There seems to be a couple of misconceptions regarding how the service works. Which is totally understandable as it isn't easy to ferret out technical details. I can't say how well the service will work in the end, as there are limitations to everything, but the technology and innovation of Onlive is really impressive nonetheless.
The servers run virtual instances of each game. They are spun up on the fly as needed, games are not 'installed', it is similar to hosted virtual desktop and application virtualization technologies if you are familiar with those. Also, don't think of it as a full blown Win XP instance for every game running either, it is much more efficient. There is little need to retire old games as the instances are only using resources when someone is actually playing. We can realistically expect no end of life for old games. Also unlike most servers, these have GPU's, lots of them, that handle the rendering of the graphics.
The video stream that is sent to the client is compressed using a pair of custom silicon chips per instance it doesn't use the graphical processor or CPU so video compression is completely independent. The hardware is custom and is another very interesting technical aspect of the service. 720p compression time is 1ms and around 4Mbps downstream throughput scaling downward depending on the game. This isn't comparable with any other remote video protocol. It is worlds ahead of TCX, ICA, PCoIP, standard RDP etc...
Latency is affected by quite a few different factors. Distance, hops, provider down to that grueling last mile aka customer prem. Onlive hasn't solved the speed of light issues, there will always be latency, but they are doing some interesting things with backbone level routing. Companies like ATT and TWC are among the investor lists, and Onlive are working with all of the major providers to improve routing. Granted there is only so much you can do with UDP.
Decompression of the video stream takes longer with the browser plug-ins but I can't recall how many ms it takes it does add to the overall latency though. The MicroConsole contains the same custom silicon as the servers for decompression and doesn't suffer much.
Another interesting component that affects latency are wireless controllers. Depending on the tech, age etc, latency of wireless keyboards, mice, controllers can exceed 20-30ms. The controllers that Onlive uses are in the 3ms range.
Being a Sys Admin that spends a great deal of time and effort in virtualization technologies I've been following Onlive since they went public, trying to understand the different facets of the underlying technologies. This is some seriously cool nerd stuff