The arrest of hedge fund millionaire Raj Rajaratnam on charges that he and his $7 billion Galleon Group hedge fund profited from illegal insider trading will no doubt feed suspicion in some corners about the way hedge funds generate fat profits.

But for anyone to assume that all hedge fund managers owe their success to getting information on the sly is unfair and wrong. The overwhelming majority of hedge funds are only as good as the quality of the research performed by their analysts and traders.

And the truth is the vast majority of hedge funds are rather ordinary. If the majority of hedge funds managers were so crafty, not so many funds would have gone bust last year–or lost bundles of money for their wealthy investors.

The true standouts in the industry are a real minority. Anyone can put together an offering statement, call themselves a hedge fund manager and go out and raise money. That’s one reason why wealthy people and pension funds who throw money blindly at hedge funds without doing adequate due diligence are being plain foolish.

Still, the charges against Rajaratnam and five co-defendants are disturbing. Hubris and greed are powerful motivators. And some hedge funds will stretch, even break the rules to get an edge–even if it’s to book just another $20 million for a fund with nearly $7 billion in assets.

Indeed, it’s worth noting that this isn’t the first time Galleon has been accused of skirting the rules to get an edge.

In 2005, Galleon paid an $800,000 fine to the SEC to settle a civil investigation into allegations it improperly profited from shorting 17 stocks. The SEC alleged the hedge fund violated securities rules by using shares obtained in a secondary offering to cover, or close out, a pre-existing short position on a stock. Regulators claimed that impermissible strategy called “collapsing the box” essentially was a risk-less one and generated $1 million in trading profits for Galleon.

Maybe the 2005 settlement put Galleon on a watch-list for prosecutors. It appears from the criminal complaint prosecutors began focusing on Galleon and its co-founder in 2006. Dealbreaker’s crack investigative reporter Teri Buhl has a good speculative piece on whom at Galleon might have been cooperating with investigators.

Also, Galleon always has had something of a cowboy culture. Years ago, the fund recruited a former Bank of America technology analyst who was fined and suspended by securities regulators because he allegedly issued misleading bullish research reports on stocks he was simultaneously advising hedge funds to sell short. I broke the scandal when I was still at TheStreet.com.

However, what may be most troubling about this latest case brought by federal authorities in New York is that one of the people allegedly providing illegal tips on leveraged buyouts and other deals was an analyst with Moody’s Investors Services, the credit rating agency. The alleged tipster got $10,000 for his work.

The allegation about the Moody’s analyst raises serious questions about safeguarding the flow of information from credit rating agencies to traders on Wall Street. We’ve already seen evidence in a civil lawsuit against UBS that suggests some at Moody’s may have discussed potential rating changes on CDOs with some Wall Street banks.

Insider trading is a problem that has been around as long as people have traded stocks. And it’s almost impossible to stamp-out insider trading, given the premium someone will put on getting inside information.

But aggressive law enforcement like the kind done in this case should serve as a deterrent–hopefully.

Did someone try to steal Goldman Sachs’ secret sauce?

While most in the US were celebrating the 4th of July, a Russian immigrant living in New Jersey was being held on federal charges of stealing top-secret computer trading codes from a major New York-based financial institution—that sources say is none other than Goldman Sachs.

The allegations, if true, are big news because the codes the accused man, Sergey Aleynikov, tried to steal is the secret code to unlocking Goldman’s automated stocks and commodities trading businesses. Federal authorities allege the computer codes and related-trading files that Aleynikov uploaded to a German-based website help this major “financial institution” generate millions of dollars in profits each year.

The platform is one of the things that apparently gives Goldman a leg-up over the competition when it comes to rapid-fire trading of stocks and commodities. Federal authorities say the platform quickly processes rapid developments in the markets and uses top secret mathematical formulas to allow the firm to make highly-profitable automated trades.

The criminal case has the potential to shed a light on the inner workings of an important profit center for Goldman and other Wall Street firms. The federal charges also raise serious questions about the safeguards Wall Street firms deploy to protect their proprietary trading systems.

The criminal case began to unfold on the evening of July 3 when Aleynikov was arrested by FBI agents at Newark Liberty Airport, after returning from Chicago. Aleynikov had just started a job with another firm in Chicago, after leaving the big firm in NY in early June. It appears the financial institution allegedly victimized by Aleynikov had alerted federal authorities that its former employee might be up to no good.

On July 4, Aleynikov was processed on a “theft of trade secrets” charge in a criminal complaint that was filed in federal court in Manhattan. As of this afternoon, he was still being held in federal custody pending posting of bail.

A Goldman spokesman declined to comment on the incident.  A spokeswoman for the US Attorney in the Southern District of New York didn’t comment. Authorities reportedly took all the computers from Aleynikov’s home in New Jersey.

Sabrina Shroff, Aleynikov’s lawyer, says the facts will bear out that her client is innocent. She’s hoping he will be released from custody soon.

His wife, Elina, says her husband is innocent. Speaking in a phone interview from the couple’s New Jersey home, she says her husband worked hard for Goldman Sachs and has been a good citizen–noting he’s lived in the US for 19 years. She seems mystified that federal authorities would arrest him on the eve of a holiday.

The Federal Bureau of Investigations, in charging Aleynikov, says he began working for the major financial institution in May 2007 as a computer programmer and left in early June. That would appear to match the description of a man  named Serge Aleynikov, as it is listed on the social networking website LinkedIn.

The bio information for Aleynikov on LinkedIn says he joined Goldman in May 2007 and was vice president for equity strategy. The bio says he was responsible for “development of a distributed real-time co-located high-frequency trading platform.” In his own words, he goes on to describe the platform as “a very low latency (microseconds) event-driven market data processing, strategy and order submission engine.”

The case against Aleynikov may explain why the New York Stock Exchange moved quickly in the past week to alter its methodology for reporting program stock trading. Goldman often was at the top of the chart–far ahead of its competitors.

On the week ending June 19, Goldman, for instance, was ranked first on the NYSE program trading list. But on the week of June 22, Goldman mysteriously didn’t appear on the list of the top 15 firms at all. It simply vanished without any explanation. Then the NYSE announced it would change some of the data for calculating the trading report. The Zerohedge blog was all over this controversy a week ago.

And now Tyler Durden of ZeroHedge has come in with his own excellent analysis of this strange, strange criminal case. I highly recommend reading it.

It’s possible Goldman asked the NYSE to alter some of its reporting methodology after the firm discovered that someone may have infiltrated the proprietary computer codes it uses.

Here’s the way the criminal complaint describes the Goldman trading platform:

The Financial Institution has devoted substantial resources to developing and maintaining a computer platform that allows the Financial Institution to engage in sophisticated high-speed, and high-volume trades on various stock and commodities markets. Among other things, the platform is capable of quickly obtaining and processing information regarding rapid developments in these markets.

Meanwhile, federal authorities appear to believe Aleynikov, who has lived in the US for more than a dozen years but frequently travels back-and-forth to his native Russia, may have had help. The German website that Aleynikov allegedly uploaded the stolen information to is registered to a person in London. That, of course, gives rise to speculation about this all being a case of international espionage.

This case is quickly unfolding and there’s plenty more information to unearth about Aleynikov. For instance, it appears that he and his wife are competitive ballroom dancers–there are some videos of them on youtube.com. The job he took in Chicago, according to the criminal complaint, paid nearly three times more than his $400,000 salary at Goldman.

Which Chicago firm hired Aleynikov? Inquiring minds want to know. But you can rule out the giant hedge fund conglomerate Citadel. It’s not them.

Also there’s more to learn about anyone who might have been helping him and the fallout this may have for Goldman.  When he was arrested, Aleynikov told the FBI he “only intended to collect ‘open source’ files on which he had worked, but later realized that he had obtained more files than he intended.” But authorities say after he uploaded the files he encrypted them and “erased” the program he used to encrypt them.

It’s not clear why the authorities and apparently Goldman waited so long to move on Aleynikov, even though they knew he had uploaded the information weeks ago.

One question investors need to ask is whether this incident will have any impact on Goldman’s second-quarter earnings. The alleged wrongoing by Aleynikov took place at the beginning of the month–although it’s not clear if it had any material impact on automated trading.

Update: The NYSE has not stopped reported program trading results. Instead, it’s altered the method it uses for putting together that report.