Why is the US Senate Democratic DeFi regulatory proposal being resisted?

Author: Zhang Feng

A proposal from the U.S. Senate Democrats titled "Preventing Illicit Financing and Regulatory Arbitrage through Decentralized Financial Platforms" has unexpectedly triggered a crisis in the bipartisan cryptocurrency market structure bill.

Coinbase CEO Brian Armstrong bluntly stated on social media X that the entire crypto industry would oppose it, revealing the general attitude of the U.S. crypto industry towards the DeFi regulatory proposals recently circulated by Senate Democrats.

1. The proposal treats DeFi front-ends as intermediaries

This controversial document was submitted by Democrats on the Senate Banking Committee to Republicans on the committee, targeting the regulation of the DeFi field. The core content of the proposal is to recommend that companies or individuals that handle the front-end customer needs of DeFi operations be registered with the U.S. Securities and Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC) and be regulated as brokers. More crucially, the proposal adopts an extremely broad definition of who would be considered an intermediary and subject to regulation. According to the proposal, any individual or entity that "designs, deploys, controls, or operates the front-end services for DeFi protocols" or "derives substantial benefits from facilitating decentralized financial protocols" would be considered an intermediary. Variant Chief Legal Officer Jake Chervinsky pointedly pointed out that this definition appears to include "everyone in the crypto space." The proposal also plans to grant the Treasury Department and other financial regulators the power to define when an entity or individual "exercises control or sufficient influence," and the Treasury Department will also be responsible for determining whether a "protocol is sufficiently decentralized."

Second, the industry is concerned that the proposal will stifle innovation and freedom

The fundamental reason for Armstrong's opposition is that he believes the proposal "will hinder innovation and prevent the United States from becoming the world's crypto capital." As the largest cryptocurrency exchange in the United States, Coinbase naturally hopes to see the United States maintain its leadership in the crypto field. He warned that the crypto industry "absolutely will not accept" the Senate Democrats' DeFi regulatory proposal. This tough statement reflects the industry's deep concern about the potential negative impact of the proposal. Chervinsky pointed out more fundamental problems with the proposal: "It would make everyone in the crypto space an intermediary, force front-end providers to apply Know Your Customer (KYC) rules to users, and give institutions 'unlimited power to selectively regulate.'" More critically, the proposal grants the Treasury Department excessive discretion. Chervinsky explained: "It allows the Treasury to regulate anyone with 'sufficient influence' on DeFi protocols, while also allowing the Treasury to arbitrarily define 'sufficient influence'. It creates a 'restricted list' of protocols and front-ends that the Treasury deems too risky, and then makes it a crime for anyone to use them." Summer Mersinger, CEO of the Blockchain Association and former CFTC Commissioner, criticized it from a compliance perspective, pointing out that the proposal "would effectively ban decentralized finance, wallet development, and other applications in the United States." Merzinger further emphasized: "As written, the current language is unadherable and will push responsible development overseas. We urge our policymakers to continue to engage in the discussion." Even within the Democratic Party, there seems to be disagreement over the proposal. Anonymous sources told well-known crypto journalist Eleanor Terret that the leaked proposal is "a starting point for discussion, not a final position," and Democrats are clearly unhappy with the document being made public. Jacques Petit, communications director for Senator Ruben Gallego, said: "They are asking for a marking date before the text is agreed upon, which is like setting a wedding date before the first date. It's ridiculous."

III. Bipartisan Game and Future Direction of the Proposal

This legislation needs to rely on bipartisan support in the Senate to meet the usual 60-vote requirement. Although the encryption work has a long list of Democratic allies, they have made it clear that they are seeking a series of changes to the previous Republican legislative draft before joining.

The Republicans reacted strongly to this proposal. Jeff Naft, Republican communications director for the Senate Banking Committee, stated, "The document sent to Republicans is not a legislative proposal; it's not written in legislative form, contains multiple incoherent policy ideas, and is not a sincere effort to improve market structure." Of course, according to anonymous sources, the leaked proposal is "a starting point for discussion, not a final position," and Democrats are unhappy with the document's release. The U.S. Senate has been advancing its own legislative work, while the House of Representatives passed its version of the Cryptocurrency Market Structure Act this summer. The Senate Banking Committee's draft aims to divide jurisdiction between the SEC and CFTC and create a new term for "ancillary assets" to clarify which cryptocurrencies are not securities. Looking at the broader regulatory landscape, the U.S. Securities and Exchange Commission (SEC) is also preparing new rulemaking, known as the "Innovation Exception," which could significantly reduce the regulatory burden on crypto projects and digital asset developers. This exception will provide tailored regulatory relief to startups and companies working on 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 in late 2025 or early 2026. When constructing a reasonable DeFi regulatory framework, policymakers need to consider the technical characteristics of decentralized finance and strike a balance between preventing illegal activity and promoting innovation. Protecting software developers' liability immunitywhile regulating participants with actual control may be a more feasible direction.

To move DeFi regulation forward, a more balanced and sensible approach is needed. The legislative process itself is an art of compromise that requires the participation and consensus building of all stakeholders. Armstrong affirmed that legislation is a process and pledged to continue fighting for the rights of investors and developers and "protecting economic freedom." He added that Coinbase leadership is "committed to participating and helping Congress do the right thing."

Fourth, Future Paths for Improving DeFi Regulation

It is generally believed that building an effective DeFi regulatory system requires balancing risk prevention and control with industry innovation, and should follow the following core paths:

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

Second, implement a risk grading and regulatory sandbox mechanism. Risk stratification will be conducted based on the protocol's degree of decentralization, user base, and systemic importance, with relaxed regulation applied to low-risk protocols. At the same time, a regulatory sandbox will be established to provide a safe testing space for innovative projects. Third, a new regulatory paradigm empowered by technology will be established. The application of regulatory technology (RegTech) will be promoted, utilizing blockchain analysis tools to monitor on-chain activity in real time. Code audits and smart contract security standards will be incorporated into the regulatory framework to achieve automated compliance verification. The ultimate goal is to build a multi-stakeholder governance ecosystem. Through clear developer liability exemptions, industry self-regulatory standards, and international regulatory collaboration, this will preserve the necessary space for innovation while maintaining financial stability. The outcome of this debate will determine the future of innovation in the United States: whether it will lead to the "cryptocurrency ban" that Chervinsky warned against, or become the catalyst for making the United States the "crypto capital of the world," as Armstrong called for. In the coming weeks, all eyes will be on the Senate Banking Committee to see whether they can make sense of this mess or leave the United States further behind in the global race to regulate cryptocurrencies.