Automated Market Maker (AMM) Background
In traditional finance, automated market making systems have been operational in the options markets for decades. The Chicago Board Options Exchange (CBOE) became the first marketplace for listed options almost 50 years ago, in 1973. Into the early 2000s, there was an “Auto-quote” terminal in each trading pit that housed a standard options pricing model and disseminated automated quotes for all of the options listed in the pit. For years the auto-quote terminal was managed by the independent market makers in each pit - typically the strongest or most vocal market makers would manually update system parameters at the terminal throughout the trading day. Market makers could also call out specific bid/ask markets to the pit’s quote reporters who would then take those markets off “auto-quote” for a period of time and post the open outcry markets instead.
In 1999, the exchange began awarding control of quote dissemination to a “Designated Primary Market Maker” (DPM) for each trading pit. The DPM was the one entity responsible for guaranteeing automated two-sided quotes in all of the options markets listed in the pit - similar to a back-stop liquidity provider. This model existed at all the largest exchanges: at the AMEX they were called “Lead Market Makers” and at the NYSE they were called “Specialists.” A critical function of any exchange is to ensure that there are liquid, executable markets available at all times. By awarding a leadership role to one well-capitalized market making entity for each pit (group of assets), the exchanges sought to guarantee consistent, competitive, and reliable liquidity provisioning for all listed assets.
In the following years, with the advancement of electronic trading technology, a new “hybrid” automated market making system took shape allowing for all of the individual market makers to submit streaming automated price quotes to the exchange from their own servers. There was still a DPM or lead market maker in each pit that served as the backstop liquidity provider, but there were several liquidity providers streaming automated quotes to the order books in all markets.