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Back-to-back letters of credit comprise two letters of credit (LoCs) that is used in a financial transaction. Usually, this letter of credit is used in a transaction that comprises an intermediary between the seller and buyer.
These are basically made up of two different LoCs. While one gets issued by the Bank of the buyer to the intermediary; the other one is issued by the bank of an intermediary to the seller. With the first LC, which is regarded as the original one and is issued by the bank of the buyer, the broker takes the letter and goes to his bank to get the second LC.
Therefore, the seller gets a reassurance of payment by fulfilling the contract’s terms and presenting the adequate documents to the bank of the intermediary. Essentially, back-to-back LCs appear as the substitute of two issuing banks’ credit to the intermediary and the buyer. This way, it helps simplify the trade between two parties who might not be able to verify the credit of each other because of the distance between them.
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Let’s take a back-to-back letter of credit transaction example here. Assume that there is a company X, which is located in India, sells heavy equipment. Now, broker Y, who represents a trading company in the U.S, has got to know that the company Z, located in London, wants to buy heavy equipment. Now, this broker Y will manage to get a deal between these two companies.
Although company X is willing to sell machinery to company Z; however, it doesn’t want to risk its payment. Moreover, the middle broker also wants the reassurance that the trade is completed and that he gets the commission.
Here, back to back letter of credits can be used to ensure that transaction is completed. Company Z will visit a financial institution in London to get an LC issued by the broker as a beneficiary. In return, the broker will be using this LC to visit a financial institution in the US and get an LC issued to company X.
Now, company X will ship the equipment. All of the three involved in the deal get reassurance of being paid for their contribution in the deal.
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