Sub-Prime Crisis in Second Life

Real-world regulators are already seriously considering action against  high interest rates for poorly-collateralized loans with high default risk (so called "sub-prime" mortgages).  Well, Linden Lab has moved strongly to eliminate a class of such loans, with a twist:  the banks are paying the high interest rates, and are the ones that tend to default on their depositors.  Here is the key statement in the Linden Lab policy regarding inworld "Banks" (their quotes):

As of January 22, 2008, it will be prohibited to offer interest or any direct return on an investment (whether in L$ or other currency) from any object, such as an ATM, located in Second Life, without proof of an applicable government registration statement or financial institution charter.  We’re implementing this policy after reviewing Resident complaints, banking activities, and the law, and we’re doing it to protect our Residents and the integrity of our economy.    (Full text here.)

My analysis and predictions below the fold.

Now, I am  on the record in Technology Review (registration required) for arguing that "I hope regulators will give markets such as Second Life's enough freedom for us to learn something about how to regulate real-world markets, and when not to try." I justify my position by pointing out that

"In medicine, we assess the effectiveness of a drug partly by denying it to a control group. But the high stakes of experimenting with deregulation of large real-world markets make it hard to get much empirical evidence about what kind and degree of regulation make the most sense, or what practices, in the absence of regulation, are most successful in protecting investors and fostering liquid markets. That's one reason Second Life excites economists: at little cost, they can create a regulation-free control group."

Well, that is clearly not to be, for banks anyway.  The stock exchanges, and the firms listed on them, are a different matter.  First Linden's FAQ (registration required) says: "As of today, this policy is generally focused on objects and schemes that involve real-time transfers of L$ and payment of interest or rates of return.  Exchanges may or may not do this, so they may or may not be covered."  This gets tricky, because right now most or all exchanges are inextricably tied to interest-paying brokerage banks (in which traders store their money and shares).  In theory, the exchanges could pay 0% interest on their brokerage accounts.

Permitting equity markets would be consistent with part of Linden Lab's reasoning for shutting down banks:  that bank's interest rates are "unsustainable." Equities, by definition, don't pay a fixed interest rate, but just provide a residual interest in the profits of the firm.  So they can't be unsustainable.  But the other part of Linden's argument is that (from the FAQs above) "Depending on what statements these so-called “banks” make, and what depositors’ expectations are, they raise the possibility that banking or securities laws may apply.   If so, they would need to be chartered or registered with applicable real world regulators, and to our knowledge, none of them is."  But many of the firms listing stock would probably be exempt from SEC registration anyway, much like the securities on Pink Sheets.  Perhaps they would just need to have a lawyers letter stating they are exempt.

I continue to hope that Linden Lab will let the exchanges run.  But what do you think? And which of the following predictions I have heard in the last 2 hours do you think will come true (my view in parens)?

• Banks will face runs, and be unable to pay investors, causing lots of losses.  (Yep!)

• Second Life's economy will tank.  (No...way to small a sector to have much influence...but there has already been evidence of land selloffs by bank owners needing immediate liquidity)

• Bankers will file a class action lawsuit against Linden Lab (people do crazy things, but they wouldn't have a chance of winning)

• Exchanges paying 0% interest on their accounts will be allowed to continue.  (Yes, but that might be wishful thinking).

• Linden Lab will be blamed for acting precipitously, waiting too long, not telling anyone about the policy in advance, telling a "feted inner core" about the policy in advance, and not giving enough lead time,  being autocratic, and ignoring resident desires.  They will also be praised for giving plenty of lead time, acting quickly, being patient, being responsive to resident desires. (All of these will happen; most already have).