DeCF (Decentralized Chit Funds): How FinTech can revolutionize Rural India.

What emerged as a simple system of lending money between members of a community, has established itself as a consequential credit instrument in India, despite its reach often being unheard – more aptly, understated – in our conversations involving credit. Chit funds have their roots entrenched in history; the first instances being reported in 1120 and its prevalence being noted by British officers in colonial India. The late-20th century formalized chit funds under the Chit Fund Act, 1982, and fully recognized them as a crucial element to the Indian financial system. It can be visualized as a type of cooperative that requires all members to contribute a specified amount each month, and the member that needs money the most can withdraw in a rather unique auction-style bidding session. However, the current concept has its fair share of drawbacks that pose serious risks. Blockchain or Decentralized Ledgers can help make Chit funds secure, smart, and super easy to use!

But, what are chit funds?

Chit funds can be seen as an all-in-one financial instrument. A definition of a chit fund varies from person to person. For some, it is a money deposit scheme or a saving cum investment scheme and for others, it is a loan or credit scheme. In its absolute form, it is a saving cum borrowing scheme where a member or subscriber agrees to contribute a fixed amount every month for a fixed period. The total amount contributed by subscribers shall be auctioned and given as prize money to the needy subscriber every month. An example will make things clear. Let’s assume that a chit fund scheme has 50 members, each paying a monthly installment of ₹1000 to have a first-month pot of ₹50,000. When the auction is announced, the member who bids to take home the least amount of the chit fund wins the bid. Let’s assume the winning bidder agrees to accept ₹45,000 of the total chit fund value for that month, the rest of the amount – ₹5,000 – is distributed equally amongst the other 49 members, after subtracting the organizer’s fees.

Are there types of Chit funds?

Chit funds can be organized formally by financial institutions or informally by community members, friends, relatives, etc. Accordingly, there are various types of chit funds, depending upon who the subscribers are and who takes responsibility for setting them up. Registered chit funds are organized by the government and registered with the Registrar of Firms Societies and Chits, in regulation with the Chit Fund Act, 1982. Unregistered chit funds, as the name suggests, are saving schemes, not registered to any state governments. Operated among close friends, family, and colleagues, these are relatively riskier to invest in. Special Purpose chit funds are saving schemes tailored for a specific purpose that is common to the members of the group. In response to the increasing popularity of e-commerce, Online Digital Chit Funds have also emerged with all the transactions and balances maintained through the Internet.

Are they safe?

For the educated crowd that is aware of bank and government credit schemes, it seems obvious the financial risk the chit members face as soon as they join. However, it is imperative to highlight the risk that chit fund owners accumulate as they attempt to convince more members to join. This scenario doesn’t just affect owners or members. There is a butterfly effect that can trigger a problematic economic crisis. India has come close to this many times due to the failure of chit funds regulation as we observed in the case of the Saradha scam. After analysis of current chit fund regulation, we can see the following risks in the Marketplace:

  1. Financial Literacy: Starting with India’s biggest economic issue, the rural population amass a literacy rate of 50.6% for females and 74.1% for males. Many get roped into unregulated funds and end up indebted to cheating moneylenders and other scams. Until we show signs of improvement, it will be hard to implement a solution with decentralized ledgers. This is also one of the biggest hindrances to the future of a Blockchain lead world. With a mix of studies done to assess technological and financial literacy rates, it is evident that the solution created to supplement current Chit fund regulation has to be simplified or UI friendly. But that’s a design solution, this is a discussion for backend solutions.

  2. Unregistered Chit Funds: Regulation has drastically improved since 1982, however, most Chit fund scams and insolvency occur with unregulated or unregistered funds. There are 2 roots to this problem, one being regulation, the other being knowledge shared. If financial literacy can be a more seriously addressed issue in rural areas, it becomes much easier to track, trace and locate where funds are being misallocated.

  3. Assessment of Credit Worthiness: We’ve looked at risks taken by investors/ members. Now, let’s assess why some registered funds face insolvency issues. There are certain measures that formal institutions put in place to protect their financial positions that informal institutions don’t follow. One of the major factors is not assessing the financial position of the members. If the members have an irregular flow of income, then it is highly dangerous for all other participants to pool in their money.

  4. Unaccounted payments: There are certain transactional powers that you let go of as you use payment forms like Cash, Bank transfer, or Check. While the concept remains old, the modes of payment and transaction have to evolve to adapt. There are far too many transactional issues for us to ignore the importance of a new accountability system. In the next section, a more secure, transparent, and decentralized solution will be highlighted with a use case example showcasing its importance.

What can we do about it?

After looking at why certain Chit funds have failed, there are certain measures we can take to add a new level of security through Blockchain. Dubbed as the RAFT (Research, Assessment & Financial Transactions) solutions, this is a run-through of Chits that are based on decentralized, distributed ledgers.

  1. Research: The internet is known as the information revolution, it has enabled millions of people to access sources of valuable information for free. It has also very positively impacted the financial services industry. Anyone with internet services can check and assess risk, past performance, statistical indicators, and more for any financial product before investing. While it is arguable how much the reach of the internet has impacted rural areas, there are straightforward signs of improvement. However, it only gets better using Blockchain. IBM elaborates on Blockchain as the following: “Business runs on information. The faster it’s received and the more accurate it is, the better. Blockchain is ideal for delivering that information because it provides immediate, shared and completely transparent information stored on an immutable ledger that can be accessed only by permissioned network members.”. This holds for Chit funds that can run on the Blockchain as well. The flow of communication is improved many times over in terms of the financial security of owners, transparency of transactions undertaken by the Chit, and the exclusivity of information to the members. More directly, this solution aims to resolve the risks faced by consumer inefficiency in information. Financial literacy is a very one-dimensional problem in this scenario is you can change the security structure for information flow without having to explain the understandings of Blockchain.

  2. Assessment: Now, that we have established information using the blockchain is more efficient, it is important to state the value to owners of chit funds as well. Many registered (and informal) Chits face the issue of non-compliance or default on payment by members. This can be due to many factors: ignorance to assess the financial background of a member, economic externalities, etc. However, one of the beneficial outcomes of blockchain is easy to access to structured data which can then be used to generate advanced analytics and accelerate machine learning. This will enable tools to get smarter and drive us further and faster toward more continuous auditing and assurance. While Blockchain does conform to security measures, it is more beneficial to all parties involved to infuse better fiscal discipline by ensuring a certain degree of risk assessment is done before adding a member to the Chit’s Blockchain. As proclaimed by many Blockchain scientists, this is the future of risk assessment and auditing. Institutions like Deloitte & ICAEW are at the forefront of research in Accounting Blockchains.

  3. Financial transactions: The most obvious solution to better secure monetary exchange for Chits is to use decentralized or automated ledgers. Since Chits require frequent monthly transactions, the chances for default are relatively high. By using automated smart contracts, that can be very simply and quickly coded, we can ensure a secure and smooth passage of money. It is also very easy to code the specifications of each type of Chit. As if you water down any requirements to a Chit, it is just a line of codable text. A problem they may face is gas fees. Since most Dapps are based on smart contracts of the Ethereum Blockchain, the prices currently are intensely high. However, as Ethereum moves to PoS over PoW, the gas fees and sustainability impact drastically reduce. There is no comparison to the actual amount Chits are losing in defaults and the amount members lose to scams. It is a worthy but hefty price to pay. DeFi as a concept in India is entirely fresh, but it has the potential to massively impact the Indian credit industry. Larger adoption of credit facilities through DeFi will also benefit more microfinance products. Cooperatives and MSMEs can massively benefit through DeFi adoption.

How will Blockchain change the economic outlook for chit funds?

Ever since its origin, chit funds continue to leave a favorable economic impact in India. According to a report by the Asian Development Bank, the turnover of 1,066 chit fund companies back in 1986 was close to ₹8,160 crores per annum. As of now, this number exceeds ₹35,000 crores per annum for the registered chit fund companies all over India. MSMEs in India also face a credit gap of close to ₹16.66 lakh crore that is bridged with the help of chit funds. It has cemented itself into the present economy as a quasi-banking system that is, extensively, used by lower-income families. But there is room for improvement and we speculate that implementing Blockchain can bring in a much-needed revolutionary change that will strengthen chit funds and their hold in the Indian financial system. The immediate change is that it would increase the people’s participation in chit funds, getting rid of the fear of Ponzi schemes and elaborate scams as a result of Blockchain’s transparent, real-time recording of transactions. Financial inclusion is certain to see an increase that’ll give even more attention to chit funds. The most immediate impact will be seen in rural economies; technical literacy will skyrocket as they get included in a vast network of chit funds and prompt even more credit-related transactions. While the vision does seem idealistic, it is hard not to see how Blockchain can benefit rural India because that is, according to our belief, where the second digital revolution is set to occur.

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