An adjustment to the market value of collateral (collateral securities posted to secure a lending/ borrowing transaction such as repo) to account for the risk that the cash that may be realized by the liquidation of collateral, if so happens, would be less than the quoted market value of the securities posted, due to a host of market related developments such as issuer credit risks and market liquidity risks associated with the securities, as well as the operational and legal risks typically inherent in all types of collateral. Similar to reserve requirements on deposits, collateral haircuts are perceived as instrumental in curbing excessive leverage.

Haircuts are set in a many different ways, and at different degrees of risk. For example, a 2 % haircut for government bonds is common, as it reflects the minimum amount of default risk inherent in such creditworthy securities. Official rate referencing and quantitative methodologies are used in setting haircuts. For example, value-at-risk (VaR) models, scenario analysis and simulation, and other techniques are often used, particularly to model market liquidity (on factors such as holding period, liquidation period, etc.)

Other forms of risk are also considered in determining haircuts, including operational risk, legal risk, and wrong-way risk (WWR)- that capitalizes on the correlation of credit risk (counterparty credit risk) with the value of collateral. However, specific forms of risk such as counterparty credit risk are, per se, irrelevant to the determination of haircuts.