Deep Dive into Swell Network: The Most Interesting L2
This article will delve into the Swell network, examining its growth and analyzing its architecture to understand how it stands out among numerous competitors.Author: Kairos Research
Compiled by: Shenchao TechFlow
Introduction
We are rapidly entering a rich era of Layer 2 (L2) technology. With the Rollup-as-a-Service (RaaS) provided by service providers, the barrier to launching an L2 is continuously lowering, unlocking a vast supply and blurring the distinctions between these new chains. For originally independent blockchains or smart contract protocols that only exist on the mainnet, transitioning to L2 is particularly meaningful. The implementation of L2 allows existing protocols or blockchains to avoid the high costs associated with launching their own validator sets and provides a more efficient vertical value accumulation pathway through transaction serialization. However, in the long run, if we truly live in a world of thousands of Rollups, this means we will see hundreds of failures and dozens of big winners. We believe that most activity will concentrate on a few general-purpose and domain-specific L2s (e.g., core vertical focus, DeFi). Ultimately, what will distinguish 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 many 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 second-layer position.
What is Swell?
Swell claims to be a "non-custodial staking protocol with the mission of providing the world's best liquid staking and re-staking experience, simplifying access to DeFi while securing the future of Ethereum and re-staking 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). Of this, 29.57% is in its liquid staking token swETH, 17.78% is in its liquid re-staking token rswETH, and the remaining 52.65% is in its L2 deposit contracts.
As you can see, the growth trajectory of Swell L2 pre-launch deposits is the fastest among all Swell products. Let's take a look at what has contributed to this growth:
As you can see, most of the deposits in Swell L2 are composed of tokens from the Swell ecosystem, such as rswETH, swETH, and related Pendle main tokens. These are the participants most aligned with the Swell ecosystem. Additionally, Swell L2 has accommodated millions of dollars in other LRTs and their related PT tokens through Pendle. If we include their $1.1 billion in total deposits, this would make them the sixth largest by TVL, surpassing well-known L2s such as StarkNet, ZkSync Era, Manta, Linea, and the newly launched Mode Network.
The most striking part of all this is that the first deposit was made about four weeks ago on April 9. In just 28 days, Swell's L2 pre-launch deposits increased from 0 to over $1 billion, making it one of the fastest Rollups to reach the $1 billion TVL milestone, second only to Arbitrum. It is worth noting that Swell L2 has not fully launched yet, but even when compared to giants like Blast that allow pre-launch deposits, Swell's growth rate is still faster, reaching the $1 billion mark 7 days earlier than Blast.
An important note is that it is claimed that most of the deposits in Swell L2 are made by one person, Justin Sun, who reportedly deposited 120,000 EtherFi's eETH into Swell L2, worth $376 million at the time. Today, his deposits account for about 30% of the entire Swell L2 TVL. However, following his deposit, we have seen some other whales starting to deposit in the seven-figure and eight-figure range, particularly Wintermute depositing about $9 million in Renzo's ezETH. Overall, since Sun's deposit, Swell L2's TVL has grown by another $360 million.
They have achieved astonishing growth in pre-launch deposits, but what exactly is Swell L2?
Understanding Swell L2
Swell L2 is indeed unique.
From an architectural perspective, they utilize AltLayer's tech stack to launch as a "re-staking Rollup," built using the Polygon (Composable Development Kit) CDK. Additionally, they will leverage EigenDA as their data availability layer, and importantly, they will also have "native yield" built on-chain, driven by staking and re-staking rewards. Finally, as an interesting caveat, they will have their own liquid re-staking token (LRT) rswETH, serving as their standard Gas token.
There is a lot to explain here, so let's take it step by step.
What is a Re-staking Rollup?
In simple terms, a re-staking Rollup is a type of Rollup that utilizes Alt Layer's vertically integrated AVS stack, which includes:
VITAL ( AVS for decentralized validation of Rollup state)
MACH ( AVS for fast finality)
SQUAD ( AVS for decentralized ordering)
Most importantly, re-staking Rollups allow for re-staking of LSTs like swETH and the SWELL token itself. When SWELL tokens are staked, they can accumulate sequencer fees. Note that this addresses a significant issue present in other L2s today. Optimism, Arbitrum, StarkWare, and many other smaller L2s have an incentive misalignment between sequencers and actual token holders, essentially creating asymmetries between users and the legal or laboratory entities behind these L2s. While most (if not all) L2s are seeking to solve this issue to improve the alignment of their protocols with users, they will ultimately catch up. From day one, Swell has provided incentive alignment for its token holders and actual users on-chain.
Through the aforementioned suite of tools from AltLayer, Swell chooses to utilize the Polygon Chain Development Kit (CDK) for their zero-knowledge (ZK) Validium Rollups. Validium Rollups, primarily promoted by Immutable X, process transactions privately off-chain and later provide their validity proof 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 tech stack, Swell also opts to use EigenDA as their data availability (DA) service provider. EigenDA contributes to the positive feedback loop we will discuss in detail in the next section. As of the writing, EigenDA is the most popular AVS, with over $9 billion in re-staking capital across 118 operators.
So, putting aside all the technical architecture, how does the Swell chain stand out?
The key lies in its clever architecture that provides a unique feedback loop, fully leveraging all key value accumulation areas of the Swell and Ethereum ecosystems.
Given that the native fuel token is rswETH, users wishing to use Dapps on Swell L2 must bridge their LRT or re-stake their ETH to obtain rswETH. The more rswETH that is bridged or staked, the higher the cryptoeconomic security of EigenLayer, thereby deepening the collective security of the entire platform, increasing the moat around EigenLayer, and attracting more developers to build AVS. More AVS expands the overall market and has the potential to enhance re-staking yields. For Dapps on Swell L2, higher re-staking yields can better utilize rswETH, the better the Dapp performs, the more users it attracts, and the more sequencer fees returned to SWELL stakers, creating a continuous cycle.
Objectively, no other protocol or L2 has a completely identical 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 the long-term value appreciation key areas provided by Ethereum.
Swell Fee Capture
For swETH and rswETH tokens, Swell has a standard 10% fee rate, which is evenly distributed to node operators and the treasury. Despite launching these two products in less than a year, as of the writing, the protocol has already accumulated over $1 million in fees. Looking ahead, based on the backdrop of a bull market, these fees may increase, potentially reaching over $5 million in a year.
Who is Building Projects on Swell?
As we have discussed, Swell L2 is ready to go live, but which projects will be deployed on its chain? In a blog post by the Swell team, they publicly stated plans to airdrop SWELL tokens to Swell L2 pre-launch depositors, and additionally, some well-known DeFi projects also plan to allocate a portion of their airdrops to Swell L2 pre-launch depositors. These projects include:
Ion Protocol: A lending platform focused on staking and re-staking assets. Ion completed a $2 million seed pre-financing in July 2023, with a TVL of $6.27 million according to DeFi Llama.
Ambient Finance: A "from 0 to 1" decentralized exchange (DEX) that operates entirely on a smart contract. Ambient is currently deployed on Ethereum mainnet, Canto, Scroll, and Blast. They raised $6.5 million in seed round financing in July 2023, with a TVL of approximately $87 million on DeFi Llama.
Brahma Finance: An on-chain execution and custody environment that has raised $6.7 million in seed and seed extension rounds in February 2022 and December 2023. Brahma is currently deployed on Blast.
Sturdy Finance: An isolated lending platform with shared liquidity that allows users to create liquidity money markets for any asset without permission. Sturdy raised $3.9 million in seed and strategic rounds in March 2022.
AVS Partnerships
Additionally, in recent days, Swell announced partnerships with three AVS on EigenLayer: Drosera, Brevis, and LaGrange. While it is still early to say, given the strong alignment of economic incentives between Swell and AVS, it may become the de facto liquidity center for all AVS tokens outside of the Ethereum mainnet. Swell is unlikely to capture all liquidity, as mature market participants will seek to arbitrage these AVS tokens by trading between CEX and DEX, but Swell may capture a significant amount of on-chain liquidity and trading of AVS tokens.
The Growth Story of Swell
To better understand Swell's prospects, we first need to understand how it has come this far. 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 the "long tail" of LSTs. On that day alone, 35,000 swETH were deposited into EigenLayer, and this amount grew by 225% until deposits were paused on January 3, 2024.
In the second phase of EigenLayer deposits starting on February 5, 2024, deposits again soared to 39,000 on the first day, an increase of 148%, and were paused again just four days later on February 9.
Today, swETH remains the second most popular re-staking LST, with Lido's stETH currently in first place. With only 27% of the total supply of Ethereum staked, there remains a huge addressable market (TAM) for liquid staking tokens like swETH. Additionally, as more ETH is staked, the staking reward rates will naturally compress. Any compression of yields in any economic environment will lead individuals to seek out other high-yield venues. For DeFi, this may manifest as swETH holders depositing funds into fixed-yield trading protocols like Pendle, where users can earn a staking reward rate of 4.46%, while the normative staking reward rate is around 3.2%. Users also employ loop leverage strategies on LSTs through lending protocols to enhance their yields. We expect swETH to continue to grow, driven by the inherent demand factors surrounding ETH and better staking yield opportunities in DeFi protocols.
Another avenue for enhancing staking reward rates comes from EigenLayer, where re-staking users can earn additional yields by delegating to operators supporting active validation services (AVS) on the network. However, re-staking LSTs carries the same opportunity cost as staking ETH, which is one of the significant value pillars of rswETH, allowing users to benefit from re-staking rewards. Furthermore, assuming there is sufficient liquidity in the pool, they can also hold liquid assets, allowing them to bypass the 7-day withdrawal period on EigenLayer. Given the demand factors surrounding rswETH, we expect the adoption of rswETH to continue to increase.
Looking ahead, we believe Swell is best positioned among all L2s to capture most of the DeFi activity related to re-staking, including but not limited to LRT tokens, AVS tokens, and protocol tokens from projects around or adjacent to EigenLayer.
Risks of rswETH
While using rswETH as a standard Gas token has advantages in creating a positive feedback loop, there are also risks involved. However, if the community is aware of the potential associated risks, it is more likely to succeed in the long run. For rswETH, we can categorize its risks into three main categories:
- Operational Risk:
- While liquid staking tokens simply stake users' ETH on the underlying Ethereum blockchain, liquid 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 will re-stake the underlying ETH across multiple active validation services (AVS) built on EigenLayer.
- At launch, AVS will not have slashing, but it is expected to be implemented shortly thereafter. Each AVS will have its own slashing conditions, and operators must ensure compliance to avoid slashing. Additionally, Swell collaborates with industry leaders in protocol risk management like Gauntlet to help create an AVS selection framework.
- Liquidity Risk:
- This applies to all LRTs, not just rswETH, but liquidity is absolutely crucial. The so-called liquidity risk refers to ensuring that there is sufficient liquidity in the pool to maintain a 1:1 price with the fair value of rswETH. In this case, the fair value is the price of the underlying assets constituting rswETH, namely the staked ETH and its associated staking rewards. Since rswETH is a non-pegged token, it follows a redemption curve that aligns with the staking reward rate. Essentially, this means that rswETH should always trade at a "premium" above ETH when traded alone. At the time of writing, rswETH is trading at a 0.55% discount to its fair value. If you want to delve deeper into the LRT liquidity landscape, please read the LRT liquidity report.
When ezETH announced the launch of the REZ token, the liquidity situation of rswETH was briefly affected by the "decoupling" of ezETH. Speculative farmers used every possible means to exchange ezETH, leading to chaos for both rswETH and rsETH. The current trading price of rswETH is slightly discounted, but this may close in a few weeks after the local rswETH withdrawal implementation.
- 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 ubiquitous risk. Swell has undergone audits from numerous auditing firms for all past upgrades and the Swell L2 pre-launch deposit contracts, such as Sigma Prime + Cyfrin auditing swETH and rswETH, and Mixbytes + Hexens auditing the pre-launch contracts. Additionally, Swell has opened a bug bounty ranging from $1,000 to $250,000 through ImmuneFi for vulnerabilities found in their contracts bug bounty.
Conclusion and Thoughts
In conclusion, no one can do it like Swell—they have successfully identified the key areas of value accumulation within the Ethereum ecosystem, and so far, they have executed well. We believe that their success in L2 hinges on encouraging DeFi Dapps, especially those focused on EigenLayer, LRTs, LSTs, and other Dapps built on the Swell L2 foundation. 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, vertically owning the stack through L2s like Swell will become a very attractive proposition. If you do not have a complete stack through sequencing and other means, unfortunately, you will miss out on or even lose part of your profits. Finally, in other areas of L2, we have yet to see an understanding of similar long-term niche markets. We expect others to follow suit and attempt to replicate the execution in the same way Swell has so far, but Swell has an undeniable first-mover advantage in leveraging this "game" of Ethereum. Winners take all, it's that simple.
