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.

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