Why is Swell Network the most interesting L2?

Compilation: Deep Wave TechFlow

Introduction

We are rapidly entering a rich era of second layer technology (L2). As service providers offer rollup services (RaaS), the barrier to launch an L2 continues to decrease, unlocking a large amount of supply and blurring the differences between these new chains. For smart contract protocols that were originally independent blockchains or existed only on the main network, the transition to L2 is particularly meaningful. The implementation of L2 allows existing protocols or blockchains to circumvent the high cost of starting a validator set on their own and provide a more efficient vertical value accumulation path through transaction serialization. However, in the long run, if we do live in a world of thousands of Rollups, this means we will see hundreds of losers, as well as dozens of big winners. We believe that most activity will be focused on a few general and domain-specific L2s (e.g. core vertical focus, DeFi). What will ultimately separate the winners from the losers will be network effects. From what we know now, Swell has the potential to be a leader in the latter category for a number of reasons. But what exactly is Swell? In this article, we’ll take a deep dive into the Swell network, examining its growth and analyzing its architecture to understand how it differentiates itself from its competitors and how it achieved its dominant second-tier status.

What is Swell?

Swell describes itself as a “non-custodial staking protocol with a mission to deliver the best liquidity staking and re-staking experience in the world, simplifying access to DeFi while safeguarding the future of Ethereum and re-staking services” ". So, what is the actual situation? As of this writing, Swell has accumulated total value locked (TVL) of $2.1 billion (713,000 ETH). 29.57% of this 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 contract.

As you can see, the growth trajectory of Swell L2 pre-release deposits is the fastest of all Swell products. Let’s see what exactly is driving this growth:

As you can see, the majority of Swell L2’s deposits are made by Swell Ecosystem tokens, such as rswETH, swETH and related main Pendle tokens. These are the players most aligned with the Swell ecosystem. In addition to this, Swell L2 houses millions of dollars worth of other LRT and its associated PT tokens via Pendle. If you include their total deposit of $1.1 billion, this would make them the sixth largest company in TVL, higher than well-known L2 players such as StarkNet, ZkSync Era, Manta, Linea, and the newly launched Mode Network.

The most striking part of all this: the first deposit was made about 4 weeks ago on April 9th. In just 28 days, Swell’s L2 pre-release deposits grew 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. The caveat here is that Swell L2 isn’t fully live yet, but even comparing it to behemoths like Blast that allow pre-release deposits, Swell is still growing faster, hitting the $1 billion mark seven days before Blast.

An important note is that the majority of deposits to Swell L2 were allegedly made by one individual, Justin Sun, allegedly from his own wallet, to Swell L2 Deposited 120,000 EtherFi eETH, worth $376 million at the time. Today, his deposits account for approximately 30% of the entire Swell L2 TVL. However, following his deposit, we saw a few other whales start making deposits in the seven- and eight-figure range, with Wintermute in particular depositing around $9 million of Renzo’s ezETH. Overall, Swell L2's TVL has grown by another $360 million since Sun's deposit.

They’ve had amazing growth in pre-release deposits, but what exactly is Swell L2?

Learn more about Swell L2

Swell L2 is truly unique.

From an architectural perspective, they leverage AltLayer's technology stack to release as a "re-pledge Rollup", built using Polygon (Composable Development Kit) CDK. Additionally, they will utilize EigenDA as their data availability layer and importantly, they will also have “native yield” built into the chain, driven by staking and re-staking rewards. Finally, as an interesting caveat, they will have their own Liquidity Recollateral Token (LRT), rswETH, as their canonical Gas token.

There is a lot to explain in detail here, so let’s go step by step.

What is re-staking Rollup?

Simply put, Re-Staking Rollup is a three-part vertically integrated AVS stack Rollup utilizing Alt Layer, which includes:

• VITAL (AVS for decentralized verification Rollup status)
• MACH (AVS for fast finalization)
• SQUAD (AVS for decentralized sorting)

The most important thing is, re-staking Rollups allow re-staking of LST and SWELL tokens like swETH and SWELL tokens themselves. When SWELL token is staked, it can accumulate sequencer fees. Note, this solves a huge problem with other L2s today. Optimism, Arbitrum, StarkWare, and many other smaller L2s have an incentive 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 looking 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 alignment to its token holders and actual users on the chain.

Through the previously mentioned AltLayer suite of tools, Swell chose to utilize the Polygon Chain Development Kit (CDK) for their zero-knowledge (ZK) Validium Rollups. Validium Rollups, mainly popularized by Immutable privacy.

In addition to being able to choose their Rollup technology stack, Swell has chosen to leverage EigenDA as their data availability (DA) service provider. EigenDA throws itself into the positive feedback flywheel that we will discuss in detail in the next section. As of writing, EigenDA is the most popular AVS with over $9 billion in re-pledged capital across 118 operators.

So, all technical architecture aside, how does the Swell chain stand out?

The key is that its clever architecture provides a unique feedback flywheel that fully utilizes all key value accumulation areas of Swell and the Ethereum ecosystem.

Given that the native fuel token is rswETH, users who want 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 greater the cryptoeconomic security of EigenLayer, thereby deepening the collective security of the entire platform, thereby increasing the moat around EigenLayer and attracting more developers to build AVS. More AVS expands the overall market and potentially increases restaking returns. 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 sorter fees are returned to SWELL stakers, forming a An ongoing cycle.

Objectively speaking, no other protocol or L2 has exactly the same vertically integrated reflective value capture mechanism as Swell. While most crypto networks rise or fall based on their liquidity network effects, Swell L2 is well-positioned to capitalize on key areas of long-term value accretion that Ethereum offers.

Swell Fee Capture

For swETH and rswETH tokens, Swell has a standard 10% fee rate, which is divided equally between the node operator and the financial department. Despite launching both products in less than a year, the protocol has racked up over $1 million in fees as of writing. Looking forward, based on the backdrop that the bull market will grow, these fees may increase, possibly reaching more than $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 their plans to airdrop SWELL tokens to pre-release depositors of Swell L2. In addition, some well-known DeFi projects also plan to allocate part of their airdrops to pre-release deposits of Swell L2. By. These projects include:

• Ion Protocol: A lending platform focused on pledging and re-hypothecating assets. Ion completed $2 million in pre-seed funding in July 2023, and according to DeFi Llama, its TVL is $6.27 million.
• Ambient Finance: A "from 0 to 1" decentralized trading platform (DEX), the entire DEX runs in a smart contract. Ambient is currently deployed on the Ethereum mainnet, Canto, Scroll and Blast. They received a $6.5 million seed round in 2023-7 and currently have 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 a liquid money market for any asset without permission. Sturdy raised $3.9 million in seed and strategic rounds in March 2022.

AVS ​​Partnership

In addition, in recent days, Swell announced the establishment of partnerships with AVS on EigenLayer, Drosera, Brevis and LaGrange. Although it is too early to say, given that Swell has the strongest economic incentive alignment with AVS, it may become the de facto liquidity center for all AVS tokens outside of the Ethereum mainnet. Swell is unlikely to capture all the liquidity as mature market participants will look 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 .

Swell’s Growth Story

To better understand Swell’s prospects, we first need to understand how it got to where it is now. When looking at Swell’s growth history, we can look at a date that contributed to the protocol’s success: December 18, 2023, which was the day EigenLayer opened deposits for the “long tail” of LST. On that day alone, 35,000swETHSwell was deposited into EigenLayer until deposits were suspended on January 3, 2024, an amount that increased by 225%.

In the second phase of EigenLayer deposits that started on February 5, 2024, deposits surged again to 39,000 on the first day, an increase of 148%, and by February 9 Day (only 4 days later) deposits were suspended again.

Today, swETH remains the second most popular re-staking LST, with Lido’s stETH currently ranking first. With only 27% of the total Ethereum supply being staked, there is still a huge addressable market (TAM) for liquid staked tokens like swETH. Additionally, as more ETH is staked, the staking reward rate will naturally be compressed. Compression of yields in any economic environment will cause individuals to look for other high-yield venues. For DeFi, this may manifest itself as swETH holders depositing funds into a fixed-rate trading protocol such as Pendle, where users can receive a staking reward rate of 4.46%, while the standard staking reward rate is about 3.2%. Users also perform loop leverage strategies on LSTs through lending protocols to enhance their returns. We expect swETH to continue to grow due to the inherent demand drivers surrounding ETH and better staking yield opportunities in DeFi protocols.

Another way to enhance the staking reward rate comes from EigenLayer. Re-staking users can earn additional rewards by delegating to operators on the network that support Active Verification Services (AVS). income. However, restaking LST has the same opportunity cost as staking ETH, which is one of the larger value props of rswETH, allowing users to take advantage of the rewards of restaking. Additionally, assuming there is sufficient liquidity in the pool, they can also hold liquid assets, which allows them to bypass the 7-day withdrawal period on EigenLayer. We expect rswETH adoption to continue to increase due to the demand drivers surrounding rswETH.

Looking forward, we believe Swell is best positioned among all L2s to capture most re-staking related DeFi activities, including but not limited to LRT tokens, AVS tokens and protocol tokens for projects surrounding or adjacent to EigenLayer.

rswETH Risks

While using rswETH as the canonical gas token has advantages in creating a positive feedback loop, it also comes with risks. However, if a community is aware of the potential associated risks, it is more likely to be successful in the long term. For rswETH, we can divide it into three main risk categories:

Operational risk:

While liquidity staking tokens simply pledge the user’s ETH to the underlying Ethereum blockchain, Liquidity Re-staking Tokens (LRT) such as rswETH are first pledged to the Ethereum blockchain and then Opt-in to EigenLayer’s restaking infrastructure. With rswETH, users choose to delegate their staked ETH to a set of whitelisted "operators" who will stake the underlying ETH across multiple Active Validation Services (AVS), which are projects built on EigenLayer.

There will be no cuts to AVS at launch, but they are expected to be implemented shortly. Each AVS will have its own curtailment conditions, which operators must ensure compliance to avoid curtailments. In addition, Swell has partnered with industry leaders in protocol risk management such as Gauntlet to help create the AVS selection framework.

Liquidity Risk:

This applies to all LRT, not just rswETH, but liquidity is definitely important. The so-called liquidity risk refers to: ensuring that there is sufficient liquidity in a pool with sufficient liquidity to be paired with rswETH to maintain 1:1 between price and 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 consistent with the staking reward rate. Essentially, this means that rswETH should always trade at a "premium" above what ETH would trade on its own. At the time of writing, rswETH is trading at a 0.55% discount to fair value. If you would like a deeper understanding of the LRT liquidity landscape, please read the LRT Liquidity report.

When ezETH announced the launch of the REZ token, rswETH’s liquidity position was briefly affected by the “decoupling” of ezETH. Opportunistic farmers used every possible method to redeem ezETH, and both rswETH and rsETH were thrown into disarray. rswETH is currently trading at a slight discount, but this may close in a few weeks after native rswETH withdrawals are implemented.

Smart Contract Risk:

This is not a type of risk specific to Swell, but it is important to mention and understand how they are trying to mitigate this prevalent risks of. Swell has received audits from numerous auditing firms for all past upgrades as well as the Swell L2 pre-release deposit contract, such as Sigma Prime + Cyfrin audited swETH and rswETH, and Mixbytes + Hexens audited the pre-release contract. In addition, Swell has opened bug bounties ranging from $1,000 to $250,000 through ImmuneFi.

Conclusion and Thoughts

In short, no one does it like Swell - they have successfully identified key areas for value accumulation in the Ethereum ecosystem, and they have executed well so far. good. We believe that the key to their success in L2 is to encourage DeFi Dapps, especially those focusing on EigenLayer, LRTs, LSTs, etc., to build on the basis of Swell L2. Their unique feedback structure, mentioned earlier in the report, highlights their understanding of network effects and their potential for sustainable growth. Additionally, with LRTs likely to become the most popular form of staking in DeFi, vertically owning the stack through an L2 like Swell will become a very attractive move. If you don't have the full stack through things like sequencing, then unfortunately you're going to miss out or even lose some of your profits. Finally, in other areas of L2, we have not seen a similar understanding of long-term market segments. We expect others will follow suit and attempt to replicate execution in the same manner that Swell has done so far, but Swell has an undeniable first-mover advantage in leveraging the “game” of Ethereum. The winner takes all, it’s that simple.

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