Author: Zhang Feng

A proposal from the Democratic Party of the U.S. Senate titled "Preventing Illegal Financing and Regulatory Arbitrage Through Decentralized Financial Platforms" unexpectedly triggered a crisis in the bipartisan cooperation on cryptocurrency market structure legislation.

Coinbase CEO Brian Armstrong openly stated on social media platform X that the entire crypto industry would oppose it, reflecting the general attitude of the U.S. crypto industry towards the recent DeFi regulatory proposal leaked by the Senate Democrats.

1. The Proposal Views DeFi Frontends as Intermediaries

This controversial document was submitted by Senate Banking Committee Democrats to their Republican counterparts, directly targeting regulation in the DeFi space. The core content of the proposal is **to suggest that companies or individuals handling customer demands at the DeFi operational front end register with the *U.S. Securities and Exchange Commission* (SEC) or the Commodity Futures Trading Commission (CFTC) and be regulated as brokers.**

More critically, the proposal adopts an extremely broad definition of who will be considered an intermediary subject to regulation. According to the proposal, any individual or entity that "designs, deploys, controls, or operates DeFi protocols" or "derives substantial benefits from promoting decentralized financial protocols" will be regarded as an intermediary. Jake Chervinsky, Chief Legal Officer at Variant, sharply pointed out that this definitional language seems to include "everyone in the crypto space."

The proposal also plans to grant the Treasury Department and other financial regulatory agencies the power to define when an entity or individual "exercises control or sufficient influence," while the Treasury will also be responsible for determining whether a "protocol is sufficiently decentralized."

2. Industry Concerns that the Proposal Will Stifle Innovation and Freedom

The fundamental reason for Armstrong's opposition is his belief that this proposal "will hinder innovation and prevent the U.S. from becoming the world's crypto capital." As the largest cryptocurrency exchange in the U.S., Coinbase naturally hopes to see the country maintain its leadership in the crypto space. He warned that the crypto industry "will absolutely not accept" the Senate Democrats' DeFi regulatory proposal. This strong statement reflects the industry's deep concerns about the negative impacts the proposal may bring.

Chervinsky pointed out more fundamental issues with the proposal: "It will make everyone in the crypto space an intermediary, forcing front-end providers to implement Know Your Customer (KYC) rules for user applications and giving institutions 'unlimited power of selective regulation.'" More critically, the proposal grants the Treasury excessive discretion. Chervinsky explained: "It allows the Treasury to regulate anyone with 'sufficient influence' over DeFi protocols while also letting the Treasury define 'sufficient influence' at will. It creates a 'restricted list' for protocols and front-ends deemed too dangerous by the Treasury, making it a crime for anyone to use them."

Summer Mersinger, CEO of the Blockchain Association and former CFTC commissioner, criticized the proposal from a compliance perspective, stating that it "would effectively ban decentralized finance, wallet development, and other applications in the U.S." Mersinger further emphasized: "The existing language is unworkable and will push responsible development overseas. We urge our policymakers to continue engaging in discussions."

Even within the Democratic Party, there seems to be a divide over this proposal. Anonymous sources told prominent crypto journalist Eleanor Terret that the leaked proposal was "a starting point for discussion, not a final position," and Democrats were clearly unhappy about the document being made public. Senator Ruben Gallego's communications director, Jacques Petit, likened it to "setting a wedding date before agreeing on the text, like setting a wedding date before a first date. It's absurd."

3. Bipartisan Maneuvering and the Future Direction of the Proposal

This legislation requires bipartisan support in the Senate to meet the usual 60-vote threshold. Although there is a long list of Democratic allies in the crypto work, they have made it clear that they are seeking a series of changes to previous Republican legislative drafts before joining.

The Republican response to this proposal has been strong. Jeff Naft, Republican communications director for the Senate Banking Committee, stated: "What was sent to Republicans is not a legislative proposal; the document was not written in legislative text form and contains several incoherent policy ideas, not a sincere effort at market structure building." Of course, according to anonymous sources, the leaked proposal is "a starting point for discussion, not a final position," and Democrats are unhappy about the document being made public.

The U.S. Senate has been advancing its legislative work, while the House passed its version of the cryptocurrency market structure bill this summer. The Senate Banking Committee's draft aims to allocate jurisdiction between the SEC and CFTC and create a new term for "ancillary assets" to clarify which cryptocurrencies do not fall under securities.

From a broader regulatory perspective, the SEC is also preparing to introduce new rulemaking called "Innovation Exemption," which could significantly reduce the regulatory burden on crypto projects and digital asset developers. This exemption will provide tailored regulatory relief for startups and companies engaged in cutting-edge digital technologies, including blockchain protocols, DeFi, tokenized assets, and other forms of digital innovation.

SEC Chairman Paul Atkins announced the timeline for this initiative, planning to launch the process by the end of 2025 or early 2026. In building a reasonable DeFi regulatory framework, policymakers need to consider the technological characteristics of decentralized finance and find a balance between preventing illegal activities and promoting innovation. Protecting software developers' liability exemptions while regulating participants with actual control may be a more feasible direction.

To advance DeFi regulation, a more balanced and prudent approach is needed. The legislative process itself is an art of compromise, requiring the participation and consensus-building of all stakeholders. Armstrong confidently stated that legislation is a process and pledged to continue fighting for the rights of investors and developers, "protecting economic freedom." He added that Coinbase's leadership "is committed to engaging and helping Congress do the right thing."

4. The Path to Improving Future DeFi Regulation

It is generally believed that building an effective DeFi regulatory system requires balancing risk prevention and industry innovation, following these core paths:

First, establish a regulatory principle centered on activities rather than entities. Abandon attempts to forcibly incorporate decentralized protocols into the traditional intermediary framework, and instead apply corresponding rules based on the functional substance of specific financial activities (such as lending and trading) to achieve precise regulation.

Second, implement risk grading and regulatory sandbox mechanisms. Layer risks based on the degree of decentralization of the protocol, user scale, and systemic importance, applying lenient regulation to low-risk protocols. At the same time, establish regulatory sandboxes to provide a safe testing space for innovative projects.

Third, establish a new regulatory paradigm empowered by technology. Promote the application of regulatory technology (RegTech), utilizing blockchain analysis tools to monitor on-chain activities in real-time, incorporating code audits and smart contract security standards into the regulatory framework to achieve automated compliance verification.

The ultimate goal is to build a multi-stakeholder governance ecosystem that retains necessary space for innovation while maintaining financial stability through clear developer liability exemptions, industry self-regulatory standards, and international regulatory cooperation.

The outcome of this debate will determine the future of innovation in the U.S.: will it transform into the "crypto ban" warned by Chervinsky, or become the catalyst for making the U.S. the "world crypto capital" as called for by Armstrong? In the coming weeks, all eyes will be on the Senate Banking Committee to see if they can make sense of this chaos or if the U.S. will fall further behind in the global race for cryptocurrency regulation.

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