Author: Kairos Research
Translation: Deep Tide TechFlow
Introduction
We are rapidly entering a rich era of Layer 2 technology (L2). With the introduction of Rollup as a Service (RaaS) by service providers, the threshold for launching an L2 continues to decrease, unlocking a large supply and blurring the differences between these new chains. For smart contract protocols that were originally independent blockchains or only existed on the mainnet, the transition 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 a few dozen big winners. We believe that most activity will be concentrated on a few general and domain-specific L2s (such as core vertical focus, DeFi). Ultimately, what will distinguish winners from losers is network effects. As far as we know, Swell has the potential to become a leader in the latter category for several 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 "unmanaged staking protocol with a mission to provide the best liquidity staking and restaking experience in the world, simplify access to DeFi, and ensure 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 21 billion US dollars (713,000 ETH). 29.57% of this is in its liquidity staking token swETH, 17.78% is in its liquidity restaking token rswETH, and the remaining 52.65% is in its L2 deposit contract.
As you can see, the growth trajectory of Swell L2 pre-deposit 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 the deposits in Swell L2 are composed 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. If their 11 billion US dollars in total deposits are taken into account, this would make them the sixth largest TVL company, 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 that the first deposit was made about 4 weeks ago on April 9th. In just 28 days, Swell's L2 pre-deposit has increased from 0 to over 1 billion US dollars, making it one of the fastest growing Rollups to reach the 1 billion US dollar TVL milestone, second only to Arbitrum. It is important to note that Swell L2 has not yet fully launched, but even when compared to behemoths like Blast that allow pre-deposits, Swell's growth rate is still faster, reaching the 1 billion US dollar mark 7 days ahead of Blast.
An important note is that most of the deposits in Swell L2 are claimed to be made by one person, Justin Sun, reportedly from his own wallet, who deposited 120,000 EtherFi's eETH into Swell L2, valued at 376 million US dollars at the time. Now, his deposits account for approximately 30% of the entire Swell L2 TVL. However, after his deposit, we have seen some other whales start to deposit in the range of seven and eight figures, especially Wintermute, who deposited approximately 9 million US dollars of Renzo's ezETH. Overall, since Sun's deposit, Swell L2's TVL has grown by an additional 360 million US dollars.
They have achieved astonishing growth in pre-deposits, but what exactly is Swell L2?
A Deeper Understanding of Swell L2
Swell L2 is indeed unique.
From an architectural perspective, they utilize the AltLayer technology stack as a "restaking Rollup" released using the Polygon (Composable Development Kit) CDK. In addition, they will utilize EigenDA as their data availability layer, and 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 as their native Gas token.
There is a lot here that needs to be explained in detail, so let's take it step by step.
What is a restaking Rollup?
In simple terms, a restaking Rollup is a three-part vertically integrated AVS stack Rollup that utilizes Alt Layer, including:
- VITAL (AVS for decentralized verification of Rollup state)
- MACH (AVS for fast termination)
- 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 restaked, they can accumulate sequencer fees. Note that this solves a huge problem with other L2s today. 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 incentives for its token holders and on-chain users.
Through the series of tools 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 data availability (DA) service provider. EigenDA is invested in the positive feedback flywheel that we will discuss in detail in the next section. As of the writing, EigenDA is the most popular AVS, with over 9 billion US dollars in restaking capital across 118 operators.
So, setting aside all the technical architecture, how exactly did Swell's chain stand out?
The key is its clever architecture that provides a unique feedback flywheel, leveraging all key value accumulation areas of the Swell and Ethereum ecosystems.
Given that the native fuel token is rswETH, users who want to use Dapps on Swell L2 must bridge their LRT or restake their ETH to obtain rswETH. The more rswETH is bridged or restaked, the higher the cryptographic economic security of EigenLayer, deepening the collective security of the entire platform and increasing the moat around EigenLayer, attracting more developers to build AVS. More AVS expands the overall market and has the potential to increase restaking rewards. For Dapps on Swell L2, a higher restaking yield can better utilize rswETH, the better the Dapp performs, the more users it attracts, the more sequencer fees are returned to SWELL restakers, forming a continuous cycle.
Objectively speaking, no other protocol or L2 has the same vertically integrated reflexive 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 key areas of long-term value appreciation provided by Ethereum.
Swell Fee Capture
For the 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 writing, the protocol has accumulated over 1 million US dollars in fees. Looking ahead, based on the backdrop of a growing bull market, these fees could increase, potentially reaching over 5 million US dollars in a year.
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-depositors on Swell L2, and additionally, some well-known DeFi projects also plan to allocate a portion of their airdrops to pre-depositors on Swell L2. These projects include:
- Ion Protocol: A lending platform focused on staking and restaking assets. Ion completed a 2 million US dollar seed pre-financing in July 2023 and has a TVL of 6.27 million US dollars according to DeFi Llama.
- Ambient Finance: A "from 0 to 1" decentralized exchange (DEX) that runs the entire DEX in a smart contract. Ambient is currently deployed on the Ethereum mainnet, Canto, Scroll, and Blast. They received a 6.5 million US dollar seed round financing in July 2023 and currently have a TVL of approximately 87 million US dollars on DeFi Llama.
- Brahma Finance: A chain-executed and custody environment that raised 6.7 million US dollars 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, allowing users to create liquidity money markets for any asset without permission. Sturdy raised 3.9 million US dollars in seed and strategic rounds in March 2022.
AVS Partnerships
In addition, in recent days, Swell announced partnerships with three AVSs on EigenLayer: Drosera, Brevis, and LaGrange. While it is still early to say, given the strongest economic incentive consistency between Swell and AVS, it could become the de facto liquidity hub for all AVS tokens outside the Ethereum mainnet. Swell is unlikely to win all liquidity, as mature market participants will want to arbitrage these AVS tokens between CEX and DEX, but Swell may capture a significant amount of on-chain liquidity and trading of AVS tokens.
Swell's Growth Story
To better understand the prospects of Swell, we first need to understand how it got to where it is now. 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 LST. 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 soared to 39,000 on the first day, a 148% increase, and were suspended again on February 9 (just 4 days later).
Today, swETH remains the second most popular restaking LST, with Lido's stETH currently in the first position. With only 27% of the total Ethereum supply staked, there is still a huge addressable market (TAM) for liquidity staking tokens like swETH. Additionally, as more ETH is staked, the staking reward rate will naturally be compressed. Any compression of returns in any economic environment will lead individuals to seek higher-yielding alternatives. For DeFi, this may manifest as swETH holders depositing funds into fixed-rate trading protocols, such as Pendle, where users can earn a staking reward rate of 4.46%, compared to the normative staking reward rate of around 3.2%. Users can also employ loop leverage strategies on lending protocols with LSTs to enhance their returns. We expect swETH to continue growing due to the inherent demand drivers around ETH and better staking yield opportunities in DeFi protocols.
Another way to enhance staking reward rates comes from EigenLayer, where restaking users can earn additional income by delegating to operators supporting active validation services (AVS) on the network. However, restaking LST carries the same opportunity cost as staking ETH, which is a significant value pillar for rswETH, allowing users to leverage the restaking rewards. Additionally, assuming there is enough liquidity in the pool, they can also hold liquid assets, allowing them to bypass the 7-day withdrawal period on EigenLayer. Due to the demand drivers around 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 restaking, including but not limited to LRT tokens, AVS tokens, and protocol tokens for 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, it is more likely to succeed in the long run if the community is aware of the potential associated risks. For rswETH, we can categorize its risks into three main categories:
Operational Risk:
While liquidity staking tokens simply stake users' ETH on the underlying Ethereum blockchain, liquidity restaking tokens (LRT) like rswETH are first staked on the Ethereum blockchain and then opt into the restaking infrastructure on EigenLayer. Through rswETH, users choose to delegate their restaked ETH to a whitelist of "operators" who restake 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. 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.
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 peg to fair value. 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" to ETH traded alone. At the time of writing, rswETH is trading at a discount of 0.55% to fair value. If you want to delve deeper into the LRT liquidity landscape, please read the report on LRT liquidity.
The liquidity status of rswETH was briefly affected by the "uncoupling" of ezETH when ezETH announced the launch of the REZ token. Speculative farmers used every possible method to exchange ezETH, and both rswETH and rsETH were thrown into disarray. The current trading price of rswETH is slightly discounted, but this may close in a few weeks after the local rswETH withdrawal is implemented.
Smart Contract Risk:
This is not a risk type specific to Swell, but it is important to mention and understand how they are attempting to mitigate this commonly existing risk. Swell has undergone audits from numerous auditing firms 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 has opened bug bounties ranging from $1,000 to $250,000 through ImmuneFi.
Conclusion and Reflection
In conclusion, no one is quite like Swell—they have successfully identified key areas of value accumulation in the Ethereum ecosystem and have executed well so far. We believe their success in L2 lies in encouraging DeFi Dapps, especially those focused on building on Swell L2 around EigenLayer, LRTs, LSTs, and more. The unique feedback structure mentioned earlier in the report highlights their understanding of network effects and their potential for sustainable growth. Additionally, with LRTs potentially becoming the most popular form of staking in DeFi, vertical ownership stacks like Swell's L2 will be a very attractive move. Unfortunately, if you do not have a complete stack through sequencing, you will miss out or even lose some profits. Finally, in other areas of L2, we have not seen an understanding of a long-tail market segment similar to what Swell has demonstrated. We expect others to emulate and attempt to replicate execution in the same way as Swell has done so far, but Swell has an undeniable first-mover advantage in leveraging Ethereum's "game". Winner takes all, it's that simple.
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