Risk Management in the Virtual Real Estate Marketplace

August 19, 2022

Virtual Real Estate (VRE) is a form of real estate that is minted on the blockchain. This is made up of unique non-fungible tokens (NFTs). An NFT can be anything digital (like drawings, music, or videos). This includes “real estate” defined through a unique set of coordinates on a virtual map.

Virtual real estate is already a big business. Celebrities have already acquired plots of virtual land for millions of dollars. They can intend to develop for a variety of purposes, and where there are celebrities, there is marketing. Global businesses are buying the best placed real estate to market their goods. They can then sell in both the virtual and real world.

A variety of Metaverse Virtual World Providers market and sell virtual real estate. This includes the following:

Decentraland
Roblox
The Sandbox
Microsoft Mesh

Ali Metaverse (by Alibaba)
Metaverse (by Facebook)
Epic Games Metaverse
Zepeto (Zara’s Metaverse)

Metaverse (by Disney)
Samsung 837X
Gucci Garden

Example: Decentraland

3D browser-based virtual world platform developed and owned by its users.
Economy is based on Decentraland’s own crypto-token: MANA, which uses the Ethereum blockchain. All “LAND” parcels except for roads and plazas can be bought, sold, and developed by the users of the game using MANA coins. LAND purchases are registered in a blockchain-based ledger of parcels.
The game’s developers have set a cap of 90,061 on the total number of LAND parcels which will ever be minted. LAND parcels are nonfungible because every parcel has a different set of (x,y) cartesian coordinates.

Risks in the Virtual Real Estate Marketplace

The VRE marketplace is exposed to the same risks as the NFT and digital assets market more broadly:

Cybersecurity: Most assets are stored on “hot wallets” (internet connected) that can be hacked and stolen more easily than unconnected “cold wallets”.
Fraud: “Rug pulls” where the creators of the NFT/metaverse abruptly shut down the project and embezzle the project funds. This is especially risky when individuals are not involved in a registered marketplace or are a customer of a custodian.
Intellectual Property Rights: The biggest NFT platform, OpenSea, recently admitted publicly that over 80% of the NFTs on the platform are “plagiarized works, fake collections, and spam.”
Market Manipulation: “Whales” and the top 10% of traders alone perform 85% of all transactions and trade 97% of all assets, thereby having disproportionate control over the market.
Scams: A “Honey pot” scam is where the programmer of the tokens inserts code preventing the buyers from selling in the future.
Insider Trading: Actors in the market can use inside information to influence the market.
Asset Valuation: There is no market standard to fairly price and value virtual real estate, which makes it difficult to understand rapid fluctuations in the value of virtual real estate or identify potential abuses of asset valuations to mask other exchanges of value and beneficial ownership.
Legal Disputes: There is no defined legal recourse or jurisdiction for disputes if something goes wrong.
Financial Crime: Illicit funds can be introduced through various wallets, including crypto accounts lacking KYC or identity verification, prior to purchasing NFTs.

Despite this multitude of risks, digital asset marketplaces (including VRE markets) continue to be highly unregulated spaces. The U.S. Department of Treasury, for example, has not issued any regulations specific to NFT markets or indicated whether NFT market participants are subject to anti-money laundering requirements – such as know your customer due diligence and filing suspicious activity reports. Until regulatory agencies create clear guidance and regulatory requirements, risk management for VRE investments is very much the responsibility of individual marketplace participants.

Virtual Real Estate Market Participant Risk Management

Cryptocurrency exchanges, commercial banks, and other VRE market participants need to have a defined strategy to answering key questions about VRE and other virtual assets:

How can true ownership be confirmed?
How can one verify Source of Wealth if the SOW is connected to virtual asset sales?
Does the blockchain have sufficient transparency to trace asset ownership from fiat currency to Crypto to VRE and back to Crypto to fiat?
What constitutes effective risk management since there are no regulations?
What constitutes effective CDD when dealing with investors in crypto and NFTs/VREs?
How would you structure a targeted due diligence process for virtual asset investors?
Is it possible to determine what activity happens at a cryptocurrency exchange?

Regardless of your role or level of participation in the VRE marketplace, understanding how the VRE ecosystem works and the mechanics of VRE ownership can help you meet risk management challenges when dealing with funds, asset ownership and due diligence associated with virtual assets including VRE.

Written by Chris Andre