How Does Novation by a CCP Mitigate Settlement Risk in Derivatives?

Novation is the process where a CCP legally substitutes itself as the counterparty to both the buyer and the seller of a derivatives contract. By doing so, the original bilateral relationship is extinguished, and the CCP guarantees the performance of the trade.

This central guarantee eliminates the risk that the original counterparty will default before settlement, thereby mitigating settlement risk.