Why a lender may value your shares below market price
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A lender that advances cash against listed shares rarely lends their full market value. The difference between the value of the shares and the amount lent, known as the haircut, is agreed at the start of the loan. It largely determines how far the share price can fall before the borrower receives a margin call, and how much room the lender has if the shares later have to be sold.
How the gap works
The SEC and FINRA put typical advance rates on securities-backed lines of credit at 50 to 65% for equities. That leaves a buffer of 35 to 50% before any price has moved. The buffer protects both parties: it covers the lender against a fall in price, and it lets the borrower absorb some price movement before receiving a call.
Regulators treat haircuts as a stability tool. The Financial Stability Board’s framework for securities financing transactions is intended to “limit the build-up of excessive leverage outside the banking system, and to help reduce procyclicality of that leverage.” It sets minimum gaps of 6% on main-index equities and 10% for other assets in scope, and it asks that methodologies moderate “the extent to which they decline in benign market environments.” The aim is a buffer that is maintained in calm markets rather than reduced and then raised sharply when conditions deteriorate.
In a model published in the Review of Financial Studies in 2009, Markus Brunnermeier and Lasse Heje Pedersen showed how margins can rise as markets become less liquid. Higher margins lead to more selling, which reduces liquidity further. They called the pattern a liquidity spiral. A haircut set conservatively at the outset, and kept stable, makes it less likely that a loan is caught in that cycle.
What sets the number
Volatility is the first factor. A stock that routinely moves 5% in a day needs a larger buffer than one that moves 1%, because the buffer has to cover any price move between a call and a sale.
Liquidity is judged against the size of the position: a holding worth a day’s trading volume can be sold quickly, while one worth several weeks of volume can only be sold at a discount to the screen price, and a careful lender values it that way from the start.
A lower advance rate therefore leaves more room before a fall in price leads to a margin call.
After a margin call
What happens after a call depends on the structure. A standard maintenance call on a brokerage or bank line gives the borrower two or three days to post more collateral or repay, according to the SEC alert. Non-recourse equity-backed financing can be built with a wider window and a capped loss. EquitiesFirst, which sets out how it manages collateral risk for clients, advances cash at a loan-to-value typically in the region of 60 to 70%, triggers a margin call at 80% of the loan value for equity facilities, and gives the client a five-day window, by written notice, to post additional stock. Because the financing is non-recourse, a client can instead end the arrangement and keep the loan proceeds, with the loss limited to the shares used as collateral.
A worked example
Take a share priced at 100. At a 50% advance rate it supports a loan of 50, and the price can halve before the collateral is worth less than the debt. At an 80% advance rate the same share supports a loan of 80, and a 20% fall is enough.
A 30% fall would leave the first loan covered, with collateral worth 70 against a debt of 50. Under the second, the collateral would be worth 70 against a debt of 80. If that loan is recourse and the lender sells the shares, the borrower owes the remaining 10. Under a non-recourse structure, the borrower’s loss would be limited to the shares. The advance rate agreed at the start largely determines which of those positions a borrower is in after a fall.