California's state legislature is holding a hearing today in Sacramento about its Money Transmission Act—a sweeping reform of financial regulations which caught a lot of payments startups in its net since its passage in 2010.

The outcome could affect a number of high-profile companies, from Square and Stripe to eBay, Intuit, and Google—and even startups like Airbnb which aren't classically thought of as financial in nature but could fall under the law's broad definition of money transmission.

Commissioner Teveia Barnes, an experienced lawyer who has run the Department of Financial Institutions since early last year, told the State Assembly's Committee on Banking and Finance that the law was needed to protect consumers.

"Money transmitters are asking permission from the state to hold other people's money—hundreds of thousands of dollars—for some period of time," she said. "I view the holding of other people's money in the same vein as holding bank deposits and holding credit-union deposits.... I don't consider these as barriers to entry. I think they're consumer protections."

But the response to the law, especially from the technology sector, caught regulators by surprise, Barnes said.

The DFI expected to grant 5-7 licenses a year. Instead, it's issued 42 licenses since the law came into effect in 2011, according to Barnes. And the department received 130 inquiries from companies wondering if they had to register as money transmitters.

Before 2010, California only regulated foreign money transmission, not domestic money transmission.

One primary problem with the law, according to lawyer Tom Brown of the firm of Paul Hastings, is that the definition of a money transmitter is "circular," he wrote in prepared remarks submitted to the committee.

The Money Transmission Act, or MTA, defines "money transmission" as the "act of receiving money for transmission."

"Everybody receives money and gives it to others," Brown told the commission. He gave the example of Uber, the service that orders up taxis or Town Cars with a smartphone app and handles payments for the ride.

He also gave the example of buying a Taylor Swift song on iTunes, where the consumer pays money and eventually—through Apple and a record label—Swift gets paid.

The act's vague language could therefore cover a host of businesses that operate as consumer-to-consumer marketplaces—like Airbnb, which collects money from a guest who stays at an Airbnb host's lodging, holds it, and then transmits the money to a host.

A Palo Alto company, FaceCash, is suing the state of California over the law. (Barnes obliquely referred to the lawsuit in her testimony.)

Barnes explained that her department looks at who controls the funds in a transaction. If a company entrusts a regulated bank with the funds it's moving, and the bank maintains control of the funds, the department typically won't classify it as a money transmitter.

But critics of the law and the DFI's implementation of it say it would be far easier if those rules were codified and published, so fast-moving startups didn't have to engage in time-consuming conversations with regulators.

Brown said that the law's requirements for bonds and minimum capital levels constituted a "barrier to entry."

For example, Stripe, which processes payments for websites and mobile apps, relies on Wells Fargo to hold funds. At present, Stripe hasn't applied for a money-transmitter license.

Square, which lets small merchants process credit-cards using smartphones and tablets, applied for a license last year after operating without one in its initial years of doing business. As a result, it's been able to offer gift cards—a financial instrument also regulated by the act. The state of Illinois, where Square is not currently licensed, recently issued the company a cease-and-desist order.

Intuit, the financial-software and -services giant, applied for a license last July and still hasn't received it.

eBay's PayPal division sent its general counsel, John Muller, to the hearing. A decade ago, PayPal faced a state-by-state battle to get its service licensed. Now it's licensed coast to coast, but that's a daunting regulatory burden for smaller companies.

Muller's expected to recommend in his testimony that payments businesses should be regulated, while marketplace businesses should not be.

The Assembly is broadcasting the hearings online—tune in and wonk out >