Bitcoin at $11,000: What the heck is going on?

Inside a Russian cryptocurrency farm
Inside a Russian cryptocurrency farm

Forget the Dow's big rally or booming tech stocks, there's a much wilder investment story happening.

Bitcoin started the year worth less than $1,000. It's now stormed past $11,000 -- a staggering jump of over 1,000%.

So how does the virtual digital currency work -- and what's behind its meteoric rise?

What is bitcoin?

Bitcoin (XBT) was created in 2009 by an unknown person using the pseudonym Satoshi Nakamoto. Many of its backers saw it as a simple global payment system for anyone to use.

Unlike the U.S. dollar or Japanese yen, digital currencies such as bitcoin aren't issued by central banks like the Federal Reserve. Instead, they are "mined" by computers using complex algorithms.

Related: Bitcoin hits $11,000 and then plummets

Payments in bitcoin can be made without traditional middlemen such as banks and without the need to give your name.

That made bitcoin popular with criminals and others who wanted to move money anonymously. But its price has taken off this year as mainstream investors have become interested.

Why have prices gone crazy?

Some experts say the biggest force pushing bitcoin prices higher this year has been ... higher prices.

Investors have been buying as they fear "they're missing the party" or "losing out on a quick profit," said Stephen Innes, head of Asia trading at online broker Oanda. "Intense media coverage" in recent months has also convinced more investors to pile in, he added.

Arthur Hayes, CEO of Hong Kong's Bitmex, an exchange for trading financial instruments based on bitcoin, said the digital currency is in a "positive feedback loop."

Related: Can anything stop bitcoin?

In other words, investors see the price is increasing and want a piece of the action, moving prices higher still.

The sentiment has been backed up by indications that bitcoin is getting greater mainstream acceptance. Next month, investors should be able to start trading bitcoin futures via the Chicago Mercantile Exchange.

That would give the virtual currency more legitimacy among professional investors.

bitcoin new

Who's buying it?

For much of this year, it's mom-and-pop investors who have been buying in.

Many are in Japan and South Korea, where recent regulation changes have made it easier to trade bitcoin, according to experts.

But the biggest gains from the virtual currency's massive rally are likely to be concentrated among a relatively small number of investors.

Related: Russia eyes cryptocurrency dominance

When you invest in bitcoin, you don't have to buy a whole unit. According to research site BitInfoCharts, the vast majority of bitcoin accounts contain just 0.1 bitcoin (about $1,000) or less. Just 3% of more than 20 million bitcoin accounts hold one bitcoin or more.

Big institutional investors such as hedge funds and assets managers have largely stayed on the sidelines. But some experts predict they'll move into the market in the coming months, despite skepticism from the likes of Warren Buffett and JPMorgan Chase (JPM) CEO Jamie Dimon.

What's next?

Some industry insiders are incredibly bullish. Hayes predicts prices could hit a mind-boggling $50,000 by the end of next year, driven by the flow of money when institutional investors "pull the trigger" on investing in the digital currency.

With a total value of around $175 billion, the bitcoin market is small compared with more established assets.

"This is a drop in the ocean compared to the trillions transacted daily" in currency and stock markets, said Thomas Glucksmann, head of marketing at Hong Kong bitcoin exchange Gatecoin. Just a small amount of mainstream investors' money would make a big difference to bitcoin prices, he said.

But some finance industry veterans are wary.

Oanda's Innes, who has worked in currency trading for decades, referenced a famous piece of investment advice from Buffett: "Be fearful when others are greedy."

"Following the herd rarely produces large scale gains," Innes said.

Investors were given a reminder of bitcoin's unpredictability on Wednesday. After topping $11,000, it plunged more than $2,000 before recovering some of those losses.

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