What are 'Back-To-Back Letters Of Credit'

Back-to-back letters of credit consist of two letters of credit (LCs) used together to finance a transaction. A back-to-back LC is usually used in a transaction involving an intermediary between the buyer and seller, such as a broker, or when a seller must purchase the goods it will sell from a supplier as part of the sale to his buyer.

BREAKING DOWN 'Back-To-Back Letters Of Credit'

The back-to-back LC is actually made up of two distinct LCs, one issued by the buyer's bank to the intermediary and the other issued by the intermediary's bank to the seller. With the original LC from the buyer's bank in place, the broker goes to his own bank and has a second LC issued, with the seller as beneficiary. The seller is thus ensured of payment upon fulfilling the terms of the contract and presenting the appropriate documentation to the intermediary's bank. In some cases, the seller may not even know who the ultimate buyer of the goods is.

As is often the case with LCs, back-to-back LCs are used primarily in international transactions, with the first LC serving as collateral for the second. Back-to-back LCs essentially substitute the two issuing banks' credit to the buyer's and intermediary's and thus helps facilitate trade between parties who may be dealing from great distances and who may not otherwise be able to verify one another's credit.

Example of a Back-to-Back LC Transaction

For example, assume that Company A is in the U,S, and sells heavy machinery. Broker B, a trading firm based in London, has learned that Company C, which is located in China, wants to purchase heavy machinery and has managed to broker a deal between the two companies. Company A is eager to sell but does not want to take on the risk of default of payment by Company C. Broker B wants to ensure that the trade is made and that is receives its commission.

Back to back LCs can be used to make sure the transaction goes through. Company C will go to a well-known financial institution in China and get it to issue an LC with Broker B as beneficiary. In turn, Broker B will use that LC to go to its own well-known financial institution in Germany and have it issue an LC to Company A.

Company A can now ship its heavy machinery knowing that once the transaction is complete it will be paid by the German bank. The broker is also assured of being paid. The credit risk has been removed from the transaction.

RELATED TERMS
  1. Straight Credit

    A type of letter of credit. A straight credit can only be paid ...
  2. Brokered Market

    A marketplace where buyers and sellers are brought together by ...
  3. Back-to-Back Loan

    A loan in which two companies in different countries borrow offsetting ...
  4. Letter Of Credit

    A letter from a bank guaranteeing that a buyer's payment to a ...
  5. Each Way

    A slang phrase used when a broker earns commissions from both ...
  6. Back-To-Back Deductible

    An insurance policy deductible that is the same as the coverage ...
Related Articles
  1. Small Business

    Letter of Credit

    A letter of credit is a document from a bank promising to pay the holder a certain amount if the holder fulfills certain obligations. Sellers in commercial transactions often require buyers to ...
  2. Investing

    The Ins And Outs Of Seller-Financed Real Estate Deals

    There's more than one way to buy or sell a house. Seller financing presents yet another unique option.
  3. Investing

    What Does a Broker Do?

    In the investment world, broker is a term used to refer to an individual or entity that helps facilitate trading in financial securities.
  4. Investing

    Ins And Outs Of Seller-Financed Real Estate Deals

    Seller financing works like this: Instead of a buyer receiving a loan from a bank, the person selling the house lends the buyer the money for the purchase.
  5. Investing

    What Does a Financial Intermediary Do?

    A financial intermediary is an institution that acts as a go-between in a financial transaction.
  6. Personal Finance

    What is an Investment Bank?

    An investment bank is a financial intermediary that performs a variety of services.
  7. Investing

    What's Trade Finance?

    Essentially, trade finance makes it possible and easy for exporters and importers to trade, and its expansion has accommodated a massive international trade growth.
  8. Trading

    Price Shading In The Forex Markets

    This practice puts brokers ahead of their clients, but it doesn't have to be a negative for traders.
  9. Investing

    Picking Your First Broker

    If you're a rookie investor, your first big investment decision should be an informed one.
  10. Investing

    How To Choose The Right Online Trading Broker

    The online broker market is becoming more competitive, but differences exist in services that can help traders choose the broker that’s right for them.
RELATED FAQS
  1. How do you use a back-to-back loan?

    Back-to-back loans or parallel loans are a financial move used by companies to curb foreign exchange rate risk or currency ... Read Answer >>
  2. What is a bank's legal liability when issuing a letter of credit?

    Learn the responsibility of banks that issue letters of credit Letters of credits ensure payment on transactions between ... Read Answer >>
  3. What's the difference between a letter of credit and a bank guarantee?

    Learn how letters of credit and bank guarantees differ, how they are used by banks and companies, and how buyers apply to ... Read Answer >>
  4. What's the difference between a bank guarantee and a letter of credit?

    A bank guarantee and a letter of credit are similar in many ways but they're two different things. Letters of credit ensure ... Read Answer >>
  5. How is it possible to trade on a stock you don't own, as is done in short selling?

    Understand how the process of short selling allows a person to sell a stock he or she doesn't technically own by borrowing ... Read Answer >>
  6. When do I need a letter of credit?

    Learn more about the function of a letter of credit for both the buyer and the seller, and get some examples showing when ... Read Answer >>
Trading Center