how back to back letters of credit work
back to back letters of credit are made up of two different letters of credit with a first one spurring the creation of the second 1with a back to back letter of credit the buyer s bank issues one letter of credit to the intermediary or broker the intermediary s bank issues the other letter of credit to the seller with the original letter of credit from the buyer s bank in place the broker goes to his own bank and has a second loc issued with the seller as the beneficiary the seller is ensured of payment upon fulfilling the terms of the contract and presenting the appropriate documentation to the intermediary s bank in some cases the buyer and seller may not even have knowledge of each other s identities depending on the type of transaction this could be valuable to the parties involved in general letters of credit locs are one of the most secure instruments available to international traders according to the u s international trade administration while gathering a foreign buyer s credit information is challenging the exporter can be satisfied with the buyer s foreign bank s creditworthiness the importer or buyer is protected as well as the goods must be shipped before payment is sent 2back to back locs essentially substitute the two issuing banks credit for the buyer s credit and the intermediary s credit the two letters of credit used in a back to back transaction typically have advantages and disadvantages of back to back letter of credita back to back letter of credit can offer privacy to a buyer and seller they may be used as a substitute if a transferable letter of credit isn t available they can also help facilitate trade between parties who may be negotiating internationally and cannot verify one another s credit however fees and other charges may apply to a back to back letter of credit and the process involves multiple steps and letters where terms may get murky or vary as a result banks tend to discourage using back to back letters of credit 3 if the beneficiary doesn t achieve the terms laid out there could be a risk to the bank issuing the second letter of credit 1example of a back to back letter of credit transactioncompany xyz is in the u s and sells heavy machinery company abc is in china and wants to purchase heavy machinery from xyz however xyz does not want to take on the risk of defaulted payment by abc a london based trading firm agrees to broker a deal between the two companies the london firm wants to ensure that the trade is made and that it receives a commission for the deal back to back letters of credit can be used to make sure the transaction goes through so abc will request a letter of credit from an established chinese bank with the london based firm as beneficiary in turn the london firm will use that letter of credit to go to its own established bank in the u k and have it issue a letter of credit to xyz because the creditworthiness of the two banks is already established it stands in for the creditworthiness of the other companies xyz can now ship its heavy machinery knowing that once the transaction is complete it will be paid by the u k bank the broker is also assured of being paid the credit risk has been removed from the transaction 