Wall Street would like you to believe that when investment banks take on risk they are largely doing it for the benefit of investors -- maybe even you and me.

Bankers say much of the capital that their firms put at risk each day is to complete trades for big corporations, mutual funds, pension funds, hedge funds and university endowments. And contrary to the conventional wisdom, proprietary trading -- bets made for a bank's own behalf -- is really just a small part of their business.

Lately, Wall Street's captains of capitalism have been aggressive in pushing the "we take big risks for our customers, not for ourselves" line of argument.

That's especially so in the wake of the public furor over the outsized trading gains at the big banks like Goldman Sachs Group, JPMorgan Chase and Barclays and even Citigroup, so soon after the collapse of Lehman Brothers.

The notion that risk is being taken for customers as opposed to for the firm's own benefit is somehow supposed to make it seem more palatable and somehow less risky.

Still, for many, the image persists that investment banks spend a lot of time and resources gambling on stocks, bonds, commodities or currencies to generate fat profits and big bonuses. And there's good reason for that image: Wall Street firms don't break out the dollars they take in from client trades versus those generated by prop trading.

Yet from the perspective of Wall Street bankers, it's perfectly logical to see much of their risk taking simply as part of trades for their customers.

Here's how:

Let's say a hedge fund calls up an investment bank and asks it to help buy a large block of shares, but it doesn't want to pay much more than a given sum and intends to finance part of the transaction. That may force the investment bank to commit some of its own capital to acquire those shares in a series of separate transactions, so as not to create an undue spike in the stock's price.

To protect itself from losing money, the investment bank may go out and enter into a number of other trades or derivatives transactions -- all intended to reduce, or lay off, its risk of a loss on the customer transaction.

And in all likelihood those follow-on trades will prompt the investment bank to engage in a series of other trades to minimize its exposure to something going awry with those hedges.

At the end of the day, what looks like a simple customer order to buy stock on margin may end up creating a daisy chain of transactions that the customer wasn't even aware were taking place. But in the mind of a Wall Street banker, all these follow-on trades are simply part of the process of completing the customer's order.

Not surprisingly, some of these follow-on transactions can rake in sizeable revenues for a bank's trading desk. That's how an ordinary customer request to buy stock can generate revenues far in excess of whatever fees the initial trade may have produced.

Of course, if things go wrong, an investment bank can just as easily lose money on some of these follow-on transactions, and that's why there's risk involved in the process.

It's hard to see what distinguishes some of these transactions from what an outside observer might label as prop trading -- a group of traders sitting around with a pile of firm capital to do with as they please. But that's not the way that bankers think about customer trades.

Maybe it's all just a case of semantics, and trying to make a distinction between customer trades and prop trading is fruitless. Ultimately, maybe all trading activities by investment banks should just be viewed as risky.

The key to taming the giant banks is to put them in a position where they must turn away customer business because of the potential risk associated with all these follow-on trades.

One way to do that would be to impose hard-and-fast caps on the size of bank balance sheets, as it would deter them from engaging in transactions that add to their assets and liabilities. To avoid any unfair advantage, the caps on bank balance sheets would have to be agreed by regulators and policy makers around the globe.

But a balance sheet cap would be easier to impose and monitor than the increased capital holding requirements Treasury Secretary Timothy Geithner is proposing for global banks.

And better yet, a balance sheet cap would have the added benefit of fostering more competition between banks by driving some business to smaller institutions.

Sometimes legal fishing expeditions pay off.

A year ago, a Connecticut hedge fund sued UBS, contending that it knowingly sold toxic mortgage-backed securities to institutional investors but never disclosed that information.

At the time, the accusation by the fund, Pursuit Partners, seemed intriguing. But because the complaint lacked any sign that it had the beef to back up its potentially explosive claim, the litigation all but fell off the radar screen.

Now, it appears the hedge fund managers were onto something, thanks to a Connecticut state judge's decision to allow Pursuit's lawyers to get limited access to some of UBS' internal emails.

In some of the emails, the investment firm's employees describe the $35 million in collateralized debt obligations sold to Pursuit in summer 2007 as "crap" and "vomit."

At first glance, it might be easy to chalk this up as simply another case of Wall Street bankers peddling securities they privately thought were junk.

But the big revelation unearthed by Pursuit's lawyers is the extent to which credit rating agency Moody's Investors Service shared information with UBS about its impending decision to lower its ratings on some of the CDOs the firm was selling.

In short, what struck a chord with Connecticut Superior Court Judge John Blawie is the evidence that Moody's gave UBS a sneak peak into its decision-making process and that UBS used the information to its advantage. In ordering UBS to post a $35 million bond in advance of a trial, the judge said the firm's bankers "were in possession of material nonpublic information regarding imminent ratings downgrades."

The judge didn't call what UBS was doing insider trading. But that's one way to think of the critical allegation in this case.

And that's why the Pursuit case could be bad news not only for UBS, but for other investment banks that packaged and sold exotic securities that were dependent on getting a stamp of approval from one of the major credit rating agencies.

It's doubtful that this sharing of information between a rating agency and a Wall Street bank was an isolated event.

In one of the emails turned over by UBS and cited by Blawie, a banker is quoted as saying, "It sounds like Moody's is trying to figure out when to start downgrading, and how much damage they're going to cause -- they're meeting with various investment banks."

That email should prompt some enterprising securities regulator or prosecutor to begin asking bankers at UBS and other firms who were packaging CDOs in the spring of 2007: What did you know and when did you know it?

In response to the bond order, a UBS spokeswoman said that "the decision by the Connecticut Superior Court is a preliminary procedure to require defendants to post security while a case is pending, nothing more," adding that the bank expects to prevail in the case.

It's less clear whether Moody's, which also is a defendant in the Pursuit lawsuit, has any liability. There's nothing to indicate that Moody's had any knowledge of UBS' plan to sell the CDOs to Pursuit.

A spokesman for the rating agency said Moody's believes the claims against it are baseless.

The litigation sheds light on the all-too-chummy relationship that exists between the big rating firms and the investment banks.

And it's just one more reason why the Obama administration needs to push harder for reforms that would make it easier for smaller credit rating firms to compete for work with the two big gorillas of the debt-rating world.

That's a lot of heat coming from a lawsuit that most on Wall Street weren't even aware of until this week.

It's time for someone in the Obama administration to read the riot act to Robert Benmosche, American International Group's new $7 million chief executive.

Since getting the job, Benmosche has spent more time at his lavish Croatian villa on the Adriatic coast than at the troubled insurer's corporate offices in New York.

And in the short term, Benmosche's vacation strategy appears to be paying dividends.

This week, AIG's shares surged 44 percent, to nearly $50, after Benmosche said that he intended to move slower than his predecessor in selling off AIG's still viable divisions.

Maybe Benmosche should consider relocating AIG's headquarters to Dubrovnik.

But the big run-up in AIG shares is merely a sideshow for momentum players, speculators and Hank Greenberg, the former AIG chieftain who controls about 11 percent of the company's outstanding shares.

The reality is that AIG exists today only because of the $180 billion lifeline the insurer has received from the federal government. Even Benmosche acknowledges that, telling The Wall Street Journal: "If the U.S. government doesn't continue to support AIG, we will fail."

The trouble is that the government continues to act as if its support of AIG is unconditional, which is why Benmosche can feel free to set his own leisurely timetable for selling AIG's assets. The former MetLife chief executive knows no one from the government is about to tell him what to do, even though American taxpayers effectively own 80 percent of the company.

But Treasury and the Federal Reserve need to be taking their cue from the Federal Deposit Insurance Corp in how to handle AIG.

Behind the scenes, Sheila Bair, the FDIC chairman, has been exerting a lot of pressure on her agency's biggest ward--Citigroup--to make changes to its management and business strategies. Treasury and the Fed should do much the same with AIG.

There's no reason for the federal government to be acting as a mere bystander in all this. After all, the government bailed out AIG chiefly to prevent a run on U.S. and European banks that had purchased hundreds of billions of dollars in guarantees on risky securities. In those scary days immediately following Lehman Brothers' collapse, AIG was too big to fail.

But nearly a year later, that is no longer the case. If AIG were to fail now it would be painful but more manageable because of the steps the Fed has taken either to guarantee or remove the most troubling assets from its balance sheet.

Yet the government's kowtowing to AIG leaves some scratching their heads.

"The controlling party here should be the government," says Brad Golding, a hedge fund manager with Christofferson, Robb & Co, who frequently shorts financial stocks, including shares of AIG in the past. "When he was made CEO, (government officials) should have called him and said: 'You are occupying this role at our whim.'"

There's talk about the Obama administration using the one-year anniversary of the demise of Lehman Brothers to give new life to its flagging financial regulatory reform package.

That's a fine idea and one that's no doubt necessary in light of the way many on Wall Street are returning to business as usual.

But here's something else Team Obama should do: Use the anniversary of the AIG bailout to set a hard-and-fast deadline for dismantling the insurer and getting the taxpayers' money back.

There's something scary about big numbers. It's one reason we in the media often like to put the biggest number we can find into a headline.

So it was no surprise that most media outlets went gaga over the Obama administration's projection that the nation's debt will grow by $9 trillion over the next decade. And sure enough, critics of the administration's efforts to reform healthcare were quick to seize on that scary number as another reason to advocate doing nothing.

But without wading into the muck of the current debate over healthcare reform, it's worth taking stock of just how much hypocrisy there is when it comes to the subject of government spending and those big bad deficits.

Let's start with the Republicans. They talk a good game about reining in federal spending, but they bear as much responsibility as the Democrats for the nation's $11 trillion in total debt.

It's sometimes hard to remember that when President Clinton left office in January 2001, the federal budget actually was in surplus. Yet by the time President Bush left town, the federal government was running a nearly a $1 trillion deficit thanks to spending on the wars on Iraq and Afghanistan, the bank bailout and increased spending on prescription drug coverage for Medicare beneficiaries.

But the Republican deficit hawks didn't really start squawking about government spending until President Obama took office and proposed a $700 billion stimulus package for the ailing economy.

In reality, no political party can claim title to being prudent fiscal managers. All that talk about reducing the deficit often is just a wedge issue that gets used by politicians -- both Republican and Democratic -- to score points and torpedo legislative proposals they oppose.

So while I'm no proponent of profligate government spending, the current budget deficit shouldn't be used as excuse to squelch a potentially worthy government program that could benefit generations of Americans.

A proposal like health care reform should be judged on its own merits and not shelved simply because government spending is currently out-of-whack largely because of a need to stave off the worst economic crisis since the Great Depression.

In considering something like health care, there's a need to take a long-term view-not the just impact on the federal budgets for the next few years.

And don't be fooled by conventional media wisdom that the average American is concerned about the deficit. Sure, in an abstract polling question most Americans will say big federal deficits are bad. But the truth is most Americans don't mind government spending when it provides a useful service or puts money in their pockets. If that wasn't true, the cash-for-clunkers program wouldn't have run out of money so soon.

The current financial crisis is in large part due to the fact that we're a society that loves to live beyond its means. It's the American way to buy more home than is necessary and run-up the credit card bill to pay for a family vacation.

Credit became way too easy during the run-up to the financial crisis, but credit isn't going away. It's simply taken a breather. That's because everyone in the federal government and on Wall Street is rooting -- almost urging -- for Americans to start spending again.

For good or ill, credit and spending is the lifeblood of a consumer economy. Yet sadly, the only real solution policymakers have for ending the economic crisis is to encourage people to starting living off their plastic cards again.

And that's why deficit spending by the federal government is probably here to stay for a long time. The government is only doing its part to help.

The Obama administration's plan for reining in derivatives leaves unchecked one of Wall Street's dirty little secrets: the ability of a derivatives dealer to redeploy cash collateral that gets posted by one of its trading partners.

On Wall Street, this practice of taking collateral and reusing it is called rehypothecation. In essence, it's a form of free money for derivatives dealers to use as they please -- even to repost it as collateral to finance their parent company's own borrowings.

And we're talking big bucks. The International Swaps and Derivatives Association recently reported that derivatives dealers have taken in $4 trillion in collateral from their trading partners. That's an 86 percent increase over the $2.1 trillion in cash collateral those same dealers reported having on their books in early 2008.

Now it's not surprising that investment firms took in more collateral from their trading partners over the last year, when the financial markets were in turmoil. Cash collateral is one way for derivatives dealers to protect themselves against the risk of a trading partner defaulting on one of these sophisticated financial contracts.

There's nothing wrong with a dealer taking legitimate steps to insure an orderly unwind of a busted trade.

But Wall Street firms should not have free license to reuse this collateral any way they see fit. The Obama administration should revise its proposal to require derivatives dealers to hold all cash collateral in segregated escrow accounts that can't be reused or touched by the dealer.

The same rule should also apply with any collateral that is posted with a regulated exchange on which a derivative contract gets traded.

Right now, a party to a derivatives contract can request that any collateral be held in an untouchable, segregated account. But most derivatives traders don't do this because dealers often charge higher fees for keeping cash in segregated accounts.

A measure banning the redeployment of collateral by dealers would not only bring fairer pricing to the derivatives markets but would also eliminate another source of leverage for Wall Street firms.

And here's another thing a ban on rehypothecation would accomplish: it would make it easier to deal with the fallout from the collapse of a major derivatives dealer.

It has been estimated that Lehman Brothers, before it collapsed in September, redeployed tens of billions in collateral it took in as a derivatives dealer.

Nearly a year later, hedge funds, banks and other financial institutions that entered into derivatives transactions with Lehman are still trying to determine just where the cash they posted as collateral for those trades went. The litigation over those collateral disputes could take years to resolve.

Michael Greenberger, a former director at the Commodity Futures Trading Commission who teaches law at the University of Maryland, says rehypothecation benefits no one but the derivatives dealer. Worse, he says, allowing investment firms to reuse and redeploy collateral only complicates the "unwinding and resolution' of a collapsed dealer.

The goal of regulatory reform should be to minimize risk and take away any incentive for Wall Street firms to engage in the kind of hanky-panky that brought about the financial crisis. Barring derivatives dealers from redeploying collateral is a good place to start.

Earlier today I wrote that Sheila Bair is one of the few financial regulators who gets it. And by getting it, I mean not sucking up to the banks and the big money interests on Wall Street. You know, the guys (and most of them are guys), who got us into this financial mess. Tim Geithner, on the other hand, is a regulator who just doesn't get it.

It's not that the Treasury secretary isn't smart--he is. And it's not that he's not up to job--he is. It's that Geithner is too much of a politician and his views have been molded by people who work on Wall Street.

So, that's why we have Geithner telling The Wall Street Journal today that Wall Street isn't reverting back to its old ways--even though everything indicates that's exactly what is going on. In Geithner's world, things are getting better and the banks are becoming better citizens:

I don't think the financial system is reverting to past practice, and we won't let that happen. The big banks are running with much less leverage now, much more conservative liquidity cushions. There has been a significant shrinking of their balance sheets, getting rid of bad assets and cleaning up. And the weakest parts of the system don't exist anymore.

But Geithner lives in the land of Oz. A land where we should ignore the man behind the screen and all the toxic assets that still line the balance sheets of the nation's banks.

The trouble is the rest of us live in the real world where the roads aren't paved with gold bricks.

Hard as it may be to believe, shares of beleaguered Citigroup are on fire.

The stock of the de facto U.S. government-owned bank is up some 300 percent after it cratered at around $1 back in early March.

The over-caffeinated stock maven Jim Cramer keeps calling Citi a "buy, buy, buy" on his nightly CNBC television show. Even the more sober-minded writers at Barron's are pounding the table a bit, predicting Citi shares could double in price in three years."

Time out! It's far too soon for anyone but stock flippers and fast money hedge funds to buy Citi right now.

That's because there's still a world of hurt for Citi in the $83.2 billion in subprime mortgage-backed securities, corporate loans, home loans and commercial real estate mortgages that the bank's finance team has stuffed neatly into something called the "Special Asset Pool."

But there's nothing special at all about these assets. This cesspool of toxic securities and floundering loans is the worst of the stuff that's been stinking up Citi's balance sheet.

And these rotting securities and loans represent a good chunk of the $300 billion in problem assets the federal government is guaranteeing under its bailout of the giant bank.

Yet what the cheerleaders for Citi sometimes forget is that the struggling bank must absorb up to $39.5 billion of the "first loss" on those troubled assets. To date, Citi says it has incurred $5.3 billion in losses on this pool of toxic assets -- meaning the bank has another $34 billion in losses to soak up before the taxpayers start footing the bill.

And the way things look today, Citi is looking at a good deal more losses to come from its Special Asset Pool.

For starters, Citi still sits on a rather sizable portfolio of subprime-backed collateralized debt obligations -- the dubious securities that helped spark the financial crisis.

At last count, Citi valued its CDO portfolio at $9.6 billion, a 56 percent decline from the value the bank placed on those securities last summer. To protect itself against a potential default on those CDOs, Citi has hedged its exposure with some $4.5 billion in credit default swaps.

But unfortunately for Citi, it didn't buy those insurance-like derivatives from American International Group, another big bailout recipient.

If Citi had been shrewd enough to have done business with AIG, it would have been able to sell its CDOs at face value to an entity set up by the Federal Reserve, just like Goldman Sachs, Deutsche Bank and Merrill Lynch and other big banks did. In a flash, Citi's CDO problem would have disappeared.

Citi, however, had the misfortune of purchasing its CDS from Ambac Financial Group, a bond insurer that many see as being on its last legs. The bond research firm CreditSights says Ambac "may run out of capital sometime in 2013."

Many others think Ambac's demise could come much sooner. On August 7, Ambac, which trades around $1, reported a larger than expected $2.4 billion second-quarter loss.

A collapse of Ambac would render the CDS that Citi holds on its CDOs all but worthless. (For related news click here).

To date, Citi, which declined to comment on its CDO exposure, has written down the value of those insurance-like derivatives by more than $1 billion, according to regulatory filings.

Even if Ambac survives in some fashion, Citi is likely looking at additional write-downs on those contracts, and potentially on the underlying CDOs they are supposed to insure.

Citi also could take more hits on some $6.2 billion in private equity investments and $8.5 billion in loans that financed debt-laden buyouts. The bank also reports having some $10 billion in Alt-A mortgages -- a home loan that's a step above subprime -- and $8.3 billion in still largely untradeable auction-rate securities.

To be fair, Citi has been aggressive in writing down the value of its $10 billion in so-called Alt-A home loans to $1.7 billion. The bank has been equally aggressive in reducing its exposure to commercial real estate loans. The bank has marked down the bulk of its $28 billion in commercial real estate-related assets to $5.1 billion.

So it would require substantial defaults in both categories of loans for Citi to incur large losses.

But to say Citi isn't going to suffer any more losses in this pool of toxic assets is way premature. And none of this analysis has focused on the $183 billion in loans to cash-strapped consumers on Citi's books that could still go bust.

In short, the safest bet on Citi shares is still a short one.

It appears Senator Chuck Schumer, aka Flash Gordon ,is going to get his way on the dubious practice of "flash trades.'' Maybe.

Schumer says the Securities Exchange Commission has told him it is close to banning flash trades--a process in which some high-frequency trading desks get a few millisecond sneak peak at market trade orders. This practice has fueled allegations that some high-frequency trading desks are getting an unfair advantage and can frontrun the general market.

Actually, the SEC isn't quite ready to that, although the commission appears to be moving towards a ban on most, if not, all flash trades. (See statement below).

A ban on flash trades would be a good thing. But it's still not clear how widespread the practice is.

And, as I've said many times before, this is the least serious issue when it comes to the matter of high-frequency trading.

I'm still waiting for Flash Schumer or SEC Chairwoman Mary Schapiro to come straight out and say they are worried about the possibility of HFT sparking a 1987-style meltdown.

A ban on flash trades is nothing more than going after the low-hanging fruit. If the SEC simply stops there it simply hasn't done its job of protecting investors from a potential HFT-sparked market meltdown in the Wall Street matrix.

UPDATE: Here's Schapiro's statement on flash trades. Note there's no direction mention of HFT in this statement, leading me to believe this review may not be as sweeping as many, including myself, would like.

I am concerned about the issues presented by dark pools as well as flash orders. Earlier this year, I asked the SEC staff to conduct an examination of dark pools. This included a review of flash orders by exchanges and electronic trading systems. Since the review was undertaken, I have asked  the staff for an approach that can be quickly implemented to elimnate the inequity that results from flash orders. Under the rule-making process, such a proposal to eliminate the ability to flash orders would need to be approved by the Comissission and be open to public comment.

UPDATE 2.0: An SEC spokesman tells me "HFT (is) being looked at generally.'' But, at this point, the SEC is not looking at eliminating it.

Is history repeating itself at Goldman Sachs?

In late 2006, Goldman shrewdly began backing away from the residential mortgage market. With little fanfare, the firm began aggressively hedging its exposure to home loans, in particular mortgages to borrowers with shaky credit histories.

This savvy and somewhat stealthy strategy enabled Goldman to pawn off lots of its soon-to-be toxic mortgages and mortgage-backed securities on other institutions -- forcing those foolhardy speculators to pay the price when the subprime market blew up.

And much to everyone else's chagrin, Goldman even made money off the housing meltdown when some of its hedges -- specifically a bet that a subprime mortgage index would plunge -- paid off handsomely.

It appears Goldman is following a similar script with U.S. commercial real estate, the next big asset class that many believe is on the verge of disaster.

Goldman recently reported owning $6.4 billion in commercial mortgage loans. It also is holding some $1.6 billion in commercial mortgage-backed securities, or CMBS. That's a big retreat from where it was just two years ago.

And in a sure sign that Goldman expects a good number of commercial real estate borrowers to default, the firm says it marked down the overall value of its commercial mortgages portfolio by nearly 50 percent.

By contrast, regional banks, many of which have disproportionately high exposures to commercial real estate, are being far less aggressive than Goldman in marking down their respective portfolios.

But Goldman, with a $950 billion balance sheet, can afford to take the lead in marking down loans and indirectly putting pressure on other lenders to follow suit, because its overall exposure to commercial mortgages is relatively light.

Goldman used to have a rather large footprint in the commercial real estate market, with some $16.27 billion in loans and $2.75 billion in CMBS on its books in late 2007. That year, Goldman ranked seventh in bundling commercial mortgages into securities, churning out $15.1 billion in so-called CMBS, according to Thomson Reuters.

By the end of 2008, Goldman managed to whittle its total commercial mortgage portfolio down to a less imposing $10.9 billion.

Goldman says in a regulatory filing that it was able to rid itself of a good deal of its "long positions" in commercial mortgages and CMBS through "dispositions," or sales of mortgages to other institutions and investors.

No doubt, Goldman also bundled some of it commercial mortgages into the nine CMBS deals it brought to market in 2007.

To be sure, Goldman has taken more hits on commercial mortgages than it did with residential real estate. The firm has taken at least $3.5 billion in write-downs. But Goldman has been able to easily absorb those losses by posting strong trading gains in bonds, stocks and commodities.

And there's the possibility that Goldman's strategy for hedging its remaining exposure to commercial real estate could pay dividends if the market collapses. Just as it did with residential real estate, Goldman says in regulatory filings that it relies on "cash instruments as well as derivatives" to reduce some of the firm's commercial mortgage exposure.

It should come as no surprise that Goldman won't talk about its hedging strategy. So there's no way to determine whether Goldman traders are betting that an index that serves as a derivative trade on the CMBS market will plunge, just as the one that tracked the subprime-backed securities market did.

So far, the main Markit indexes for tracking the performance of the highest-rated CMBS are off just 10 to 13 points from their respective par values. By comparison, the most widely followed Markit index for tracking the performance of subprime-backed debt dropped by more than 80 points at its nadir.

Right now, the odds of subprime-like collapse in CMBS valuations appear long and that's not good news for anyone selling the index short. But further declines would appear likely given the deep haircut Goldman has taken on its own portfolio of commercial mortgages.

No matter what, it would appear Goldman is in a better position than most banks to weather a further slide in the commercial mortgage market. It could even benefit if the market improves and Goldman gets to write up the value of some of the mortgages it's marked down.

And, if lightning strikes twice, Goldman might even profit while others feel only pain..

(Editing by Martin Langfield)

–Matthew Goldstein is a Reuters columnist. The views expressed are his own.–

Did someone try to steal Goldman Sachs’ secret sauce?

While most in the United States were celebrating the Fourth of July holiday, a Russian immigrant living in New Jersey was being held on federal charges of stealing secret computer trading codes from a major New York-based financial institution.

Authorities did not identify the firm, but sources say the institution is none other than Goldman Sachs .

The charges, if proven, are significant because the codes that the accused, Sergey Aleynikov, tried to steal are the secret sauce to Goldman’s automated stock and commodities trading business.

Federal authorities contend 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 gives Goldman an advantage over the competition when it comes to the rapid-fire trading of stocks and commodities. Federal authorities say the platform quickly processes rapid developments in the markets and using secret mathematical formulas, allows 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 charges also raise serious questions about the safeguards that Wall Street firms deploy to protect these costly-to-build proprietary trading systems.

The criminal case began to unfold on the evening of July 3, when Aleynikov was arrested by FBI agents at Newark Airport after returning from Chicago.

Aleynikov apparently had just started a job with another big firm in Chicago after leaving his previous employer in New York in early June. It appears that 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. As of Sunday morning, he was still being held at the Metropolitan Correction Center in Brooklyn.

A Goldman spokesman declined to comment on the incident. A spokeswoman for the United States Attorney’s Office in Manhattan did not comment.

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 and has been a good citizen — noting he’s lived in the United States for 19 years. She seems mystified that federal authorities would arrest him on the eve of a holiday.

The Federal Bureau of Investigation, 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 matches the description of a man named Serge Aleynikov on the social networking site LinkedIn (the difference in spelling of the first name could not be immediately explained).

The biographical 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.”

The case against Aleynikov may explain why the New York Stock Exchange moved quickly last week to stop reporting program stock trading for its most active firms.

Goldman was often at the top of the chart — far ahead of its competitors. It’s possible Goldman had asked the NYSE to stop reporting the number after it 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.”

Federal authorities appear to believe Aleynikov may have had help. The German website that Aleynikov is accused of uploading the stolen information to is registered to a person in London.

While the case is still unfolding, there is more information to unearth about Aleynikov. For instance, it appears he and his wife are competitive ballroom dancers — there are videos of them on YouTube.com.

Many questions remain.

Which Chicago firm hired Aleynikov? The job he took in Chicago, according to the criminal complaint, paid nearly three times more than his $400,000 salary at Goldman.

Also, there’s more to learn about anyone who might have been helping him and the fallout the case 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.”

Quick, get this guy a good lawyer.

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