Latin American Capital Markets

130 KAREN GOLDSTEIN ROSSOTTOfluctuations because they must fulfill requests for redemption at any time. If faced witha significant amount of requests, a fund may be forced to sell a substantial amount ofsecurities to meet redemptions (Kaminsky, Lyons, and Schmukler 2000). However; diversifiedfunds may hold greater amounts of equity and other higher-risk investmentsto abate the effects of local stock market volatility (Rea 1996). As mutual funds manageincreasing amounts of retirement assets, they have begun to take on a longer-termoutlook and, like pension funds, are more likely to weather a crisis and remain investedDomestic institutions may also potentially diffuse adverse market effectscaused by foreign investors. Foreign investment may benefit local capital markets andeconomies through an influx of liquidity and capital. However, in illiquid and concentratedmarkets, such as those in Latin America and the Caribbean, a sudden liquidationof a large foreign investor's shares could destabilize the local market Domesticinvestors may negate the effect of foreign investors by holding local securities, therebyminimizing the percentage of a single investor's holdings in a single security. Furthermore,because domestic institutions hold other locally listed shares, they may be sensitiveto the effects of a market disruption on their own portfolios, whereas a foreigninvestor would notProduct Innovation and Market ModernizationAs competition within the institutional investor sector develops, the need for betterperformance and sophisticated investment objectives leads institutions to develop innovativeproducts and investment strategies. For example, in response to competitivepressures, mutual funds have developed more cost-efficient products (for example, indexedand money market funds) and products that may reduce tax implications (forexample, exchange-traded funds). Institutions also contribute to market efficiency byacting as short-term lenders and arbitrage traders.Because institutional investors require liquid markets that can accommodatesophisticated products, the markets are compelled to modernize (U.S. SEC 1992). Forexample, in an effort to attract institutional trading in the 1970s, U.S. securities marketsimplemented new trading mechanisms to absorb large blocs typical of institutionaltrades (U.S. SEC 1994). Institutional investors are also pushing for technologydrivenmarket developments, such as enhanced access to information, and for faster;cheaper trade execution through electronic trading systems, such as electronic communicationnetworks. 6 Furthermore, to facilitate local diversification, institutional in-6 An electronic communication network is a computerized trading network that displays and matches buy orders withsell orders in NASDAQ stocks. Electronic communication networks may provide faster trade execution and potentialprice improvement over market-maker quotes.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub