Dr. Ozden’s STO Bible: Cross the River by Touching the Stone

November 9, 2018


RockTree LEX continues to evaluate and accept an increasing number of Security Token Offering (STO) cases from North America and Asia to help our clients successfully complete their STOs. As discussed in our previous LEX Views, LEX anticipates the next wave of disruptive blockchain innovation to be in Security Tokens. This article is part two of our LEX View series on STOs which continues discussing the development of Security Tokens and the current path towards STOs.

Dr. Omer Ozden, Founder and CEO of RockTree LEX, is a New York licensed Lawyer and has more than 20 years legal practice experience in securities and finance. Dr. Ozden was formerly a Partner with Baker & McKenzie LLP in New York, where he was legal counsel to Facebook. He was also with the Silicon Valley law firm of Morrison & Foerster LLP where he was a part of the team that invented the variable interest entity (VIE) structure for foreign investment venture capital and IPOs for Chinese technology companies, and successfully completed venture capital investments and IPOs for top technology and other types of companies using his invented VIE structure such as Alibaba, NetEase, Baidu and New Oriental, with investors such as SoftBank and Goldman Sachs.

Dr. Ozden and his LEX team of international lawyers and finance professionals in New York, Toronto and Beijing have collectively worked on over 120 public security and utility token projects, and hundreds of security private placements, in 18 jurisdictions. Most of these cases have been from the United States, Mainland China, Canada, Hong Kong, Singapore and the United Kingdom. His in-depth understanding of blockchain and legal experience on international securities offerings has made him the leading expert in STO structuring, generation, finance, and listing. Dr. Ozden is guiding various STOs as mentor and business partner during these critical “early mover” days for projects seeking to conduct a successful STO.

Dr. Ozden knows the key steps for mentoring a small to medium sized company and turning it into a multi-billion dollar company, fast. In addition to working with various companies during their early days in Zhongguancun and Silicon Valley such as New Oriental (China), Facebook (US), Baidu (China), NetEase (China) and WIND Mobile (Canada) which all became multi-billion dollar ventures, Dr. Ozden continues to work with a number of other Blockchain projects and non-Blockchain projects to help their explosive growth. For example, Dr. Ozden is co-founder of UCommune, which started in 2015, and within three years today has a valuation of RMB 11.26 Billion, and co-founder of 5LMeet which started in 2016, and within two years today has a valuation of RMB 3.7 Billion. If Dr. Ozden decides to accept a project, he knows the critical steps for making those early smaller-sized projects massive, and just as importantly, what pitfalls for the projects to avoid.

Dr. Ozden believes that Security Tokens are becoming a new major path for well-managed high growth companies to accelerate their growth. Growth accelerated through this new layer of financial and legal infrastructure that LEX, and its various international partners, are creating in the blockchain digital asset world. Blockchain has already revolutionized finance through Bitcoin and ERC-20 Utility Token offerings. Security Tokens are the next wave of this disruptive evolution. Security Tokens involve a combination of technical engineering, legal engineering, and Wall Street-style financial engineering all brought together for innovation. LEX is a one-stop portal for Chinese and U.S. Blockchain technology, Wall Street Finance, and Global Legal Compliance, which are the key pieces for the best projects to conduct their successful STO. LEX is the legal compliance partner of its Investment Partner, Huobi of Beijing, and also has various strategic partnerships with other groups in the STO world such as Securitize, SharesPost and Polymath, amongst others on both the East and West side of the Pacific Ocean. This makes LEX the first place projects seeking STO should start with for their technology, legal compliance, token architecture and strategy, finance, and ultimate listing. If LEX decides to accept your project, it will be on a path to rapid growth on the STO process.

“High growth private companies are now deferring their IPOs. So many exceptional companies that have become unicorns have done so without rushing to IPO on an international stock exchange, such as UBER, GitHub and WeWork. Much of these investment opportunities have been traditionally open only to the top angel and venture capital institutions in Palo Alto, Zhongguancun, and Wall Street. STOs will provide access to these high growth opportunities to a wider range of investors, while at the same time, providing global capital access to small and medium sized companies” explained Dr. Ozden. The top 20 leading venture capital funds have $40 Billion to invest over the next 10 years. However, the next several tiers of investors have significantly more. “STOs will drive innovation because capital finance is the fuel for technological and entrepreneurial growth,” said Dr. Ozden.

Security Token Smart Contracts

As previously discussed, Security Tokens are generally being issued on the Ethereum blockchain using the ERC-20 standard (the standard previously used for utility token issuances), but modified to address the security aspect of the Token. Some groups are also coming out with their alternative protocols to ERC-20 in the STO space. There are a number of platforms that can help make the Token generation process simpler and even embed appropriate regulatory restrictions into the Security Token itself.

As we detailed in Part I of this Article on STOs we released end of October, 2018, LEX has a strategic partnership with Securitize of San Francisco, which has designed its own DS Protocol platform of smart contracts tailored for specific events such as dividends and voting, and DS Services for programmed compliance and registry.

LEX also has a strategic partnership with Polymath of Toronto, which has developed a Security Token platform that allows for issuers, investors, KYC providers and advisors to participate in an STO. The Security Token Standard spearheaded by Polymath (ERC1400) embeds regulatory requirements into the tokens themselves, restricting trading to authorized participants only. The flexibility of the Polymath framework and ERC1400 allows issuers to conduct a Security Token Offering and maintain regulatory compliance in the primary and secondary market, regardless of the jurisdiction of the offering or investors. “In July 2018, Polymath brought together Ethereum developers, securities lawyers, exchange operators, KYC providers, custody providers, transfer agents, business owners and regulators to develop and formalize the Ethereum Improvement Proposal for Security Tokens. With the help of all of these parties we are now moving forward on making ERC1400 the industry standard for Security Tokens,” said Chris Housser, Chief Operations Officer and Co-Founder of Polymath. “We are excited to be working with partners like RockTree LEX to help drive the growth and standardization of the STO market.”


As we cross the river by feeling the stones under our feet, one of the future promises of Security Tokens is enhanced liquidity compared to traditional private securities. There are a number of platforms currently being built in anticipation of providing domestic and cross-border trading of Security Tokens.

1.Development of Security Token Exchanges

On March 7, 2018, the U.S. Securities and Exchange Commission (“SEC”) released an announcement warning crypto investors to avoid unregulated crypto exchanges. The SEC is of the view that crypto exchange platforms provide a mechanism for trading assets that meet the definition of a “security” under U.S. securities laws. In order for investors to receive the protections offered by U.S. securities laws and SEC oversight when trading digital assets that are securities such as Security Tokens, platforms and entities that facilitate trading and exchange of such digital assets must register as a national securities exchange or fall within an exemption from such registration, which is a requirement that was first highlighted by the SEC in the DAO Report released in July 2017. National securities exchanges in the U.S. are limited and include the NYSE, NASDAQ and the CBOE, amongst others. One exemption from registration as a national securities exchange allows firms to conduct exchange activities if the firm is registered as alternative trading system (“ATS”).

2.Alternative Trading Systems

Under U.S. securities laws, an ATS is any platform that (a) constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange; and (b) does not (i) set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on the platform; or (ii) discipline subscribers other than by excluding them from trading.

As many digital asset platforms or exchanges technically fall within the ATS definition, these platforms will need to appropriately register with the SEC. In order to do so, the platform must first register as (or buy) a broker-dealer and then register as an ATS (or alternatively purchase an existing ATS).

3.Broker-Dealer Registration

Any person engaged in the business of effecting transactions in securities for the account of others or buying and selling securities for its own account must generally be registered as a broker-dealer under the U.S. Securities Exchange Act of 1934 and register with a self-regulatory organization (usually the Financial Industry Regulatory Authority, Inc. (“FINRA”). Firms applying for a broker-dealer license must describe their business and compliance policies and controls in detail and be subject to an in-person new membership interview. As the application and development of policies and controls can be a time-consuming process, some firms have opted to acquire an existing broker-dealer firm instead (such an acquisition is subject to FINRA approval, however).

4.ATS Registration

If a firm is already a broker-dealer but is not an ATS, the firm must submit an application to FINRA describing the ATS platform and demonstrate to FINRA how the ATS technology operates to FINRA. Once FINRA is satisfied with the ATS platform, the firm is then able to notify the SEC and being operating its platform. FINRA is technically required to review and process a substantially complete application within 180 calendar days after receiving it. Sometimes, FINRA can complete this faster, but it is not always certain how long the review process with FINRA will actually take for many of the blockchain-based trading platforms, as the proposed Security Token trading platforms are emerging technologies for which FINRA staff do not currently have extensive experience or technical knowledge (although, like the SEC, is taking recent steps to improve).

5.The Current Security Token Exchange Landscape

As a result of the regulatory requirements discussed above and similar requirements in other jurisdictions, a number of crypto exchanges have started looking into either acquiring or partnering with licensed securities dealers in order to be compliant with local securities regulations, particularly in the U.S., Canada, Japan, and the European Union. This would enable them to become legitimate securities dealers and trading platforms in both traditional and crypto financial worlds, and also serves as a milestone for crypto exchanges to strengthen the infrastructures to provide better support to security token liquidity. LEX is of the view that regulated and licensed Security Token exchanges will provide greater trust to investors, and the increasing number of regulated Security Token exchanges will expedite tokenization of different securities classes, providing investors with more options to participate in traditional (equity and debt) and Financially Engineered (income streams, securitized assets) and “Hybrid” or “Dual” (security tokens and utility tokens) STOs and secondary trading of such assets.

tZero was one of the first exchange platforms to move into the Security Token space. In September 2017, tZero announced it was working on launching a platform to trade Security Tokens. Trades would be conducted through Pro Securities LLC, an ATS that is owned by tZero. tZero is also in partnership with BOX Digital to develop a U.S. national securities exchange for trading Security Tokens.

Coinbase was valued at $1.5 Billion in late 2017. It went on to acquire a Broker Dealer and ATS Keystone Capital and Venovate Marketplace in June 2018, for the purpose that this provides regulated Security Token trading, margin and over-the-counter (OTC) trading, and new market data products. Even with significantly less trading pairs and trading volumes than many other exchanges such as Binance, Coinbase’s closed its latest round of financing on October 30th, 2018 with a $8 Billion valuation. You do the math.

SharesPost, another strategic STO partner of LEX and with whom LEX is collaborating on STO projects, anticipates to have at least two Security Tokens trading before the end of 2018, and a few dozen by the second half of 2019. SharesPost has major advantages in that it has a network of 60,000 accredited investors on its platform and is currently building a novel system called the Global Liquidity and Settlement System (“GLASS”), a decentralized network of crypto trading platforms, to pool liquidity and enable compliant settlement of cross-border digital securities transactions. GLASS will be the shared compliance and settlement infrastructure of member exchanges. The network will route digital securities transactions from exchanges to licensed broker dealers in jurisdictions where their clients are resident for settlement. As a result, member exchanges can facilitate legal transactions in all jurisdictions while minimizing their compliance costs. SharesPost being the first such member exchange on the GLASS network will enable settlement of compliant Securities Token transactions for U.S. residents. Licensed entities in other jurisdictions who become member exchanges on the GLASS network will enable the creation of a truly global Securities Token trading network. SharesPost is currently working with exchanges in Singapore, Hong Kong, Dubai and London to become member exchanges on the GLASS network and anticipates more jurisdictions being added in the next 12 months.

“SharesPost is working with key partners like RockTree LEX to build compliant, end-to-end infrastructure supporting STO’s and secondary trading globally,” said Greg Brogger, CEO and Founder of SharesPost. “We are integrating primary issuance standards from the leading global players to encourage standardization in the market. In parallel, the GLASS Network will enable compliant, cross border trading of security tokens as regulators provide clarity in more jurisdictions. SharesPost will be just one node on this decentralized settlement network. And because we see a substantial pipeline of STO’s, we are confident that the volume of security token secondary trading will scale as the lockup periods on these primary offerings expire.”

Outside of the U.S., a number of projects are also emerging. SIX Swiss Exchange (formerly SWX Swiss Exchange and Switzerland’s main stock exchange), is building a fully integrated trading, settlement and custody infrastructure for security tokens called SIX Digital Exchange. The Malta Stock Exchange has partnered with Neufund and Binance to create a regulated and decentralized, global stock exchange for listing and trading tokenized securities alongside crypto-assets. In Canada, the Canadian Securities Exchange has also announced they are developing a securities token trading, clearing and settlement platform.

At the moment, there are a limited number of Security Tokens that are available to be listed with SharesPost or any of the other proposed security token trading platforms as most Security Tokens have been issued through exemptions from registration requirement under the U.S. Securities Act of 1933 and are still subject to the 12-month hold period before they can be resold and traded. There are certain ways that this can be legally structured so that in some cases, the Security Tokens can be resold and traded after a much shorter 90-day hold period, that LEX is currently structuring for some of its STO projects. LEX anticipates that as existing Security Tokens come out of their hold periods and are listed on Security Token trading platforms, the tide of interest in STOs will grow rapidly.

LEX is also of the view that obtaining proper regulatory approvals is the inevitable path for any crypto exchange to become successful in the emerging STO landscape. LEX is observing the U.S. crypto exchanges transitioning into holders of broker-dealer and ATS licenses. This ongoing trend will provide current crypto investors, and those larger institutional investors that are planning to enter the crypto market, with greater confidence and protections when participating in Security Token investing and trading, which will ultimately promote the global acceptance and liquidity of Security Tokens.

6.Global Trading Considerations

While the anticipated enhanced global liquidity for Security Tokens is a positive feature of tokenization, it also raises questions as to how the Tokens should be treated as they leave one jurisdiction and enter another. For example, if a Token that is considered a Security Token for U.S. purposes is traded to a holder in Singapore and the token would technically meet the test to be considered a utility token under Singapore law, is the Token now no longer a security? What happens if a utility token issued under Singapore law is traded to a U.S. person? Will the utility token become a Security Token while held by a U.S. person? And what happens when the U.S. person then trades it to someone in Malta? Does it remain a Security Token or could it transform back into a Utility Token? The differing approaches to Tokens, particularly the views of the SEC in comparison to other jurisdictions in the world, is causing uncertainty in the market, which will only become more prominent as STOs grow in number and these resulting tokens are listed on exchanges and traded across the world. For a more detailed explanation of this issue, please refer to Part I of this LEX View Article on STOs.

LEX’s view is that, when observed from a U.S. securities law perspective and taking into account commentary from the SEC (such as the statement from Jay Clayton, the Chairman of the SEC, that every initial token offering he has seen is a “security” and are “investment contracts”), currently all digital tokens will likely be viewed by the SEC as Security Tokens and when issuers conduct token offerings outside of the U.S. they should be aware of that U.S. securities laws issuance and resale restrictions would apply to such tokens, particularly if there is a possibility of such tokens being traded into the U.S. or to U.S. persons. This includes even simple activities such as “airdrops” and creating token burning structures. One development we may eventually see from the SEC in the future is a “No Action Letter” regarding flexibility or exemptions for Utility Tokens which have a current and clear “Use Case”. However, that is something that may be possible in the future, and is not available today.

On October 18, 2018 the SEC announced the launch of their Strategic Hub for Innovation and Financial Technology (“FinHub”), the purpose of which is to serve as a resource for public engagement on fintech-related issues, including distributed ledger technology and digital assets. The FinHub will be led by Valerie A. Szczepanik, Senior Advisor for Digital Assets and Innovation and Associate Director in the SEC's Division of Corporation Finance, whom LEX spoke to previously about the current state of STOs as discussed in our previous LEX View STO article. While there has been no official guidance from the SEC on global token trading and characterization issues, LEX anticipates the SEC will begin to engage on these issues through FinHub and will provide more clarity and guidance in 2019 on these issues and Security Tokens in general, as the uncertainty will continue to hamper growth of the blockchain industry in the U.S.

Dr. Ozden and LEX are currently preparing the “Understanding Security Tokens: Guidelines for Government & Practitioners” with the Token Alliance, led by former Commissioner of the SEC, Mr. Paul Atkins and former Chairman of the U.S. Commodity Futures Trading Commission, Dr. Jim Newsome, and other leading experts around the world. LEX is the only expert from Asia co-authoring these STO guidelines, which are anticipated to be the “Bible” for STO practitioners and government alike. This comes after LEX co-authored with the Token Alliance the famous 110 page report “Understanding Utility Tokens: Guidelines for Government & Practitioners”, which it submitted to U.S. Congress, the SEC and CFTC in July 2018.

The Future of STOs

The shift to STOs is beginning to build momentum. LEX sees the queue of U.S. and Canadian cases are building, with more and more projects from Asia entering the queue. And we are seeing Chinese projects developing a great deal of interest in this area, yet the key factor for their success is to work with experts. Experts who have already completed many public securities offerings (IPOs) and private securities placements in the past in the major jurisdictions, such as United States, China, UK and Canada. Because of the fast growing demand, the legal and technical infrastructure to support STO projects and Security Tokens are also rapidly taking shape. Many projects are vying to disrupt centralized institutions that deal in securities, like stock exchanges, by creating highly efficient, transparent and decentralized substitutes, as well as enabling the tokenization of assets that have been historically illiquid. LEX’s view is that for STO projects, the key consideration to a successful STO is liquidity. This benefit is being realized not only by blockchain technologies, but also by the development of platforms to enhance and facilitate legal and regulatory compliance in STOs and trading of Security Tokens. While some would argue that regulation of the industry conflicts with the decentral nature of blockchain, LEX sees regulation as the path towards investor confidence in crypto investments, which will further promote the Security Token market and drive increasing liquidity. And will drive the critical fuel for technological innovation, through financial and legal innovation in Blockchain through Security Tokens.

LEX also believes Security Tokens will enable new and “Wall Street Style” Financially Engineered forms of securities in the future, and there may even be new blockchain platforms developed specifically for Security Tokens. For instance, certain types of niche exchanges and offerings for Security Tokens of certain major asset classes, such as for real estate will emerge. Just the tokenization of real estate in itself will be a multi-Trillion dollar opportunity that can be unlocked over the next decade for the early movers. Based on conversations LEX has had with various groups and its current projects, LEX sees STOs as a growing trend that will continue into 2019 and beyond as the benefits of tokenization securities are realized. We do not know when the “hockey-stick” growth of Security Tokens will first come, whether in 10 months from now, or 10 years from now, but looking back at the geometric growth that the peer-to-peer aspects of blockchain provides the world of finance through instantaneous settlement and global 24/7 transactions, it will come faster than most outsiders who do not understand blockchain anticipate. Only those in the core blockchain circles understand the speed at which the blockchain and cryptocurrency market moves – faster than Internet speed.

In the meantime, we are all taking steps together as we ‘cross the river by feeling the stones under our feet’, just as China’s leaders and Chinese people did decades ago when embarking China on a path of economic growth that was enormous and unprecedented. What is on the other side of that river? It is the bridging of markets globally, particularly from the East and the West side of the Pacific Ocean. It is global access to capital for earlier stage companies and faster liquidity for private investors. It is tokenization of different asset classes such as real estate and art. And it is the building of a global digital asset infrastructure for Security Tokens that LEX, along with its partners Securitize, SharesPost and Huobi, amongst many others are building together today utilizing talent and expertise in computer science innovation, legal innovation and financial innovation. And ultimately, whatever that new layer of blockchain-based financial innovation of Security Tokens will look like 10 years from now, we can all expect it to be enormous and unprecedented.