Back-to-back credits, along with transferable credits, are two useful tools for middlemen dealing with international sale transactions.
Middlemen, i.e. intermediate dealers between the manufacturer and the retailer or customer, are, by definition, both buyers and sellers. The advantage of back-to-back credits for middlemen is that they can use the letter of credit both as a method of payment and as a financial asset. In practice, they can carry out the two sale transactions, one as buyers and the other as sellers, without having to anticipate cash or to raise funds with their banks.
What Is A Back-To-Back Credit Arrangement
In a back-to-back credit arrangement, the middleman uses the letter of credit that the buyer has opened in his favor as security to open a letter of credit in favor of the manufacturer.
Let’s see this with a practical example. Suppose that a Singaporean dealer buys wood products from a Malaysian manufacturer, and resells them to a British retailer.
The Singaporean dealer could pay the Malaysian company in cash, or negotiate credit with his bank. Or, he can use a back-to-back credit arrangement.
The Singaporean dealer (S) will ask the British firm (B) to open a letter of credit in his favor (Credit 1). Then, S will use Credit 1 as security to open a letter of credit with the Malaysian manufacturer (M) as beneficiary (Credit 2). We drew this arrangement in the following picture.
When M presents the conforming documents, Bank S will pay him. At this point, S must substitute M’s invoice with his, and submit it to B along with the same documents received by M. Upon presentation of documents, Bank B will pay S.
As we wrote in the beginning, the great advantage for S is that he does not have to anticipate any cash nor to raise funds. S can simply use what is in practice a payment arrangement to carry out both transactions.
The Problem With Back-To-Back Credits
Too good to be true? Perhaps. The problem with back-to-back credits is that they expose the middleman’s bank to a great amount of risk.
When B opens Credit 1 in favor of S, B requires certain documents to be presented. As S opens Credit 2 in favor of M, S has to ask that M provides the same documents required by B. However, the two credit transactions are separated. What does it mean?
If, for any reason, the documents requested under Credit 1 and Credit 2 are not the same, this is what happens:
- M presents the documents that comply with Credit 2
- Bank S pays M according to Credit 2
- S passes to B the same documents, but these do not comply with Credit 1
- Bank B refuses to pay S due to not compliance with Credit 1
Essentially, Bank S has already paid M, but it is not going to get paid by B. Bank S could resort to litigation, but unfortunately, both M and B are in foreign countries. The only party left in the transaction is S. However, if S does not have sufficient liquidity to cover the impairment, Bank S could find itself in an very bad situation.
While convenient to the middleman, back-to-back credits expose the middleman’s bank to high risks, and therefore banks are extremely reluctant to get involved in such type of transactions.
Globartis Research Center