MD5 is a encryption system, highly recommended for passwords and secret data, ex:
My password is: 123
My password with MD5 is: 202cb962ac59075b964b07152d234b70
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To activate md5 in passwords conf/login-server.conf:
// Store passwords as MD5 hashes instead of plaintext ?
// NOTE: Will not work with clients that use <passwordencrypt>
use_MD5_passwords: yes
(i'm using 2013-08-07 and md5 works fine)