How Does a Clearing House Mitigate Counterparty Risk in a Derivatives Trade?

A clearing house mitigates counterparty risk through a process called novation, where it legally substitutes itself as the buyer to every seller and the seller to every buyer. This means the original parties no longer bear the risk of the other party defaulting; their counterparty is now the financially secure clearing house.

Furthermore, the clearing house requires both parties to post margin, which acts as collateral to cover potential losses from adverse price movements, creating a financial buffer against default.