Bank executives, ever financially conservative, are allying with the Securities and Exchange Commission in their belief that the veil of secrecy over hedge funds should be lifted-as high as possible. But Federal Reserve chairman Ben Bernanke and former Fed chair Alan Greenspan respectfully disagree, saying the funds have to remain nimble and can't operate if they're hamstrung by too much regulation. Those two economic powerhouses have been joined by a loud chorus from Commodity Futures Trading Commission and the Treasury Department.

Banks remain steadfast. In a recent survey of executives in the U.S. financial services industry by PricewaterhouseCoopers, 85 percent said they believed the funds should be more heavily regulated. Since bank laws restrict the activities of hedge-fund lenders-banks themselves-shouldn't the funds be subject to the same oversight? Hedge funds have long operated between the lines of regulation. They are not subject to the Securities Act of 1933 (there are no public offerings); the Securities and Exchange Act of 1934 (they're not publicly traded firms); the Investment Company Act of 1940 (they're not mutual funds); and the Investment Advisors Act of 1940 (they're not public investment advisers). Hedge funds, whose roots trace back to the 1940s, are subject to the antifraud provisions of the 1933 and 1934 acts, as well as various investor protections. And funds with more than $100 million in assets are required to file quarterly Form 13F reporting holdings of Nasdaq and New York Stock Exchange-listed stocks, but they don't have to report OTC Bulletin Board and penny stocks.

Since the 1990s, hedge funds have been growing in popularity. The marketplace is a vastly different place than it was a few years ago, when a handful of such funds catered only to the uber-wealthy, with at least $1 million in investable assets. Today, there are more than 8,000 funds with $2.4 trillion of assets under management-and investors can jump into the ring with only a $25,000 entrance fee. And with hedge funds' high fees-typically two percent of assets under management and 20 percent of profits, compared to mutual funds, which charge 1.5 percent on average and take no slice of the gains-investors expect the benefits to outweigh the risk. In 2005, the largest hedge funds boasted returns of 30 percent-plus.

The downside: In 2005, more than 800 funds failed, mostly due to insufficient capital, according to industry estimates. The SEC still points to the 1998 collapse of Long-Term Capital Management, which prompted a meltdown that damaged Asian currencies and contributed to a global financial crisis.

Not only do these investments, which use short-selling, market-neutral strategies and arbitrage, affect volatility in the stock market, but they're exposing more ordinary investors to high risk through pension plans. Hedge-fund managers have become more vocal in the internal governance of many public companies they buy, pressing executives to distribute excess cash and spin off successful divisions. But a key issue is this: With so much cash sloshing around the investment world these days, are too many hedge funds pursuing too few legitimate opportunities, thereby raising risk? How's an investor to know?

On June 22, a federal court struck down an SEC rule-which became effective in December 2004-that required hedge-fund advisers to register as investment advisers. The U.S. Court of Appeals for the District of Columbia Circuit said the SEC rule was "arbitrary," because it exempted funds with 100 or fewer investors from Investment Company Act regulations, but required registration for those with 15 or more investors under another act. The suit was brought in late 2004 against the SEC by Opportunity Partners of Pleasantville, NY. That decision was a major blow for the SEC. In the last few months, hedge funds have captured the headlines, as it was revealed that the SEC is investigating Pequot Capital Management, a $7 billion Connecticut fund, for potential insider trading. Referred by the NYSE, the case is evidence, say anti-regulation advocates, that relaxed regulation of hedge funds works. But could it have been caught earlier-or prevented altogether-if the SEC had been allowed to improve disclosure rules and structural requirements?

Still, the momentum is decidedly against the SEC. At a recent Federal Reserve Bank of Atlanta conference, Bernanke emphasized that the market discipline of hedge funds' creditors, trading partners and investors was the best constraint on the funds' behavior. If these funds, which shun a public paper trail, are doing so well at self-regulating, why should they resent a little light in their corner? But for regulators to demand banks increase their oversight of hedge funds that borrow from them while allowing the funds to act without restraint seems off balance. Remember Ronald Reagan's operational motto: trust, but verify. (c) 2006 U.S. Banker and SourceMedia, Inc. All Rights Reserved. http://www.us-banker.com http://www.sourcemedia.com

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