In a previous article I asked some very tough questions about the Second Life virtual economy. That article provocatively proposed a case as to why I believe Second Life's much hyped economy resembles a pyramid Ponzi , or more accurately a type of high yield investment program ( HYIP ) scheme. After posting that article I was partially convinced by many respondents that Second Life probably is not a Ponzi scheme as a precise legal definition -- at least probably not in most jurisdictions. Indeed, after learning more about HYIPs, and in particular HYIP Games, Second Life and the game's system of "virtual currency" satisfy many of the attributes of such schemes. More about HYIPs later. First, some background:

Brief Background

I covered the background of Second Life in some detail in my previous article. Second Life is a type of online computer game often referred to as a Virtual World. Virtual Worlds, while marketed as computer games and produced by computer game developers, are thought by many to represent the natural evolution of the web. In fact, there are probably myriad noble and interesting applications of Virtual Worlds to things like education and community collaboration.

What I am concerned about here is only the virtual economy or virtual marketplace aspect of Second Life. It is the claims of real gold in the Second Life virtual hills that has caused most of the recent media hype around the game. The makers of Second Life, Linden Research (privately held; San Francisco; funded by Benchmark Capital et. al., "Linden Labs", "LL") themselves actively encourage this view of Second Life, judging from self-promoting links on Linden's own official Second Life website:

Second Life: It's not a game Fortune's David Kirkpatrick reports on why IBM's Sam Palmisano and other tech leaders think Second Life could be a gold mine .

Fortune's David Kirkpatrick reports on why IBM's Sam Palmisano and other tech leaders think . I got my job through Second Life Looking for work? Your best bet may be an interview in virtual reality. Fortune's Katie Benner explores the cutting edge of corporate recruitment.

Looking for work? Your best bet may be an interview in virtual reality. Fortune's Katie Benner explores the cutting edge of corporate recruitment. Starting a Second Life Business Find out what entrepreneurial opportunities the virtual world of Second Life has to offer .

Where There's Smoke...

In that now infamous article I concluded that Second Life's supposed economy wasn't a whole lot more than a typical pyramid scheme, where most of the money paid in by new recruits ends up realized by the organizers and a handful of early entrants. I was promptly assured by any number of the Second Life faithful that I was wrong, and that there were literally thousands upon thousands of real, financially valuable businesses making money, providing jobs, growing at astonishing rates, and redeeming their virtual Linden dollars (L$) for real money.

I challenged the Second Life community to offer forth a typical, average business for quantitative financial analysis. In fairness, a handful of apparently honest folks came forward with offers to participate; even one of the most well known of the "virtual oligarchs" (one of those in the handful of players at the top of the virtual economy) signaled some interest in the project.

Things took a hard turn when I was forced to cancel that project along with most of my Second Life public discussions and debates. Perhaps I can discuss the particulars later, but suffices for now to say that many in the Second Life community have zero tolerance for critics and criticism.

Nonetheless, I did become more curious after the severe anti reaction I received. Especially so when even seemingly objective researchers and academics took a see-no-evil attitude, dismissing my analyses without serious treatment.

Even though I played the game myself on and off for more than two years, up until the middle of last year, I was still surprised. The economic part of the game was always there, but never as a source of practically religious devotion. What the hell is going on in Second Life?

Redeemable Virtual Tokens

The L$ is often referred to as a virtual currency. In fact, it is not a currency at all. It is a micropayment token system. I have been around micropayment systems for many years in their application to mobile phone carriers. The Economist (Feb. 17, 2007) features a cover story that includes discussions about micropayments vis-à-vis digital cash.

Most justifications for why Linden Research had to create the L$ center around micropayment issues. In reality, telecoms, Apple iTunes, Microsoft, and others have proven that floating an independent currency is not requisite to enabling a functional micropayment system. I myself am partial to the iTunes batch-billing approach, keeping payments denominated in real currencies. Even the more prepaid-credit approaches taken by Microsoft in the Xbox Live Marketplace avoid the complications of currency management introduced by independent, pseudo currencies like the L$.

Regardless of the reasons, the fact remains that the Linden dollar is objectively not a currency. In Linden's Terms of Service agreement, sections 3.3 and 5.3, Linden clearly states that players have no financial or legal claim to their L$, and that L$ are a consumable entertainment product which can be revoked or deleted at any time, without reason. Not quite up the standard of a fiat currency.

But Linden Research does promote, market, and manage the L$ as if it were a legitimate, independent fiat currency. They operate an official "virtual currency exchange", the LindeX, on which players can either buy L$ with real money or redeem L$ for real money deposits to their PayPal or bank accounts. And the redemption rate, or as they call it "exchange rate" implying the Forex equivalent of that term, is floating.

The Wiki on the Linden dollar asserts (emphasis added):

Residents may purchase L$ directly through the client, or convert between Linden currency and U.S. currency through either Linden Lab's currency brokerage, the LindeX Currency Exchange, or other third-party currency exchanges. The ratio of USD to L$ fluctuates daily as Residents set the buy and sell price of L$ offered on the exchange, and fluctuated between L$240/USD and L$350/USD between October 2005 and September 2006.

Virtual Interventionists

There are all kinds of macroeconomic tangents I could take at this point. Without straying too far, we can safely say that Linden Research has taken on the role as "virtual central banker", and "virtual treasury", in minting and distributing their own "virtual currency". (The Second Life economy is built upon a system of "sources and sinks" which, while sometimes cited as a monetary control lever, really more represent the virtual economy's fiscal policy.)

The exchange rate is not freely set by supply and demand; it is not a floating exchange rate. In recent months, Linden Research has sold relatively large amounts of L$ themselves on their own LindeX market.

Clearly a form of seigniorage (selling newly minted currency for net revenues), Linden claims they do this in order to manage L$ / $USD volatility. In other words, they want to keep the redemption rate stable, right around the L$250-L$300 per $1USD range. Currency intervention.

More economically astute readers will immediately recognize the conceptual and logical hazards and complications this implies. Managing exchange rates of currencies is something which is extremely difficult, and terribly expensive to do over any period of time. The lack of theoretical limits to how weak or strong various interests wish for a virtual currency to become only further complicates an interventionist strategy.

So, Linden Research is selling L$ which they print themselves. Players buy the L$ with real money, but they don't really own the L$ they bought. And, Linden Research uses the LindeX pseudo-Forex exchange market in order to stabilize the redemption rate of these virtual L$ tokens. So, will Linden be so willing to buy back L$ when demand falters?

Growth, Growth, Growth

Linden has boasted unbelievable growth numbers, even proudly displaying them on their Second Life home page. In fact, Clay Shirky didn't believe the numbers, and challenged them in myriad forums (earning him fierce sometimes slanderous attacks from the Second Life faithful). Eventually, Linden acquiesced ("Overcounts", Shirky) and provided more thoughtful statistics which showed that Second Life, while indeed growing rapidly as measured by first-time-visitors (account creations), in fact has only about 200,000 active users (those investing more than a week of time into the game).

From my perspective, these overcounts and growth exaggerations further aggravate my initial HYIP claims. Simply, Linden Research cannot count on perpetual growth, given their own reported statistics, to support the L$ / $USD redemption rate. They will have to start buying back a lot of L$ in the near future. Or, more likely, the L$ will just devalue rapidly, leaving everyone with money left in the game S.O.L.

Not Just Words

I love narratives as much as any other blogger. But, the proof is in the numbers. I've taken the liberty to put Linden Research's own data through my analysis grinder, and I offer my results.

I created all these analyses from Linden Research provided data, using Microsoft Excel, Crystal Ball, SAS and my hp 49 g+. Click the graphs to see the full size versions.

Conclusion: The L$ to $USD redemption rate depends upon unrealistic growth assumptions.

The growth (charted in the previous section) depends upon the assumption of an exponential growth curve (yielding a coefficient of determination of 0.70). Inspecting the actual forecast values clearly demonstrates the flaw in this assumption.

Supporting the current regime in which Linden Research is always a net seller of L$ in order to support (i.e. weaken) the L$ compared to the $USD, Second Life must register around 45 million unique players by the end of 2008; a growth rate of 40% per month by that point. (Using an exponential growth formula, with conservative initial conditions. This matches historical growth with R-Squared = 0.70).

Note, this is a ceteris paribus analysis. Linden Research could, and most certainly would attempt to use "virtual fiscal levers" with its series of controlled sources and sinks to strengthen the L$ in the face of diminishing growth. I maintain, however, that these efforts will probably succeed only for very short durations and, like taxation in real world economies, ultimately produce far worse unintended negative outcomes. For example, attempting to support L$ strength by forcing in-game deflation would almost certainly result in a serious "virtual recession" by depressing the game's "virtual commerce".

Growth is too volatile to count on going forward.

Absolute player growth, as measured by unique players and by registrations, produce equally volatile growth curves.

At best, real growth trends experienced within Second Life are sporadic and barely predictable. In this example, a 2nd order polynomial fit function still only produces 50% predictability. Such growth is consistent with the type of media-induced hype that has caused a recent influx of new Second Life users, but which may be a short lived effect.

Growth of hours per player (unique) is even more volatile, and does not yield reliable regression predictions.

Summary statistics from Linden Research provided data for Unique Players, Registrations and User Hours, for reference:

Hours per total unique player is weakening even while hours per new player is beholden to spikes in media hype.

Take note of the consistent decline in hours per total unique player, barely breaking even from mid 2005 until only last month (January 2007) in an amazing reversal. Historical trends predict future months will return to hours per unique player declines.

Hours as measured by allocation only to incremental new players produces more stable results. Media cycles are more readily visible in this view also, as are periods of system downtime. Summary statistics, for reference:

Most troubling, L$ Spend per Unique Player is weakening.

This again returns to the conclusion:

This chart shows the rapidly declining L$ purchased per new player as total unique players has grown exponentially. L$ purchased per all unique players has also declined, although less rapidly, implying that most economic activity is supported by existing players, with growth in total L$ spending coming purely from new players trying the game, then abandoning it shortly thereafter.

One other bit to consider in the context of the above graph is the trend towards seigniorage.

Unlike economies in the real world, the Second Life economy is strictly zero-sum. Therefore, every real $1 USD extracted from the game comes from someone who put a $1 USD in, whether directly from new users buying L$, or indirectly through internal "sinks", which amount to little more than the redistribution of players' future $USD redemption potentials.

High Yield Investment Programs

After reading and viewing the data and charts in this article, make up your own mind about similarities between the Second Life L$ based economy and a HYIP game. The following are attributes of HYIP schemes and games.

It is theoretically possible for a HYIP to be legitimate, and not a pyramid Ponzi scheme. To date, however, all HYIPs have turned out to be Ponzi schemes.

HYIPs are normally offered over the internet.

Entry costs (initial deposits) are very low, often less than $10USD.

HYIPs usually utilize e-currencies or virtual currencies, making it possible to accept very small investments and easily cross jurisdictions and other boundaries.

HYIP virtual currencies usually introduce psychological "breakage" by being denominated in sub-penny units, making inbound investments, internal activity and unrealized gains feel larger to participants.

HYIP participants strongly encourage and self-enforce thinking of internal activity only in virtual units, not in $USD translated value.

HYIPs disclose little about internal strategy, management, or operations. They often publish financial data, sometimes large amounts of detailed financial data, but they almost always refuse to do so in a meaningful, methodological manner which can be verified.

HYIPs usually present emotional appeals, appeals to faith, promises of financial freedom, or promises of a new economic reality with active members best positioned to benefit financially.

HYIPs often claim returns of greater than 1% per day [that is an order of magnitude per year. Some Second Life banks offer 1% per day interest, incidentally; Many Second Life "businesses" boast 50% per month revenue growth].

Three types of people typically enter HYIPs: Naive, unwary, and ignorant. These are most HYIP recruits. They are usually recruited or referred. They are attracted to the HYIP as a source of income, often one which they are desperate to have. Once the HYIP fails, this group is often considered to be undeserving victims. Gamblers. A smaller group are those who know the HYIP is inherently unstable. Some even see it as a Ponzi scam from the start. But, they calculate that they are early enough or can outsmart the game and earn returns nonetheless. Cheerleaders and shills. Some in this group are the organizers or first entrants. Others are those who've realized small profits from the game, and seek to grow the game in order to push themselves up in the pyramid structure, thereby amplifying their returns.

Most HYIPs are positioned as low or no risk opportunities, being that little money is needed to start, and time invested is not considered a cost.

HYIPs are zero-sum games by definition. All realizable returns come from real money investments.

Forum, blog, and email list users will gain trusted reputations, ensuring others they have indeed been able to withdraw real profits. They will quickly surround, counter and drown out any criticisms to the contrary.

These games are not defensible as lotteries (although some have used this legal defense) because the odds of winning returns cannot be calculated ex ante.

Public forms which endeavor to monitor HYIP games and warn unwary investors are nearly always overrun by cheerleaders and shills.

The mainstream media often mistake HYIPs as legitimate, lacking understanding of internet communications (and thereby ascribing credibility to testimonials by cheerleaders and shills).

It is often argued that the Second Life virtual economy does not qualify as a HYIP type of structure because the nature of internal commercial activity largely involves productive endeavors. By productive endeavors they are generally referring to virtual item design and creation. At a detailed level, these are largely graphics design, 3-D computer modeling, computer art, and script programming activities.

I maintain this is false. While lower-level players may earn some returns, by and large their investments into the game (both capital and labor) are trapped and not monetizable at fair market redemption rates. Two detailed responses to the productive endeavors objection:

It is unclear how much of a percentage of the virtual economy is driven by these "productive endeavors" versus the online gambling, sex and real-estate markets. The first two are clearly not productive endeavors and likely constitute a significant portion of the internal L$ economy. The latter is by definition not creating financial value because players have no financial claim on their virtual property -- they have no effective virtual property rights under current US and California laws. Further, there exist no supply or production function restrictions which would enable long-term price stability of virtual real estate. Over time virtual real estate will be worth only its marginal cost to provide as a product (disk space, electricity, router depreciation, etc.). Productive activities produce real returns for players only insofar as they are able to redeem L$ cash flows for real money -- players have no financial claims on anything which resides on Linden Research's servers or network, including Linden dollars (only on limited forms of conceptual intellectual property). The continual weakening of the L$ by Linden Research is a mechanism by which potentially realizable financial gains instead accrue to the game's organizers, and to others with a similar ability to run their own L$ - $USD redemption exchanges. Therefore, these players, even while feeling they are engaging in productive endeavors with positive financial returns, more serve to enrich those at the top of the game while also acting as testimonials to attract new game entrants.

Cult Second Life

I learned a valuable lesson my first go around with the Second Life faithful. Second Life is not a game to many involved. It's more of a cult. I attempted to honestly engage all of my critics. Unfortunately, I learned that such is a wasted effort when dealing with the blind faith that afflicts Second Life True Believers. In the end, it's not all that much different from trying to talk rationally with someone about Amway, Herbalife or Robert Kiyosaki.

OK, one thing really annoyed me. A few supposedly prominent Second Life blog authors dismissed my first article because I was anonymous. In fact, I was not and never have been. But they, like pretty much everyone else in the Second Life universe, were. [Shouted Elaine Benes style through a hand megaphone] "You're Anonymous!"

And a Disappointment...

I was particularly disappointed by some in the academic community, as a response to my original article. I understand and appreciate the intense interest among academics in Second Life. Indeed, many are interested in aspects of sociological, communications, pedagogical, and cultural phenomena related to the Second Life Virtual World. I cannot speak to these topics with any knowledge or authority. However, I am baffled by the response from some "virtual worlds economics" authorities. One response in particular dismissed my first article as "so obviously wrong it was hardly worth discussing". Further, it went on to claim that harsh criticisms such as mine threatened to destroy the very future of Virtual Worlds. And, finally, we were told that Second Life is really a lot like fictional "Mayberry", and not the brutal world of markets and numbers I suggested.

That response stretches the credibility of its author. If one guy can knock over Second Life or the future of Virtual Worlds in general, then they are hardly deserving of our attention. And, Second Life is "so obviously not Mayberry", on so many levels, that "it's hardly worth discussing". I cannot help but wonder what vested interest one has in Second Life in order to resort to wholesomely painting it as the black & white home of Any Griffith. Just a few obvious shots (the Second Life echo machine's endless repeating of the Mayberry analogy set these up for me, even if they are easy targets):

Mayberry never printed their own money. No one spent Barney Bucks at Walker's Drug Store.

If Mayberry started printing Barney Bucks, Andy would have arrested them for counterfeiting.

There weren't all too many prostitutes and call girls hanging out at the Mayberry Hotel.

Myer's Lake was not a big casino where people sat around playing rigged Tringo games and got paid to sit in chairs pulling rigged slot machines.

Explicit interspecies sexual role playing wasn't seen as mainstream behavior, not to mention ageplay.

Tax evasion, money laundering, gambling, sex trade? No, all Mayberry had was a tad bit of moonshining from time to time.

Eventually Wal-mart would have put Weaver's Department Store out of business, despite the protestations of any authoritarian artisan community or overtly anti-capitalist Bourgeoisie.

Corrections and Press Policies

I will make corrections, as discovered by myself or readers, to the original article by annotating such within the original work. These notations will consist of bracketed annotations "[]" and strikeouts " strikeouts ", as appropriate.

Unfortunately I cannot accept requests from "mainstream media" for interviews or commentary. I will respond to emails which request clarification or explanation about something I have written, although I much prefer use of the open comments section on the blog site. Mainstream media is defined as newspaper, magazine, radio and television.

Disclaimers