Authors: Iris, Mao Jiehao
When we talk about domestic Web3 entrepreneurship, we always talk about the 924 document of 2021, and emphasize that providing virtual currency financial services within the country is an illegal financial activity, which will constitute a crime and be subject to criminal liability in accordance with the law.
However, we will also find that in recent years, there has been a model between Hong Kong and Shenzhen called "front shop and back factory", that is, setting up projects/companies in Hong Kong, facing supervision and overseas capital; organizing development and some operational links in Shenzhen, enjoying strong technology research and development and low costs.
This makes people wonder: Is this model really compliant? If it is compliant, does it mean that I can set up a project in Hong Kong and then operate it in the mainland?
I have to say, this is an interesting and very practical question.
Why does “front shop and back factory” exist?
Some people may be curious. Since the 924 document of 2021 has clearly pointed out that conducting virtual currency-related financial activities in the country is illegal, why has this "front shop in Hong Kong, back factory in Shenzhen" model been active in the vision of many Web3 entrepreneurs in recent years?
In 2023, Kong Jianping, director of Hong Kong Cyberport, publicly stated in an interview with The Paper that the "front shop and back factory" model between Shenzhen and Hong Kong will facilitate the development of Web3.
*Image source: The Paper
Attorney Mankiw believes that the reason why this model can exist is that the focus of supervision is not only on whether the project directly serves domestic users, but also on the location of the project's actual operation, core decision-making and fund management, that is, the actual control and distribution of key resources.
From the surface structure, the Web3 project will register all legal entities and businesses in Hong Kong or other overseas jurisdictions; through technical means such as IP restrictions and KYC, the provision of financial services is limited to Hong Kong and overseas users; at the same time, fund settlement, license application, market promotion and other links are also completed through overseas entities.
In this way, whether in terms of business operations or service objects, users within the country of China are avoided and China's regulatory policies are complied with.
From the perspective of underlying development, the choice to set up a technical team in Shenzhen is based on cost, efficiency and technical advantages. As an important part of the Guangdong-Hong Kong-Macao Greater Bay Area, Shenzhen has a mature technical research and development foundation and a large number of Web3 talent reserves. Compared with the local development team in Hong Kong, Shenzhen has obvious advantages in terms of employment costs, R&D cycles and technical accumulation. For many Web3 project parties, purely outsourcing underlying R&D to Shenzhen is a normal business choice, which is not much different from the "overseas company + domestic outsourcing development" model in the traditional Internet industry.
In short, the Hong Kong-Shenzhen "front shop and back factory" model seems to have temporarily avoided the risk of direct regulatory intervention by clearly dividing domestic and overseas operational functions. However, this model is still inherently highly sensitive to compliance.
Potential challenges of “front shop, back factory”
On the surface, the "front shop and back factory" model seems to have achieved a "clear division" between domestic and overseas businesses by registering a compliant entity in Hong Kong and retaining only the technical research and development links in China, in order to circumvent regulatory red lines. But the problem lies precisely in the fact that the technical development, product iteration and business operations of the Web3 project itself are highly coupled. In many cases, the domestic technical team may not only undertake the development work, but also inevitably intervene in the token design, partial operation, data processing and even user support, which buries the hidden danger of the compliance of the Web3 project.
Because regulators will not only look at whether the nominal structure complies with regulations, but will also look at the actual control chain of the project - who controls the core operation rights of the project, the decision-making power of capital flow, and the management rights of user data. If the daily operation management, key decision-making, and capital handling of the project are still concentrated in the country, even if the project entity is registered in Hong Kong and the service objects are limited to overseas users, it is easy for regulators to identify it as "substantially" using domestic resources to provide illegal financial services in disguise.
What is more noteworthy is that some projects choose to outsource some marketing, community management and even customer service to Shenzhen teams in order to save costs or for efficiency reasons, or even directly initiate operations for global users from domestic teams. At this time, the regulatory authorities may well believe that the core operation chain of the project is not clearly divided and is suspected of circumventing legal regulations.
In addition, since the technical team is deeply involved in the product logic design, even if on the surface the project is a new product or new function launched overseas, its development and launch process may have been completed in Shenzhen long ago, which further blurs the boundary between the domestic team and financial services.
In other words, the risk of "front shop and back factory" never lies in whether a compliance entity is established on the surface, but in whether the domestic and foreign resources have truly achieved functional isolation. As long as the domestic team is involved in the core links of funding decision-making, operation management or user services, the compliance risk of Web3 projects will suddenly increase, and it is very likely to be identified by the regulatory authorities as "selling dog meat under the guise of sheep", and then pursue legal responsibility.
Attorney Mankiw recommends
As mentioned above, the "front shop and back factory" model has achieved a seemingly compliant structure by setting up a Hong Kong compliance entity and restricting the participation of domestic users. However, at a time when regulatory authorities are increasingly paying attention to "substance over form", if Web3 project parties want to truly reduce legal risks, formal division of functions alone is far from enough.
Attorney Mankiw suggested that Web3 startup teams must pay attention to the following points when adopting the "front shop and back factory" model:
First, the core control chain at home and abroad must be completely cut off. Whether it is daily project decision-making, capital flow, user data processing, or marketing and operation management, it must be ensured that it is completed independently by overseas registered entities, and relevant functions must not be outsourced back to domestic teams. Technology development can be undertaken by the Shenzhen team depending on the project, but it needs to be strictly limited to the "pure research and development" link, and cannot involve sensitive content such as capital management, user operations, and market activities after the project goes online, so as to prevent touching the regulatory red line.
Secondly, avoid mixing technical research and development with product operation functions. Many projects are used to letting the technical team participate in token design, user interaction, etc. at the same time because the technical team has a high degree of mastery of product logic. This will actually lead to the blurring of domestic and foreign functions. The project party should clarify the scope of work of the technical team, strictly separate it from the compliance team and operation team of the Hong Kong entity, and ensure that technology development only exists as a "back factory" rather than participating in the business operation of the "front store".
In addition, a clear legal and compliance firewall should be established. With the assistance of professional legal personnel, Web3 project parties should establish a clear isolation mechanism with domestic teams at the contract level, personnel structure level, and capital flow chain. This includes but is not limited to explicitly prohibiting domestic teams from getting involved in fund settlement, token distribution, and user management in the technology development contract; at the same time, an independent overseas legal person or foundation should be established to hold project IP, assets, and brand rights to prevent domestic entities from being held accountable as de facto partners or co-operators for nominal "technical services."
Finally, make compliance filings in various jurisdictions in advance. If the main body of the Web3 project is registered in Hong Kong, it is recommended to apply for relevant licenses as soon as possible, either independently or by hiring professional legal advisors to assist, to ensure that all financial services for users are operated within the compliance framework. At the same time, avoid conducting any promotional marketing, community operation, payment settlement and other activities in mainland China to reduce the risk of being identified as "providing services to domestic residents in disguise."
In the final analysis, the current "front shop and back factory" model can still be a realistic option, but the premise is that the team must truly achieve a clear separation of domestic and foreign resources and rights and responsibilities, and avoid turning domestic technology development into an "invisible support" for overseas financial business. However, under the current regulatory policies, this model is not the best long-term solution. With increasingly stringent supervision, risks will inevitably increase. If you are not careful, you may face criminal penalties and all your previous efforts will be wasted.
Therefore, Mankiw still advises Chinese entrepreneurs to try their best to truly realize the "going overseas" model, fully implement technology research and development, corporate governance and financial operations overseas, and accept compliance management from overseas regulatory agencies.
