The clearing industry is in consolidation mode after three difficult years.

The drop-off in market trading and narrowing profit margins have finally caught up with the clearing industry, which some analysts believe is in the early stages of a consolidation period that could greatly diminish the number of players in the market.

A couple of blockbuster deals have already clearly signaled that the industry's landscape is undergoing profound change.

The largest of the deals happened earlier this year, when Bank of New York paid more than $2 billion for the Pershing unit of Credit Suisse Group. Other deals quickly followed. Wachovia and Prudential Financial agreed to combine into one brokerage and clearing operation, forming a company with assets exceeding $500 billion. In April, Fidelity Investments announced a deal to purchase Correspondent Service Corporation (CSC) from UBS PaineWebber, a unit of Swiss services firm UBS AG. Last summer Fiserv Inc. bought up the clearing business of Investec Ernst & Company, a division of international banking group Investec.

Observers note that the activity isn't a surprise. The clearing industry has become a commodity business, and with the drop-off in trading and revenues the big are seeking to become bigger and scale their businesses by acquiring smaller competitors. It's something advisors need to consider when considering service providers, they note.

"I think the age of the small clearing firm is dead," says Mark Goldberg, president of Royal Alliance, which is part of AIG Advisor Group. "It's just not a viable business alternative unless it's supporting some other activity. I see more of the smaller firms being swallowed."

The merger and acquisition activity has already led to a shakeup in the industry's top hierarchy. Before the Bank of New York/Pershing deal, the largest clearing firm in the nation was Bear Stearns, which earlier this year was estimated to have a market share of about 12%. The purchase of Pershing-the second-largest clearing firm-moved Bank of New York to the top position. At the time of the sale Pershing, founded in 1939, had a 10% market share.

"It's a volume-based business, and as profit margins have come down you need more and more volume," Goldberg says. "The market has dictated that these mergers take place."

That's why the activity is expected to continue, says Matt Bienfang, senior analyst with the TowerGroup in Needham, Mass. He sees the industry going from dozens of players to possibly as few as five to ten within the next five to seven years. Another trend that might pick up momentum, he says, is an increase in the number of broker-dealers that abandon self-clearing operations and sign on with a clearing provider for greater cost efficiency.

Clearing firms, he says, are in the same boat as their broker-dealer clients: Trading volume is down, profit margins are tightening, and outlays on technology are rising, while advisors are looking for a fuller menu of services to help them compete in tough times. "This is not a couple of instances of people looking for strategic partners," he says. "The clearing game has really become a commoditized business."

Prices have been squeezed to the point where clearing firms are really competing on the breadth of their services, Bienfang says. To afford such services, clearing firms are scrambling to increase revenues.

"They need to gather the assets, just like the broker-dealers," Bienfang says of clearing firms. "The correspondent clearing firms really gather assets to make money and compete on service levels, not so much on price."

For advisors, that means an assessment of a clearing firm's staying power may be an important ingredient when choosing a service provider. But even the best assessment may be guesswork. Bienfang notes that before it was acquired by Bank of New York, Pershing was probably considered more of a potential buyer than a takeover target.

"That's an inherent risk, no matter what," he says.

This means the clients of merged clearing firms can count on some teething pains as organizations meld into one another, he says. "You've got a lot of correspondent clearing firms thrust into new relationships, new platforms and into what is in effect a conversion," Bienfang says. "Any time you take away systems and processes that a rep has become familiar with and has established his or her business around, it presents a challenge."

At least one client says the deal was a positive development. Peter Mangan, CEO of Shareholder Services Group-a custodial firm for independent advisors that launched in June-says the merger will result in more services for his clients. Coincidentally, Shareholder Services was considering both The Bank of New York and Pershing for its clearing services as it was preparing for launch, he says. The merger, however, made the decision to use Pershing's services much easier, he adds.

"What it does for us is it provides us with a broader range of products and services," Mangan says.

He says, for example, that Pershing has a much broader selection of features and products in the mutual fund area. The Bank of New York, meanwhile, is stronger in areas such as American Depository Receipts.Those involved in the mergers say their clients shouldn't confront any significant disruptions and claim that, in the long run, the mergers will lead to expanded services. At Pershing, which now has more than 1,100 clients as a result of its merger with Bank of New York, some of the services the deal will bring to its platform are mortgage and trust services, says Jim Crowley, Pershing's managing director. The deal could also open access to the managed account products of Lockwood Financial Advisors, which was also recently acquired by Bank of New York.

"Bank of New York was building a substantial clearing firm both domestically and globally, and they were doing that through a series of acquisitions they started five to six years ago," he says.

Under the deal, Bank of New York's more than 200 domestic clearing clients will be converted to the Pershing platform by October 1, Crowley says. Conversion of the bank's global clearing business onto the platform is likely to follow, he adds. "There are many, many synergies between the organizations."

Crowley feels the price tag required to compete in the clearing services industry, underscored by new federal laws that place greater demands on firms in terms of compliance, will fuel further consolidation in the industry.

"I think you will end up with four or perhaps five major players in that space," he says.

Fidelity's purchase of CSC was partly an effort to make the clearing firm a full-service operation, says Norman R. Malo, president of Fidelity's National Financial unit. Fidelity has traditionally been a strong player in the banking and insurance industries, he says. The CSC deal, however, now gives the company a foothold in the professional and institutional markets. "It's helping us drive toward long-term, greater full-service capabilities," he says.

The merger will add CSC's 150 correspondent clients and $31 billion asset base to Fidelity's 155 clients and asset base of about $234 billion, Malo says, and Fidelity is "very much interested" in pursuing other acquisitions. "I definitely think (reduced) margins have had an impact on firms deciding what is mainstream for them and what's not," he says. "We see it as just another avenue to continue to grow."

Bob Beriault, executive vice president at Fiserv, says merger and consolidation in the clearing industry was inevitable after a three-year market downturn that caused trading volume to plummet. As a result, clearing firms throughout the industry were left with excess capacity in their trading systems-and a burning desire to fill it.

Fiserv isn't a neophyte when it comes to expanding through acquisitions. Since going public in 1986, Fiserv has grown 17% to 19% a year in revenues and earnings, he says. Traditionally a clearing service for banks and thrifts, the company branched into securities, insurance and back-office services through acquisitions in the late 1990s, Beriault says.

"We and others have been looking to acquire other firms that would allow us to migrate customers onto our existing systems," Beriault says.

From a seller's point of view, he says, the return on investment in the clearing industry has been getting less attractive as time goes on. The compression of pricing and profit margins has put further pressure on clearing firms, he says. "It's pretty challenging to keep on meeting clients' needs ... when a lot of companies aren't making money in this business," he says.