LONDON -- Earlier this month, one of Britain' biggest merchant banks, Kleinwort Benson Lonsdale PLC, revealed that its securities business lost $12.3 million in the first half of the year. Later, Shearson Lehman Bros. International, the London branch of the U.S. investment bank, announced plans to lay off 150 members of its securities staff.

Both developments signaled the start of phase two of London's financial deregulation: the shakeout.

It's been almost a year since last October's "Big Bang" lifted market restrictions in the City of London -- Britain's Wall Street -- and set off changes that no one could predict.

Big Bang sent salaries soaring at financial firms for everyone from Eurobond dealers to securities analysts. London's financial district has become bigger, busier, more high-tech and more globally oriented since deregulation converted "a dozy little backwater into a major international market," as one analyst put it.

But people kept warning that the party wouldn't last, and it hasn't. The widely predicted shakeout has begun sooner than some had expected.

Financial firms began cutting back operations and laying people off as early as last March, getting out of markets that they couldn't wait to get into less than a year ago. These days even the rumor of a firm scaling back its operations is enough to send its staff scurrying to the competition. And as Big Bang nears its birthday on Oct. 27, no one is predicting that the ride will get easier.

"The market has been able to sustain a large number of players because we've had this long running bull market," said Rex Cooper, deputy chief executive at Barclays de Zoete Wedd (BZW), the investment banking arm of Barclays Bank PLC. "But that has come unstuck in recent weeks, when it has been much harder to make money. There hasn't been a major weeding out yet, and the big people like ourselves wish it would come a bit faster."

BZW is, along with S.G. Warburg Group PLC, one of the two companies usually cited as riding the crest of the deregulation wave, doing well in all areas. Most others haven't had it so good.

"Initially, they all tried their hand at doing probably too much and trying to be too big in too many areas at once," said Cooper. "The weaker players are going to get shaken out, and the sooner the better."

Big Bang -- as the United Kingdom's sweeping deregulation of financial services is known -- abolished fixed commissions and lifted restrictions that prevented individual firms from performing multiple functions such as buying and selling stocks for clients while simultaneously dealing on their own. It also enabled non-British firms to enter the London market.

As both British and foreign companies scurried to equip themselves as one-stop investment centers for the new, more competitive world, all sorts of marriages were made between brokers, market-makers and sources of capital.

True to expectations, business has boomed. The Stock Exchange estimates that trading in British stocks has roughly quadrupled since Big Bang to as many as 75,000 share transactions a day -- worth about $2.5 billion. But at the same time, commission rates for stock deals have roughly been halved, and the number of equities market-makers has almost doubled. With major Japanese and American securities firms somewhat slow to enter the fray, the competition can only get fiercer.

Particularly in the now cutthroat market for British government gilt-edged bonds, competition is taking its toll. Firms thronged to get in on the "gilts" business, sending salaries for experts soaring, when the Bank of England opened up the market into a primary dealership system similar to the U.S. method of trading Treasury bonds.

Where there used to be seven firms making markets in gilts, there are now 26, and the bank may authorize more soon. While turnover in gilts has roughly tripled since Big Bang to about $8.2 billion a day, commissions have all but disappeared and few players, if any, are thought to have achieved the 10 percent market share that analysts estimate a firm needs to make a significant profit.

"I don't think anybody's made much money out of gilts in the last year," said John Tyce, a banking analyst at Alexanders Laing & Cruickshank, a securities firm in the process of being sold to the French bank, Credit Lyonnais. In June, the merchant banking subsidiary of Lloyds Bank PLC closed its money-losing gilts operation. Lloyds also pulled out of the Eurobond market; the two moves combined meant laying off about 100 people.

In July, Morgan Grenfell Group PLC cut its 24-person gilts team in half. "We're not making a lot of money, but we're not losing money," said Morgan Grenfell spokesman Byron Ousey, who estimated that the firm has about 2 percent of the gilts market. "We can hold that market share, but we don't need the same number of people," he said. "We're not going to throw money at it just to buy market share."

Middle-sized merchant banks like Morgan Grenfell are feeling the worst of the post-Big Bang squeeze, existing in a sort of "no man's land ... too big to be niche players and too small to be major league investment banks on their own," said Hugh Pye, a financial analyst at County NatWest Securities, an arm of National Westminster Bank PLC.

British merchant banks, akin to U.S. investment banks, traditionally specialized in areas such as corporate and trade finance. With deregulation, some of the smaller ones concentrated on finding profitable specializations. But others jumped right into the competition as multifaceted investment firms and few, analysts say, have the capital to stay there.

Today, of the eight or so major merchant banks quoted on the Stock Excange, analysts say only Warburg -- with total capital resources of about $1 billion -- is big enough to be sure of continuing to operate profitably on its own.

For the others, takeover rumors run high.

Hill Samuel Group PLC, a well-respected midsize merchant bank that had tried to go it alone, seemed on the verge of announcing an agreed takeover by Union Bank of Switzerland -- which also owns London brokers Phillips & Drew -- until talks abruptly broke down last month.

Last week, Hill Samuel fired its two top corporate finance executives for negotiating the potential sale of their department to another firm. Now the merchant bank's very future seems uncertain; a spokesman confirms that breaking up is being considered.

Another financial services group -- Mercantile House, also mid-sized by measure of its capital resources -- became a classic Big Bang victim when its takeover by British & Commonwealth Holdings PLC was finalized last week.

B&C, a shipping company that has moved increasingly into financial services, is in the process of selling off the money- and stock-brokering parts of Mercantile House's business.

Mercantile House had intended to become a major force in international investment banking, but analysts say it didn't have the financial clout to take on the big players -- and didn't have the capital to keep trying. Mercantile House's pretax profits for the year ended in April fell by 44 percent.

"We were ultimately caught in the middle ground that lies between the small specialist boutiques and the well-capitalized major players," John Barkshire, Mercantile House chairman, wrote to shareholders in the company's annual report published last month.

While gilts were also central to Mercantile House's troubles, life hasn't been smooth sailing in the stock business, either.

Earlier this year, Shearson stopped making markets in some UK stocks and this month halved the total number of stocks it handles, to about 200. In March, Midland Bank PLC's Greenwell Montagu Securities unit pulled out of equities market-making altogether, though it continued as a stock brokerage.

Like many other firms, Midland had acquired an experienced stock brokerage, but not one of market-makers. "They got second-rate people and they paid the price," said one analyst.

Midland Bank is itself the subject of recent takeover speculation, though analysts say the clearing bank's financial troubles stem from its commercial banking side and that its departure from equities market-making didn't have much of an impact on its balance sheet.

Since March, as many as a dozen securities experts, including analysts and salespeople, have left Midland for Morgan Stanley and other firms. In July, Midland rejected an approach from Morgan Stanley International, an arm of the U.S. investment bank, to buy Greenwell Montagu Securities, and it maintains it is committed to the equities market.

While headhunters report that previously soaring salaries for red-hot candidates like gilts experts are leveling off, demand is still running high. Most of those leaving firms so far have had little trouble finding other positions quickly.

According to one executive recruiter, a 25-year-old gilts trader with between 18 months' and two years' experience can still command as much as $98,000 a year -- before counting in bonuses and a company car.

In the run-up to Big Bang, "there was almost an act of desperation to create the teams to demonstrate credibility in these new markets," said Tony Barnes, managing director of another headhunting firm, KornFerry International. Firms grabbed some people with experience of months rather than years because there were so few to go around.

"I think they lost sight of the objective here and just threw money at them," Barnes said. Locking in such high overheads in huge salaries, instead of relying more on performance-related bonuses, has made the going for many firms that much rougher.

As if all this weren't enough to contend with, the sheer weight of the now huge securities business threatens to bury some players.

Especially with the large share issues created by the British government's privatization program, a steadily growing mountain of paperwork has caused major backlogs in securities firms' settlement departments.

While its transactions remain unsettled, a firm carries the risk on its own books; if the market falls sharply it could force some smaller companies into bankruptcy. The Stock Exchange plans to introduce a computerized, nonpaper distribution system, but it won't be ready before 1989.

In the meantime, the exchange last week announced that next month it will begin fining firms with very old transactions that still are unsettled.

Last month, the exchange also assumed powers to restrict trading by firms with too much business outstanding, and is considering increasing capital requirements for the worst offenders.