How do I set a VLC instance to run as a Live Wallpaper

VLC does support video as background. Simply run the cvlc command:

cvlc --video-wallpaper --no-audio /your/videofile

There are other helpful options to cvlc such as aspect ratio etc. You can find them using

vlc --help

If you still want icons on your desktop you may need to take a look at xwinwrap, but it requires a little digging. There is an option to set movies as background. I dont know how to do it with VLC but it has been done with mplayer.