The term "naked CDS (Credit Default Swap)" has been tossed around a lot lately, with little to no examination of the etymology of the term. You may have heard of "naked short selling" of stock, and a bit of Google action will tell you that naked short selling is generally illegal. So, you'd be inclined to think that naked CDS must be similar in nature to naked short selling, and inevitably conclude that naked CDS would be illegal but for Wall Street's tentacles. But of course, you'd be wrong.
Naked Short Selling
Naked short selling has nothing to do with being a hedonistic financier. Ordinarily, to short sell a stock, you (i) borrow the stock and then (ii) sell it to someone else. This pair of transactions leaves you with an amount of cash equal to the price of the stock at the time of the sale and an obligation to the deliver stock to the lender at some time in the future. If the price of the stock drops after the sale, you can purchase the stock in the market for less than the price you sold it for, deliver the stock to the lender, and pocket the difference. Fantastic. Naked short selling is very similar, except you never actually borrow the stock. That's right, you sell something you don't actually own. There are circumstances where this wouldn't be much of a problem (e.g., I don't own the stock right now but I will in the next couple of minutes) and we might want to allow the practice to occur. But exactly when the practice is acceptable is beyond the scope of this discussion. The key point is that naked short selling involves the sale of an asset you do not currently own.