Encoding is the process of converting a raw data stream into a format which can be later played back. On the Fly means that It does it in real-time. Meaning that it doesn't have to store the data somewhere first and then convert it as a later step. It just does it all in one step. It's a nice feature.
It doesn't do anything to improve the quality of a mp3. However it does simplify and speedup the process of creating an mp3.