Betting against your co-investors’ misery

I don’t remember the name of the driver who drove me home that rainy night. I remember asking him, but it was almost three years back and I’ve forgotten. As was my usual practice then, I was sitting in the front seat of the cab, and chatted up the driver as we navigated the heavy Koramangala traffic. Our conversation would get interrupted by him getting calls asking him for money.

He had lost a considerable amount of money in chit funds, he explained. There was a chit fund in which he and his family members had invested. The fund gave them what he called “good returns” in the first cycle. The fund opened again for a second cycle, and once again he and his cousins all invested. This time, however, the fund manager had disappeared, taking with him his investors’ money.

While running a fund well for one cycle and disappearing with investors’ money the next is a classic fraud scheme in undocumented financial services, what intrigued me was that the driver and all of his cousins had invested in the same chit fund. The reason I was surprised is that in chit funds you bet against the misery of your co-investors. Let me explain how this works.

It is like a game played out by N investors over a period of N months (notice that the number of investors and the period of the cycle are equal). Each month, each investor contributes a fixed sum to the pot. And then the pot gets auctioned to the same set of investors, and goes to the investor who is willing to take the biggest “haircut”. Investors who are more desperately in need of money are likely to bid to take a larger haircut than those who need the money less. Once an investor has taken the discounted pot, he loses the right to bid for the pot in subsequent rounds (though he continues to contribute the fixed sum). Each round, the money left over after paying the “winning” investor is distributed as dividend among other investors (with the fund manager taking a portion as management fees).

Notice that this single instrument serves as both savings and loan instrument, with the catch being that it is all in-house. The “haircut” that investors are willing to take while they bid for the pot can be considered equivalent to the interest rate they are willing to pay on that loan (it is a loan – since they need to continue to pay the “premiums” for the full period of the fund). The assumption is that when you assemble a chit fund with a set of investors, each of them has different preferences in terms of when they need the money. Some see it as a savings instrument, and are liable to bid for the pot in later rounds. Others see it as a loan instrument, and bid for it in an early round. All the fund manager is doing is to facilitate this intra-group lending through a formal mechanism.

Also notice that the larger the haircut your co-investors are willing to take, the bigger is the profit that you stand to make. If nobody in the group is desperate for money at any point in time, the bids for the haircuts are going to be rather low. So if you invest in a chit fund and hope to make money off it, you must have reason to believe that there are other investors who are much more desperate for the money than others. So if I invest in a chit fund along with you, I’m betting that at some point in time you’ll need money so badly that you are willing to take a large haircut, so that I make a good dividend. So in effect, I’m betting against your misery!

So if a chit fund investor is actually betting against the misery of other investors in the same fund, there is no point in two people from the same family to invest in the same chit fund – they stand nothing to gain by betting against each other. It was a long drive home that day, and I explained it to the driver, and told him that it doesn’t make sense for him to invest along with his relatives in the same fund. He understood, he said, and added that he didn’t want to invest in the fund that he had lost money in (where the manager decamped), but his relatives accused him of being a “traitor” for not investing along with them, and so he complied! And they all went down together.



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