* Dealers and investors prepare for September roll-out     * Bank CDS spreads to diverge from old contracts     * CoCos included but limited to Tier 2 debt      By Christopher  Whittall     LONDON, July 25 (IFR) - The countdown has begun to the most substantial overhaul of the US$21trn credit default swap market in over a decade, as a new contract designed to insure against sovereign and bank debt restructurings is set to be rolled out in a matter of weeks.     Dealers and investors have stepped up preparations ahead of the unveiling of the 2014 credit definitions on September 22, which will spark the creation of a two-tier market for bank and sovereign CDS, where the most substantive contractual changes are taking place.     It is a response to high-profile credit events and regulatory developments that exposed flaws in the old legal documentation, such as the largest ever sovereign debt restructuring in Greece and the introduction of bail-in bank debt.     "There are some very important economic changes for CDS, particularly on bank and sovereign debt, as well as lots of smaller changes to fix issues that became apparent during the financial crisis and the various CDS auctions. We expect there to be a significant positive impact for the CDS market," said Mark New, assistant general counsel at ISDA.     The headline reforms include the introduction of a new government intervention credit event, when bank debt is forcibly written down. Allowing assets other than bonds to be delivered into CDS auctions to determine payouts to protection holders is another crucial development.     The changes - which will coincide with the next roll date for Markit's CDS indices - are expected to have a major impact on CDS spreads. JP Morgan estimates European banks' senior CDS will trade 9% tighter on average under the new contract compared to the old, while subordinated CDS should widen by a whopping 48%.     "The whole idea of the project is to make CDS and bonds more directly linked to each other - that if there is a loss on a bond, you're compensated through CDS. Bonds have changed over the past decade and CDS needs to adapt too. These changes should make bonds and CDS trade much more closely to each other," said Saul Doctor, credit derivatives strategist at JP Morgan.          RESTORING FAITH     Credit traders view the amendments as being critical to restore investor faith in the product, which has been deeply eroded over the past few years. Blind spots in the old contract first became apparent during protracted negotiations over Greece's debt restructuring. This culminated in the embattled sovereign shaving 100bn off its debt pile in 2012 and a near-miss for US$3.2bn of CDS holders, who only received adequate payouts by pure chance when the debt exchange occurred before a CDS auction could be held.     Further misery was heaped upon CDS users when Dutch policymakers opted to entirely wipe out junior bondholders in SNS Reaal last year to plug capital holes in the bank. A quirk in the CDS rules meant that protection holders went away empty-handed - a brutal demonstration that the instrument would not be fit for purpose under a bank bail-in regime.      The magnitude of the changes to bank and sovereign CDS contracts means participants have only agreed for them to be applied to new trades, as traders were unwilling to forego any benefits the old contract might afford them. Sellers of sub CDS protection, for instance, would not want to swap their contracts for something that would increase substantially the likelihood of them making a pay out to protection holders.     This will create a two-tier market, where the old and new contracts trade side by side, for some time to come. The big question on everyone's lips is how long this parallel universe will persist, and what the spread differential will be.     "There are operational changes and costs for investors, who have to understand the protocol they're signing, but the main thing people are struggling with is how the rolling process will work for index positions. It's not clear where the new indices should trade - particularly on bank CDS - and when liquidity on the old contracts will disappear," said Abel Elizalde, a credit strategist at Citigroup.       "For bank and sovereign CDS, people will have to actually close out on positions and open new ones. There is a danger that if everyone is doing the same thing, the pricing becomes very technically driven."     JP Morgan's Doctor expects liquidity, particularly in sub CDS, to move to the new contract and trades in old contracts to mostly involve closing out legacy positions. "It makes no sense to have two different contracts for clearing purposes - people should want to trade the new contract," said Doctor.          COCO CDS     The new contracts also have a "CoCo supplement" for those who opt to use it, but it will only apply to Tier 2 debt for the time being. This initiative is essentially aimed at Swiss banks, which are the only firms with notable amounts of outstanding T2 bonds.     ISDA's New said the CDS documentation could theoretically apply to either Additional Tier 1 or Tier 2 debt, but he added that ISDA expects it only to apply to Tier 2 initially.      There has been a surge in bank capital issuance this year: 34bn by the end of June, according to Citigroup, with 11bn coming in the Additional Tier 1 space. But despite mutterings of the development of a CDS market to complement this new asset class, participants have lately poured cold water on the idea of CoCo CDS ever taking off beyond Swiss banks' Tier 2 obligations.     "People don't see the need right now for CDS on Tier 1 and Additional Tier 1 debt, which are considered more like equity rather than credit products," said Doctor.   (Reporting By Christopher Whittall, editing by Alex Chambers, Julian Baker)  ((christopher.whittall@thomsonreuters.com)(+44 20 7369 7350)(Reuters Messaging: christopher.whittall.thomsonreuters.com@reuters.net))