Some of the city of London's biggest banks are behind a huge tax avoidance trade "cheating" European countries of hundreds of millions of euros a year, in a development that sheds fresh light on David Cameron's decision to wield Britain's EU veto to protect the Square Mile.

A two-month study by the Bureau of Investigative Journalism has uncovered a £65.7bn market in European equity dividends whose "central" purpose is tax avoidance. The bureau's analysis suggests the European tax loss – mainly to France, Germany and Italy – is up to £500m a year. The scale of tax avoidance will fuel further anger within the EU towards the Square Mile, where the vast majority of the trade, known as dividend arbitrage, is conducted.

It also serves as a stark reminder to George Osborne that British banks are engaged in risky activities before the chancellor on Monday formally responds to Sir John Vickers' independent commission on banking, whose report recommended ringfencing banks' high street businesses from their "casino" investment banking arms.

Dividend arbitrage is complex. But at its heart, a bank or hedge fund lends equities in often high-yielding French, German or Italian companies to another institution. The receiving institution then passes the equities through a network of low- or no-tax jurisdictions, before returning the equities to the original owner using a subsidiary in another tax haven. In this way, banks can avoid the 15% average "withholding tax" levied on dividends in European countries.

For hedge funds based in the Cayman Islands or Bermuda, the trade is particularly useful in slashing tax bills.

Credit Suisse, the giant Swiss financial services institution, is among a host of international banks and hedge funds involved. The bureau has seen a Credit Suisse document that details how to implement dividend arbitrage strategies and has received confirmation from a senior derivative executive that the bank is an active participant. When asked whether Credit Suisse engaged in aggressive tax avoidance, the bank declined to comment.

Among other banks said by City sources to be major dividend arbitrage players are Barclays Capital, Bank of America and Morgan Stanley. All declined to comment.

Josh Galper, managing principal of Finadium, a US-based securities lending consultancy, and an expert in this area of finance, says: "The dividend tax element is central to the trade; without it there would be no reason to engage in dividend arbitrage."

On learning of the bureau's findings, the former Liberal Democrat treasury spokesman Lord Oakeshott called for the Financial Services Authority (FSA), the Treasury and the European commission to launch an investigation to ensure full disclosure of all dividend arbitrage transactions.

"This looks like a highly artificial operation by London investment banks to cheat German and French taxpayers," he says. "If these are genuine commercial transactions for clients, why do they have to be washed through an eye-wateringly convoluted string of offshore vehicles? This sort of behaviour poses huge reputational risks for the City.

"The FSA, Treasury and the European commission must work closely together to ensure the whole sequence of transactions of this type is fully disclosed to the British, German and French tax authorities. We must stamp out abusive artificial tax-dodging transactions together with our European partners, and stop pretending they are out to undermine the City of London as a responsible and pre-eminent financial centre."

"This issue highlights a structural flaw in our current international financial system," says Markus Meinzer, applied researcher and analyst at the Tax Justice Network. "Governments refuse to institute robust transparency and co-operation mechanisms in view of aggressive financial sector lobbying and because of the bizarre, yet largely unchallenged view of alleged benefits flowing from competition between states," he said.

Icap, the brokerage run by the former Conservative party treasurer and outspoken critic of the EU's financial transaction tax proposal, Michael Spencer, is the broking firm most used by banks to buy and sell equities for the purpose of "dividend washing", as the trade is more commonly known, according to four well-placed City sources.

Suggestions from three of these sources that Icap acts as a principal in dividend arbitrage by buying equities were flatly denied by the company.

The firm added: "Icap's clients do not disclose to Icap their commercial rationale for the transactions that they execute. Icap takes its legal, compliance and regulatory responsibilities extremely seriously and performs all obligations that are required of it by the FSA and other regulatory bodies. It is not Icap's role to ascertain any of its clients' tax affairs, which are confidential and a matter for them and their relevant tax authorities."

While dividend arbitrage is a completely legal trade, some brokers and advisers spoken to by the bureau opt not to participate in it. One says dividend arbitrage "sails close to the wind" because of its tax avoidance focus.

Dividend arbitrage also creates huge jumps in equity lending volumes in the second quarter of a year, when most companies release their dividends.

According to US-based Risk Management Association, European equities worth $136.9bn were lent in the second quarter of 2011, compared with an average of $70.75bn in the three other most recent quarters where data is available.