Strict new rules to undercut synthetic ETFs-report

* New ESMA guidelines on synthetic ETFs due within weeks

* Uncertainty already impacting synthetic ETF volumes

By Anjuli Davies

LONDON, Jan 6 (Reuters) - Imminent new guidelines on the regulation of exchange-traded funds (ETFs) in Europe could force Europe's burgeoning synthetic ETF industry into decline, crimping its growth to rates in line with U.S. counterparts, a report on Friday said.

Research and advisory firm Celent warned that an emphasis on controlling counterparty and systemic risk linked to the use of derivatives could repel investors in the synthetic ETF industry in Europe, which in 2010 accounted for almost 90 percent of global issuance of synthetic ETFs.

ETFs are funds that trade like a share and track an index such as the FTSE 100. They are popular as a means to get cheap exposure to indexes without buying a wide range of shares.

Conventional ETFs take in baskets of the underlying assets tracked by the index, but so-called synthetic ETFs replicate index returns through the use of derivatives that critics warn could expose investors to collateral and counterparty risk.

Growth and innovation in the industry have prompted health warnings from international watchdogs, including the Financial Stability Board, the International Monetary Fund and the Bank of Internation Settlements.

As a result, the European Securities Markets Authority (ESMA) has drawn up new guidelines to improve the transparency of the market, and is expected to begin public consultation on those during January, a spokeswoman for the ESMA said.

It is also considering whether ETFs should be divided into "complex" and "non-complex" products and whether the sale of derivative-based synthetic ETFs to retail investors should be restricted.

Synthetic ETFs have grown steadily and in 2011 made up more than 45 percent of the overall European ETF market, the Celent report shows. This compares with the United States, where assets under management for synthetic funds are low due to regulatory restrictions.

But uncertainty surrounding the new rules has already seen inflows decline in Europe. In January through October 2011, synthetic European-listed exchange-traded products (ETPs) accounted for a meagre $1.25 billion of around $28.1 billion of new inflows recorded. In 2010, by contrast, they attracted more inflows than their physical counterparts.

Celent cited the fact that Credit Suisse recently decided to convert four of its synthetic ETFs into physical ETFs as an indication of dramatic changes in the industry.