UPDATE 2-Swiss opt against Iran oil ban despite U.S., EU moves

* Cites "foreign policy reasons" for decision

* Big oil firms seen unlikely to exploit loophole

* Switzerland a major hub for physical oil trading

* Swiss president defends neutrality on Iran (Recasts, adds background, quote from President in paras 11-13)

By Emma Farge

GENEVA, July 5 (Reuters) - The Swiss government will not match European Union sanctions on Iran, deciding on Thursday that its own pending set of toughened measures would exclude a ban on trading Iranian oil and defending its traditional neutrality in the face of U.S. pressure.

The move offers top Swiss-based oil traders such as Glencore and Trafigura a legal loophole for dealing in Iranian crude, although the prospect of falling foul of U.S. and EU restrictions will almost certainly deter them.

Both firms said they have halted all Iranian oil trade.

Switzerland is one of the top centres for physical oil trading and also hosts a branch of the National Iranian Oil Company NICO, although the country does not import oil from Iran.

New Swiss sanctions, which come into force on Friday, will affect supplies for the petrochemical industry, telecommunications equipment, as well as the purchase and sale of precious metals and diamonds, the Federal Department of Economic Affairs (FDEA) said.

They follow an EU ban on the importation, purchase or shipping of Iranian oil which was rolled out on July 1 in an effort to pressure the Islamic Republic over its disputed nuclear programme.

Toughened U.S. sanctions on Iran took effect on June 28.

"The public relations penalty they the larger traders will pay if caught trading with Iran is colossal," said Matthew Parish, partner at Geneva-based law firm Holman Fenwick Willan.

"The space preserved by the decision is really for smaller traders, who operate only in Switzerland and other countries operating outside of international sanctions," he said.

Switzerland has faced diplomatic pressure from Western countries such as the United States to replicate tough measures against Iran.

Not an EU member and traditionally neutral, Switzerland has no legal obligation to follow EU sanctions, although in recent years it has tended to harmonise its laws with those of its main trading partners.

U.S. Ambassador to Switzerland Donald S. Beyer said last month that the United States was disappointed that Swiss authorities had not adopted the EU embargo, adding that he did not expect them to permit the evasion of sanctions.

The country in April also exempted Iran's central bank from its asset freeze.

NEUTRALITY DEFENDED

Current Swiss President Eveline Widmer-Schlumpf defended the country's independent stance, adding that this is helping U.S. interests by allowing communication between Tehran and Washington.

"It's not easy to explain for example to the United States why we are not on the same side for this or that measure," she told Reuters this week in response to a question about Switzerland's position on the Iran sanctions.

"It's worth it to stay in this situation of neutrality, as we help the United States in Iran and can do it only because we are neutral," she said.

Switzerland has represented U.S. interests in Iran since Iran's Islamic revolution in 1979.

The FDEA said that all oil transactions with Iran had to be reported to the Swiss Economics Ministry and the government might take further measures later based on these reports. It is unclear how much of Iran's oil exports are currently traded or financed via Switzerland.

The director of a Swiss federal department said in an interview that Swiss-based oil firms were not exploiting government indecision on whether to follow the EU's ban on Iranian oil.

OPEC member Iran's crude exports averaged 2.2 million barrels per day in 2011, but have fallen sharply because of sanctions, with a National Iranian Oil Company official last month acknowledging exports had fallen by 20-30 percent.

(Reporting by Emma Farge; editing by Andrew Heavens and Jason Neely)