Quant physics

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Meliti: we can overlay information from the impact of economic downturns on other markets to construct quantitative models for Middle East markets, even though there is a lack of historical financial data for the Middle East region.

Riad Meliti, CEO of Arqaam Capital, talks about derivatives, quant models, and how the firm aims to attract and retain the best financial minds in the Middle East.

What are you working on at the moment?

The first product we're going to be launching is a market making capacity for equity derivatives on regional exchanges. We're in close contact with a number of the regional regulators, and we intend at the end of the third quarter to be fully functional with the capacity to be a market maker on regional stocks. In any kind of sophisticated capital markets operation, they use a lot of quantitative models and a mathematical approach to identify and quantify risk. Using the same techniques that are being utilised and implemented in the bulge bracket firms, we're bringing that to the region to create a platform, to create products.

Do the GCC markets have the depth and maturity for structured products?

I think they're maturing extremely rapidly, and now is the time to start to capitalise on that opportunity. If you look at the G7 mature economies, derivatives are a multiple of the underlying cash. I believe that we're at the beginning of this development phase and it's going to happen over the next five to seven years. As a firm, we intend to be one of the leaders in the pack.

What barriers are there to entry?

One is a lack of regulatory understanding in the region. A lot of firms have one or two compliance officers looking at the Middle East. If you look at the GCC alone there are 13 separate potential regulators, between the securities authorities, the exchanges and the Central Bank. If it was in the UK, you would have a team of people working with the FSA. I think the other barrier to entry is human capital arbitrage, whereby the resident pool of talent in the region isn't being harnessed specifically to focus specifically on this area. Our compensation with the model is based on international standards and we have a clearly defined policy whereby individuals who work for the firm become shareholders in the firm and our model is not too dissimilar to the partnership model that existed previously at Goldman Sachs. Goldman used to have the lowest turnover rate in terms of staff.

Has the cost of borrowing in the Middle East gone up as a result of the liquidity crisis, or was the region unaffected?

When the Asian crisis kicked off, credit spreads shot out and Russian bonds dropped to 70 cents in the dollar. Lebanese government bonds wobbled for a day and a half, then went back to exactly the levels where they were trading before. There is just so much liquidity in the region that the pricing of Middle East assets by all the liquidity allows for it to be a little bit sheltered from international volatility.

Some quant funds suffered in the credit crisis. Does this show a flaw in using mathematical models?

In terms of risk management, quantitative analysis is one of a variety of tools you would use to properly risk manage your business. The other tool is diversification of the various business lines in terms of revenue generation. The problem when you're using a quant model to manage one specific fund is that there's only strategy, one business line, one revenue stream. When that model breaks down, there's nothing else cushioning the breakdown of that model in terms of it working. Models are normally built using historical analysis - it's pretty difficult to build a forward-thinking model. The second issue that you have is that the models in this scenario were built on aliquid underlyings, and you had a scenario where when the models broke down it wasn't possible to liquidate the position.

Is it a problem for your models that there isn't historical data for an economic downturn in the Middle East?

That is definitely an issue, but we have had a major downturn, we've had a major rally, in fact we've had major volatility in the marketplace. When we're doing our analysis in terms of the positions we have and the product we need to create, we can overlay that with scenarios of what's happened in other exchanges globally onto the Middle East marketplace and we can see how that affects our risk profile at the firm. I don't think I can go into all our risk management techniques, but that was definitely an issue that we had to address.

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