks. They typically draw haircuts in the 5%–20% range because of their consistent revenue streams and minimal price swings, which make them safer collateral.

Illiquid or penny stocks 

Since it could be challenging to sell them quickly at fair prices, securities with very low market capitalization or thin trading volumes carry greater risk. Brokers may, as a precaution, give these stocks haircuts of 40%–60% or more to reflect the difficulties in liquidating them.

Importance of Haircut in Margin Trading 

The MTF haircut is a cornerstone of risk management in margin trading. By reducing the collateral value, brokers protect themselves from steep losses in the event of sudden market downturns. Here are the significant reasons that increases its importance: 

Protects brokers against market risk 

The haircut in the share market creates a buffer for brokers in case the value of pledged securities falls sharply. This protection ensures they can recover funds even during market turbulence.

Clarifies your real buying power 

Brokers assist you in understanding the true collateral value that is available for trading by applying a discount to pledged securities. This keeps your leverage in check and avoids overestimating your ability.

Encourages disciplined trading 

By restricting your credit options, the MTF haircut encourages you to keep your portfolio in balance and refrain from taking on more debt than you can handle, which could endanger your investments.

 

Stabilizes the trading environment 

Brokers value collateral uniformly when haircut policies are consistent. This encourages transparency and reduces the possibility of forced liquidations that could cause market turbulence.

Supports prudent use of leverage 

You can plan strategies that fit your risk tolerance and prevent financial stress during volatile times by taking haircut percentages and applicable MTF charges into account before entering trades.

Advantages and Disadvantages of Haircut in MTF 

The haircut system in margin funding brings both strengths and limitations that you must weigh carefully. Below is the detailed information for your understanding: 

Advantages 

Strengthens risk protection for brokers 

Brokers establish a buffer against abrupt drops in the value of pledged securities by implementing a haircut in the share market. With their exposure under control, they can now securely offer margin loans.

Promotes responsible trading habits 

The MTF haircut ensures you cannot borrow beyond a reasonable limit. It acts as a natural brake, encouraging you to select quality securities and maintain adequate collateral to cover your obligations.

Enhances market stability 

In volatile markets, well-calibrated haircut policies help preserve order by encouraging uniformity among brokers and lowering the possibility of forced liquidations or panic selling.

Helps assess true collateral value 

For margin purposes, a haircut offers a realistic assessment of the value of your holdings. This allows you to more effectively allocate funds, control leverage, and plan trades with this clarity.

Disadvantages 

Limits borrowing capacity 

A haircut decreases your trading margin because it lowers the eligible value of pledged securities. This may limit your ability to enter larger positions, particularly when markets are rising.

 

Tightens liquidity during volatility 

 
Brokers may increase haircut percentages during volatile markets, which would further devalue collateral and possibly lead to margin calls if your positions are heavily leveraged.

 

Adds to overall trading costs 

Increased haircuts may necessitate higher margins, which could result in additional MTF expenses and raise the overall price of leveraged trades.

 

Impacts high-risk securities more severely 

Steep haircuts are frequently applied to illiquid or highly volatile stocks, which reduces their appeal as collateral and restricts your options for margin funding.

Also Read: https://www.mstock.com/articles/margin-trading-facility 

Conclusion 

In the share market, the haircut is more than just a technical term; it is an essential safety feature that supports the ecosystem of margin trading. You can manage leverage more effectively if you have a clear understanding of how MTF haircut percentages are determined and applied. Before pledging securities, always keep haircut deductions and associated MTF charges into consideration. This will help you make wise decisions, safeguard your investments, and improve your trading performance.