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The passwords are stored on the client side in a trivial encoding of the cleartext, and transmitted in the same encoding. The encoding is done only to prevent inadvertent password compromises (i.e., a system administrator accidentally looking at the file), and will not prevent even a naive attacker from gaining the password.
The separate CVS password file (see section 18.104.22.168 Setting up the server for password authentication) allows people to use a different password for repository access than for login access. On the other hand, once a user has non-read-only access to the repository, she can execute programs on the server system through a variety of means. Thus, repository access implies fairly broad system access as well. It might be possible to modify CVS to prevent that, but no one has done so as of this writing.
Note that because the `$CVSROOT/CVSROOT' directory contains `passwd' and other files which are used to check security, you must control the permissions on this directory as tightly as the permissions on `/etc'. The same applies to the `$CVSROOT' directory itself and any directory above it in the tree. Anyone who has write access to such a directory will have the ability to become any user on the system. Note that these permissions are typically tighter than you would use if you are not using pserver.
In summary, anyone who gets the password gets repository access (which may imply some measure of general system access as well). The password is available to anyone who can sniff network packets or read a protected (i.e., user read-only) file. If you want real security, get Kerberos.
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