All videos are encoded - that's what a codec (enCOde-DECode) is for. Video programs normally do this transparently - behind your back without any notice. VLC tells you it's doing it.
VLC is open source - if you don't trust it, download the source, make sure there's nothing sneaky in it and compile it yourself. (Trust me, if there was one line of code in there that was the least bit questionable, it would be all over the web in minutes. That's one of the good points of open source software - no one can be reading your emails while you're watching a video. Or grabbing your passwords. An open source program that tried that would be dead in minutes. There are people who download source code just to see how others do it, or to learn nre techniques. If they saw something sneaky in such a popular program they'd be posting on every forum they could connect to.)