Regulating Virtual Money

Posted on 02 July 2009 by Karl Anderson

China banned the use of virtual money for the purchase of real-world goods this week in an attempt to prevent the rise of online credits as a parallel currency.

Up until now, the 220 million members of China’s largest virtual economy could purchase CD’s, makeup, online entertainment and adult chat services using QQ Coins, units of virtual currency issued by internet company Tencent Holdings Ltd. Since it was possible to both earn income and purchase goods without using Yuan, the trend constituted a theoretically uncontrolled expansion of China's money supply, a host of problems for its taxation system, and greater scope for money laundering and illicit trade.

Even if this ban succeeds in keeping China's virtual economy virtual, regulating these economies to limit the potential for fraud, money laundering and tax evasion is still a tricky business. China is not facing this challenge alone, with popular games such as World of Warcraft and Second Life creating headaches worldwide.

All of these systems allow members to transfer credits to one another, constituting unregulated cross-border money transfers. Real and virtual currency can be exchanged through a huge number of unregulated brokers, ranging from retail shops in Beijing to online auction sites. The markets are even sufficiently liquid that the exchange rates are stable. The scope for money laundering is obvious and expanding with the popularity of the virtual economies.

Fraud has so far been quite innocuous. Within Second Life, players are free to enter arbitrary contracts, and purchase land and securities. They are equally free to deceive one another, and there is no authoritative dispute resolution system to apply to. Of course, because nothing material is transacted there is no pressing need for regulation, though some have argued that since real people and, through the exchange mechanism, real money are involved, property rights and common law rules should extend into virtual worlds.

Fraud is unlikely ever to take off in closed virtual economies, since the desire of their private owners to retain and attract members incentivises them to detect and prevent fraudulent behaviour. Arbitrary rules can be enforced by the software itself, and because all online transactions are recorded in perfect detail, data-mining techniques that have been successful for organisations like PayPal can be applied.

On taxation, governments have been quick to make clear that virtual profits are taxable, though so far only when those profits are converted back into a real currency. This is a sensible approach with the benefit that it fits within existing taxation frameworks.

Virtual profits are made in lots of ways, but the most interesting is the flourishing "Gold Farming" industry in which thousands of people are employed to slay online dragons to accumulate virtual gold, in the case of World of Warcraft. The spoils are sold for profit to wealthier players who would prefer not to slay the dragons themselves. An estimated 150,000 people are employed in this way, trading US$500m annually. In Second Life, a handful of players are reported to cash out over US$1m p/a, most of which is earned on the virtual property market.

VAT legislation has been extended in the EU to cover the purchase of virtual land in Second Life and other in-game services, in order to create parity with the provision of other entertainment. Whether any governments see fit to apply inheritance taxes to virtual assets has yet to be seen, but given their similarity to illiquid online securities such a move seems inevitable.

Gambling legislation introduced in recent years has also affected online worlds. The sudden closure of Second Life’s casinos in 2007 caused a bank run that led to the downfall of one virtual bank, but thankfully nobody is proposing virtual minimum capital ratios.

Other than QQ Coin, no virtual currency appears to be on the brink of becoming a parallel currency for real goods and services, so there is no immediate need to apply China's ban elsewhere. Western economies, never to shy from financial innovation, will fill that gap soon enough.

Supported By:

Regulating Virtual Money

Member Comments