Saturday, January 26, 2008

Virtually 1929

NOTE: I first ran across this story in the (print edition of the) Wall Street Journal. Unfortunately, the Journal keeps most of its material off-limits to non-subscribers (or at least those who don't care to swim in DMCA waters by scraping the material off the Journal's site as it comes out). However, the identical story also appeared elsewhere online, for example here in the Bloomington-Normal, Illinois Pantagraph. I have no idea how long it will be archived there, or what the point of this whole song-and-dance might be. Meanwhile, back at the ranch ...

It seems that banks had been opening in Second Life, where you could deposit your Linden dollars and earn a handsome rate of return -- 200% in one case. Given that Linden dollars are exchangeable for U.S. dollars, and 200% is well above the current risk-free rate of return, this is clearly no ordinary savings account.

In fact, the owners of the banks promising these rates used deposited funds to speculate in Second Life real estate, which is virtual space but ultimately valued in real money. Others were into gambling, again all ultimately based in real money. Effectively, you're not depositing into a savings account at all. You're buying a junk bond in a (virtual) real-estate speculation or (other) gambling concern.

Except you can't sell your bond on to someone else directly. You can only withdraw your money, that is, sell the bond back to the company. Since your de facto position is dressed up as a bank account, you have the illusion of liquidity, but if the bank's speculative activities hit a rough patch, that liquidity dries up in a hurry, as the unfortunate and possibly unknowing bondholders discovered when they came for their money en masse. At least one such bank eventually made the arrangement official by issuing bonds to depositors when it couldn't directly honor withdrawals. It then defaulted on the bonds.

All of which seems a somewhat harsh way to drive home a basic point: If there's real money involved, real laws of economics apply. Real financial regulations ought to apply as well, and indeed that's exactly what has come to pass.

[Note the date on the post ... things in the real world of finance wouldn't really start getting hairy until later in the year, but the clouds were already on the horizon -- D.H. Dec 2018]

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