back-to-back letter of credit
Back to back letter of credit is when a bank issues a fresh letter of credit to a supplier, using an existing letter of credit from a buyer as the backing.
In plain English
Think of a middleman trader in Lagos who has just landed a big order from a buyer in Dubai for bags of cashew nuts, but that trader does not grow a single cashew tree himself, he only knows the man in Kano who does.
The buyer in Dubai has already opened a letter of credit in the trader's favour, promising to pay once the goods arrive. That letter of credit is solid gold on paper, but it does not put cash in the Kano farmer's hand today, and the farmer wants assurance before he releases a single bag.
So the trader goes back to his bank, shows them the letter of credit from Dubai, and asks them to issue a second, separate letter of credit in favour of the Kano supplier. The bank looks at the first letter of credit as security and issues the second one. That second one is the back to back letter of credit, standing on the shoulders of the first.
This is common in international trade financing, especially for traders and exporters who do not have deep pockets but have solid contracts. A Nigerian exporter of processed cocoa selling to a buyer in Rotterdam might use this same trick to pay a local processor in Ondo State without touching his own savings.
In the United Kingdom, a trading company in Manchester importing furniture from Vietnam and reselling to a retailer in Leeds could use a back to back letter of credit in exactly the same way, using the Leeds buyer's letter of credit to open financing for the Vietnamese factory.
It sounds technical, but the heart of it is simple. It lets a trader use someone else's promise to pay as proof that they too can be trusted to pay, and that is often the difference between a deal happening and a deal dying on the table.
A Lagos trader receives a ₦120,000,000 letter of credit from a buyer in Dubai for garri exports. His bank uses that letter of credit as security to issue a second one worth ₦95,000,000 to the local garri supplier in Benue, who now agrees to load the trailer.
Questions people ask
Why would a bank agree to issue a second letter of credit like this?
Because the first letter of credit, from a reputable buyer, acts as comfort that the trader will eventually get paid, which lowers the bank's risk in issuing the second one.
Is a back to back letter of credit risky for the middleman trader?
Yes, because the trader is on the hook to pay the supplier through the second letter of credit even if the buyer somehow delays or disputes payment on the first one, so the terms of both must match carefully.
Can a small business in Nigeria actually access this kind of arrangement?
Yes, though the bank will usually want to see a strong, credible first letter of credit and a track record of successful trade deals before agreeing to issue the second one.
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