In November 2020, Inca’s Investigation Team noticed unusual transaction patterns occurring in Compound protocol on Ethereum. These unusual transactions potentially indicate crypto whales moving large amounts of DAI across the Compound protocol to drive up the key DeFi adoption indicator – TVL.

TVL is a popular metric in the DeFi ecosystem representing the total value of assets locked or supplied into a DeFi application’s smart contracts. It is used to assess the amount of liquidity available on the protocol and is often considered as a measure of the project’s strength.

At the time of writing, the TVL across the whole Ethereum ecosystem was just over $30B, up over $20B in just the last three months. This jump was facilitated by the ease of DAI loan access.

First, an entity borrows $45M in DAI from Maker protocol. Then they transfer 31M DAI to Compound protocol. After that, they borrow 21M DAI from the same Compound protocol. To profit, they park 21M DAI in a separate Ethereum address and repeat this supply-borrow manipulation five times, constantly transferring funds to a new address. Essentially this trader took out loans of approximately 67% of the deposit amount and deposited the loan back into the Compound protocol. This procedure tricks the protocol into thinking that the TVL has increased by $82.6M in DAI.

The whole cycle of fund flows (red – funds supply; green – borrowed funds; black – fund transfer to the other address of the same entity), Nov 2020. Source: NTerminal

To clarify, Compound protocol makes it possible for one entity to lend and borrow from it at the same time. Moreover, this can be done multiple times. The Compound protocol looks at everyone who has lent money to the smart contract and who has borrowed from it and gives them COMP tokens. This allows the trader to collect almost $550K COMP tokens on a series of deposits and loans. This trading strategy is at the core of yield farming in the DeFi ecosystem. Free tokens are gained by borrowing and lending to incentivize traders to participate in the protocol. While the whales are profiting from the free tokens, the protocol creators get to inflate their TVL metric.

Total value locked in Compound protocol (DAI)

Out of $336M protocol supply increase illustrated in the diagram above, at least 25% of the funds were borrowed from the same lending protocol. This phenomenon severely distorts the real picture of what is happening in the DeFi space and makes this area vulnerable to flash crash attacks.