Letters of credit are often used in commercial transactions, and especially high value or international transactions, to ensure that the buyer doesn't walk away with the goods or services without paying for them. A back-to-back letter of credit involves two letters of credit among three parties where, for example, a seller sells his or her goods or services to a buyer, or middleman, who turns around to sell those goods or services to another buyer. The first letter of credit is actually the one obtained by the final buyer for his or her transaction with the middleman. The middleman then uses that letter of credit to secure the second letter of credit — hence the term, back-to-back letter of credit — in order to secure the goods from the initial seller. This type of piggyback financing is a technique used by middlemen to secure goods from local parties while being presented as the primary contact for the foreign buyer.
There are typically two banks involved in applying for an issuing a letter of credit for a transaction between two parties. The buyer instructs his or her bank — known as the issuing bank — to create the letter of credit to guarantee payment once the seller presents proof he or she has shipped the goods. The seller also uses a bank — known as an advising bank — to facilitate receipt of that payment.
Turning this transaction into one that involves a back-to-back letter of credit, the seller will present the ultimate buyer's letter of credit to the advising bank. The advising bank is asked to issue another letter of credit — therefore becoming the issuing bank for this second letter of credit — in favor of a third party supplier. The original letter of credit is used as collateral to secure the second letter of credit. Since the ultimate buyer's letter of credit is an irrevocable guarantee of payment from a reliable source, the advising bank can use it to extend credit, knowing that it will be able to collect its money. The transaction becomes a change of shipments and document presentations, where the original supplier ships to the initial buyer, or middleman, and collects payment for that transaction. That initial buyer turns around and becomes the seller in the second transaction, ships the goods to the ultimate buyer, and collects payment based on the first letter of credit.
The back-to-back letter of credit is a common tool of middlemen. In international transactions, for example, a middleman facilitates sales between local suppliers in his or her home country and foreign buyers. The middleman rarely wants the buyer to know there is another party that is the source of the goods, for fear of being cut out of the transaction. In this case, the middleman, or exporter, arranges for the second letter of credit for the purchase of the goods from the original supplier. That second letter of credit is secured on the strength of the original letter of credit without informing the buyer, and is typically structured to allow for enough time to receive the goods from the original supplier and turn them over to the ultimate buyer, or importer.