My understanding is that for the general population you are correct in the naked short selling is illegal. Market makers - those paid to create liquidity in the market when nobody is buying or selling - can undertake short term naked short sales to create liquidity.
So following up here are a few snippets from wikipedia -
http://en.wikipedia.org/wiki/Naked_short_selling
"In 2008, the
SEC banned what it called "abusive naked short selling"
[2] in the United States, as well as some other jurisdictions, as a method of driving down share prices. Failing to deliver shares is legal under certain circumstances, and
naked short selling is not per se illegal.
[3][4][5] In the United States, naked short selling is covered by various SEC regulations which prohibit the practice."
"The SEC enacted Regulation SHO in January 2005 to target abusive naked short selling by reducing
failure to deliver securities, and by limiting the time in which a broker can permit failures to deliver.
[28] In addressing the first, it stated that a broker or dealer may not accept a short sale order without having first borrowed or identified the stock being sold.
[29] The rule had the following
exemptions:
- Broker or dealer accepting a short sale order from another registered broker or dealer
- Bona fide market making
- Broker-dealer effecting a sale on behalf of a customer that is deemed to own the security pursuant to Rule 200[30] through no fault of the customer or the broker-dealer.[29]"
"However, at September 17, 2008, the SEC issued new, more extensive rules against naked shorting, making "it crystal clear that the SEC has zero tolerance for abusive naked short selling". Among the
new rules is that market makers are no longer given an exception. As a result, options market makers will be treated in the same way as all other market participants, and effectively will be banned from naked short selling."
So looks like you are right Uni and that whilst market makers used to be able to naked short sell, that all changed with the GFC.
