A prime money market fund works by pooling investor cash and lending it out, very short-term, to corporations and banks through commercial paper, certificates of deposit, and repurchase agreements. In exchange for taking on a small amount of private-sector credit risk, you earn a slightly higher yield than a government-only money fund — typically 10 to 25 basis points more — while keeping same-day access to your money. The fund is governed by SEC Rule 2a-7, which caps maturities, forces diversification, requires sizable liquidity buffers, and (after a 2024 overhaul) changes how the fund can charge fees when a lot of investors try to leave at once.
What the Fund Actually Holds
The portfolio is built from private-sector debt rather than Treasury bills or agency paper. The largest piece is usually commercial paper: unsecured short-term IOUs that corporations issue to cover payroll, supplier invoices, and other near-term expenses. These notes mature in anywhere from a few days to a few months and depend entirely on the issuer’s creditworthiness. Large-denomination bank CDs are another core holding, locking in a fixed return over a brief window.
Repurchase agreements fill out most portfolios. In a repo, the fund buys a security from a counterparty with an agreement to sell it back at a slightly higher price, often the next day. Every instrument in the fund carries some exposure to a private company or bank, and that is where the extra yield comes from. Government money market funds avoid that credit exposure entirely, which is why their yields run a bit lower.
Rule 2a-7 requires every security the fund buys to qualify as an “eligible security,” meaning the fund’s board has to determine it presents minimal credit risk. The rule does not demand a particular letter rating from a credit agency. The board evaluates the issuer’s financial condition, liquidity sources, and ability to repay under stress, and fund managers layer their own credit research on top. No single security can have more than 397 calendar days to maturity.1eCFR. 17 CFR 270.2a-7 – Money Market Funds
Retail Shares and Institutional Shares
The SEC splits prime money market funds into two categories by who owns them. Retail prime funds must adopt policies “reasonably designed to limit all beneficial owners of the fund to natural persons.”1eCFR. 17 CFR 270.2a-7 – Money Market Funds Fund companies usually verify this by requiring a Social Security number at account opening. Some funds also accept trusts whose beneficiaries are natural persons, but the regulatory definition centers on individual human beings.
Institutional prime funds serve corporations, pension plans, endowments, and other large organizations, often with minimums in the millions. Keeping the two pools apart matters because institutional investors tend to move cash in and out more aggressively, which changes how each fund type manages its liquidity and prices its shares. Expense ratios differ too: retail share classes generally carry higher operating costs, while institutional classes benefit from scale.2Federal Reserve Bank of Boston. Are Retail Prime Money Market Fund Investors Increasingly More Sensitive to Stress Events?
Stable NAV vs. Floating NAV
Retail prime funds hold their share price at a stable $1.00 using amortized cost accounting, which smooths tiny day-to-day fluctuations in the underlying commercial paper and CDs.1eCFR. 17 CFR 270.2a-7 – Money Market Funds For an individual investor, it feels like a bank account: principal stays constant, and earnings pay out as dividends.
Institutional prime funds use a floating NAV instead, calculated to four decimal places. The share price might be $1.0003 one day and $0.9998 the next, reflecting the actual mark-to-market value of the portfolio.1eCFR. 17 CFR 270.2a-7 – Money Market Funds When the underlying commercial paper loses value, the share price drops below $1.0000 and investors realize that loss when they sell. Institutional treasurers get a transparent, real-time view of gains and losses rather than one masked by amortized accounting.
The Rule 2a-7 Guardrails
Rule 2a-7 imposes hard portfolio limits on every prime fund, retail or institutional. They are designed to keep holdings short-dated, diversified, and liquid enough to meet redemptions.
- Weighted average maturity cannot exceed 60 calendar days, which limits how much the fund’s value can swing when interest rates move.1eCFR. 17 CFR 270.2a-7 – Money Market Funds
- Weighted average life cannot exceed 120 calendar days, measured without adjusting for interest rate resets.1eCFR. 17 CFR 270.2a-7 – Money Market Funds
- No more than 5% of total assets can sit in securities from a single issuer, with a narrow exception allowing up to 25% for three business days after acquisition.1eCFR. 17 CFR 270.2a-7 – Money Market Funds
- At least 25% of total assets must be in daily liquid assets — securities that convert to cash within one business day.3eCFR. 17 CFR 270.2a-7 – Money Market Funds
- At least 50% must be in weekly liquid assets, meaning they convert to cash within five business days.3eCFR. 17 CFR 270.2a-7 – Money Market Funds
Those daily and weekly minimums were raised substantially by the 2024 reforms, up from 10% and 30% respectively, to give funds a bigger buffer against sudden redemption spikes.4U.S. Securities and Exchange Commission. Money Market Fund Reforms
What Happens If Lots of Investors Try to Leave at Once
The SEC rewrote the rules on redemptions in 2023, phasing most changes in through 2024. Descriptions of prime funds written before then are out of date on this piece of the mechanics.4U.S. Securities and Exchange Commission. Money Market Fund Reforms
Redemption Gates Are Gone
Under the old framework, a fund’s board could halt all withdrawals for up to 10 business days within a 90-day period. The 2024 amendments eliminated that power entirely.4U.S. Securities and Exchange Commission. Money Market Fund Reforms The SEC concluded that the mere possibility of a gate made runs worse, because investors who feared being locked out would rush to redeem first. No prime money market fund can suspend redemptions under the current rules.
Mandatory Liquidity Fees for Institutional Funds
Institutional prime funds now face a mandatory liquidity fee whenever daily net redemptions exceed 5% of the fund’s net assets. The fee has to reflect the estimated cost the fund would incur to sell portfolio securities to meet those redemptions, so investors who leave during a stressed period bear the transaction costs their departure creates rather than passing them to shareholders who stay. There is an exception when the fund determines those liquidity costs are negligible. Retail prime funds are exempt from this mandatory fee.1eCFR. 17 CFR 270.2a-7 – Money Market Funds
Discretionary Liquidity Fees
Any non-government money market fund, retail or institutional, can still impose a discretionary liquidity fee of up to 2% on redemptions if the board decides the fee is in the fund’s best interest.1eCFR. 17 CFR 270.2a-7 – Money Market Funds That authority is no longer tied to a specific weekly liquid asset threshold the way the old rule was. The board can delegate the fee decision to the adviser, subject to written guidelines and ongoing oversight.5Federal Register. Money Market Fund Reforms; Form PF Reporting Requirements for Large Liquidity Fund Advisers; Technical Amendments to Form N-CSR and Form N-1A Once imposed, the fee stays in place until the board decides it is no longer needed.
How Prime Fund Earnings Are Taxed
Earnings arrive as ordinary dividends reported on Form 1099-DIV, even though the underlying income comes from interest on commercial paper and CDs.6Internal Revenue Service. Instructions for Form 1099-DIV Because the fund is structured as a mutual fund, the IRS treats its distributions as dividends. These do not qualify for the lower rate that applies to qualified dividends from stocks; they are taxed at your ordinary income rate.
Institutional investors in floating-NAV prime funds get one useful break. The IRS will not treat a redemption that produces a small loss as a wash sale, even if the investor buys back into the same fund shortly afterward.7Internal Revenue Service. Revenue Procedure 2014-45 Without that relief, the floating NAV would create constant tiny wash sale complications every time a treasurer redeemed and reinvested. The exemption applies only to funds operating as floating-NAV money market funds under Rule 2a-7.
What’s Protected and What Isn’t
A prime money market fund is not a bank account. No money market fund carries FDIC insurance. If you hold the shares through a brokerage account, SIPC protection applies, but only if the brokerage firm itself fails. SIPC coverage runs up to $500,000 per customer, with a $250,000 sublimit on cash claims.8Securities Investor Protection Corporation. What SIPC Protects SIPC restores securities and cash that were in your account when the broker went under; it does nothing to protect against investment losses in the fund.
The scenario everyone worries about is “breaking the buck,” when the NAV falls below $1.00 and investors get back less than they put in. It has happened twice in the industry’s history: a small government fund in 1994, and the Reserve Primary Fund in September 2008, whose Lehman Brothers commercial paper triggered a wider panic across prime funds and pushed the SEC toward the tighter rules in place today. The layered requirements of Rule 2a-7 — short maturities, diversification caps, high liquidity floors, and board-supervised credit analysis — exist to make a repeat as unlikely as possible, though they cannot eliminate the risk entirely.