A naked short sale is a type of market transaction. In a typical short sale, a trader sells borrowed shares in hopes of buying them cheaper later and profiting on the difference. A "naked" short is when traders sell shares without borrowing them first.
Naked short selling is not necessarily a violation of the federal securities laws or the SEC's rules. In certain circumstances, naked short selling contributes to market liquidity. For example, broker-dealers that make a market in a security generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers. Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market. This may occur, for example, if there is a sudden surge in buying interest in that security, or if few investors are selling the security at that time. Because it may take a market maker considerable time to buy or arrange to borrow the security, a market maker engaged in bona fide market making, particularly in a fast-moving market, may need to sell the security short without having arranged to borrow shares. This is especially true for market makers in thinly traded, illiquid stocks such as securities quoted on the OTC Bulletin Board, as there may be few shares available to purchase or borrow at a given time.
Although no federal or state law directly criminalizes naked short selling, the SEC's Regulation SHO says a broker-dealer must have “reasonable grounds” to believe that it could borrow and deliver the security within three days. If the broker-dealer fails to deliver for 13 days, the regulation imposes a “close out” duty to purchase and deliver securities “of like kind and quantity.” 
On May 18 of 2010, German's financial regulator announced it would ban naked short-selling of eurozone government bonds and shares in 10 key German financial institutions until March 31 of 2011. It was not clear how Germany could enforce it effectively in the debt and CDS markets, which stretch across national borders. Germany's financial regulator said the ban was due to the extraordinary volatility in government bonds in the euro zone. Massive short-selling could have endangered the stability of the financial system, it said.
Germany's unilateral ban on naked short sales of securities caught other European Union governments unaware, drawing an angry response from France even as financial markets fretted that other countries might follow suit.
- German Trading Curbs Hit Markets Hard. Associated Press.
- Division of Market Regulation, Key Points About Regulation SHO. Securities and Exchange Commission.
- Naked Shorts at the Supreme Court. Bloomberg View.
- SEC Announces Aggressive New Short-Selling Rules. Traders Magazine.
- Germany Declares Solo War On Speculators. Reuters.
- EU Call for Unity on Short-Selling Ban Angers France. WSJ.com.