How Back-to-Back Letters of Credit work
Imagine a client in another country wants to buy some shoes from you. The client goes to their local bank and promises to pay you if you send the shoes to them. But you don’t trust their bank because you don’t know them. So you go to your own bank and ask for help.
Your bank sends a message to your client’s bank saying, “I have a promise from your customer that they will give me money if they receive the shoes. Can you give me a promise that you will pay me that money if I send you the shoes?” Your client’s bank agrees, so your bank sends you a message saying, “Your client’s bank promised to pay us, so we promise to pay you. Send the shoes!”
This way, everyone can feel more confident that they will get what they want without worrying about the other person cheating. But it can take a long time for all the messages to be sent, and there might be fees to pay.
When is Back to Back Letter of Credit used?
Back-to-back letters of credit can be used when a supplier needs to purchase raw materials or goods from another supplier to fulfil an order.
In this scenario, the supplier may not have the necessary cash or credit to purchase the goods upfront, or may not have a relationship with the other supplier that allows them to secure favourable payment terms.
By using back-to-back letters of credit, the supplier can use the buyer’s letter of credit as collateral to obtain a second letter of credit from their own bank, which they can then use to pay the other supplier of the raw materials.
This allows the supplier to fulfil their order and complete the sale to their customer, without having to take on undue financial risk.
Parties involved in Back to Back LC
Parties involved in back-to-back letters of credit include:
- The supplier, who is the party initiating the letter of credit (the exporter) and requesting payment.
- The buyer, who is the party accepting delivery of goods or services under terms of an international sale contract (the importer).
- A bank (or banks) that issue and negotiate both sides’ letters of credit.
Benefits and Drawbacks of using Back-to-Back LC
| # | Benefits | Drawbacks |
| 1 | Serves as an alternative financing option for businesses with limited cash or credit | Can be complex and time-consuming |
| 2 | Allows companies to expand their global supply chains with new suppliers | Can be expensive due to the multiple fees involved. |
| 3 | Reduces the risk of non-payment | Can create additional financial risk for the buyer if the goods do not meet their specifications |
| 4 | Provides a secure method of payment for both the buyer and the seller, as both parties can rely on the security of the letters of credit | Can be limited by the availability and creditworthiness of banks |
| 5 | Can be customized to fit the specific needs of the buyer and the seller | Requires a high degree of trust among all parties involved |
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