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Back-to-Back Letters of Credit

Give me the basics

Back-to-back letters of credit in crypto refers to a financial arrangement where two parties use cryptocurrency as collateral to secure two separate letters of credit, one to a supplier and the other to a buyer. This arrangement is useful for reducing risk and ensuring timely payment, especially in international trade transactions involving cryptocurrency.

In-depth explanation

International trade has been greatly revolutionized with the advent of digital currencies, especially Bitcoin and other cryptocurrencies. Unlike traditional fiat currencies, cryptocurrencies offer faster and cheaper cross-border transactions, low transaction fees, and improved security. However, crypto-based international trade still faces some challenges, especially in the area of risk management, trust, and assurance of timely payment.

One way of addressing these challenges is through the use of Back-to-Back Letters of Credit (LCs). In simple terms, Back-to-Back LCs refer to a financial arrangement where two parties use cryptocurrency as collateral to secure two separate LCs, one to a supplier and the other to a buyer. This arrangement is useful for reducing risk and ensuring timely payment, especially in international trade transactions involving cryptocurrency.

Back-to-Back LCs in Detail

The process of executing a Back-to-Back LCs transaction in crypto involves the following steps:

  1. The buyer approaches their bank (the issuing bank) and requests a Back-to-Back LC to be issued to the seller’s bank (the advising bank). The LC specifies the terms of the trade, such as the amount of cryptocurrency, price, and delivery date.

  2. The issuing bank then contacts the advising bank and requests them to issue a second LC in favor of the supplier (the beneficiary). The second LC is collateralized by the cryptocurrency pledged by the buyer to secure the first LC. The advising bank will only issue the second LC if they receive confirmation from the issuing bank that the first LC has been fully funded with the required amount of cryptocurrency.

  3. The supplier then ships the goods to the buyer and presents the second LC to their bank (the negotiating bank). The negotiating bank verifies that the goods have been shipped and then presents the second LC to the advising bank for payment.

  4. The advising bank verifies that the conditions of the second LC have been met and then presents the first LC to the issuing bank for payment. The issuing bank releases the cryptocurrency collateral to the advising bank, which then pays the negotiating bank, who finally pays the supplier.

Advantages of Back-to-Back LCs in Crypto

  1. Reduced Risk: Back-to-Back LCs help to reduce the risk of non-payment by ensuring that the cryptocurrency pledged as collateral is available to pay the supplier when the goods are shipped. This arrangement provides assurance to both parties that they will receive their due payment.

  2. Improved Trust: Back-to-Back LCs help to improve trust between the parties involved in the trade transaction. This is because the use of LCs ensures that the buyer and the seller are dealing with reputable banks, which provides an added level of security.

  3. Timely Payment: Back-to-Back LCs help to ensure timely payment by providing a clear and well-defined payment mechanism. This arrangement ensures that the supplier receives payment as soon as the goods are shipped and the buyer receives the goods as soon as payment is made.

  4. Improved Security: Back-to-Back LCs in crypto are more secure than traditional LCs because they use blockchain technology to record and verify transactions. This provides an immutable and transparent record of the transaction, which is accessible to all parties involved.

Conclusion

Back-to-Back LCs in crypto offer a secure and efficient means of conducting international trade transactions using digital currencies. This arrangement provides assurance to both parties that they will receive their due payment and reduces the risk of non-payment. As the use of cryptocurrencies in international trade continues to grow, Back-to-Back LCs will become increasingly important in managing risk, improving trust, and ensuring timely payment.