Harness Money

Back-to-back letters of credit (LCs) are a financial arrangement commonly used in international trade transactions to facilitate the buying and selling of goods between two parties, usually involving an intermediary.

Here’s how it works:

1. Buyer’s Perspective: The process begins when the importer (buyer) wants to purchase goods from a foreign supplier (seller). However, the supplier may be hesitant to extend credit directly to the buyer or may require additional financial security.

2. Intermediary’s Role: To bridge this gap and ensure a smooth transaction, an intermediary, typically a bank, steps in. The buyer’s bank issues a letter of credit (LC) to the supplier, guaranteeing that the buyer will fulfill their payment obligations once the goods are received and confirming the terms of the trade.

3. Supplier’s Perspective: The supplier now has the assurance of payment from the buyer’s bank, making the trade less risky for them. However, the supplier might also need to purchase raw materials or goods from other suppliers to fulfill the buyer’s order.

4. Back-to-Back LC: To address this situation, the supplier can use the original LC received from the buyer’s bank as collateral to obtain a second LC from their own bank. This second LC, known as the back-to-back LC, acts as a guarantee to their suppliers that they will receive payment once the goods are delivered.

5. Chain of LCs: This creates a chain of letters of credit. The buyer’s bank issues an LC to the supplier, and the supplier’s bank issues another LC based on the original LC as collateral. This process continues down the supply chain if multiple intermediaries are involved.

Back-to-back letters of credit facilitate international trade by providing security to all parties involved and helping to manage the credit risk associated with complex transactions. It’s essential for the parties to carefully coordinate the terms of both LCs to ensure a smooth flow of goods and funds throughout the process.