MONEY MARKETS-Dlr funding strains remain; ECB injects euro cash

* Dollar funding remains costly for European banks

* European banks take up hefty 50 bln euros of 6-month ECB loans

* Overnight rates seen subdued near ECB deposit rate of 0.75 pct

By Emelia Sithole-Matarise

LONDON, Aug 10 (Reuters) - Euro zone banks snapped up six-month euro-priced funds from the European Central Bank on Wednesday as they built up cash buffers against an intractable sovereign debt crisis which is costing them dearly to access U.S. dollar funding.

Despite the Federal Reserve's unprecedented step on Tuesday to pledge to keep policy rates extraordinarily low for at least two more years, strains in dollar funding markets persisted.

In the euro/dollar cross currency market, where a bank can swap euro interest payments with a lender for dollars, the three-month cross rate was mired at its most expensive rate since the end of 2008 around -83.

This was more than 20 basis points above Monday's levels but still way off a spike to minus 300 basis points seen in the fourth quarter of 2008 when money markets froze after Lehman Brothers collapsed.

Morgan Stanley strategists expect the euro/dollar basis swap to be capped around -100 bps, which is what the ECB charges on its dollar swap line offered weekly but has so far seen no take-up from banks because of the stigma attached.

"There's clearly signs of stress creeping up in the system as a whole and you can see that in the high euro/dollar basis swaps and spot Libor. It's much more expensive for European banks to borrow from the dollar market," said Morgan Stanley strategist Elaine Lin.

"Term funding for Spanish and Italian banks has gone quiet for borrowing dollars one to three years. None of the European banks recently has been able to issue paper."

U.S. money market mutual funds cut their holdings of securities issued by European banks in July, spurred by the region's debt problems, according to J.P. Morgan Securities.

London interbank offered rates for three-month dollars rose to a fresh four-month high of 0.28061 percent despite the Fed's pledge to keep interest rates near zero for at least two more years.

Equivalent euro rates fixed lower at 1.50188 percent, from 1.51188 percent, on increased excess liquidity in the system after the ECB offered banks more unlimited cash to ease strains in financial markets.

ECB CASH BONANZA

Worries over banks' holding of lower-rated government debt and a slump in global equities have added to banks' nervousness, prompting them to turn to the central bank instead of their commercial peers, with other cash tenders this week seeing demand beat market expectations.

Investors' nerves were frayed further as speculation swirled about the health of France's Societe Generale , pushing its credit default swaps 65 bps wider to 334 bps and its shares and those of other French banks sharply lower.

European banks took up almost 50 billion euros at the ECB's one-off six-month tender on Wednesday, in line with the outcome of a Reuters poll of money market traders, which should boost the cash surplus to as much as 130 billion euros in coming weeks.

This should keep liquidity-dependent key overnight rates subdued near the ECB's deposit rate of 0.75 percent over the bank's August reserve maintenance period.

The Eonia rate dropped sharply during the latter part of the last maintenance period which ended on Tuesday. It averaged 1.09 percent, some 41 basis points below the ECB's main refinancing rate, on the surge in surplus cash and as markets priced out interest rate hike expectations.

"The ECB purchases of Italian and Spanish bonds in the secondary markets and the unlimited fixed price eat-all-you-want (ECB liquidity) buffets will continue until the year end at least seems to have, for the time being, assuaged fears of contagion," said Kevin Pearce, a broker at ICAP.

"Even so ... the market will still keep a healthy interest in the (main refinancing operations) and ensure that on a weekly basis they stay very liquid, which will keep day-to-day rates below 1 percent leading to higher use of the deposit facility than we've seen over the last few months."

The sharp drop in Eonia has widened the spread between key euro-priced interbank rates to the most since May 2009 with the September Euribor/Eonia gap at 48 bps, from around 35 early last month, also showing increasing credit concerns in the euro zone.

With trust between banks eroding again, they have parked increasing amounts of money at the ECB's overnight facility instead of lending to each other.

Deposits have been close to 150 billion euros in recent days, their highest level in a year. However, they are still well below the highs reached in the first half of last year, when excess liquidity was much bigger. (Editing by Susan Fenton)