Ethereum Is Booming in the NFT Frenzy—So Is Network Congestion

The gains in ether, the second-largest cryptocurrency by market value behind bitcoin, have accelerated even as bitcoin’s momentum has slowed. Ether gained more than 40% in April, while bitcoin fell about 2.4%.

Ethereum, launched in 2015 on the concepts behind bitcoin, is a platform for developers to build and operate apps, much like Android or iOS. Unlike those operating systems, which are owned by and controlled by

Alphabet Inc.

and

Apple Inc.,

respectively, Ethereum is an open-source software project, which means no central party has control.

The rally in ether is tied to the recent burst of activity on the network. About seven million new Ethereum addresses—or accounts able to hold ether balances—were created in the first four months of 2021, bringing the total to more than 55 million, according to analytics firm IntoTheBlock. And the dollar value of transactions on the platform totaled $1.5 trillion in the first quarter, according to research firm Messari, more than the previous seven quarters combined.

Another stamp of approval: The European Investment Bank, a lender owned by European Union member states, issued $120 million worth of two-year bonds last week on the Ethereum network, a first for such a large-scale issuance.

“Right now, the value and the use case of Ethereum has been validated,” said

Danny Kim,

the head of revenue at crypto prime broker SFOX.

That success, however, has led to network congestion and rising transaction fees that have prompted competitors to enter the market, along with increasing worries about the environmental impact of cryptocurrencies.

For most of its existence, Ethereum held more promise than payoff. That changed over the past year thanks to NFTs and defi.

NFTs are bitcoin-like tokens, with a twist: Only one at a time is created and they aren’t interchangeable, as currency tokens are. The NFT is connected to a digital work of art or other real-world item and sold as a unique digital property.

Since the launch of the National Basketball Association’s “Top Shot” collectibles six months ago, NFTs have become a cultural phenomenon. The band Kings of Leon sold NFTs tied to an album release.

Twitter Inc.

Chief Executive

Jack Dorsey

auctioned an NFT of his first-ever tweet. The zenith? Digital artist Beeple sold an NFT artwork at Christie’s for a record $69 million.

The total value of NFT sales on the Ethereum network surged to $2 billion in the first quarter from $94 million in the fourth, according to data-tracking site NonFungible.

The defi market, meanwhile, comprises a broad array of financial services that allow crypto holders to borrow against their holdings or lend them out. With more institutional investors entering crypto markets, fueling the rally in bitcoin and the expansion of derivatives bets, there has been a corresponding demand for borrowing crypto assets.

The total amount of crypto held in defi protocols on Ethereum—a number referred to as “total value locked”—has skyrocketed to $68 billion, according to website DeFi Pulse, from about $900 million a year ago.

The boom in both NFTs and defi coincides with a wild market ride in everything from stocks to home-building materials that has stirred fresh fears that global markets are in a bubble. Many investors are speculating markets have more room to run, thanks to aggressive stimulus from the Federal Reserve, which has pledged to keep interest rates near zero for the foreseeable future.

The growth in markets like NFTs and defi has been “mind-boggling,” said

Jean-Marie Mognetti,

the chief executive of asset manager CoinShares. “Ethereum as a network is what makes this all possible.”

For all the recent hype, Ethereum is a software project still under development, and the obstacles it faces are material.

The burst of activity has raised questions about Ethereum’s energy usage, given similar concerns about the bitcoin network. Ethereum’s energy usage is much lower than bitcoin’s, however.

The Ethereum network expends about 568 terahashes per second—a measure of the total computing power on the network—according to data provider YCharts. Bitcoin, by contrast, expends about 143 million terahashes per second. Moreover, Ethereum is in the middle of an upgrade cycle that will switch to an even less energy-intensive system.

Its biggest challenge, though, is the same since its launch: scalability. The network aims to be a “world computer,” handling traffic from hundreds of millions of people around the world. The recent surge in traffic has resulted in significant network congestion, spurring a lag in settlement times and a steep rise in transaction fees.

The fees are essentially tolls for access, but they go up or down depending on traffic. The average fee hit a record $38 in February, according to statistics website BitInfoCharts, and rose back to $30 on April 20, making it especially unattractive for small transactions.

“As you add more users to the platform and more activity, it increases the fees,” said

Wilson Withiam,

an analyst at research firm Messari. “As you try and grow, it’s becoming a less friendly user experience.”

It is for these reasons that Top Shot, the most popular NFT, doesn’t run on the Ethereum network. Dapper Labs, a Vancouver-based startup that created and runs the program with the league and players, designed its own network, called Flow.

Ethereum’s scaling problems made it impractical for Dapper Labs to use, something the company discovered back in 2017 when it launched CryptoKitties, a game that allows users to create and trade unique animated cats. It was essentially the first NFT and the first popular app to run on Ethereum. And as soon as it launched, it nearly ground Ethereum to a halt.

“Twenty-four hours after we launched, the [Ethereum] network was at capacity,” said Dapper Labs Chief Executive

Roham Gharegozlou.

“And it has been ever since.”

Although Dapper Labs isn’t specifically angling for Flow to replace Ethereum, there are a handful of other projects that are looking to take advantage of Ethereum’s problems.

The crypto exchange Binance has created its own version of Ethereum, called Binance Smartchain. Other competitors include Solana, Cardano, Cosmos and Polkadot. All seem attractive now, Mr. Withiam said, but as they grow, they are likely to see the same scaling problems Ethereum has.

“It’s going to be a tough problem to solve,” he said.

Write to Paul Vigna at paul.vigna@wsj.com