Answers to some more of the questions:
 
What parser is used when manipulating XML inside SQL Server Engine,.
XMLRW which is the new small stream based parser for native code.
 
Are XML Schemas stored in the database or referred to externally? Where are they stored if they are stored? Can I import from the web if they are stored? Can I import from the filesystem if they are stored.
They are stored in the database’s meta data in a shredded form (lots of catalog tables are available to look at the info and an intrinsic to get it back into an XML schema). You can load it from a file and using the CLR inside the database, you could also import it from the web.
 
Is there any support for DTDs with XML-DT.
Only for entity expansion and defaulted attributes. Otherwise the DTD will be ignored and DTDs will not be stored.
 
For small documents might it be better to update the entire document in place rather than use an XQuery update.
That obviously depends on a variety of factors.