Define Back-To-Back Letter of Credit:

"A back-to-back letter of credit is a financial arrangement that involves two separate letters of credit (LCs) to facilitate a trade transaction between a buyer and a seller, with an intermediary typically involved."

Explain Back-To-Back Letter of Credit:

Introduction

A "back-to-back letter of credit" is a financial arrangement that involves two separate letters of credit (LCs) to facilitate a trade transaction between a buyer and a seller, with an intermediary typically involved. This type of LC is commonly used in international trade, particularly when there are multiple parties or when the seller requires an assurance of payment before fulfilling their end of the contract.

Here's how a back-to-back letter of credit works:

1. Scenario: Let's assume there are three parties involved in the transaction:

   • Buyer A: The importer or buyer of goods who wants to purchase products from a foreign seller.
   • Seller B: The exporter or seller of goods located in a different country.
   • Intermediary Bank C: The bank that acts as the intermediary between Buyer A and Seller B to facilitate the trade transaction.

2. First Letter of Credit (LC1):

   • Buyer A applies to their local bank for an LC (LC1) in favor of Seller B. LC1 serves as a guarantee from Buyer A's bank to Seller B that payment will be made once certain conditions are met (usually after the shipment of goods).

3. Second Letter of Credit (LC2):

   • Upon receiving LC1, Seller B may have its own supplier or needs to purchase raw materials to fulfill the order from Buyer A. To ensure payment to their supplier, Seller B may request a back-to-back LC (LC2) from their local bank, using LC1 as collateral.

4. Intermediary Bank's Role:

   • Intermediary Bank C issues LC2 to Seller B, using LC1 as the basis for the credit. This means that the payment obligation of LC2 is dependent on the payment received from LC1.
   • Seller B can then use LC2 to pay its supplier or use it as collateral to obtain financing for the production of goods.

5. Shipment and Payment:

   • Once the goods are produced and shipped to Buyer A, Seller B presents the required documents to Intermediary Bank C as proof of shipment and compliance with the terms of LC2.
   • Intermediary Bank C examines the documents to ensure they comply with the requirements of LC2. If everything is in order, the bank will make payment to Seller B, using the funds received from Buyer A's bank (LC1).

By using a back-to-back letter of credit, both Buyer A and Seller B can mitigate risks associated with international trade transactions. Buyer A knows that payment will only be made once the required documents are presented, ensuring that the goods are shipped as agreed. Seller B, on the other hand, gains confidence that they will receive payment from the Intermediary Bank C, using the LC1 from Buyer A as collateral.

Numerical Example:

Assumptions:

• Buyer A wants to import electronic components from Seller B located in a different country.
• The total value of the electronic components is $50,000.
• Buyer A's bank issues LC1 in favor of Seller B for $50,000, guaranteeing payment upon the presentation of required documents.
• Seller B needs to purchase raw materials from a supplier to fulfill the order, and the cost of the raw materials is $30,000.
• Seller B's bank issues LC2 in favor of the supplier for $30,000, using LC1 from Buyer A's bank as collateral.

Steps in the back-to-back letter of credit transaction:

1. Buyer A's Bank issues LC1:

• Buyer A applies to their local bank for LC1 in favor of Seller B for $50,000.
• Buyer A's bank issues LC1 to Seller B, guaranteeing payment upon the submission of specified documents.

2. Seller B's Bank issues LC2:

• Seller B, upon receiving LC1 from Buyer A's bank, applies to their local bank for LC2 to pay the supplier for raw materials.
• Seller B's bank issues LC2 to the supplier for $30,000, using LC1 from Buyer A's bank as collateral.

3. Shipment and Payment:

     a. Purchase of Raw Materials:

• Seller B orders raw materials from the supplier for $30,000.
• Seller B's bank notifies the supplier about the issuance of LC2, assuring payment upon meeting the required conditions.

     b. Shipment to Buyer A:

• Supplier ships the raw materials to Seller B, and the required shipping documents are prepared.

     c. Document Presentation:

• Seller B presents the shipping documents and other required documents to their bank (Intermediary Bank C) to claim payment under LC2.

     d. Intermediary Bank's Role:

• Intermediary Bank C examines the documents presented by Seller B to ensure they comply with the terms of LC2.
• If the documents meet the requirements, Intermediary Bank C makes payment to the supplier for $30,000, using the funds received from Buyer A's bank (LC1).

e. Seller B Receives Payment:

• Upon receiving payment from Intermediary Bank C, Seller B can now pay the supplier for the raw materials and fulfill the order for Buyer A.

Conclusion

By using a back-to-back letter of credit, Buyer A is assured that payment will only be made to Seller B upon the presentation of the required shipping documents, ensuring that the goods are shipped as agreed. Seller B gains confidence that they will receive payment from Intermediary Bank C, using the LC1 from Buyer A's bank as collateral, allowing them to purchase the raw materials and complete the transaction smoothly.