U.S. securities regulators proposed tough new rules for money market funds to help avoid a repeat of what happened when the collapse of the Reserve Primary Fund triggered a wave of redemptions in the $3.67 trillion market.

Money market funds were long considered as safe as cash until the collapse of Lehman Brothers Holdings last fall pushed the value of the Reserve Fund below $1 a share, forcing the creation of a government program to backstop the market.

The Securities and Exchange Commission unanimously voted for a proposal that prohibits money market funds from buying illiquid securities and requiring them to hold at least 5 percent in liquid securities such as cash.

Until last fall, few investors had concerns about investing in money market funds, said Andrew Donohue, the SEC's investment management director.

The SEC proposed to shorten the average maturity of debt that money market funds can hold to 60 days from the current 90 days. Retail money market funds would have to hold at least 5 percent of their assets in cash, U.S. Treasury securities or other cash equivalents.

Institutional funds, which experienced greater liquidity challenges, would have to hold at least 10 percent of their assets in liquid securities.

The SEC also proposed to prohibit the funds from investing in so-called second tier securities, or the second highest category of rated assets.

SEC Commissioner Troy Paredes had some reservations and questioned how this might hurt the ability of companies to raise capital. Currently most funds are allowed to hold up to 5 percent of such assets.

The agency avoided taking a stance on a controversial idea to consider a fluctuating net asset value instead of the current $1 NAV, or the level the fund needs to maintain in order to pay back its customers if they want to redeem their shares. Instead the SEC seeks comments on whether this is needed.

Overall, the new rules would boost the funds' liquidity and help ensure investors can get their money out of a fund, if they choose.

This will enable money market funds to be better positioned to meet demands from investors who want to redeem their shares on a short term basis, SEC Chairman Mary Schapiro said at the meeting.

Other proposals include periodic stress tests, monthly fund portfolio disclosures to the SEC and allowing a fund's board of directors to suspend redemptions in extraordinary circumstances to allow for an orderly liquidation.

Some of the SEC's proposal is aligned with the mutual fund industry's recommendations as well as the Obama administration's plan for regulatory reform.

The SEC is considering the role of the credit rating agencies and whether fund boards should designate certain rating agencies to evaluate and monitor its securities -- an idea that highlighted deep divisions among SEC commissioners.

Reliance on credit ratings amount to a government sanctioned oligopoly for the dominant three rating agencies Moody's Corp , McGraw-Hill Cos Inc's Standard & Poor's and Fimalac SA's Fitch Ratings, Commissioner Kathleen Casey said.

The SEC has already proposed removing references to ratings in most of its rules but the powerful mutual fund lobby, the Investment Company Institute, has criticized attempts to remove rating requirements for money market funds.

Mutual fund executives contend that the current rules -- which require money market funds to hold highly rated securities -- helps protect investors.

Commissioner Luis Aguilar called it a crucial investor protection to have both the credit rating as well as the fund's own credit analysis.

The proposal is open for a 60-day comment period and the SEC would have to vote again to adopt the rules. The federal government's backstop is due to expire in mid-September.

(Reporting by Rachelle Younglai, editing by Gerald E. McCormick, Lisa Von Ahn, Tim Dobbyn)

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