Merchants who purchase goods from importers often need to get letters of credit. Letters of credit guarantee each bank involved in a transaction that the other bank will forward money to it from its customer. If a merchant must deal with not just one, but two importers, he may need back-to-back letters of credit. These letters guarantee that the first bank will get its money from the first seller and the second bank will get its money from the second seller involved in a transaction.
More Complicated Transaction
If a transaction requires two letters of credit from separate banks, the transaction may require back-to-back letters of credit. These types of letters of credit are often required if a seller goes through a middleman. For example, suppose a seller must get a letter of credit to purchase diamonds for resale. The merchant he resells to must get a separate letter of credit to purchase the diamonds from him. These letters together are called back-to-back letters of credit.
Back-to-back letters of credit are different from transferable letters of credit. In a situation involving a middleman, if the middleman gets a transferable letter of credit, she transfers the rights to purchase the items on credit to the merchant she resells to. If the situation involves back-to-back letters of credit, each merchant must get a separate letter of credit from the bank she is dealing with.
The back-to-back letters of credit require two issuing banks to deal with one another. The bank that issues the second letter of credit lends funds to a merchant so that the merchant can purchase goods. That bank then approaches the bank who issued the first letter of credit to get reimbursed for its investment. Each merchant involved in the transaction thus owes money to his issuing bank after the transaction is complete
Back-to-back letters of credit are used less commonly than other letters of credit. Scotia Bank reports that banks often discourage clients from engaging in this type of credit transaction because technical problems can cause one or both banks to lose money on the transaction. In addition, back-to-back letters of credit are only used in transactions involving several sellers, so many transactions may not require them in the first place.