Eurozone leaders and banks are close to reaching a deal on a 50%writedown for private bondholders on their Greek debt, an EU source said on Thursday.
Negotiations at a summit meeting of eurozone leaders were centred on agreeing a writedown or "haircut" with private bondholders on a voluntary basis.
Eurozone states want private investors to accept the haircut in an effort to reduce Greece's debt burden by about 100 billion euros.
Failure to agree on a voluntary writedown could lead to a full-scale default in Greece's debt, with a heavy knock-on impact on markets.
German sources said Chancellor Angela Merkel and French President Nicolas Sarkozy were now negotiating directly with representatives of the banking industry to try to forge a deal in which the banks will accept a writedown of at least 50% on their holdings of Greek government bonds.
The talks were expected to drag on into the night, with positions far apart on perhaps the most complex element of the three-part "comprehensive package" that euro zone leaders are trying to pull together.
"They only started now on the hard core of the matter, which is the PSI (private sector involvement)," one EU source said.
However, the leaders earlier made progress on two other elements - bank recapitalisation and moves to scale up the size of the eurozone's 440 billion euro (USD 600 billion) bailout fund.
A draft statement from the summit, obtained by Reuters, outlined two options to leverage the fund designed to shore up heavily indebted states and thwart market attacks.
It said details would not be nailed down until next month, suggesting the second summit in four days will have sketched broad intentions but failed to produce a detailed master plan to resolve a crisis that threatens the single currency project.
Those three elements are so intertwined that euro zone leaders face an all-or-nothing showdown.
"It is going to disappoint the market, particularly given the emphasis policymakers put on this meeting," said Jessica Hoversen, foreign exchange analyst at MF Global in New York.
A senior EU source said the eurozone leaders wanted private sector creditors to accept a writedown of 50% or more on their holdings of Greek government debt to reduce Greece's total outstanding private sector debt by around 100 billion euros.
While there is consensus on the need for European banks to raise around 110 billion euros (USD 150 billion) in extra capital to withstand a potential Greek debt default, governments and banks are at odds over the scale of write-offs.
"There has been no agreement on any Greek deal or a specific 'haircut'," Charles Dallara, head of the Institute for International Finance which represents private sector creditors, said in a statement. "There is no agreement on any element of a deal." Sources said the IIF could present another offer, a move that is likely to further extend negotiations.
For the European Financial Stability Facility, where more progress was made, one proposal involves creating a special purpose investment vehicle (SPIV) to tap foreign sovereign and private investors, such as Chinese and Middle Eastern wealth funds, to buy bonds of troubled eurozone countries.
The other method for scaling up the rescue fund, which was set up last year, involves using it to offer partial guarantees to purchasers of new euro zone debt. The two options could be used simultaneously and the International Monetary Fund could also help.
Eurozone finance ministers will be asked to finalise the terms and conditions in November, the statement said.
EU sources said the EFSF was expected to be leveraged by something like a factor of four giving it scope of around 1 trillion euros. It has about 250-275 billion euros available given funds set aside for aid to Greece, Ireland and Portugal and for recapitalising the region's banks.
Sarkozy is expected to talk with Chinese President Hu Jintao soon on Beijing's participation in the bailout fund.
US stocks rallied on the pledge to boost the power of the fund, while the euro fell as investors awaited details that will not be forthcoming until next month.
Earlier, Merkel said it was a crunch time for Europe, while defending its long track record of peace and prosperity.
"No one should take for it for granted that there will be peace and affluence in Europe in the next half century," said Merkel, a pastor's daughter from Communist eastern Germany.
"The world is watching Germany and Europe to see if we are ready and able to take responsibility. If the euro fails, Europe fails," said Merkel, in a characteristically sober tone.
European leaders' pattern of responding too little, too late to a debt crisis that began in Greece has spawned a wider economic and political crisis that threatens to undermine the euro single currency and the European Union project.
EU leaders agreed the outlines of a package on bank recapitalisation, including raising the core capital ratios of European banks to 9% by the end of June 2012, but they did not provide a headline figure, which will depend in part on negotiations over Greek debt.
The European Banking Authority said the eurozone banks needed to raise 106 billion euros of capital to meet that ratio with Greek and Spanish banks facing the most work.
Italian IntentMerkel won a parliamentary vote of support for strengthening the rescue fund after warning in a dramatic speech that Europe was facing its most difficult situation since the end of World War Two.
Merkel told parliament that private bondholders would have to take a substantial write-down so that Greece's debt could be reduced to 120% of gross domestic product by 2020 from 160% this year.
Experts said that implied a 50% "haircut" for private investors.
Also weighing on the summit was deep concern about Italy, which is now in the bond market firing line.
Under huge pressure from its eurozone partners, Rome promised a package of reform steps to boost growth and control its public debt, including labour and pensions reforms and additional revenues from property divestments.
In a letter sent to the summit in Brussels, the government said it would produce a plan of action to boost growth by November 15, promising to raise the retirement age to 67, cut red tape and modernise state administration to improve conditions for business and raise 5 billion euros a year from divestments and improved returns from state property.
Rome's inability to deliver a substantive plan for reforming its pensions system has raised doubts about Prime Minister Silvio Berlusconi's seriousness in tackling a crisis that threatens the euro zone's third largest economy.
Italy has the euro zone's largest sovereign bond market, with a public debt of 1.8 trillion euros, 120% of GDP. If it went the same way as Greece, Ireland and Portugal, the rescue fund would not have enough money to bail Rome out.
Mario Draghi, the incoming head of the European Central Bank threw the eurozone a lifeline hours before the summit, signalling the ECB would go on buying troubled states' bonds as leaders of the 17-nation single currency area struggled to agree a convincing set of measures.
"The Eurosystem (of central banks) is determined, with its non-conventional measures, to prevent malfunctioning in the money and financial markets creating an obstacle to monetary transmission," he said in typically coded ECB language in a speech text released in Rome.
Draghi, who will succeed Jean-Claude Trichet on November 1, made clear that measures could only be a temporary expedient and said it was up to governments to tackle the roots of the debt crisis that began in Greece two years ago.
However, his statement appeared to rebuff pressure from Germany's powerful Bundesbank for the ECB to end the bond-buying programme which prompted the resignation of the two most senior German ECB policymakers this year.
