Can the 'front store and back factory' model of Web3 entrepreneurship in Hong Kong + Shenzhen be Compliance?

The ‘front store, back factory’ model in Hong Kong and Shenzhen seems to temporarily avoid direct regulatory intervention by clearly dividing the operational functions between domestic and overseas. However, this model still inherently carries a strong sensitivity to Compliance.

Writing: Iris, Mao Jiehao

When it comes to domestic Web3 entrepreneurship, we always talk about the 924 document of 2021, and emphasize that providing virtual currency financial services within the country is illegal financial activity, which constitutes a crime and will be criminally liable.

However, we will find that in recent years, there is a model between Hong Kong and Shenzhen called ‘front shop, back factory’, that is, setting up projects/companies in Hong Kong facing regulation and overseas capital; organizing development and some operational processes in Shenzhen, enjoying strong technological research and development and low costs.

This inevitably raises questions: Is this model really Compliance? If Compliance, does it mean that I can set up a project in Hong Kong and operate domestically?

I have to say, this is a very interesting and very practical question.

Why does the ‘front store back factory’ exist?

Some people may be curious why, since Document 924 of 2021 has clearly stated that conducting financial activities related to virtual currencies within the country is illegal, the ‘front shop in Hong Kong, back factory in Shenzhen’ model has been active in the vision of many Web3 entrepreneurs in recent years?

In 2023, Kong Jianping, a director of Hong Kong Cyberport, also publicly stated in an interview with PingWest Technology that the ‘front store, back factory’ model between Shenzhen and Hong Kong will facilitate the development of Web3.

* Image Source: The Paper

Lawyer Mankiw believes that the reason behind the existence of this model is that the focus of regulation is not only on whether the project directly serves domestic users, but also on the actual operation of the project, the location of core decision-making and fund management, that is, the distribution of actual control and key resources.

From a superficial perspective, Web3 project parties will register all legal entities and businesses in Hong Kong or other overseas jurisdictions; through technical means such as IP restrictions, KYC, the target of financial services provision is limited to Hong Kong and overseas users; at the same time, fund settlement, license applications, market promotion, and other processes are all completed through overseas entities.

In this way, both from a business operation perspective and from a service target perspective, it avoids Chinese domestic users and caters to China’s regulatory policies.

From the perspective of underlying development, choosing to establish a technical team in Shenzhen is based on considerations of cost, efficiency, and technological advantages. As an important part of the Guangdong-Hong Kong-Macao Greater Bay Area, Shenzhen has a mature technological research and development foundation and a large reserve of Web3 talent. Compared to local development teams in Hong Kong, Shenzhen has obvious advantages in terms of labor costs, development cycles, and technological accumulation. For many Web3 projects, purely outsourcing underlying development to Shenzhen is a normal business choice, not much different from the “overseas company + domestic and overseas outsourcing development” model in the traditional internet industry.

In short, the ‘front shop and back factory’ model in Hong Kong - Shenzhen appears to temporarily avoid the risk of direct regulatory intervention by clearly delineating domestic and overseas operational functions. However, this model still inherently carries strong Compliance sensitivity.

Potential Challenges of ‘Front Store, Back Factory’

At first glance, the ‘front shop, back factory’ model seems to have achieved the ‘clear division’ of domestic and foreign businesses by registering a Compliance entity in Hong Kong and keeping only the technical research and development domestically, in order to avoid regulatory red lines. However, the problem lies in the fact that the technical development, product iteration, and business operation of Web3 projects are highly integrated. In many cases, the domestic technical team may not only undertake development work but also inevitably get involved in token design, some operations, data processing, and even user support, laying hidden Compliance risks for Web3 projects.

Because regulatory agencies will not only look at whether the nominal architecture complies with Compliance, but will penetrate and focus on the actual control chain of the project - who controls the core operational rights of the project, the decision-making power of fund flow, and the user data management rights. If the project’s daily operation management, key decision-making, and fund handling are still concentrated domestically, even if the project is registered in Hong Kong and the service is limited to overseas users, it is easy for regulators to determine it as a “substantial” use of domestic resources to provide illegal financial services in a disguised manner.

It is worth noting that, in order to save costs or for efficiency considerations, some projects choose to outsource some market promotion, community management, and even customer service to Shenzhen teams, or even directly launch global user operations from domestic teams. At this time, the regulatory authorities may completely consider that the core operation chain of the project is not clearly cut, and it may be suspected of circumventing legal requirements.

In addition, due to the deep involvement of the technical team in the design of the product logic, even though it may seem on the surface that the project is a new product or feature launched overseas, the development and launch process may have already been completed in Shenzhen, further blurring the boundaries between domestic teams and financial services.

In other words, the risk of “front store and back factory” lies not in whether a Compliance entity is superficially established, but in whether domestic and foreign resources truly achieve functional segregation. As long as the domestic team is involved in fund decision-making, operation management, or user service, the Compliance risk of Web3 projects will rise sharply, and it is highly likely to be identified by regulatory authorities as “false advertising,” and thus held legally accountable.

Mr. Mankiw’s advice

As mentioned above, the ‘front store back factory’ model appears to achieve a Compliance architecture by setting up a Hong Kong Compliance entity and restricting domestic users. However, as regulatory authorities pay more attention to the current trend of ‘substance over form,’ Web3 projects need more than just formal functional division to truly reduce legal risks.

Lawyer Mankiw suggests that Web3 entrepreneurial teams must pay attention to the following points when adopting the ‘front store, back factory’ model:

First, thoroughly cut off the core control chain between domestic and foreign entities. Whether it’s daily decision-making, fund transfers, user data processing, market promotion, or operational management of the project, it must be ensured that it is independently completed by overseas registered entities, and avoid outsourcing related functions to domestic teams. Technical development can be undertaken by the Shenzhen team according to the specific needs of the project, but it must be strictly limited to the ‘pure R&D’ stage, without involving sensitive contents such as fund management, user operations, and marketing activities after the project goes live, to prevent crossing the regulatory red line.

Secondly, avoid mixing technical research and development with product operation functions. Many projects tend to involve the technical team in token design, user interaction, etc., due to the high level of understanding of the product logic by the technical team, which actually leads to the blurring of domestic and foreign functions. The project party should clarify the scope of work of the technical team, strictly separate them from the Compliance team and operation team in Hong Kong, ensuring that technical development only exists as the “back factory” rather than participating in the business operation of the “front store”.

In addition, establish clear legal and Compliance firewalls. Web3 projects should, with the assistance of professional legal personnel, establish clear isolation mechanisms at the contract level, personnel structure level, and fund flow chain with the domestic team. This includes but is not limited to explicitly prohibiting the domestic team from engaging in fund settlement, token distribution, and user management in technical development contracts; at the same time, establish overseas independent legal entities or foundations to hold project IP, assets, and brand rights, to prevent domestic entities from being held accountable as actual partners or co-operators due to being nominally “technical services”.

Finally, make advance preparations for Compliance filings in various judicial jurisdictions. If the Web3 project is registered in Hong Kong, it is recommended to apply for relevant licenses early or with the assistance of professional legal advisors to ensure that all financial service activities for users operate within the Compliance framework. At the same time, avoid conducting any promotional marketing, community operations, payment settlements, etc. in mainland China to reduce the risk of being identified as providing services to residents in a disguised manner.

Ultimately, the current ‘front store, back factory’ model can still be a practical choice, but the premise is that the team must truly achieve clear separation of domestic and foreign resources and responsibilities, avoiding turning domestic technical development into the ‘invisible support’ of foreign financial business. However, under the current regulatory policies, this model is not the best long-term solution. Regulatory measures are becoming more stringent, and risks are inevitably increasing. A little carelessness may lead to criminal penalties, undoing previous accomplishments.

Therefore, Mr. Mankiw still advises Chinese entrepreneurs to try to truly achieve the “going global” mode, fully landing the overall overseas technology research and development, corporate governance, and financial operations, and accepting Compliance management of overseas regulatory agencies.