Section 7.4.4 contains the sentence (braces inserted to indicate the intended reading)

{If no argument is supplied or if the argument is the context item} and the context item is undefined an error is raised: [err:XPDY0002]XP.

which can easily be misread as:

If no argument is supplied or {if the argument is the context item and the context item is undefined} an error is raised: [err:XPDY0002]XP.

The same problem also occurs for fn:normalize-space().

Possible alternative wording:

If no argument is supplied or the argument is the context item then an error is raised if the context item is undefined: [err:XPDY0002]XP.

However, the same error is raised if the argument is any other expression whose value depends on the context item, for example @att; the error here is nothing specific to this function. So I would suggest changing the paragraph in which the sentence occurs to:

If no argument is supplied, $arg defaults to the string value of the context item (that is, the value of the expression string(.)). If the context item is undefined this will result in an error: [err:XPDY0002]XP.