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learntosuccess- November 20, 2024
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Back-to-Back Letter of Credit
A Back-to-Back Letter of Credit (LC) is a type of LC issued by a bank on behalf of a customer (usually a trader or intermediary) based on the security of an existing LC. It involves two separate LCs: the master LC issued by the buyer’s bank and the back-to-back LC issued by the intermediary’s bank to the supplier. This arrangement facilitates trade where the intermediary does not have sufficient funds or credit to pay the supplier upfront.
Payment Against Back-to-Back Letter of Credit
Payment under a back-to-back LC is made to the supplier once they present the required shipping documents, proving that the goods have been shipped as agreed. The payment to the supplier is covered by the master LC, ensuring that funds flow smoothly through the chain.
Who Needs a Back-to-Back LC?
- Intermediary Traders: Businesses that act as middlemen between the buyer and the supplier.
- Importers and Exporters: Especially those dealing with international trade, where trust and liquidity are concerns.
- Small or New Businesses: Enterprises without sufficient capital or credit lines to directly purchase goods from suppliers.
Why Is a Back-to-Back LC Needed?
- Facilitating Trade: Allows intermediaries to fulfill orders without needing upfront capital.
- Building Trust: Ensures suppliers receive guaranteed payment, even if they are dealing with a new or unknown intermediary.
- Enabling Large Transactions: Supports large-scale trade deals where the intermediary cannot finance the transaction on their own.
Benefits of a Back-to-Back LC
- Liquidity Management: Intermediaries can manage cash flow without needing significant upfront funds.
- Risk Mitigation: Both buyers and suppliers gain security, as banks guarantee payments.
- Facilitates Global Trade: Enables businesses to handle complex international transactions smoothly.
- Profit Opportunities: Intermediaries can earn profits by purchasing goods at a lower price and selling them at a higher price, facilitated by the LC.
Who Issues a Back-to-Back LC?
A commercial bank issues a back-to-back LC based on the original master LC provided by the buyer. The issuing bank evaluates the intermediary’s credibility and the terms of the master LC before issuing the back-to-back LC to the supplier.
Expiry Date of a Back-to-Back LC
The expiry date of a back-to-back LC typically aligns with or is slightly earlier than the expiry date of the master LC. This ensures that all transactions under the back-to-back LC are completed before the master LC is due, allowing the intermediary to settle obligations without delays.
Real-Life Example
Scenario:
- A buyer in the USA issues a master LC for $100,000 through their bank to an intermediary trader in Bangladesh for purchasing garments.
- The intermediary trader doesn’t have sufficient funds to pay the garment manufacturer (supplier) in Bangladesh.
- The intermediary requests a back-to-back LC from their local bank in Bangladesh, using the master LC as collateral.
- The Bangladeshi bank issues a back-to-back LC worth $90,000 to the supplier (allowing the intermediary to retain a profit margin).
- The supplier ships the goods and submits the required documents to the Bangladeshi bank.
- The supplier receives payment through the back-to-back LC, and the intermediary collects payment from the buyer via the master LC.
Conclusion
A back-to-back LC is a powerful financial tool for facilitating trade, especially for intermediaries in global transactions. It allows businesses to operate effectively without substantial upfront capital while ensuring all parties in the transaction are protected. By leveraging the security of a master LC, back-to-back LCs enable smooth, risk-free trade operations, fostering trust and financial stability in international trade.
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