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As far as I know, the mod in question only allows users to play "backups" of games - not to run arbitrary code (including cheats). So the concerns of people cheating are a little off the mark. As is the idea that the detection could really be moved to the server side - any detection regimen is going to have to look at the drive's firmware or some characteristic of the disk and this looking is going to be done at the client end.

We're seeing Trusted Computing at its finest.

Trusted Computing: noun
The act of trusting that any possible attack vector against a computers expected behavior will be done so by those that have nothing better to do than to game the system.

A couple of things:

1) To re-iterate what others are saying, the firmware hack does not defeat executable signatures, so the integrity of game code has not been compromised, however, game data files can be, and have been, compromised (Exo's GoW hacks). The simple solution is to update the executable with hard-coded data file checksums to go along with their weak signature security (in this case, on the GoW data files). So it's not entirely true that the firmware hack doesn't allow cheaters - but Microsoft has other avenues they can pursue in preventing cheaters. This wave of bannings represents an escalation in Microsoft's policy toward modders.

2) Something that many here miss, is that Microsoft has no direct access to the firmware for some models of the DVD drive they are using. Toshiba-Samsung MS28 drives, for example, have "Firmguard" - an attempt to thwart modders that has backfired on Microsoft. Why? Because powercycling the DVD with the correct VIA SATA chipset bypasses Firmguard as part of it's "Bad Flash" recovery mode. Microsoft cannot do this on the 360. This means they cannot read, nor write firmware to these drives.

There were several techniques Microsoft employed against modders in this last wave, verified by special debugging firmware employed - Microsoft was using an anomaly in the firmware's fetch of special sectors to determine if backups were employed (moddded Hitachi drives gave up the goods on this one), as well as more strict checking of those sectors (catching non-"stealth" backups), and finally, using Challenge/Response commands to do threshold timing (many used slower or faster timings on the firmware, which was detectable as being outside of thresholds).

There are still less reliable checks Microsoft may employ, but that dragnet will scoop up some legitmate users, too (No DVD Error code check, used to see who's been using their Xbox 360 as a power supply for the drive as they flashed it). If I was on the team, I'd rule that one out. There are a few other techniques, which I won't mention, since they haven't been discussed publicly, as the others I mentioned have (besides, Microsoft KNOWS how they are checking currently) - which have been identified and "fixed" in the current iXtreme 1.0 firmware.

For what it's worth, many, many 360 modders have NOT been banned. It may be these checks were only performed when they were actively playing a backup on Live... no pattern has emerged, and much of the data is suspect (panicky users, usual liars, etc...).

If Microsoft wants to defeat cheaters, all they need to do is employ a couple of interns to surf the scene sites for hack news, then simply order up special bannin' updates for those hacked games, to detect cheater's data files and ban those specific machines. Future game releases could incorporate some security libraries to make data files more secure (the code currently cannot be hacked).