UPDATE 2-Euro zone money market spike driven by French bank contingency tests -traders

(Updates with ECB comment)

By Dhara Ranasinghe

LONDON, Nov 22 (Reuters) - A sudden jump in the European Central Bank's new ESTR interest rate benchmark this week was triggered by French banks bidding for extra cash as part of contingency tests, two sources familiar with the bloc's money markets said on Friday.

The euro short-term rate, ESTR, spiked around 3 basis points to -0.511% at Wednesday's fixing from the previous day . It had fallen back to -0.542% at Thursday's fixing.

The spike raised eyebrows in euro zone bond and money markets, where investors are assessing how the ECB's overnight rate responds to the central bank's new tiered interest rate structure.

Two sources told Reuters that the jump in the ESTR rate was sparked by unexpected pressure from one or more French banks doing some contingency testing. That would involve the lenders bidding for additional cash in the overnight market.

"The French testing their limits in the system is the more correct reason for the jump in ESTR," said one money market source, asking not to be named. "I guess it makes sense to make sure there is enough debt in case you need liquidity."

The ECB launched its new benchmark rate in October in the biggest change for market plumbing since the introduction of the euro two decades ago.

The new ESTR rate is based on daily money market transactions and replaced Eonia, the euro overnight index average.

"It's not something that worries me because we have had such spikes in the old rate around this time of year," said Pooja Kumra, European rates strategist at TD Securities.

"But because it is a new rate, it is on everyone's radar and the ECB is probably keeping an eye on it to make sure there is no volatility."

The ECB said it did not comment on day-to-day changes in ESTR.

"By construction a transaction-based benchmark can be volatile, reflecting the underlying effective transactions," a spokesperson for the bank said in an email. "This can also be observed in the historical data (pre-ESTR), which has also shown volatility on some days."

SPOTLIGHT

Money market rates are in the spotlight after wild swings in U.S. money markets in September.

In the euro area, the impact of the ECB's new tiered rate structure is also in focus.

Another trading source said that while contingency testing is not unusual, the jump in ESTR may have come about because market liquidity has been thinned by banks parking excess cash at the ECB to take advantage of the new tiered rate policy.

The tiering system allows eligible banks a 0% interest rate on part of the reserves they hold at the ECB, rather than the deposit charge that equates to the bank's depo rate of -0.5%.

"Because of tiering, when banks do this testing it's harder to find the liquidity," the trader said. "But I don't think there will be a lasting impact."

He said banks had probably used up their reserve allocation with the ECB at the preferential 0% rate, meaning any additional demand for overnight borrowing should be absorbed by the market.

Commerzbank analysts, however, were cautious.

"The jump in the ESTR fixing to a new high raises concerns about the stability of the new fixing under tiering," they said in a note. "This could have wider implications as it would restrict the ECB's potential to cut rates again if tiering doesn't work."

(Reporting by Dhara Ranasinghe; Editing by Catherine Evans)