I wonder if Face ID is still able to partially detect a masked user's face, just with a much lower confidence interval. Maybe the presence of the watch allows Face ID to lower the confidence threshold when it detects a mask blocking half of the face. This is just a guess, I have no idea how Face ID works.

If Face ID can't detect anything when a user wears a mask then I completely agree with you. It seems really silly to require the mask in order for the watch unlock to work. I don't understand the security model there.

It works because you put your watch on, unlock your watch. Your watch remains unlocked until you take it off. I was under the impression if you’re wearing your watch and it’s unlocked, and then you pick up your iPhone, it acts as the key to your phone.

The watch will only unlock your phone when you're wearing a mask. If FaceID doesn't see a mask it will ignore the Apple Watch.