Pit trading and open outcry are soon to become a footnote in the free-market system.
In October, the Minneapolis Grain Exchange released a statement: "After a long history of futures and options open outcry trading, MGEX is closing its trading pits effective December 19, 2008."
Today, many people associate futures trading with larger markets related to energy and financial products, but it started with grain markets over 125 years ago. In Minneapolis, the hard red spring wheat contract and pit trading date back to 1883, about six years after the start of oats, corn and soft wheat trading at the Chicago Board of Trade (CBOT) and the hard red winter wheat trading at the Kansas City Board of Trade (KCBOT).
Side-by-side trading (electronic and open outcry in the pit) in grain futures began in August 2006. In the largest agricultural contract -- Chicago corn futures -- it took just five months for electronic trading to account for more than half of total volume (it reached 87 percent by this October). The shift to electronic trading of MGEX spring wheat futures was more gradual. In the first year, it never exceeded 30 percent of volume. However, growth was steady, crossing the 50 percent level in June and reaching nearly 80 percent in October.
The volume of trade in Minneapolis spring wheat futures is not deep enough to sustain a pit when the majority of trading occurs electronically. Officials at the CBOT and KCBOT have publicly repeated their commitment to keep their trading pits open, but it is just a matter of time. Where two markets exist, trading eventually concentrates in a single market.
I spent eight years trading in the MGEX wheat pit. Pit trading is an exciting way to earn a living, but few aspects of the free-market system are more confusing and less understood.
First, what's with this loud, messy and confusing system of open outcry and hand signals? The purpose of open outcry is simple: Every trader -- whether large or small, hedger or speculator -- gets an equal opportunity to respond to every bid and offer. The pits are tiered to enhance equality by giving every trader a clearer view of the action.
Trades in the pit occur on a first-come, first-serve basis, and it is the fairest system you can imagine (electronic trading stays true to this principle). It is taboo to favor your buddy or ignore the jerk in the red jacket. Sometimes a newcomer to the pit does not appreciate the need to be fair and trades a few contracts with an adjacent person, ignoring the guy who was first to respond but 12 feet away. Bad move. Every trader in the pit sees this small moment of injustice -- and the new trader is about to learn what it's like to be ignored by every trader in the pit.
Second, isn't futures trading just another form of legalized gambling? There is an important distinction between speculation and gambling. Speculation involves risks that are real and inherent to the market -- grain prices rise and fall in response to uncertainties in weather, demand, policy, etc. Futures trading allows the hedger, who wants to manage risk, to transfer that risk to the speculator, who voluntarily accepts it for a chance to profit.
Gambling involves risks that are not real but rather are created for entertainment purposes. Whether it occurs in the pit or electronically, futures trading will survive because it serves an important economic purpose.
Pit trading and open outcry provide a fast and efficient way to execute trades. As a former pit trader and as one who loves the open-outcry system, it pains me to admit that electronic trading is even faster and more efficient. Some people look at the demise of pit trading in Minneapolis as a dent in the armor of capitalism. On the contrary, the move to electronic trading is capitalism at its finest -- the best system moves forward.
Edward Usset is a grain marketing specialist for the Center for Farm Financial Management at the University of Minnesota. His book, "Grain Marketing is Simple (it's just not easy)," was released last year.