A Holy Grail of Internet commerce has always been the establishment of an effective microcurrency. How do pay someone three cents to hang out at your location online? How do you get someone to pay you thirty-five cents for a pair of virtual sunglasses? The transaction costs have traditionally been greater than the value of the transaction, so the transaction does not take place. In Second Life, Linden Lab has come closest to addressing the problems of a low transaction cost microcurrency. Yet their latest actions are damaging their ability to be an effective microcurrency processor.

One issue that needed to be addressed in establishing an effective microcurrency is that the Internet is global and microcurrency needs to be transnational. One of the expensive transaction costs is converting the microcurrency to whatever the local currency of user. Any sovereign currency could be chosen as the default currency and as long as users kept their money in the specific currency, the transaction costs would not be incurred. However, there would remain the currency risk of the specific country.

By establishing a completely different currency that acts independent of any specific country, Linden Lab, with their Linden Dollar mitigated country specific currency risk as well some of the nationalistic issues surrounding supporting a currency. The move also may have mitigated some legal risks.

A second issue that the Linden Dollar addressed is that the basic unit was sufficiently small, approximately a third of cent to facilitate very small transactions. Items that cost ten Linden Dollars can easily be bought and sold.

Since the Linden dollar is tied to an authenticated user account, the authentication only needs to be done when a user connects to Second Life. This facilitates a much easier way of completing a microtransaction. A user can simply click on another user or an object and select ‘pay’. Other microcurrency systems require repeated authentication as you move from one site to the next and as such provides a disincentive to use.

However, establishing an effective microcurrency system can bring with it a new set of problems. First, there are scammers. As it becomes easier to move money, it also becomes easier to scam people. Then, there are the money launderers. The easier it becomes to move money, the easier it is to launder it. With these problems comes another problem, the governments. They seek to protect people from scammers and money launderers.

It is not clear to what extent the recent decision by Linden Lab to prohibit unregistered banking was driven by governmental authorities. Yet one thing is clear. There unilateral action, considered by many to be arbitrary and capricious, has seriously damaged the credibility of Linden Dollar. It has overnight drastically reduced the value of various people’s invests in Second Life.

If Linden Lab is capable and willing to make such decisions, what is to prevent them from make such decisions again in the future? The wise resident should keep their investments in Second Life to a minimum to protect against this sort of currency risk.

There are other ways that this could have been approached. Some of these ways could perhaps still be used to recover, at least in part, from Linden Lab’s poor decision. To the extent that the concern is the transfer of funds between different accounts, a Second Life Merchant Bank, set up as a registered and regulated bank could be used to facilitate such transactions. The Second Life Merchant Bank would have the responsibility to make sure that legal issues of transferal of funds are addressed. This would absolve Linden Lab of much of the legal liability that many believe drove their decision.

Such a merchant bank would need to keep sufficient records of its users. It would need to submit to regulatory audits. The bank would need to find some way to cover expenses, and like other merchant banks, would probably need to charge a transaction fee. It would probably be more complicated than the simply click to pay mechanisms in Second Life. In short, it would return some of the transaction costs to the Second Life microcurrency.

Another approach would be to create some sort of Second Life Deposit Insurance Corporation. Setting up such a corporation could be done as a regulated financial corporation. By making all transfers to and from banks through such a corporation, the corporation could create better fraud checking. It could track the reserves and interest rates of the different banks and set the premiums as a function of this. It could follow the example of the FDIC and only insure deposits up to a certain size.

These are just a couple short-term ideas that occurred to me without much effort. I’m sure that there are people out there that can take these ideas, expand upon them, or come up with even better ideas.

Perhaps the most important approach, however, would be to work with national and trans-national organizations to adopt banking and securities law to the twenty first century and the emerging technologies. This is a longer term approach that anyone seriously interested the future of the internet should be engaging in.

There is one other approach that seems fairly likely. People will move away from using Linden Lab altogether in the capital markets area. Central Grid has been working on setting up a business oriented alternative grid. It is based on OpenSim, an open source project to create alternative Second World like simulators. The folks at OpenSim, like the folks at Linden Lab have punted on the important issue of microcurrencies, yet since OpenSim is open source, groups like Central Grid can add extensions to support currencies in new and innovative ways. Several other companies, a few of whom are currently doing business in the Second Life capital markets are also exploring these options.

An effective microcurrency remains a Holy Grail in Internet commerce. Linden Lab made important headway in establishing an effective microcurrency. They appear to have taken a wrong turn. Hopefully, they will return to a wiser path soon. Otherwise, we will need to look for other companies to move us forward.