Patryn of Elvenshae said:
Unless the ability lets you cloak yourself in shadow somehow. However, it doesn't mention this, so we can't assume it lets you do it.
The reason humans and others cannot see the SD is because, for them, the shadow exists. For dwarves and elves (possibly), the shadow does not exist.
It does not matter if the shadow exists for the elves and dwarves or not.
The shadow exists. That is all that is needed.
The shadowdancer does not even have to be in the shadow.
The shadow just needs to exist.
A close analogy is that it is cooler in the shadows on a hot day. The Dwarf still feels cooler in the shadows, even if he cannot see the shadows.
Shadows exist in the game. The ability does not state anything about anyone's perception of shadows, it merely discusses what the character can do if the shadow is within 10 feet of him.
As you stated, the Hide skill requires that someone:
1) Not be under direct observation;
2) Have cover or concealment
The Hide in Plain Sight ability ignores both of these. Being within 10 feet of a shadow is not within cover or concealment. Being out in the open is being under direct observation.
Your entire position hinges on the shadow providing concealment in the case of humans and not providing concealment in the case of dwarves and elves, but concealment is not a pre-requisite of the ability.
A shadow within 10 feet is the pre-requisite of the ability.