Back-to-back letters of credit — an explainer
Definition
– Letter of credit (LoC): a bank promise to pay a beneficiary when specified documents and conditions are presented. It shifts payment risk from one commercial party to the issuing bank.
– Back-to-back letters of credit: two separate, linked LoCs used in the same overall trade to enable an intermediary (for example, a broker or trading house) to buy goods from a supplier using the buyer’s LoC as the basis for obtaining a second LoC in favor of the supplier.
How it works (step-by-step)
1. Buyer and intermediary agree on a sale. The buyer asks its bank (issuing bank A) to open an LoC in favor of the intermediary (beneficiary 1).
2. Intermediary presents that first LoC to its own bank and asks that bank (issuing bank B) to issue a second LoC in favor of the ultimate seller (beneficiary 2).
3. Seller ships goods and presents documents to bank B in compliance with the second LoC.
4. Bank B pays the seller, then presents the documents/claim to bank A and is reimbursed under the first LoC, provided documents comply.
5. Once documents and conditions are accepted, payment flows and the intermediary typically receives any agreed commission.
Why use back-to-back LoCs
– They let an intermediary arrange trade without revealing one or both parties to each other.
– They substitute the credit of two banks for the commercial credit of buyer and intermediary, useful when traders can’t vet each other’s credit.
– They support triangular trades where the intermediary never takes delivery.
Key characteristics
– Two distinct LoCs: the original (buyer → intermediary) and the second (intermediary’s bank → seller).
– Typically used in international trade.
– Often structured so neither party needs to disclose identities or take commercial credit risk.
Checklist — practical steps and documents
For the buyer:
– Confirm the exact terms (amount, expiry, shipment/incoterms, documents required).
– Instruct issuing bank to name the intermediary as beneficiary and state whether the LoC is transferable (see differences below).
For the intermediary (broker/trader):
– Verify the exact wording of the buyer’s LoC before asking your bank to issue the second LoC.
– Check fees, expiry alignment, and any restrictions on presentation period.
– Keep a clear record of the commission arrangement and responsibilities for discrepancies.
For the seller:
– Review the second LoC carefully to confirm it is consistent with the contract (shipment terms, invoices, bills of lading, certificates).
– Prepare documents to match the LoC terms exactly.
For both banks:
– Verify documentary compliance; track expiry and presentation deadlines.
– Coordinate any amendments in writing and with consent of all involved parties.
Pros and cons (summary)
Pros:
– Protects exporter: payment is made by a bank on compliant documents.
– Protects buyer/intermediary: goods must be shipped and documentary conditions met.
– Useful when parties don’t have direct credit lines or prefer confidentiality.
Cons:
– Complex: two LoCs mean duplicative documentation and more room for discrepancies.
– Costs: fees charged by both banks can be meaningful.
– Banks may be reluctant: the second issuing bank carries payment risk if the first LoC or beneficiary documents fail or become contested.
– Amendments are harder: changing terms can require coordination of all parties and both banks.
Risk highlights
– Primary bank risk: the bank that issues the second LoC may have to pay even if the first LoC is later rejected or if the intermediary fails to deliver required documents.
– Presentation/document risk: discrepancies in documents are common; non-compliance can delay or block payment.
– Timing risk: mismatched expiry or shipment dates between the two LoCs can cause gaps.
Are back-to-back LoCs the same as transferable LoCs?
– No. A transferable LoC allows the beneficiary of a single LoC to pass some or all rights and obligations under that LoC to another party. In contrast, a back-to-back arrangement uses two separate LoCs that are linked by collateral or reference but are distinct instruments; the second LoC is not a transfer of the first.
Are they usually irrevocable?
– Most back-to-back arrangements are structured using irrevocable LoCs. An irrevocable LoC cannot be cancelled or changed without agreement of all parties, which helps give the seller confidence that payment cannot be unilaterally withdrawn. Note: amendments are still possible but typically require written consent of all concerned.
Worked numeric example (illustrative)
Assumptions
– Sale price: $500,000 payable under a back-to-back LoC.
– Bank fees: issuing bank A charges 0.3% to open the LoC; issuing bank B charges 0.5% to issue the second LoC.
– Commission to intermediary: $10,000 (agreed separately
Calculations (continuing the worked numeric example)
Step 1 — Compute each bank’s fee
– Issuing bank A fee = 0.3% × $500,000 = $1,500.
– Issuing bank B fee (for the second/back-to-back LoC) = 0.5% × $500,000 = $2,500.
Step 2 — Add the intermediary commission
– Commission to intermediary = $10,000.
Step 3 — Total charges and net proceeds
– Total fees/commission = $1,500 + $2,500 + $10,000 = $14,000.
– Net cash to seller (illustrative) = $500,000 − $14,000 = $486,000.
Notes and assumptions behind these numbers
– Who pays what: this example assumes the seller ultimately bears the intermediary commission and both issuing-bank fees are charged against the same underlying transaction amount. In practice, the allocation of fees between buyer, seller, and banks is contractual and can differ.
– Fee bases: banks may charge on face amount, on utilized amount, or as a flat fee. Here we used the sale price (face amount) as the fee base.
– Other possible costs (not included): documentation charges, confirmation fees (if a confirming bank is used), negotiation/discounting fees, interest on any pre-shipment advance, taxes, and legal costs.
– Timing: some fees are paid up front, others on issuance or on reimbursement. Cash-flow timing affects working-capital needs.
– Currency effects: if fees or payments are in different currencies, FX conversion spreads and timing create additional costs and risks.
Practical checklist for parties involved in a back-to-back LoC
– Buyer:
– Confirm the issuing bank’s creditworthiness and that the LoC is irrevocable (if required).
– Specify documentary requirements clearly to avoid discrepancies.
– Agree on fee allocation in writing.
– Seller (intermediary beneficiary of first LoC):
– Verify that the second (back-to-back) LoC mirrors the required terms for the seller’s supplier.
– Obtain confirmation (a confirming bank) if you need extra payment assurance from a local bank.
– Check whether the original LoC allows issuance of a back-to-back LoC or requires consent.
– Banks:
– Confirm permitted uses and collateral arrangements; ensure documentation complies with UCP 600 (or applicable rules).
– Agree on reimbursement mechanics and any standby/cash collateral required.
– Suppliers/third parties:
– Ensure invoice and transport documents will strictly meet the LoC’s documentary conditions.
– Understand presentment and negotiation deadlines.
Common risks and mitigants (brief)
– Documentary discrepancies: strict documentary compliance requirement — use experienced trade-documentation staff or advisers.
– Bank credit risk: use a confirming bank or require a higher-rated issuing bank.
– Double financing / fraud risk: request originals only where appropriate, use escrow or independent inspection if needed.
– Currency and country risk: hedge currency exposure; consider political-risk or export-credit insurance for higher-risk jurisdictions.
Worked sensitivity example (quick)
– If a confirming bank charges an extra 0.4% (0.4% × $500,000 = $2,000), total fees rise to $16,000 and net proceeds fall to $484,000.
– If fees were instead charged on only 90% of the LoC face amount (e.g., due to a retained margin), recalculate each percentage on $450,000 rather than $500,000.
Further reading (reputable sources)
– Investopedia — Back-to-Back Letters of Credit: https://www.investopedia.com/terms/b/back-to-back-letters-of-credit.asp
– International Chamber of Commerce (UCP 600 overview) — Uniform Customs and Practice for Documentary Credits: https://iccwbo.org/resources-for-business/uniform-customs-and-practice-for-documentary-credits/
– U.S. Department of Commerce — Exporter’s Guide: Letters of Credit: https://www.trade.gov/letters-credit
– World Bank — Trade Finance: https://www.worldbank.org/en/topic/trade