(FORTUNE Magazine) – On a recent Saturday night, I punched in the code to enter the offices of a friend's startup in San Francisco. It was dark, so I stumbled through the maze of cubicles toward a bright light across the large loft space. There, projected on the wall, was South Park: Bigger, Longer & Uncut in its hysterical glory. The source? My friend's PC's hard drive.

The quality wasn't bad, considering the pirated film was captured on a camcorder, reformatted, and compressed for transmission over the Internet. The images were clear, though once in a while the shadow of someone running to the restroom would obstruct the view. The soundtrack was a little fuzzy, so it was hard to make out the deliciously raunchy lyrics in the movie's songs.

It's not that my friend can't afford to see these films in the theater. (Yup, he's another Internet millionaire.) So why does he bother spending hours (12 hours or more, even on a T1 line) to download pirated movies? "Because it's possible," he says. "You do it to show your friends you're one step ahead."

He double-clicked on a "movies" folder and showed me his wares: The Matrix, The Phantom Menace, Big Daddy, The Blair Witch Project, Election, EdTV, and both Austin Powers flicks--almost all current features you can't yet rent or buy.

My friend has tapped into a community of pirates. There are sites that help traders find out about new releases and establish who has what. Then would-be downloaders meet in the dark back alleys on Internet Relay Chat to trade. My friend (call him Deep Download) says pirates have written tools--there's one called VCDgear--that help them convert video CDs to MPEGs, which can then be played on a software MPEG player, like the Windows Media Player.

For the motion picture industry, online movie piracy is a looming threat, in the same way illegal MP3 files are endangering the profits of the music industry. Most pirate activities take place among college students. But as broadband high-speed access becomes more common in homes and the processing power of computers increases, it's going to get a lot worse. Already, within a week of the release of The Phantom Menace in theaters, Netheads were trading copies. People in Europe were downloading the movie and watching it on their computers a month before the film was released there.

The Motion Picture Association of America has had a pretty schizophrenic response. Perhaps it's fearful of what's been going on in the music industry. When the Recording Industry Association of America tried to frighten people into complying with the law, downloads grew exponentially--all the talk about MP3 files educated people on the new way of finding music. Fearful of a similar phenomenon, Mikhail Reider, staff supervisor for the MPAA's antipiracy operation, says: "It's a very, very small community of people. It's not doing severe damage to our industry now." But later in our conversation, she admits the threat could become serious. "As quality improves and delivery options improve, it could seriously harm our industry."

Regardless of what the MPAA says externally, the association is getting tough. It has tracked people down, mostly college students who have been expelled for using high-speed connections at their universities. Reider hints that you never know whom you're trading with in chat rooms--a co-conspirator or an MPAA plant. But to traders like Deep Download, the risk probably makes trading more fun.

--Jodi Mardesich

The previous two articles first appeared in Valley Talk, FORTUNE's online column covering Silicon Valley. You can read it on the Web or subscribe to it by surfing to www.fortune.com/technology/daily.