Prime Money Market Funds: Liquidity & Regulation

• Prime Money Market Funds are SEC-regulated open-end funds investing in short-dated, high-quality debt instruments like commercial paper and repurchase agreements.
• They serve as wholesale liquidity providers, channeling crypto-induced fiat outflows into mechanically regulated purchases of AA-rated corporate paper under Rule 2a-7.
• Empirical models show that DeFi-driven inflows can narrow credit spreads by several basis points, highlighting their stabilizing role in short-term funding markets.

Prime Money Market Funds (MMFs) are Securities and Exchange Commission (SEC)-regulated open-end mutual funds specializing in very short-dated, high-quality, dollar-denominated debt instruments, primarily commercial paper (CP) issued by corporations, bank deposits, and repurchase agreements collateralized by Treasury and agency securities. In contrast to Treasury MMFs, which invest solely in government obligations, Prime MMFs differentiate themselves through the "prime" credit quality of their corporate paper holdings. Functionally, they serve as wholesale dollar liquidity providers for nonbank borrowers—including corporates and financial intermediaries—offering funding at maturities between one day and 120 days. Prime MMFs play a crucial intermediary role for institutional cash-management clients, such as pensions, insurers, and crypto-native players, and their shares typically trade at or near a $1 net asset value (NAV), establishing them as effective cash substitutes for large institutions. Recent research highlights the centrality of Prime MMFs in the cross-market "liquidity recycling" dynamic connecting decentralized finance (DeFi) with traditional finance (TradFi) (Lin, 13 Jan 2026).

1. Regulatory Structure: SEC Rule 2a-7 Constraints

The operational landscape for Prime MMFs is defined by SEC Rule 2a-7, which prescribes strict asset, maturity, diversification, liquidity, and valuation guidelines aimed at preserving capital stability and mitigating run risk. Key provisions of Rule 2a-7 include:

• Credit Quality: All portfolio holdings must be “eligible securities” rated at least A-1/P-1 (or equivalent) by two Nationally Recognized Statistical Rating Organizations (NRSROs), or in the highest denominator rating if only a single rating is available (Sections (d)(2) & (a)(11)).
• Maturity Restrictions: Weighted average maturity (WAM) is capped at 60 days, and weighted average life (WAL) at 120 days.
• Issuer Diversification: No more than 5% of total assets may be allocated to a single issuer; the aggregate exposure to unaffiliated issuers cannot exceed 10% per issuer.
• Liquidity Buffers: At least 10% of assets must be in daily liquid assets (such as Treasury bills or cash), and at least 30% must be held in weekly liquid assets.
• Valuation and NAV Stability: Funds are required to mark assets to market, with fluctuations in NAV limited to within ±0.5% of par. Mechanisms such as redemption gates and fees are triggered if liquidity buffers are breached.

This regulatory framework enforces significant asset and duration discipline, which drives the mechanical asset allocation processes within the Prime MMF structure (Lin, 13 Jan 2026).

2. Prime MMFs as the Engine of "Liquidity Recycling"

Prime MMFs operate as the central mediating mechanism in the “liquidity recycling” phenomenon that links DeFi-originated shocks to traditional money markets. The pathway initiates with DeFi hacks—such as bridge exploits or smart contract vulnerabilities—which cause abrupt spikes in on-chain gas fees (labeled "payment frictions") and catalyze large-scale stablecoin redemptions (the so-called "run"). For instance, the referenced threshold analysis identifies that when Ethereum gas fees rise above approximately 33 gwei, aggregate net outflows of USDC and USDT average roughly $290 million per event.

Stablecoin issuers responding to redemptions must liquidate their reserve portfolios—comprised mainly of Treasury bills and high-grade CP—thereby increasing supply pressure in short-term funding markets. Concurrently, the fiat cash generated from these redemptions, typically originating from risk-averse crypto-native investors, is largely allocated to Prime MMFs, which are the dominant institutional vehicle available at scale. Regulatory requirements under Rule 2a-7 dictate that this influx must be redeployed into "eligible securities," most notably 3-month AA-rated commercial paper. Due to binding regulatory constraints, Prime MMFs thus function as automatic, mechanical buyers of the very assets whose supply has risen as a result of stablecoin issuer liquidations (Lin, 13 Jan 2026).

3. Modeling the Impact: Spread Dynamics and Market Depth

The referenced work models the daily change in the spread of 3-month AA CP to contemporaneous Treasury bill rates using a structural equation framework. The formulation captures the interplay of demand and supply shocks:

$\Delta s_t = \alpha D_t - \beta S_t + \epsilon_t$</p> <p>where:</p> <ul> <li>$\Delta s_t = s_t - s_{t-1}$$is the daily change (in basis points) in the CP spread;</li> <li>$$D_t$$quantifies the institutional “flight-to-quality” demand, specifically MMF inflows (in$$ million) invested in AA-rated CP;

$S_t$ is the reserve-liquidation supply shock (in $million) from stablecoin issuer sales;</li> <li>$\alpha, \beta > 0$are price-impact coefficients (basis points per$million):$\alpha$for downward pressure from demand,$\beta$ for upward pressure from new supply.

A structural variant is expressed as:

$\Delta\text{Spread}_t = \lambda (1-n) R_t$

with $\lambda$ as a market-depth parameter, $R_t$ as redemption volume, and $n = D_t / S_t$ as the "panic multiplier." This parameterization quantifies the degree to which demand associated with flight-to-quality flows exceeds the contemporaneous increase in supply (Lin, 13 Jan 2026).

4. Quantitative Estimates and Empirical Findings

Sparse Granular IV 2SLS estimation, employing protocol-level idiosyncratic outflows as an instrument, isolates the exogenous component of MMF-driven flows. Results indicate that every $100 million of DeFi-driven inflow into Prime MMFs produces a tightening of the 3-month AA CP spread by approximately 2.65 basis points (α ≈ −2.65 × 10⁻⁸ bps per$, post-event). Importantly, while supply shocks from stablecoin issuer asset sales alone would be expected to widen spreads, the dominant demand effect leads to net narrowing.

Decomposing the structural equation:

$\Delta\text{Spread}_t = \lambda (1-n) R_t \quad \text{with} \quad \lambda \approx 1 \ \text{bps per}\ \$100 \ \text{million}$</p> <p>the analysis finds$(1-n)<0$and$n \approx 3.65$, indicating that every$1 of actual stablecoin issuer sales triggers about$3.65 of “flight-to-quality” demand for AA-rated CP.

Event-study methodology further validates these dynamics: on and immediately following major DeFi hacks, the 3-month AA CP spread falls by 3 to 5 basis points, with the effect persisting over a three-day window (Lin, 13 Jan 2026).

5. Systemic and Policy Implications

Prime MMFs, through their role as mechanical credit reallocators, serve as "automatic stabilizers" in segmented short-term funding markets. By absorbing DeFi-originated funding shocks via the re-intermediation of cash outflows and enforcing investment into high-grade, short-term CP, these funds transiently enhance market liquidity and reduce borrowing costs for high-grade issuers.

The limited size of the 3-month AA non-financial CP market, with approximately $200–300 billion outstanding and daily net issuance of$1–5 billion, renders it highly sensitive to episodic, large-sum inflows. A $300 million flow can shift yields by several basis points.

A central regulatory trade-off is highlighted: while some policymakers fear that DeFi–TradFi linkages primarily introduce contagion risk, operational-risk shocks such as hacks can, under current institutional architecture, result in unexpected liquidity support for traditional markets. Measures that unduly restrict on-ramp/off-ramp mechanisms or increase transaction frictions may undermine this stabilizing channel. The SEC’s Rule 2a-7 is critical: it ensures inflows are mechanically funneled into the highest quality, shortest maturity CP, converting safety-seeking capital into robust demand for safe corporate paper (Lin, 13 Jan 2026).

6. Interpretation and Broader Context

The evidence supports a reversal of the "Contagion Hypothesis" in contexts where crypto-native distress prompts mass stablecoin redemptions: instead of amplifying stress, the regulated architecture of Prime MMFs induces a strong "Flight-to-Quality" phenomenon that narrows CP spreads and fortifies short-term liquidity conditions. A plausible implication is that preserving compliant fiat on-ramps and understanding the mechanics of MMF regulation remain crucial for systemic market resilience.

The study’s combination of event-study analysis and structural modeling underscores that, under the binding ruleset of SEC Rule 2a-7, Prime MMFs can transform crypto-originated panic into a substantial, and even over-compensating, liquidity provision for traditional short-term funding markets (Lin, 13 Jan 2026).