Back to back letter of credit arrangement comprises of two different documentary credits issued by two banks. The first letter of credit is issued on the buyer’s application by its issuing bank in favor of the broker. The second LC is issued by the broker’s bank in the favor of the manufacturer or seller.
A back to back LC provides an alternative to a transferrable credit. It helps all parties in an international trade involved to utilize the credit facility issued by the first bank. However, the approval of the second LC or the back-to-back credit proves often difficult.
What is the Back to Back Letter of Credit?
A back to back LC includes issuing two separate letters of credit. The second letter of credit is issued using an existing export LC in favor of the broker with consistent terms and conditions.
The terms and security pledged with the first letter of credit works as the collateral for the issuance of the second LC. These letters are issued in international trades where an intermediary or broker works as the middleman between the actual buyer and the seller.
How Does the Back to Back Letter of Credit Work?
Under the normal trade arrangements, the buyer issues a Letter of credit in favor of the seller. The seller then manufactures the goods and receives the payment through LC after the due process completes. Often the seller needs to outsource the production for timely fulfillment or to purchase in bulk raw materials. Either way, sellers require credit facilities to smoothly operate their operations.
A favorable way for the sellers is to utilize the credit guarantee that comes through the LC issued by the buyer’s bank. The sellers (or Brokers) can pledge the security of the LC with their banks to issue another LC in favor of their supplier (or the actual seller).
Normally, the original buyer would be aware of such arrangements. However, in modern trade deals, the brokers acting as intermediaries may not necessarily inform the buyer of the complete arrangements.
The Approval of Back to Back Letter of Credit
As there are two banks and two separate applicants, both arrangements can take place separately. The first bank would issue an export LC in favor of the first beneficiary after the creditworthiness assessments. Once the first LC is issued, the primary beneficiary can pledge it to its bank for the issuance of another Letter of Credit.
In the process, two banks issue two letters of credits as:
- The first LC is issued in favor of the broker or the middleman,
- The second LC is issued in favor of the manufacturer or the seller.
The broker’s bank may require further evidence of creditworthiness from the broker as well. The trade arrangements can cause a delay in the clearance of the first LC that can make the issuance of the secondary credit a risky transaction.
The terms and conditions for the second LC remain the same as in the first LC for consistency. However, the second bank may not approve the full amount as in the first credit facility. The bank may also change:
- The credit amount approved
- The goods shipment dates
- LC issuance and expiry dates
- Unit prices, interest rates, and service charges.
Key points with a Back to Back Letter of Credit
As there are two different credit facilities involved in the back to back letter of credit arrangement, it involves several key points.
- The first bank issues the primary credit regardless of the back to back LC arrangement.
- The second bank may require collateral other than the primary LC.
- The terms and conditions for the second LC remain the same as in the first one.
- The second bank has no obligation to issue the second LC or may not approve the same credit limit as in the first LC.
Example of the Back to Back Letter of Credit
Suppose a buyer company Techno Star Co. in the US makes a contract of computer chips with a trading company Blue Tech in the UK. The first applicant for the primary credit here will be the Techno Star Co. in the US. The first LC will be issued in favor of the Blue Tech company in the UK. Blue tech outsources the production to another company Star Tech in China. The applicant for the second LC will be Blue Tech in the UK in favor of the Star Tech in China.
The release of the first LC will ensure the repayment of credit for the second LC. The second bank issuing the back to back LC incurs greater risk, hence may charge higher interest rates. The Star Tech company in China can now ship the goods to Blue Tech in the UK. The Blue Tech is also assured of the payment as it has already received the LC from Techno Star US.
Advantages of the Back to Back Letter of Credit
Back to back LC provides an alternative source of finance for the broker acting as the middleman. The arrangement provides several benefits to other parties in the international trade as well.
- It is issued by the second bank, which does not affect the trade deal made by the buyer.
- The second LC is secured by the first credit issued in favor of the first beneficiary.
- The back to back LC provides an alternative source of finance to the broker.
- It helps arrange complex and large international trade deals.
Disadvantages of the Back to Back Letter of Credit
The back to back LC involves two banks issuing two separate letters of credit. Thus, it can become a complex arrangement in large international trades involving three parties. Some of the main limitations of the back to back LC include:
- It may be issued without informing the buyer, which may put them in a riskier position.
- The second bank may not perceive collateral presented through an LC as sufficient to issue another documentary credit.
- Any delays from the third party i.e. the secondary beneficiary may cause delays for the primary trade deal.
- Default or delay in one credit can result in the default of the other credit as well.
- Two banks may interpret terms and conditions, creditworthiness, and trade deals differently.
Conclusion
Back to back LC involves issuing two documentary credits. It helps facilitate all three trade parties with an alternative source of finance. The source of repayment for the second bank and collateral remains the proceeds of the first documentary credit.
