Dive into Swell Network: The Most Interesting L2

Author: Kairos Research

Translation: Deep Tide TechFlow

Introduction

We are rapidly entering the era of Layer 2 technology (L2). With the Rollup as a Service (RaaS) provided by service providers, the barrier to entry for L2 continues to decrease, unlocking a significant supply and blurring the differences between these new chains. For smart contract protocols that were originally independent blockchains or only existed on the mainnet, transitioning to L2 is particularly meaningful. The implementation of L2 allows existing protocols or blockchains to avoid the high cost of launching their own validator set and provides a more efficient vertical value accumulation path through transaction serialization. However, in the long run, if we really live in a world of thousands of Rollups, this means we will see hundreds of losers and dozens of big winners. We believe that most activity will focus on a few general and domain-specific L2s (such as core vertical focuses, DeFi). Ultimately, what will differentiate winners from losers will be network effects. As far as we know, Swell has the potential to become a leader in the latter category for various reasons. But what exactly is Swell? In this article, we will delve into the Swell network, examine its growth, analyze its architecture, understand how it stands out from numerous competitors, and how it achieves a dominant position in the second layer.

What is Swell?

Swell claims to be an "unhosted staking protocol whose mission is to provide the best liquidity staking and restaking experience in the world, simplify access to DeFi, and safeguard the future of Ethereum and restaking services." So, what is the actual situation? As of the writing of this article, Swell has accumulated a Total Value Locked (TVL) of $2.1 billion (713,000 ETH). 29.57% of this is in its liquidity staking token swETH, 17.78% in its liquidity restaking token rswETH, and the remaining 52.65% in its L2 deposit contract.

As you can see, the growth trajectory of Swell L2's pre-launch deposits is the fastest-growing among all Swell products. Let's take a look at what has led to this growth:

As you can see, most of Swell L2's deposits consist of tokens from the Swell ecosystem, such as rswETH, swETH, and related Pendle primary tokens. These are the most consistent participants in the Swell ecosystem. In addition, Swell L2 also accommodates millions of dollars' worth of other LRT and their related PT tokens through Pendle. With their $1.1 billion in total deposits, this would make them the sixth-largest company by TVL, surpassing well-known L2s such as StarkNet, ZkSync Era, Manta, Linea, and the recently launched Mode Network.

The most remarkable part of all this is: the first deposit was made around 4 weeks ago on April 9th. In just 28 days, Swell's L2 pre-launch deposits have increased from 0 to over $1 billion, making it one of the fastest-growing Rollups to reach the $1 billion TVL milestone, second only to Arbitrum. It is worth noting that Swell L2 has not yet fully launched, but even when compared to behemoths like Blast that allow pre-launch deposits, Swell's growth rate is still faster, reaching the $1 billion mark 7 days ahead of Blast.

An important note is that most of Swell L2's deposits are reportedly made by one person, Justin Sun, who allegedly deposited 120,000 EtherFi eETH from his own wallet into Swell L2, valued at $376 million at the time. Today, his deposits account for approximately 30% of the entire Swell L2 TVL. However, following his deposit, we have seen some other whales start depositing in the range of seven and eight figures, especially Wintermute depositing around $90 million of Renzo's ezETH. Overall, since Sun's deposit, Swell L2's TVL has increased by $360 million.

They have achieved remarkable growth in pre-launch deposits, but what exactly is Swell L2?

Deep Dive into Swell L2

Swell L2 is indeed unique.

From an architectural perspective, they utilize AltLayer's technology stack to release a "restaking Rollup" and build it using Polygon's Composable Development Kit (CDK). Additionally, they will leverage EigenDA as their data availability layer, importantly, they will also embed "native revenue" on-chain, driving through staking and restaking rewards. Finally, as an interesting note, they will have their own liquidity restaking token (LRT) rswETH, serving as their Gas token for specifications.

There is a lot of content to explain in detail, so let's take it step by step.

What is a restaking Rollup?

Simply put, a restaking Rollup is a three-part vertically integrated AVS stack Rollup utilizing Alt Layer, including:

• VITAL (AVS for decentralized verification of Rollup state)

• MACH (AVS for fast finality)

• SQUAD (AVS for decentralized ordering)

Most importantly, restaking Rollups allow for restaking of LST and SWELL tokens themselves, such as swETH. When SWELL tokens are staked, they can accumulate sequencer fees. Note that this solves a huge problem in today's other L2s. Optimism, Arbitrum, StarkWare, and many other smaller L2s have a disconnect between sequencers and actual token holders, essentially creating an asymmetry between users and the legal or lab entities behind these L2s. While most (if not all) L2s are seeking to address this issue to improve the consistency of their protocols with users, they will all eventually catch up. From day one, Swell has provided incentive adjustments for its token holders and on-chain users.

Through the range of tools provided by AltLayer mentioned earlier, Swell chooses to utilize the Polygon Chain Development Kit (CDK) for their zero-knowledge (ZK) Validium Rollups. Validium Rollups, primarily promoted by Immutable X, handle transactions privately off-chain and later provide proofs of their validity on the main chain (in this case, Polygon), improving transaction speed and privacy compared to optimistic Rollups.

In addition to being able to choose their Rollup technology stack, Swell also chooses to utilize EigenDA as their

We are a Data Availability (DA) service provider. EigenDA is dedicated to the positive feedback loop we will discuss in detail in the next section. As of the time of writing, EigenDA is the most popular AVS, with over $9 billion in repledged capital across 118 operators.

So, setting aside all technical architectures, how does Swell Chain stand out? The key lies in its ingenious architecture that provides a unique feedback loop, leveraging all key value accumulation areas of the Swell and Ethereum ecosystems.

Given that the native fuel token is rswETH, users wanting to use Dapps on Swell L2 must bridge their LRT or repledge their ETH to obtain rswETH. The more rswETH bridged or pledged, the higher the cryptographic economic security of EigenLayer, deepening the overall platform's collective security, thereby enhancing the moat around EigenLayer, attracting more developers to build AVS. More AVS expands the overall market and potentially increases repledging rewards. For Dapps on Swell L2, a higher repledging yield can better utilize rswETH. The better the Dapp performs, the more users it attracts, the more sorter fees returned to SWELL pledgers, forming a continuous cycle.

Objectively speaking, no other protocol or L2 has the same vertically integrated reflective value capture mechanism as Swell. The rise and fall of most crypto networks depend on their liquidity network effects, and Swell L2 is well-positioned to leverage Ethereum's long-term value appreciation key areas.

Swell Fee Capture

For swETH and rswETH tokens, Swell has a standard 10% fee rate, with this fee evenly distributed to node operators and the finance department. Despite launching these two products in less than a year, as of the time of writing, the protocol has accumulated over $1 million in fees. Looking ahead, based on the growing bull market, these fees could increase, potentially reaching over $5 million a year from now.

Who is Building on Swell?

As we have discussed, Swell L2 is ready to go live, but which projects will deploy on its chain? In a blog post by the Swell team, they openly stated plans to airdrop SWELL tokens to pre-launch depositors on Swell L2, and some well-known DeFi projects also plan to allocate a portion of their airdrops to pre-launch depositors on Swell L2. These projects include:

• Ion Protocol: A lending platform focused on staking and restaking assets. Ion completed a $2 million seed round in July 2023, with a TVL of $6.27 million according to DeFi Llama.

• Ambient Finance: A "from 0 to 1" decentralized exchange (DEX) running entirely on a smart contract. Ambient is currently deployed on Ethereum mainnet, Canto, Scroll, and Blast. They secured a $6.5 million seed round in July 2023, with a TVL of approximately $87 million on DeFi Llama.

• Brahma Finance: A chain-executing and hosting environment, raising $6.7 million in seed and seed extension rounds in February 2022 and December 2023. Brahma is currently deployed on Blast.

• Sturdy Finance: A shared liquidity isolated lending platform allowing users to create liquidity money markets for any asset permissionlessly. Sturdy raised $3.9 million in seed and strategic rounds in March 2022.

AVS Partnership

In addition, Swell recently announced partnerships with Drosera, Brevis, and LaGrange, three AVSs on EigenLayer. While it is still early to say, given the strongest economic alignment between Swell and AVS, it may become the de facto liquidity hub for all AVS tokens outside the Ethereum mainnet. Swell is unlikely to capture all liquidity, as mature market participants may seek arbitrage opportunities by trading these AVS tokens between CEX and DEX, but Swell may capture a significant amount of on-chain liquidity and AVS token trading.

Swell's Growth Story

To better understand Swell's prospects, we first need to understand how it got to where it is today. When examining Swell's growth history, we can look at a date that facilitated the protocol's success: December 18, 2023, the day EigenLayer opened deposits for LST's "long tail." On that day alone, 35,000 swETHSwell was deposited into EigenLayer, a 225% increase until deposit suspension on January 3, 2024.

In the second phase of EigenLayer deposits starting on February 5, 2024, deposits surged again to 39,000 on the first day, a 148% increase, until deposit suspension on February 9 (just 4 days later).

Today, swETH remains the second most popular repledged LST, with Lido's stETH currently in the lead. With only 27% of Ethereum's total supply staked, there is still a significant addressable market (TAM) for liquidity staking tokens like swETH. Furthermore, as more ETH is staked, staking rewards will naturally be compressed. Any compression of returns in any economic environment will lead individuals to seek higher-yielding opportunities elsewhere. For DeFi, this may manifest as swETH holders depositing funds into fixed-rate trading protocols like Pendle, where users can earn a 4.46% staking reward rate, compared to a normative staking reward rate of around 3.2%. Users also employ loop leverage strategies on lending protocols to enhance their returns. We expect swETH to continue growing due to inherent demand drivers around ETH and better staking yield opportunities in DeFi protocols.

Another way to enhance staking reward rates comes from EigenLayer, where repledging users can earn additional income by delegating to operators supporting active validation services (AVS) on the network. However, repledging LST carries the same opportunity cost as staking ETH, a significant value pillar of rswETH, allowing users to leverage repledging rewards. Additionally, assuming there is enough liquidity in the pool, they can also hold liquid assets, enabling them to bypass the 7-day withdrawal period on EigenLayer. Due to demand drivers around rswETH, we expect rswETH adoption to continue to increase.

Looking ahead, we believe Swell is best positioned among all L2s to capture most of the DeFi activities related to repledging, including but not limited to LRT tokens, AVS tokens, and protocol tokens of projects around or adjacent to EigenLayer.

rswETH Risks

While using rswETH as the normative Gas token has advantages in creating a positive feedback loop, it also comes with risks. However, if the community becomes aware of potential associated risks, it is more likely to have a long-term perspective, making it more

It may succeed. For rswETH, we can divide it into three main risk categories: 1. **Operational Risk**: Although liquidity collateral tokens simply stake users' ETH on the underlying Ethereum blockchain, liquidity re-staking tokens (LRT) like rswETH are first staked on the Ethereum blockchain and then choose to join EigenLayer's re-staking infrastructure. Through rswETH, users choose to delegate their re-staked ETH to a whitelist of "operators" who re-stake the underlying ETH across multiple active validation services (AVS) built on EigenLayer projects. At launch, AVS will not have slashing, but it is expected to be implemented shortly. Each AVS will have its own slashing conditions, and operators must ensure compliance to avoid slashing. Additionally, Swell also collaborates with industry leaders in protocol risk management such as Gauntlet to help create AVS selection frameworks. 2. **Liquidity Risk**: This applies to all LRTs, not just rswETH, but liquidity is absolutely crucial. Liquidity risk refers to ensuring that there is sufficient liquidity in the pool, with enough liquidity paired with rswETH to maintain a 1:1 price-to-fair value ratio. In this case, fair value is the price of the underlying assets that make up rswETH, namely the staked ETH and its associated staking rewards. Since rswETH is a non-rebasing token, it follows a redemption curve that aligns with the staking reward rate. Essentially, this means that rswETH should always trade at a "premium" higher than ETH traded alone. At the time of writing, rswETH is trading at a 0.55% discount to fair value. If you want to delve deeper into the LRT liquidity landscape, please read the report on LRT liquidity. When ezETH announced the launch of the REZ token, the liquidity status of rswETH was briefly affected by the ezETH "decoupling." Speculative farmers used every possible method to exchange for ezETH, causing confusion for rswETH and rsETH. The current trading price of rswETH is slightly discounted, but this may close a few weeks after the implementation of local rswETH withdrawals. 3. **Smart Contract Risk**: This is not a risk type unique to Swell, but it is important to mention and understand how they attempt to mitigate this commonly existing risk. Swell has undergone audits from numerous auditing companies for all past upgrades and the Swell L2 pre-deposit contracts, such as Sigma Prime + Cyfrin auditing swETH and rswETH, and Mixbytes + Hexens auditing the pre-deposit contracts. Additionally, Swell offers bug bounties ranging from $1,000 to $250,000 through ImmuneFi. **Conclusion and Reflection**: In summary, no one can match Swell—they have successfully identified key areas of value accumulation in the Ethereum ecosystem and have executed well so far. We believe that their success in L2 lies in encouraging DeFi Dapps, especially those focused on building on the Swell L2 with EigenLayer, LRTs, LSTs, etc. Their unique feedback structure mentioned earlier in the report highlights their understanding of network effects and their potential for sustainable growth. Furthermore, as LRTs may become the most popular form of staking in DeFi, owning a vertical stack through L2s like Swell will be a very attractive move. If you do not have a complete stack through sequencing, unfortunately, you will miss out or even lose some profits. Finally, in other areas of L2, we have not seen an understanding of similar long-tail markets. We expect others to emulate and attempt to replicate execution in the same way as Swell has done so far in leveraging Ethereum's "game." The winner takes all, it's that simple.