Money market tensions stayed high on Tuesday, with players on alert for signs that euro zone banks were being shut out of dollar funding markets and forced to borrow from the ECB, even after banks' demand for euro-denominated loans fell.

Dollar borrowing costs were on an upward path and the cost of insuring euro zone financial debt rose, putting investor focus on the European Central Bank's offering of dollar liquidity on Wednesday.

Last week, one bank borrowed $500 million, accessing the emergency credit line for the first time since February.

If we see the same amount (borrowed) or higher, it will be a real indication of stress in the money market, said Alessandro Giansanti, strategist at ING in Amsterdam.

This will affect the euro interbank market and the peripheral banks will be the ones to suffer most after this.

However, at an ECB tender of euro-denominated funding, banks borrowed less than they did a week ago, indicating a reduced appetite to take extra cash as a buffer against market stress.

There has been a little bit more stability in the system, so it may be a question of banks not wanting to hoard as much cash as they wanted to in the past, said Orlando Green, strategist at Credit Agricole in London.

Nevertheless the level of money in the system above that needed for banks' daily operations remained high, showing institutions were still cautious about lending to one another.

Earlier this month banks borrowed 50 billion euros at a special one-off ECB tender of six-month loans designed to counter rising tension stemming from the euro zone's sovereign debt crisis.

DOLLAR FOCUS

Market participants were keen to see whether more banks were being priced out of the unsecured interbank lending market and forced to turn to the ECB's costly dollar swap lines.

It is definitely something that we have to monitor -- especially with the euro/dollar basis very wide -- but I don't think we're in a situation where there's a squeeze in dollar funding for European banks, said Credit Agricole's Green.

Euro/dollar cross-currency basis swaps, which measure the cost of swapping euros for dollars, remained at levels indicating elevated stress. The three-month swap rate was last at -89 basis points, having fallen to its lowest since 2008 at nearly -100 bps last week.

Traders continue to highlight the scarcity of unsecured funding for longer than one-month available in both the dollar and euro lending markets.

Fitch ratings said on Monday that the largest 10 U.S. money market funds reduced exposures to European banks and also cut the duration of their loans.

Three-month dollar Libor rates rose to their highest since February at 0.31178 percent. The rate has been steadily increasing since late July, and eurodollar futures <0#ED:> point to further rises, signalling increasing costs for euro zone banks to raise dollar funding.

Nevertheless, the dollar Libor/OIS spread -- a measure of counterparty risk which rose sharply at the end of August -- was steady at 21 bps.