A Letter of Credit is a critical document in any export transaction as it is a guarantee from the importer’s bank that the payment to the exporter will be made on time subject to the agreed conditions. Depending on the agreement, one of the types of Letter of Credit is selected to ensure a seamless export-import transaction between involved parties.
What is a Back to Back Letter of Credit?
A Back to Back LC means that two Letters of Credit will be raised to finance a single transaction. It is usually opted in cases where there is a broker, agent or intermediary involved in the process between the importer and exporter. These are primarily used for international transactions where goods are expected to be shipped from one country to another1.
What is the need for a Back to Back LC?
A Back to Back LC essentially helps solve challenges in terms of trust between parties in a transaction that involves an agent or intermediary. As there are more than two parties involved, different LCs must be issued. In some cases, the importer is not even aware of the exporter’s identity as the agent is dealing on behalf of the latter. To solve this, a Back to Back LC is used.
How does a Back to Back LC work?
The importer issues a principal LC to the agent rather than the exporter. The agent then submits it to the bank as collateral and requests another LC, which can be given to the exporter in exchange for the shipment. The second LC issued by the bank of the intermediary is known as a Back to Back LC.
Benefits of a Back to Back Letter of Credit
Some of the key benefits of a Back to Back LC are2:
Reduce financial complexities
If executed appropriately, Back to Back LCs can reduce financial complexities in international trade
. As agents, brokers and middlemen are involved, it brings uniformity in the process.
As agents usually lack access to financial facilities that can offer credit directly, the use of Back to Back LCs make the entire process more flexible.
The use of a Back to Back LC offers better trading opportunities to middlemen. The credit record of the primary importer is tapped to generate secondary credit by the agents.
Contents in a Back to Back LC
A Back to Back LC is similar to a regular Letter of Credit
. Here are some details mentioned in a Back to Back LC:
· Beneficiary details
· The period in which payment will be made to the bank
· Exporter’s bank details
· Payment mode
· List of documents
· Notifying address
· Goods description
· Confirmation order from a local bank
Example of a Back to Back Letter of Credit transaction
Company X from China manufactures glass items. Agent Y, based in London, identified an importer Company Z in Germany. Agent Y acts as a bridge between the two parties to lead a trade agreement and, in return, generates a commission from the deal. A Back to Back LC can be used in this case. Company Z will go to a trusted finance company in Germany and request an LC in favor of Agency Y, who will use that LC to request LC in favor of Company X.
The above-mentioned example is fictional and has been used to demonstrate the concept.
What are the risks under a Back to Back LC?
Settlement date of principal LC
There is a possibility that the payment date in the principal LC does not include a buffer period. In case of a delay with documents from the agent’s bank, the principal LC can expire, making the settlement process tricky.
Terms and conditions
With more parties and financial institutions involved, the terms and conditions for the primary and secondary LC can vary from each other. This can lead to differences in understanding and execution of the deal, which can make the settlement cumbersome3.
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Published on November 30, 2022.