It is the form of documentary credit where the first party uses a letter of credit to secure another Letter of Credit facility. It uses two letters of credit for one financial transaction. The sellers use this option to secure a credit facility by pledging the credit received from the buyer’s bank. It may work as an alternative to a transferrable letter of credit with some different features.
A back to the back letter is often used by the middleman or sellers outsourcing raw materials in large quantities. It is not necessary to inform the buyer in the first place about issuing another letter of credit. The seller or the first beneficiary of the prime credit remains the ultimate obligator for the trade terms.
How does it work?
Once two parties agree on trade terms, they proceed for a documentary credit as financial security and mode of payment. In many cases, the seller may not be the producer of the goods. In other cases, the seller may need to outsource large raw material quantities and make upfront payments. One option for sellers to obtain the credit is to utilize the prime letter of credit received from the buyer.
The seller uses the prime or master LC as a pledge to obtain a secondary credit facility in favor of the supplier or actual manufacturer. The supplier receives the financial security of the payment and proceeds the manufacturing or raw material supplies as per needs. The middleman or the seller can then fulfill the trade order to the first buyer and receive the payment in the form of a master LC.
The terms specified in the back to back LC should ideally be the same as in the master LC. It creates consistency in the trade agreement and the sub-contract. However, the seller will certainly change the amount and due dates to fulfill the primary order requirements.
Back to back LC is one of the collateral to secure a sub-ordinate credit from another bank. However, it does not ensure that the second bank will oblige to the seller’s credit application. The second bank will also appraise the seller’s creditworthiness before approving the back to back letter of credit.
Example of a Back to Back Letter of Credit
Suppose a trading company C in the UK secures a commercial order of garments from another company B in Germany. The trading company C can locally produce the garments or outsource the order to another company A in China. All three parties in this trade will look for financial assurance. Back to back LCs can solve the problem for all three parties.
Company B in Germany will approach its bank and issue a master LC in favor of C in the UK. Company C will use the master LC to secure back to back LC in favor of A in China.
The amount, delivery period, transaction terms, and other clauses will be adjusted to create room for the order fulfillment for both parties A and C in this case.
The trading company will ship the garments to B in Germany and release the back to back LC. Upon receiving the garments the company B’s bank will release the master LC.
The timing of a triangular trade agreement plays a critical role. Also, the middleman needs to adjust the pricing to create margin or commission.
Advantages of Back to Back Letter of Credit
If done appropriately, back to back LCs can reduce the financial complexities in large international trades. Trading companies, brokers, and middleman agents all work similarly. They often lack access to credit facilities directly. A mast LC provides collateral to pledge against a back to back LC providing greater flexibility.
As with other forms of LC, back to back LCs help facilitate international trades. The creditworthiness of the first buyer can be used to obtain a secondary credit. It offers wider trading opportunities to brokers and agents with limited resources.
Disadvantages of Back to Back Letter of Credit
The complexities involved in back to back LC are substantial. There are several banks and financial institutes involved in back to back LCs. It is essentially transferring the creditworthiness of one client to another.
The issuing bank of master LC appraises their applicant as in any other form of documentary credit. The issuing bank of back to back LC, however, would require more security than relying on a documentary credit.
Some key issues with back to back LCs can be:
- The second bank may not approve the credit with an LC as collateral.
- The timing of documentary clearances can be critical.
- The second bank would require the credit profile of the broker or a line of credit.
- Amendment, rejection, or delay in back to back LCs can delay the actual trade transactions affecting all three parties in the trade agreement.