Europe still has a chance of safely shepherding Greece through an increasingly inevitable default and could restore faith that investors can protect themselves against governments not repaying debt.

Time is fast running out. Greece cannot pay a 14.5 billion euro (12.0 billion pounds) bond falling due on March 20, and a deal with bondholders needs to come well before that, because the paperwork alone takes at least six weeks.

Many in markets would welcome an orderly default, whereby Greece's lenders allowed it to renege on its commitments to repay, provided it avoids a far more painful hard default, which could herald the end of the single currency.

People often ask if Greece is going to default which ... is a misnomer because Greece is (already) defaulting, said Richard McGuire, a strategist at Dutch bank Rabobank.

A managed default would trigger a pay-out of Credit Default Swaps (CDS), which offer insurance against default of a company or country, and would restore trust in these financial tools that are crucial for investors to hedge against risk.

Regulators across the world would breathe a sigh of relief that hedges many of their regulated financial entities have on their European positions are effective, said one market participant, asking not to be named.

The future of the market for sovereign CDS has been put in doubt because politicians were initially adamant banks and other investors should voluntarily swap their Greek bonds for new ones worth half the original value. Such a voluntary agreement would likely leave investors unable to claim the protection offered by CDS.

But Greece is now openly threatening to force unwilling investors into the deal, bringing an element of coercion into the negotiations that will likely be sufficient to trigger a CDS payout.

Lehman Brothers triggered widespread market panic on fears that up to $400 billion in CDS would be payable when it collapsed in 2008. But the amounts that was actually paid out was relatively small, and is smaller for Greece.

The maximum that could change hands from a Greek default is $3.34 billion, according to the Depository Trust & Clearing Corporation, a clearing and settlement company.

LET'S NOT GET MESSY

At all costs, Athens and Europe want to avoid a hard default, where Greece fails to reach a debt deal and runs out of money, because a deal with creditors is a precondition for securing its second international bail-out.

We're at this stand-off ... You will see some 11th-hour brinkmanship because it's only when these agents are staring fully down the barrel of a messy default that one of them or more will give ground, said Rabobank's McGuire.

Ratings agency Standard & Poor's also said this week it believed Greece would default on its debt, but left unanswered what form the default would take.

The market is assuming Greece is going to default, said Marc Ostwald, strategist at Monument Securities.

But the working assumption is that it's going to be something that's sold as an orderly default. Therefore, a hard default would come as a shock.

A hard default would be seen as a sign politicians had lost control of the single currency, and markets would immediately take aim at other weak countries such as Italy, Spain and Ireland, Ostwald and other traders said.

Even a less harmful managed default could lead markets to focus on other weak European countries.

You've got to think it will put further pressure on Portugal and Ireland and they start pricing in something similar, a government bonds trader in London said.

WAYS OF NOT PAYING

The focus this week is on ways to turn discussions with creditors, suspended on Friday over the interest rate on new Greek bonds, into talks on orderly default. Negotiations are due to resume on Wednesday.

It is becoming ever more likely that Athens will force at least some creditors into the deal by writing provisions known as Collective Action Clauses into contracts.

These would force the conditions of the bond swap on all other creditors, regardless of whether they sign up for the deal or not.

Writing such clauses into law wouldn't amount to a default, but using them to squeeze out bondholders would, and would almost certainly trigger payouts.

Triggering the CDS for Greece is the right thing to do because in the end with Greece it's already in default so it should be triggered, said Alessandro Giansanti, a fixed-income strategist at ING in Amsterdam.

If you buy a CDS and an event happens, you want to be rewarded for it, he said.

(Additional reporting by Sarah White; Editing by Jodie Ginsberg and Erica Billingham)