Jamie,
We aren't ready to disclose details of the Mesh API. That being said, we don't prohibit third parties from encrypting their data using their own auth system before sync'ing the data in the Mesh:
Microsoft has invested heavily to insure Live Mesh is safe and secure. We use Windows LiveID to manage authentication and encrypt any upload/download and syncing of files and folders. Furthermore, we empower users to manage their own sharing settings and security when they are managing files and folders within Live Mesh. As with all online services and offerings, users are encouraged to use file password protection, to use their best judgment when uploading and sharing files.
Hope that helps somewhat!
Richard
Richard Chung [MSFT]