UPDATE 3-U.S. SEC proposes tough rules for money market funds

* SEC proposes to cut debt maturity to 60 days from 90

* Second tier securities cut from funds under proposal

* Periodic stress tests would be required

* Commissioners spar over use of credit rating agencies

* Funds would have to hold min 5 pct highly liquid assets (Recasts with vote, adds comments from Aguilar, Paredes, further detail on redemptions, second tier assets)

By Rachelle Younglai

WASHINGTON, June 24 (Reuters) - 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 (LEHMQ.PK) 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.