As the cryptocurrency universe expands, with innovative offerings and thousands of new users each week, the U.S. regulatory response has been slow and uneven.

In certain areas, U.S. regulators have successfully applied traditional models. The Securities and Exchange Commission treats those who issue new speculative cryptocurrencies like issuers of securities. The Treasury Department’s anti-money-laundering office, the Financial Crimes Enforcement Network, regulates firms that transfer or exchange cryptocurrencies as money-service...

A bitcoin ATM in New York, Feb. 9.

Photo: justin lane/Shutterstock

As the cryptocurrency universe expands, with innovative offerings and thousands of new users each week, the U.S. regulatory response has been slow and uneven.

In certain areas, U.S. regulators have successfully applied traditional models. The Securities and Exchange Commission treats those who issue new speculative cryptocurrencies like issuers of securities. The Treasury Department’s anti-money-laundering office, the Financial Crimes Enforcement Network, regulates firms that transfer or exchange cryptocurrencies as money-service businesses—like Western Union —with the accompanying responsibility of knowing their customers and monitoring for suspicious activity.

But huge swaths of the crypto universe, such as the decentralized finance, or DeFi, sector, have been left ungoverned, creating risks to consumers and national security. Some DeFi products promise 8% to 12% returns to customers, who have no legal recourse if their money disappears. Users can set up multiple “unhosted” wallets anonymously and move millions of dollars across borders with no one guarding against transfers to terrorist groups or countries that are subject to sanctions.

For years regulators underestimated these risks, viewing cryptocurrencies as a niche pursuit for cyber enthusiasts, speculators and libertarians. No more. Between 20 million and 46 million Americans hold cryptocurrencies. The total market capitalization for cryptocurrencies is around $2 trillion, exceeding the global supply of Japan’s yen and on track to eclipse the British pound. In the past year investments in DeFi projects, which allow the borrowing of money and trading of currencies without intermediaries, has grown by 6,000%, with as much as $100 billion currently held in them.

Regulators are now wide awake. In July, Treasury Secretary Janet Yellen convened the President’s Working Group on Financial Markets to study stablecoins—a type of cryptocurrency that seeks to peg its value to fiat currencies like the dollar—to address risks related to market stability, consumer protection and money laundering. In Congress, legislation has been introduced to ensure comprehensive regulation of cryptocurrencies. And the Financial Action Task Force, the international standard-setting body on combating money laundering, issued draft guidance this spring calling on all countries to regulate unhosted wallets, including by holding accountable those who control and profit from these applications. Cryptocurrencies now top the agenda of finance ministers and central-bank governors around the world.

Americans should welcome the regulators imposing safeguards. From my career advancing U.S. sanctions and anti-money-laundering goals, I know that one of the best ways to track bad actors is to follow the money. Unhosted wallets coupled with tools designed to mask the movement of funds on the blockchain threaten the ability of law enforcement to trace criminal and terrorist financing.

At the same time, the government must avoid overregulation. Cryptocurrencies offer promising new ways of moving funds and delivering financial services. My law firm helped the Venezuelan National Assembly, led by Interim President Juan Guaidó (recognized as the legitimate Venezuelan government by the U.S. and 60 other governments), to deliver direct payments in cryptocurrency to more than 60,000 health workers fighting Covid in Venezuela, circumventing the Maduro regime’s stranglehold on the country’s banking system. Cryptocurrencies could also bring down the costs of cross-border remittances, the more than $500 billion sent home each year by migrants, some of whom pay as much as 10% in fees per transfer.

It is imperative, then, that regulators get this right. With DeFi in particular, where individuals invest and exchange money via algorithms and smart contracts rather than intermediaries, older regulatory models may not work.

The best outcome will emerge from collaboration between regulators and the crypto industry. Regulators will need private-sector expertise to help map a rapidly evolving landscape and avoid unintentional damage. And cryptocurrency companies would benefit from involvement in the rulemaking process and being able to test a range of compliance approaches under a regulatory safe harbor.

Such public-private collaboration won’t be easy. Regulators generally prefer to do their work behind closed doors. And many crypto developers and investors were drawn to this space precisely to escape government regulation. For them, a regulated DeFi environment is an oxymoron, and the best approach is resistance. But regulation is coming. Western governments will not simply ignore the $100 billion DeFi sector, which carries such serious ramifications for consumers, market stability and national security.

Nor will Western regulators be cowed by the argument that regulation will push the sector offshore. A tremendous amount of the investment, innovation, and user base of DeFi applications is in the West. Western regulators have leverage to restrict the participation of their companies and citizens in unlawful offshore platforms. Further, China and other authoritarian governments are also threatened by platforms that allow for anonymous financial transactions, if for reasons other than ours. The Financial Action Task Force’s statements suggest that the world’s largest economies agree on the need to regulate the DeFi space.

Some in the crypto community understand the inevitability of regulation and are working on solutions. Innovators are developing cryptographic tools under which access to a DeFi application could be limited to users whose identity has been vetted by a reliable third party, enabling certain anti-money-laundering safeguards in an ecosystem without custodians. More such innovative thinking will be needed.

But for companies that want to have a hand in influencing the outcome, now is the time to engage with the government. Public-private collaboration provides the best hope to craft regulation that preserves the promise of DeFi without upending safeguards that protect us all.

Mr. Szubin is of counsel at Sullivan & Cromwell. He served as acting Treasury undersecretary for terrorism and financial intelligence (2015-17) and director of Treasury’s Office of Foreign Assets Control (2006-15).

A Biden plan to monitor cash in and out of bank accounts. Photo: EPA/Shutterstock The Wall Street Journal Interactive Edition