Commoditization of Virtual Currencies

An entry on Daniel Terdiman's CNET News blog reports that Brock Pierce, the head of IGE, the leading marketer of virtual goods and currency, feels that virtual currencies are increasingly a commodity product. As a result, profit margins are shrinking as gamers discriminate among suppliers by price alone. It sounds like much of the commoditization push comes from China:

In fact, [Pierce] said, as Chinese competitors get more and more sophisticated, they are also willing to accept less and less profit margin. And that means, "they're perfectly happy to accept $20,000 in profit on $2 million of revenue."

Perhaps because of this economic shift, Pierce himself is planning to leave IGE.

From a purely economic point of view, there is no reason to find this development surprising. A quantity of Everquest platinum sold by IGE is identical in all respects to the same quantity sold by another vendor. The only difference, perhaps, is the reputation of the vendor: a small no-name outfit is more likely to be scam rip-off than a large well-established business.

The real question moving forward (as Terdiman notes) is how the game operators react to the increasingly off-shore nature of the secondary markets. It's much harder to threaten a firm in China with legal action than a firm in the U.S. So how do they respond to users of their virtual worlds, when such ventures are willing to accept 1% gross profit margins? Do game operators prefer the U.S.-/European-based gold farmer to the Chinese/Vietnamese/etc gold farmer? More generally, at what point does a game operator decide demand for currency is too pervasive and they are letting the gold farmer take money out of their pocket? At which point does it make sense, either from a profit or a control perspective, to simply create their own regulated market, much like SOE did with Station.com?

The Courts Weigh In

In what could have very significant implications for virtual worlds, there was an important ruling last week on the enforceability of the contracts governing virtual world usage. Last year, Second Life user Mark Bragg sued Linden Lab over the cancellation of his Second Life account. Linden Lab argued that Bragg had violated the terms of service (TOS) agreement for Second Life. Linden Lab charged that Bragg had found a way to buy land in Second Life at below market prices and so terminated his account. Unfortunately for Bragg, he lost the thousands of dollars of land he had purchased.

The Pennsylvania court entertaining Bragg's lawsuit ruled on May 30 that Linden Lab's TOS was not enforceable, according to a Reuters story. The 46-page ruling is available as a PDF here. Specifically, the court found the requirement of arbitration for dispute resolution to be unreasonable:

In effect, the TOS provide Linden with a variety of one-sided remedies to resolve disputes, while forcing its customers to arbitrate any disputes with Linden. This is precisely what occurred here. When a dispute arose, Linden exercised its option to use self-help by freezing Bragg’s account, retaining funds that Linden alone determined were subject to dispute, and then telling Bragg that he could resolve the dispute by initiating a costly arbitration process. The TOS expressly authorized Linden to engage in such unilateral conduct. [p.34]

The court summarized its opinion thusly:

Taken together, the lack of mutuality, the costs of arbitration, the forum selection clause, and the confidentiality provision that Linden unilaterally imposes through the TOS demonstrate that the arbitration clause is not designed to provide Second Life participants an effective means of resolving disputes with Linden. Rather, it is a one-sided means which tilts unfairly, in almost all situations, in Linden’s favor. [p.41]

And concluded:

Finding that the arbitration clause is procedurally and substantively unconscionable, the Court will refuse to enforce it. [p.42]

I expect this ruling has enormous implications for virtual worlds. As the first judicial ruling on the enforceability of TOSs (or alternatively, EULAs), all future suits will likely turn to this one for precedence.

Virtual China

Entropia Universe scored a big win yesterday, announcing that it had been selected by China to build a cash-based virtual world for that nation, according to an AFP story. The agreement with China's Cyber Recreation Development Corp. (CRD) apparently took a year to negotiate.

Here are some of the newsworthy facts to emerge so far:

• CRD estimates that this new virtual world (or worlds) will create 10,000 real-world jobs in China.
• Up to 7 million people will be able to access the virtual world simultaneously. (This compares to a typical level of around 40,000 concurrent users today in Second Life.)
• The goal is to sign up 150 million residents globally.
• The virtual economy will generate $1 billion in commerce annually.
• One goal is reduce pollution levels by allowing increased telecommuting in the virtual world.
• The go-live date is September 2008.

This is definitely one development to follow. I suspect that China is doing this in part to better monitor and control what happens in virtual worlds.

Also, I am skeptical about whether a government entity like the CRD can compete with privately-run virtual worlds in terms of adopting the latest technologies and responding to user demands. Virtual worlds are already moving so fast that it's difficult for bureaucracies to keep up.

UPDATE: A story on BusinessWeek.com notes that "virtual police will exist in the Chinese game, and that it won't allow players to protest the 1989 Tiananmen Square crackdown, which killed hundreds of people."

Virtual Terrorism in Second Life

Last night cyber-attackers set off some sort of bomb on the ABC island in Second Life. As the before and after pictures show (hat tip: Kotaku), the bomb utterly nuked the place. While the island was restored within a few hours, ABC did spend tens of thousands of dollars to create the island in the first place, according to News.com.au.

If we place this event in the larger context of virtual worlds (as I am wont to do), this cyber-attack raises the issue of virtual property. What was the damage to ABC? It would seem that ABC simply lost any revenue it might have earned from the island during the downtime. But other questions intrude. What if it wasn't vandals, but an electrical problem with one of Linden Lab's server farms? Would Linden Lab be on the hook for damages? (I suspect there is something in the Linden Lab EULA/TOS that is on point.) Alternatively, what if the real benefit of ABC Island is not a revenue stream, but community relations and branding? How does one place a value (to ABC) on users being unable to download video or interact with others on the island? Indeed, it has been suggested that the main benefit for big corporations is not sales but customer relationships, branding, or gathering market data.

ABC Island is the 3rd most visited commercial site in Second Life, BTW.

Virtual Money, Real Pizza

A recent news story reports that Second Life residents will soon be able to order -- from within SL -- real pizza for delivery to their home. (This ability was once available for players of Everquest, but has been discontinued.) More importantly, residents can pay for the pizza with Linden dollars.

Now, in and of itself, this is not a major development that will dramatically change the nature of virtual worlds. Nonetheless, this service does cross a meaningful line that opens the door for much more complex treatment of virtual worlds: using virtual currency for the purchase of real goods or services.

Suppose I have a Second Life business that generates Linden dollar income for me. Suppose also that I cash out all my profit into US$, and dutifully report that income on my tax return. Now, however, if I spend $20 on this virtual pizza service, does that $20 escape tax-free because it never gets converted to US$. In the real world, with a traditional salary, I could also spend $20, but that $20 is still reported as part of my AGI. (Obviously, the tax on $20 is pretty trivial, but the underlying principle is what’s important. What if I buy a car with Linden dollars?)

What is the proper tax treatment of real-world purchases using virtual currency? Should I report $20 as ordinary income? As barter income? If I do, that could raise my compliance costs since I have to file Schedule C. What about horizontal equity – the tax treatment of individuals in similar economic circumstances? If I don’t report the $20, but my buddy who spends $20 on pizza using salary income does, then I will end up paying less in taxes, even if he and I make exactly the same amount of income.

Cross-Platform Transfers

Now this is interesting: a new venture will soon be offering cross-platform transfers, as in transfers between two different virtual worlds. Reuters reports that Anshe Chung Studios will offer the ability to transfer virtual money from Second Life to Entropia Universe, and vice verse. Now this project still won’t directly offer users the ability to trade virtual currencies for dollars (or other real currencies), but both Second Life and Entropia already allow dollar-to-virtual currency exchanges. Thus, someone could take Linden dollars, transfer them to Entropia PEDs, and then convert the PEDs to U.S. dollars. In fact, Anshe Chung Studios is itself planning to issue an ATM card which would allow Entropia residents to withdraw cash. Reuters posted a correction noting the ACS is not planning to offer ATM cards. However, MindArk, the parent firm of Entropia, is planning to issue such an ATM card.

Why is this interesting? Well, first, as the Reuter story correctly notes, this opens up a wide world of arbitrage opportunities. The Linden dollar is set to a floating exchange rate with the U.S. dollar, while the Entropia PED has a fixed exchange rate (10 PEDs = US$1).

Second, this development is another indicator of how fast these virtual worlds are moving. Before most governments are even aware of the economic value created in virtual worlds or their tax implications, innovators are pushing the envelope to introduce new financial mechanisms.

Third, such cross-platform transfers would seem to make tracking money transfers much harder to do. If funds can freely move in to, out of, and between virtual worlds, it would seem to make the job of tracking down cybercrime like money laundering more difficult. Fortunately, Chung’s Dreamland website, which allows individuals to buy and sell Linden dollars, seems aware of potential problems and offers this limit on the purchase of Linden dollars: “We currently do not execute orders above 300 US$ / 250 EUR per customer per week!”

Fourth, this venture underscores the international nature of the business of virtual worlds. Anshe Chung Studios is based in Wuhan, China, while Entropia is based in Sweden and Second Life operates out of California. Anshe Chung, who along with her husband is the woman behind Anshe Chung Studios, lives in Germany. Given such diverse geographical bases, it begs the question of which nation's (or nations') laws apply and how to enforce them.

Where to next?

U.K. Report on Financial Crimes in Virtual Worlds

A new report from a British group has concluded that there is a growing risk of financial crimes in virtual worlds, according to Reuters. The panel also recommends that governments treat transactions on MMO websites "as genuine financial instruments covered by existing laws and regulations." The report specifically discusses the potential problems with credit card fraud, database vulnerabilities, money laundering, tax evasion, and international currency transfers. The report comes from the Fraud Advisory Panel of Institute of Chartered Accountants in England & Wales.

Unfortunately, the report does not appear online, but you can check out the press release.

For my own part, it should not surprise anyone that the threat of cybercrime is legitimate. Any time there is a new medium of economic exchange, it is unavoidable that cybercrime will surface. That fact, however, should not stop efforts to prevent such crimes from taking place.

Interestingly, the press release did not appear to call for any new laws or penalties, merely the application of existing ones to the virtual world space.