Infrastructure Bill’s Cryptocurrency Measures Risk Pushing Criminals Further Underground

The provision in the bill requires anyone handling cryptocurrency transactions to report gross proceeds to the Internal Revenue Service, along with the names and addresses of the parties. It is intended to capture billions of dollars in tax revenue the IRS says is lost each year and would also give law enforcement and regulators visibility into a market in which bad actors can too easily operate anonymously.

Few dispute the need for disclosure of cryptocurrency transactions as a way to monitor potentially illicit activity. But the bill as written captures corners of the industry not focused on transactions, including everything from miners and stakers to producers of the hardware and software used in crypto markets.

Thus some intelligence and law-enforcement officials are joining industry leaders in warning policy makers against overly aggressive regulations that risk exacerbating national-security hazards.

Overregulation “may push illicit use and criminal actors deeper into anonymizing methods and corners of the internet that would make it more difficult for law enforcement,” said

Jeremy Sheridan,

assistant director of the U.S. Secret Service’s investigations office.

A bipartisan group of senators sympathetic to the warnings of overregulation introduced an amendment exempting tertiary businesses from the disclosure requirements by limiting disclosure requirements to brokers, but the Senate declined to adopt it. The bill is now set to be taken up by the House, and a bipartisan group of representatives called the Blockchain Caucus say they will try to advance the failed amendment. (The blockchain is the technology behind cryptocurrencies.)

A rash of ransomware attacks in which international criminals demand payment in cryptocurrency have thrust oversight of the market into the national spotlight, spurring fears that cryptocurrencies have facilitated the work of terrorists, criminals and other bad actors. That attention, along with a push by other major economies to roll out comprehensive crypto policy frameworks, has spurred a push in the U.S. to rein in the nascent markets.

But regulation has to be calibrated to spur innovation domestically and not push the market’s development out of the country, the current and former security officials warn.

“This is the most urgent national-security issue of our time,” said

Sigal Mandelker,

Treasury’s former undersecretary for terrorism and financial intelligence and now at Ribbit Capital, a venture-capital firm invested in crypto.

“The U.S. has to make a decision if it wants to be a center of…transformational technology that can bring many more people into the financial ecosystem,” Ms. Mandelker said. If regulations push innovation out of the country, she said, within five years, “the U.S. will really get left behind, and that is the threat here.”

The cryptocurrency market is evolving at such a pace that authorities say they are having difficulty using existing laws—many written decades ago—to protect against fraud, money laundering and other illicit activities. Security officials and law enforcement rely on the ability to monitor transactions through banks, central banks and other regulated institutions. Because cryptocurrency transactions happen outside such institutions and aren’t subject to the same reporting requirements, they don’t have the same visibility.

But poorly calibrated regulations or overly aggressive oversight not only risks flight to other crypto markets but also threatens a critical U.S. national-security advantage: the dollar’s dominance as the world’s reserve currency, some officials and industry figures say.

The U.S. leverages unprecedented power through the dollar with sanctions that cut off access to the world’s biggest economy. The more industry moves overseas and nations such as China create alternative financial systems outside of U.S. reach, industry and security officials warn Washington risks losing that power.

“Jurisdictional arbitrage is a real vulnerability,” said

Ari Redbord,

a former senior national-security official at the Treasury Department who is now at a company that analyzes crypto transactions across platforms.

The proposal in the infrastructure bill epitomizes those collective worries, many industry leaders and former security officials say. As written, the IRS reporting requirement could hit crypto businesses that don’t deal with customers, said Mr. Redbord.

Criticism of the proposal doesn’t mean national-security officials and industry leaders don’t see the need for regulation. Rather, said Ms. Mandelker, “We’re going to have to move swiftly, but we also have to act very, very smartly.”

Traditional finance largely relies on mediators such as banks to manage trillions of dollars in transactions every year. By requiring those financial intermediaries to know their customers and report suspicious transactions, and through extensive disclosures from the securities industry, the government has visibility into markets. Crypto markets haven’t been subject to the same requirements.

“We have a pretty strong regulatory framework around bank deposits, for example, or money-market funds,” Federal Reserve chief

Jerome Powell

told lawmakers last month. For cryptocurrencies, he said, “That doesn’t really exist.”

Stephanie Dobitsch,

deputy undersecretary of the Office of Intelligence and Analysis at the Department of Homeland Security, and other senior officials have called for a comprehensive regulatory framework and new statutory authorities that would mandate similar requirements for cryptocurrency firms.

More regulation—and greater clarity about how existing rules apply—is needed to address the security vulnerabilities that come with an unregulated, mostly anonymous financial ecosystem, those people say.

“We have significant information and intelligence gaps about where that money is going and how it’s ultimately used,” said Ms. Dobitsch.

The Treasury Department has issued new guidance in recent years to that end, enabling the Secret Service, the Federal Bureau of Investigation and the IRS to bust international child-pornography rings, freeze terrorist accounts and disrupt financing for North Korea’s nuclear-weapons programs.

Officials estimate they seized $2 billion in cryptocurrencies from terrorists and money launderers last year.

But illicit actors have taken advantage of the gaps in the regulation to stay anonymous, including by migrating to platforms offering direct transfers between parties, moving transactions overseas, and using cryptocurrency shell companies.

Security officials say the administration also must step up diplomatic efforts to build out a global framework for oversight.

The Treasury Department has in recent years outlined international standards through the global anti-money-laundering and terror-finance watchdog, the Financial Action Task Force. But the FATF doesn’t have the power to force governments into compliance, and some former U.S. security officials are concerned that new proposals by the watchdog also overreach.

The issue must be championed as a diplomatic priority and through leadership summits, the former security officials said.

“We have to have a much bigger view of what our long-term objectives are and how we’re going to achieve them,” said Ms. Mandelker.

Write to Ian Talley at ian.talley@wsj.com