Not So Funny Money

Inside the growing—and very lucrative—world of virtual currency

Illustrations: Chris Gash

While hosting friends at his Montreal home, Sri Lankan-born Duleepa “Dups” Wijayawardhana struck upon a novel idea for a website. Similar to the grand epiphany that inspired Facebook, the revelation came several six-packs into what would become a very boozy night. But unlike Mark Zuckerberg, who reportedly created his social network in retaliation against an ex-girlfriend, it was Karl Marx’s treatise on capitalism that fueled their imaginations while scrolling, yes, their friends’ Facebook pages, and gave birth to their idea.

“We were just sitting there going, you know, there’s got to be some sort of value to all of this,” says Wijayawardhana. “Oddly enough, we started talking about a passage from Das Kapital, where [Marx] says everything that you do—any good you produce—has economic value. And if it has economic value, then it can be tradable. To us, he may as well have been talking about virtual currency.”

What spawned from such a high-minded idea is Empire Avenue, an online game-cum-social experiment in which players buy and sell shares of their friends based on their standings on social networks like Facebook and Twitter. The more wall posts a friend writes, be it a pithy one-liner or a quickie review of the new Lady Gaga album, the more his or her stock rises in value. And when stocks rise, investors reap dividends.

But the profits these players gain aren’t payable in cold hard cash, at least not in the classic sense. Rather, to play, and so to buy and earn dividends, they first have to purchase the game’s official currency, Eaves. (Eaves can also be used to buy ads—sent out on players’ social networks—to get more investors.) Also, in a deal being hatched with Ford, players will soon be able to purchase an array of branded goods, like a virtual Mustang. The 10-month old startup is in the market to raise $1 million in funding, and about a half-million shares are traded in a given week, says Wijayawardhana. “We have our own self-contained economy, but we want to fuel the real-life economy.”

Way south of Empire Avenue’s office, in Franklin, Tenn., Roy Riggs runs his virtual goods company, Malevay Studios, on Second Life. The company, which opened for business just two weeks ago, creates and sells breedable mutt-like creatures called “meeroos.” It has already made some $8,000 (that’s roughly some 2 million Lindens, at an exchange rate of $1 = 253 Lindens), from the sale of some 20,000 of these digital pets.

Lovers of meeroos, or any of Second Life’s goodies, need only to log their credit card numbers on its official marketplace website, where Lindens are bought in bulk, and, voila, a bacchanal of digital goods jolts onto the screen. But unlike Empire Avenue, which doesn’t allow players to cash out for real money, Second Life residents like Riggs can exchange their virtual Lindens for dollars.

“Other than spending about $500 on [a bank of] servers . . . it’s just pure profit,” says Riggs, who, outside of the virtual world of Second Life, has never met either of his two business partners.

What these entrepreneurs have in common—besides, apparently, free time—is a willingness to dive headlong into the unregulated waters of the virtual marketplace. Whether through Eaves, Credits, Lindens, WoW Gold, Karma Points, Project Entropia Dollars, or hundreds of other currencies now being sold on mainstream sites like Facebook and kiosks at Best Buy—as well as on independent online currency exchanges—millions of consumers are growing more comfortable spending real money on virtual goods.

For anyone who’s purchased a gift card from Best Buy or Barnes & Noble, the idea is simple enough: pay cash, get in-store credit. More recently, the strategy has been reinvented by tech entrepreneurs. Their idea: create free entry to games, and then, after people are hooked, charge them for virtual goods that supposedly enhance—and sometimes move forward—play. The goods are bought with virtual currencies sold in bulk. So unlike, say, the dime you oh-so-long-ago slid into the coin slot each time you needed a pay phone, you would have had to buy a pre-paid phone card, which meant making more calls—or talking for far longer—than you would have if left to your own, less expensive, devices.

Virtual good markets are already so sophisticated that some social games reportedly have offered misleading lead-generation tactics—e.g., the offering of virtual cash in exchange for marketing offers—sticking players with charges or services they didn’t want.

Due, however, to an overall increase in consumer confidence, analysts believe the sale of virtual goods could rake in more than $2.2 billion this year and around $12.5 billion worldwide, according to ThinkEquity. That’s a dramatic burst of cash compared to just two years earlier, when the virtual goods market tallied $738 million in the U.S. and $6.3 billion worldwide. Those numbers reflect the increasing demand for everything from a digital tractor on FarmVille to a bulletproof Jackal ATV on Mafia Wars, to augmented breasts for your avatar (really) on Second Life.

As such, Silicon Valley’s tech behemoths are making big plays to take control of this  burgeoning market. After dabbling more than a year on tests with its Credits system, Facebook’s virtual currency hit its stride last September when it became, among other things, the exclusive payment method for most applications created by Zynga, the developer of a roster of games including Mafia Wars and FarmVille; the latter now boasts 65 million players. Besides online, Credits can be purchased in the form of gift cards at brick-and-mortar retailers such as Walmart, Best Buy, and Target. And they aren’t just exchanged for dollars, but euros, Danish krone, and 13 other currencies.

“I really think [Facebook would] like to see Credits used as a virtual currency for everything—for real world goods and everything else,” says Michael Pachter, a stock market analyst at Wedbush Security, considered a leading authority on video games. “Facebook would like to replace Amazon—they’re just not going to tell you that.”

As for Google, it’s been scooping up a bevy of tech startups in a bid to dominate the growing demand for virtual goods. Among these are Angstro, which specializes in building social networks, and Jambool, a group that designs virtual goods and currencies for use on those very networks. Apple, of course, remains the leading vendor of both music and applications, and has profited through the sale of pre-paid gift cards for its iTunes store.

With such high stakes it’s hardly a surprise that a micro-payment battle is being waged—one not unlike the war three decades ago between Beta and VHS—that could result in one dominant virtual currency. With Facebook now requiring some 400 of its app designers to use Credits as their official currency, the social network has a huge advantage. But most tech observers believe Apple will follow suit, allowing customers to use their iTunes credits not only to buy apps on their iPhones but, at some point, even goods on FarmVille.

“I think there’s a real case to be made that this is a war of standards,” says Edward Castronova, an economics professor at Indiana University in Bloomington, who has written extensively about virtual economies. “My vision of this is that this is largely dystopian because what I know about monetary economics is that single currencies are best. You don’t want to have multiple economies because economic policy does best when you don’t have a million wildcat banks moving in different directions.”

While the use of virtual currency is relatively new in the U.S., game makers in China and Korea were deploying a similar business model as early as 1997 to battle rampant piracy. After authorities failed to curb the tide of illegal software, game companies like Nexon Korea began hosting its games on servers and charging small monthly fees (which led to the world’s first massively multiplayer online games). As the number of subscribers multiplied, Nexon created an online game, Crazyracing Kartrider, that could be accessed for free. In it, players raced one another to the finish line and, through Nexon Cash, the world’s first virtual payment system, could purchase things such as faster cars and better tires.

“You started out with a little wood cart and ended up with a super-charged, rocket-turbo, jet-powered car,” says Pachter of Wedbush Security. “But you obviously had to pay for all the upgrades, and that’s kind of how social games were first invented.”

In the 15 years since those keystrokes, the virtual goods market has grown far beyond little wooden carts into its own ecosystem. Here, social networks and online games (read: marketers) thrive alongside entrepreneurs like Riggs; they all use new social advertising models and focus on new uses for virtual goods. In March, for instance, Facebook offered screenings of the Warner Bros. movie The Dark Knight for 30 Credits, or the equivalent of $3. And in April, it linked with Mobile Interactive Group, an application that works with TV shows. The partnership could translate to, say, paid voting with Credits on reality shows like American Idol.

Even more lucrative, some analysts believe, are the wave of mobile applications now getting in on the craze. With ShopKick, a shopping rewards app launched earlier this year, consumers can collect (for free) its virtual currency, called Kicks, at stores including Best Buy, Macy’s, Sports Authority, American Eagle, Crate & Barrel, and Target. There, they can exchange them for gift cards—or Facebook Credits. ShopKick gets a percentage of each Kick, and retailers increased traffic. (The app also allows consumers to scan, say, a sweater, to learn more about it; plus, merely scanning a product earns someone more Kicks.)

The idea, says Jeff Sellinger, ShopKick’s co-founder, is to compel users to get off their computers—or, in this case, their phones—and into brick-and-mortar stores. Ironically, however, about 43 percent of Kicks have been redeemed for Credits.

“In retail, there hasn’t been a whole lot of innovations in the last 100 years or so,” says Sellinger. “By far the biggest problem in retail today is the lack of foot traffic, and if foot traffic is so important, we thought, why not reward users who visit the stores?”

The world of fake currency now flexes enough muscle to move markets. By one estimate, the sheer weight of the competing virtual currencies is second only to the dollar in terms of daily transaction activity. As a result, game makers in Korea and China routinely pay employees to sit in cyber cafes, or virtual sweatshops, as they’re called, racking up currency in their own games and then selling them for a profit on any number of underground virtual marketplaces or to overseas customers. It was recently reported that a Chinese labor camp has its inmates “gold farming” as well, forcing them to play games well into the night (after working all day) to earn virtual credits to turn around and sell.

In England, where the virtual goods business model is also extremely popular, a 29-year-old hacker was caught stealing the identities of two Zynga employees and, with their account information, swiping $12 million in the company’s virtual currency. Before he was convicted in March, however, he managed to unload about $85,700 of it on the black market—although he stood to rake in nearly $300,000, according to prosecutors.

With so many economic elements at play, some analysts and even a few startups in the U.S. believe more stringent federal regulations are long overdue. In fact, some experts are taking a cue from China, which has set limits on the widespread trade of virtual currency, which in 2008 reached $2 billion in that country. As such, the currencies have risen sharply against China’s official currency, the renminbi. From rules governing gift certificates—perhaps the closest thing to virtual currency—to state money transmitter laws and federal banking and money laundering laws, federal regulators in the U.S. are now wrapping their heads around an industry that only a decade ago hardly existed.

For more than a year, the Treasury Department’s Financial Crimes Enforcement Network, a watchdog arm that regulates money transmission services like PayPal, has been considering new rules that would significantly restrict the sale of what lawyers call “stored value,” which is another way of describing both gift certificates and virtual currency. Under the rules, which could come as soon as this summer, businesses would be greatly restricted from trading virtual currency internationally.

Unsurprisingly, says Dax Hansen, a technology lawyer at Perkins Coie, companies like Facebook and Apple are reeling. If the administrative rules pass, they could cost large companies and entrepreneurs millions in future profit, he says. “These rules stifle innovation and are an unnecessary overreach,” notes Hansen, who has been lobbying on behalf of the Entertainment Software Association to scrap or soften the rules, which would be added to administrative law without a legislative vote. “The Internet is, by definition, international, and, by definition, peer to peer.”

As for the privacy issues that kept credit cards offline for years, a 2009 study says consumers no longer care—or, rather, their concerns are too illogical to matter. In their experiments, Carnegie Mellon scholars determined that, when offered varying degrees of protection, more participants chose convenience over privacy. The new findings, which have been studied by tech startups, suggest that many people value their privacy less than they do convenience or simply a really good deal, says George Loewenstein, a professor of economics and psychology.

Although the study was published long before hackers broke into Sony’s PlayStation Network this month and stole sensitive information about more than 100 million users, Loewenstein doesn’t believe such a breach will deter consumers from handing over their own information to online businesses.

“A lot of our studies can be explained by people just being extremely lazy,” says Loewenstein. “Not only in terms of spending time, but even just putting in a little mental effort.”

If it seems like small-time entrepreneurs and tech giants are showering outsized attention and capital on the virtual marketplace—spilling over, as it is, with digital trinkets—analysts say the space still shows promise for significant growth.

Since 2008, Lightspeed Venture Partners, a tech-focused venture capital firm that has invested more than $10 million in several virtual goods companies, has poured funds into Kixeye, which creates games similar to Zynga’s. But unlike FarmVille, etc.—and a litany of games by competitors like Playdom—the applications published by Kixeye are designed with the male core gamer in mind, as women have been more eager, thus far, to till the fields and grow the produce. (Google jumped into the hardcore gaming industry as well, just last week co-leading a massive funding round for men’s game developer Kabam.) 

Because men gravitate to shoot-’em-ups like Call of Duty and World of Warcraft, says Lightspeed Venture managing director Jeremy Liew, a recent wave of social games like Backyard Monsters has soared to new heights with regards to what tech observers call the stickiness ratio, or the ratio of daily users to monthly users. Further, where players might spend between $15 and $30 a month on virtual goods sold on applications like CityVille or FarmVille, male-dominated games suck between $40 and $60 a month from a typical user’s wallet, according to ThinkEquity.

“These male players are actually spending way more on their games,” says Liew. “There aren’t as many of them, but the amount that they spend each year is much, much greater, and that, I think, is an area where we’re seeing some real innovations.”

There are echoes of Liew’s view in the way meeroo-creator Riggs describes his mostly female consumers: “I guess in real life our biggest customer base is probably, like, 30-year-old stay-at-home moms. I think they just find pets are cute and fun to have and play with. And they’re virtual, so you don’t have messes to clean up.”

But even if only 51 percent of the population is a potential buyer, it hasn’t fazed Riggs, who’s already thinking about his company’s next step. The professional software programmer says he and his partners are already laying the framework to create a limited liability company. What’s more, he says, they’re seriously considering launching their own currency—just like Facebook.

“We’ll have a store where you can buy upgraded items, or homes for your pets and stuff like that—so it would be a virtual currency on top of a virtual currency,” says Riggs. “It’s the wave of the future—except it’s already here.”