'Derivatives can protect local investors’

Riad Meliti forgoes a six-figure salary in London to pursue his Middle East dream.

The Libyan-born entrepreneur had more than a decade’s experience behind him at some of the world’s most prestigious financial institutions such as Credit Suisse First Boston and Barclays, but for him the trappings of the city were not enough.

“The year 2004 was a turning point,” says 34-year-old Meliti. “I wasn’t married and I was at the top of my career. I had a large team and a lot of responsibility and had come to the conclusion that one of the motives of working in finance is wealth accumulation, but the incremental value of money falls beyond a certain point.

“If I have car, why do I need two? I’m not flash. I’m a pretty simple guy.”

As the motivation for personal wealth – and with it the need for job security – began to wane, Meliti’s entrepreneurial streak came to the fore, together with a desire to return to his roots. So in 2004 he quit as director of the Middle East desk at Barclays Capital to set up Arqaam Capital.

“I’m of Middle East origin and wanted to be closer to the Middle East market. I’m one of those people who when they see something broken they want to fix it or if they see some thing challenging they want to go for it,” he says.

“I saw this opportunity in the local market place and it’s really one of the most exciting investment banking and capital markets opportunities in the world.” By this, Meliti means the Gulf’s nascent derivatives market, which he says accounted for less than one per cent of the turnover of the GCC stock markets last year.

Arqaam used a private placement to raise $140 million (Dh514m) capital from 60 diverse investors, which include the Pension Fund of Kuwait and Emirates Bank International, with the remit to develop the Gulf’s stuttering derivatives market.

“If you look at the Dow Jones, the Nikkei or any industrialised country, derivatives as a volume are a multiple of the volume of the underlying cash equity.

“In the region, derivatives are virtually invisible, so they offer one of the largest opportunities in the region. Derivatives are only one per cent of the market turnover in the GCC, but this could rise to 25 per cent over the next five years. Turnover last year was around $1.3 trillion, so you’re talking about $300bn or more and that’s if the stock market stays the same size. The upside is tremendous,” says Meliti.

FANTASTIC TOOL

Meliti, who grew up in the United States, describes derivatives as a fantastic tool for risk management to protect investors against volatility in the local marketplace.

He also blames the 2006 market crash, which saw the UAE stock exchanges decline by a combined 44 per cent, on a lack of sophistication in terms of products that are available to investors.

“The best way to protect local investors is through the derivatives market, which at present does not exist in any comprehensive fashion at all.

“The more interest in the market the better it is for us, we don’t want to have 50 per cent market share. If we have 10 per cent share we have way exceeded our budget.” Meliti says his biggest challenge is the size of the market, which he describes as ‘astronomical’.

Arqaam deals exclusively with institutional investors, although the company is designing derivative products for retail banks to sell to their customers. Meliti would not say when these would be launched.

“For somebody who wants to have a portfolio of stocks in the region, if he makes a commitment for three years, I can give him 60 per cent upside, with his capital guaranteed,” he says.

“This is a standard financial product across the world but is not available for local stocks in this region. Local banks have a strong appetite because this is the sort of product they want to distribute to their customers.”

Guaranteed capital may seem too good to be true for the lay reader, but Meliti draws an analogy with the insurance industry to explain how this is possible.

“Say I insure a car, I’m not guaranteed to make money on that car, but if I work out that the probability of that person not making a claim is 55 per cent, I then need to insure as many people as possible to make this probability more certain.

“If I insure 10 people there’s good chance I might lose money, but if I insure 100,000, then the 55 per cent mark becomes much more likely.

“Say I toss a coin five times it might come up heads on the first four occasions, but if I toss the coin 100,000 times there’s a 99 per cent probability it will be heads 50 per cent of the time. I manage my risk on a portfolio basis,” says Meliti.

To put it another way, the greater the number of contracts, the less chance there is of a statistical anomaly. This means that start-up derivative brokers will be more vulnerable to losses because the smaller the portfolio, the less diversified the risk.

“The key is not to overexpose yourself, but build up the business over time. We have budgeted for a three to five year timeframe to expand our business,” he says.

The above analogy is especially appropriate because Meliti believes the expansion of the Middle East’s insurance market will be key to the growth of derivatives.

Conventional insurance is prohibited under Shariah law because it is based on uncertainty (Al Gharar), gambling (Al Maisir) and interest (Riba), which means most Arab families do not have any insurance beside compulsory vehicle cover.

However, the fast-growing takaful, or Shariah-compliant, insurance industry looks set to change that. The global takaful market was worth Dh15.8 billion in 2005 and is predicted to triple by 2010.

“The GCC is hugely underinsured and as the insurance sector grow, premiums will increase and insurance companies will need to manage their liquidity.

And where do they go to do this? The Capital markets operations of investment banks.

“So the products we’re creating go hand-inhand with the development of financial services in the region.”

GLOBAL APPEAL

This untapped market is what drove the affable Meliti to set up Arqaam, but going alone was only the first step. The next was to find others who shared his vision.

“I had to find a group of 40 like-minded professionals who think the same way and convince them to leave their homes across the world to come here to Dubai with this unifying vision of creating a truly special organisation.

“Backing that is 60 shareholders to bring international best practice to the region to create products for the local markets and international clients wanting to access the local markets.

“My satisfaction comes from achieving that goal and it’s really in the spirit of Dubai.

“Dubai gives a visionary hope. Some people make it and some people don’t, but it gives you the means to try, so the entrepreneurs rise,” says Meliti.

He praised the GCC’s regulatory environment, saying he does not believe any criticism is deserved.

“It’s vital to look at this question in context. The regulators have only been in place for a decade, maybe less, so the work they have done in this time is exceptional and in the five to 10 years they will become on par with some of the best regulators in the world.”

Riad Meliti, CEO and Chairman of Arqaam Capital

Riad Meliti, 34, was born in Tripoli, Libya.

With a degree in economics from University College London, Meliti’s former employers include Credit Suisse First Boston, UBS and Barclays.

The financier loves to play golf.

Derivatives

Derivatives are essentially a way for traders to hedge their bets and their origins can be traced to ancient Greece.

Aristotle describes how fellow philosopher Thales predicted the olive harvest the following autumn would be exceptional and so made agreements with the local olive press owners to guarantee him exclusive use of their machinery at harvest time.

He was able to negotiate low prices because the press owners could not know the quality of the future harvest, so were happy to hedge against the possibility of a poor yield.

Happily for Thales, his prediction of a bumper harvest came true and he was able to rent out the presses for a good profit.

Options are just one type of derivative instrument.

Derivatives are contracts that are based on or derived from some underlying asset, reference rate, or index.

Their simple monetary value means they are far more flexible than the underlying asset itself and most contracts are settled in cash terms.

This enables investors to bet on price movements without having to deal with the actual assets.

Derivatives can also be highly leveraged so they are geared to be worth many times the value of the underling asset.

Such leveraging magnifies gains, but also losses, which led Warren Buffett to describe derivatives as financial weapons of mass destruction.

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