Back-to-Back Letter of Credit

A back-to-back letter of credit is an arrangement in which two separate letters of credit are linked through an intermediary. A trader who has sold goods to a buyer receives a credit issued in its favour by the buyer's bank. The trader then asks its own bank to issue a second credit, on similar terms, to the supplier who will actually produce or ship the goods. The first credit, called the master or export credit, acts as the main comfort for the bank issuing the second one.

The structure is used mainly by middlemen, commodity traders and sourcing agents who do not have the cash or credit lines to pay suppliers themselves. It is a form of trade finance and is often compared with the transferable letter of credit, which achieves a similar result with a single credit. Both are governed in practice by the International Chamber of Commerce rules known as UCP 600.

Picture a shop owner who has a firm order from a big customer but no money to buy stock from the factory. The customer's bank has promised in writing to pay the shop owner once the goods are delivered with the right paperwork. The shop owner takes that written promise to their own bank and says: please give the factory a similar promise, and you will be repaid from the first one.

The bank agrees because it can see where the money will come from. The factory ships, gets paid by the shop owner's bank, and the shop owner then passes the shipping papers along to collect from the customer's bank. The shop owner keeps the difference between the two prices as profit, without ever putting up much cash.

A typical transaction runs in this order:

1. The buyer's bank issues the master credit in favour of the intermediary, setting out the goods, price, shipment date and documents required.
2. The intermediary applies to its own bank for a second credit in favour of the supplier, offering the master credit as support.
3. The second credit mirrors the first but with a lower amount, an earlier expiry date and an earlier latest shipment date, so the intermediary has time to swap documents.
4. The supplier ships and presents documents such as the bill of lading and its own invoice to the intermediary's bank, which pays it.
5. The intermediary substitutes its own commercial invoice, at the higher selling price, and presents the full set under the master credit.
6. The buyer's bank pays the intermediary's bank, which recovers what it paid the supplier and passes the margin to the intermediary.

The two credits are legally independent. The bank that issued the second credit must pay the supplier against complying documents even if the master credit later fails, which is the main source of risk in the structure.

Banks treat back-to-back credits cautiously because the master credit is not true collateral; it only pays if the intermediary later presents documents that comply with its terms. Key risks include:

• Document mismatch. If the supplier's documents contain errors, or the dates and descriptions do not line up, the intermediary may be unable to make a clean presentation under the master credit.
• Timing gaps. Late shipment by the supplier can push the presentation past the master credit's expiry.
• Counterparty quality. The credit risk of the buyer's bank and the country it sits in matters, because that bank is the ultimate source of repayment.
• Fraud. Forged documents, or goods that do not exist, have featured in several trade finance losses, and a chain of two credits gives more points of failure.

Because of these risks, many banks will only issue the second credit if the master credit is confirmed by a strong bank, if the intermediary has a solid track record, or if it posts cash margin or other security.

The intermediary pays issuance fees on the second credit, often amendment and discrepancy fees, and sometimes confirmation fees on the master credit. Margins in commodity trading can be thin, so these charges are an important part of the deal's economics. Incoterms in the two credits should match, since a mismatch between, for example, FOB and CIF terms changes who arranges freight and insurance. Wording also matters: the second credit often allows invoice substitution, the intermediary's bank may act as the nominated bank under the master credit, and the intermediary usually wants to keep the supplier's identity and price hidden from the end buyer.

A transferable credit lets the first beneficiary ask a bank to make part of the same credit available to a second beneficiary. It avoids a second issuing bank taking on fresh liability, which usually makes it cheaper and easier to approve. It requires the buyer to agree that the credit is transferable, however, and the transfer must largely keep the original terms. A back-to-back structure gives the intermediary more flexibility over terms and confidentiality but is harder to arrange. Related tools include the back-to-back guarantee for guarantee business and the standby letter of credit, which serves as a payment backstop rather than the main settlement method. For lower-risk trades, parties may prefer a cheaper documentary collection or open-account terms.

• International Chamber of Commerce