In over-the-counter (OTC) derivatives and wholesale securities markets, central banks require transactions to clear through Central Counterparties (CCPs). A CCP reduces counterparty credit risk through a legal process known as Novation. [1, 2]
The Novation Intermediary Framework
Novation breaks the original direct contract between a buyer and a seller, inserting the clearinghouse into the middle of the transaction:
[Original Trading Buyer] <--- Direct Counterparty Risk ---> [Original Trading Seller]
                                    |
                                    v (The Novation Process)
                                    v
[Original Trading Buyer] <---> [Central Counterparty (CCP)] <---> [Original Trading Seller]

Following novation, the CCP becomes the buyer to every seller and the seller to every buyer, netting outstanding exposures across participants and reducing systemic default risks. [1]
 
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