FORTUNE — Inside a white chalet in the tiny village of Magglingen, tucked into the Jura mountains in the northwest corner of Switzerland, skilled artisans create luxury watches like the Dentelle et Diamants et Roses, an 18-carat gold confection with 101 pink and white diamonds that fetches up to $89,100.
But the establisseurs, or assemblers, at Delance SA, one of dozens of tiny firms in this cradle of Swiss mechanical watchmaking, are not feeling Delance’s motto of “audacious, erotic, feminine, and powerful” these days.
A shocking ruling by Swiss regulators on Oct. 25 will allow Swatch Group, the behemoth watch empire headquartered across nearby Lake Biel, to cut back sales of critical parts to Delance and other competitors.
Swatch, the world’s largest watch company, known for its colorful plastic watches, owns a near-monopoly on the manufacturing and sale of precision mechanical movements and components in the Alpine nation. But starting next year it will cut essential supplies it has sold to competitors for more than three decades, first by 25%, then tapering them each year until Dec. 31, 2019, when it will pull the plug entirely.
The landmark ruling has shell-shocked small firms like Delance — and sparked speculation that Switzerland’s multi-billion dollar luxury watch industry, a highly fragmented world whose roots date to the 1500s, may be due for a shakeout.
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The ruling “will put a lot of small companies in great pain,” Giselle Rufer, the chief executive of Delance, wrote in an email. She added that she would have to tie up working capital by stockpiling supplies, scrambling for new suppliers and potentially raising her prices for watches like the Dentelle. One looming problem: The tailored cases of Delance watches might not fit parts from other suppliers. Rufer, regarded as the most influential woman in the male-dominated world of Swiss watchmaking, should know: She launched Swatch’s children’s line before leaving the giant to found Delance in 1996.
The ruling is one of the biggest shifts to hit Swiss watchmaking since its founding four centuries ago in Geneva, when Calvinist reforms prohibiting the wearing of jewelry spurred goldsmiths to invent watches.
Now dozens of smaller, privately owned makers are buzzing about whether they can afford tens of millions of dollars needed to invest in their own manufacturing of parts. Industry analysts are whispering about potential acquisitions of smaller watchmakers by investors and the consolidation of makers into larger groups. And some makers are wondering whether China may become a new supplier.
While the ruling does not affect escapements — the elaborate, spiral-shaped wheels that make a watch tick — it does cover other parts critical to the “Swiss-Made” mystique and label, including balance wheels, gear trains, and mainsprings.
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Beatrice Howald, a spokeswoman for Biel-based Swatch, said that the company views the ruling as “a positive, albeit tentative, first step toward finally making it clear to all the brands and groups in the Swiss watch industry that they have to invest in their own mechanical movements and assume the associated industrial risk themselves.”
Along with private banking and chocolate, luxury timepieces are Switzerland’s trademark. Swiss watch exports rose 11% last year to a record 21.4 billion Swiss francs (almost $24 billion), according to the Federation of the Swiss Watch Industry, a trade group. Wealthy Asian and Middle Eastern consumers now account for 54% of sales.
With its quartz-powered, funky designs, Swatch, founded in 1983, is viewed by old-world competitors as a down-market parvenu that tarnishes the Swiss mystique. But in recent years the company has pushed into the luxury market, acquiring storied brands like Blancpain, whose heritage dates to 1735; Breuguet, referenced by Stendahl and Pushkin; and jeweler Harry Winston, whose diamonds draped Marilyn Monroe in Gentlemen Prefer Blondes.
Swatch, which also owns mid-range brands like Omega and Tissot, now accounts for one one-third of all Swiss watch sales. Its net profit soared 26% last year to 1.6 billion Swiss francs ($1.76 billion). Swatch wants to cut parts sales to have more parts for its own watches; analysts say in doing so, the giant could boost its own watch sales by $4 billion.
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While the ruling carves out an exception for smaller watchmakers like Delance, its loose wording leaves uncertain how Swatch will choose watchmakers to which it will actually sell parts. “Swatch Group is a gatekeeper to the ‘Swiss Made’” label,” says a 2010 Harvard Business School report on the industry. Even prestige brands like Rolex, Patek Philippe, and Jaeger-LeCoultre use some Swatch-made parts. At least 50% of a watch must be made in Switzerland in order to bear the coveted “Swiss Made” label.
Paul Swinand, an equity analyst at Morningstar Investment Services who covers the industry, said the ruling left open some key questions. “What if somebody’s big and Swatch likes them, but what if they’re small and Swatch doesn’t,” he said.
Arash Farin, a vice president specializing in consumer goods and media at The Sage Group, a boutique investment bank in Los Angeles, said that consumers who favor smaller niche luxury brands like Delance and Frederique Constant may be soon be paying higher prices. “Nearly every Swiss watchmaker uses Swatch components,” Farin said, adding that smaller players may have to consolidate with competitors or sell themselves. “The magnitude of this decision should not be underestimated.”
Mechanical Swiss watchmaking nearly collapsed in the 1970s and 1980s amid the introduction of cheap Japanese quartz watches. The hidebound industry has been slow to innovative, with Swatch effectively subsidizing research and design of parts, but it has clung to its image and prestige.
But Swatch’s crown jewel is ETA, a manufacturing plant in nearby Grenchen that makes over 75% of the core mechanisms used in watches made by luxury competitors. Still another Swatch subsidiary, Nivarox-FAR, makes over 90% of the balance springs that regulate watches. Watch industry insiders call the near-monopoly “bolt to a dolt.” Sellita and Soprod, smaller competitors, produce parts in much smaller volumes; Sellita even relies on ETA for some supplies for assembled pieces. The company did not respond to requests for comment.
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Peter Stas, the co-founder and chief executive of Frederique Constant, called the ruling “a bombshell” on the company’s website, adding that “a number of smaller manufacturers will be forced out of business.” Deloitte said in a 2013 industry report that smaller brands unable to build production capacity for parts would face higher supply costs.
But Swatch has threatened for more than a decade to taper supplies, giving competitors plenty of heads-up. Along the way, COMCO, the Swiss regulator, confused matters when it initially vetoed Swatch’s tapering plan last July.
Some large watchmakers have paid attention.
Tag Heuer, part of French luxury group LVMH Moet Hennessy Louis Vuitton, is building a parts plant in Chevenez. It has also begun using parts from Seiko, a Japanese rival to Swiss makers.
Richemont Group, a giant Swiss luxury conglomerate with brands like Baume et Mercier, Cartier, and Piaget, is pouring money into research and development to create its own parts-manufacturing plants and has been buying up tiny parts suppliers in recent years, Farin said.
“Richemont is largely self-sufficient in terms of watch movements,” a company spokesman said. “The Group enjoys an excellent relationship with Swatch, which is an important business partner. We do not anticipate that the recently announced ruling will have any impact on Richemont’s businesses.”
Delance’s Rufer, meanwhile, is worried. “The small companies will find it very difficult to survive,” she said. “That is very bad because the creativity is in their hands.”
