Introduction:

We are quickly approaching the age of L2 abundance. The barrier to entry for launching an L2 is continuously decreasing due to Rollup as a Service (RaaS) providers, unlocking an influx of supply, blurring the differentiation amongst all these new chains. Becoming an L2 fundamentally makes sense for previously sovereign blockchains, or protocols that only existed as smart contracts on mainnet. An L2 implementation allows for an existing protocol or blockchain to circumvent the costly issue of bootstrapping their own validator set, and allows for a more efficient avenue for vertical value accrual via transaction sequencing. However, over the long run, if we truly live in a world of thousands of rollups, that means we will see hundreds of losers, and a few dozen big winners. We believe that most activity will aggregate across a select few general purpose, and domain specific L2s (i.e. core vertical focus, DeFi). What will divide the winners and losers will ultimately come down to network effects. As it stands today, we believe Swell has the potential to be a leader in that latter category for a multitude of reasons. But, what exactly is Swell? In this piece we’ll take an in-depth dive into the Swell Network at large, examining their growth and dissecting their architecture to understand what separates them from the crowd and how they can achieve dominant L2 status.

What is Swell?

Swell is a self described “non-custodial staking protocol with a mission to deliver the world’s best liquid staking and restaking experience, simplify access to DeFi, while securing the future of Ethereum and restaking services”. So, what does this look like in actuality? Well, it’s pretty spot on. Swell has amassed a grand total TVL of $2.1bn (713k ETH) at the time of writing. Of that $2.1bn, 29.57% is in their liquid staking token swETH, 17.78% is in their liquid restaking token rswETH, and the remaining 52.65% is sitting on their L2 deposit contracts.

Source: https://dune.com/queries/2426388/5266531

As you can see, Swell L2 Pre-Launch deposits have had the sharpest growth trajectory of any Swell product. Let’s see what exactly constitutes that growth:

Source: https://dune.com/queries/3609574/6082440

Source: https://dune.com/queries/3609900/6082638

As you can see, the majority of Swell L2 deposits are constituted of Swell ecosystem tokens such as rswETH, swETH, and the affiliated Pendle principal tokens. This makes sense as these are the most aligned Swell ecosystem participants. Outside of that, Swell L2 is also home to millions of dollars of other LRTs and their affiliated PT tokens via Pendle. If you were to count their total deposits of $1.1bn, it would put them as the 6th largest by TVL, which puts them above notable L2s such as StarkNet, ZkSync Era, Manta, Linea, and newly launched Mode Network

Source: https://l2beat.com/scaling/tvl

The most striking part about all of this: the first deposit was roughly 4 weeks ago on April 9th. In just 28 short days Swell has gone from $0 to over $1bn in pre-launch deposits for their L2, making them one of the fastest Rollups to hit the $1bn TVL mark, second only to Arbitrum. One caveat here is that the Swell L2 is not fully live, but even when you compare it to a behemoth such as Blast which also allowed for deposits pre-launch, Swell still grew faster, reaching the $1bn mark 7 days before Blast.

Source: DeFi Llama

One important caveat is that the majority of deposits for Swell L2 were allegedly constituted by one single individual, Justin Sun. The wallet, alleged to be his own, deposited 120k of EtherFi’s eETH to Swell L2, worth a cool $376m at the time of the transaction. Today, his alleged deposit constitutes roughly 30% of the entire Swell L2 TVL. However, following his deposit we saw a few other whales initiate deposits in the seven and eight figure range, notably with Wintermute depositing roughly $9m of Renzo’s ezETH. Overall, since Sun’s alleged deposit, Swell L2 TVL grew an additional $360m.

Source:https://platform.arkhamintelligence.com/explorer/address/0x38D43a6Cb8DA0E855A42fB6b0733A0498531d774

Okay, so they’ve had some incredible growth in pre-launch deposits, but what exactly is Swell L2?

Swell L2; Under the Hood

Swell L2 is truly unique for a number of reasons:

From an architectural standpoint, they are leveraging AltLayer’s tech stack to launch as a “restaked rollup” built using the Polygon (Composable Development Kit) CDK. Additionally, they’ll utilize EigenDA as their data availability layer, and importantly, they’ll also have “native yield” baked into the chain powered by staking and restaking rewards alike. Lastly, as an interesting caveat they will have their own Liquid Restaking Token (LRT), rswETH, as their canonical gas token.

That’s a lot to unpack, so let’s break it down piece by piece.

What is a restaked rollup?

Simply put, a restaked rollup is a rollup that leverages Alt Layer’s three-part, vertically integrated AVS stack consisting of:

VITAL (AVS for decentralized verification of rollup’s state)

MACH (AVS for fast finality)

SQUAD (AVS for decentralized sequencing)

And most importantly, restaked rollups allow for restaking of both an LST such as swETH, and the SWELL token itself. When the SWELL token is staked, it can accrue sequencer fees. Note that this solves a huge issue with other L2s today. Optimism, Arbitrum, StarkWare, many other smaller L2s have an incentive disconnect between the sequencer and the actual token holders, essentially creating an asymmetry between the users and the legal or lab entities behind these L2s. While most, if not all, L2s are looking to solve this issue to improve their protocol-to-user alignment, they will ultimately all be playing catch up. From day one, Swell will have incentive alignment for their token holders and the actual users of their chain as well.

Source: AltLayer Documentation https://docs.altlayer.io/altlayer-documentation

Through AltLayer’s suite of tooling mentioned earlier, Swell is choosing to utilize the Polygon Chain Development Kit (CDK) for their Zero Knowledge (ZK) Validium Rollups. Validium Rollups, largely popularized by Immutable X, process transactions privately off-chain and later provide proof of their validity on the main chain (in this case, Polygon), improving transaction speed and privacy in contrast with optimistic rollups.

In addition to being able to choose their rollup tech stack, Swell also is choosing to use EigenDA for their data availability (DA) service provider. EigenDA feeds into the positive reflexive flywheel we’ll discuss in detail throughout the next section. EigenDA is the most popular AVS at the time of writing, with over $9bn in restaked capital across 118 operators.

Source: u—1.com

So, all technical architecture aside; How does Swell Chain actually differentiate itself?

Well the key to the differentiation is actually because of their clever architecture which offers a unique reflexive flywheel which capitalizes on all the pivotal areas of value accrual for Swell and the Ethereum ecosystem at large.

Given the native gas token is rswETH, users that want to use Dapps on Swell L2 will have to bridge their LRT, or restake their ETH to get rswETH. The more rswETH bridged or staked, the more crypto-economic security is added to EigenLayer, deepening the pooled security for the entire platform, thus increasing the moat around EigenLayer to attract more developers to build AVS. More AVS grows the pie and potentially improves restaking yield. Higher restaking yield is better for the Dapps on Swell L2 productively utilizing rswETH. The better the Dapps do, the more users they will attract. The better the Dapps do, the more sequencer fees are accrued back to SWELL stakers. Ouroboros.

Objectively, no other protocol, or L2, has quite the same vertically-integrated reflexive value capture mechanisms that Swell has. Most, if not all, crypto networks live and die by their liquidity network effects, and Swell L2 is well positioned to capitalize on the long term key areas of value accrual that Ethereum offers.

Swell Fee Capture

For both the swETH and rswETH token, Swell has a standard 10% take-rate with an even 50/50 split of that fee to node operators and the treasury alike. Despite only launching these two products in less than a year long time frame, the protocol has already accrued just over $1m in fees at the time of writing. When looking forward, these fees are likely to increase, potentially reaching over $5m a year from now using our bull case growth scenario.

Who is Building on Swell?

As we’ve already discussed Swell L2 is poised to hit the ground running, but what projects will be deploying on their chain? In a blog post from the Swell team, they openly state that they plan to airdrop the SWELL token to pre-launch depositors of Swell L2, but additionally some notable DeFi projects that will be deploying on Swell also plan to allocate a portion of their airdrops to pre-launch depositors of Swell L2 as well. These projects include:

Ion Protocol: a lending platform that focuses on staked and restaked assets. Ion raised a $2m pre-seed round in July 2023, $6.27m in TVL per DeFi Llama.

Ambient Finance: a “zero to one” decentralized trading platform that runs the entire DEX inside one smart contract. Ambient is currently deployed on Ethereum mainnet, Canto, Scroll, and Blast as well. They raised a $6.5m seed round in July 2023 and currently have around $87m in TVL per DeFi Llama.

Brahma Finance: an on-chain execution and custody environment which has raised $6.7m in capital across a seed and seed extension round in February 2022 and December 2023 respectively. Brahma is currently deployed on Blast.

Sturdy Finance: an isolated lending with shared liquidity which allows users to permissionlessly create a liquid money market for any asset. Sturdy raised $3.9m in March 2022 for a seed and strategic round.

AVS Partnerships

Additionally, the last few days Swell has announced partnerships with Drosera, Brevis and LaGrange, three AVS on EigenLayer. While it may be too early to say, given Swell’s economic incentive alignment is strongest with AVS, it could potentially become the de facto liquidity hub for all AVS tokens outside of Ethereum mainnet. It’s unlikely that Swell will win all the liquidity, as sophisticated market participants will want to trade the CEX<>DEX arb for these AVS tokens, but Swell could potentially capture a decent amount of this onchain liquidity and trading for AVS tokens.

Swell’s Growth Story

To best understand where Swell is headed, we first need to understand how they got here. When examining the history of Swell’s growth, we can look to one date which helped catalyze the protocol’s success: December 18th, 2023. This is when EigenLayer opened up deposits for the “longer tail” of LSTs. In that one day alone, Swell had 35k swETH deposited to EigenLayer on the first day, which grew a whopping 225% before deposits were paused on Jan 3rd, 2024.

Source: https://dune.com/queries/3294704/5521576

In the second phase of EigenLayer deposits for Swell which started on Feburary 5th, deposits spiked again with 39k on the first day, growing 148% to 97k until deposits were paused again on Febuary 9th, only 4 days later.

https://dune.com/queries/3429649/5760098

Today, swETH is still the second most popular restaked LST, with Lido’s stETH currently holding the number one spot. With only 27% of the total ETH supply staked, there is still a massive total addressable market (TAM) for liquid staked tokens such as swETH. On top of this, as more ETH becomes staked, the staking rewards rate will naturally be compressed. A compression of yield in any economic environment will lead individuals to seek out other venues for higher yield. For DeFi, this can come in the form of swETH holders depositing to fixed income yield trading protocols such as Pendle where users can receive a 4.46% staking rewards rate versus the canonical staking rewards rate of around ~3.2%. Users have also been known to engage in loop leverage strategies with LSTs on lending protocols to enhance their yield. We anticipate swETH to continue its growth due to the inherent demand drivers around ETH plus better staking yield opportunities in DeFi protocols.

However, another avenue for enhanced staking rewards rates comes via EigenLayer as users who opt in for restaking can receive additional yield by delegating to an operator who supports Actively Validated Services (AVS) on the network. However, restaking an LST poses the same opportunity cost as staking ETH. This is one of the larger value props of rswETH as it allows users to capitalize on restaked rewards, plus they have the benefit of holding a liquid asset that allows them to circumvent the 7 day withdrawal period on EigenLayer, assuming there is enough pool liquidity. Because of the demand drivers surrounding rswETH, we expect adoption of rswETH to continue to increase.

Looking forward, we believe Swell is best positioned out of any of the L2s to capture the vast majority of DeFi activity as it relates to restaking; including but not limited to LRT tokens, AVS tokens, and protocol tokens for projects that are building around or adjacent to EigenLayer.

Source: https://dune.com/queries/3609900/6082644

rswETH Risks

While using rswETH as the canonical gas token has advantages for creating positive reflexive loops, there is also risk associated with this aspect as well. However, if the community is cognizant of the potential associated risks, then there is a better likelihood it will succeed in the long run. For rswETH, we can boil it down to three main risk categories:

• Operational Risk
• Liquidity Risk
• Smart Contract Risk

Operational Risk:

While Liquid Staking Tokens merely stake a user’s ETH to the underlying Ethereum blockchain, Liquid Restaking Tokens (LRT) such as rswETH are first staked the the Ethereum blockchain, but then opt-in to EigenLayer’s restaking infrastructure. Through rswETH, users are opting in to delegating their restaked ETH to a set of whitelisted “operators” who will then restake the underlying ETH across several Actively Validated Services (AVS), which are projects that are built on EigenLayer.

At launch AVS will not have slashing, but it will be implemented sooner rather than later. Each AVS will have their own slashing conditions which operators will have to make sure they adhere to in order to avoid slashing. Note that Swell has also collaborated with industry leaders in protocol risk management such as Gauntlet to help create a framework for AVS selection which you can read more about he re.

Liquidity Risk:

This goes for all LRTs, not just rswETH, but liquidity absolutely matters. What we mean here by liquidity risk is: ensuring there is ample liquidity paired against rswETH across enough liquidity pools to maintain a 1:1 “peg” of price to fair value. In this case, fair value is the price of the underlying assets constituting rswETH, which is the staked ETH plus the staking rewards associated. Given rswETH is a non-rebasing token, it instead follows a redemption curve in line with the staking rewards rate. Essentially, this means that rswETH should always trade at a “premium” to ETH alone. At the time of writing rswETH is trading at a slight discount of 0.55% to fair value. The reasoning behind this is nuanced and if you want to dive deeper into the LRT liquidity landscape, we suggest you read our report on LRT liquidity here.

In normal conditions, there should be enough liquidity for rswETH to remain soft pegged to fair value. Also, note that withdrawals are also helpful with allowing the peg to be retained as it offers an additional avenue for an arbitrageurs to close the discount. Lastly, it’s important to note that out of the top five liquid restaking tokens, rswETH has roughly the second best liquidity to TVL ratio.

Source: https://dune.com/Henrystats/liquidity-restaking-protocols

The liquidity profile of rswETH was briefly impacted by the ezETH “de-peg” as they announced their REZ token. Opportunistic farmers used all methods possible to swap out of ezETH, and rswETH along with rsETH both got caught in the crosshairs of the chaos. rswETH is currently trading at a shallow discount, but this is likely to be closed following the implementation of native rswETH withdrawals which should be live in a few weeks.

Source: https://dune.com/queries/3602452/6069726

Smart Contract Risk:

This is not a type of risk exclusive to Swell by any means, but it’s important to mention it and understand how they’re attempting to mitigate this omnipresent risk. Swell has received audits for all past upgrades, and for the Swell L2 pre-launch deposit contracts, from a plethora of auditing firms such as Sigma Prime + Cyfrin which audited swETH and rswETH, and Mixbytes + Hexens audited the pre-launch contracts. All of the audits can be found here. In addition to this, Swell has open bug bounties through ImmuneFi ranging from $1k up to $250k depending on the severity of the bug. Details of the bounties and scope can be found here.

Conclusion & Closing thoughts

In conclusion, no one is doing it quite like Swell. They’ve successfully identified the key areas of value accrual for the Ethereum ecosystem at large and have done well with their execution thus far. We believe that their key to success within the L2 landscape will come down to encouraging DeFi Dapps, specifically those focused around EigenLayer, LRTs, LSTs, etc, to build on Swell L2. Their unique reflexive structure mentioned earlier in the report highlights their understanding of network effects and their potential to sustainably grow the pie. Additionally, as LRTs likely become the most popular form of collateral across DeFi, vertically owning the stack via an L2 like Swell will become a very attractive move. If you don’t own the full stack, via sequencing et al, then you are unfortunately leaking value and leaving money on the table. Ultimately, we don’t see a similar level of understanding for carving out a long-term niche elsewhere in the L2 landscape. We anticipate that others will follow suit and try to copy-execute the same way Swell has thus far, but Swell has an undeniable first mover advantage for capitalizing on the ETH “meta game”. Winners win, simple as.

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