Chit funds have been around for as long as money and stock markets began. Well, at this stage, with so many prior lessons and experiences to learn from, one can only say that the people were stupid but at the same time, one has to realize that subscribers to chit funds are usually people will modest or poor means and who need money to tide over desperate times.
So how exactly do these chit funds work?
Actually, they were started between groups of people in small towns and villages, where there was no or poor access to bank loans to meet day-to-day or emergency expenses like marriage of daughter, fixing the roof, digging the well and so on. How this worked was - a group of know 15-20 people came together; let us assume 30. Each person was supposed to contribute Rs.1000 per month for the next 30 months ( usually number of people in the group and months match). So each month, the group collected Rs.30,000. There would be one person, who would be the organizer who will schedule the meetings and the venue and time. When the group meets every month, the people who need the money desperately make the bid. The one who makes the lowest bid gets the total money of that month. Suppose 2-3 people made bids , depending on their need for say, Rs.28,000 or Rs.29,000 or Rs.27,000. The lowest bid was at Rs.27,000 so that person will get the money. The organizer gets around 5% of Rs.30,000 per month as his 'fees' which is Rs.1500. So the winner of the bid will get Rs.25,500 (Rs.27,000 - Rs.1500) that means he has taken a loss of Rs.4500 which will be a profit for the other 29 members, and that will get divided between them, which is Rs.150. Thus the lowest bidder because he is in a desperate need, suffers a loss while the others benefit. The next month, the one who took the money cannot bid but will continue to contribute the said amount of Rs.1000 and the rest of the process will remain the same. There is no repayment of loan or interest payment. But the one taking the money on a discount indirectly pays an interest and those who stay back, earn more, like dividends. The last person earns the most.
Thus essentially, chit funds are like self-help groups formed by people will poor or modest means. But then big companies got in, giving it a 'corporate' feel but essentially operated the same way. The companies being the 'organiser' pocketed all the money but more importantly, they were getting funds at much cheaper rates than commercial, which in turn were thus diverted into more lucrative deals like real estate or gold.
South India and Delhi are notorious for the amount of chit funds operating and some of the biggest scams in chit funds, not surprisingly, happened in these places. When scams became rampant, the Govt put in place the token Chit Funds Act, 1982, which does not really offer much protection. The law does not stipulate the maximum number of subscribers per scheme, thus allowing scores of people in one scheme. Also there is no law on the required minimum quorum for the bidding - though there could be 1000's of subscribers, if even two members come for the monthly meet, the lowest bidder amongst the two will be given away the money. Thus companies ensure poor subscriber participation thus once again pocketing the money. The schemes are allowed to run for 5 or 10 years. And when the subscriber base gets large, the promoter of the company usually scoots away with all the money and people are left high and dry.