(Bloomberg) -- Decentralized finance, a corner of crypto that is both a practical and philosophical rejection of traditional banking, is being tripped up by the collapse of a brick-and-mortar bank.

As Silicon Valley Bank collapsed on Friday, crypto traders and skeptics alike were on high alert for any revelations that might further shake an asset class already reeling from the fall of Silvergate Capital Corp., one of the few digital-asset friendly banks.

  • Read: Silvergate Bet Everything on Crypto, Then It All Evaporated

Enter Circle Internet Financial Ltd., issuer of USD Coin — the second-largest stablecoin by circulation. Late on Friday, Circle disclosed that around 8% of the reserves backing the stablecoin was held at the failed Silicon Valley Bank. News of that $3.3 billion exposure sent its token sharply below $1, the stablecoin equivalent of a money market fund breaking the buck. 

Stablecoins, in contrast to more volatile tokens like Bitcoin or Solana, are intended to hold a set value. They come in a variety of forms and many, like Circle’s, are underpinned by reserves such as US dollars and cash equivalents to ensure they maintain a $1 peg. 

  • Read: If Stablecoins Are Stable, Why Are Regulators Tense?: QuickTake

The action in USD Coin, which trades under the ticker USDC, reverberated into the decentralized crypto pools that depend heavily on the assumed reliability of stablecoins to function. Decentralized finance protocols let people trade, lend and borrow without intermediaries — and often anonymously — through the use of automated software programs. Investors often park funds in stablecoins as they move between other, more complex kinds of crypto trades.

“While centralized stablecoins such as USDC have been a boon for payments and accessibility, they carry the downsides that come with reliance on any centralized actor, even one as transparent and upstanding at Circle,” Tom Schmidt, general partner at crypto investment firm Dragonfly, said. “I’m overall optimistic about the recovery path for USDC, but also hope this serves to renew the mission to build the holy grail of a truly decentralized stablecoin.”

Data from blockchain data firm Nansen shows that seven of the 10 largest so-called liquidity pools running on the Ethereum blockchain use USDC for transactions, an example of the often hidden connections in crypto. These pools are essentially automated market-making services made up of caches of crypto that are supplied by users in exchange for a fee. 

DAI, the largest decentralized stablecoin, also uses USDC as a main liquidity source to keep its peg close to one dollar. As USDC slipped below $1, DAI also traded below its peg.

MakerDAO — the community that runs DAI — is currently the largest holder of USDC in DeFi, according to Andrew Thurman, researcher at Nansen. Other top holders of USDC in DeFi include bridges, or software projects that allow tokens designed for one blockchain to be used on another; Aave, a DeFi lending project; and decentralized exchanges Curve Finance and dYdX. 

Aave, one of the most popular decentralized lending projects, announced that the community backing the platform was pausing all lending and borrowing activities of USDC and DAI as well as other stablecoins including No. 1 Tether on Aave v3 running on the Avalanche blockchain.

USDC’s plight magnifies a sore spot in DeFi, whose advocates have long wanted to reduce the sector’s exposure to centralized tokens such as USDC. The algorithmic stablecoin project TerraUSD — which was designed to keep its 1-to-1 peg through mathematical calculations and a sister token rather than reserves — had gained traction in 2022 before its epic collapse. That left the status quo largely in place.

“Due to its size and backing by US institutions, USDC has been seen as a reliable representation of USD in the DeFi ecosystem,” said Nick Cannon, vice president of growth at crypto risk modeling firm Gauntlet. Cannon estimated that there are 35 billion USDC tokens circulating in the Ethereum ecosystem. “This week highlights the risks of on-chain systems relying on centralized custodians who may not be able to provide the same 24/7 transparency on the condition and risks of their assets.”

Contagion as a result of mispriced counterparty risk, whether due to poorly understood or undisclosed connections, has featured prominently in several of the high-profile crypto blow ups of the last 12 months. These risks, and in particular the spectacular collapse of the centralized crypto exchange FTX, fueled calls for greater transparency across the industry and had emboldened DeFi proponents who see their protocols as more resilient.

  • Read: Decentralized Exchange Pledges Transparency After FTX Collapse

Curve, a popular exchange used mainly for stablecoin trading, logged a record $7 billion in daily trading volume on Saturday, it said on Twitter. Traders rushed to swap USDC and DAI for Tether, with USDC’s future clouded.

The USDC situation is “a short-term shock wave — I’d imagine it will suck a lot of liquidity out of DeFi as folks flee USDC and other dollar-backed stables,” said Nathan Allman, co-founder of Ondo Finance, a decentralized investment platform.  “But longer-term, I think this creates an opportunity for DeFi to show its resilience.”

Circle said on Saturday that it continues to “operate normally” as it awaits clarity on the status of its trapped funds — and vowed to cover any shortfall “as required by law under stored-value money transmission regulation.” 

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