Most instances I've seen are used to host music uploaded by the original authors, or collections of CC-licensed music, etc. I actually have yet to see anyone using funkwhale to share music publicly they didn't create themselves or have permission to share. It does have a private mode for that, so you could upload your music collection and share it with just a few friends or something.

(Edit: I tried funkwhale out as a way to privately share a small online radio station's music library with its DJs. It didn't suit our needs ultimately -- I felt the UI & search / filtering affordances were lacking for our use case -- but you could use it in a hybrid public/private way like that if you want. Libraries have some access control features.)

It's a federated model so it would be up to each instance to police it's self.

Because you are hosting your own legally owned music library on your server.