It uses emulation. While it is true the user needs to download a 'game image' rather than play the game directly from disc this is because that image is a virtual hard disk that contains the game and a customised Xbox 360 virtual machine that has tweaks for the game. It is similar to PC console emulators that have specific configs for certain games.
That's actually probably the case. Xbox 360 banned making arbitrary pages executable (not even the Kernel could do it, the Hypervisor call to mark a page as executable had to come with the signatures signed by Microsoft's private key).
So they probably can get away with static recompilation.
