The replace function is used to replace an asset that is currently in your scene, or the whole scene itself. When used for individual assets, the replace function will replace the selected asset and retain its qualities (if applicable). For example, when a character is replaced they retain the same positioning, sizing, and any actions/effects added to the character.
When the replace function is selected, the asset's corresponding library panel will open and this is where you will choose a new asset to replace the existing one. The replace function only works in the scene you are actively working in - it does not replace assets throughout an entire video or all scenes (Check out Global Edit for this type of functionality).
Note: Replacing characters with differing animation styles can result in a change of the action assigned to the character (e.g. you replace a character and the replacement is assigned a standing action rather than what the previous character was assigned). This is due to differences in available actions across animation styles.