Specific points must be used for a given reservation and must be available at the time of the booking. They won't automatically substitute and use other points to your advantage just because you have an existing reservation. This applies to banked and borrowed points as well. But they will often be able to sub them once you get to the 60 day window (holding acct) if you call and ask.
In this scenario they would cancel the first reservation and use the best points from your contract to schedule the one you got on waitlist. Usually it's the same points but it doesn't have to be. The problem is if the second option is less points and the remaining points are distressed in some way (banked, borrowed, too late to bank or in holding) you could easily lose them. Holding is where you cancel less than 31 days and can only use the points short notice, within 60 days or travel. All distressed points will expire at the end of the UY. So your thinking is correct, it's just that in this specific case the WL is significantly less points than the original, something that's not that common overall but does happen. There are situations where you might want them to use other points, maybe you banked points after you made the existing reservation or have other points in a holding account and want to use those; always tell them these things to make sure they use the weakest points first.
Make sure it's not still going, don't just assume it canceled. An email to make sure should be sufficient and word it in such as way if they did match you in the interim, that you could argue it should not have been ongoing.
