As most Exchange-Traded Funds (ETFs) engage in securities lending or are based on total return swaps, they expose their investors to counterparty risk. In this paper, we present a framework to study counterparty risk and provide empirical estimates for a sample of physical and synthetic funds. Our findings contradict the allegations made by international agencies about the poor quality of the collateral used by ETFs. Furthermore, we find that the counterparty risk exposure is higher for synthetic ETFs but that investors are compensated for bearing this risk. Using a difference-in-differences specification, we uncover that ETF flows respond significantly to changes in counterparty risk. Finally, we theoretically show how to construct an optimal collateral portfolio for an ETF.