A brief introduction to chit funds and how they work

1. CHIT FUNDS
An insight to the mechanism,
concept and statistics regarding chit
funds

2. What are chit funds ?
• A chit fund company is a company that manages, conducts, or supervises such a
chit fund, as defined in Section of the Chit Funds Act, 1982. According to Section
2(b) of the Chit Fund Act, 1982:
• Chit funds operate in different ways, and this may lead to many fraudulent tactics
practised by private firms. The basic necessity of conducting a 'Chitty' is a group
needy people called subscribers. The foreman — the company or person conducting
the chitty — brings these people together and conducts the chitty. The foreman is
also responsible for collecting the money from subscribers, presiding over the
auctions, and keeping subscriber records. He is compensated by a fixed amount
(generally 5% of gross chitty amount) monthly for his efforts. Other than that, the
foreman has no specific privileges, she is just a chitty subscriber. A simple formula
depicts the pattern of the chitty:
• Monthly Premium × Duration in Months = Gross Amount
• The chit funds are mainly governed by The Chit Funds Act, 1982

3. Mechanism of chit fund
• E.g., 1000 * 50 = 50,000/- Where 1000 is the maximum monthly contribution needed from a
subscriber, 50 is the duration of the chitty in months and 50,000 is the maximum sum
assured. The duration also equals the number of subscribers, as there must be (not more or
less) one subscriber to receive the prize money every month.
• The chitty starts on an announced date, every subscriber come together for the auction/lot.
As per Kerala chit act, the minimum prize money of an auction is limited to 70% of the gross
sum assured that is 35,000 in the above example. When there are more than one person
willing to take this minimum sum, lots are conducted and the 'Lucky subscriber' gets the prize
money for the month. If there is no person willing to take the minimum sum, then a reverse
auction is conducted where subscribers open-bid for lower amounts; that is from 50,000 >>
49,000 >> 48,000, and so on. The person bidding the lowest sum will get the bid amount.
• In both the cases the auction discount, that is the difference between the gross sum and
auction amount, is equally distributed among subscribers or is deducted from their monthly
premium. For example, if the auction is settled on a sum of 40,000, then the auction discount
of 10,000 (50,000 - 40,000) is divided by 50 (the total number of subscribers) and every one
gets a discount of 200. The same practice is repeated every month and every subscriber gets
a chance of receiving some money.

4. Objective of the study
• To study various economical and geographical
statistics of the chit fund industry and hence
inferring about the basic structures of the
industry as a whole
• To carry out the financial statement analysis of
the major chit fund companies

5. Data Analysis and findings
• Study of the chit fund industry
i. To study the size of the registered chit fund industry
ii. To study the characteristics and the financial needs of the
chit participants
• Financial Statement Analysis of the
representative companies of the four states
i. Preparation of comparative financial statements of
individual companies with respect to previous years
ii. Preparation of comparative financial statements comparing
the representatives companies

6. Difference between a chit fund and
Ponzi Scheme
• A Ponzi scheme is a fraudulent investment operation where the operator, an
individual or organization, pays returns to its investors from new capital paid to the
operators by new investors, rather than from profit earned through legitimate
sources. Operators of Ponzi schemes usually entice new investors by offering
higher returns than other investments, in the form of short-term returns that are
either abnormally high or unusually consistent.
• Ponzi schemes occasionally begin as legitimate businesses, until the business fails
to achieve the returns expected. The business becomes a Ponzi scheme if it then
continues under fraudulent terms. Whatever the initial situation, the perpetuation
of the high returns requires an ever-increasing flow of money from new investors
to sustain the scheme.
• A chit fund company is the one which manages, conducts or supervises, as
foremen, agent or in any other capacity, chits as defined in Section 2 of the Chit
Funds Act, 1982. Such schemes can be conducted by organised financial
institutions or may be unorganised schemes between friends and/or relatives.
Chit Funds can be misused by its promoters and there are many several instances
of people sunning such Ponzi schemes and then absconding with investor’s money.

7. Saradha Scam
 The group collected around ₹200 to 300 billion from over 1.7 million
depositors
 The paid huge incentives to the agents. Incentives as high as 40% of the
total money collected from villagers. This helped in establishing a rapid
network of investors, agents and word of mouth beneficiaries.
This continued well into the late 2008.
 In April, 2013, Mamata announced a Rs 500 crore relief fund to
compensate the Saradha fraud victims.
 With each passing day, investigators dig deeper into the Saradha scam and
new revelations send shock waves across Bengal.
 But neither the state government nor the Opposition parties can offer any
hope to about 17 lakh investors who invested in Sudipta Sen’s company.
 The four companies of Saradha Group were by the names: Saradha Realty
India Ltd, Saradha Housing Pvt Ltd, SaradhaGarden Resort and Hotels Pvt
Ltd and Saradha Tours and Travels Pvt Ltd. The West Bengal police have
received a total of 560 complaints regarding the fraudulent companies.

8. Few safety measures before investing in a chit
fund.
Like any schemes, chit funds have its positive and negative features. So before you
take a call on putting your money in a chit fund, there are few things you need to
know.
Registered firms: It is mandatory that companies offering chit fund investment
schemes must be registered with the respective state governments. But, there are
many small unregistered companies, who may advertise heavily or are operated by
a known contact, who would aim to gain your confidence through their length of
association. Look beyond these factors to objectively assess the company or
scheme.
No fixed returns: They don't offer fixed returns like other deposit schemes. The
returns of a chit fund depend on the reverse auctions taking place each month. If
you are an investor looking for assured returns, it may be prudent to avoid chit
fund investments.
Liquidity issues: You cannot liquidate your investment until the chit fund completes
its cycle or unless you win a successful reverse auction. Many investors believe
that chit funds are useful to raise funds in an emergency, but to get money when
you wish you will have to lower your reverse auction bid, thereby reducing your
financial corpus.

9. NRI participation: The RBI has recently allowed NRIs to invest in regulated chit funds.
All NRIs can now invest in chit funds, provided the investment is done through a regular
banking channel and accounts managed in India.
There is no upper limit on the amount of investment an NRI can make in chit funds.
Possible manipulations: Chances are finite that fraudsters may join chit fund schemes
to bid and usurp the money they get in advance; thereafter, they may discontinue
further payments. Members who are in financial crunch may also drop out, as it
happens in the case of loan defaults. Such drop outs affect the scheme as a whole,
sometimes to the extent that the company finds it difficult to even complete the
scheme's cycle. All these would affect the investments of members.
The fine print: Investors need to be extra careful while joining a chit fund. They should
check the whereabouts and backgrounds of the promoters and go through every
aspect of the fine print before participating in the scheme.
Bidding rules: There are chances that some desperate members may drive the auctions
to very low levels. But chit funds regulated by the government have been mandated to
ensure that bids cannot be lesser than 70 per cent of the chit value. The maximum
commission a foreman can charge per bidding is five per cent, under the Chit Funds Act
1982. Private chit funds are also expected to follow this.

10. Why are chit funds a good investment option ?
• This question can be answered from two angles – from safety viewpoint and
investment viewpoint. In India, there are both large chit fund companies like
Shriram Chits and Margadasi Chit Funds as well as several small unregistered
ones. Registered funds are regulated and governed by law; but unregistered
chit funds are not bound by any regulations. When fraudulent chit funds
closed shop, several investors lost their hard earned money. It is therefore not
advisable to invest in such unregistered chit funds. Further, it is not advisable
to invest in chit funds where the other members are unknown to you. Thus,
the key to investing in chit funds is in choosing the right one.
• However, from an investment viewpoint, a chit fund does not promise returns
for an investor. It is not possible to calculate exact returns from a chit fund as
this depends on the level of emergency of members for funds, and this is a
highly variable factor. That said, a chit fund is a good saving instrument for
small investors and brings about a discipline in saving regularly. It is also useful
in getting funds when in an emergency. As chit funds are essentially not
investment products, you must consider investing in them only if you foresee a
need for funds in the near future, which you may not be able to get from your
bank, and thus start saving towards this need in a chit fund.