What is Back-To-Back Credit?
Back-to-back credit is a form of financing where one letter of credit guarantees another, holding the parties in a transaction to their obligations. If either fails to complete the transaction, the letter of credit offers backing and a guaranteed payment. This is most commonly seen in the import-export business and is a common tool for anonymizing transactions, since the use of a back-to-back letter of credit allows a middleman to control the transaction.
In a simple example, a buyer approaches a middleman to request a shipment of widgets. The buyer must furnish a letter of credit from her bank, sending it to the middleman's bank for verification. Meanwhile the middleman approaches a widget manufacturer to establish a sales contract and then opens a line of credit with the bank to favor the supplier. One line of credit backs the other, creating a back-to-back credit.
This process can take varying lengths of time, depending on the parties and nations involved. The banks will take steps to verify credit eligibility and identify any areas of concern, and the middleman has to structure contracts carefully to avoid unreasonable risk. Once the supplier fills the order, the buyer can use the line of credit to pay for it, and start repayments with the bank. If there is a problem with the process, the middleman's back-to-back credit will cover expenses incurred by the supplier.
Also known as a back-to-back guarantee or reciprocal letter of credit, the back-to-back credit provides some assurance for transactions. The use of a third party also makes it possible to conceal identities. The supplier does not know who is placing the order, because the middleman backs the order with his own line of credit. The buyer will not know the source of the items, because the middleman is responsible for delivery. There can be advantages to this process, such as limiting contact between buyers and suppliers to prevent them from making their own contracts.
Most large banks will handle back-to-back credit on behalf of their clients, especially if they do business internationally. In cases where a person's regular bank does not offer this service, it is possible to open a new account to start the process. This will take longer, as the bank needs the customer to be in good standing before it will issue credit. As with any sales transaction, it is important to review and understand the contract before approving it for delivery.
@David09 - You’re right. But it’s not just the integrity of the buyer and seller that is an issue in my opinion; it’s that of the banks.
A line of credit is only as good as the bank itself. The existence of a line of credit is not a slam dunk for either bank. Banks have been known to fail, as we know too well in the United States.
However I assume that during the vetting process the banks would go to great lengths to check each other out to ensure that they are solvent enough to facilitate the financial transaction. That’s the best that you can hope for really.
This seems like a risky procedure, although I understand it’s probably the only way to conduct international trade in many cases. I think it’s risky because a lot depends on the veracity of the buyer and seller.
Also, what protections exist to ensure that the process doesn't suffer from fraud and abuse? I understand that the banks go to great lengths to make sure the buyer and seller are reputable, but when you’re doing international transactions, the fact is there is a lot that is outside your control.
You can’t take people to court like you could in the United States. Still, there is no doubt that the procedure is used and I can’t think of any reasonable alternatives really.
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