Earlier quoted context omitted.
That's roughly how Mastodon works. Each instance is responsible for moderation of their own users. If an instance does not meet arbitrary standards of moderation, other instances may choose not to federate with them, but nothing can stop willing instances from federating.
One problem: as far as I understand a number of high profile instances enforced a rule where they would block any instance that didn't block certain other instances. I'm all for blocking a good number of instances myself, but putting limits on others, that is a whole different thing.
A working system when your community is popular to deal with