What Are Back-to-Back Letters of Credit?

Back-to-back letters of credit (LoC) are two different letters used in correspondence to carry out a financial transaction between two parties. The transactions usually involve a third party that acts as an intermediary. Their most common use is in international transactions when companies from different countries do business together. The third party, often a financial broker, is responsible for getting the required amount from the buyer to the seller following the contract signed by both parties. The intermediary receives a letter of credit from the buyer and, using a medium, delivers the money to the seller by another letter of credit. Hence, two LoCs are involved in the transaction completion, hence the name “back-to-back letters of credit.”

Back-to-back LoC offers a number of advantages to companies willing to do business overseas. With its help, safe trade is possible with adherence to relevant laws and policies. Companies involved in such trades have to pay a fee to the intermediary for their services as well.

How Do Back-to-Back Letters of Credits Work?

There are no direct transactions between the buyer and seller; instead, they hire a financial broker or a third-party mediator who ensures the smooth payment process. When the deal is confirmed, the buyer's financer issues an LoC to the third party. The seller then follows the rules of the contract and delivers the product to the buyer. After the successful dispatch, the third party's financer issues an LoC to the seller, and the seller receives the full payment.

Example of Back-to-Back LoC

Suppose company A is operating in region A and is looking to buy some raw materials from company B in region B. Company A is hesitant to do business with company B due to a lack of personal understanding and international trading rules. Both companies hire a financial broker from company C. A deal is secured amongst all parties. Company A issues an LoC with company C as a beneficiary. Company B delivers the raw material to Company A following all the contract rules. Then, Company C issues an LoC with Company B as the beneficiary and transfers the agreed amount to their accounts.