The gap beneath the collateral

The bond may be dependable; the financing against it may not be. An owner who borrows heavily can run short of cash after a small fall in its market price, long before repayment of the bond itself is in doubt. In the repurchase-agreement market, the haircut helps determine how much room that owner has.

A repo combines a sale of securities with an agreement to repurchase them later. Economically, it resembles a loan secured by those securities. The lender earns a return through the repurchase price; the borrower gets cash without permanently giving up the position. The New York Federal Reserve describes this structure in its guide to repo and reverse repo transactions.

How $2 supports a $100 position

The haircut is the gap between the collateral's value and the cash advanced, expressed here as a proportion of collateral value. In a deliberately simplified example, a lender advances $98 against securities worth $100. The haircut is 2%. If the borrower defaults, the extra collateral provides some protection against a price decline or disposal costs. It is separate from the interest charged for the loan.

For a borrower financing the whole position through this repo and its own money, that arrangement leaves $2 of equity supporting $100 of assets. A $1 loss in the securities' value consumes half of that initial equity before interest and other costs. That is the leverage in this hypothetical position, before considering any other assets or funding the borrower may have.

Now let the collateral fall to $99 while the agreed haircut remains 2%. The amount that can be financed falls to $97.02. A borrower that initially received $98 would need to reduce the loan by 98 cents, or meet an equivalent collateral requirement, under an arrangement that recalculates coverage this way. The exact process depends on the contract.

The cash demand can grow further if a renewed transaction carries a larger haircut. At a 5% haircut, the same $99 of securities supports only $94.05 of financing. Relative to the original $98, the borrower must find $3.95. A change in financing terms has compounded the effect of a modest asset-price move.

Zero does not describe everything

Observed repo practice is more complicated than the textbook transaction. An August 2025 study by America's Office of Financial Research found zero haircuts on 56% of outstanding repo in its non-centrally cleared bilateral collection during the first five months of 2025. Excluding transactions between affiliates reduced that share to 42%. The percentages describe that collection and period, not the whole repo market.

Zero haircuts do not prove that lenders ignore risk. A separate New York Fed discussion explains that counterparties may manage exposure across a wider relationship, including offsetting positions and other protections. Conversely, knowing the haircut on one trade cannot establish the resilience of the whole relationship. A prudent assessment needs the accompanying limits, legal arrangements and exposures.

Protection can create pressure elsewhere

Higher collateral requirements can make an individual lender safer while forcing a borrower to raise cash quickly. If many borrowers sell similar securities to do so, prices may fall further. Whether this becomes a destabilising feedback loop depends on leverage, liquidity reserves, contract terms and other buyers' willingness to step in. A BIS account of March 2020 found evidence of forced Treasury selling by leveraged investors.

The timing of the protection matters. A borrower entering a position with more of its own capital has less leverage from the start. A borrower asked for additional cash after prices have fallen may have few convenient ways to obtain it. Research published by the New York Fed also warns that the relationship between larger haircuts and system-wide stability is not mechanically straightforward.

For the borrower in the example, the immediate problem is finding $3.95, not deciding whether the bond will eventually repay. Cash reserves, the next financing date and the rules for revaluing collateral determine whether it can keep the position. A sound asset does little to solve a cash call that falls due first.