The Hidden Dangers of Unregulated and Private Chit Funds

Chit funds have long been a part of India’s informal financial ecosystem. Blending aspects of savings and borrowing, these schemes are often woven into the social fabric of small towns, urban neighbourhoods, and even office circles. On the surface, chit funds seem like a convenient, flexible, and even trustworthy way to manage finances.

But beneath this familiarity lies a significant risk—especially when the chit fund is unregulated, privately managed, and operated outside the bounds of formal finance. Investors lured by the promise of higher returns may find themselves caught in a web of defaults, mismanagement, and financial ruin.

This article outlines the key dangers of investing in such schemes and why cautious, informed decision-making is essential.

Understanding How Chit Funds Work

A chit fund is a type of rotating savings and credit association (ROSCA). A group of people contribute a fixed amount of money every month. At periodic intervals, one member receives the total pot, either through auction, lottery, or mutual agreement. The cycle continues until every member has received the fund once.

At its core, this mechanism relies heavily on mutual trust and timely contributions.

There are two types of chit funds:

1. Registered/Regulated Chit Funds – Operated under the Chit Funds Act, 1982, and supervised by a Registrar of Chits in each state.
2. Unregulated/Private Chit Funds – Often informal, community-based, and completely outside the purview of regulatory oversight.

Why Unregulated Chit Funds Are Risky

1. The Trust Trap

Most unregulated chit funds are run by familiar individuals—friends, relatives, or local business people. The emotional bond and social trust may give a false sense of security. However, financial systems need more than goodwill—they need structure, accountability, and transparency.

When subscribers default, the entire scheme can be thrown into chaos. No matter how trustworthy the foreman (organizer) is, they are often ill-equipped to handle default risk, legal complexities, or liquidity issues.

2. The Default Domino

The system works only if every member makes regular contributions. If even one significant member defaults, it can trigger a liquidity crunch. The fund cannot pay the next recipient, causing panic and loss of trust. This often leads to more defaults, and the system can collapse entirely.

In such situations, the foreman is left with no legal recourse, no recovery mechanism, and no capital buffer. It’s not uncommon for well-meaning organizers to simply disappear or shut down the chit abruptly, leading to total loss for investors.

 3. No Legal Protection

Unregulated chit funds operate in legal grey zones. If the organizer absconds or the group collapses, there is no legal safety net for investors. Unlike bank deposits (which are insured) or regulated investment products (which come under SEBI or RBI oversight), these funds offer no recourse or dispute resolution mechanisms.

The law does not protect informal verbal agreements or undocumented contributions—leaving investors entirely exposed.

Regulated Chit Funds: A Safer, But Limited, Option

If you’re still inclined toward chit funds due to their flexibility or community aspect, your best bet is to go with regulated, professionally managed chit companies. Some of the most reliable names include:

• MSIL Chits – Operated by Mysore Sales International Ltd., a government-owned entity.
• Shriram Chits – In operation for over 40 years and governed by the Chit Funds Act.
• Margadarsi Chits – Another well-established and professionally run chit fund company.

These organizations:

• Register each chit scheme with a government registrar.
• Maintain capital reserves and risk-mitigation strategies.
• Disclose auction results and commissions transparently.
• Follow strict KYC norms and participant due diligence.

However, it's important to manage expectations: because of operational costs, commissions (foreman fees), and prudent risk controls, net annual returns are usually around 5-6%, not the 12–15% many informal chit organizers claim.

Why Higher Returns Are a Red Flag

Unregulated chit funds often dangle the carrot of higher returns—typically quoting 12–15% annually. But there’s a catch:

• The foreman’s commission is usually around 5%.
• Early members may win the pot at a steep discount, reducing the value left for others.
• The entire scheme is sensitive to participant behaviour—one person’s delay or default affects everyone else.

When adjusted for these factors, the realistic net return is often below 6%, making it comparable to returns of safer instruments like debt mutual funds or fixed deposits—but with 10x the risk.

 As alternate to formal financing (loan) option: As mentioned earlier, Chit Funds may also be seen as a way of credit or financing (taking loan). Perhaps this dual nature is also reason for their popularity in the unorganized and unbanked community. Getting the loan (the chit fund prized awarded to your bid) is not certain but one can get the loan with minimal or nil documentation and nil collateral. This happens only with unregistered chit funds and the fundamental source of default risk. Getting the chit fund prized (bid), i.e. taking loan from the organized & registered chit funds is as much hassle as getting loan form an organized financial institution or a bank. This is because these banks and registered chit funds put in place processes, documentation and collateral requirements to safeguard other subscribers or depositors. So, chit funds are rather easy ways to get loan for those people for whom it is difficult or impossible to get loan from bank. So, for people who can get loan from formal banking system, chit funds do to work out to be good source of financing also, as they can get loans from the banks on better terms (lesser interest rate than what it works out to be from an unregulated chit fund).

 Comparison: Regulated vs. Unregulated Chit Funds

Feature	Regulated Chit Funds (e.g., MSIL, Shriram Chits)	Unregulated/Private Chit Funds
Registered under law	✅ Yes	❌ No
Foreman accountability	✅ Yes	❌ No
Legal contracts/documentation	✅ Yes	❌ No
Risk management processes	✅ Yes	❌ No
Investor protection	✅ Moderate	❌ None
Expected returns	5-6%	Claimed 10–15%, often misleading
Default buffer/reserve fund	✅ Yes	❌ No

 Government and RBI Warnings

The Reserve Bank of India (RBI) and the Ministry of Finance have repeatedly warned citizens against investing in unregulated schemes—including informal chit funds. Many state governments have blacklisted private chit fund operators who were involved in large-scale frauds or pyramid-like setups.

The infamous cases of Sahara, Saradha, and Rose Valley demonstrate how dangerous unregulated savings schemes can be. In most of these cases, lakhs of small investors lost their life savings.

The Behavioural Trap: Why People Still Join

Despite the risks, chit funds continue to thrive in many regions. Why?

• Social pressure: It’s hard to say no when friends or family members organize it.
• Low entry barrier: Monthly contributions are small, making it feel “harmless.”
• Lack of alternatives: In semi-urban and rural areas, formal credit systems are often inaccessible.
• Financial illiteracy: Many people don't assess risk-adjusted returns—they only see the gross return.

Education and awareness are the only long-term solutions to this behaviour.

What Should Investors Do?

If you’re considering a chit fund, here’s a quick checklist:

Question	Yes	No
Is the chit fund registered under the Chit Funds Act?	✅	❌
Is the organizer a government entity or reputed company?	✅	❌
Are returns illustrated clearly, after commissions and fees?	✅	❌
Are member defaults covered or insured?	✅	❌
Is there legal documentation for your investment?	✅	❌

If the answer is "No" to any of the above, stay away. There are better, safer, and more rewarding ways to grow your wealth.

Conclusion: Trust Structure, Not Just People

Trust in people is valuable—but in financial matters, trust must be supported by systems, regulations, and transparency. Unregulated chit funds are akin to building a house on sand—it might stand for a while, but the moment trouble comes, it collapses, often irreparably.

If you are serious about building wealth, consider safer alternatives like:

• Bank recurring deposits
• Government-backed savings schemes
• Mutual funds
• Regulated chit funds (if absolutely necessary)

Always remember: when something seems too good to be true, it usually is.

Financial prudence starts with asking the right questions. Don’t let familiarity blind you to risk. Choose safety, structure, and regulation over promises of high returns.