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When Virtual Crises Turn Real

A run on the bank at the increasingly popular Second Life shows how an online "universe" needs regulation, too. But how to regulate it?

Linden Lab, a private company founded in 1999, resists becoming a nanny state. The health and happiness of its avatars do not affect its business. But it has nothing to gain by allowing crime in its world — Second Life servers are housed in the United States, and it must comply with those laws.

Benjamin Duranske, an intellectual-property lawyer who writes Virtually Blind, a blog about legal issues affecting virtual worlds, says the fallout from the recent financial crises will likely attract the attention of regulators and encourage users to desire more transparency. “Regulation is inevitable,” he argues. “It’s inconceivable that the Securities and Exchange Commission is not going to pay attention to the fact that someone is running a stock exchange and that something that looks an awful lot like money is changing hands on it.”

Thus far, financial regulators in this country have kept their distance. Asked about the potential for criminal activity within virtual worlds, John Nester, an SEC spokesman, was unaware of how such crimes would work. “While we are charged by Congress with administering the U.S. securities laws, the prospect of having an avatar spokesman to answer questions like this is very enticing,” he told CFO.com. The SEC, he says, presides over U.S. securities markets.

Naturally Selecting a Regulator

The SEC may get its wish. A virtual counterpart to America’s securities regulator appears to be evolving among a group of avatars: the Second Life Exchange Commission is currently in the process of crafting the Second Life Securities Exchange Act of 2007, which, according to its Website, will closely resemble real securities law. Representatives of the SLEC could not be reached for comment, but according to its online mission statement, the supervisory body will be dedicated to “assisting in providing market stability and investor confidence.”

Although virtual worlds may seem to be a regulatory nightmare, they do offer researchers a remarkable laboratory for investigating how markets react to different rules or none at all. Robert Bloomfield, an accounting professor at Cornell University’s Johnson School of Management, has spent much of the summer inside Second Life watching how financial regulation evolves organically. Beyond the SLEC, users are also forming a Second Life version of the Better Business Bureau (BBB). The groups are trying to agree on what practices to promote.

“Whatever regulations do arise have to be more like mutually-agreed-upon best practices,” says Bloomfield. “Firms that get SLEC approval will enjoy a lower cost of capital.” But in rapidly changing virtual worlds, the lack of true oversight erodes trust in would-be regulators. Some owners of skeptical avatars have said the new BBB is extortionist, unfairly blacklisting some firms. Others have condemned the SLEC for being closely tied to one of the big stock exchanges. According to Duranske, the same people starting the SLEC also run the stock exchanges. But ultimately, the final say comes from the creators.

Executives at Linden Lab hold many of their meetings in Second Life, enjoying digital face time and the new addition of voice capabilities that allow far-flung shareholders to communicate avatar-to-avatar. CFO Zdanowski, whose avatar is called Zee Linden, says he spends 10 to 15 business hours per week in-world. He manages the exchange rate with a peg to the U.S. dollar and pumps out additional Linden dollars as needed. What’s more, every transaction made within Second Life can be watched and tracked, while big ones are automatically flagged. The company also puts limits on how much users can buy and sell in one day, based on their in-world experience, to stifle potentially illegal transactions.

Real-world regulators may be largely ignoring virtual worlds because it is unclear what there is to regulate. Do virtual currencies, islands, and buildings have real value? Although they are in demand within Second Life, Zdanowski explains that such assets really just function as intellectual property. As of this month, 9,541 islands have been bought, according to Second Life’s Website; users who spend about $1,675 (the green ones) to purchase one are actually just renting space on Linden Lab servers.

What they do on those islands is up to them, but Linden Lab has certain advantages that agencies such as the SEC do not when fighting fraud. “The threat is there, the danger is there,” says Zdanowski, who serves as CFO, central banker, and, in effect, chief regulator. “The reality is that unlike the real world, in Second Life it just so happens that we know everything that happens.”

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