What Are Back-to-Back Letters of Credit?

Back-to-back letters of credit are two letters of credit (LoCs) used together to finance a transaction. These are used primarily in international transactions. The first letter of credit serves as collateral for the second letter of credit. Back-to-back letters of credit are usually used in a transaction involving an intermediary between the buyer and seller, such as a broker.

How Back-to-Back Letters of Credit Work

Back-to-back letters of credit are made up of two different letters of credit, with a first one spurring the creation of the second.

With a back-to-back letter of credit, the buyer's bank issues one letter of credit to the intermediary or broker. The intermediary's bank issues the other letter of credit to the seller. With the original letter of credit from the buyer's bank in place, the broker goes to his own bank and has a second LoC issued, with the seller as the beneficiary.

The seller is ensured of payment upon fulfilling the terms of the contract and presenting the appropriate documentation to the intermediary's bank. In some cases, the buyer and seller may not even have knowledge of each other's identities. Depending on the type of transaction, this could be valuable to the parties involved. Back-to-back LoCs essentially substitute the two issuing banks' credit for the buyer's credit and the intermediary's credit. The two letters of credit used in a back-to-back transaction typically have:

• Different amounts or values
• Different expiration, shipping, and presentation dates
• Invoices allowed as substitutes
• Other terms in common

Advantages and Disadvantages of Back-to-Back Letter of Credit

A back-to-back letter of credit can offer privacy to a buyer and seller. They may be used as a substitute if a transferable letter of credit isn't available. They can also help facilitate trade between parties who may be negotiating internationally and cannot verify one another's credit.

However, fees and other charges may apply to a back-to-back letter of credit, and the process involves multiple steps and letters where terms may get murky or vary. As a result, banks tend to discourage using back-to-back letters of credit. If the beneficiary doesn't achieve the terms laid out, there could be a risk to the bank issuing the second letter of credit.

Example of a Back-to-Back Letter of Credit Transaction

Company XYZ is in the U.S. and sells heavy machinery. Company ABC is in China and wants to purchase heavy machinery from XYZ. However, XYZ does not want to take on the risk of defaulted payment by ABC. A London-based trading firm agrees to broker a deal between the two companies. The London firm wants to ensure that the trade is made and that it receives a commission for the deal. Back-to-back letters of credit can be used to make sure the transaction goes through. So, ABC will request a letter of credit from an established Chinese bank, with the London-based firm as beneficiary. In turn, the London firm will use that letter of credit to go to its own established bank in the U.K. and have it issue a letter of credit to XYZ. Because the creditworthiness of the two banks is already established, it stands in for the creditworthiness of the other companies. XYZ can now ship its heavy machinery, knowing that once the transaction is complete, it will be paid by the U.K. bank. The broker is also assured of being paid. The credit risk has been removed from the transaction.

The Bottom Line

The term back-to-back letter of credit describes a transaction involving two separate letters of credit, issued by banks on behalf of clients. These are often used to finance international transactions by companies that want to avoid the risk of doing business with an unknown trading partner.

Relying on this process while engaged in international trade can offer benefits and disadvantages, particularly if the letters are not structured well. Consult with a financial professional or your banker to discuss the potential risks and rewards of a back-to-back letter of credit.