I talked to steven on IRC last night, and he made a quick change to the exe, and found out it was a setting in his coding.
Basically from what I understand the server sends compressed jpeg screenshots to the server to help the 802.11b bottlenecks to the client. The compression was set at 90 (0 being the worst quality 100 the best) If you have used the "save to web" function on photoshop and try to save to jpg and play around with the quailty setting you will see how it affects the images.
However the setting at 90 in photoshop is nowhere near the 90 on the client. Steven said he is using a MS encoder to compress the jpgs and it must not be as efficient as the adobe one. He said some day he may look into a new encoder, and a configuation option in xlobby to change it as desired.
He sent me a new exe that uses 100 (highest quality) and I didn't notice much of a increase in lag, but the quality difference was night and day to me, I didn't see any artifacts or pixelation like before. But I'm a little picky about image quality