How Virtual Goods Caused the Market Crash of 2016
No, that’s not a typo. I have seen the future. And in the future, a burgeoning virtual goods economy that has been building over the past few years will lead to the next great financial bubble and crash.
Far-fetched? Read on.
In some ways, virtual goods are almost as old as role-playing games. Experience and special weapons are time consuming to earn, so a light grey market to “cheat” by purchasing equipment or characters has always existed.
This ecosystem exploded with popularity of massively multiplayer games, like World of Warcraft, and virtual worlds, like Second Life. For the first time, cottage industries of real human beings sprang up to devote full time effort to investing time and resources into accumulating virtual wealth.
While typical Silicon Valley chit-chat turned to the impressive revenues that virtual goods firms began generating in 2008 & 2009, it wasn’t until Zynga IPO’ed in 2010 with eye-popping revenues of more than a quarter billion real dollars that the concept of virtual economies really became mainstream. Major players from across the entertainment and technology domains raced to enter the market, and to leverage the powerful virality of social platforms combined with the fundamental addictiveness of gaming. Add the final magic ingredient – pure monetary greed, and you had all the animal spirits needed to create the great virtual goods boom.
Unfortunately, as described in Devil Take the Hindmost, almost all great booms and busts are created through a combination of financial innovation in products that create leverage combined with a technology innovation that drives wildly optimistic views of future value.
Virtual goods and virtual economies had all the right elements to boom. Initially, the conversion from real world stores of value into virtual stores was highly controlled. Some of these economies allowed for the transfer of goods and virtual wealth, and some didn’t. Quickly, however, competition forced a basic truth – people like obtaining virtual wealth in the form of virtual goods. They like seeing that value multiply and grow. More and more innovative services and economies were built, and increasingly they enabled mechanisms to convert those virtual stores of value into other virtual stores. They also enabled players to compound their virtual wealth. In fact, some even enabled the conversion back into real money.
Thus the vicious cycle was born. Converting real money into virtual goods, and then taking advantage of the ability to compound that virtual value at unrealistic rates, set off a true boom. The rate of return on virtual investments was so high compared to the anemic returns offered by the still moribund real economy, that early adopters looked like geniuses. In 2014, the meme began to spread that everyone should have a portion of their portfolio allocated to “virtual assets”, which were not highly correlated to traditional stores of value. Funds sprang up to allow the average individual without the time or inclination to invest and build virtual wealth to access the market.
The companies providing these ecosystems had no reason to dampen this enthusiasm. Their systems, like those of investment bankers or market makers of yore, ensured a percentage of all transactions as revenues. They made money as people converted real currency to virtual currency, and technically, as they converted it back. Like central bankers with no fear of inflation, they juiced their economies to juice their own revenues. Fortunately, the higher the internal rates of return in the virtual worlds, the less people were incented to take their virtual goods out and convert to real money. Everyone effectively let their money ride, watching their virtual wealth grow.
By 2015, the notional value of virtual goods exceeded $1 Trillion for the first time. Government bureaucrats began to explore the possibility of taxing these virtual economies to help cover increasing deficits. Lobby groups sprang up to protect this “new economy” from destruction. Pundits debated this nightly on all major cable networks. People borrowed real money at relatively low rates in the real world to invest in virtual goods, because the returns were so much higher. Real debt grew, savings dropped, but virtual assets grew faster.
Then, in 2016, one of the more flagrant virtual worlds began to see withdrawals rise. Not significantly at first, but it turned out they had allowed virtual wealth of their members to grow high enough that people began to “retire”. Everyone was in the game, so new entrants with smaller balances could match the asset loss. Suddenly, the bear arguments, which had been discussed for years (beginning with a famous blog post from 2009) began to make more sense.
No one had the real money to cover these virtual “liabilities” the companies implicitly had to their members. There was no virtual FDIC to cover accounts. There was no regulation to ensure that these accounts would be paid. The first “run” on a virtual economy had begun.
Suddenly, it became clear that these virtual economies were linked, even if owned by different giant companies. People who lost money in one virtual economy, began pulling real money out of others. One virtual world froze conversion, like a panicked 20th century third world nation. Then the run really began.
Virtual asset values plummeted. But the real debts did not. Suddenly it turned out that more companies had their fingers in the virtual pie than most people thought. Asset management firms. Insurance firms. Hedge funds. Large banks. Tech giants.
And that’s how virtual goods caused the market crash of 2016.
Do I believe that it will really happen? No. Do I believe that conceptually, virtual goods and economies could lead us into uncharted waters economically if we are not careful? Yes.
I’ve read quite a bit in the past decade about the history of market bubbles and panics, and the patterns of each. In every case, financial innovation creates some new way for people to assume liabilities in a highly leveraged way, outside of existing regulation or norms. In combination, some technology offers the world hope of a much larger economic future. Given the new found ability to invest heavily in that future, and radically different perceptions of that future, people invest, creating a virtuous cycle of high returns and increased investment that sucks almost all the air out of the system… and then keels over.
A fun mental exercise for a Thursday night.
Still I wonder. Since it’s only 2009, I feel like I don’t own enough stock in these companies. It’s going to be quite a ride.