Misunderstanding the Second Life Lindex

A lot was written a few weeks ago about the instability in the Second Life™ Lindex. Darrius Gothly wrote: The Math Behind the LindeX. It has enough misconceptions I am moved to provide a counter point and more accurate information.

Marionette - 3

Marionette – 3

I’m moved to do it at this time because of a recent post in the forum. Some one thought selling L$ at L$265/US$1  on July 29 was setting the price to high… high!?! No that is pretty low, for a seller. 

Back to Darrius. He admits he isn’t a trained economist. But, one doesn’t need to be to understand a commodity market. If you have ever haggled over the price of anything you bought or sold, you understand the process, the economics, and how human nature fits into the process.

First a commodity is defined as: a raw material or primary agricultural product that can be bought and sold, such as copper or coffee. A boarder use of the term is any ‘thing’ that can be bought and sold. Americans tend to think of commodities as items that can be mass produced. So, something becomes a commodity when bought or sold in mass. Handmade items are often spared the designation but, that is a cultural nuance.

Currencies are unique commodities. They have their own markets. They are thought by many to NOT be a commodity. But, if we eliminate our preconceptions of currencies and look only at how people use money, the resemblance to a commodity is obvious. So, understanding the Lindex is easy when looked at as a commodity market. A currency exchange is just the name for a market trading only currencies.

First Misconception

Darrius says there is no regulatory agency or body of laws to control how the Lindex works. That is wrong. For the last couple of years we have been reading how the Lab is handling the exchange of L$ for various currencies around the world. Because of U.S. laws governing how the Lindex can operate and the U.S. Treasury Dept. being interested in the Lindex plus the laws of various countries many things have had to change. (Reference – 30k articles on subject.)

Second Misconception

The Buy-Sell Gap Darrius refers to as being imposed by the Lab is just a normal part of any trading activity. It isn’t imposed by the Lab.

Look at gold, silver, or any commodity and you will find buy-sell prices. There is always a gap. The reason is simple, human nature. I’ll explain.

The price of gold changes based on supply and demand plus a number of other factors. Supply in this case is not just a matter of how much we can dig out of the ground. It is also a matter of how much people want to sell at any given time.

During times of economic crisis more people want to trade currencies for gold to protect their wealth and fewer people want to sell their gold for currencies and risk losing wealth. The result is demand increases, supply decreases and the price of gold in terms of currencies goes up… or more realistically the value of currencies goes down. Historically gold has a very stable price when measured by how much corn or wheat it will buy.

Risk is all in how we see the future. The future is unknown and uncertain. So, each of us evaluates it and decides how much risk there is for any action or decision we may want to undertake. The number of people deciding the risk one way or the other decides the market’s buy-sell prices. As more people disagree on what will happen we see the price gap grow. As people evaluate the risks at similar levels the smaller the gap. (Reference – 258 million explanations)

Third Misconception

The price gap stops money laundering… On this one I am amazed. First money laundering is a high profit dangerous business. Illegal in all countries, AFAIK.

So, what is it? In general someone is getting money from some illegal activity. Let’s say drug sales of illegal substances. The IRS (in the US) watches what we spend. They compare that to our earnings to see if we are reporting all our income and paying appropriate taxes. So, before you can spend your ill-gotten gains you need to pay taxes and doing that requires you show how you got the income. If that is via illegal means, the IRS is going to rat you out to the proper authority (which depending which attorney you talk to is illegal). Big Problem.

So laundering is all about hiding where money is coming from. If you watched Breaking Bad, you saw Walter White, wife Skyler, and attorney Saul Goodman coming up with ideas on how to hide their drug money income.

If you cash L$ out to any RL currency you know you have to provide RL identification. This is the deterrent to laundering through Second Life. The buy-sell price gap is no deterrent. Think about it.

If you have millions stacking up in your closet and can’t spend it, it is basically worth nothing. So, how much of that would you spend to ‘clean’ the money? If I had to buy L$ at L$260/US$1 and sell it at L$275/$1 that’s not that bad a deal. Its only 5%. When BoA was busted for laundering money they were charging way more. (Reference – 194k articles on story.) So, the SL L$ gap is a good deal, an incentive, not a deterrent for money laundering.

Also, if you look at commodities you will find some buy prices are more and some less than the sell price. So, if only a high buy price stopped money laundering, there would still be a load of commodities that could be used for laundering. It’s the ID requirement, not the price that stops laundering. (Reference – 336k related articles)

Fourth Misconception

Darrius is on about the stable and unstable nature of the Lindex and how it affects the Lab’s income. Anyone that uses the stock market or commodities markets knows that the broker, which is what the Lab is, makes money on every trade. The broker’s incentive is to induce more trades, more activity. In the US there are laws against doing that and they do apply to the Lab and their Lindex. The Lab cannot legally instigate trading.

An unstable market creates lots of activity and broker profits. But, it is a short term thing. A less volatile market encourages more people to trade and makes for greater but longer term profits for everyone. (Reference – 3 million market stability related articles.)

Upside Down Pricing

When considering pricing in a commodities market you’ll see lots of confusing statements. Most deal with what is a high or low price for something. The confusion comes from the sellers and buyers seeing price differently.

In the Lindex we can say a seller is selling L$ and buying dollars. If dollars are expensive it takes a lot of L$ to buy one. If a car is expensive we pay lots of dollars to buy it. Our frame of reference is what decides what is expensive and cheap.

So, for a L$ seller a price of L$239/$1 is cheaper than paying L$258/$1. But for a L$ buyer a price of L$268/$1 is more expensive than buying L$296/$1. In one case a lower number is better than a higher number while in the opposite case it is reversed and higher is better than lower. (Prices from 7/29/2016 – 8±AM)

Until someone is willing to offer L$ below L$258/$1 (bigger number is lower price for L$) or someone is willing to bid more than L$268/$1 (smaller number is a high price) nothing happens, no transactions.

Summary

About the references, they are a mix of articles that support and disagree with what I have explained. In general they support my explanations. You have to read them with skepticism and thought and make your own decisions.

8 thoughts on “Misunderstanding the Second Life Lindex

  1. The L$ that someone has in his account are just an integer in a database, that someone with access to that database could change. The Lindens have access to that database and could that way print money. To convert that to USD, they would have to sell those L$ at the Lindex, which would result in a decrease of the exchange rate, because of additional supply. I suppose that is what happened the past weeks. They are not a broker, they are the central bank. The price gap exists because of transaction costs.

    • Not really the same with SL and the Lab. Explain where in the data base the Lab will make the change to expand the L$ supply.

      • I currently have 1000 L$ in my account. Where are those? -The viewer/website fetches this number from a database somewhere. They are a simple number in a database, just like almost all money that does exists in this world. Actual paper money is just a tiny fraction of the total volume of money in any currency. Somebody that is an administrator of that database could simply add money to an account, for example Money Lindens. Who then sells money at the Lindex for USD. The increase in supply will result in a devaluation of the L$.

        A real bank btw creates money in a similar way. Only about 3% of the total money in circulation is actually created by the central bank. All the other money is created by commercial banks, simply by writing numbers in a database or bank account. That is why they are afrait of bank runs, because they don’t actually have that much money.

        All money is debt. No debt = No Money. This is a significant flaw in our economic system. It is kind of a legal ponzy scheme (because of the interest), which in the long run must collapse, since it assumes unlimited growth. That is why many people find cryptocurrencies so interesting. They have real value, which Euro or USD have not. Euro or USD have only value as long as people have trust in them. Cryptocurrencies are scarce, a feature that gold has as well and therefore have value. That is why I hope Philip Rosedale will implement a cryptocurrency in High Fidelity as he promised.

        • Your idea that ALL money is debit is erroneous. The simple proof is a gold coin. It has value, intrinsic value, based only on the gold within the coin.

          Banks in general do not create currency. Only the government controlled banks are allowed to create currency and the US Treasury to print it. In the US the Central Banks or Fed control how much currency and money is created. While creation is a bookkeeping entry in a database it is not as simple as it sounds.

          On currency in circulation you are misstating it. As of June 1, 2016 there is $1.46 trillion in circulation of which $1.4 is in Federal Reserve Notes. (See Federal Reserve data) Almost 100% of currency in circulation is paper money and coins.

          You are also wrong about commercial banks creating currency/money/value by simple bookkeeping entries. It is more complex than that. In the US we use a fractional reserve system. They can loan money that is deposited in their bank thus creating duel claim to the same money. They are often said to be multiplying currency. I’ll concede that it can be legitimately said commercial banks create money but, not that it is just a bookkeeping entry.

          Because it is a fractional reserve system, even if all debit were paid off, there would still be $1.46 trillion in liquid cash. So, No Debit = No Money is erroneous.

          I suspect you are trying to express the M1 and M2 concepts but abbreviating them to support your idea that the Lab can do whatever it pleases with the L$. In doing so you have to mix M1 and M2 thinking. While there is only $1.46T in currency there is $11T in money (M1 + M2). M1 alone is $2.8T. And you are right this presents a problem for the banks if everyone wants their money at the same time.

          The $1.46T difference to cover the full M1 amount is not all that big a problem. The Treasury prints the additional $1.4T to make $2.8T in Federal Reserve Notes and hands it out. But, for the commercial banks they have to come up with something a bit less than $9T to cover the M2. That is the bump in a run.

          But, there is no M2 in Second Life and very limited M1. In SL we are dealing with only currency in circulation and there are no banks within SL to multiply currency. Any bookkeeping entry change in any account including Money Linden’s has to be justified, legal… RL legal. So, just as I COULD rob a bank, he could make illegal bookkeeping entries.

          You are right. The entire house of cards is based on trust and perception.

          Anything that would limit government control of money would likely be a good thing. Crypto-currency… it has possibilities. But, so few people understand money… even math… much less economics, I believe the general public is never going to go for it. Plus the change over as the free market corrects to a sane position would be way painful for many and that is likely politically unacceptable.

        • An example. Let’s create a new economic system. There is no money yet. So the government creates a central bank. They now create 100 money units and emitt those to the economy by lending them to a commercial bank for 1 % interest. The commercial bank now lends that to a company for 2 % interest and that company employs people and pays them wages, which then enables them to buy the products, which brings the money back to the company and so on. In this example we have just one of each. One year later the central bank requests the 100 units of money back plus 1 unit of interst. But there is only 100 in circulation. So the commercial bank requests a new loan of 101 to cover that. The money in circulation therefore increased. That will result in inflation, unless the economy grows, meaning the workers create more products. And this goes on and on and on. The economy has to always grow to cover interest and the total volume of money has to increase by the same rate as the economy grows. If it does not, we get inflation or deflation. Of course I am talking about fiat money. A gold coin is different. But what you see is, all money originates at the central bank as debt. It then is multiplied by a commercial bank, but still all debt. They are regulated by the central bank on how much money they can create of course. Still all money is debt. When I own 10 USD then you or somebody else owes me products valued at 10 USD, you are in debt. If the people and the government pay back all their debt, then money would cease to exist. Check out the video “Money as Debt” at Youtube. It would be a waste to print bank notes for all the money in circulation, because only a tiny amount is actually needed. Most transactions a digital and most money exists in a digital form.
          Anyway. Why shouldn’t Linden Lab just print money? Imagine we suddenly had 10.000 new residents in SL. That would require additional L$. Where would they come from. Of course Linden Lab would have to create them. They need to be an actor at the Lindex. If they balance supply and demand, the exchange rate would be stable. If not, then it changes. I don’t think there is a law which limits the Lab in creating additional L$? Besides the Lab pays every premium member in SL 300 L$ per week. That is freshly created money and results in a growth of the total L$ volume. At the same time the SL economy is shrinking slowly. How come the exchange rate used to be stable up to now? Linden Lab must create or destroy L$ accordingly.

          • You didn’t move your argument forward. You basically said the same things in a slightly different way and ignored addressing my points.

  2. The simple fact of the matter is that you can look at the average sell price over the last 5 (or more) years and see that “natural” causes have kept the average right at about 250/$1 for years, very very steady. In the last 2 months it has suddenly climbed 10L. I am unable to understand how it would do this naturally without assistance. Do we all have to offer Ls at $245 and tighten our belts and wait to naturally push a change? For those making their RL living in SL, this 10 extra L can be a pretty decent chunk of change. I watch every day, and when all of the Ls offered at $259 sell, suddenly someone dumps 15-20million L back in at that price. It seems pretty fishy to me. Source on sell prices: http://www.gridsurvey.com/lindex.php

    • In RL currency exchanges governments get involved, the political and economic costs are considerable. Others that can influence markets do so for their reasons. Almost all of those manipulations are impossible in SL… well… unprofitable.

      In SL the Lab makes money when users make transactions, like any broker. US$3 minimum otherwise 1.5% and $15 max. Figure L$10 as 4% of the price at 250/1. On US$60 million that is $2 million. So, it seems reasonable they would have incentive. But, start figuring the Linden cost to manage the market and the cost they would incur buying or selling L$ to stabilize the market. Start figuring the cost.

      For the Lab to sell L$20 million they have to literally put up US$80k. If users cash out that L$20 million it is a RL cost. How often are you seeing this happen? Once a week? That is 52 times per year. That figure to 52x80k = $4.2 million… There is currently L$316 million or US$1.3 million offered for sale at less than L$247/$1. Way more than $80k…

      If people are cashing out, say L$10k per transaction, that makes for 31,000+ transactions at 1.5% = US$0.6 so US$3 min = US$93k, they could still make US$13k if they tossed in US$80k. Or they could stay out of the selling and make US$93k…

      The natural cause for the Lindex moving up and down is people.

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