This image was lost some time after publication.
This image was lost some time after publication.

Linden Lab's virtual world — a much-hyped online amusement arcade of cartoon porn, avatars of IBM executives and frog bands — has an annual GDP of about $220m, according to Fortune Magazine's David Kirkpatrick. That's only the size of the economy of Guinea-Bissau, one of the world's poorest countries, but pretty impressive for a virtual economy, no? No. Many transactions within Linden Lab's environment are circular, more akin to stockmarket volume rather than GDP. One would have to take the Benchmark-backed economic ecosystem more seriously if some of the online sexchat workers and other Second Life entrepreneurs could show that their accumulated virtual earnings could truly be converted into real currency. But, as this financial consultant explains, anonymously, withdrawing money from the Benchmark-backed vitual world is about as hard as cashing out of a pyramid scheme.

In 2005 I began working as a venture consultant for some entrepreneurs and investors regarding some fairly ambitious "RMT" ideas. My work resulted in my collection of a large amount of RMT market data for most of the popular MMO/VW games. Although the new venture was never pursued (largely due to my analysis of the true RMT market), one game stuck out as an aberration: Second Life. Unlike most other games, the operators of Second Life not only allowed and encouraged exchange of game currency for real money, but they facilitated it. In fact, even in 2005 I began noticing a rumbling from the interest-focused blogs about the exploding market that was Second Life, complete with in-game banks, multiple currency exchanges, a floating currency exchange rate, and a burgeoning in-game commerce/business base.

In other words, fertile ground for investment and arbitrage.

I didn't expect Second Life to be the NASDAQ. To the contrary, I was counting on the fact that Second Life was a rapidly developing, yet still immature marketplace rife with information asymmetry and mispricing of all kinds of stuff.

One good example of a fairly obvious arbitrage opportunity found around mid July 2006 involved interest-rates paid to depositors at in-game banks versus lending rates, compared to the prevailing exchange rates between the SLL (the generally utilized abbreviation for the Linden dollar, the "currency unit" for virtual world transactions) and the US Dollar, or USD. In this case, interest-rate-parity revealed that two in-game banks were mispricing rates implying a 2,786.32% return per USD invested.

As I discussed this type of stuff with a self-fashioned hedge fund manager friend, he determined to sink a more sizable amount into testing the Second Life market. After all, talk about uncorrelated returns. He'd read about Second Life in increasingly more sophisticated business and financial press. The Economist, The Financial Times, etc. All of which touted the large and exponentially growing size of the SL "economy". So a mere $10,000 USD shouldn't be but a drop in the bucket, given the fact SL was supposedly producing virtual millionaires.

Once we started playing with real money in SL, however, the truth about the supposed economy therein quickly came to light:

• You can earn a lot of Linden dollars in SL, in fact fairly rapidly sometimes, but...

• If you can actually collect your SLLs from your counterparty - which turns out to be an enormous problem - you can't cash them out for USD easily or profitably.

It turns out that inside the game, counterparty risk is tremendous. In fact, entire banks will suddenly disappear. Or banks will simply renege on obligations without recourse. Worse yet, the very people who provide the source of nearly all demand-liquidity within Second Life, those guys at the top of the virtual playpen pyramid, are the same ones who effectively set the SLL/USD exchange rate. Mid-2006, they even owned the only practical exchange market, a fact which I believe is even more true today. (The company run exchange turns out to be impractical for real trades of any volume. It is more of an open currency auction than a spot market.)

What should have been a relatively small SLL/USD exchange trades given media claims about millions of dollars flying around per week in 2006, in reality caused the exchange markets to distort tremendously. We could not effectively move sums of more than a couple thousand dollars out of SL without the exchange market confiscating most of our returns (through rate reflectivity). Example: in July 2006 USD/SLL was 293.0/279.2 bid/ask on the primary open exchange. Our attempts to trade resulted in settlement bids of more than 350. Interestingly, these trades tended to net returns of right around 4%, which was the prevailing dollar deposit rate.

This didn't make sense. After all, the liquidity supposedly existed to support these simple, smallish trades. Well, when the guys running the banks and the exchange trading floor are the guys with most of the SLLs, it's no surprise that outsiders are not permitted to extract any significant returns.

We concluded that we weren't playing in a market at all. We were suckered in by a classic pyramid scheme, albeit one with a pretty new user interface. New entrants plow real money into the game. Only the guys at the top can extract that money with any volume (and in excess of the risk-free rate of return). Attempts to move anything more than token amounts out of the game generally result in real-returns of almost exactly the prevailing USD deposit interest rate.

It is my conjecture that the perpetrators of this scheme are themselves utilizing the mispricing of USD to SLL vis-à-vis in game rates (whether implied rates or explicit rates) to arbitrage everyone else. Or in other words: a financial ponzi scheme. Each new sucker is encouraged to bring in more new suckers, supposedly helping the economy to grow so that they can start cashing those SLL checks. And if you're really successful and even more lucky, you'll get about 4% real return for all that effort and risk.

So given that:

• One cannot profit at greater than the risk-free rate of return for investments into Second Life;

• "Virtual labor" performed by the denizens of the game on their various Second Life business projects is always compensated far below the real-world USD equivalent;

• SLL are effectively illiquid beyond small volume trades —

What you're left with is lots of people putting USD in, and a small group taking those USD out, leaving the rest with no financial claims on anything - just an imaginatively sexy avatar.