The recent financial crisis witnessed a bifurcation in the prime brokerage business: big hedge fund clients got the same or better terms from big prime brokers, and smaller hedge fund clients got worse terms or got shut out altogether. In large part, this was the result of frozen credit markets and pervasive risk aversion. One of the key services provided by prime brokers to hedge funds is lending, see “In Frozen Credit Markets, Enhanced Prime Brokerage Arrangements Offer a Rare Source of Hedge Fund Leverage, But Not Without Legal Risk
,” Hedge Fund Law Report, Vol. 2, No. 8 (Feb. 26, 2009), and just as banks ceased making loans to all but their most creditworthy borrowers, so did big prime brokers cease making loans (or providing other services) to all but their most creditworthy hedge fund clients. Creditworthiness in this context generally was assessed based on assets under management (AUM). As a rough rule of thumb, from the perspective of the larger prime brokers, AUM of less than $500 million generally presented an unpalatable level of risk. To compensate for that perceived risk, the big prime brokers charged higher or separate fees to funds below that threshold, and cut back on the range and level of services offered to smaller funds. In some cases, the big prime brokers “fired” smaller hedge fund clients altogether. A new crop of boutique prime brokers has arisen to fill the services void left by the retrenchment among the larger prime brokers. While smaller hedge funds may be perceived as too risky or not sufficiently profitable for the larger prime brokers, smaller hedge funds are precisely the type of client that the new group of boutique prime brokers is structured to serve. In other words, supply has arisen to meet the market demand. This article details the services provided by prime brokers (large and small); the terms that are becoming “market” in agreements between hedge funds and boutique prime brokers; terms in prime brokerage agreements that warrant special attention from hedge funds and their counsel when such agreements are being negotiated; the arrangements between boutique prime brokers and larger prime brokers with respect to trade execution and clearing; custody of assets, and in particular, services whereby prime brokers will offer custody of assets with a trust partner or affiliate; the rationale for the rise of smaller prime brokers; and the likely future shape of the small prime brokerage industry.