Back-To-Back Letters Of Credit
Back-to-back letters of credit is a reference to the credit facility arrangement rather than to the type of letter of credit. Those used are typical commercial documentary letters of credit.
This type of credit facility grants a possibility to a middle-party or a trader who has limited monetary resources or assets to use their receipt of a letter of credit issued on behalf of the end-buyer, often introduced as a master credit, as comfort to their financier for the issuance of a separate letter of credit to the end-supplier, introduced as a counter credit. The letters of credit do not carry the names 'master' or 'counter'; these names are used to depict and to differentiate their part in the back to back process (Jones S.A, 2018, p.249).
How the master credit and counter credit work
The master and counter credit in facility structure (Jones S.A, 2018, p.249):
- The master credit, in a back-to-back credit facility structure, is issued by the bank of the end-buyer and collected by the middle-party via an advising bank. After that, the middle-party requests their own bank to issue an independent counter credit in favor of the end-supplier. This will be for a lower expense than the master credit so that the middle-party can realise a benefit between the cost and sales value. On a genuine back to back basis the equipment will be shipped direct by the end-supplier to the place of the end-buyer. Deviating from the subject, there will be substantial differences between the master and the counter credit. which diminish the comfort afforded by mirror or backing Lc's.
- The counter credit is issued by the bank who must register its full value against a credit facility for sake of the middle-party. Whilst the proceeds of the master credit will grant an identifiable source of repayment for the counter credit, this is subservient upon complying presentation of documents.
Explanation of back-to-back credit
Just like the name hints, a back to back documentary credit is actually two separate documentary credits:
- Opened by the buyer who names the seller as the beneficiary;
- Opened by the seller who names the supplier of the goods as the beneficiary.
We use the back-to-back credit in instances where the original credit is not transferable and the bank is keen on opening the second credit at the request of the seller, and using the first one as the collateral or a support for the second credit. However, the bank has no obligation to issue the second credit. Most banks usually refuse to open such a credit unless they have full confidence in the seller's creditworthiness and ability to perform. Thanks to the complexity of the transaction, banks view the first credit as less collateral than as an item of support for issuance of the second credit.
As the seller is the applicant for the second credit, he is also responsible to the payment regardless of whether or not be himself is paid under the first credit.
The second credit needs to be precisely worded require all documents (in exception with the commercial invoice) as required under the first credit. Considering the fact that there is a time lag between issuance of the first credit and the second one, the second credit is expected to be worded to require that documents be presented in time to meet the requirements of the first credit (Hinkelman E.G, 1996, p. 38).
Disadvantages of the back-to-back credit
According to Edward G. Hinkelman: Since the first credit names the seller as the beneficiary the buyer is unaware that there is a supplier other than the seller. This credit is generally for use only by more sophisticated traders. The more paperwork and the more parties to the transaction, the greater the opportunity for problems (Hinkelman E.G, 1996, p. 38).
Examples of Back-To-Back Letters Of Credit
- A back-to-back letter of credit involves two separate letters of credit. The first letter of credit is issued by the buyer’s bank and is issued in favor of the supplier. The second letter of credit is issued by the supplier’s bank and is issued in favor of the buyer. The two letters of credit are linked together, and the payment of the supplier’s letter of credit is contingent upon the payment of the buyer’s letter of credit.
- A back-to-back letter of credit is also used in international trade transactions when a supplier requires payment before they will ship goods. The buyer's bank issues a letter of credit to the supplier's bank, and the supplier's bank issues a letter of credit to the buyer. The buyer will not pay the supplier until they have received the goods. The supplier will not ship the goods until they have received payment. The back-to-back letters of credit ensure that both parties receive payment.
- A back-to-back letter of credit is also used to finance the purchase of goods by a third party. In this situation, the buyer’s bank issues a letter of credit to the supplier’s bank, and the supplier’s bank issues a letter of credit to the third party. The third party will not pay the supplier until they have received the goods, and the supplier will not ship the goods until they have received payment from the third party. The back-to-back letters of credit ensure that all parties receive payment.
- Another example of a back-to-back letter of credit is when a buyer is purchasing goods from a supplier and the supplier requires payment in advance. The buyer's bank will issue a letter of credit to the supplier's bank, and the supplier's bank will issue a letter of credit to the buyer. The buyer will not pay the supplier until they have received the goods, and the supplier will not ship the goods until they have received payment from the buyer. The back-to-back letters of credit ensure that both parties receive payment.
The following are other approaches related to Back-To-Back Letters Of Credit:
- Standby Letters of Credit (SLOCs): These are financial instruments which are issued in order to guarantee the performance of certain contractual obligations. SLOCs are usually used to secure payment or performance of a contract and provide compensation in case of a breach of contract.
- Bank Guarantees: A bank guarantee is a promise from a bank to cover any debts or losses incurred by a customer in the event of a default. Bank guarantees provide security to both the customer and the bank, allowing the customer to obtain credit or services from the bank without having to pay upfront.
- Performance Bonds: Performance bonds are a type of surety bond which provides assurance that a contractor will complete a project according to the terms of the agreement. Performance bonds protect the project owner from financial loss in the event that the contractor fails to fulfill its contractual obligations.
In summary, Back-To-Back Letters Of Credit are just one approach to securing a financial transaction. Other approaches include Standby Letters of Credit, Bank Guarantees, and Performance Bonds. Each of these instruments provides a unique type of security and assurance for the parties involved in a financial transaction.
| Back-To-Back Letters Of Credit — recommended articles |
| Payment guarantee — Transferable letter of credit — Conditional sale agreement — Counter guarantee — Contract guarantee — Tri party agreement — Retention bond — Collecting bank — Shipping guarantee |
References
- Hinkelman E.G, (1996), llustrated Guide to Letters of Credit, World trade press, Usa
- Jones S.A, (2018), Trade and receivables finance: A practical guide to risk evaluation and structuring, Palgrave Macmilan, Switzerland
- Siddaiah T, (2011), Financial services, Pearson, India
Author: Jakub Winiarski
