Back-to-Back Letters of Credit

A back-to-back letter of credit (LoC) is a financing arrangement used in international trade when an intermediary (such as a broker or trading house) sits between a buyer and a seller. It uses two separate letters of credit: the buyer’s LoC is issued to the intermediary, and that original LoC is used to secure a second LoC issued by the intermediary’s bank in favor of the seller. The structure substitutes the issuing banks’ credit for the buyer’s and intermediary’s credit, enabling transactions when counterparties cannot directly verify each other.

Key takeaways

Two distinct letters of credit are issued: one from the buyer’s bank to the intermediary, and a second from the intermediary’s bank to the seller.
The arrangement relies on bank creditworthiness rather than the trading parties’ credit histories.
Back-to-back LoCs are useful when intermediaries are involved or when parties prefer anonymity.
They are more complex and costlier than single LoCs, and banks often discourage their use because of added risk.

How it works

Buyer requests an LoC from its bank with the intermediary as beneficiary.
The intermediary presents that LoC to its own bank as collateral to obtain a second LoC issued to the seller.
Seller ships goods and presents the required documents to the issuing/advising bank to claim payment under the second LoC.
Payment under the second LoC is made upon compliance with documentary conditions; the first LoC remains the basis for the intermediary’s bank to settle with the buyer’s bank.

Common features:
* The two letters are separate instruments and may differ in amount, shipment dates, presentation deadlines, and other terms.
* Invoices may be used as substitute documents depending on agreement.
* Both LoCs are typically irrevocable, meaning they cannot be canceled without agreement of all parties.

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Pros

Facilitates trade when buyer and seller cannot or do not want to rely on each other’s credit.
Provides privacy: buyer and seller can remain unaware of each other’s identities.
Substitutes reliable bank credit for uncertain commercial credit, reducing seller’s payment risk.

Cons and limitations

More costly: additional bank fees and charges apply.
Complex to administer: multiple documents, differing expiry/shipment dates, and potential mismatches in terms.
Banks may be reluctant to issue the second LoC because they assume risk if the intermediary or original beneficiary fails to comply.
Amendments are complicated because the second LoC depends on the first.

Example

A Chinese buyer secures an LoC from its bank in favor of a London trading firm. The trading firm uses that LoC to obtain a second LoC from its U.K. bank in favor of a U.S. machinery exporter. The exporter ships the machinery and is paid by the U.K. bank upon presentation of compliant documents, while the trading firm and its bank rely on the Chinese bank’s LoC to settle the transaction.

Main risks

The issuing bank of the second LoC faces risk if the original beneficiary (the intermediary) does not meet the first LoC’s conditions or if documentary discrepancies arise.
Timing and expiration mismatches can create exposure if one LoC expires before the other or if shipment/presentation windows do not align.
Documentary non-compliance can delay or prevent payment.

Back-to-back vs. transferable LoC

Transferable LoC: a single LoC issued to a beneficiary can be transferred (in whole or in part) to another party when the original LoC is expressly marked transferable.
Back-to-back LoC: involves two separate LoCs and is not a transfer of rights from one LoC to another.
They achieve similar goals (enabling intermediaries to pass financing along) but use different legal mechanisms and carry different operational implications.

Practical considerations

Ensure tight alignment of documentary requirements, shipment and presentation deadlines, and amounts across both LoCs.
Expect higher fees and require clear agreement on commissions and responsibilities between buyer, intermediary, and banks.
Consult trade finance specialists or legal counsel to draft precise terms and manage amendment procedures.

Conclusion

Back-to-back letters of credit can solve complex international trade problems involving intermediaries or limited counterparty credit information by leveraging bank credit. They provide payment security for exporters and privacy for contracting parties but introduce complexity, cost, and added bank risk. Use them only with careful structuring and professional advice to manage documentary and timing risks.