You are correct that I could pass an image (even an animated gif) to Windows and it will animate it on the desktop (at least when active desktop is enabled IIRC).
However Wallpaper Cycler has the following flow. When it cycles it first selects a wallpaper based on your wallpaper cycling settings. Then it will select a layout based on layout cycling settings and the selected wallpaper. A default generated layout will be used if you are running the lite version. Then wallpaper cycler starts to render the desktop into memory. Rendering means drawing the selected wallpaper, rendering text, calendars, webcams, ... based on the selected layout to a memory bitmap. After that the memory bitmap is stored as a bitmap in your temp directory and then Wallpaper Cycler tells windows to use that bitmap as the desktop background.
[ Microsoft MVP VC++ since 2007 ]