Discover more from Charterless
Play-to-Ponzi: STEPN and the Economics of Virtual Worlds
The rise of play-to-earn gaming. The silliness of "gaming purity." And the nuanced ponzinomics of virtual economies.
The Roots of Play-to-Earn
In case you missed it, there was a round of press coverage this past week about STEPN - the latest hot play-to-earn game.
Play-to-earn caught fire in 2020 with the rise of Axie Infinity. Axie is best thought of as a simple, super commercial version of Pokemon. Players buy monsters that they can train, use in battle (to win more coins) and breed (to create more monsters that they can sell). Play-to-earn is controversial in the gaming world because everything crypto is controversial.
But there is no support for claims that a simulated economy somehow corrupts the game. The first massive in-game economies were born in the early 2000s in games like EVE ($36M GDP per year in 2013) and World of Warcraft (~$770M in trading volume in 2021) . These are games that die-hard gamers love.
And, in reality, the digital goods economy predates even gaming.
In 2001, five-digit ICQ membership numbers (which proved the user had been on the chat app early) sold for >$3000 on eBay. In China, the QQ Instant Messaging app’s virtual currency, originally used to buy virtual avatars and clothes for those avatars, rapidly became a standard across the Chinese internet. By 2007, the virtual currency was large enough that the Chinese Central Bank began regulating it!
So – the commercialization of digital spaces is not unique to crypto. But in each of those cases - the value of the goods sold was clear (if alien to many of us). People bought items in these games for status or for utility in the gameworld. The ability to profit off of speculation was a potential motivation, but it was not as in-your-face as it is with Play-to-Earn games.
And this brings us back to STEPN.
STEPN is a simple app. You download it on your iPhone. You give it permission to track your location. Then like your Apple Health app it tracks your walking or running distance.
But the difference between STEPN and fitness apps is that to get real value from STEPN, you need to buy a pair of virtual sneakers. These sneakers are selling right now for a minimum of 11 Sol (~$450 USD). On a personal note, this is more expensive than any sneaker I own.
But for that money - you are not just getting a cute virtual sneaker - you’re getting a yield generating asset. For every mile you run or walk on STEPN, your shoe generates tokens. You can spend these tokens to maintain or upgrade your shoes. The tokens can, of course, also be bought or sold for cash.
STEPN rewards you for working out, but where exactly is the money coming from? The answer, of course, is new users who are buying tokens to purchase sneakers or other in-game items.
It was about at this point in explaining the game when my good friend, Aran, remarked: “Yes, that’s called a Ponzi scheme.”
This is a frequent charge leveled against play-to-earn games. It’s also not a great look for STEPN that their CEO has written two separate articles in the last six months arguing that STEPN is not, in fact, a Ponzi scheme.
I mean, buddy, if you have to keep saying it…
But the STEPN case is worth diving into because almost every new financial instrument in history was once derided as some kind of a Ponzi scheme.
And that includes standards of our institutional regime like banks (who keep a fraction of your reserves on-hand and loan out the rest) or social security (who is paying out to old workers if not new workers?).
So I spent some time understanding Ponzi schemes, play-to-earn gaming and the thin line that divides them.
The History of Ponzi Schemes
The first Ponzi scheme was not, as you might have expected, organized by Charles Ponzi.
Forty years before Charles ripped off his investors to the tune of $15M (~$216M in today’s value), Sarah Howe launched the Ladies Deposit.
Sarah Howe advertised an 8% interest rate to female savers in the United States. When she was unable to return it – because it was a Ponzi scheme – authorities arrested her and she served three years in prison.
A Ponzi scheme is actually a pretty simple program.
You raise money from a first round of investors, promising them a wild return.
Then you leverage those investors to attract a larger second round of investors.
When that second round “invests”, you use their money to pay out profits to the first group of investors.
The “success” of that first round attracts a third round of investors. So you pay out the second round of investors from their deposits…
Rinse and repeat.
The problem becomes clear quickly. Here’s how a US Government Social Security (oh, the irony…) website describes it:
“To pay a 100% profit to the first 1,000 investors you need the money from 2,000 new investors. To pay the same return to these first 3,000 investors in the next round, you need the money from 6,000 new investors. If all the investors stay in the scheme, then you will need 18,000 new investors to pay off the first 9,000 investors. In fact, if all the investors stay in the scheme, the number of investors participating has to triple with every round of investments. In Ponzi's scheme, starting with only 1,000 investors, after the 15th round the number of investors would exceed the population of the earth.”
Each generation has had its major Ponzi Scheme. Lou Pearlman, the creator of the Backstreet Boys and 'NSYNC had a 300M operation. In 2001, Minister Gerald Payne used his church to run a $450M Ponzi operation. And, of course, the grandaddy of all Ponzis – Bernie Madoff ran a $20B operation before his arrest in 2008.
But is it a Ponzi?
The first signs of this scheme are clear. A Ponzi Scheme occurs when you use funds from new investors to pay out old investors. But actually – that’s not that rigorous of a boundary.
Speculation naturally has a bit of Ponzinomics to it. Real estate speculators buy properties invested in by older investors in the hope that they, too, will be able to flip it for a profit.
The difference between a Ponzi and a speculative investment is that a real investment generates value outside of speculation.
This is the distinction that matters, and it’s one that we need to pay attention to when we are considering games like STEPN.
STEPN’s creators are particularly sensitive to the Ponzi accusation. In a blog post, they outline the exact dynamics that can create a Ponzi-like effect in Play2Earn games.
I’ll paraphrase their summary.
In a Play-to-earn game, users purchase an NFT for $100 and earn payouts of, say, $1 per day, that can be used in-game to upgrade items or to cash out. But how can a user cash out? Most games bootstrap a liquidity pool that pegs the value of their token to a relative value of USD. As the game progresses, and more players join, the liquidity pool grows and becomes more robust so that players can buy-in or cash-out at will.
But this result only arises when the supply of tokens and demand for tokens are well-balanced. If demand outstrips supply, the price for tokens will rise (as speculators bet). But if supply outstrips demand, then the value of tokens will begin to collapse. This sets off a run-on-liquidity where early investors may still profit, but new investors (who bought in at a higher price) get screwed.
So the key to any play-to-earn game is twofold:
1. Keep the supply of tokens constrained;
2. Ensure that demand for tokens stays high.
Doing the first is simple if the tokenomics are well designed. Bitcoin, for example, has a total fixed supply. And most play-to-earn games introduce ways to “burn” tokens by buying items from the game itself.
The second, though, is where the magic lies. To keep demand high, you have to attract/retain users and keep finding new ways for them to spend their tokens.
And that is actually the most difficult thing to do in game development. Games are novelty engines. People love playing games until they master them. But then, the games become repetitive. At that point, users are likely to churn to find something new to play. In traditional gaming, the company would then move onto investing in a new title. In play-to-earn games, user churn triggers a hyper-inflationary death-spiral that hurts late adopters.
Now, there are occasional games that manage to succeed and entertain sustainably. World of Warcraft is 18 years old. EVE is 19 years old. SecondLife is 19 years old. But far more often, titles spike in popularity and disappear. Remember Pokemon Go?
So a better analogy for STEPN and other play-to-earn games might be real estate investment.
Say that I start a great new neighborhood called Charterless City. I offer you the opportunity to buy a condo in my new town for $1,000,000. You like what I’m doing with the city and believe that it will continue to be an attractive place to live so you buy-in. And, yes, you enjoy living in Charterless City, so you’re getting value out of your money. But you’re also hoping that other people will want to live here and buy your house. This is how you will profit off of your investment in the future.
If I do my job well as a city planner, your investment could be profitable.
But if, instead, Charterless City starts to lose its luster and new planned communities crop up around the city limits, people will start moving out of Charterless City. If you don’t sell quickly, you could lose your entire investment.
So you start selling. And so do your neighbors. Now, you bought in early, so when your condo sells for $1.2M, you’re pretty happy. But our new investors, who bought in at a higher price of say, $2M per condo, are now down 40% on their investment.
There’s nothing illegal about that, but it’s important for any investor to understand the risks involved. And that’s the problem with Play-to-Earn gaming. Users need to understand exactly what they are speculating on. They are not only investing in an asset that will generate income for them. They are betting that the game creators continue attracting new players while retaining existing players.
That could well happen. This is not a pure Ponzi where the dominos have to fall at some point. There are long-running virtual worlds with robust and sustainable virtual economies.
But, is STEPN likely to be one of them?
Is it really likely that in five years, people are still going to be using virtual NFT sneakers to earn yield on running?
If you think that the answer is yes, or you believe that the company will successfully expand into other exercise-to-earn products then, by all means, you should buy in. But even success stories like Peloton know that it's hard to retain exerciser attention.
So if that’s not your vision of the future then, yes, you’re really just sending your money to Mr. Charles Ponzi and praying you’re one of the early elect. And, look. Gamble-to-Earn has made some people rich. It just has made a lot of people poor. So you should always be clear about the game that you're playing.