Bonding time with Mike Nicholas of the Bond Dealers of America and featuring Ted Karn of The Karn Group

This series will also include discussions with trading platforms, technology firms vendors and consultants, in addition to sale side dealers and focus on the many challenges and opportunities that tech is providing to overall bond market structure. Now on to Bonding Time.

Welcome to Bonding Time. This is the BDA's podcast series on technology and market structure, and featuring BDA members. In this case we're really happy to feature Ted Karn of The Karn Group to talk about fixed income compliance, fixed income technology, business conditions, market structure, some challenges and opportunities for dealers, large regional, middle market and small, and what's in the pipeline at TKG we can look forward to hearing about.

So with that, welcome Ted Karn. Thank you very much for being a member of the BDA. Thank you for taking time to do this podcast. I thought maybe we could start off with you talking about who The Karn Group is and maybe how you differentiate yourself, your firm, from others in this space.

Ted Karn: Thank you, Mike. Thank you for inviting me to Bonding Time and the introduction. The Karn Group is a fixed income compliance and technology firm. Our services are supporting a broad range of firms, from national firms, broker/dealers and banks down to the regionals and boutique shops.

We differentiate ourselves along several different dimensions. I will start with talking about our expertise and support. When you talk to The Karn Group you're talking to someone who has multiple years of experience supporting compliance officers or trading desks or trading support people. You call the person who has the answers, not someone to take a message.

We also have a very involved and sophisticated technology. We've been doing this since 2007. We are the largest provider of fixed income compliance solutions. Our solutions have evolved as the regulatory space has changed and evolved, and our customers find when they engage us that they get a full set of solutions to their problems.

We also differentiate ourselves in terms of the type of technology that we make available. So in addition to being able to provide trade supervision and support, we also provide a lot of pricing information and support around that. Often people in the compliance space are using third party prices. These may not be particularly descriptive in terms of the source of the prices and how they are used. In the case of TKG, we support multiple types of pricing models. We have a great deal of transparency about our prices, and these are very helpful to both our trading desk partners and our compliance officers in terms of performing their relative tasks.

Mike Nicholas: I appreciate that. That's a great overview. You mentioned compliance. Among other things you mentioned compliance. I wanted to dive into a couple of areas. The first is the fixed income compliance solutions that TKG provides for firms. One I believe is a BestX trade supervision product and the other is BestX statistics. I wonder if you could talk about those two products?

Ted Karn: For sure. We provide support and compliance at all stages of the trade. It can be pre-trade, so prior to the trade being executed. It could be point of trade, where the trade executes and you get immediate analysis of it. Or it could be on a T+1 basis. We have customers across all those different time periods.

In each case, depending on where they are and how it's integrated into their workflow, we provide support information for that. On a pre-trade basis it obviously connects very closely to how trading is done. The concept is in order to engage the pricing and the compliance requirements prior to the trade actually being executed. This has multiple benefits to the customer in terms of elimination of potential trading errors, needing to do cancels, corrects, and so on.

Other times, in terms of the live cycle it allows you to do more detailed types of analysis. For instance, on a T+1 basis, that gives you an opportunity to do markup, markdown, see if the commission grids are being adhered to, and various other types of requirements.

When TKG is supporting a customer we typically have two types of customers, one that has already had some kind of technology solution, but they're now introduced to TKG, which would be a more advanced and sophisticated product, or sometimes we have... And this is especially true with the smaller BDs, this is their first automated solutions, so this is a daunting regulatory environment. Then in addition to that, we have the issue that they haven't worked with this type of technology before.

What we do is that we consult with the customer and then we provide an out-of-box solution that is a similar solution to what their peer group might be doing for compliance purposes. Once they have that they get familiar with it, and then they can start giving us input in terms of the particulars of their firm, characteristics of their supervisory processes, and we can customize the solution for them.

Mike Nicholas: So I would imagine before... I want to turn to trading technologies, but as you're talking about the solutions you're providing I'm thinking about COVID and work from home, and I would imagine it's... Well, obviously 2019, 2022, completely different time periods, right? We're 2021 and now '22, where hopefully there will be more trading and meeting with clients in person this year.

But I'm just curious, how has COVID and work from home with traders now working out of their basement as opposed to everybody to get together on the desk... How has that affected your relationship with the industry, with sale side dealers? Because the need for compliance hasn't changed. There was a little reprieve, obviously, from the regulators, but the need for compliance hasn't fundamentally changed, but their relationship with folks like you has had to adjust I would imagine.

Ted Karn: Well, I actually think that we've been very fortunate in terms of that our cloud based solution supported very easily and directly a disseminated model versus a centralized model. Previously our customers obviously all worked in a common office and they had direct contact, and there are many benefits to that.

But they had also be acclimated to being able to use a centralized cloud based service such as TKG, and they've been able to do their workflow, case management, books and records, and so on all through our platform.

Once COVID came upon us and they had to start working from home, and so on, the tools became much more of a integration service than they were previously, but the same type of work and management of their compliance models didn't change, so I felt that we were very fortunate in that the transition worked so well.

Now I think going forward many people who have adopted to working from home and the model where everyone is going to be in the office at the same time is probably been permanently changed, so I expect that service to continue to perform that function of providing integrated information for the various compliance officers and so in.

Now on the trading side, it's been I think more of a loss than on the compliance side in terms of without the direct contact between the traders, and so on the communication has been compromised a little bit.

What we've been doing over the last two years is developing technology where they can express their pricing models and their market views through the system. Specifically, they can define sectors, they can build different type of sector curve spreads, and so on, and this can be used for a whole variety of purposes, including spot trading or responding to RFQs.

Mike Nicholas: Yeah, that makes sense. Thanks for that description. Turning to trading technologies is another aspect that I wanted to discuss today, how do the compliance tools integrate with the trading technology tools. Just generally could you talk a little bit about the automated bidding tools and market intelligence tools that you feature on your website?

Ted Karn: We came to trading technology in a somewhat unusual path. We started as a fixed income compliance service provider, and we found that fixed income compliance is highly dependent on the pricing services that you use. So we, obviously like many participants, first looked to existing third party pricing services, but we found that they were deficient for these purposes for a couple of reasons.

One is is they were typically end of day prices, and they were also typically designed for inventory pricing for the buy side. These were not very good fits for the sale side, did not express inter-day types of transactions or specific liquidity issues on individual securities, so we started building from the ground up pricing capabilities based upon a whole range of different pricing methodologies, including looking at last prints, looking at different types of yield structure based pricing, comparable pricing, and so on.

In terms of similarities, both compliance and trading on a pre-trade basis is very close in terms of you have to start with a fair value concept, and in the case of compliance you have spreads representing allowable markup/markdowns from that reference price. In the case of trading, the bands represent the type of spreads the trader requires in order to provide the liquidity services that they have, so how do you maintain a bid offer spread versus how do you maintain fair value for your customers.

Mike Nicholas: And the market intelligence component, does that just feed off of... It sounds to me like a lot of this feeds off of the compliance needs of a broker/dealer, but could talk a little bit specifically about the market intelligence component that TKG provides?

Ted Karn: Sure. Many of the trading systems are essentially black boxes, so you get your auto-bidder, you get your automated responses to RFQs, but you're now requiring a black box solution in order to provide your reference pricing. You do get obviously a set of controls and knobs, and so on, but these are not the way that the trader is naturally pricing.

Our approach is very different in terms that we are trying to leverage and augment the trader's expertise and knowledge. The trader has the type of in-depth knowledge that is difficult to impossible to capture through a fully automated system, and part of that could be reflected in the fact when you look at third party prices that they are often off market from a trading perspective.

What we've done is built with market intelligence a platform that allows the trader to define the sector, define how they wish to draw yield curves and the market structure from that sector, then introduce their spreads, and then now off of that base be able to automatically respond to RFQs, or be able to use this for very quick spot pricing, or be able to run an bid list against that.

Mike Nicholas: So dividing compliance in trading, could you talk a little bit about some of the challenges... And you're talking to broker/dealers every day about their challenges and solutions that TKG can provide. Do you see unique challenges that maybe some of the smaller and regional broker/dealers... Some of the obvious challenges are just manpower, capital, et cetera, to invest that some of the larger firms don't have as much of an issue with in some of these solutions.

But are there specific unique challenges that you see when you're talking to smaller and regional broker/dealers?

Ted Karn: Oh, for sure. Just to maybe enhance a little bit some of the points that you've made, the regulatory environment is becoming increasingly complex with more requirements and demands. The smaller regional broker/dealers obviously have a manpower limitation, but that doesn't apply to the scope of regulations that they have to respond to, so they're drawn thinner and thinner as the regulations pile on.

The amount of resources required for the audits and examinations is also increased. I'm seeing surprisingly long examination audit processes, some of them running for multiple months. Often the examinations are looking back in time. It could be up to two years previously, so these are all administrative, organizational and resource challenges.

When people use a platform such as TKG some of these are addressed, because we maintain our deep histories, books and records, demonstration of contemporaneous compliance solutions, so we ease the burdens of working with this. But many of the smaller broker/dealers have not yet had an automated system or process in place, and so they would be particularly challenged.

In the cases that someone is transitioning from a manual system, workflow, and so on into an automated platform, they now have to work in new territory, and in these cases we try to support those customers through our various expertise, shared experiences in terms of what regulatory and audit priorities are, and so on.

Obviously things have to be cost effective in a smaller BD, and again we've tried to make compliance accessible to all by offering a full suite for all broker/dealers, independent of their size. What we do is we scale the pricing in order to make it cost effective for the smaller BDs.

Mike Nicholas: And just the technology that you have in-house and the delivering software as a service to broker/dealers and banks nationwide regardless of the size to me I think creates an opportunity for middle market, regional, and smaller broker/dealers that are not building this in-house, some of these solutions in-house.

It seems to me that some of the solutions that TKG is providing can actually provide opportunities for smaller firms to increase market share in an existing product or move into a new product without building it necessarily organically or through acquisition.

Ted Karn: Yes. That's part of our objectives in terms of to some degree we like to democratize the landscape in the compliance and in the trading technology space. We feel that the expertise and hands on and the high touch capabilities to the smaller BDs can be leveraged with technology to make them very formidable in terms of the competitive landscape.

Very few firms actually cost effectively build their own types of technology in this space. There really are only a dozen or so firms that do this I would say the type of high quality service that TKG provides, and outside of those firms, not all of which choose to do an internal solution... Outside of those, we offer a competitive product.

Specifically in terms of what happens when you introduce something like market intelligence to a smaller BD, where you have a limited number of traders let's say, or institutional sales people, is that you now can introduce the type of speed in pricing, the type of market structure analysis. You can also be more responsive. You can support [inaudible 00:16:22] lists. You can do multiple functions at a higher level and make the firm very competitive with the largest firms and their capabilities.

I actually feel that the combination of introducing the advanced technology and the high touch close relations with the smaller BDs creates very significant opportunities for those BDs.

Mike Nicholas: I think that's exactly right. I know we at BDA have talked to other firms and agree with that conclusion. So you've got a lot on your plate obviously, and doing a lot of great work on at least two fronts in the industry. I'm wondering are there any new projects in the pipeline at TKG?

Ted Karn: Thank you for asking on that, Mike. We try to be responsive, have our ear to the ground, and be a little bit of a forecaster of what's happening in the regulatory space, because the development lead times are significant and we have to be ahead of the curve if we're going to need to have the product available at the time it's in demand.

Specifically what we're seeing in the landscape now is with the new SEC Chair, Gary Gensler, we're hearing a lot of talk about market data transparency. Currently market data is very fractured in terms of the various platforms that have the market data do one of two things with it. Either they try to create a fee stream, economic stream associated with that data, or they wish to drive business to their platforms using that data.

What the SEC is talking about is creating a system similar to what's [inaudible 00:17:58] with the NMS, where you have a consolidated fee both with time and sales, but also of quotations. As this occurs, I believe this is going to be used as a basis to encourage, and I use encourage in quotes... Direct the market to do more pre-trade type of analysis and more precision pricing.

TKG is in the process of building infrastructure and so on to support this type of information as it becomes more widespread and available. So I see a lot of advancement in the pre-trade type of analysis and that the market will need to adopt to that.

I also see that there is new trends around PMP, so prevailing market price. This has been used in order to provide additional information on customer confirms. What I see happening is is that this may enter the compliance regulatory space, where there's going to be expectations of measuring execution quality against PMP. The prices that are being used for reference will not be any longer a raw price without any attribution to how it's derived, but the prices will need to be modeled after the PMP waterfall, so I see an introduction of PMP pricing concepts into the compliance space.

These are the two near term trends that I see, and I think they'll have a very significant impact on the broker/dealer community.

Mike Nicholas: Yeah. That's very helpful, and no doubt especially the pre-trade discussion coming out of the SEC and Chair Gensler. He is strongly focused on that in talking with the SEC as well as FINRA about where that is headed.

Many thanks to Ted Karn and The Karn Group for doing this, for being a member of the BDA. Let me remind folks that if you have any questions about The Karn Group, any followup for Ted directly, please go to karngroup.com, directly to their website, where a lot of these questions may be answered right there on the site, but certainly contact Ted directly with any questions or followup, or us obviously at the BDA.

This podcast, again, is part of the BDA, Bonding Time series podcast. It will appear on the BDA website, distributed through email and social media, as well as on the BDA iTunes app, which is called Bonding Time. It'll be available in a few days. Please check that out. Contact us if you have any questions or comments.

Again, Ted Karn, thanks for the time. Thank you very much.

Ted Karn: Thank you, Mike, and thank you, BDA.

Mike Nicholas: We'll talk to you soon. Take care.

Ted Karn: Bye-bye.