Tuesday, December 05, 2006

Virtual Currency and its Importance in the Real World

My friend and fellow blogger Mr. Locoweed has a post about the taxation of virtual currency. Lately I have been giving virtual currency some thought and his post drove me to put my thoughts down.

Virtual currency such as World of Warcraft Gold or Linden Dollars from Second Life was created to enable trade in its respective virtual world. Each virtual currency was irrelevant to the outside world until the moment that players started to trade it outside of the system. At that instance, the virtual currency was valuated against some real currency and an exchange rate was set.

Today there are exchange rates being kept for most of these currencies, and some such as the Linden Dollar even have dedicates exchanges running online. The volume on one such exchange reached in excess of USD 100,000 for certain days in December. While that's not monumental, it is certainly significant.

What are people buying when they buy a virtual currency? This is the scary part. When you buy Linden Dollars, you are essentially giving your money to Linden Labs and buying a currency that is not backed by any bank, it is not backed by any tangible assets, and in essence it is not much different than monopoly money. If Linden Labs went under tomorrow, I suspect all those Linden Dollars would be worthless. And yet it doesn't feel like that. It feels like there is some real value there.

I think it will help to think of Linden Labs as an independent country that has a certain currency, and the stability of that currency depends on the government of that country. This means that Linden Labs has in essence created an economy governed by a corporation.

If Linden Dollars are starting to look and act like real money, what can you do with them and what's coming? As Mr Locoweed mentioned, governments are seeing the value being created in these virtual environments as their real currencies are being sold for virtual ones. They are afraid that people are going to be spending (and making) more and more of their disposable income in these environments and they are afraid of losing their slice. After all, there are many things that people already buy online - so why not move it into the virtual world where you can buy it tax free. An mp3 store would work just fine. Thus taxation is an issue that has recently started getting some attention. It will be interesting to see the various schemes tried by various governments, and the reactions from users. I can imagine people who make their living in Second Life moving to countries with better taxation laws. As long as they have an internet connection those people will be able to live anywhere. This is not some far away future by the way. There has already been a USD millionaire from earnings in Second Life.

Another thing that I believe will become much more prominent in the near future will be banking in the virtual worlds. There are already banks in World of Warcraft and Second Life, but these don't offer financial services as we think of them. There is some lending in Second Life but it is at a very high interest rate and from a 'Bank' that is not controlled in any sense. It has been described as banking in the wild west. Wells Fargo has already made a venture into Second Life, although only to promote their brand and educate their customers. I think it will not be long before a bank from the real world decides it is worth their while to set up shop in Second Life. Real estate is a big deal in Second Life and it would only seem natural that real banks realize there is a money lending market in the virtual world. It will be interesting to see what position Linden Labs takes in this since they are essentially the central bank of that virtual world.

As with any new financial instrument, there will be opportunities for criminal activities of all sorts. Surely there will be plenty of scams , cons and other conventional crimes happening within these virtual worlds. This is not what I am talking about however. Since the Linden Dollar is something that one can buy and sell with real currency, it offers a means to transfer value from the real world to the virtual world and back. Money launderers will surely be some of the first to exploit this system. Moving money from one country to another via banks leaves a paper trail. A money Launderer can use Second Life as a tunnel to send money anywhere they choose. Sometimes it is very difficult to send money via the banking system. Think of 'terror harboring countries' moving money to the US. Again, Second life can potentially be used to tunnel money around such a barrier. Bribes are another thing that can be done nicely using virtual currencies.

I expect that I have not even scratched the surface of how virtual worlds and their economies will influence our lives in the next few years. I wonder how long before I am working for a virtual client.

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