If everyone plays nice, you get to have really big islands. But that’s only if your overlords (the mods) allow it. If they don’t like an instance, see ya! I don’t think this happens often other than blocking spam and illegal activity, but you can clearly see how this will make all the mini islands.
It’s essentially like email. If you have a gmail, you can communicate with anyone on any other email service. If gmail determines that spamsite.xyz, you won’t send or recieve any emails from that domain. Same thing here. You’re using lemmy.world. If lemmy.world defederates with my server sh.itjust.works, you won’t see my messages. We will just never cross paths.
I’m not sure on this, but I think it’s the latter that you mentioned.