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. Letter Of Credit

    A letter from a bank guaranteeing that a buyer's payment to a ...
  3. Fully Funded Documentary Letter ...

    A written promise of payment provided by a buyer to a seller ...
  4. Settlement Agent

    1. The party involved in completing a transaction between a buyer ...
  5. Back-to-Back Loan

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

    A second guarantee, in addition to a letter of credit, that commits ...
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

    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.
  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

    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.
  5. Investing

    The Pros and Cons of Owner Financing

    Details on the upside and risks of this type of deal for both the owner and the buyer.
  6. Investing

    7 Tips for Writing a Homebuyer’s Letter to a Seller

    To win a real estate bidding war, use these 7 tips for writing a homebuyer’s letter to a seller that’s engaging and personal.
  7. Investing

    Picking Your First Broker

    If you're a rookie investor, your first big investment decision should be an informed one. Read about how to choose your first broker here.
  8. Investing

    What is a Financial Market?

    “Financial market” is a broad term used to describe any forum where buyers and sellers meet to trade assets.
  9. Investing

    What Are Transaction Costs?

    Transaction costs are expenses incurred from buying or selling securities.
  10. Investing

    How Do Real Estate Agents Get Paid?

    Here's how real estate commissions on home sales really work. And, yes, they're negotiable.
RELATED FAQS
  1. 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 >>
  2. 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 without technically owning it. Read Answer >>
  3. When is it necessary to get a letter of credit?

    Capitalize on assets and negate risks by using a letter of credit. Letters of credit are often requested for buying, selling ... Read Answer >>
  4. If everyone is selling in a bear market, does your broker have to buy your shares ...

    A broker won't lose money when a stock goes down because he or she is usually nothing more than an agent acting on sellers' ... Read Answer >>
Trading Center