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Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

What is a chit fund?

Mistaken for multi-level marketing schemes, chit funds get a bad name when there is an MLM scam

By Lisa Pallavi Barbora

Saradha Group has been under intense media scrutiny in the last few weeks. The collapse of its public investment schemes, run under the façade of a collective investment scheme (CIS), which is regulated by the Securities and Exchange Board of India, caused severe losses to many people. While it is alleged that it was running organised chit funds, the matter requires deeper scrutiny on whether it was actually a chit fund.

There are various such financial schemes such as chit funds, multi-level marketing schemes or ponzi schemes which are all different from one another. Here is a quick look at what chit funds are and whether it’s a suitable instrument to park your money.

While unorganised chit funds that may be run informally among family, friends or acquaintances are still common, there are organised and regulated chit funds, too, which are any day safer.

Unorganised chit funds

In simple terms, a chit fund is an arrangement that a group of people arrive at to contribute money in a defined manner at periodic intervals into a pool or a kitty. During the process of collection, any member can draw a lump sum through various ways like a lucky draw, an auction or a member can even fix a payout date based on a known expenditure.

The number of members equals the number of times a contribution is made to ensure everyone gets a turn. For example, if a group of say 15 people pay 2,000 each a month, the total monthly pool becomes 30,000. Now, in case of an auction, if three members need money at the same time, one is chosen through a process of bidding and the lowest bidder gets the deal. So if three people put in their bids (the bid amount is usually slightly lower than the total pool amount) and the lowest bid is 25,000, then the bidder will get 25000 immediately; the remaining amount gets divided among the remaining members at the end of the tenor.

These schemes are very popular in tier II and III towns in India and even in rural India, thanks to under-penetration of banking services, as they are a way of raising quick money or catering for sudden liquidity needs or even a planned expenditure. Says Ashvin Parekh, partner, national leader, global financial services, Ernst and Young LLP, “These schemes have become popular because of the limited reach of banking in small towns. Also, banks haven’t recognised the fact that the common man with a small income finds it very difficult to undergo the entire procedure of getting a loan, adjusting to bank working hours and other demands."

Organised chit funds

There are many organised companies incorporated to do this as a business and these are governed by state or central laws. There is a central Chit Funds Act of 1982, apart from a number of state chit fund Acts. There is an office of “registrar of chit funds" in every state that monitors operations which are quite stringent. Utilisation and appropriation of subscribers money is strictly prohibited.

While there are many companies, too, that have defrauded people, Parekh says that there are genuine companies as well that cater to the cash requirements of members locally. The first step of regulation, therefore, comes at the state level; hence it’s the state government which is responsible for any fraudulent activities by chit fund companies. The issue arises because there is no entry barrier to start operations.

Says Parekh, “Setting up a scheme is an overnight exercise and it is difficult to have these regulated by a central regulator, hence states have to be involved in the implementation and monitoring of any regulation around these schemes."

Should you go for it?

While a simple form of chit fund operates to fund the needs of members, it can get complicated when it enters the realm of things like getting members to fund real estate projects and so on.

The bad experiences have left individuals in some areas more vigilant. Ahmedabad based Siddharth Shah, owner Shalibhadra (Master Investment Broker), an investment products distributor, says, “Here there are no opportunities for such schemes as investors previously lost money in things like plantation schemes. As a result, chit funds and the like have no acceptance and no market here." Organised or otherwise, this is not an investment plan, rather it is a way of funding your big spending by ensuring you get a large amount on a certain date. The lump sum comes at a reasonable cost and provides high convenience as compared with say a bank loan. Chit funds remain an option for those outside formal finance, those with bank accounts can stay away.

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