Mr Donaldson called for a new environment of integrity

In testimony to the US House of Representatives, Securities and Exchange Commission (SEC) Chairman William Donaldson said that the dramatic surge in hedge fund activities has left market overseers struggling to keep up.

The agency is currently soliciting comments on how, if at all, it should regulate hedge funds, which use the money invested in them to play complex bets on markets the world over and often bet amounts which are sizable multiples of their assets.

The SEC hopes to come up with new rules sometime "in early fall", Mr Donaldson said, following a meeting with industry representatives in mid-May.

We have no access to them. We can't get inside them. That's bothersome William Donaldson SEC chairman

In the US alone, over $600bn is thought to be lodged with the funds, more than 10 times their assets a decade ago.

"That's too much money for us to know as little as we know now about what's going on," the former investment banker and New York Stock Exchange chairman told the committee.

In the US alone, over $600bn is thought to be lodged with the funds.

"We have no access to them. We can't get inside them. That's bothersome."

Selling short

The wildfire growth of the hedge fund industry has come partly because it is so unregulated, observers believe.

Investors in the funds have hitherto tended to be the super-rich or large financial institutions, but many are now marketing themselves to the general investing public too.

That has made the question of regulation an urgent one, triggering both the SEC investigation and the House Financial Services Committee's own inquiry.

The committee's chairman, Michael Oxley, told Mr Donaldson that he had had reports of fiddles involving analysts - the very people over whose misbehaviour Wall Street paid out $1.4bn earlier this month.

According to Mr Oxley, analysts were coming under pressure to downgrade their opinions on stocks which were "shorted" by funds in which their employers had invested.

"Shorting" involves selling borrowed shares and then buying them back once they have fallen.

The practice is entirely legal - unless the falls are manipulated.

There is little evidence to suggest hedge funds fail more often than other kinds of investment, but the most famous hedge fund failure almost broke markets around the world.

Long Term Capital Management (LTCM) went under in 1998, having betted on currency movements with amounts borrowed at massive multiples of its asset base.