What Is ‘Novation’ and How Does It Relate to the Function of a CCP?

Novation is the legal process of replacing one party in a contract with a new party, with the agreement of all parties involved. A Central Clearing Counterparty (CCP) uses novation to insert itself into a trade.

Once the original buyer and seller agree to a trade, the CCP novates the contract, creating two new contracts: one between the original seller and the CCP, and another between the CCP and the original buyer. This act is what makes the CCP the buyer to every seller and the seller to every buyer, effectively centralizing and standardizing counterparty risk.