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There is a new and complex innovation paradox confounding America’s financial regulatory system.

Decentralized distributed ledgers and digital assets have disrupted traditional financial services, broadening access to capital and creating new market opportunities and efficiencies. In the same way that the internet transformed many components of our daily lives, these evolving technologies are transforming financial systems to the benefit of mainstream investors, Main Street businesses, and American consumers alike.

But while digital assets present so much possibility, their technological backbone is complex and many potential applications are still being realized. This places policymakers in a difficult position as they seek to ensure sound technological development. Overburdensome or poorly tailored regulation can stifle future innovation or push development offshore. A complete lack of regulation threatens to undermine the prudent regulatory frameworks developed over the decades of oversight of traditional financial markets.

This is the innovation paradox the American financial system currently faces.

Recently, in an effort to find ways to pay for the bipartisan infrastructure bill, a handful of U.S. senators reportedly in conjunction with President Biden’s Treasury Department quietly drafted and introduced a provision that would vastly broaden the definition of broker and also define digital assets as securities for the purposes of taxation—sweeping definitional changes uprooting years of legal precedent for the sake of funding an infrastructure bill. Although the revenue calculation was never publicly released, the bill claimed that these reporting requirements would generate $28 billion to offset the $1 trillion infrastructure package. 

Drafted outside of the committee process and without stakeholder input, the basic premise of the provision failed to recognize the technological concepts foundational to digital assets and distributed ledgers. To enforce these provisions, the tax language may even include fines or prison time for those who fail to fully comply with the reporting requirements. As a result, the proposed reporting standards were found to be unworkable for nascent industries like decentralized finance (DeFi), wallet providers, and digital asset mining. These provisions are bound to send DeFi and mining related companies, technologies, and jobs overseas. To compound these issues, the Treasury Department reportedly privately relayed that it believed it already had these authorities to tax and require reporting, but was simply trying to avoid litigation and a more open-ended public comment period. 

Unfortunately, that provision was successfully tucked into the 2,702-page Infrastructure Investments and Jobs Act, which passed the Senate earlier this month.

As it stands today, a tiny provision – drafted without public input – in a trillion-dollar piece of legislation has the future of U.S. digital asset policymaking hanging in the balance. It also sets a dangerous precedent on multiple fronts—extending broker status to those who are not brokers and securities status to assets that are not securities—all through a broken process. If enacted, it would represent the first time a federal law has defined digital assets as securities, potentially opening the door for financial market regulators, such as the SEC, to expand its jurisdiction over the growing industry.

While this deeply flawed tax language was a surprise to industry stakeholders, the drafted amendment was apparently floating around for months—making for the second policy-related five-alarm fire drill for digital asset stakeholders in the past year after Treasury and FinCEN pursued a last-minute rulemaking process on unhosted wallets in January before the administration change. 

Over the past weeks, grassroots efforts to stop the Senate from proceeding with this provision were nothing short of spectacular – a testament to the democratizing power of the technology itself and to those working in the field. Senators Lummis, Toomey, Portman, Sinema, Warner with significant help from Wyden, and the Biden Administration worked together to find a compromise that would fix some of the damaging aspects.

Fortunately, the upcoming budget reconciliation process is an opportunity for that bipartisan agreement to be adopted. And even if that effort fails and the current provision becomes law, Treasury and the IRS will have to conduct a fair and transparent, although more limited, rulemaking period, giving digital asset market participants an opportunity to provide meaningful input and inform the regulatory process.

But as an industry, digital assets must step up and better integrate into the public policy process and engage in a proactive, thoughtful, and trustworthy manner. As digital assets markets continue to grow, they will only attract more attention and tighter scrutiny from Washington. It is essential that the industry prioritizes positive engagement with lawmakers and regulators for the sake of furthering institutional adoption, fostering market integrity, and forging positive regulatory relationships. The status quo is not working for the industry or policymakers and is not a sustainable path forward. It’s time to work together – collaboratively, constructively, and professionally.

A University of Chicago study released this month that 13 percent of Americans traded in digital assets in the past 12 months. By comparison, 24 percent of Americans invested in stocks over the same time period. Investors in these digital assets tended to be younger, and more diverse in terms of gender, race, and ethnicity, relative to retail stock investors. At the same time, a spirited debate on the technology is occurring on Capitol Hill.

The sector’s growth and potential are undeniable. That is why we are seeing positive and negative reactions to the technology. The impetus is thus on the industry to start to organize in a sophisticated and thoughtful way and demonstrate the true potential of the technology and attempt to solve the regulatory innovation paradox. The future of finance in the United States and the global competitiveness of our financial services industry depend on it.

Michelle Bond is the CEO of the Association for Digital Asset Markets, which works to foster fair and orderly digital asset markets where participants can transact with confidence.

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