Back-to-back letters of credit involve two letters of credit between three parties, used to secure goods or services in high-value or international transactions. This technique is often used by intermediaries to secure the goods of local parties while posing as the primary contact for the foreign buyer.
Letters of credit are often used in business transactions, and especially high-value or international transactions, to ensure that the buyer does not walk away with goods or services without paying for them. A back-to-back letter of credit involves two letters of credit between three parties where, for example, a seller sells his goods or services to a buyer or intermediary, who turns around to sell those goods or services to another buyer. The first letter of credit is actually the one obtained by the final buyer for his transaction with the intermediary. The intermediary then uses that letter of credit to secure the second letter of credit, hence the term, back-to-back letter of credit, to secure the initial seller’s goods. This type of match financing is a technique used by intermediaries to secure the goods of local parties while posing as the primary contact for the foreign buyer.
Typically, there are two banks involved in a letter of credit request for a transaction between two parties. The buyer instructs his bank, known as the issuing bank, to create the letter of credit to guarantee payment once the seller presents proof that he has shipped the goods. The seller also uses a bank, known as an adviser bank, to facilitate the receipt of that payment.
By converting this transaction to one involving a back-to-back letter of credit, the seller will submit the ultimate buyer’s letter of credit to the advising bank. The advising bank is asked to issue another letter of credit, becoming the issuing bank of this second letter of credit, in favor of an external provider. The original letter of credit is used as collateral to secure the second letter of credit. Since the final buyer’s letter of credit is an irrevocable guarantee of payment from a reliable source, the advising bank can use it to extend credit, knowing that it will be able to collect your money. The transaction becomes an exchange of shipments and document submissions, where the original supplier ships to the initial purchaser or intermediary, and collects payment for that transaction. That initial buyer turns around and becomes the seller in the second transaction, ships the goods to the final buyer, and collects payment based on the first letter of credit.
The consecutive letter of credit is a common tool of intermediaries. In international transactions, for example, a middleman facilitates sales between local suppliers in your home country and foreign buyers. The intermediary rarely wants the buyer to know that another party is the source of the goods, for fear of being left out of the transaction. In this case, the intermediary, or exporter, arranges the second letter of credit for the purchase of the goods from the original supplier. That second letter of credit is secured on the strength of the original letter of credit without informing the buyer, and is generally structured to allow sufficient time to receive the goods from the original supplier and deliver them to the final buyer or importer.
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