Back to Back Letters of Credit - Explained
What are Back-to-Back Letters of Credit?
Written by J. Mance Gordon
Updated at April 21st, 2024
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What are Back-To-Back Letters Of Credit?
A letter of credit is often written by a bank or an institutional intermediary promising that it will be responsible for a holder's payment to a beneficiary if the holder does not make the payment. A back-to-back letter of credit is used when an intermediary is involved in a financial transaction between a buyer and a seller. A broker or a financial institution can act as an intermediary between the buyer and seller. In such case, one letter of credit is issued to the intermediary. Two letters of credit (LCs) are involved in a back-to-back letter of credit transaction.The intermediary then secures a second letter of credit to complete the transaction.
How is a Back-To-Back Letter Of Credit Used?
Back-to-back letters of credit occur in transactions wherein the seller is guaranteed to receive payment once the proof that the terms of the transaction have been completed is presented to the bank (intermediary's bank).
In most cases, no direct interaction occurs between the buyer and the seller. Arrangements are made by the intermediary on behalf of the buyer. Two distinct letters of credit (LCs) are used in back-to-back letters of credit. One is given to the intermediary and issued by the buyer's bank while the other is issued by the intermediary's bank to the seller where the seller is a beneficiary. The first LC serves as the collateral for the second LC.
Back-to-back LCs are mostly used in international trade.
Example of a Back-to-Back Letter of Credit Transaction
Qualified Intermediaries, mostly brokers can facilitate transactions between buyers and sellers regardless of the location of both parties. Here is an example; A back-to-back letter of credit can be used if company A which is based in the United States wants to sell an equipment to Company C which is based in Japan. Due to risk of default of payment, Company A might be reluctant to sell the equipment to Company C. A broker firm serving as an intermediary between these two parties can facilitate and manage the business deal. Using the back-to-back LCs, brokers ensure that this business deal falls in place while they also get their commission from it.